Estate and Succession Planning
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Many of today’s modern estate plans employ a marital trust under Code sections 2056(b)(7) or 2523(f) known as a QTIP trust (QTIP stands for Qualified Terminable Interest Property). This is a trust which grants a life income interest to spouse and upon his or her death, named beneficiaries receive the remainder. The property funding the trust passes from the decedent or donor tax-free via the unlimited federal marital deduction (assuming spouse is a US citizen). Upon spouse’s death, the value of the property is included in his or her gross estate under Code section 2044.
Many use QTIP trusts to (1) delay taxation on the trust property until his or her spouse’s death; (2) provide income for his or her spouse’s life; (3) control the disposition of the remainder interest on his or her spouse’s death; (4) protect assets from creditors, as discussed in an earlier post; and (5) balance the taxable estates of spouses to assist a less wealthy spouse in using his or her estate tax unified credit.
It sounds like a win-win situation, but not every arrangement ends to the satisfaction of all parties. There may come a time where it is necessary or desirable to terminate the QTIP trust, perhaps because of conflict among the beneficiaries or simply because of the needs of spouse or remainder beneficiaries. This most commonly arises in multiple marriage situations where spouse and kids from the prior marriage do not enjoy getting together for the holidays. This decision is not to be entered into lightly because the termination of a QTIP trust gives rise to significant gift and income tax consequences.
Gift Tax Consequences
When a QTIP Trust is terminated, usually it involves one of the following three scenarios:
(1) Spouse retains the present value of their life income interest (calculated at the time of termination under Code section 7520) and the balance goes to the remainder beneficiaries;
(2) All property in the QTIP trust is distributed to spouse and the remainder beneficiaries receive nothing; or
(3) Spouse receives less than the value of their life income interest and the remainder beneficiaries receive the balance.
Scenario 1
If the QTIP trust is terminated and spouse receives the present value of his or her life income interest, spouse is treated as making a gift under Code section 2519 to the remainder beneficiaries of the fair market value of the trust less the present value of his or her life income interest determined under Code section 7520. Here is a simple illustration:
Value of Trust Property in 2011: $5,000,000
Present Value of Age 75 Spouse’s Income Interest: $1,034,000
Section 2519 Gift in 2011 to Remainder Beneficiaries: $3,966,000
Amount Actually Received by Remainder Beneficiaries: $3,966,000
A Code section 2519 gift is not eligible for the $13,000 annual exclusion. When a Code section 2519 gift results in actual gift taxes, spouse has a right to recover from the trust the gift tax under Code section 2207A. This results in a “net gift” whereby the gift tax is calculated based upon the amount of property actually received by the remainder beneficiaries. However, spouse must use his or her gift tax exemption against the gift since the right of recovery under Code section 2207A applies only to actual taxes incurred. For example, if the QTIP trust termination discussed in this scenario were to occur in 2011 and spouse had all of his or her gift tax exemption remaining, the Code section 2519 gift would cause spouse to use $3,966,000 of spouse’s gift (and estate) tax exemption. But if the termination occurs in 2013 (and the facts are otherwise the same) when the gift tax exemption is set to be $1,000,000, the following would occur:
Value of Trust Property in 2013: $5,000,000
Present Value of Age 75 Spouse’s Income Interest: $1,034,000
Section 2519 Gift in 2013 to Remainder Beneficiaries: $3,966,000
Gift Tax Resulting from Section 2519 “Net Gift” Calculation: $952,452
Amount Actually Received by Remainder Beneficiaries: $3,013,548
It should be noted that if a tax results from the QTIP termination and spouse chooses not to exercise their right of recovery under Code section 2207A, spouse will be treated as making an additional taxable gift equal to the amount of taxes spouse could have collected. See Reg. 25.2207A-1(b).
Scenario 2
If the QTIP trust terminates and spouse receives all of the trust property, the remainder beneficiaries are treated as making a gift to spouse equal to the value of the remainder interest. See Priv. Ltr. Rul. 199908033. If no property is distributed to the remainder beneficiaries, no gift from spouse will occur under Code section 2519. However, if more than the value of the income interest determined under Code section 7520 is distributed to spouse but some property is also distributed to the remainder beneficiaries, the same gift by spouse under Code section 2519 would occur (i.e., a gift of the full remainder value, $3,966,000 in the examples above) and a gift by the remainder beneficiaries of the value of property distributed to spouse in excess of spouse’s income interest would also occur.
Value of Trust Property in 2011: $5,000,000
Present Value of Age 75 Spouse’s Income Interest: $1,034,000
Section 2519 Gift in 2011 to Remainder Beneficiaries: $3,966,000
Gift in 2011 to Spouse by Remainder Beneficiaries: $1,000,000
Amount Actually Received by Spouse: $2,034,000
Amount Actually Received by Remainder Beneficiaries: $2,966,000
Scenario 3
Spouse may agree to a QTIP termination whereby spouse receives less than the present value of his or her life income interest. In this scenario, spouse will still be treated as making the Code section 2519 gift of the remainder interest as well as a gift of a portion of the life income interest under Code section 2511.
In order to illustrate the consequences of each gift, assume the same facts as the 2013 QTIP termination described in Scenario 1 above, but that spouse receives only $500,000 for spouse’s life income interest. Here’s what happens:
Value of Trust Property in 2013: $5,000,000
Present Value of Age 75 Spouse’s Income Interest: $1,034,000
Section 2519 Gift in 2013 to Remainder Beneficiaries: $3,966,000
Gift Tax Resulting from Section 2519 “Net Gift” Calculation: $952,452
Amount of Additional Section 2511 Gift by Spouse: $534,000
Additional Gift Tax to Spouse Resulting from Section 2511 Gift: $225,300*
Amount Actually Received by Remainder Beneficiaries: $3,547,548
Amount Actually Received by Spouse: $500,000
(*this gift tax is NOT paid from trust but from spouse’s other assets)
If spouse were to take nothing for spouse’s life income interest and allow the remainder beneficiaries to take all the property in the trust, the entire present value of spouse’s life income interest would be a Code section 2511 gift to the remainder beneficiaries.
Unlike when a Code section 2519 gift is made, spouse has no right of recovery under Code section 2207A for the gift tax resulting from a Code section 2511 gift.
Income Tax Consequences
There are also income tax consequences to consider in deciding whether to terminate a QTIP trust. Code section 1001(e) provides that, for purposes of determining gain or loss on the disposition of the income interest in the QTIP trust, the adjusted basis of the life income interest should be disregarded. Therefore, when spouse “sells” his or her income interest when a QTIP trust is terminated, the entire value of the property received in exchange for the right to receive income is treated as gain. On the flipside, when the remainder beneficiaries “sell” their interest when a QTIP trust is terminated, there may be gain or loss attributable to them depending upon the amount of proceeds received and their tax basis.
Divide the QTIP Trust First?
It may be possible to divide a QTIP trust into two separate trusts prior to termination so that the above tax implications can be minimized to the separate trust that is subsequently terminated. See Priv. Ltr. Ruls. 200723014 and 199926019.
