Leaving a trust behind for your husband or wife after you die isn’t a sign that you don’t think he or she can handle your money; instead, it’s a crafty tax technique designed to minimize the taxes paid on your estate at your death and also those due and payable after your spouse’s death.
No matter what type of marital trust you’re administering, the value of that trust on the surviving spouse’s date of death is included in his or her estate tax calculations after he or she dies. Even though you may have avoided paying estate taxes on it after the first spouse’s death, you probably won’t avoid paying taxes the second time if the surviving spouse’s estate is large enough.
All marriages aren’t alike; neither are all marital trusts.
Free rein for the surviving spouse: Unlimited marital trusts
In an unlimited marital trust, the surviving spouse is entitled not only to all the net income but also as much of the principal as he or she desires. Net income includes interest, dividends, rents, business income, income from other trusts or estates, and state tax refunds, but excludes capital gains and the expenses paid from income for administering the trust (like the trustee’s and tax preparer’s fees).
Unlimited marital trusts, sometimes also referred to as power of appointment trusts, contain one of two types of power of appointment:
A general power of appointment: The trust beneficiary may name anyone he or she designates, including himself or herself, at any time during his or her lifetime or upon his or her death, as the recipient of the trust property.
A limited power of appointment: The grantor designates a group of acceptable appointees.
You typically find powers of appointment buried deep within the actual trust instrument. If a single trust instrument contains the governing provisions for several different trusts, the power of appointment for each trust will be stated with the provisions that are specific to that particular trust. Powers of appointment can be exercised in the will of the power holder or in a separate document.
If a power of appointment isn’t exercised, the trust instrument will contain provisions for distributing the assets after the death of the trust beneficiary, so never fear, the assets don’t just sail off into the sunset if the surviving spouse forgets to exercise the power or otherwise ignores it.
Defer estate taxes for a noncitizen spouse: Qualified domestic trust
The unlimited marital trust is the norm, but it only works if the surviving spouse is a U.S. citizen. If the surviving spouse is a citizen of another country, you have to find a different way to skin this particular cat. And that way is the QDOT, or the qualified domestic trust.
The quick-and-easy description of a QDOT is that it’s a type of trust that allows a non-US citizen surviving spouse to defer, but not avoid, the estate taxes due upon the first spouse’s death until after his or her own death. Unlike the unlimited marital trust, though, you can’t make the assumption that all the assets will still be in the U.S. when the second spouse dies.
For a trust to qualify as a QDOT, it must meet the following conditions:
At least one trustee must be a U.S. citizen or a U.S. or state registered bank or trust company.
The estate’s executor must make an irrevocable QDOT election to qualify for the marital deduction on the federal estate tax return within nine months of the decedent’s date of death.
If the QDOT’s assets are $2 million dollars or less, no more than 35 percent of the value can be held in real property outside of the U.S. unless
The trustee is a U.S. or state regulated bank.
The individual U.S. trustee furnishes a bond for 65 percent of the QDOT’s asset value (based on the values at the decedent’s date of death).
The U.S. trustee furnishes an irrevocable letter of credit from a banking institution to the U.S. government for 65 percent of the value.
If the QDOT’s assets are more than $2 million dollars, then either
The U.S. trustee must be a U.S. or state regulated bank or trust company.
The individual U.S. trustee is required to furnish a bond of 65 percent of the QDOT’s asset value as of the decedent’s date of death.
The individual U.S. trustee must furnish an irrevocable letter of credit issued by a banking institution to the U.S. government for 65 percent of the value.
The easiest way around the QDOT regulations is for the surviving spouse to become a U.S. citizen before the filing deadline (nine months after date of death) for the Form 706, Estate Tax Return.
Tighter control: Marital estate trust
The marital estate trust may be funded with almost all the deceased spouse’s estate, just like the unlimited marital trust. However, the terms of a marital estate trust are typically less freewheeling. You as the trustee may have the discretion to distribute income as well as principal. At the death of the surviving spouse, who is also the trust beneficiary, the assets are paid directly into his or her estate.
Rein in the surviving spouse: Qualified terminable interest property trust (QTIP)
This trust has nothing to do with cotton swabs. Instead, the qualified terminable interest property trust (QTIP) beneficiary receives the net income (paid at least annually) but is not required to receive any of the principal, during lifetime.
Unlike the unlimited marital trust, where the trust beneficiary designates where the principal goes during his or her lifetime or after his or her death, the grantor of a QTIP trust makes that determination in the trust instrument. The trust beneficiary, the surviving spouse, has no say.