What Are Marital Trusts?

Considering the tax and non-tax implications of spousal gifts

May 07, 2024

This is a continuation of the series on everything you ever wanted to know about estate planning trusts. For an intro and index to this series, please click here. The linked article will have a series index that gets updated periodically as well, so please bookmark it.

Background

In a prior article, we discussed the credit shelter trust (also sometimes known as a family trust, bypass trust, disclaimer trust, or B trust when funded at death, and also a SLAT when funded during life). This type of trust is traditionally used in a married couple’s estate plan to capture, at first death, the unused estate tax applicable exclusion amount available to the deceased spouse’s estate. This inflation-adjusted amount is currently $13,610,000 (from a base of $10,000,000), but the inflation base is set to be reduced to $5,000,000 in 2026 if Congress takes no action to change it between now and then. With inflation adjustments, this should take the 2026 exclusion down to ~$7,300,000.

What do we do, however, if the adjusted gross estate of the first spouse to die exceeds their remaining applicable exclusion amount? Do we incur estate tax?

Generally, with prudent planning, the answer is no. But, getting there requires the use of either the unlimited estate tax marital deduction, or the unlimited estate tax charitable deduction, to zero out estate tax. This article focuses on practical deployment of the estate tax marital deduction.

Spousal Gifts

Frequently, transfers to a surviving spouse have no strings attached. These come in the form of an outright transfer under a will or trust, or sometimes a transfer outside of the will or trust (by beneficiary designation or right of survivorship). Community property rights can also create an outright spousal transfer. This is the basic structure of the “sweetheart” estate plan.

But, the sweetheart plan has its shortcomings owing to the fact that the surviving spouse is free to transfer the now-combined estate - their assets plus the deceased spouse’s assets - how they wish. This level of control, especially over the deceased spouse’s assets, allows the surviving spouse to completely change the estate plan of the deceased spouse. The following are some issues that can arise:

In a blended family, the surviving spouse could intentionally or unintentionally disinherit the children of the deceased spouse if they are not also children of the surviving spouse.
In the event of remarriage, the assets could go to a new family, intentionally (through a change to the estate plan) or unintentionally (through the creation of an elective share, or commingling to create community property, for the benefit of the surviving spouse’s widow).
The assets of the deceased spouse, in the hands of the surviving spouse, are exposed to judgment creditors and divorce claims (in the event of remarriage).

These issues can be overcome by the use of a trust. But, trusts do not automatically qualify for the estate tax marital deduction. Why? Because of the terminable interest rule.

Terminable Interests

Terminable interests are a confusing concept. Generally, a terminable interest includes any property interest of the surviving spouse that will terminate during the life of the surviving spouse, or at the surviving spouse’s death.

Since a surviving spouse’s interest in a lifetime trust terminates at their death, this would usually be a terminable interest.

Likewise, a spouse’s interest in a term-limited trust (like a GRAT or QPRT) that terminates during the spouse’s life would be a terminable interest.

(Another important point is that a survivorship condition must be limited to 6 months or less in order to avoid being classified as a terminable interest.)

Simply being a terminable interest is not the end of the road, however. The significance in this context is that the estate tax marital deduction can only apply to a deductible terminable interest.

There are a handful of trust structures that are treated as deductible terminable interests (and thus qualify for the estate tax marital deduction). These include:

The qualified terminable interest property (QTIP) trust;
The general power of appointment trust;
The estate trust;
The qualified domestic trust (QDOT); and
The charitable remainder trust.

Of these trusts, the first four are usually considered to fit this broad category we are calling “marital trusts.” Put differently, a marital trust can usually be considered to be a trust that qualifies for the estate tax marital deduction.

(Although certain charitable remainder trusts qualify for the marital deduction, we will not lump them in because they actuarially split their estate tax deduction between the marital deduction and the charitable deduction. This will be a discussion for a different set of articles.)

Before diving in, we should consider the general structure that is common to the first two trusts – the QTIP trust and the general power of appointment trust – as well as the QDOT. In a substantial majority of cases, marital trusts will use these structures and thus have the same basic chassis.

Life Estate Chassis

Generally, marital trusts will be built around a chassis of a life estate under IRC Sections 2056(b)(5) or 2056(b)(7). This means that the following requirements must be met before a marital deduction can be applied to the trust:

1.      The spouse must be the sole beneficiary for life.
2.      All income must be distributed to the spouse, at least annually. In this vein, a spouse’s unrestricted right to use property (like a residence) free of rent can suffice. Likewise, an unrestricted power to withdraw income may suffice.
3.      No principal distributions are required, but principal cannot be distributed to anyone other than the spouse during the spouse’s life.
4.      No third party can have a power to appoint principal to anyone but the spouse, either during the spouse’s life or at the spouse’s death.

While not directly stated as a requirement, it is important to note that the marital deduction acts as an estate tax deferral method instead of an estate tax avoidance technique. This means there is a trade-off requirement that the remaining assets of the marital trust be included in the spousal beneficiary’s gross estate for estate tax purposes at their death. The method of gross estate inclusion determines how the various trusts above differ. Likewise, a lifetime relinquishment of the spouse’s interest in the marital trust is treated as a taxable gift of the principal of the trust.

For the general power of appointment trust, the spousal beneficiary must hold a general power of appointment. While there is no requirement of specific appointees, this generally means that the spouse’s estate and/or creditors must be included as permissible appointees in order to create a valid general power of appointment. And, while the estate trust does not require a power of appointment, the balance is paid to the spousal beneficiary’s estate at death – creating the functional equivalent of a general power of appointment.

There are no requirements with regard to the remainder beneficiaries of the marital trust. This allows the deceased spouse to “lock in” their desired remainder beneficiaries, such as in a blended family or remarriage, to prevent disinheritance. But, a power of appointment gives the spousal beneficiary the power to reduce or eliminate the interests of remainder beneficiaries depending on the class of permissible appointees. This possibility should be taken into account when considering the structure of a power of appointment, and this usually means that the general power of appointment and estate trust structures are not optimal for achieving this outcome. Use of exclusionary powers of appointment may be key.

Another issue that arises has to do with the spouse’s guaranteed income right. Distributions of net (accounting) income must be made at least annually. While more frequent distributions are permitted, there is no requirement that the marital trust assets actually generate income. But, the spouse must be given the right to require the trustee to sell “unproductive” property that is not generating income, and reinvest the proceeds in income-producing “productive” property. For this reason, business interests and heirloom assets (which the deceased spouse wishes to preserve for remainder beneficiaries) may not be a good fit for marital trusts.

Overqualification of Marital Deduction

Before the portability election was created, overqualification of the marital deduction was a concern. Why? Because transfers qualifying for the marital deduction do not use the applicable exclusion of the deceased spouse. Without a portability election, this unused exclusion is lost.

While portability does indeed “save” some or all of the deceased spouse’s unused exclusion (while also creating greater basis step-up opportunities at the surviving spouse’s death), choice of marital trust also drives some of this potential overqualification of the marital deduction. The choice becomes whether the marital deduction automatically applies, or if there is an option to use the marital deduction for some or all of the trust assets. As we will find out, only one marital trust creates this choice.

General Power of Appointment Marital Trust

As noted above, one choice of structure for a marital trust that qualifies for the marital deduction (as a deductible terminable interest) is a combination of (1) the life estate chassis, and (2) a general power of appointment granted to the beneficiary spouse.

For this type of structure, the marital deduction automatically applies to every dollar of value added to the trust that is subject to the general power of appointment. This increases the risk of overqualification of the marital deduction, and requires the use of either a (1) portability election or (2) a spousal disclaimer (a topic to be covered another time) to avoid overqualification. It is this general power of appointment that achieves the required gross estate inclusion for the beneficiary spouse under IRC Section 2041.

Many older estate plans used the general power of appointment trust, as it predated the QTIP trust structure. For those drafters who grew accustomed to this type of trust, it can sometimes be blindly included in estate plans.

QTIP Trust

This is now the most popular choice of marital trust. No power of appointment – general or special – need be created. Instead, we have two basic requirements for the application of the marital deduction: (1) the life estate chassis, and (2) an election to treat specific trust assets, or all trust assets, as qualified terminable interest property on Schedule M of Form 706.

Note that if a general power of appointment is granted to the beneficiary spouse, the QTIP election will not be possible. But, a spouse can be given a special power of appointment.

One might ask, if inclusion in the gross estate of the surviving spouse is a requirement, how can this be accomplished if there is no general power of appointment? The answer lies in IRC Section 2044, which generally requires QTIP-elected property to be included in a surviving spouse’s gross estate. Further, IRC Section 2519 treats a disposition of QTIP during the spouse’s life as a gift of the QTIP property itself, instead of a gift of the income interest/life estate.

The QTIP trust creates additional flexibility, but with the trade-off of requiring the filing of IRS Form 706 at the first spouse’s death. Note, however, that the return does not have to be timely – the Regulations simply require that the first filed 706 include the QTIP election. But, if the 706 also contains a portability election, there is a time limitation. Likewise, if a 706 is required, there could be penalties for late filings.

In this vein, however, the true flexibility lies in the choice of which spouse’s applicable exclusion to use. The QTIP election is like a light switch, on an asset-by-asset basis (or even for portions of assets). If the election is made, it will use the exclusion of the surviving spouse through the application of IRC Section 2044. If the election is not made, it will use the exclusion of the first spouse to die.

And, for the non-elected assets (i.e., the assets or portions thereof for which the QTIP election is not made), these assets do not have to continue to be administered under the life estate chassis. They can be added to a credit shelter trust, or administered as a share of the marital trust which abandons the life estate chassis (often to mirror terms like a credit shelter trust). This election of an alternative trust structure for non-QTIP-elected assets is often known as a Clayton QTIP election.

Note, however, that both the QTIP election and Clayton QTIP election must be made by the executor of the estate of the first spouse to die. Often, this executor is the surviving spouse. Some authority suggests that the surviving spouse, as executor, should not make the Clayton QTIP election. Instead, having an independent executor make this election is safest. Why? Because this avoids a deemed gift by the surviving spouse.

It is also important to note that co-ownership between a marital trust, and other individuals or trusts, can force a discount.

QDOT

QDOTs will be discussed in a separate article. For the time being, however, a QDOT reflects the only way to claim an estate tax marital deduction for a transfer to a spouse who is not a U.S. citizen at the time of the transfer (or subsequent election). This trust uses a life estate chassis, but is coupled with certain requirements of a U.S. trustee, withholding of deferred estate taxes on distributions, limitations on use of DSUE by the beneficiary spouse, and a required election on Form 706. Unlike the QTIP trust, no partial QDOT election is possible.

Estate Trust

The estate trust is not often used, but does exist as an alternative. This trust is described in Treas. Reg. 20.2056(c)-2(b)(1). Subparagraph (iii) of this Regulation describes a structure whereby income is accumulated for the spouse’s life or a term of years, with the remainder (including all accumulated income) payable to the spouse’s estate.

Perhaps the hallmark of this trust is an abandonment of the life estate chassis, as the spouse no longer has to be given a lifetime income right (and, ergo, does not have to be given the right to demand that the trustee convert nonproductive property into productive property). But, the trade-off is the payment of the remainder to the spouse’s estate, which sends all of the common non-tax goals and flexibility goals of the marital trust out of the window.

Perhaps a use case for this type of trust would be for business interests with a mandatory buy-out (by redemption and/or cross-purchase) at the surviving spouse’s death, where the spouse’s control (through their estate) of the proceeds of the sale of the buy-sell is of less importance than control (through the buy-sell) of the business interest itself.

Conclusion, And What’s Next

Marital trusts are extremely common in estate planning for married couples, even where a couple’s net worth does not suggest possible estate tax issues. But, this article only tells part of the story. Fully understanding marital trusts requires understanding the methods of funding between the marital trust and credit shelter trust. Traditional estate plans use written funding formulas, while more modern estate plans may abandon formulas in favor of elections by the spouse and/or executor at first death such as the QTIP election, reverse QTIP election (for GST tax purposes), portability election, spousal disclaimer, and/or Clayton QTIP election.

In this vein, there are often formulas applicable at both deaths – one to balance between the marital trust and credit shelter trust, and the other to balance the combination of these trusts and the surviving spouse’s estate into descendants’ trusts. Coming up, we will explore these funding formulas and their permutations – including choice of property (including income accumulated within the estate prior to funding the trusts), income tax effects, and the balancing of deductions between the 706 (if any) and the 1041. We will also explore ways to assist a surviving spouse in navigating these various elections, especially for plans that have abandoned the traditional funding formula(s). There will also be a broader series on zeroing out estate tax for unmarried individuals.

(Most of these upcoming articles will be for paid subscribers, given the complexity of the material.)