Introduction. Every individual who is married to a U.S. citizen is allowed to transfer unlimited amounts to his or her spouse free of estate and gift taxation. In addition, the first $1,500,000 (increasing per the new tax act to $2,000,000 in 2006-2008; and $3,500,000 in 2009; with repeal of the estate tax in 2010 and reinstatement of the estate tax in 2011)) of taxable transfers (i.e., gifts or transfers at death) are effectively exempt from estate and gift taxation. Such amount is commonly referred to as the "exemption equivalent". A married couple can thus theoretically pass double the exemption equivalent tax free without using the unlimited marital deduction.

Transferring all of one’s property to his or her spouse at death creates an opportunity cost since the first exemption equivalent is wasted. That is, when the survivor dies, only one exemption equivalent will be available.

Most estate plans are designed to take advantage of both exemption equivalents. This is typically accomplished via the first decedent transferring an of property valued at the exemption equivalent to a trustee of a bypass trust (a.k.a., credit shelter trust) for the benefit of the survivor and transferring the balance to the survivor. On the death of the survivor, the assets in the bypass trust pass to the children (or others), "bypassing" the taxable estate of the survivor.

THE RISK ON ORDER OF DEATHS

The so-called "risk on the order of deaths" arises when one spouse is wealthy and the other (the "poor" spouse) does not have sufficient assets to fully fund the tax savings bypass trust if he or she dies first. If the wealthy spouse survives, the poor spouse’s exemption equivalent will be partially or fully wasted. (This wasting of the exemption equivalent also occurs where all of the assets are jointly held with rights of survivorship.)

Most estate planners "solve" the "risk on the order of deaths" problem by recommending that the wealthy spouse transfer sufficient assets to the poor spouse to enable the poor spouse to fully fund the bypass trust if he or she dies first. The difficulties, of course, are two-fold. First, there probably is a reason the wealthy spouse has not already transferred sufficient assets to the poor spouse. Second, making such a transfer does not in and of itself assure that the poor spouse will actually "do the right thing" with the transferred assets.

A sophisticated "solution" to the "risk on the order of deaths" problem is the inter vivos qualified terminal interest property trust (IV-QTIP). (Inter vivos means during lifetime, as opposed to testamentary, which means established on death.) The wealthy spouse declares that he or she is holding certain assets as trustee of an irrevocable trust for the benefit of the poor spouse.

The IV-QTIP trust is designed so that the contribution to the trust qualifies for the marital deduction, so there is no taxable gift. The trust is designed to provide income to the poor spouse for life (and possibly principal distributions based on need.)

As a practical matter the wealthy spouse can control the amount of income via the investments made. Stock in S corporations or interests in partnerships which are controlled by the wealthy spouse are particularly useful assets for this purpose because the trust only has distributable income if the corporation or partnership makes distributions. To qualify for the marital deduction, the poor spouse must have the right to make the trust investments productive, but exercising such right would be the practical equivalent of a declaration of war, and the income would presumably offset alimony. (The trust may not provide that the poor spouse loses the right to income on divorce.)

So long as the both spouses are living and the couple is married, taxable income and losses from the trust investments must be reported by the wealthy spouse as if the wealthy spouse owned all of the trust assets. A separate income tax return is not necessary.

The "trick" comes on the prior death of the poor spouse. The trust assets will be included in the poor spouse’s taxable estate. But the trust can provide a testamentary special power of appointment allowing the poor spouse (or a third party) to appoint trust assets with a value equal to the poor spouse’s exemption equivalent to a bypass trust for the benefit of the wealthy survivor and the balance of the trust assets to the wealthy spouse. If the poor spouse fails to do so, the assets pass to the wealthy spouse as trustee for the benefit of the children or others designated in the trust.

Of course, there are some subtle decisions to make, such as the extent of special powers given to the poor spouse and the selection of successor trustee. But the net estate and gift tax effect of funding an IV-QTIP trust is similar to what would have happened if the wealthy spouse made a gift of sufficient property to the poor spouse to allow the poor spouse to "do the right thing".

[As an aside, it should be noted that estate planners have an ethical problem whenever representing both spouses for estate planning. The ethical problem is potentially acute in this situation - usually depending on how well the spouses communicate with each other - and may require the estate planner to insist on the spouses having separate representation.]

©2007 Steven M. Chamberlain, Esq. All rights reserved. Republication with attribution is permitted.