Using the QTIP election to maximize generation-skipping transfers.

The qualified terminable interest property (QTIP) election under Sec. 2056(b)(7) is a handy pre- or post-mortem planning technique. it enables an estate owner to provide income and some principal for a surviving spouse during life while ensuring that the eventual disposition of the assets is in accordance with his wishes. A trust is created to hold the assets for the benefit of the spouse, with the remainder often passing to the children of the first spouse at the survivor's death. If properly structured, the assets in the QTIP trust escape taxation in the first estate (because they qualify for the unlimited marital deduction). They are includible in the estate of the second spouse and taxed accordingly. Coupling the deferred taxation of the assets with the control aspects of the QTIP trust makes a compelling argument for the use of this technique, especially in remarriage situations.

Unfortunately, while the QTIP trust makes eminent sense for the reasons given, it falls short with respect to the generation-skipping transfer tax (GSTT). For GSTT purposes, the surviving spouse is considered to be the transferor of the assets to the third generation, and any GSTT implications are calculated in the survivor's estate. if the surviving spouse has a sufficient amount of the $1 million lifetime GSTT exemption available to cover such a transfer, and the first spouse did not intend to leave much more than $1 million directly to his grandchildren, this may not be a problem. However, if the assets passing directly to the grandchildren are large enough, such a strategy may cause some or all of the first spouse's GSTT exemption to go unused.

Fortunately, there is a little-known solution to this problem. For generation-skipping transfers made, or treated as made, after Oct. 22, 1986, Sec. 2652(a)(3) allows the executor of the decedent's estate to make what is sometimes called a "reverse QTIP election" with respect to the assets in a QTIP trust. Essentially, what that means is that the trust is treated for GSTT purposes as if the first spouse were the transferor.

The flexibility in this technique enables one to control effectively the use of the GSTT exemption in both estates.

Example 1: Individual H has an estate valued at $1 1,000,000. His current (second) wife, W, has nominal assets. H wishes ultimately to pass the bulk of his estate to his children and grandchildren, yet he wishes to provide adequately" for W during her lifetime.

H should consider establishing a $1,000,000 "reverse QTIP" type of trust for W's benefit, with the remainder to his grandchildren. enables H to take advantage of the GSTT exemption in his own estate, while still qualifying for the marital deduction for the assets transferred in trust. H should also consider establishing a $1,000,000 "straight" QTIP trust. This "straight" QTIP trust does not qualify for the GSTT exemption in H's estate. It does, however, qualify in W's estate. Since W's other assets are nominal, the full $1,000,000 in this trust will pass to H's grandchildren at her death and be protected by her GSTT exemption. In reality, this trust should probably be funded with somewhat more than $1,000,000 so that, by the time of W's death, the trust will have sufficient funds to pay the estate taxes in her estate on both QTIP trusts, and the trust should be so drafted. If the trust is "overfunded" for GSTT purposes (i.e., it is left with more than $1,000,000 after the payment of taxes), the instrument can provide for splitting the trust into two trusts. One trust will have no more than $1,000,000 (or as much as remains of W's GSTT exemption), while the balance will either be held in a separate trust or distributed to the children outright.

This plan accomplishes a number of goals. First and foremost, the grandchildren are assured of receiving at least $2,000,000 of assets at W's death. W was provided for in a meaningful way without having actual control of the assets at any time. Finally, the GSTT exemptions available to both spouses will be used in full.

The estate does not have to be so large to benefit from a reverse QTIP.

Example 2: Consider a relatively small estate of $2,000,000, all owned by the husband, H. * Scenario 1: H sets up a QTIP trust in his will and leaves the full $2,000,000 to his wife, W, and the remainder to his grandchildren. Result: Upside: H provides for W and protects the grandchildren. Downside: The unified credit is wasted in H's estate; no GSTT exemption is used (or available) in H's estate; and $1,000,000 of the $2,000,000 will be subject to GSTT in W's estate. * Scenario 2: H sets up a credit shelter trust for $600,000 (income to W, remainder to grandchildren] and a QTIP trust for $1,400,000. Result: Upside: Each party is still protected, while the unified credit is used in H's estate. Downside: Only $600,000 of H's GSTT exemption will be used; the remaining $400,000 will be wasted. GSTT tax will be due on W's death. * Scenario 3: H sets up three trusts: unified credit for $600,000; a straight QTIP for $1,000,000; and a reverse QTIP for $400,000. Result: Upside: Again, all parties are protected. H's GSTT exemption is used in full, as is W's. H's unified credit is not wasted. Downside: None.

When an estate is large enough to have GSTT implications, there is no reason to leave behind any of the available exemption. Using a combination of the QTIP and reverse QTIP elections enables a couple to leverage the GSTT exemptions to the fullest in a relatively painless manner.