Federal Estate and Gift Taxes -- the Marital Deduction

A baseline policy of the federal estate and gift taxes is to tax wealth once every generation. For that reason, transfers from one spouse to another are made deductible, and therefore not taxed--subject to some important qualifications.  You'll often see this referred to as the "unlimited marital deduction."

The unlimited marital deduction applies to any outright transfer to a spouse, and any transfer in trust where the assets of the trust will be included in the spouse's gross estate, and subject to tax, at the spouse's death.  Before 1988, there were three trusts that qualified for the marital deduction:

• Any trust where the spouse has a lifetime right to income and a "general power of appointment"--a right to withdraw assets from the trust, or direct them to his estate or creditors at death.  Often called a "life estate plus power of appointment" trust, this was the most common arrangement.
• A trust where the spouse has a lifetime right to income and the property passes at the spouse's death to charity.  (In this instance, there will be no tax on the second death because the property will qualify for a charitable deduction.)
• An "estate trust," which accumulates income while the spouse is living and pays it to her estate at death.  These were used as investment vehicles back in the days when trusts paid income taxes at much lower rates than individuals. In about 20 years of private practice, I have yet to encounter one.

Most married people want to devote assets to the care of their spouse, and then pass them on to the next generation after both spouses are deceased.  If, in order to take advantage of the marital deduction, you left property to the spouse outright or in a trust with a general power of appointment, you ran the risk that the spouse might divert the assets to someone else--this was a particular concern of spouses in blended families, or in situations where a relatively young widow remarries.  If you designed the trust to prevent this by restricting the spouse's control, or providing for a forfeiture of benefits if the spouse remarried, you gave up the marital deduction and incurred a tax.

The response to this was the "qualified terminable interest property" election added to the tax code in 1988, which is nicknamed "QTIP.".  To qualify for the QTIP election, a trust must meet three criteria:

• The spouse must receive all of the income of the trust while living.
• The trust may not have any other beneficiary while the spouse is living.
• The estate must make a "QTIP election" on the estate tax return.

The QTIP rules allow for a fair bit of flexibility in trust design.  The spouse can have no right to principal at all, or a right to principal distributions in the trustee's discretion, or even a limited right to make annual withdrawals.  The right to principal distributions can terminate, or be restricted, on remarriage.  Because it allows for more control than the old life estate plus power of appointment trust, the QTIP trust is the one I use the most in my practice.

One last little detail: the marital deduction is only available if the spouse is a U.S. citizen.  For non-citizen spouses, there is still a marital deduction of sorts, but the rules are a lot more complicated.  We'll discuss that topic in our next installment.