A QTIP trust allows a deceased spouse to maintain a certain level of control over the final disposition of his or her property while still qualifying for the unlimited estate tax marital deduction. However,one oft overlooked problem is the failure to appropriately plan for the tragic death of a child beneficiary. In general if a child beneficiary passes away prior to receiving his or her interest in the QTIP trust, the property passes to his or her kids. This is called a skip transfer resulting in the application of the generation skipping transfer tax ("GSTT") (taxed at the same rate as the estate tax).
Basically, the GSTT functions to capture the estate tax that is avoided at the skipped generation. If the child does not receive it but the grandchild does, such property is not taxed in the child's estate. Well, the IRS says such property should be taxed as if it had been included in the skipped generation's estate.
As with anything, the IRS is kind enough to offer an exemption. Currently, the GSTT lifetime exemption tracks the estate tax exemption, so for 2009, it is $3,500,000 per individual. However, since a QTIP trust is not included in the deceased spouses estate, no portion of his or her GSTT exemption is applied to the QTIP Trust. Imagine the following scenario:
Survivor's Trust = $1,000,000.00
Bypass Trust = $3,500,000.00
QTIP = $2,000,000.00
So, upon the first death, Bypass trust utilizes decedent spouses estate tax exemption, and the QTIP qualifies for the estate tax marital deduction resulting in no estate taxes at death. As per the standard course, the trust document provides that decedent's GSTT exemption shall be applied to the Bypass trust as needed. For simplicity purposes, assume this is the ultimate distribution scenario upon the second death:
2 children living and one deceased child leaving 3 surviving issue. Everything distributed equally from each trust. Assume date of death values of the trusts at the following:
So, from each trust, the following amounts are allocated to skip persons, i.e., grandchildren resulting in imposition of the GSTT
Survivor Trust to Grandchildren = $3,000,000.00
Bypass Trust to Grandchildren = $1,500,000.00
QTIP Trust to Grandchildren = $2,000,000.00
Now, combined, husband and wife have, in 2009, a GSTT exemption of $7,000,000.00. Above, the survivor has made $5,000,000 in GSTT transfers and the decedent spouse made $1,500,000. Since the exemption is limited to $3,500,000 per individual, and since, for tax purposes, the surviving spouse is considered the transferor of the QTIP Trust property, $1,500,000 is likely subject to the GSTT, at an applicable rate between 40-50%.
Could this have been avoided? Yes. Utilization of the reverse QTIP election magically makes this tax headache go away. Give us a call if you want to know how to ensure you have the Reverse QTIP protection.