A key element of the unified estate and gift tax system is the unlimited marital deduction. The estate and gift tax structure permits essentially unlimited transferability of property between spouses (gifts during lifetime and transfers upon death) free of any tax. This policy is embodied in the gift tax marital deduction, and the estate tax marital deduction, a deduction allowed from the gross estate for property interests which are includable in the gross estate but which pass from the decedent to his or her surviving spouse. The marital deduction is set forth in Internal Revenue Code I.R.C. §2056. A "qualified domestic trust" is necessary as a means to utilize the marital deduction when a spouse is not a U.S. citizen.
Property can be transferred back and forth between spouses without gift tax consequences and transferred to the surviving spouse upon the death of the first spouse to die, without estate tax consequences. Only upon the death of the second spouse will the "family unit's" wealth be taxed (except to the extent that property may have been transferred outside the family unit (i.e., other than to the surviving spouse) when the first spouse died. It should be noted that transfer by the first spouse to die, of his or her entire gross estate to the surviving spouse, although it will eliminate any estate tax when the first spouse dies, may not be desirable from a longer-range estate planning viewpoint. A will creating a credit shelter trust (sometimes referred to as a bypass trust or family trust or non-marital trust) can result in estate tax savings by taking full advantage of the unified credit in the estates of both spouses (without relying on portability) thus sheltering from estate taxation an amount equal to two times the applicable exemption amount.
Consistent with this approach, the unified transfer tax system assumes -- and indeed, attempts to assure -- that any of the property of the first spouse to die, which passes tax free under the marital deduction to the surviving spouse, will be includable in the gross estate of the surviving spouse when he or she dies. In this respect the unlimited marital deduction is essentially a mechanism for deferral of tax which might otherwise be payable upon the death of the first spouse to die.
In order to qualify for the marital deduction the subject property must have been included in the decedent's gross estate and have passed from the decedent to his or her surviving spouse. For this purpose, property is deemed to qualify as passing from the decedent to the surviving spouse only under seven possible circumstances set forth in I.R.C. §2056(c):
by bequest or devise from decedent;
by inheritance from decedent;
through dower or curtesy rights, or their statutory equivalent, under local law;
by transfer from the decedent during lifetime (in a manner which caused the transferred property to be includable in the gross estate; e.g., a gift "with strings attached" under I.R.C. §2036, 2037 or 2038);
by accession to decedent's share of jointly owned property, through joint tenancy with right of survivorship;
by exercise of a power of appointment by the decedent, or by the surviving spouse's taking by reason of non-exercise of such a power over the property;
by receipt of insurance proceeds on the life of decedent.
Transfers to a surviving spouse which qualify for the marital deduction may take a variety of forms, from outright full ownership, to various trust arrangements in which the surviving spouse (or his or her estate) receives, or has the right to direct the disposition of, the benefits of ownership. In essence, the surviving spouse must have an interest sufficient to cause the trust property to be included in his or her gross estate when he or she dies.
If the interest passing to the surviving spouse is subject to possible termination (with the beneficial enjoyment passing to another party) at some future point, the spouse's interest is not considered sufficiently vested in the spouse to give rise to the marital deduction. For example, if the surviving spouse were to receive beneficial ownership for only five years, and then the property is to pass to someone else, a marital deduction cannot be taken for the value of the property (or even for the present value of the five-year interest). This type of interest and other interests in a surviving spouse which may terminate by passage of time, the happening of a contingency, or the failure of an event or contingency to occur, are referred to as "terminable interests." Because of the possibility that the interest of the surviving spouse may terminate before his or her death, it would be inappropriate to assume that the value of the property will eventually be included in his gross estate, and thus, it must be included in the gross estate of the first to die (i.e., no marital deduction is allowable). This general principal is sometimes referred to as the "terminable interest rule." There are exceptions to the general rule that a terminable interest does not qualify for the marital deduction. These are spelled out in I.R.C. §2056(b)(5), dealing with situations in which the surviving spouse holds a power of appointment; §2056(b)(7), dealing with life estates which can be made "qualified terminable interests" by election; and §2056(b)(8), dealing with "qualified charitable remainder trusts." A critical common element is that the property in question will eventually be included in the surviving spouse's gross estate or pass to charity.
Forms of Property Transfer to Surviving Spouse
Property transfers to a surviving spouse, qualifying for the marital deduction, may be in the form of outright transfer of full ownership or a variety of trust arrangements, utilized to meet certain specific objectives, depending on factual circumstances. Again, an essential element of any such transfer in trust is that the trust be established in such a manner that the property of the first spouse to die will eventually be included in the gross estate of the surviving spouse.
This is the most straightforward accession of ownership by the surviving spouse. No trust is involved, and the survivor merely takes unrestricted outright legal title. This could occur, for example, through direct transfer from the decedent by will or survivorship with respect to joint tenancy property.
Power of Appointment Trust
Property is transferred to a trust which provides for income to be paid to the surviving spouse for life, with the spouse being granted a general power of appointment over the property. Although this is technically a terminable interest, it is specifically excepted from the terminable interest rule by §2056(b)(5); the exception is based upon the fact that the subject property will ultimately be includable in the gross estate of the surviving spouse by reason of the power of appointment. I.R.C. §2056(b)(5) contains specific requirements in order for such a transfer to qualify for the marital deduction. The surviving spouse must be entitled to all of the income for life, payable at least annually. He or she must have a power of appointment over the property, which may be exercisable during lifetime or by will (or either) in favor of himself or herself or his or her estate. (Although §2056(b)(5) requires that the power of appointment be exercisable in favor of the surviving spouse/power holder or his or her estate, it does not use the term "general power of appointment," which is defined in §2041. Under that definition a power of appointment is a "general" power of appointment if it can be exercised in favor of the power holder, his/her estate or creditors of either of them. Thus, whereas a power to appoint to creditors but not to the power holder or his/her estate directly would qualify as a general power of appointment, it would not qualify the power of appointment trust for the marital deduction under §2056(b)(5).) The power of appointment must be exercisable by the surviving spouse alone and in all events. No other person may have a power to appoint to someone other than the surviving spouse. This type of trust arrangement, with the power of appointment exercisable by will only, might be desirable as an alternative to outright ownership in situations where the decedent has doubts about the surviving spouse's ability to deal appropriately with the property during his or her lifetime.
A variation on the power of appointment marital deduction trust is the so-called "estate trust." In the case of an estate trust the income from the trust property goes ultimately for the exclusive benefit of the surviving spouse, but the trustee has discretionary authority over whether to distribute income currently or to accumulate the income, adding it to the trust corpus. In any event the trust property, including any previously undistributed income, goes to the estate of the surviving spouse on his or her death. See Regs. §2056(e)-2(b)(1).
Qualified Charitable Remainder Trust
Suppose that a decedent's will establishes a trust which provides for annual distribution to the surviving spouse of an amount equal to 5 percent of the net market value of trust assets, and upon his or her death, the trust corpus is to be distributed to the American Red Cross. Technically, the property interest given to the surviving spouse is a terminable interest, since it will end when he or she dies. The general terminable interest rule would prevent the first decedent from claiming a marital deduction for the value of the surviving spouse's life income interest. However, §2056(b)(8) provides an exception when the holder of the remainder interest (following the interest of the surviving spouse) is a qualified charity. This exception is based upon the fact that if the property is going to ultimately pass to a qualified charity, and therefore, would be deductible from the gross estate of the surviving spouse (and would be deductible from the first decedent's gross estate if given outright to the charity, without the spouse's intervening life estate), there is no reason to subject the property to tax in the estate of the first decedent, who made the split-interest transfer. The effect of §2056(b)(8) is simply to eliminate any technical impediment to the complete deductibility of a split-interest transfer, where the only recipients of interests in the property are a surviving spouse and one or more qualified charities. In order for §2056(b)(8) to apply, the remainder interest in the charitable organization must be such that it would qualify for the gross estate charitable contribution deduction of I.R.C. §2055 as an interest in either a charitable remainder annuity trust or a charitable remainder unitrust.
Qualified Terminable Interest Property ("QTIP") Trust
As previously mentioned, one of the exceptions to the terminable interest rule is the election permitted under §2056(b)(7) with respect to "qualified terminable interest property," often referred to as the "QTIP" election. In general, a QTIP election will allow the marital deduction to be taken with respect to property as to which the surviving spouse has been given a life income interest, but which passes to another party upon the surviving spouse's death. Such an interest in a surviving spouse is a terminable interest within the general rule of §2056(b)(1), and absent the QTIP provision, no marital deduction would be available. This is consistent with the underlying rationale of the terminable interest rule because the terminable interest property would not be includable in the gross estate of the surviving spouse (absent a general power of appointment). The QTIP election permits the personal representative of the estate of the first spouse to die to make an election, the effect of which is to allow the marital deduction for property not otherwise deductible, in return for acceptance of the consequence that the property will later be included in the gross estate of the surviving spouse. The inclusion of QTIP property in the gross estate of the surviving spouse is mandated by I.R.C. §2044.
In order to qualify for the QTIP election, certain conditions must be met. The property must pass from the decedent, and the surviving spouse must have a qualifying income interest for life. The surviving spouse has a qualifying income interest for life if he or she is entitled to all of the income from the property, payable annually or at more frequent intervals (or has a usufruct interest (in general, the term "usufruct interest" means the right to enjoy the physical fruits of (as opposed to rental income from) real property. For example, the right to harvest crops or to exploit mineral resources for life in the property), and no person has a power to appoint any part of the property to any person other than the surviving spouse (unless exercisable only upon or after the surviving spouse's death). The personal representative of the estate must make the election in the estate tax return, and the election is irrevocable. The election may be made as to the entire amount of the subject property (as to which the surviving spouse holds the requisite life estate), or as to any specified fractional or percentage portion. Any such partial election must be in terms of a fractional or percentage share of the property (rather than a stated dollar amount) so that the portion as to which the election is made will reflect the proportionate share of any increase or decrease in value when it is ultimately included in the surviving spouses gross estate. The fraction or percentage may be defined by means of a formula. This ability to make a QTIP election as to any proportionate share of the trust is a significant post-death planning tool.
The significant difference between the QTIP trust under §2056(b)(7) and the power of appointment trust under §2056(b)(5) is that under the power of appointment trust the property will be brought into the surviving spouse's gross estate by reason of his or her possession of a general power of appointment, whereas, with a QTIP trust, the surviving spouse need not have a power of appointment, the property being includable in his or her gross estate by reason of the QTIP election having been made. In this respect the QTIP trust is particularly useful in situations where the decedent wishes to direct the disposition of the property after the death of the surviving spouse, and does not want the surviving spouse to have the power to change it (through exercise of a power of appointment). QTIP trusts are often used where an individual's children of a prior marriage are to be his or her ultimate beneficiaries, however, the decedent wants to take full advantage of the marital deduction.
In order to satisfy the requirement that the surviving spouse holds an income interest for life in a power of appointment trust or a QTIP trust, the trust provisions may not impose restrictions on the spouse's degree of beneficial enjoyment of the trust property which are inconsistent with the normal rights of a life beneficiary under the general law of trusts. Thus, the requirement that the surviving spouse be entitled to all of the income will not be satisfied if the primary purpose of the trust is to safeguard property without providing the spouse with the required current beneficial enjoyment. This would apply to trusts which expressly provide for the accumulation of income and trusts which indirectly accomplish a similar purpose. For example, assume that the trust consists substantially of property which is not likely to produce income during the life of the surviving spouse. An interest passing to such a trust will not qualify for the marital deduction unless the applicable trust law and rules for trust administration require, or permit the life beneficiary to require, that the trustee make the property currently productive or convert it to alternative income-producing property. In general, the designation of the surviving spouse as sole income beneficiary for life will be sufficient to qualify the trust unless the terms of the trust and the surrounding circumstances considered as a whole evidence an intention to deprive the spouse of the requisite degree of enjoyment.
Qualified Domestic Trust
As previously mentioned, a transfer to a surviving spouse who is not a U.S. citizen will not generally qualify for the marital deduction. Since the marital deduction is merely a deferral privilege, it presumes that the property of the first spouse to die will eventually be taxed as part of the estate of the surviving spouse. However, this critical presumption may well not be applicable when the surviving spouse is not a U.S. citizen, since there is a material risk that the original decedent's property will be removed from U.S. taxing jurisdiction before the death of the surviving spouse. See Qualified Domestic Trust.