The marital deduction allows property to be transferred between spouses—either during life or at death—without triggering either the federal estate tax or the federal gift tax. For the transfer to qualify, certain requirements must be met. One is that property given or left to the spouse can’t be a “terminable interest.” That’s an interest that can expire after the passage of time or the occurrence—or non-occurrence—of an event. This general rule notwithstanding, tax law does allow certain types of “terminable interests” to qualify for the marital deduction.
QTIP trusts are an example.
Qualified terminable interest property (QTIP) is property in a decedent’s estate that, even though it’s a terminable interest, can still qualify for the estate tax marital deduction. The term also includes property given to a spouse during life that qualifies for the gift tax marital deduction, even though it’s subject to similar restrictions. For a terminable interest to qualify for either the estate or gift tax marital deduction, it must meet the legal criteria of a “qualified” terminable interest. This can be a lifetime income interest. The executor must make an election to treat the trust as a QTIP trust.
The will of the first spouse to die directs that certain property be placed in a QTIP trust. The deceased’s executor elects whether to qualify the property for the marital deduction. All of the income from the trust must then be paid to the surviving spouse no less frequently than annually for his or her life. No one can have a power to appoint any part of the property to anyone other than the surviving spouse. At his or her subsequent death, the trust principal passes to beneficiaries designated by the spouse in creating the trust. During the period that the trust is providing the surviving spouse with a lifetime income, the spouse has the right to require conversion of nonproductive property into productive property.
At the first spouse’s death, the marital deduction may be claimed—even though the transfer is a terminable interest. At the second spouse’s death, the transfer will be included in his or her gross estate, even though the spouse had no ownership or interest over the property.
A QTIP trust is an effective, flexible tool. It can provide lifetime income for a surviving spouse without leaving the property outright to the spouse. It can place restrictions on the property and still claim the marital deduction. A QTIP trust can also be structured to direct the disposition of property in the event of a surviving spouse’s subsequent remarriage, easing concerns about how the marriage might affect the rights of children and other beneficiaries.