How trusts provide for a spouse and later heirs
Key takeaway
Trust terms can provide income for a surviving spouse and direct the remaining principal to children. In Minnesota, for example, trustees must consider the beneficiaries' respective interests, and other states differ.
Start with the QTIP requirements below, then review the distribution language, election and trustee duties with counsel.
Research notice: Based on primary sources linked below. Review distribution terms, retained powers, income tax treatment and estate inclusion separately. Ask an estate attorney or CPA to confirm the trust language, applicable law, election, filing decision or deadline before acting.
What is a spousal lifetime access trust?
A SLAT is a trust type reviewed here through the gift and tax rules below. Review the instrument's distribution provisions and reserved powers with counsel.
How do retained powers and income provisions affect a SLAT's tax treatment?
Does an irrevocable label make a gift complete?
No. Gift completeness depends on the donor relinquishing dominion and control so that no power remains to change the property's disposition for the donor's benefit or another person's benefit.
Reserved disposition powers can make the gift wholly or partly incomplete, depending on the facts. Examine each reserved power's terms and scope before reaching a conclusion. For proposed changes, use the guide to changing an irrevocable trust and the trusts guide to prepare questions for counsel.
For gift tax credit, annual exclusion eligibility and current exemption amounts, use the federal estate, gift and GST tax guide. Bring the proposed transfer and reserved powers to that separate review.
When does income for a spouse create income tax ownership?
The grantor is treated as owner of a trust portion whose income, without any adverse party's approval or consent, is or may be distributed to the grantor or spouse, or held for their future distribution.
Any distribution or accumulation discretion described here belongs to the grantor, a nonadverse party or both. An adverse party has a substantial beneficial interest in the trust that would be adversely affected by exercising or not exercising the power that party possesses. A nonadverse party is someone who is not an adverse party.
The spouse income rule excludes a power affecting beneficial enjoyment only for a period beginning after an event if the grantor would not be treated as owner under section 673 were that power a reversionary interest. After that event, the grantor may be treated as owner unless the power is relinquished.
When the grantor is treated as owner of a trust portion, the grantor reports that portion's income, deductions and credits. Income tax ownership and gross estate inclusion are separate tests. Bring the income provisions and retained powers to a CPA for a reporting review.
Does income tax ownership guarantee a basis adjustment at death?
No. In the IRS ruling linked below, income tax ownership did not produce a section 1014 basis adjustment at the grantor's death under the following facts.
The grantor transferred an asset by completed gift to an irrevocable trust. The asset had appreciated by the grantor's death. A retained power caused income tax ownership of the entire trust without causing inclusion of its assets in the grantor's gross estate.
At death, trust liabilities did not exceed the basis of the trust assets, and neither the trust nor the grantor held the other's note. The ruling's conclusion is confined to those facts and does not establish the basis treatment of every SLAT.
For carryover basis, gift tax basis adjustments and inherited property exceptions, consult the federal tax guide. Take the transfer records, asset basis records, retained powers and any debt documents to that review.
How can marriage changes affect trust tax treatment and provisions?
Does divorce necessarily end federal income tax attribution?
No. Federal grantor trust income tax attribution includes powers or interests held by someone who was the grantor's spouse when those powers or interests were created.
For this creation test, legal separation under a decree of divorce or separate maintenance does not count as marriage. Attribution also reaches powers or interests held by someone who later becomes the grantor's spouse, but only for periods after marriage. This tax attribution rule does not determine distribution rights.
Does divorce revoke former spouse provisions in a trust?
In Minnesota, for example, dissolution or annulment after execution revokes specified former spouse provisions in a sole settlor's trust with reserved alteration, amendment, revocation or termination powers, unless the trust expressly provides otherwise. Covered provisions include beneficial dispositions, powers of appointment and appointment as trustee. Other states differ.
In Minnesota, for example, provisions revoked solely under that rule revive upon remarriage to the former spouse. Other states differ.
In Minnesota, for example, separation that preserves marital status is not dissolution. Other states differ. Do not extend this Minnesota rule automatically to an irrevocable SLAT.
How can a trust provide for a surviving spouse and later heirs?
Can QTIP provide income for a spouse and principal for children?
Yes. A qualified terminable interest property arrangement, or QTIP, can provide lifetime income for a spouse and principal for children at the spouse's death. Property must pass from the decedent, the spouse must have a qualifying income interest for life and the executor must elect.
For the income trust described here, the spouse must receive all income at least annually, and nobody may appoint property to anyone else during the spouse's life. Powers exercisable only at or after the spouse's death are excepted. A remarriage cutoff fails the lifetime income requirement.
Principal distributions require authority under the arrangement, which QTIP status alone does not supply. For noncitizen spouse requirements, credit shelter trust funding, portability, deceased spousal unused exclusion amounts and election relief, use the federal tax guide.
Can QTIP property enter the spouse's estate even if children receive it?
Yes. Section 2044 includes property in the surviving spouse's gross estate when the spouse held a qualifying income interest for life and a deduction was allowed under section 2056(b)(7) or 2523(f).
Section 2519 must not have applied to a disposition by the spouse of part or all of that property. Inclusion is separate from who receives the remainder, including children. For QTIP tax recovery and lifetime dispositions, consult the federal tax guide linked above.
Can a Clayton arrangement make the spouse's income interest depend on the QTIP election?
Yes. Governing terms may make the spouse's qualifying income interest for life contingent on the executor's QTIP election and direct nonelected property to other beneficiaries.
Neither that contingency nor the direction of nonelected property elsewhere defeats qualification by itself. The other QTIP requirements discussed above still apply.
A partial election must cover a fractional or percentage share of the property. The elected portion must reflect its proportionate share of increases or decreases in the entire property's value for purposes of section 2044 or section 2519.
The regulation limits this contingency rule to estate tax returns due after the effective date specified in Sources. Review the governing terms and proposed election against the QTIP election regulation. A label such as “B trust” has no universal meaning.
Who makes the QTIP election and when?
The executor makes the QTIP election by listing the property and its value on Form 706, Schedule M. The executor appointed, qualified and acting within the United States makes the election regardless of possession of that property.
If no such executor exists, a person may elect for property in that person's actual or constructive possession. That person may also elect for other property if the person possessing that other property does not elect.
The controlling return is the last estate tax return filed by the due date, including extensions, or the first late return if none was timely. An election may be revoked or modified on a subsequent return filed by the due date, including extensions actually granted. Otherwise, the election is irrevocable.
After an executor appointed under local law elects for one or more properties on that controlling return, no subsequent election for other gross estate property may be made after that return is filed. Review the filed returns and extension records with the person responsible for the election.
Is meeting the nine month deadline enough for a qualified disclaimer?
No. A qualified disclaimer under section 2518(b) also requires an irrevocable, unqualified written refusal, no acceptance of the interest or its benefits, and passage of the interest without the disclaimant's direction.
The writing must reach the transferor, the transferor's legal representative or the property's legal titleholder within nine months after the later of the transfer creating the interest or the disclaimant reaching age 21.
The interest must pass to the decedent's spouse or someone other than the disclaimant. These requirements concern section 2518(b), rather than alternative statutory treatment. Compare this timetable with the QTIP return rules above before discussing either route.
What trustee duties apply when a spouse and children have interests in a trust?
In Minnesota, for example, a trustee administering a trust with two or more beneficiaries must act impartially, giving due regard to their respective interests. Other states differ.
In Minnesota, for example, accepting trusteeship requires administration in good faith under the trust's terms and purposes, beneficiary interests and applicable law. Other states differ.
In Minnesota, for example, even broad discretionary language requires the trustee to exercise discretion in good faith under the trust's terms and purposes and in the beneficiaries' best interests. Other states differ.
These Minnesota duties neither guarantee a particular inheritance nor require a professional trustee. For trustee selection and joint appointment powers, use the trusts guide.
Common questions
When does the reciprocal trust doctrine apply?
The reciprocal trust doctrine applies when interrelated trusts, to the extent of mutual value, leave their settlors approximately where they would have been economically with trusts naming themselves as life beneficiaries.
Neither a quid pro quo nor a tax avoidance motive is required, and different property character did not prevent application. The decision establishes no timing or drafting safe harbor. Read the decision linked in Resources with counsel before evaluating a proposed pair of trusts.
Does a directed conversion into a terminable interest qualify for the marital deduction?
No. The marital deduction is denied for an interest the decedent directs an executor or trustee to convert after death into a terminable interest for the surviving spouse.
Denial applies even without another person's interest and even if an exception for life estates, life insurance or annuity payments with appointment powers would otherwise allow a deduction. A terminable interest purchased under those directions does not qualify as QTIP. Take the conversion instruction to counsel for review alongside the QTIP provisions.
Resources to check out
- IRS Instructions for Form 706: Schedule M: Read the instructions for the QTIP reporting discussed above.
- Treasury regulation: QTIP elections: Review qualification, Clayton arrangements and election provisions.
- IRS Revenue Ruling: Basis of grantor trust assets at death: Read the ruling and facts behind the basis discussion.
- Reciprocal trusts: Supreme Court decision: Read the decision discussed in the reciprocal trust question.
- Federal qualified disclaimers: Requirements: Review the statutory requirements for a qualified disclaimer.
- Minnesota trust chapter: Trustee duties and marriage changes: Read the chapter supporting the good faith and marriage examples, including the duty of impartiality.