Transfers between spouses are free from gift and estate tax by virtue of what is commonly referred to as the “unlimited marital deduction”. Thus, spouses may make unlimited lifetime gifts to each other, and may leave an unlimited amount at death tax free. The unlimited marital deduction is the reason that there is rarely any estate tax on the death of the first spouse to die.

To qualify for the marital deduction, a gift or bequest may not be “terminable.” That is, the transfer may not be subject to some future contingency such as the subsequent death or remarriage of the surviving spouse. For example, a transfer in trust for the surviving spouse “unless she remarries” does not qualify for the marital deduction.

Transfers which qualify for the marital deduction basically fall within three categories:

1. outright transfers to the surviving spouse;
2. transfers in trust for the benefit of the surviving spouse over which he or she has a “general power of appointment”, and
3. transfers into a Qualified Terminable Interest Property (“QTIP”) trust. Outright transfers are self-explanatory.

POWER OF APPOINTMENT TRUSTS

A transfer in trust over which the surviving spouse has a general power of appointment can best be explained by example:

Husband has an estate of $800,000. He leaves $650,000 outright to his children and places the balance ($150,000) in a Marital Trust. The Marital Trust provides that all income and principal is to be used for the benefit of the surviving spouse during her lifetime with the balance remaining in trust at her death to pass to the beneficiaries she designates in her Last Will and Testament.

The Marital Trust in the example contains a general power of appointment since the surviving wife has the power to appoint beneficiaries of her choosing at the time of her death. The $150,000 principal of the Marital Trust qualifies for the marital deduction, thereby passing estate tax-free to the surviving spouse.

QTIP TRUSTS

The QTIP marital deduction is a recent creation (1981), and was designed to address the needs of the changing American family. The traditional forms of marital deduction described above (outright transfer and general power of appointment) were not thought to be appropriate in second marriage situations. It was believed that if the surviving spouse was required to have a general power of appointment or received an outright distribution of the marital portion, the surviving spouse would not name the first spouse’s children as beneficiaries of the balance of the Marital Trust at his or her death.

In second marriage situations, the QTIP trust strikes a balance between the financial needs of the surviving spouse and the deceased spouse’s wish to leave an inheritance to his or her children not of the marriage.

A QTIP trust does not permit the surviving spouse to appoint QTIP assets. Upon the death of the surviving spouse, the QTIP distributes to the beneficiaries named by the first spouse.

To be a qualified QTIP trust, the marital trust must meet the following conditions:

1. all income of the QTIP must be distributed to
2. the principal of the marital trust may not be used for any beneficiary other that the surviving spouse during the surviving spouse’s lifetime.

In second marriage situations, the QTIP trust strikes a balance between the financial needs of the surviving spouse and the deceased spouse’s wish to leave an inheritance to his or her children not of the marriage.

NON-CITIZEN SPOUSES

Special estate planning is required for non U.S. citizens. No marital deduction is available if the surviving spouse is not a U.S. citizen, and only a limited marital deduction is permitted for lifetime gifts to a non-citizen spouse. Thus, special planning is necessary where one or both spouses is not a citizen of the U.S. Often the best advice for couples who intend to permanently reside in the U.S. is to apply for and receive U.S. citizenship. Also, a Qualified Domestic Trust (“QDOT”) may be used to qualify for the marital deduction in situations where the non-citizen spouse does not wish to obtain U.S. citizenship. Property passing to a non-citizen spouse is eligible for the Unified Credit ($650,000 in 1999).

Estate tax on assets qualifying for the marital deduction is not forgiven, it is merely postponed. Assets qualifying for the marital deduction are included in the estate of the surviving spouse. Outright distributions are included in the surviving spouse’s estate since the surviving spouse is the outright owner of the asset. Assets over which the surviving spouse has a power of appointment are included by virtue of the rule which includes in the estate of the decedent all assets over which the decedent has a general power of appointment. QTIP assets are included in the estate of surviving spouse by virtue of a special Code provision requiring such inclusion.

Congress recognized that it would be unfair to include QTIP assets in the estate of surviving spouse, yet distribute such assets to the other spouse’s children. To solve this inequity, the Code allows the estate of the surviving spouse to recover the additional estate tax resulting from the inclusion of the QTIP assets in the surviving spouse’s estate from the QTIP beneficiaries.

For all of its apparent advantages, reliance on the unlimited marital deduction can actually result in higher overall estate tax. Without proper planning, the first spouse to die may simply leave everything to his or her surviving spouse. Although there would be no estate tax on the death of the first spouse to die, the couple may have set themselves up for a much higher tax on the surviving spouse’s death. By passing the entire estate to the surviving spouse, the couple would fail to take advantage of the $650,000 exemption equivalent (1999) of the deceased spouse. In larger estates (over $650,000), it is important that each spouse adopt a Revocable Living Trust to fully utilize each spouse’s Unified Credit.