More than half of all marriages in America end in divorce. Add in widows and widowers to the numbers of divorced couples, and the likelihood of a second marriage that includes children of a prior marriage is significant. While there are significant psychological issues where there are children of prior marriages, estate planning issues are equally important.
The primary issue is what happens to the property of the spouse who dies first. In many cases, the deceased spouse will want to provide financial security for the surviving spouse and provide for his or her own children after the surviving spouse has passed away. There are two primary ways to accomplish that goal.First, the decedent leaves his or her property outright to the surviving spouse and relies on the surviving spouse to provide for the children of the deceased spouse. This method does not always work the way it is intended to work.
Second, the decedent uses a trust which economically protects the surviving spouse and then distributes any remaining trust property to the children of the first deceased spouse when the surviving spouse dies. This special trust is called a Qualified Terminable Interest Property trust, or QTIP trust. (Properly used, the QTIP trust "qualifies" for special estate tax treatment under the Internal Revenue Code). The QTIP trust is "Terminable" because the surviving spouse's rights in the trust terminate at the survivor's death.
A QTIP trust is a very effective estate planning mechanism for second marriages where the decedent's estate is in excess of the estate tax-free amount, $625,000 (1998 exemption). Here is an example. Assume that husband and wife have been married before, and the first spouse to die is worth $800,000. They establish a QTIP trust arrangement. The first decedent's property is divided into two trusts: a Credit Shelter Trust and a QTIP Trust. As you'll see below, $625,000 of the decedent's estate should go to the Credit Shelter Trust and $175,000 should go to the QTIP trust.
Now, let's detour for a minute then return to our example. In 1998, a deceased spouse may leave $625,000 to any combination of persons free of estate taxes. However, the first deceased spouse's $625,000 exemption can be wasted. If the first decedent leaves $625,000 directly to the surviving spouse, it passes tax free because of the Unlimited Marital Deduction; therefore, the decedent's $625,000 exemption is not needed, so it is wasted. If the surviving spouse had $625,000 of his or her own, and directly received the additional $625,000 from the deceased spouse, the total would be $1.25 million. If the surviving spouse died with the $1.25 million (in 1998) in his or her estate, estate taxes would total $246,000! Instead, the first decedent indirectly leaves the $625,000 to the surviving spouse via a Credit Shelter Trust, which provides a lifetime benefit for the surviving spouse. That transfer utilizes the first decedent's $625,000 exemption, but the value remains outside the survivor's taxable estate. So, the exemption is utilized and not wasted.
Now, back to our example. The Credit Shelter Trust would receive $625,000 of the first decedent's assets and the QTIP Trust would get the remaining $175,000. Both transfers would occur free of estate taxes.
Both trusts could be designed to provide maximum or minimum financial security to the surviving spouse. At the death of the surviving spouse, the assets of the Credit Shelter Trust would pass to the children of the first decedent and remain estate tax free; the assets of the QTIP Trust would also pass to those children, but the value would be included in the taxable estate of the surviving spouse.
The QTIP Trust arrangement allows the couple to minimize or eliminate estate taxes, and the children of prior marriages are made secure in their inheritance.
QTIP Trust planning is easy to understand if you'll let your estate planning attorney draw you a diagram. When you see the diagram, and have it explained to you, you'll quickly grasp how the QTIP can save estate taxes and ensure financial security for the children of the deceased spouse and for the surviving spouse as well.