This is a part in a series of articles I have written on various types of irrevocable trusts.
It’s not the QTIP you’re thinking of!
To better understand this concept, it’s advised that you first read my article about estate taxes and then my article on bypass trusts.
The QTIP trust is a popularly-used strategy to limit potential estate taxes among married individuals, while also being able to control the destination of assets after the death of the surviving spouse. This is especially useful for those who also have blended families, but even for those who don’t.
The A-B-C Trust
An A-B-C trust means that when one spouse dies first, the trust will require a split of the trust into three subtrusts, the A trust and the B trust and the C trust.
The A trust is known as the Survivor’s Trust or Marital Trust.
The B trust is known by many names: the Bypass Trust, Decedent’s Trust, Exemption Trust, Credit Shelter Trust, and/or the Non-Marital Trust.
The C trust is known often as the QTIP Trust or the Marital Deduction Trust.
In the article entitled “What is a Bypass Trust,” I answered why a trust would split into two trusts – the A trust and the B trust.
But why would a trust split into three trusts?
An A-B-C trust can be useful when there could be estate tax exposure.
For example, let’s say H and W created an A-B-C trust in 2005. When H died in 2020, the estate was worth $30 million. In an A-B-C trust, this is what would happen at the first death:
- The A trust would be funded with $15 million, which represents W’s share of the assets.
- The B trust would be funded up to H’s unused exemption of $11.58 million.
- The C trust would be funded with $3.42 million, which represents the balance of H’s share of the assets ($15 million less the $11.58 million)
The assets in the A trust would escape estate taxes because of the unlimited marital deduction (assuming W is a U.S. citizen). A has total control over these assets.
The assets in the B trust would escape estate taxes because they are funded using H’s unused lifetime exemption. These assets can grow estate-tax free (although there are some restrictions of the assets in this trust typically including the loss of step-up in basis and greater costs and administration).
The assets in the C trust are the subject of discussion here.
Qualified Terminable Interest Property (QTIP)
Prior to 1981, the terminable interest rule required that in order to qualify for the federal estate tax marital deduction, the spouse’s interest in the trust (or other property) must not terminate for any reason. Under this rule, a life estate does not qualify for the marital deduction, and in most cases, the only kind of interest that satisfied the terminable interest rule was outright ownership.
An exception to this rule is a general power of appointment trust, wherein the unlimited marital deduction was available if the surviving spouse: (1) was entitled to all of the income of the trust for life; and (2) had a “general power of appointment” at death. A “general power of appointment” means the surviving spouse has the ability to determine who gets the assets after she dies. This caused a problem for planners who wanted to ensure that the surviving spouse could not re-route the destination of the assets in the trust.
Thus, prior to the QTIP trust, planners had two options. First, they could leave assets to the surviving spouse in a trust, but the rights given to the spouse would terminate such that when the survivor died, the assets would ultimately pass to the children. This meant though that there could be estate taxes due at the first death, because such a “terminable” trust would not transfer estate-tax free. Second, they could get the unlimited marital deduction and transfer assets estate-tax free but it would also mean leaving the assets either outright to the spouse or through a general power of appointment trust, where the spouse could dictate and control the future beneficiaries of the assets.
In 1981, Congress permitted the Qualified Terminable Interest Property (QTIP) trust, which allows for the deceased spouse to pass property through a trust for the benefit of the surviving spouse, using the unlimited marital deduction (thus, estate-tax free), as well as ensuring that the surviving spouse could not re-designate the ultimate beneficiaries of the trust.
However, the conditions and features of the QTIP trust are as follows:
- The surviving spouse – and only the surviving spouse – must receive lifetime income (or use) from the trust (this cannot be terminated at remarriage of the surviving spouse). The surviving spouse must have the power to require that the trust produce a reasonable income, including the power to require that investments be sold and reinvested so as to produce a reasonable income;
- The surviving spouse – and only surviving spouse – has a right to the principal from the trust, although this right is optional. If this is provided for, it can be limited to HEMS (health, education, maintenance, and support) of the surviving spouse (with the qualification that the support is to be in accordance with the surviving spouse’s “accustomed standard of living”). Additionally, the surviving spouse can be given the annual non-cumulative power to withdraw the greater of $5,000 or 5 percent of the value of the trust. Alternatively, the surviving spouse can also be given a limited power of appointment over the principal, which permits the surviving spouse to determine among a class of beneficiaries who should enjoy the assets at her death (e.g., when the remainder beneficiaries are children of the surviving spouse, and the limited power of appointment gives the surviving spouse the power to change the proportionate shares among the children);
- The executor must elect to claim a marital deduction to take advantage of the QTIP trust;
- At the death of the surviving spouse, the trust assets are included in the gross estate of the surviving spouse for estate tax purposes;
- The first spouse to die can specify who receives the property after the second death, which the surviving spouse typically cannot change in the case of a blended family for example. Otherwise, a limited power of appointment could also be granted to the surviving spouse, as stated above;
- The surviving spouse must be a citizen of the United States. If the surviving spouse is not a citizen of the United States, then a special form of QTIP trust known as a “qualified domestic trust” (or “QDOT”) becomes necessary.
The Clayton election is a trust that contains the ability for the surviving spouse to decide after the first death what to do with the assets. In other words, the surviving spouse is given flexibility to see the tax situation after the first death and then determine whether it makes sense to put certain assets in a Bypass Trust (to reduce estate tax liability) or, rather, a QTIP trust (to preserve step-up in basis). What’s important to note is that after the first death, all the assets begin in a Bypass Trust; a QTIP election moves the assets out of the Bypass Trust and into the QTIP (or C Trust). If the QTIP election is not made, then all the decedent’s assets will remain in the Bypass Trust.
Let’s revisit the example above.
H and W created a trust in 2005 that contained a Clayton Election. Thus, when H died in 2020, the estate was worth $30 million. W may decide to elect QTIP status for some of the assets or W may decide not to elect QTIP status.
If the QTIP election is made, then:
- The A trust would be funded with $15 million, which represents W’s share of the assets.
- The Bypass Trust would be funded up to whatever amount W determines is most tax-efficient, but not more than the value of H’s unused exemption ($11.58 million), thus ensuring that no estate taxes will be owed arising from the Bypass Trust. Here, it may make sense to fully fund the B trust with the $11.58 million.
- The QTIP Trust (C Trust) would be funded up to whatever amount W determines is most tax-efficient. If the B trust was maxed out at $11.58 million, then the C trust would be funded with the balance of $3.42 million, which represents the balance of H’s share of the assets ($15 million less the $11.58 million).
However, let’s imagine that at H’s death, the estate was only worth $10 million. Again, because it contained a Clayton Election, W has options at the first death. She may decide to elect QTIP status for some of the assets or decide not to elect QTIP status.
For example, she may decide the following:
- The A trust would be funded with $5 million, which represents W’s share of the assets.
- The Bypass Trust would be funded up to whatever amount W determines is most tax-efficient, but not more than the value of H’s unused exemption ($11.58 million), thus ensuring that no estate taxes will be owed arising from the Bypass Trust. Here, the B trust may be funded with $0 because there is no estate tax issue.
- The QTIP Trust (C Trust) would be funded up to whatever amount W determines is most tax-efficient. If the B trust was not funded, then the C trust would be funded with the balance of H’s share of the assets ($5 million).
- W could elect portability of H’s unused $11.58 million, thus ensuring that the $10 million of assets in the A trust and C trust could pass tax-free to the heirs at her death. This does not take into account W’s own estate tax exemption in the year she passes away.
Therefore, the Clayton Election gives flexibility to the surviving spouse to determine what to do with the assets after the first spouse dies. This gives a “second look” in terms of planning, using current law at the time, rather than trying to predict what the future estate tax will look like years or decades later when one spouse eventually dies.
Just as important, the assets in the QTIP trust qualify for a full step-up in basis at the death of the surviving spouse, because these assets are included in the surviving spouse’s gross estate.
Why Wouldn’t I Include a Clayton Election?
The Clayton Election is a good option for those who have more sizable assets but are unsure whether an estate tax will apply in the future and/or those blended families who want to ensure that assets are available to the beneficiaries without the surviving spouse changing the ultimate beneficiaries after the death of the first spouse.
Still, there are a few things to consider before deciding to include a Clayton Election in your trust:
- It is not enough to draft a QTIP trust or a Clayton Election in your trust and expect that it will work automatically. In other words, after the death of the first spouse, everything goes into a mandatory Bypass Trust first as a matter of law. The only way to move assets out of there and into the QTIP trust is for someone to affirmatively elect QTIP status on the Form 706 after the death of the first spouse.
- Electing QTIP status will cost more money and will take more work, as the filing of the Form 706 is not inexpensive necessarily, and will include the cost of additional items such as appraisals of all the assets as well as tax filings to be done in a timely manner.
- If someone has an estate tax and forgets to do the QTIP election, it can lead to an overfunding of the Bypass Trust potentially, eclipsing the estate tax exemption cap that is permitted. This is highly unlikely though.
- If someone does not have an estate tax and forgets to do the QTIP election, it can lead to an unnecessary funding of the Bypass Trust. This is less risky as one can potentially still seek reformation of the Bypass Trust under Probate Code §15403.