gift & GSTT implications of spouse leaving income in QTIP trust?

[george2010]

What is the name of your state (only U.S. law)? TX

I am trying to determine if there are any gift tax or GSTT consequences if a surviving spouse, who is the beneficiary of a QTIP trust, decides to leave income in the trust, rather than take a distribution.

Background: QTIP trusts require that the surviving spouse be entitled to all income from the trust. However, the actual wording of 20.2056(b)-7(d)(2) [which in turn references 20.2056(b)-5(f)(8)] stops short of requiring that the income be distributed... the spouse has the option to leave the income in the trust, where "the trust income is to be accumulated and added to corpus." (I first learned about this while reading an excerpt from Sebastian Grassi's "Drafting Marital Deduction Trusts, paragraph 6.1(d) http://files.ali-aba.org/thumbs/datastorage/skoob/articles/ch06 MDTrusts_2006Supp-7_thumb.pdf)

The estate planning lawyer that I am currently working with has produced draft documents that mandate annual distribution of all income from the QTIP. I suggested that instead we use wording that gives the spouse the option of leaving the income in the trust. My lawyer is extremely resistant to that idea, based on an assertion that the spouse's choice to leave income in the trust would be viewed to be a lapse of a power of appointment, which would be viewed as a transfer of property by the spouse to the trust, which my lawyer states "would have potential gift and generation-skipping tax implications."

I've been studying the relevant gift and GST codes (IRC Chapters 12 and 13), and I'm having difficulty understanding my lawyer's concern.

First off, what I am proposing merely adds post-mortem flexibility; it does not force the spouse to leave the money in the trust. So presumably, even if my lawyer is right about potential gift or GST consequences, my spouse could use professional tax advisers to decide upon the optimal course of action when the time comes.

Secondly, I understand that the 5% or $5000 limits come into play when determining the size of the gift, so even if the spouse's decision not to take a distribution was viewed as a transfer of property back to the trust, the deemed size of the transfer would be reduced. eg. say the trust is worth $1,000,000 and generates $100,000 in income. If Spouse leaves the $100,000 in the trust, only $100,000 - 5%(1,000,000) = $50,000 would be viewed as a transfer. Or said another way, the first $50,000 of income that the spouse chooses to leave in the trust would be ignored.

Thirdly, I'm failing to understand why such a transfer would even be viewed as a gift in a normal QTIP trust, which eventually will end up in surviving spouse's estate anyway. If the only current beneficiary of the QTIP is the spouse, then who is the gift to? It seems to me that the transfer of property is just from one part of spouse's estate to another. Where is the gift?

Things get a bit murky if the trust has had a "reverse QTIP" election for GST purposes, because in that case the deceased spouse continues to be considered the transferor for GST purposes. But even in that case, if a failure to take an income distribution were viewed as a transfer by surviving spouse into the trust, then couldn't the surviving spouse allocate GST exemption to that transfer, to maintain the 1.0 inclusion ratio of the trust?

Anyway... long winded post, but I'm hoping for someone to either support my belief that my lawyer is leading me astray, or alternatively smack me upside the head if he's correct and I should be following his advice to prevent income accumulation in the QTIP trust.

Thanks in advance.

 

[george2010]

partly answering my own post, I found what I believe is a relevant IRS private letter that addresses the basic concept
www.legalbitstream.com
The key part, at the end says

Spouse's retained interests (right to receive income plus the right to receive distributions of principal under an ascertainable standard) in the transferred property are valued at zero, for purposes of determining the amount of the gift. See § 2702(a)(2).

That clarifies why a gift is deemed to have been made: the spouse's interest in the QTIP is being valued at zero. Seems counter-intuitive to me, given that 100% of the QTIP is still going to be in spouse's gross estate, but at least that explains why the transfer is viewed as a gift.
It still doesn't strike me as a reason to force annual income distributions from the QTIP... the 5% or $5000 allowance could allow a significant amount of money to accumulate in the trust free of gift or GST issues. And gifts to the trust wouldn't necessarily be a problem if the spouse has lifetime gift exemption remaining.

I found another related article that discusses similar issues, but specifically with respect to having IRA's inside QTIP's: http://www.dgslaw.com/documents/articles/303534.PDF
If I understand it correctly, Rev Ruling 2000-2 indicates that if an IRA is inside a QTIP, and the spouse is allowed by the QTIP trust to forgo distributions, it could allow funds to accumulate in the IRA tax free -- a significant benefit.

So at this point I'm still of the opinion that forcing annual distributions of income from the QTIP is a bad idea. I am starting to understand my lawyer's concerns, but it appears to me that as long as the surviving spouse has competent tax & legal advisors, the additional flexibility to leave income in the QTIP won't cause any negative impacts, and might provide some benefits.

 

[TrustUser]

if i am not mistaken, the first income dollars of a trust are taxed at the highest bracket ?

if your wife would already be taxed at the highest bracket, it may not make a difference.

but you might want to consider the tax consequences regarding your decision, if you havent done so already.

 

[george2010]

but you might want to consider the tax consequences regarding your decision, if you haven't done so already.

I think we should assume that the surviving spouse will be responsible for paying income taxes on all assets, whether inside or outside the trust, and that it will all be at maximum marginal rates. So assuming that is true, the question is what are the gift and GST consequences of allowing the spouse to decide whether or not to receive income from a QTIP trust, and considering those consequences, is there a compelling reason to force the spouse to take 100% of the income every year (as my lawyer has suggested), or is it OK to give the flexibility to the spouse to either take the money, or leave all or part of it in the trust each year.

 

[Kiawah]

Flipping thru some of the trusts in binder previous discussed, I briefly looked at a couple of the QTIP trusts and the language was:

"Beginning at my death my trustee 'shall' (my quotes) pay to my wife the net income, at least quarter-annually, for life. If at any time my wife's income shall be insufficient to provide.....(it goes on to specify how much principal can be distributed).



However there was a revocable trust that listed in it's overview "to provide discretion to distribute income and principal to spouse"....and the language in that one under the distribution of trust asset section, says:

"Upon my death if my spouse survives me, my trustee 'may' (my quotes) pay income and principal to my spouse in any amounts and for any purposes as my trustee considers advisable."



The difference between 'shall' and 'may'.

 

[george2010]

"Beginning at my death my trustee 'shall' (my quotes) pay to my wife the net income, at least quarter-annually, for life.

The majority of sample QTIP's I have read do use language like "shall", which is also what my lawyer is using, and it is clear that by using "shall" it removes all possibility of unintended gift and GST consequences. But a significant minority of QTIP's use more flexible language, and as I've continued to do my research I think I now have a pretty solid understanding of the issues, which has solidified my belief that the more flexible language is better. The following link The CPA Journal goes one step further in explaining the issue, in the section entitled "Gift Tax: Lapsing or Nonlapsing Powers", because it explains that even if the amount of income left in the trust exceeds the "5 and 5" limits, it only will cause gift taxes to be paid if the spouse has already used up his/her lifetime unified gift tax credit. So my conclusion is that including the flexible language can provide significant opportunities for optimizing the management of the QTIP, and that the potential negative consequences are easily identified and avoided.

Would still be interested in additional comments from anyone reading this post who has specialized knowledge (eg. tax lawyer or CPA). The one thing that still doesn't make sense to me is the interpretation of section 2702 regarding the valuation of the retained income interest in the QTIP. If the retained income interest in the QTIP is not considered to be "qualified", and therefore is valued at zero, then the net result in the event that the spouse has already used up the lifetime gift tax credit is that the un-withdrawn income would be subject to double transfer taxation: gift tax would apply when the power to withdraw lapsed, but then estate tax would also apply when the spouse died. Since double transfer taxation is not the intent of the law, I wonder whether this interpretation is valid. This may still be unsettled law. (note that in the CPA Journal article quoted above, author uses word "probably" when stating how section 2702 would come into play.)

In any event, I think I understand the issue well enough at this point to tell my lawyer to change his approach.

 

[Kiawah]

Introduction to Estate Planning


Any reason why you are locking yourself in to a QTip trust?

 

[george2010]

The money and assets that are titled in this trust, upon your death, are going to create two buckets of money, right?

Yes, your description of the two trusts is correct. But my expectation is that the surviving spouse will be able to live comfortably with the 1/2 of the estate that is owned outright (community property state, so estate will essentially be split 50/50). So in the absence of unforeseen circumstances, there would be no need for the surviving spouse to take money out of either trust. Avoiding unwanted income distribution from the marital trust would remove the administrative hassle of shuffling money from an investment account inside the QTIP to an account outside. Plus leaving assets inside the QTIP provides some asset protection which is lost once the money is distributed to the spouse.

 

[Zigner]

I suggest that you pay for a second opinion from a different local trust attorney.

 

[george2010]

Any reason why you are locking yourself in to a QTip trust?

The goal is to get the marital deduction, while still controlling the ultimate disposition of the assets, which would be to my (our) kids. You could think of it as a kind of preemptive prenup, that prevents any future gold-digging 2nd spouse from marrying the rich widow/widower and causing the assets to be redirected away from my kids.

 

[george2010]

I suggest that you pay for a second opinion from a different local trust attorney.

Yeah, I've been thinking about doing exactly that. But frankly, I don't know how to find someone with the required expertise, who I know will answer my question accurately without wasting my time and money. The guy I'm using I selected after talking with half a dozen lawyers; he seemed ideal, with 30+ years as a board-certified estate planning attorney, and yet he clearly doesn't have the in-depth knowledge of this particular issue that I would have hoped for. So I'm doubtful I'll be any more successful getting good advice from a second lawyer.

I'm also considering buying a book called "A Practical Guide to Drafting Marital Trusts" by Sebastian Grassi. I believe that book has a complete explanation of this issue in a section 9.1(e)(1) "Lapse of Power of Withdrawal". So for $199, I could get that book, which is probably cheaper than paying a lawyer for a second opinion, and I'd have more confidence I was getting the info from an expert in the field.

 

[TrustUser]

However there was a revocable trust that listed in it's overview "to provide discretion to distribute income and principal to spouse"....and the language in that one under the distribution of trust asset section, says:

"Upon my death if my spouse survives me, my trustee 'may' (my quotes) pay income and principal to my spouse in any amounts and for any purposes as my trustee considers advisable."



The difference between 'shall' and 'may'.

from my past research, that would have given too much control to the surviving spouse, such that it would be considered her money, and therefore lose out on the exemption of the deceased spouse.

 

[TrustUser]

hi george,

i am a bit confused. do you have community property that you are not putting in your living trust ?

 

[george2010]

i am a bit confused. do you have community property that you are not putting in your living trust ?

Not sure where you are going with your question... the issue isn't about how the QTIP is funded, it is the specific issue of the gift and GST implications if the spouse does not withdraw 100% of the annual income of the trust.

 

[george2010]

from my past research, that would have given too much control to the surviving spouse, such that it would be considered her money, and therefore lose out on the exemption of the deceased spouse.

I think you are thinking about "bypass trusts" also called "credit exemption trusts". The subject of this thread is a "marital trust", for which we WANT the assets to be considered part of the surviving spouse's estate, hence we give the spouse significant control. "QTIP" refers to a specific set of conditions (such as the right of the spouse to receive the income of the trust for life) that must be adhered to by the trust in order for the trust to be considered part of survivor's estate.