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Remarried with children? Maintain control of your family fortune

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in Small Business Tax

Common situation: You've remarried and both you and your spouse have children from previous marriages. If you leave most of your fortune to your surviving spouse, it appears at first glance that you'll face no major estate-tax concerns. But there's no guarantee the money will ever wind up in your kids' hands. The current estate-tax exemption can cover direct transfers to your children of up to $1.5 million, but that's all.

Strategy: Set up a QTIP (Qualified Terminal Interest Property) trust. The trust pays out money to your surviving spouse while he or she is alive. Upon your spouse's death, the assets go to the beneficiaries you've selected (typically, your children).

Best of all, there's no estate-tax bill when you die. And you can shelter the subsequent transfer to your children using a higher estate-tax exemption (see box at right).

Here's the whole story: The unlimited marital deduction says that any assets transferred from one spouse to another are generally completely estate- and gift-tax free. (The spouse who receives the assets must be a U.S. citizen for this tax-free transfer.) So, if you leave assets to your spouse when you die, the spouse faces no tax whatsoever.

But the marital deduction generally isn't allowed for assets passing to a spouse for his or her life and then to someone other than the surviving spouse.

Fortunately, an exception is allowed for assets in a QTIP trust. If the trust meets certain requirements and if your estate executor makes an on-time election, the value of the assets in the trust qualify for the marital deduction. Subsequently, the remaining assets are included in the taxable estate of the surviving spouse.

How does a family qualify for the QTIP exception? The surviving spouse must have a "qualifying income interest for life." That means the following conditions must be met:

• The spouse must be entitled to all the income from the assets for life.

• The income is payable annually or at more frequent intervals.

• The surviving spouse has the right to enjoy the assets for his or her lifetime.

• No one, including the surviving spouse, has the power to transfer any part of the assets to another person while the surviving spouse is still alive.

Although QTIP trusts are commonly used in second and third marriages, they can serve other purposes. For instance, if you're concerned that your surviving spouse will squander his or her inheritance, a QTIP can do the trick.

The election to qualify for the QTIP exception is made by the executor of the estate of the first spouse to die. Once the election is made, it's irrevocable.

Final tip: In some cases, it may be better to forgo the QTIP election. Reason: The surviving spouse may end up with an unusually large estate. So, the overall estate-tax bill to the children may be greater than it would have been without the QTIP election. Your executor can make this determination.

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