For married couples with taxable estates it is common practice to use a Qualified Terminal Interest Property Trust, or “QTIP” Trust to hold the assets over the amount that can pass free of estate taxes at the death of the first spouse. Using a Separate, or B/C Trust, the amount that can be passed free of estate tax is allocated to the “B” or Bypass Trust (also known as Credit Shelter, Exemption or Family Trust), with any excess trust assets allocated to the “C” or QTIP Trust (also sometimes known as the Marital Trust). With a Joint, or A/B/C Trust, the surviving spouse’s share of the trust assets are allocated to the “A” or Survivor’s Trust, while the deceased spouse’s share is allocated between the “B” and “C” Trusts.
In order for the “C” Trust to qualify for the unlimited marital deduction (and thereby avoid estate tax at the death of the first spouse), the trust must provide that the “C” Trust assets cannot be appointed to anyone other than the surviving spouse during her lifetime. The surviving spouse must also be entitled to all the “C” Trust income and be able to demand that “C” Trust assets be made productive.
Traditional drafting has been to give the surviving spouse a mandatory income interest in both the “B” and “C” Trusts. Some attorneys also provide the spouse with entitlements to principal for health, education, maintenance, and support from the principal of the “B” and “C” Trusts. Finally, the surviving spouse is sometimes given a limited withdrawal power, known as a “five and five” power, from both trusts. While this type of drafting gives the surviving spouse maximum flexibility, it is not usually the best strategy for minimizing estate tax.
A better strategy is to appoint a trustee other than the surviving spouse to serve over the “B” Trust and make distributions from the “B” Trust fully discretionary. This technique will preserve the estate tax exempt assets of the “B” Trust, allow them to grow over time, and give the added bonus of protection from the creditors of the surviving spouse.
To compensate for this more restrictive access to the “B” Trust income and principal, the surviving spouse can be given liberal access to the income and principal of the “C” Trust. Any depletion of the “C” Trust assets should at least in part be compensated by the tax-free growth of the “B” Trust. As the “C” Trust is reduced in size, the potential for an estate tax at the surviving spouse’s death due to inclusion of the “C” Trust assets in the surviving spouse’s estate is reduced.
The tax leverage can even be further enhanced if the surviving spouse uses the income and principal distributions from the “C” Trust to purchase a life insurance policy in an Irrevocable Life Insurance Trust. The death benefit from the life insurance policy will pass income and estate tax free to the children and grandchildren.
While this strategy may not be appropriate in all circumstances (especially where there are children from a previous relationship of one or both spouses), it is certainly worth exploring with clients who have taxable estates.
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