For many clients, estate planning is as much about having an estate to pass on as it is about how that transfer will occur. In prior articles, we have discussed the estate tax benefits of lifetime trusts for a spouse (see, e.g., our articles on Spousal Lifetime Access Trusts (“SLATs”) and “Bert and Earnie” Trusts ). However, lifetime trusts for a spouse can also be extremely beneficial in situations where, because of available tax exemptions, estate taxation is unlikely to occur. In this article, we focus on the asset protection benefits of lifetime (“inter-vivos”) transfers to irrevocable “QTIP” marital trusts. The big distinctions between these trusts and SLATs and “Bert and Earnie” Trusts is that, with inter-vivos QTIP marital trusts, the trustmaker spouse need not give up the right to use and benefit from contributed trust property after his or her spouse’s death, and the couple’s beneficiaries can benefit from capital gains income tax step-ups when each spouse dies.
We have long touted the benefits of Inheritance Trusts for protecting inheritances from creditors’ and divorce claims against the inherited assets that loved ones receive. But for many clients, especially those such as physicians and other likely litigation targets, the burning question is often how to protect their assets from such potential creditors during their own lifetimes. For unmarried individuals, this is difficult. Under express Maryland law , the property of a revocable trust is subject to claims of the creditors of the trustmaker during the trustmaker’s lifetime. With regard to irrevocable trusts, Maryland law allows the trustmaker’s creditors to reach the maximum amount of trust assets that can be distributed to or for the benefit of the trustmaker. An individual trustmaker cannot, therefore, immunize his or her assets from creditors’ claims in Maryland without irrevocably giving up the benefit of those assets. Note that for married couples with tenancy by the entirety asset protection, the surviving spouse becomes such an unmarried individual and loses this tenancy by the entirety protection after the initial decedent spouse’s death.
These limitations can be avoided by married couples. If one spouse (“the donor spouse”) gifts assets to the other spouse without any intent to defraud actual or likely creditors, the gifted assets are no longer subject to future claims by unforeseen creditors of that donor spouse. This is true regardless of whether the recipient (“donee”) spouse chooses thereafter to apply those assets for the shared benefit of the donor spouse. In addition, if the donor spouse chooses to gift his or her assets to a trust for the benefit of the donee spouse, the donor spouse can make that trust a “spendthrift” trust that immunizes the gifted assets from the claims of potential creditors of the donee as well.
Why the “Qualified Terminable Interest Property” Concept is Important for Asset Protection Purposes
“QTIP” is an estate and gift tax law acronym for “qualified terminable interest property”. Nonqualified terminable interest property is an interest in property that can be terminated upon the occurrence of an event, such as the death of the beneficiary of that property. Believing that what a married couple owns should be subject to estate taxation at the death of the survivor of that couple, federal and Maryland estate tax laws ordinarily do not allow a marital deduction for gifts for the benefit of a spouse if what the spouse receives is a property interest that can be terminated at or prior to her or his death. Estate and gift tax laws, however, make exceptions for certain transfers of terminable interest property if the transfer is a “qualified” transfer of QTIP. Qualified terminable interest property is property in which a spouse receives an interest that entitles her or him to all the annual or more frequently paid income of the property during her or his lifetime, for which no other person has right to share in the benefit of that property while the spouse is alive, and for which the donor spouse has made an election that the property interest in question be QTIPed.
The esoteric niceties of such QTIP property are important outside the estate and gift tax context because Maryland law has adopted the QTIP concept for trust property asset protection purposes. By statute the trustmaker spouse is expressly not deemed to be an individual whose creditors can reach the assets of the QTIP trust during the lifetime of his or her spouse. Those creditors also cannot reach trust assets that can be distributed to or for the benefit of the donor trustmaker if he or she becomes the remainder beneficiary of the trust assets after the donee spouse’s death. Thus, by transferring property to a “spendthrift” lifetime QTIP marital trust, the donee spouse places those assets beyond the reach of both his or her spouse’s creditors and his or her own unforeseen potential creditors.
It is important to note that property transferred to an inter-vivos QTIP marital trust may not be protected if the conveyance to the trust is made with the intent to defraud known or reasonably foreseeable creditors of the donor spouse. All states have a form of statute regarding conveyances with the event to defraud such creditors, and care must be taken to avoid transfers resulting in a violation of these statutes.
The QTIP Marital Trust Must Be Irrevocable
The hallmark of an inter-vivos QTIP marital trust is that it must be irrevocable when and after it is created. This is unlike a revocable trust which by statute subject is to claims of the creditors of the trustmaker during the trustmaker’s lifetime. In addition, to qualify as QTIP property under applicable law, no person other than the donee spouse can ever have a right to share in the benefit of the property while that spouse is alive, and the donee spouse must be guaranteed to have the right to receive all the income of the property throughout her or his lifetime. Those requirements cannot be attained unless the QTIP trust cannot ever be changed while the donee spouse remains alive. Such irrevocability means that both spouses need to be committed to the QTIP planning, both during the donee spouse’s lifetime and thereafter. They must understand that they will probably be unable to change the trust design during their respective lifetimes without the assistance of disinterested neutral parties. For example, no changes to the QTIP trust are likely to be possible were either spouse to remarry after the first spouse’s death or have children with another spouse.
Because of this irrevocability, couples wishing to undertake this strategy must be certain that their marriage is rock-solid. In the event that the spouses subsequently separate or divorce, each will lose his or her indirect access to the assets established for the other. For this reason and because divorce courts seem to be inclined to equally divide marital assets, it is usually desirable that equal amounts of trust property be contributed to each spouse’s QTIP marital trust for the benefit of the other.
Income Taxation of QTIP Marital Trust Income
With regard to potential separation or divorce, it is also important to understand how the income of QTIP marital trusts is taxed for income tax purposes. Since all of the income of a QTIP trust is required to be distributed to the donee beneficiary spouse, one might expect that that trust income would be taxed to the donee spouse at her or his individual rates as “distributable net income” (with the possible exception that capital gains would be taxed to the trust itself). However, under special income tax rules , a trustmaker continues to be treated as the owner of any portion of a trust whose income is or may be distributed to the trustmaker’s spouse. Because of this provision, all of the income of a QTIP marital trust continues to be individually taxed to the trustmaker during the lifetime of the donee spouse as “grantor trust” income. While both spouses remain alive, no separate income tax returns are required for their respective QTIP marital trusts. As such, however, each donor spouse must be aware of his or her liability for income tax on the income and capital gains of the QTIP marital trust he or she creates and make sure that he or she has sufficient cash flow to make the tax payments on behalf of the trust. Where a subsequent divorce occurs, this liability for income tax on income received by the donee beneficiary spouse must be dealt with in a marital settlement agreement or it will be a difficult pill for the trustmaker spouse to swallow.
Irrevocability Does Not Mean Inflexibility
Irrevocability, however, does not necessarily mean that the trust must be inflexible, especially after the death of the donee beneficiary spouse. In general, married couples will want to allow access to QTIP trust income and principal for the original trustmaker after the death of the donee spouse if the donee spouse dies first. A second QTIP trust for the original trustmaker can be provided for after that first death so that the trustmaker retains the trust’s creditor protection for these assets and so that beneficiaries after the trustmaker’s subsequent death will obtain a second step-up in the capital gains basis of these assets. Contingent remainder interest provisions after the donee spouse’s initial death can also be included to cover the possibility of divorce. In addition, the QTIP marital trust can include provisions for an independent “Trust Protector” with authority to add post-mortem trust beneficiaries, to rewrite trust language in the event of tax law changes, and to grant powers of appointment taking effect after the first spouse’s death. In my experience, however, most clients are not worried about the possibility of divorce or other changes in the future and want a guarantee that their plan will be carried to effect as initially established. In this sense, the trust irrevocability is consistent with their desire to protect as much of their estate as possible to pass on their loved ones and their other overall estate planning goals.
Plan for Other Potential Pitfalls: Citizenship and the Reciprocal Trust Doctrine
In deciding whether to use inter-vivos QTIP marital trusts, clients need to be aware of two other factors applicable to this relatively high-level estate planning: First, both spouses undertaking this strategy must be citizens of the United States. Under applicable tax law and the Maryland law cited above, QTIP marital trusts may not be established for the benefit of non-citizen spouses. Therefore, if noncitizen spouses wish to consider using this strategy, they must also consider naturalization before doing so.
Second, and more importantly, under the Reciprocal Trust Doctrine, if both spouses create inter-vivos QTIP marital trusts for the other that are the same, creditors of either can “uncross” the trusts to establish that each has created a trust for his or her own benefit. Under such circumstances, the trustmaker’s creditors may be allowed to reach trust assets under the theory that they are in reality distributable to or for the benefit of the trustmaker (instead of his or her spouse). Care should be taken to make sure that this Reciprocal Trust Doctrine is not applicable to clients’ planning. Fortunately, there are a number of ways to make the trusts different so that this is not the case.
Final Considerations
As with most advance estate planning strategies, using inter-vivos QTIP marital trusts to protect one’s nest egg can be somewhat complicated. Nonetheless, in the hands of the experienced estate planning practitioner, this technique can provide significant peace of mind with little or no practical inconvenience to the parties involved. For the happily married couple, the same assets will be available to the clients as were present before the transfers to the QTIP trusts and will have the same income tax consequences for them if they routinely file joint marital income tax returns. If you would like to utilize this strategy for your own peace of mind, please do not hesitate to contact us.
© Richard T. Wright 2023
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