Law Office of John S. Palmer Attorney at Law

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QTIP Trusts

Posted Friday, February 1, 2013 by John S. Palmer

QTIP Trusts are a popular way for a married person to set aside property for the support of a surviving spouse, and control disposition of the remainder after the surviving spouse’s death.

In 1981, Congress made such trusts possible by deferring any estate tax owed on the property until after the death of the surviving spouse. Prior to that a married person had to choose between leaving all property directly to a spouse (to avoid estate tax) or leaving a bequest to others, usually children (subjecting the property to estate tax but ensuring they inherit something, particularly if they are children from a prior relationship who may not inherit from the surviving spouse.)

The root of the problem lies in how the IRS treats terminable interest property. The tax code defines a “terminable interest” as an interest that will terminate on the lapse of time, or the occurrence of an event. For example, in the case of a life estate in real property (e.g., leaving a home to A for life, then outright to B), A is given a terminable interest.

The problem was that terminable interest property left to a surviving spouse did not qualify for the unlimited marital deduction for estate tax purposes. The solution enacted in 1981 was to allow certain terminable interests left to a surviving spouse to qualify for the marital deduction. Such property is referred to a qualified terminable interest property, or QTIP. As explained in a House committee report at the time the law was passed, “if certain conditions are met, a life interest granted to the surviving spouse will not be treated as a terminable interest. The entire property…will be treated as passing to such spouse and…the entire interest will qualify for the marital deduction.” Otherwise, the committee found, “a decedent would be forced to choose between surrendering control of the entire estate to avoid imposition of estate tax at his death or [foregoing the marital deduction] to insure inheritance by the children.”

In order to for terminable interest property left to a surviving spouse to qualify for the marital deduction, the estate of the first spouse to die must make a QTIP election on the deceased spouse’s estate tax return. Such an election does not avoid estate tax entirely; it only defers taxation until after the death of the second spouse. Any assets remaining in the QTIP Trust must be included in the taxable estate of the second spouse. The advantage, though, is that the first spouse gets to make the property available for the support of a surviving spouse, unreduced by front-end taxation, while still controlling the ultimate disposition of the property.

Since 2005, Washington State taxpayers have been able to defer Washington estate tax on QTIP by making a similar election on the state estate tax return. Before then, such an election was not necessary because of the way Washington’s estate tax was structured. Between 1981 and 2004, Washington’s estate tax was actually a portion of the federal estate tax the U.S. government gave to the state through a credit claimed on a decedent’s federal estate tax return. (I think it is interesting to note that this approach was adopted because in the early 1900’s several states abolished their death taxes in order to attract wealthy residents, thereby putting pressure on other states to abolish their death taxes. The federal tax credit for state death taxes eased this pressure because an estate would pay the same amount of tax no matter what; if the applicable state had no death tax, the federal government would keep the entire amount collected; if the state had a death tax, the federal government would share a portion of the amount collected with the applicable state.)

Under this regime, a state QTIP election was unnecessary because Washington only taxed estate property when the federal government did. This all changed in 2001, when Congress adopted legislation that phased out the state death tax credit over 4 years. As a result, Washington was forced to adopt a new separate, stand-alone death tax that is independent of the federal estate tax. This new law allows for a state QTIP election and the deferral of state tax on QTIP until after the death of the second spouse.

The Washington Supreme Court was recently faced with an interesting question: if the estate of a deceased spouse made a QTIP election prior to 2005, the estate of the second spouse will have to pay federal estate tax on any remaining QTIP, but can Washington also now tax that same QTIP, even though no state QTIP election could be made when the first spouse died?

In a unanimous decision issued in Estate of Bracken v. Dept. of Revenue, decided October 18, 2012, the court ruled against the state and held that Washington’s current tax laws do not allow the state to include QTIP in the taxable estate of a spouse dying now unless a post-2005 state QTIP election was made by the estate of the first spouse. Six justices held that the current state law only imposes a tax when property is actually transferred by a decedent (or where a voluntary election to defer state taxes is made); because the QTIP at issue was transferred upon the death of the first spouse prior to 2005, and no state QTIP election was made, it cannot be taxed now. In response to DOR’s argument that this would result in a windfall to taxpayers, the court said a QTIP election also carries risk that more tax will be paid if tax rates go up:

We will not be distracted…by DOR’s concern about asserted windfalls to some taxpayers. Individuals who elected QTIP treatment for federal tax purposes before May 17, 2005 assumed the risk of what future changes in federal tax law might mean for the deferral. They did not invite or assume the risk of a state reaching into the grave and taxing a transfer 25 years after the fact.

A 3-justice minority disagreed with the majority’s analysis, and found that a potentially taxable transfer of property does occur upon the death of the second spouse; however, the minority concurred in the result, finding that the current law including regulations adopted by DOR only allow QTIP for which a state election is made to be included in the Washington taxable estate of the surviving spouse.

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Law Office of John S. Palmer11911 NE 1st St, Ste. B204,Bellevue, WA 98005-3056