Does Your Revocable Living Trust Need a QTIP?

While it is true that most revocable living trusts created prior to the 2012 American Taxpayer Relief Act (the “ATRA”) need to be cleaned up, I’m not referring to cotton swabs.  QTIP is the abbreviation for a qualified terminal interest property trust.  As a result of the Marital Deduction and Portability (concepts described below), there are tremendous tax advantages to adding QTIP Trust provisions to the revocable living trusts of married couples.

For decades, each U.S. Resident has been allotted a credit against estate taxes commonly known as the Applicable Exemption Amount (“AEA”).  The current AEA is $11,400,000.  Here is what the AEA has looked like since the turn of the century:

Prior to the ATRA, upon the death of the first spouse to die (herein, the “Deceased Spouse”), the terms of a revocable living trust of married couples needed to establish an irrevocable “Bypass Trust” in order to utilize the AEA of the Deceased Spouse.

For example, consider a married couple in 2001 worth $2,000,000 with a revocable living trust with the following terms, “Upon the death of the Deceased Spouse, everything is to be transferred to the Surviving Spouse, outright and free of trust.” Upon the death of the Deceased Spouse in 2001, the Deceased Spouse’s share of the trust assets ($1,000,000, assuming all assets are community property) would pass to the Surviving Spouse. This transfer would not be subject to estate taxes, because of the Marital Deduction (transfers between spouses are exempt from estate and gift taxes because of the Marital Deduction). If the Surviving Spouse died later in that same year with $2,000,000 in his or her estate, the difference between the $2,000,000 and the Surviving Spouse’s AEA ($1,000,000 in 2001) would be taxed at a rate of 50%, leading to a $500,000 estate tax bill (50% x ($2,000,000-1,000,000)).

Rather than risk a $500,000 estate tax bill, couples in the pre-ATRA era created revocable living trusts with the following terms, “Upon the death of the Deceased Spouse, all of the Deceased Spouse’s assets are to be transferred to an irrevocable Bypass Trust that provides the Surviving Spouse with reasonable health, support, and maintenance.”  The key tax benefit of the Bypass Trust, at that time, was that the assets of the Bypass Trust were not included in the estate of the Surviving Spouse.  Take the couple in the foregoing example… had they utilized the Bypass Trust, the Deceased Spouse’s share of the assets, $1,000,000 (assuming all assets are community property) would have been transferred to the Bypass Trust and exempt from estate taxes because they are equal or less than the Deceased Spouse’s AEA.  Since the Bypass Trust is not included in the estate of the Surviving Spouse, the Surviving Spouse will die with $1,000,000 in his or her estate.  The Surviving Spouse’s AEA can then be used to wipe out all estate tax liability.  By using the Bypass Trust, the couple avoids in estate taxes altogether, saving $500,000 for their beneficiaries.

Many couples have not updated their revocable living trust since the ATRA and the same Bypass Trust provisions now do little or nothing to prevent estate taxes but can create large capital gains income tax liability. 

As mentioned above, the ATRA granted portability.  Portability is a tax reporting procedure that allows the Deceased Spouse to transfer his or her unused AEA to the Surviving Spouse.  Today, for example, if all of the Deceased Spouse’s assets are transferred outright and free of trust to the Surviving Spouse, because of the Marital Deduction, none of the Deceased Spouse’s AEA will be used.  Unlike in 2001, however, the representative of the Deceased Spouse’s estate can now file an estate tax return that transfers the Deceased Spouse’s unused AEA to the Surviving Spouse.  Thereafter, so long as the Surviving Spouse does not remarry, the Surviving Spouse will effectively have an AEA of $22,800,000. There are not a lot of couples out there that can boast estate tax liability under the current tax regime!

“That’s all fine and dandy!” some may say, “but I want my assets held in a trust.  I don’t want my surviving spouse to squander my share or disinherit the children and give it all to her tennis instructor!”  Well, when the protection of an irrevocable trust is desired, the solution is swapping the Bypass Trust for a QTIP Trust.

A QTIP Trust is an irrevocable trust used to support the Surviving Spouse that, because of its wording and a required tax election, is eligible for the Marital Deduction, and is therefore included in the estate of the Surviving Spouse.  Under Internal Revenue Code section 1014, the tax basis of assets included in the estate of a decedent are adjusted to fair market value at the decedent’s date of death. This code section is why a QTIP Trusts can prevent capital gains income tax liability.  The assets in a Bypass Trust get a tax basis step up at the Deceased Spouse’s date of death but, because they are not included in the Surviving Spouse’s estate, they do not get a tax basis step up at the Surviving Spouse’s death.  Here is a comparison of two couples:

Couple A.

2018 – Couple A is worth $10,000,000. All of their assets are community property.  Couple A has a revocable living trust that creates and funds a Bypass Trust with $5,000,000 when the Deceased Spouse dies in 2018. The other $5,000,000 is transferred to a Survivor’s Trust.  $5,000,000 of the Deceased Spouse’s AEA is applied to the transfer to the Bypass Trust, and an estate tax return is filed to “port” the remaining $6,400,000 of unused AEA.  The Surviving Spouse now has an effective AEA of $17,800,000.

2024 – The Surviving Spouse dies.  The assets of the Bypass Trust have grown in value and are now worth $8,000,000, but they have a tax basis of $5,000,000 because they did not receive a step up at the Surviving Spouse’s death.  When the children of Couple A sell the assets of the Bypass Trust, they incur capital gains income taxes on $3,000,000 of gain occurring between the Deceased Spouse’s death and the Surviving Spouse’s death.

Couple B.

2018 – Couple B is worth $10,000,000. All of their assets are community property.  Couple A has a revocable living trust that creates and funds a QTIP Trust with $5,000,000 when the Deceased Spouse dies in 2018. The other $5,000,000 is transferred to a Survivor’s Trust.  The transfer to the QTIP Trust qualifies for the Marital Deduction, none of the Deceased Spouse’s AEA is used, and an estate tax return is filed to “port” the Deceased Spouse’s unused AEA to the Surviving Spouse.  The Surviving Spouse now has an effective AEA of $22,800,000.

2024 – The Surviving Spouse dies.  The assets of the QTIP Trust have grown in value and are now worth $8,000,000.  Because assets of the QTIP Trust are considered part of the Surviving Spouse’s estate, they are entitled to a tax basis step up – in this case, to $8,000,000.  When the children of Couple B sell the assets of the QTIP Trust, they incur no capital gains income taxes.  The $3,000,000 of gain occurring between the Deceased Spouse’s death and the Surviving Spouse’s death is not taxable.

For Californians, capital gains income tax rates can be as high as 37.1% for those in the top tax bracket. Note: the capital gain income from a sale is included and can push one into a much higher tax bracket.

If you have a revocable living trust prepared prior to 2012, or one that unwittingly includes a bypass trust, it could use a QTIP.  Please contact us now for a complimentary consultation to see if your trust is still appropriate for you.