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QTIP trusts are wise estate tool; but cancel in case of divorce

by on
in Small Business Tax

If you've never heard of a qualified terminable interest property (QTIP) trust, you should have.

QTIP trusts are key estate-planning tools for many people. Reason: They pull the assets and future appreciation out of your taxable estate. They help you provide for your spouse. And they can ensure that the trust's assets eventually go to the heirs you choose, including children from a previous marriage.

But what if you're remarrying and want to hedge your bets in case the marriage doesn't work out? A new IRS private letter ruling shows how to combine a lifetime QTIP trust with a prenuptial agreement to safeguard your assets in case your marriage ends up in a divorce. (IRS LR 200413011) In essence, you retain some control until a certain time period has elapsed, say 20 years.

Case study: Bob and Mary

In the IRS ruling, Bob married Mary, created a trust and transferred his own property to it. Under the trust terms, Bob retained the power to distribute the trust's income, but not to himself or his creditors. After 20 years, this power will lapse.

As long as Bob is alive, and after his death, the trustee is to pay all of the trust's net income to Mary, who also can receive the trust principal for her health, support and education.

Under its terms, the trust will terminate if Bob and Mary both agree, and the trust principal will be distributed to her.

Also, Bob and Mary entered into a prenuptial agreement that provides for the division of their property in case of divorce. That agreement says that the property transferred to the trust will retain the same form it had before the transfer: as Bob's property or as "marital" property. So the property Bob transfers to the trust will be divided according to the prenup, in case of a divorce. Again, the prenup will lapse after 20 years, or if Bob formally annuls it.

In this ruling, the IRS said that each time Mary receives a payment from the trust, these payments will be untaxed gifts, thanks to the unlimited gift-tax marital deduction. If and when Bob's power to distribute trust principal and income lapses, Bob can make a lifetime QTIP trust election. After the QTIP election, no gift tax will be due and the trust assets will be out of Bob's estate.

Bottom line: What does all this accomplish? In case of a divorce, Bob's assets will be divided according to the prenuptial agreement. If the marriage lasts more than 20 years (or if Bob decides sooner that he's in a blissful marriage), the trust can be converted into a lifetime QTIP, with the assets out of Bob's estate.

Similarly, if Bob dies before divorce or the 20-year mark, the executor of his estate can make a QTIP election, removing the assets from Bob's taxable estate.

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