Using IRAs to fund QTIP trusts.

• Author: Johnson, Linda M.
• Position: Qualifying income interest for life; minimizing estate tax liability

EXECUTIVE SUMMARY

* If a taxpayer and spouse have enjoyed a long, happy marriage and have common objects of affection, a QTIP trust may serve little purpose.

* The "qualifying income interest for life" requirement becomes more complicated when retirement assets, rather than stock or bonds, are used to fund a QTIP trust.

* Rev. Rul. 2000-2 allows spouses to let the excess of IRA earnings over the RMD remain in the IRA for the benefit of the remainder interest holders.

An IRA account may well be the largest asset in a taxpayer's estate; thus, it may be a natural choice for funding a qualified terminable interest property (QTIP) trust. However, such trusts are not for every client, and should be created and funded with care. This article examines important issues in funding a QTIP trust with an IRA, including a recent IRS pronouncement that liberalized some of the rules.

Good estate planning involves not only minimizing estate tax liability, but also ensuring that the taxpayer's nontax objectives are met. A qualified terminal interest property (QTIP) trust is a popular device that allows a taxpayer to provide a surviving spouse with the income from (or use of) property undiminished by estate taxes for life, while ensuring that the former's wishes will be followed after the latter's death. This is accomplished by qualifying the trust property for the estate tax marital deduction, even though a terminable interest exists. Many taxpayers may need to consider funding QTIP trusts with retirement assets. This article analyzes the requirements for effective use of a QTIP election for a trust funded by an IRA, in light of the liberalized distribution requirements set forth in Rev. Rul. 2000-2.(1)

When to Use a QTIP Trust

The decision to use a QTIP trust is a function of the relationships among the taxpayer, his spouse and the intended remainder interest holders. When a taxpayer leaves property outright to a spouse, it becomes the spouse's property to control; thus, the spouse decides the property's next owner. If a taxpayer and spouse have enjoyed a long, happy marriage and have common objects of affection, a QTIP trust may serve little purpose. In fact, a QTIP election may erode the control the surviving spouse has over the children. In such a case, a general power of appointment trust, qualifying under Sec. 2056(b)(5), might be more appropriate, permitting the spouse to appoint property to children according to need, while limiting amounts transferred to less needy or responsible offspring.

Sometimes, there are no common objects of affection. If a taxpayer has children from a prior marriage, conflicting testamentary wishes with a spouse or concerns about the spouse remarrying, the desire to ensure an intended distribution of assets may outweigh a QTIP trust's relative inflexibility. QTIP trusts are also useful when there is a significant age disparity between a taxpayer and spouse,(2) or when a taxpayer is concerned that the surviving spouse may not be competent to manage or conserve assets. Trusts that qualify for the marital deduction avoid probate at the surviving spouse's death, and defer the payment of estate taxes until that time. Thus, even if the surviving spouse has adequate assets for support, the estate tax deferral allows the estate to grow undiminished, while allowing for the possibility that the estate tax may be reduced of eliminated in the future.

The QTIP Election

Because Federal tax law requires that property be taxed at least once every generation, an estate tax marital deduction generally is not allowed for a terminable interest. According to Sec. 2056(b)(1), a "terminable interest" exists if an interest passing to a surviving spouse will terminate or fail on the occurrence (or failure to occur) of an event or contingency. Sec. 2056(b)(7) allows a marital deduction for a terminable interest when a surviving spouse receives a life estate in property for which a QTIP election is made.

This provision gives taxpayers the opportunity to both guarantee their nontax wishes and qualify for the marital deduction on property transferred to a surviving spouse.(3) Under Sec. 2056(b)(7)(B)(i), an estate tax marital deduction is permitted from the decedent's estate (even though a terminable interest has been transferred), if the following three requirements are met:

1. Property passes from the decedent.

2. The surviving spouse has a qualifying income interest for life in such property.

3. An election is made to treat the property as QTIP.

   The distributive arrangements specified in the QTIP trust cannot be changed by the surviving spouse. If a QTIP election is made, Sec. 2044 requires the fair market value (FMV) of the QTIP be included in the surviving spouse's estate.(4)

   The "qualifying income interest for life" requirement becomes more complicated when retirement assets, rather than stock or bonds, are used to fund a QTIP trust. When using nonretirement assets as QTIP, the income produced therefrom (e.g., interest and dividends) is distributable to the surviving spouse; the trust corpus is preserved for the remainder interest holders. When using retirement assets such as IRAs, the required minimum distribution (RMD) rules come into play; generally, the RMD differs from the IRA's annual earnings.

   RMDs

   Sec. 401(a)(9)(C)(i) requires a traditional IRA owner to begin receiving RMDs no later than April 1 of the year following the year he turns 70 1/2,(5) or incur a 50% penalty under Sec. 4974(d). Prop. Kegs. Sec. 1.408-8, Q&A-6, provides that each RMD equals the IRA balance on December 31 of the previous year, divided by the required distribution period. During an IRA owner's...