Reprinted from Volume 15, Number 6 (June 2003) - Probate Practice Reporter

By Jonathan E. Gopman 

A qualified terminable interest property ("QTIP") trust is a form of marital deduction trust permitted by §§ 2056(b)(7) and 2523(f) of the Internal Revenue Code (the "Code"). Under §§ 2056(b)(7)(B) and 2523(f)(2) of the Code, QTIP is any property that is transferred by a donor or decedent spouse (a "Donor") in which a donee or surviving spouse (a "Spouse") has a "qualifying income interest for life" and which is subject to a QTIP election. A Spouse has a qualifying income interest for life if the Spouse is entitled to all of the income from the property in such trust, payable at least annually, and no person has the power to appoint any property in the trust to any person other than to the Spouse. In drafting a QTIP trust, estate planners often fail to consider methods of optimizing the asset protection aspects of the trust. This article discusses a checklist of issues to consider when drafting a QTIP trust to enhance the asset protection aspects of the trust.

1. Distribution of Income during Spouse’s Life. Most QTIP trusts provide for the distribution of income on a quarterly or more frequent basis; however, mandating distributions in this manner is not required to qualify for the marital deduction. The terms of a QTIP trust or applicable local law need only direct the trustee to distribute income annually. More frequent distributions can be permitted under the terms of the trust, however, to enhance the asset protection aspects of the trust it is recommended that the discretion to make such distributions be given to a disinterested or independent trustee. For example, an income distribution provision in a QTIP trust could provide:

The Trustee shall pay the net income from the QTIP Trust, at least annually or at such more frequent intervals as the Independent Trustee deems appropriate, to the Settlor’s Spouse during his/her life.

A provision in the QTIP trust should also be included to fix the date for the mandatory distribution of income, e.g., December 31 of each year, with all other potential distribution dates during the year being discretionary distribution dates. A marital deduction savings clause is also recommended for inclusion in the document. (See e.g., Rev. Rul. 77-440, 1975-2 C.B. 372; TAM 199932001; and PLR 8440037.)

2. Manner of Distributing Income. Under Regulations §§ 20.2056(b)-5(f)(4) and 25.2523(e)-1(f)(3), income from a QTIP trust can be applied by the trustee "for the benefit of the spouse" rather than making a direct distribution of such income to a Spouse. To enhance the asset protection aspects of a QTIP trust, give the trustee the flexibility to apply the income for the benefit of the Spouse.

3. Distribution of Stub Income at Spouse’s Death. Many QTIP trusts provide for the payment of "stub income" to the Spouse’s estate. Stub income is the income earned during the period immediately following the last distribution of income and ending at the Spouse’s death. Under Regulations §§ 20.2056(b)-7(d)(4) and § 25.2523(f)-1(c)(1)(ii), distribution of such income is not required to qualify for QTIP treatment. To enhance the asset protection aspects of the trust, it should contain a provision directing its stub income to be distributed to the successor beneficiaries or successor trusts. A specific provision in the trust is recommended because the laws of many states direct stub income to be distributed to the Spouse’s estate. For example, Subsection (2) of Florida Statute § 738.303 provides in relevant part:

When a mandatory income interest ends, the trustee shall pay to a mandatory income beneficiary who survives that date, or the estate of a deceased mandatory income beneficiary whose death causes the interest to end, the beneficiary's share of the undistributed income that is not disposed of under the terms of the trust. (Emphasis added.)

By way of example, a provision in a QTIP trust directing stub income to be paid to the successor estate or beneficiary could provide:

Upon the death of the Settlor’s husband, the Trustee shall deal with the balance of the principal of the QTIP Trust, together with any net income then on hand, as provided in Article ____.

The stub income rule in Regulations §§ 20.2056(b)-7(d)(4) and § 25.2523(f)-1(c)(1)(ii) can also be used to enhance the creditor protection aspects of the Spouse’s mandatory income interest in the QTIP trust. In this regard, Subsection (1) of §155 of the Restatement 2d of Trusts provides in relevant part:

if by the terms of a trust it is provided that the trustee shall pay to or apply for a beneficiary only so much of the income and principal or either as the trustee in his uncontrolled discretion shall see fit to pay or apply, a transferee or creditor of the beneficiary cannot compel the trustee to pay any part of the income or principal.

Comment c to §155, however, provides that the foregoing rule applies only when the trustee may in its absolute discretion refuse to make any distribution to or for the benefit of a beneficiary. As previously mentioned, the income interest in a QTIP trust is a mandatory interest, meaning the income from the trust must be distributed to the Spouse annually as long as the Spouse is living. According to the comment, the rule set forth in §155 "is not applicable where the trustee has discretion merely as to the time of payment, and where the beneficiary is ultimately entitled to the whole or to a part of the trust property." According to the comment, the beneficiary’s interest may be reached by a creditor if the provisions of the trust agreement require the trustee to distribute to or apply for a beneficiary any portion or all of the income or principal of the trust. Thus, the question is whether a mandatory income interest in a QTIP trust can be designed to avoid the exception to the rule in §155 that is set forth in comment c. If structured properly, this should be possible. The mandatory income interest in a QTIP trust should be able to be designed so that the Spouse is not entitled to receive anything from the trust, whether income or principal, unless living on the mandatory income distribution date. To accomplish this result the stub income must be directed to be distributed to a successor beneficiary or trust rather than the Spouse’s estate. As previously explained, a QTIP trust may provide for distribution of its income on an annual basis and require the Spouse to be living on such date to receive the income. If the Spouse dies prior to the distribution date, the stub income can be required to be distributed to a beneficiary other than the Spouse’s estate. In such a case, it is unlikely that a creditor should have the ability to reach the Spouse’s income interest until its distribution from the trust. Comment e of §155 supports this conclusion, providing in relevant part:

If by the terms of a trust it is provided that the trustee shall pay to or apply for a beneficiary so much of the income and principal or either as the trustee in his uncontrolled discretion shall see fit to pay or apply, and upon the death of the beneficiary shall pay to another person all of the income and principal not so paid or applied, a transferee or creditor of the beneficiary cannot compel the trustee to pay over any part of the trust property.

Of course, inclusion of a spendthrift provision (discussed in Section 5 of this article) can also help further protect a Spouse’s income interest in a QTIP trust as well as a provision enabling the trustee to apply the trust income for the benefit of the Spouse.

4. Provision Regarding Unproductive Property. Many QTIP trusts contain provisions granting a Spouse the right to direct the trustee to make all assets productive of income or direct the trustee not retain unproductive assets without the Spouse’s consent. The genesis of such a provision is found in the language of Regulations §§ 20.2056(b)-7(d)(2), 20.2056(b)-5(f)(1), 25.2523(f)-1(c)(1)(i) and 25.2523(e)-1(f); however, such a provision is not required to qualify for QTIP treatment. (See e.g., TAMs 8638004 and 9237009.) It is sufficient for the trust to manifest the Donor’s intent that the Spouse be given the requisite income interest in other ways. To enhance the asset protection aspects of a QTIP trust, it is suggested that alternative provisions be used to ensure the Spouse is given the requisite income interest in the trust to qualify for QTIP treatment. For example, a provision in a QTIP trust could provide:

To the extent that the Settlor’s personal representative makes a QTIP election for the Marital Trust, the Settlor intends, by the provisions of this Article, to obtain for his/her estate the advantage of the marital deduction or other similar benefit, if any, that may be available under the Federal estate tax law applicable to the Settlor’s estate. No provision of this Agreement shall apply to the Marital Trust to the extent that its being made applicable would defeat the intent expressed in the preceding sentence. Furthermore, the amount of net income distributed to the Settlor’s Spouse from the Marital Trust shall never be less than the amount required to be treated as "income" under the marital deduction provisions of the Internal Revenue Code and the Treasury Regulations issued thereunder, and the composition of such net income shall include all items within the meaning of the term "income" in the marital deduction provisions of the Internal Revenue Code and the Treasury Regulations issued thereunder. Accordingly, the Settlor’s Spouse shall have substantially that degree of beneficial enjoyment of the trust estate of the Marital Trust during his/her lifetime that the principles of the law of trusts accord to a person who is unqualifiedly designated as the life beneficiary of a trust and the Trustees shall not exercise their discretion or apply any provision of this Agreement in a manner that is not consistent with this intention. The Trustees shall invest the trust estate of the Marital Trust so it will produce for the Settlor’s Spouse during his/her life an income or use that is consistent with the value of the trust estate and with its preservation.

5. Spendthrift Provision. A spendthrift provision that prohibits the voluntary or involuntary transfer of an interest in a trust by a Spouse will not cause the trust to fail to qualify for QTIP treatment. Such a provision is condoned by Regulations §§ 20.2056(b)-5(f)(7) and 25.2523(e)-1(f)(7). Nevertheless, a spendthrift provision that provides that a Spouse’s income interest will be forfeited or converted to a discretionary interest would cause a trust to fail to qualify for QTIP treatment. See e.g., Miller v. U.S., 267 F. Supp. 326 (M.D. Fla. 1967); and TAM 8248008. To enhance the asset protection aspects, a trust should always include a spendthrift provision, however, care should be taken to ensure that the spendthrift provision does jeopardize qualification for QTIP treatment.

6. Clayton QTIP Election to Deal with the Potential Insolvent Disclaimant-Spouse. Use of a Clayton style QTIP trust is condoned by Regulations §§ 20.2056(b)-7(d)(3) and 20.2056(b)-7(h), Example (6). Under the terms of a Clayton style QTIP trust, if a personal representative fails to make a QTIP election over all or a portion of the trust property, then such property (or portion thereof) will be disposed of in an alternative disposition that typically would not qualify for a marital deduction such as to a wholly discretionary trust for the benefit of a Spouse and other beneficiaries. (A Clayton style QTIP trust gets its name from the trust in Estate of Clayton v. Com’r., 976 F.2d 1486 (1992). A line of related cases with similar holdings also exist. See e.g., Robertson Est. v. Com’r., 15 F.3d 779 (8th Cir. 1994 ), rev'g 98 T.C. 678 (1992); Spencer Est. v. Com’r., 3 F.3d 226 (6th Cir. 1995) , rev'g 64 T.C.M. 937 (1992); and Clack Est. v. Com’r., 106 T.C. 131, acq. in result only, 1996-2 C.B. 1 (AOD 1996-011).) Many states have disclaimer statutes that prohibit a beneficiary from disclaiming an interest in property if the beneficiary is insolvent. (See e.g., §§ 689.21(6) and 732.801(6) of the Florida Statutes which provide, "The right to disclaim otherwise conferred by this section shall be barred if the beneficiary is insolvent at the time of the event giving rise to the right to disclaim" and "The right to disclaim otherwise conferred by this section shall be barred if the disclaimant is insolvent at the time of recording the disclaimer," respectively.) Whether a disclaimer can defeat the claim of a creditor of an insolvent disclaimant may depend on applicable law, including federal tax law (see e.g., Drye v. United States, 528 U.S. 49 (1999); and Choate v. Tubbs, W.D. Tenn., No. 01-1288-T, 4/4/03). A Spouse’s mandatory income interest in a QTIP trust is a valuable interest in property that could be the subject of a disclaimer. Although a spendthrift provision may prove helpful in thwarting the claims of potential creditors to reach a mandatory income stream, a Clayton style QTIP trust could provide additional flexibility to a Spouse experiencing creditor issues. Where applicable law might not permit an insolvent Spouse to disclaim a mandatory income interest, it may not be able to prevent a personal representative (particularly an independent party serving in such capacity) from failing to make a QTIP election, thereby diverting all or a portion of the trust assets to another more protected form of disposition. (Of course, this planning may come with a price, that is, the potential loss of the use of the credit for the tax on prior transfers under § 2013 of the Code and the loss of the benefit of the marital deduction.) To enhance the asset protection aspects of a QTIP trust, include Clayton style election provisions in the trust and grant the power to make or not make the QTIP election to an independent party.

7. Gift to Inter-Vivos QTIP with Retained Secondary Life Interest. For estate and gift tax purposes, Regulations §§ 25.2523(f)-1(d)(1) and (2) and 25.2523(f)-1(f) Examples (10) and (11) permit a Donor of an inter-vivos QTIP trust to retain a secondary life interest in the trust if the Donor survives the Spouse. (See also P.L.R. 200406004.) Inclusion (or potential inclusion) in the Spouse’s estate under Code § 2044 is deemed to cleanse the trust of any taxable strings under §§ 2036 and 2038 of the Code. This cleansing process is deemed to occur despite existing authority in the tax law that would seem mandate a different result. (See e.g., Herzog v. Com’r., 116 F.2d 591 (2d Cir. 1941) (but c.f., Vanderbilt Credit Corp. v. Chase Manhattan Bank, N.A., 100 AD2d 544, 473 N.Y.S.2d 242 (2d Dep’t. 1984)); Wells v. Com’r., T.C. Memo 1981-574; Estate of Uhl, 241 F.2d 867 (7^th Cir. 1957); Estate of German v. U.S., 85-1 U.S.T.C. ¶13,610 (Ct. Cl. 1985); Outwin v. Com'r., 76 T.C. 153 (1981); Paolozzi v. Com'r., 23 T.C. 182 (1954); Estate of Paxton v. Com'r., 86 T.C. 785 (1986); Rev. Rul. 76-103, 1976-1 C.B. 293; Rev. Rul. 77-378, 1977-2 C.B. 347; PLR 9332006; PLR 8829030; PLR 8037116; PLR 9837007 and PLR 9332006.)

Under the trust law of most states, a Donor’s creditors can reach the Donor’s interest in the trust to satisfy claims against the Donor. (See Restatement Second Trusts Section 156(2) providing, "[w]here a person creates for his own benefit, a trust for support or a discretionary trust, his transferee or creditors can reach the maximum amount which the trustee under the terms of the trust could pay to him or apply for his benefit." This black letter rule is commonly referred to as the "Self-Settled Trust Doctrine.") In most U.S. jurisdictions, one should be mindful that, although the QTIP Regulations create this fiction for estate and gift tax purposes, a creditor’s ability to "bust the trust" should remain the same. In other words the cleansing process for federal transfer tax purposes should not affect the self-settled nature of the trust for state law purposes. The application of the Self-Settled Trust Doctrine may be avoided by establishing (or moving) this type of QTIP trust in a jurisdiction that has reversed the doctrine. A few states have reversed this doctrine by statute. (See e.g., Alaska Laws, SLA 1997, Ch. 6 (H.B. 101), A.S. §§13.12.205(2), 13.27.050(a), 13.36.035, 13.36.310, 13.36.390, 34.40.010, 34.40.110(a), 34.40.110 (Alaska); 12 Del. Code Ann. §§ 3570-3576 (1997) (The Qualified Dispositions in Trust Act) (Delaware); M.R.S. §§428.005-428.059, 456.020, and 456.080 (Missouri); N.R.S. §166.040 (Nevada); Title 18, Chapter 9.2 of the General Laws of Rhode Island (The Qualified Dispositions in Trust Act) (Rhode Island) and R.C.U. §25-6-14, H.B. 299 from 2003 Legislative Session (Utah).) In 1997, Alaska and Delaware each revised its trust laws causing the use of domestic self-settled trusts to become a popular planning technique. In such states, a settlor, regardless of his or her state of residence, can establish a self-settled trust and remain eligible to receive discretionary distributions of income and/or principal from the trust. If the statutory guidelines of such states are followed and the formalities of the trust relationship are adhered to, it should be possible for a Donor to obtain some degree of creditor protection for a wholly discretionary interest in the secondary trust. Perhaps greater creditor protection can be achieved by structuring the arrangement in one of many foreign jurisdictions that permit asset protection trusts such as Nevis, the Cook Islands, the Bahamas or Mauritius.

If asset protection is important to the Donor, care should be taken in structuring this arrangement and selecting the appropriate jurisdiction to establish the trust. For instance, in the facts of Examples (10) and (11) of Regulation § 25.2523(f)-1(f), the Donor retains a mandatory right to receive income in the secondary trust. Under A.S. 34.40.110(b), the creditor protection benefits of an Alaska asset protection trust otherwise granted to a settlor seem to be negated by retention of a mandatory income interest; however, § 3570(10)b.3. of the Delaware Qualified Dispositions in Trust Act seems to permit retention of a mandatory income interest in a trust by a settlor without the loss of the asset protection benefits granted by the act. To obtain asset protection benefits for a Donor’s secondary life interest in an inter-vivos QTIP trust, a Donor will need to consider establishing the trust in a jurisdiction that has reversed the Self-Settled Trust Doctrine. Additionally, if the Donor retains a mandatory income interest in the trust, the Donor may be even more limited in the jurisdictions where the trust can be established in order to secure creditor protection under local law.

8. Naming a QTIP trust as the Beneficiary of Retirement Account. Many states grant exemptions from the claims of creditors for assets held in certain retirement plan accounts. (See e.g., F.S. § 222.21.) In some states such as Florida, this exemption applies not only to the plan participant or account owner but also the designated beneficiary of the account following the owner or participant’s death. Designating a QTIP trust as the beneficiary of the proceeds of a retirement account may have an adverse effect by rendering a portion of the value of such account subject to the claims of a beneficiary’s creditors, thus stripping away some of the benefit granted by the exemption. For instance, under Florida’s statute, all of the income paid from a protected retirement plan continues to be exempt from the claims of a beneficiary’s creditors after it is distributed from the plan. Nevertheless, if income from such an account is first required to be distributed to a QTIP trust, it will be necessary for the trustee to distribute such income to or for the benefit of the Spouse. If the Spouse receives the distribution outright, creditors may be able to seize the income in the hands of the Spouse because the Florida exemption would not protect such income. To enhance the asset protection aspects of a QTIP trust be certain to consider the effect of state law exemptions on the assets that may be used to fund the trust.

9. Payment of Taxes on Assets in Reverse QTIP Trust from an Outside Source. Maximizing a tax benefit is also a form of asset protection because it minimizes the depletion of family wealth by the tax system. Under Examples (7) and (8) of Regulation § 26.2652-1(a)(5), the estate tax liability imposed on the transfer of the value of the assets in a Reverse QTIP trust can be paid from a source other than the Reverse QTIP trust without adversely affecting the trust’s inclusion ratio. For example, the tax liability can be paid from a non-exempt QTIP trust, if any, or from the Spouse’s own assets. To the extent possible, the Donor’s estate plan and the Spouse’s estate plan should take advantage of this rule and properly apportion the payment of the estate tax liability on the assets in a Reverse QTIP trust to a source such as the non-exempt QTIP trust or the Spouse’s own assets.

10. Investment of Assets in QTIP Trust in Limited Liability Entities. In F.S.A. 199920016, the issue was whether there had been a disposition of a Spouse’s income interest in a QTIP trust under § 2519 of the Code because of an investment of the trust assets in a family limited partnership ("FLP"). The Spouse and her daughter were co-trustees of the QITP trust and the Spouse, her daughter, two of her daughter’s children and the QTIP trust formed the FLP. The daughter and her two children received general partnership interests in exchange for capital contributions of cash to the FLP and the daughter also received a limited partnership interest in exchange for a capital contribution of certain assets to the FLP. The Spouse and the QTIP trust received limited partnership interests in exchange for capital contributions of cash and securities. The daughter was appointed as the managing partner of the FLP. As managing partner she possessed "sole discretion with respect to distribution decisions" from the FLP. (Presumably this discretion was subject to the business judgment rule under applicable state law.) The limited partners were prohibited from participating in the operation or management of the business of the partnership. Interests in the FLP were freely transferable to parents and descendants of partners, however, a transfer to any other person or entity would trigger an option in the other partners to purchase the assigned interest for 70% of its fair market value. In holding that the contribution of trust assets to the FLP was not a disposition under § 2519 of the Code, the F.S.A. provided:

[Spouse]’s conversion of the trust assets into FLP interests is not the typical disposal of the income interest envisioned under the provisions of section 2519. By converting the trust assets into FLP interests, she has disposed of the corpus rather than the qualifying income interest. Facially this appears to be a permissible conversion. Thus, in order to invoke 2519, the conversion of the trust assets must work such a limitation on her right to the income as to amount to a disposition of that income. Although the conversion to partnership interests could yield this result, it does not necessarily follow. An investment in a partnership, despite possible restrictions on distribution, could be, under the right circumstances, a very lucrative investment.

The ruling recognized that the managing partner had the power to withhold distributions from the FLP, however, under the facts the Spouse had continued to receive the same proportionate share of the income from the assets in the FLP. Additionally, the Spouse did nothing that affected her right to receive the income from the trust. Finally, the ruling recognized that a QTIP trust "can be originally funded with partnership interests or, for that matter, closely held stock" and those types of investments could possibly distribute no income in a given year. (See e.g., P.L.R. 199915052) According to the ruling, "The right to annual income is not tantamount to a fixed right to yearly income, rather it is a right to any income to the extent it exists, on at least an annual basis."

Providing the trustee of a QTIP trust with the flexibility to invest trust assets in limited liability entities such as corporations, limited partnerships and limited liability companies can enable the trustee to better protect the assets of the trust from potential creditors, provide additional flexibility to structure investment of the trust assets and provide opportunities to reduce the Spouse’s estate and gift tax liability. As F.S.A. 199920016 demonstrates, providing the trustee with this discretion should not hinder the qualification of the trust for the marital deduction. Thus, to enhance the assets protection aspects of a QTIP trust, the trustee should be given the discretion to invest trust assets in limited liability entities such as corporations, limited partnerships and limited liability companies.

To qualify for the marital deduction, a QTIP trust must be drafted to meet the requirements set forth in the Code. For example, the Spouse must be given the right to receive all of the income from the trust at least annually and no other person is permitted to have a current interest in the trust during the Spouse’s life. Nevertheless, too often QTIP trusts are drafted to provide the Spouse with interests or rights that can be attractive to creditors of the Spouse. As this article illustrates, this is not necessary to qualify the trust for the marital deduction and in many respects is contrary to the fundamental purpose of a trust, that is, to the protect the trust assets from creditors and the indiscretions and inability of the beneficiary.