Articles for Financial Advisors

Marital Deduction Trusts

Marital Deduction Trusts

Marital deduction trusts are similar to QTIP trusts in that taxes on trust property can be postponed until the death of the surviving spouse and the surviving spouse is the life beneficiary of the trust. Before QTIP trusts, marital trusts were the only way to obtain the full marital (unlimited) deduction and retain control of the property during the surviving spouse's life. 

Today, the QTIP trust has replaced these trusts in popularity, but marital deduction trusts may still be useful in situations where one of their special features is desired. Your client may want to create a marital deduction trust if the client wants: [1] the spouse to be able to give away trust principal to someone else (i.e., child) during the spouse’s lifetime; [2] the spouse can choose who will inherit trust property after his/her death; [3] the trust can hold non-income-producing property; or [4] the trust can hold property such as a business and will need to reinvest the income, rather than pay it regularly to the surviving spouse.
Marital deduction trusts are quite technical and must comply with applicable tax law and IRS rules. These trusts must be drafted by experts experienced with this type of trust. Like a QTIP, one spouse creates a trust, naming the other spouse the life beneficiary. Trust property qualifies for the marital deduction, so no estate tax on property in the trust is paid when the first spouse dies. The trust property that remains when the second spouse dies is included in the taxable estate of that spouse. There are two types of marital deduction trusts (see below).

Power  of  Appointment  Trusts

A power of appointment trust names the spouse as the lifetime beneficiary. As in a QTIP trust, the spouse is entitled to receive trust income and can require trust property be converted to income-producing property. But with this type of trust, you must also give the surviving spouse either the right to invade the trust principal for any reason or to name the beneficiaries that will receive the trust property when the surviving spouse dies or during his/her life. This is called a power of appointment. This is in direct contrast to a QTIP trust, where your client would normally limit the right to invade principal and name the final beneficiaries.
The flexibility of invading principal and giving gifts of principal can be very attractive. When you prepare your trust, it may not be at all clear whether your surviving spouse will need access to the trust principal. Perhaps one or more of the final beneficiaries will genuinely need some of the trust principal while the surviving spouse is alive. One way to handle these uncertainties is to create a power of appointment trust and give the spouse power to make gifts of principal.
The spouse does not have to have both an unlimited power to invade principal and a power to name beneficiaries. Just one of the powers, such as the power to choose who inherits trust property, is all that is required. The trust document could name only certain people (such as children) who could receive principal. Or, your client can choose not to grant the power to invade principal to anyone, including the spouse. The surviving spouse does not have to use the powers granted by the trust document. 

Estate  Trusts

An estate trust is a type of marital deduction trust requiring that when the surviving spouse dies, all remaining trust principal must go into his/her estate. This means the surviving spouse gets to choose the final beneficiaries, by will or within a living trust. Estate trust property will go through probate on the death of the surviving spouse. What makes this trust special is trust property can be, and remain, non-income producing. In all of the other trusts that defer taxes because of the marital deduction (including QTIP trusts), this is not possible.
The other special feature of an estate trust is that when the trust property does produce income, it does not have to be paid out to the spouse. At the trustee’s option, income can be accumulated, increasing trust principal. If this occurs, income is taxed at trust tax rates (very bad). This disadvantage may be offset by allowing for business growth or other investment purposes.

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