by Cathy Pareto, CFP®, AIF®

Before we begin talking about these types of trusts, let's first begin by introducing the term "unlimited marital deduction." The unlimited marital deduction refers to the amount allowed by the federal estate-tax laws for all property passed to a surviving spouse who is a U.S. citizen. This deduction allows any individual to pass their estate to a surviving spouse without any deferral estate tax being assessed.

However, after the surviving spouse dies, it will be included in his or her taxable estate unless it has been spent. If the surviving spouse gifts the assets while living, a federal gift tax or a federal estate tax may be levied.

Now that we have identified the concept of unlimited marital deductions, let's review marital trusts and non-marital trusts.

Marital Trust
A marital trust (sometimes referred to as an A- trust) is a unique estate planning tool that allows you to provide for your spouse and at the same time ensure that your children also receive an inheritance. Why is this so important? It's difficult to control future circumstances after your death: wouldn't you like to know that if your spouse remarries, she will not leave your assets to the new spouse while disinheriting your children? This is the purpose of the marital trust. In essence you are protecting the assets from the claims of a subsequent spouse.

The property placed inside a marital trust qualifies for the marital deduction in the gross estate of the decedent. So even though the amount is included in the decedent's estate, it is not subject to estate tax. Married couples can pass unlimited amounts of money and assets to each other, either during life or at death, without any gift tax or estate tax implications.

The way these trusts usually work depends on the type of marital trust. In some cases, your spouse will receive the income generated by the trust throughout his or her lifetime. In other cases the trust will also allow for principal distributions for reasons, such as healthcare, education, maintenance, etc. The interpretation can be quite subjective, depending on the trustee or administrator of the trust, which is often the surviving spouse or the spouse and co-trustee.

Forms of Marital Trusts
Marital trusts can take one of the following three forms:
  1. A general power-of-appointment (GPA) marital trust may be created for the sole benefit of the surviving spouse during his or her lifetime, with terms that provide the surviving spouse with an income interest for life. Typically, the spouse is also granted a general power of appointment of the assets remaining in the estate. This is the most liberal and least restrictive of the marital trust forms.
  2. A QTIP trust may be used for the sole benefit of the surviving spouse during his or her lifetime, but its terms require that the surviving spouse have a qualifying income interest for life only. According to the Internal Revenue Code, this means that the property must be payable to the surviving spouse alone at intervals of at least once annually. The balance, or corpus, of the trust is often bequeathed to children or other heirs. QTIP trusts are typically used by individuals who have been married more than once and have children from a previous marriage they want to continue to provide for. The main advantage of this type of trust is that it allows you to retain control of the trust even after the surviving spouse dies, by allowing you to dictate who should receive the property after your spouse. But it's worth noting that in order for the property to be treated as QTIP property, the election must be made on the decedent's tax returns.
  3. An estate trust may be used to provide discretionary distributions to the surviving spouse during his or her lifetime, but it requires that the remainder of the trust pass to the surviving spouse's estate at death.
All of the marital trusts described have a common thread: the value of the assets held by each trust will be included in the gross estate of the surviving spouse. In other words, bequests to these trusts do not eliminate federal estate tax, but instead merely defer it.

With regard to income taxes, for the assets inside the trust, income is taxed to the grantor under the grantor trust rules until the grantor's death. After the grantor's death, the income from a power-of-appointment trust or QTIP trust will be taxed to the grantor's spouse because of the mandatory distribution of income to the spouse. After the grantor's death, income from an estate trust will be taxed to the grantor's spouse if distributed, or to the trust if not distributed.

Non-Marital Trusts
A non-marital trust, also known as a bypass trust or credit shelter trust, is a type of trust that also allows you to take care of your spouse and ensure that your children will inherit your estate. It is called a bypass trust because in essence this trust bypasses both your estate and your spouse. Why is this important? Estate taxes! (For more information, read Get A Step Up With Credit Shelter Trusts.)

With a bypass trust, the grantor places the assets in a trust that names the grantor's spouse and other family members as income beneficiaries. The trust is typically irrevocable, or becomes irrevocable upon the grantor's death. This trust is funded with property transferred upon the decedent's death. Typically, the amount transferred to the trust is equal to the applicable exclusion of $2 million for 2008. This number may change depending on congressional actions or inaction. Upon termination of the trust or death of the surviving spouse, the trust's assets will pass estate tax-free according to its terms. This trust usually has a two-fold purpose:
  1. To ensure that the grantor will fully use the available credit amount.
  2. To allow the grantor's spouse to have access to the trust assets if needed, while allowing such assets to "bypass" the spouse's estate.
As long as a completed transfer of assets takes place that satisfies the three-year rule, assets in a bypass trust are excluded from the grantor's gross estate. Under this three-year rule, if the transfers were completed within a three-year period from the grantor's death, the assets will be included in the grantor's estate and the bypass will be voided unless an exception applies.

Irrevocable Life Insurance Trusts (ILIT)
An irrevocable life insurance trust (ILIT) is an integral part of a wealthy family's estate plan. In estates with more assets than the applicable exclusion amount, life insurance is usually a cornerstone of the estate plan. An ILIT provides the grantor a flexible planning approach as well as a tax-savings technique, since it enables the exclusion of life insurance proceeds from the estate of the first spouse to die and from the estate of the surviving spouse. This type of trust is funded with a life insurance policy. The trust becomes the owner of the policy and also becomes the beneficiary of the policy, but the grantor's heirs can remain beneficiaries of the trust itself.

In order for this planning to be valid, the grantor must live three years from the time of the policy transfer, otherwise the policy proceeds will not be excluded from the grantor's estate. If the trust is funded, any income that is or may be used to pay premiums on a life insurance policy on the grantor or the grantor's spouse will be taxed to the grantor under the grantor trust rules .This is because any income from the trust is reported on the grantor's personal income tax return.

Aside from ensuring the validity of the trust, the following are some negatives associated with an ILIT:
  • It can be costly to establish the trust, as it may be necessary to engage the services of an estate planning professional to ensure that the trust satisfies the ILIT requirements.
  • They are generally irrevocable, and there are narrowly defined exceptions under which provisions, including the dispositional terms, can be changed.
  • Taxpayers often avoid ILITs because of the perceived high level of complexity.
Qualified Domestic Trust (QDOT)
Estate planning for non-citizen spouses has its challenges. Normally all property passing outright to a surviving spouse qualifies for the marital deduction, unless that spouse is not a U.S. citizen. Some of the limitations include:
  • Limit for annual gifts between spouses is $128,000 (not unlimited as with two U.S. citizens).
  • Property held jointly between spouses is not automatically considered one-half owned by the surviving spouse and is instead based on consideration.
  • There is no unlimited marital deduction.
So, how do you deal with this challenge? A qualified domestic trust (QDOT) allows a non-citizen spouse to benefit from the marital deduction normally allowed to other married couples. Unfortunately, the unlimited marital deduction is denied for property transferred to a spouse who is not a U.S. citizen unless the property specifically passes to a QDOT. With this type of trust, the surviving non-citizen spouse must be entitled to all income from the assets held in the QDOT.

This trust allows for the surviving spouse to receive income for life, but not principal. This is done so as to avoid the surviving spouse removing the assets from the control of a U.S. taxing authority. For a trust to qualify as a QDOT, certain requirements must be met, including the following:
  • A QDOT election must be made on the decedent's tax return by the executor.
  • At least one trustee must be a U.S. citizen or domestic corporation.
  • The trust instrument must require that no distribution of corpus from the trust may be made unless the trustee has the right to withhold from the distribution the QDOT tax imposed on the distribution.
  • The requirements of all application regulations must be met.
A U.S. bank must serve as trustee for trusts with over $2 million in assets, unless the U.S. trustee furnishes a bond in favor of the IRS in an amount equal to 65% of the fair market value of the trust assets, or the U.S. trustee furnishes an irrevocable letter of credit (ILOC) issued by a bank in an amount equal to 65% of the fair market value of the trust assets.

If the estate-tax value of the assets passing to the QDOT is $2 million or less, the trust instrument must require that no more than 35% of the fair market value of the trust assets will consist of real property located outside the U.S., or the trust will meet the requirements for QDOTs with assets in excess of $2 million during the term of the QDOT.

Next: Estate Planning: Charitable Trusts »


comments powered by Disqus
Trading Center