Marital Trusts: More Useful, and More Flexible than Ever!

Written by: Wills, Trusts, & Estate Administration

Prelude/Spoiler Alert:
Two of my earlier blogs 12-18 months ago mentioned the ‘tie in’ between marital trusts and the exemption amount. The point of both of those, and this article, is that if your Will contains a credit shelter trust (a/k/a “bypass” trust), and/or a marital trust, and is more than a couple or three years old, you should review it. And if its more than 5 years old (ie, prior to ‘portability’ which was enacted at the end of 2012), it is even more imperative that you seek a review. Failure to do so can have some truly unintended, and perhaps very disappointing, or even disastrous, consequences for you and your spouse and loved ones!

Let’s start with a quick review of what we would refer to as “traditional” estate planning for a couple, which went largely unchanged in general approach throughout the 1980s, 1990s and well into the 2000s even to present. For a married couple, especially if a first marriage, and assuming some moderate net worth, one would frequently see a “one trust” or “two trust” Will. A “one trust” Will generally meant a credit shelter, or “bypass” trust. A “two trust” Will generally meant the bypass trust, along with a marital trust, known as a QTIP (qualified terminable interest property) trust.

A marital QTIP trust is a trust in which assets are held solely for the benefit of the surviving spouse. The surviving spouse is required to receive all of the income, and any encroachments on principal can be only for the spouse. There is no other permissible beneficiary during the lifetime of the surviving spouse. Upon the death of the surviving spouse, the assets then generally pass to the children.

It’s worth a quick moment to review the tax difference between a Bypass and a Marital trust.

A. Bypass Trust. The purpose of a “bypass trust” was and is to utilize the estate tax exemption of the first spouse to die to take the maximum amount of assets that a decedent could pass to someone other than his or her spouse without incurring estate taxes and hold it in trust. (This was especially important back prior to 2013, because the exemption was “use it or lose it”). This trust could provide for the spouse, and also the children. The tax benefit of the bypass trust was that the creation of this trust resulted in the exclusion of the initial funding amount, as well as the growth thereon, from federal estate tax in the estate of both the first and the second spouse to die. The tax detriment of these trusts was that since the assets (and their growth) were not included in the taxable estate of the second spouse to die, the assets, when eventually paid out to the children, did not receive a second step up in basis at the death of the second spouse, such that the children inherited the assets with built in appreciation that had accrued since the date of the first spouse’s death, such that a capital gain tax would be incurred upon a subsequent sale.

B. Marital Trust. The purpose of a Marital Trust was to hold whatever assets exceeded the exemption amount with which the Bypass trust was funded. As noted above, this Martial Trust, if elected as a QTIP trust, (as was nearly always the case), could by law benefit only the spouse for life. These assets were then included in the taxable estate of the second to die spouse, such that they received a second step up in basis at the death of the surviving spouse.

The same as with any other trust, there were, and are, countless reasons why one might want to utilize a marital trust. These include: (i) traditional tax reasons—to include the assets in the second to die’s estate to achieve a second step up in basis; (ii) to protect assets from potential future creditor claims of the surviving spouse; (iii) to protect the assets from a subsequent marriage of the surviving spouse; (iv) to provide for the spouse, but prevent the spouse from having direct or absolute control over the assets or how they are invested; (v) the ability to benefit the surviving spouse, but still be able to control the final disposition of the assets.

That’s a lot of background. But its important background! Now to the real point. First, understand that all QTIP trusts are“marital trusts,” but not all marital trusts are “QTIP” trusts….

WHY, you ask, do you care? Or WHY am I trying to convince you that maybe you should care? There are two main reasons.

First, (and its worth repeating) as pointed out in some prior blogs, in light of the dramatically increased estate tax exemption, and combined with the portability of the exemption between spouses, you may in fact want to force all assets into the surviving spouse’s estate in order to achieve the second step up. This is directly contrary to most of the traditional planning of the last 30-40 years; the goal then was to force the maximum amount first into the bypass trust. (And if you have a Will that is just a mere decade old, which contained a typical formula provision, what would have gone in the bypass trust in 2008 was the first $2 million of your assets; now, in 2018, it’s the first $11.2 million!!)¹⁾

Second, In light of the estate tax exemption recently increasing from $5,000,000 indexed for inflation, to now being $11,000,000 indexed for inflation, there is simply much greater flexibility than we’ve ever had, such that we might not look only at a typical bypass trust or traditional marital QTIP trust.

By way of illustration: previously, only the “bypass” trust could benefit the spouse and children. The marital trust, if elected as QTIP, could only benefit the spouse (and that remains the case). In other words, in many moderate sized estates of several million dollars, there was generally no tax effective way to achieve a second step up in basis at the death of the second spouse, while also benefitting both the spouse and children in the same trust under a typical/traditional two trust Will where we were planning with much lower estate tax exemptions. You could benefit spouse and children (bypass trust) or get a second step up (marital trust), but generally not do both.

However, now, if you are not bumping up against the $11,000,0000 estate tax exemption, you may can have the best of both worlds. You might create a trust where the spouse is the primary beneficiary and receives all the income. You might give the spouse the power to appoint assets among the children during the spouse’s life or even have permissible encroachments for children. Finally, you might give the spouse a testamentary general power of appointment. You wouldn’t have likely seen this combination of factors in a trust for the benefit of a spouse 10 or even 5 years ago, as this would not have (and still does not) qualified for QTIP, and with a much lower exemption amount and the fact that the exemption wasn’t portable, one might have unnecessarily incurred estate taxes. Now, however, it might be ideal to do this. Such a trust will not qualify for the marital deduction because it does not meet the QTIP requirements. And it will ‘waste’ the exemption amount of the first spouse to die because of the power of appointment which will force inclusion in the estate of the second spouse to die. But if you are not close to the exemption limit, a waste of the exemption is not a problem, and you create a second step up in basis, while still having most of the protections of a marital trust, and the flexibility in beneficiaries of a bypass trust!

In closing, this article is not meant to imply that ‘traditional’ estate planning is a thing of the past. Nor that your Will is ‘bad’ if it contains a traditional QTIP marital trust. Nor that it’s the end of the world if your Will contains a Bypass trust. Instead, this article should be taken for the premise that there have been major, truly significant, changes in the estate tax laws in the last 3 to 5 years, more so than at any time in the last 30 years, and if your Will does have a Bypass Trust, or a QTIP trust, and is older than a couple of years, you absolutely should seek a review with your estate planning attorney.