A Q-TIP Trust is a method used to minimize estate taxes payable by a married couple. It is designed to allow both spouses to utilize their federal and state estate tax exemptions under current tax laws. Here is how the Q-TIP trust works.
When the first spouse dies, the estate is divided into three parts:
- One part, an amount up to the Massachusetts estate tax exemption allowed by law, is placed in a “credit shelter” trust. In 2011, this amount is $1,000,000. The assets placed in the credit shelter trust escapes estate taxation.
- One part, an amount up to the difference between the state estate tax exemption and the federal estate tax exemption is placed in a “marital trust.” For 2011 and 2012, the federal estate tax exemption is $5,000,000. However, this amount is scheduled to drop significantly in 2013 if Congress does not address the federal estate tax laws.
There is no tax paid in the estate of the first spouse to die because of the unlimited marital deduction. However, such property is includible in the surviving spouse’s subsequent estate for estate tax purposes. On the death of the surviving spouse, any assets remaining in the marital trust is subject only to Massachusetts estate tax and not federal estate tax.
- Any remaining assets in excess of the federal estate exemption amount may be passed directly to the surviving spouse or placed in another marital trust and held for the benefit of the spouse. In either case, because of the unlimited marital deduction, this portion also escapes estate taxation, regardless of its value, on the death of the first spouse. Any assets remaining in the marital trust or includible in the surviving spouse’s subsequent estate will be subject to both Massachusetts and federal estate taxes.
CREDIT SHELTER TRUST
The surviving spouse may receive income for life from the credit shelter trust. The trust is usually established so that the principal that was deposited in the trust at the first death is retained for later passage to heirs when the surviving spouse dies. In addition to receiving income, the surviving spouse may be given liberal rights in the trust that allow her or him to:
- Serve as the sole trustee of the trust during his or her survivorship years.
- Withdraw principal for purposes of health, education, support and maintenance.
- Exercise a limited power of appointment over the trust principal, i.e., spouses may be able to appoint the principal to anyone except themselves, their estates, their creditors, or the creditors of their estates.
- Withdraw annually the greater of $5,000 or 5% of the principal.
The surviving spouse, however, need not be given any control over, or rights to, trust principal. The fact that the trust can be drawn so as to give the surviving spouse literally no control or rights to the trust principal means that the decedent spouse may lock in his or her desired remainder beneficiaries under the terms of the trust. Thus, the surviving spouse can be barred from diverting away the first decedent’s trust property to a spouse in a later marriage, children from a subsequent marriage, or the children of a later spouse.
The trustee or the surviving spouse may also have discretion to provide income and/or principal for persons in addition to the spouse, such as the children or others designated in the agreement. There are also a wide variety of arrangements for disposition of the credit shelter trust upon the death of the surviving spouse. When the second spouse dies, the credit shelter trust may terminate or continue. All assets remaining in the trust at the second death are either distributed outright to the heirs, or held in trust for the benefit of the heirs if the trust agreement so specifies. This latter arrangement is especially beneficial when the heirs are minor children or persons who have not demonstrated financial responsibility.
Despite the right to income and principal, the credit shelter trust is not included in the surviving spouse’s gross estate at death. The assets remaining in the credit shelter trust pass estate tax free to the final beneficiaries. This may provide a significant windfall to the final beneficiaries if the surviving spouse does not need to use the assets from the credit shelter trust and they continue to grow in value during the surviving spouse’s remaining lifetime.
Upon the death of the first spouse, the surviving spouse is entitled to all income generated by the funds in the marital trust(s). The surviving spouse may withdraw principal for his or her health, education, maintenance and support. He or she may also request the greater of $5,000 or 5% of the value of the principal annually.
The marital trust is less flexible than the credit shelter trust. The assets in the marital trust cannot be distributed to anyone other than the surviving spouse during his or her life. In addition, the surviving spouse is required to receive all the income of the marital trust. Upon the death of the surviving spouse, any undistributed income passes to his or her estate, and the remaining principal is added to the credit shelter trust.
When the surviving spouse later dies, the assets remaining in the marital trust(s) will be taxed as part of the surviving spouse’s estate. Thus, the estate tax on the marital trust(s) is merely deferred until after the surviving spouse dies. The balance of the marital trust(s) that remain after estate taxes are paid will pass to the final beneficiaries.
The surviving spouse will also still have his or her own estate tax exemptions. The surviving spouse’s separate assets will pass estate tax free to the final beneficiaries up to the Massachusetts and Federal estate tax exemption amounts. Anything over the applicable exemption amounts will be taxed.
To minimize estate taxes on the estate of the surviving spouse, the funds from the marital trust(s) should be used before using principal from the credit shelter trust.