Understanding Credit Shelter Trusts: QTIP Trust vs Marital Gift Trust

Estate planning offers individuals with significant assets the opportunity to reduce or eliminate the taxable value of their estate, while at the same time providing financially for their family, friends and important charities. Credit shelter trusts are becoming increasingly popular as an estate planning tool. Two of the more popular trusts are the Qualified Terminable Interest Property trust (QTIP) and the marital gift trust. Both of these trusts are considered credit shelter trusts because they preserve the estate tax exemption of the donor to be utilized at a later date by the trust beneficiaries. Thus, individuals can direct the division of their estate in a manner that reduces the overall amount of estate tax paid.

With a credit shelter trust (sometimes called a bypass trust), a donor's will bequeaths to the trust an amount up to the value of the estate tax exemption (currently, $5,250,000). The remainder of the estate is then passed directly to the spouse tax-free using the unlimited marital estate tax deduction. The assets placed in the credit shelter trust will remain estate tax-free, even in the event the assets increase in value. Further, upon the death of the surviving spouse, the value of the trust assets will not be included in the surviving spouse's estate because they did not control the distribution or investment of the principal.

As an example, assume the estate of Spouse A and Spouse B has a value of $9 million and also assume that their estate plan does not include a credit shelter trust. Spouse A dies and passes his entire $9 million estate to Spouse B and, using the unlimited marital exemption, Spouse B does not pay any estate tax. Upon Spouse B's death, the $9 million estate is passed to her children. Utilizing her unified exemption in the amount of $5,250,000, her estate pays estate tax on the remaining $3,750,000. In scenario two, assume the same information except that Spouse A's will established a credit shelter trust for the maximum amount of his unified exemption ($5,250,000). Upon Spouse A's death, $5,250,000 gets placed in a credit shelter trust and the remainder of the estate ($3,750,000) is directly passed to Spouse B. The trust assets are not subject to an estate tax and the amount distributed directly to Spouse B is not taxed due to the unlimited marital tax exemption. Upon Spouse B's death, $9,000,000 is distributed to her heirs in accordance with her wishes and the terms of the credit shelter trust. The estate is able to utilize Spouse B's unified exemption ($5,250,000) as well as the "sheltered" unified exemption of Spouse A ($5,250,000). Thus, the $9 million is distributed to the heirs without paying any estate tax, compared to the first scenario where the heirs would pay a hefty estate tax rate on $3,750,000. In scenario two, even if the value of the estate had increased, there would be no estate tax paid until both exemptions were fully used ($10,500,000).

What is a QTIP Trust?

A QTIP Trust is a trust created upon the death of a spouse. The assets that are placed in the trust are used for the benefit of the surviving spouse until that spouse passes away. At that point, the ultimate beneficiaries, as established by the original donor, receive the remainder of the trust. Essentially, the surviving spouse is entitled to the income from the trust during their lifetime but the principal is preserved for the donor's beneficiaries. One key benefit of a QTIP trust is that the estate taxes on the trust assets are deferred until the second spouse dies. Without this tax deferral, the trust's ultimate beneficiaries would be required to pay estate taxes immediately upon the death of the donor.

QTIP trusts are designed primarily for individuals with multiple marriages who have children from these previous marriages. Under a QTIP trust, the donor is able to take care of their current spouse's financial needs for the remainder of their life, while at the same time ensuring that their children's inheritance is secure. A QTIP trust can also be useful in families where there have not been multiple marriages because of the tax benefits and because the trust framework can protect against any poor financial decisions made by the surviving spouse. The trust can also protect the inheritance from persons, like a new boyfriend or spouse for the surviving spouse, who seek to prey on the trust's assets.

What is a marital gift trust?

Under a marital gift trust with powers of appointment, the estate is split into two shares. The A share is placed in a trust fund. The B share is gifted directly to the surviving spouse. Again, at this point there is no estate tax assessed against either share. The surviving spouse receives income and, depending upon the terms of the trust documents, also has access to the trust fund's principal. In many instances, the trust fund documents will give the surviving spouse the power to appoint beneficiaries of the trust upon the death of the surviving spouse. This lack of control over the ultimate beneficiary of the trust fund makes the QTIP trust the more favored credit shelter trust vehicle, especially in cases where one or both spouses have children from a previous marriage. One benefit of a marital gift trust is that, unlike a QTIP trust, the surviving spouse is not required to take distributions of income on an annual basis. Instead, the surviving spouse can leave the principal intact, which may increase the overall value of the trust for all parties.

Special Circumstances.

Credit shelter trusts are only available where the surviving spouse is a United States citizen. However, estates of citizen and noncitizen spouses can create a Qualified Domestic trust (QDOT). Under a QDOT, a citizen spouse is entitled to bequeath to a noncitizen spouse assets up to, but not exceeding, the $5,250,000 estate tax credit. Because the assets are owned by the trust and not the noncitizen, there is no estate tax assessed.

Credit shelter trusts are only available between spouses. Due to the varying treatment that states give same sex marriages and domestic partnerships, credit shelter trusts have not been available as a reliable estate planning tool for these couples. The Supreme Court's decision to strike down the Defense of Marriage Act (DOMA), means that, under current law, same sex couples can utilize credit shelter trusts in their estate planning.

Careful estate planning can eliminate a significant estate tax burden for surviving spouses and their beneficiaries. Credit shelter trusts, including QTIP and marital gift trusts, can be a useful tool in preserving an estate's assets. Determining which option is best in a given situation depends on the amount of control desired by the original donor and the income needs of the surviving spouse.

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