If a client has an older form of estate plan that creates a true bypass trust on the first death between married spouses, and that trust is funded with up to the amount of the first spouse to die estate tax exemption, the trust beneficiaries will lose the step up in income tax basis at the second death between the spouses.
Thus, if the survivor’s estate is likely to be less than the estate tax exemption, even if the decedent’s part of the estate is included in the survivor’s estate when they die, the family will want to cause inclusion of the bypass trust in the survivor’s estate in order to get bypass trust assets income tax basis step up to date of death value at survivor’s death.Why would they want basis step up? In order to have less capital or other gain when the property in the bypass trust is sold. Income Basis step up to date of death fair market value at the survivor spouse’s death happens when property is includible in the surviving spouse’s estate when they die, for estate tax purposes, even if no estate tax is due at their death.
Beware: Congress may change this rule at anytime.
In the meantime, there are several ways to solve this problem and obtain income tax basis step up to survivor date of death fair market value.
Below, I discuss the possible solutions under current law.
Objective: Bypassing the Bypass Trust (for Estate Tax Purposes) in order to get step up in basis of Bypass Trust assets for income tax purposes at the second death
We can agree: $24 million is substantial for most people.
Now, for a married couple, it’s considered a “small estate,” which is what estate planning practitioners refer to when the taxable estate value is below the lifetime exclusion amount. If the couple had a “large estate” (more that $24 million in 2020) then there would be estate tax due when the second spouse passes away.
Under the Tax Cuts and Jobs Act, it’s especially important for Estate Attorneys and CPAs to design and recommend an estate plan review so the client is not left with an outdated estate planning structure that creates more administrative burdens with less tax planning benefits. While solutions are available when planning opportunities are missed, they may come at a cost.
The Typical A/B Trust
What happens if the first spouse dies, but estate planning documents haven’t been updated to reflect the significant increase to the lifetime basic exclusion amount of $12 million per individual in 2020 (the law is schedule to reduce the exemption in 2026 and thereafter)?
Previously, when exclusion amounts were much lower and portability did not exist, trusts for married couples with small estates were drafted to require creating a survivor’s trust and a bypass trust at the first settlor’s death. This drafting approach was appropriate when the objective was to exclude appreciating assets from the survivor’s estate at his or her death. But, funding highly appreciating assets into a bypass trust can cause a lost opportunity for receiving a step-up in basis at the second death without the benefit of saving any estate tax. This is especially true when there’s a lengthy time frame between the first and second death.
Notice: However, the existence of the Bypass Trust may still be useful for
- creditor protection planning
- blended families; and
- other situations
Strategies for Avoiding a Bypass Trust
Spouse No. 1 has died and the trust is irrevocable. What can be done?
The following are some post-mortem planning solutions for the surviving spouse when a bypass trust is mandatory, but no longer offers estate tax planning benefits. In all solutions, the assumption is made that all beneficiaries are treated the same for both the survivor’s trust and the bypass trust.
Option 1: Petition the Court
Under California Probate Code Sec. 15403, if all beneficiaries agree, a trustee or beneficiary of an irrevocable trust may compel modification or termination of the trust upon petition to the court. The challenge with this approach is identifying all the beneficiaries and, if there are minors or unborn beneficiaries, there may be additional steps to ensure their legal rights are adequately represented. The court may have discretion on whether to grant such requests even with a unanimous beneficiary agreement.
If the beneficiaries are not in agreement, then relief may be available under California Probate Code Sec. 15409 due to a change of circumstances not anticipated by the settlor.
Option 2: Private Party Agreement
(No Court Order)
The parties can agree that the trustee will not have to fund the bypass trust. This could be a viable solution unless objections are raised later.
If the beneficiaries require further assurance, the surviving spouse can agree to restrict her authority over the survivor’s trust by requiring beneficiary consent. For example, consent could be needed prior to altering distribution standards, making charitable gifts and paying expenses over a certain dollar amount—all things not normally seen in a typical, revocable survivor’s trust.
For example, the spouse and remainder trusts can agree that the bypass trust trustee (usually the surviving spouse) can make a distribution of all of the bypass trust assets to the survivor spouse’s revocable living trust, for ‘health, education, maintenance, and/or support’ of the surviving spouse, if the bypass trust has that provision. Now, the survivor trust owns the former bypass trust assets. Then, when the survivor dies, those assets are included in their estate and obtain full step up in basis at the second spouse death, under current law.
However, the fiduciary will remain exposed to future claims by not obtaining a court order.
Option 3: Make QTIP Election on Bypass Trust
If the terms of the bypass trust contain the key provisions to allow it to qualify as a marital trust, a QTIP election can be made on Form 706 and the assets would get a step-up in basis on the second death. See QTIP Election discussion below.
Option 4: Do Nothing!
This option is simple, but risky. Periodic reviews can evaluate whether the bypass trust should be funded at a later time based on the size of the estate, asset appreciation and tax law. It’s difficult to give this guidance to clients, but the risk is relative when the surviving spouse is older, has an estate in the $1 million to $3 million range and no complexities exist, such as a blended family. Clients can, and do, choose this option as many simply don’t want to incur the cost of the options mentioned above. As always, it’s best to document the Attorney/CPA/client discussion regarding any risks and decisions and maintain those records indefinitely.
Planning for the Unknown While both spouses are still alive
While the couple are both still alive, annual estate planning reviews will help identify these issues earlier and trust provisions can be amended to offer more planning flexibility. For example:
The most flexible planning design is to give the surviving spouse the option to disclaim assets, which would then fund the bypass trust. This optional A/B split offers the trustee time to determine if the greater tax benefit is avoiding estate tax or receiving a full step-up in basis at the second death. It’s important to work with YAHNIAN LAW CORPORATION on the specific requirements and timing for making a qualified disclaimer under IRC Sec. 2518.
For larger estates, a Clayton Contingent QTIP provision [(Estate of Clayton v. Commissioner, 976 F2d 1486 (5th Cir. 1992)] can provide even more flexibility. At the first death, this provision allows the trustee to select assets for the QTIP. Any other assets not selected will automatically be funded into a bypass trust. This approach allows the trustee more time to identify which assets are suitable for each trust based on the current economic conditions and ongoing tax reform. The trustee will then make a QTIP election only for the assets selected for the QTIP trust to receive the full step-up in basis at the second death.
The Partial QTIP Election for a Marital Deduction Trust
The Executor of the estate of the first spouse to die can elect to make what is called a partial QTIP election. Thus, no bypass trust has to automatically be part of the will or living trust. The decedent’s share can be fit entirely into a QTIP trust. A QTIP trust is an irrevocable trust that give the executor the option to elect or not marital deduction treatment at the first death. If not elected, the QTIP is treated like the bypass trust. If elected in whole or part, the QTIP is a marital deduction trust that results in the trust assets being included in the survivor’s estate when they die. The executor can even make a late QTIP election. See below.
The availability of the marital deduction under IRC §2056(b)(7) and the resulting inclusion of the property in the QTIP trust in the surviving spouse’s gross estate is contingent upon the executor of the first spouse to die making a QTIP election.
In certain situations, it may be more advantageous to decline to make the QTIP election. In other situations, making a partial QTIP election, which is permissible, may be more advantageous.
A QTIP trust allows the executor of the first spouse to die to make these decisions after the death of the first spouse.
The Unwanted Bypass Trust
What if it’s too late? If the bypass trust has already been funded and there’s now a desire to terminate it so the assets will obtain a new basis upon the death of the surviving spouse—and assuming no power to terminate is authorized under the governing instrument—a trustee or beneficiary may petition the court to do so, especially if the value of the trust principal is low in relation to the cost of administration (CA Probate Code 15408).
There are also strategies for spending down a bypass trust to reach this threshold requirement. For example, a trustee may exercise its discretion to make principal distributions and accelerate the spending down of corpus (i.e. terminating distribution).
These strategies will not apply in every circumstance and termination may not be possible. For example, if the trust has been in existence for many years and contains assets that cannot easily be spent down, such as partnership interests with a healthy cash flow. The trust simply may not be able to be terminated and the second step-up will be unavailable.
Estate planning advisers are in a unique position to help clients plan ahead by finding opportunities for greater flexibility through the changing tax laws and life circumstances. The increase to the exclusion amounts from the Tax Cuts and Jobs Act is set to expire after 2025, so tax reform will continue to be on the horizon. If and when we revert back to a $5 million exclusion amount or less, the small estates will instantaneously become large estates again.
Making the QTIP Election
QTIP the Bypass Trust: You can make the late QTIP election on a late 706 if it is the first filed 706 for the estate.
Qualified Terminable Interest Property (QTIP) Election
Internal Revenue Code §2056(a) provides an unlimited marital deduction for property transferred from the deceased to the surviving spouse, except as limited by IRC §2056(b) (dealing with the types of interests that will qualify for the deduction) and IRC §2056(d) (dealing with transfers to noncitizen spouses).
Internal Revenue Code §2056(b)(7) allows the transfer of “qualified terminable interest property” (QTIP) to qualify for the marital deduction. There are several requirements to qualify property as qualified terminable interest property that will be entitled to claim the marital deduction.
An important requirement is that the representative make a timely election under IRC §2056(b)(7). This election must be filed with the estate tax return and is irrevocable. IRC §2056(b)(7)(B)(v). See §12.26A.
The QTIP property will be included in the estate of the surviving spouse. IRC §2044.
If the surviving spouse is not a citizen of the United States, transfers to the surviving spouse will not qualify for the marital deduction. However, if certain requirements are met, a special type of marital deduction may be applied to such transfers, the net effect of which is to defer estate taxes that would otherwise be due until the death of the surviving spouse. IRC §§2056(d), 2056A.
The QTIP election is made by listing the qualified terminable interest property on Part A of Paragraph 3 of Schedule M and deducting its value. The QTIP election will be deemed to apply to the entire interest in each trust listed on Part A of Paragraph 3 of Schedule M unless that schedule clearly reflects the fractional share of the entire interest to which the QTIP election will apply. This means that if a partial QTIP election is being made, the fractional share to which the partial election applies must be clearly indicated on Schedule M.
(1) Making QTIP Election on Late or Supplemental Return
If the election is not made at the time the original Form 706 is filed, it can be made on a supplemental return if filed by the date the original return was due. The IRS has been liberal in allowing late elections when no election was made on the original return. See IRS Letter Rulings 200526017, 200215025.
(2) Inclusion of QTIP Property in Estate of Surviving Spouse
The value of any property that was the subject of that election and that is still held by the trust for which the QTIP election was made on the surviving spouse’s death must be included in the surviving spouse’s gross estate at its then fair market value for purposes of determining the federal estate taxes due from the surviving spouse. IRC §2044.
If a QTIP election is made that was not necessary to reduce the estate tax liability of the first spouse to die, the IRS will disregard the election and treat it as null and void for purposes of IRC §§2044(a), 2056(b)(7), 2519(a), and 2652. Rev Proc 2001–38, 2001–1 Cum Bull 1335. See, e.g., IRS Letter Ruling 200535026 (inadvertent QTIP election for bypass trust was void under Rev Proc 2001–38). Thus, the property will not be included in the estate of the surviving spouse, the spouse will not be treated as making a gift of the property if the spouse disposes of the income interest with respect to the property, and the spouse will not be treated as the GST tax transferor with respect to the property.
Relief is not available, however, if a partial election is required with respect to a trust to reduce the estate tax liability and the trustee has made an election with respect to more trust property than necessary to reduce the estate tax liability to zero or did not clearly indicate that the QTIP election will apply only to a fractional share of the trust listed on Schedule M.
NOTE: The revenue procedure does not prevent the executor from intentionally making a QTIP election for a portion of an eligible bypass trust for which no tax will be due on the death of the surviving spouse in any event, in order to obtain another step-up in basis for the property on the death of the surviving spouse.
If an estate tax return is being prepared at the death of a surviving spouse (i.e., the second death), making the QTIP election will only be an issue if the surviving spouse remarried and is survived by the new spouse. Otherwise, the focus at the death of the surviving spouse will be the effect of the previously made QTIP election on the survivor’s estate.
Note: The practitioner should review any federal estate tax return filed by the estate of a previously deceased spouse to determine whether an election was made under IRC §2056(b)(7) to treat any property transferred into a trust with income for life to the surviving spouse as qualified terminable interest property.
Property that is owned by the surviving spouse, individually or in a “survivor’s” trust, is not aggregated with QTIP property for purposes of determining the value of the property subject to federal estate taxes at the surviving spouse’s death. Estate of Harriett R. Mellinger (1999) 112 TC 26, acq 1999–2 Cum Bull 763. This can be important if fractional interests in property are owned by the trustee of the QTIP trust, the trustee of a “survivor’s” trust, and/or the surviving spouse individually, because discounts for minority or fractional-share ownership may be available.
How to make the qualified terminable interest property (QTIP) election on the estate tax return.
The election to claim the estate tax marital deduction for qualified terminable interest property (QTIP) must be made by the executor of the decedent’s estate on the estate tax return (Form 706). 14
The QTIP election can be made by the executor whether or not the decedent’s will instructs the executor to make the election. 16
A valid QTIP election can be made on the last estate tax return filed on or before the due date, including extensions, or, if a timely return is not filed, on the first estate tax return filed after the due date. 17
If the time for filing the original return has not expired, the QTIP election can be claimed on an amended return filed on or before the due date of the original return. 18 According to IRS, the last estate tax return filed before an extended due date was the relevant return for determining whether the QTIP election was properly made. The estate had requested and received a six-month extension to file the estate tax return. Nevertheless, the estate mailed a completed estate tax return to IRS on the original due date, but did not make the QTIP election on that return. A few days before the extended due date, an amended estate tax return was filed on which the QTIP election was made. IRS ruled that the filing of a completed estate tax return before the original due date did not destroy the effectiveness of the extension of time granted to file the return. Because the QTIP election must be made on the last estate tax return filed before the due date (see the text at footnote 17), the election was effective. 19
The QTIP election may no longer be available once an estate tax return has been filed, without the election, and the due date for the return has passed. Thus, no QTIP election could be made where the time for filing had expired and a return had already been filed without the election. 20
However, IRS has granted an extension of time, under Reg § 301.9100-1 to make a QTIP election with respect to a number of parcels of real estate omitted from a decedent’s Form 706, where the Form 706 had been timely filed but no QTIP election had been made on the return with respect to any property included on the return. The estate’s personal representative, in preparing to close the decedent’s probate estate, had discovered that the accountant who had prepared the Form 706 had failed to include these parcels owned by the decedent at death in the decedent’s gross estate as reported on the Form 706 as well as in the decedent’s probate estate. 20.1
21Instructions to Form 706, Schedule M, (8/2015), p. 36.
22Instructions to Form 706, Schedule M, (8/2015), p. 36.
23IRS Letter Ruling 9116003.
23.1IRS Letter Ruling 199902014.
23.2Chief Counsel Advice 200248007.
24Higgins, John T. Est, (1988) 91 TC 61, affd(1990, CA6) 65 AFTR 2d 90-1231, 897 F2d 856, 90-1 USTC ¶60011, reh den (1990, CA6) 1990 US App LEXIS 7101.
24.1Higgins, John T. Est, (1988) 91 TC 61, affd(1990, CA6) 65 AFTR 2d 90-1231, 897 F2d 856, 90-1 USTC ¶60011, reh den (1990, CA6) 1990 US App LEXIS 7101; Spohn, Harry Est v. U.S., (1990, DC IN) 66 AFTR 2d 90-5982, 90-2 USTC ¶60027; IRS Letter Ruling 8427007; IRS Letter Ruling 9117007.