3 Trusts Married Couples Should Consider for Their Wills

Trusts have fallen out of favor as part of the wills of married couples, and that could be a mistake for many.

Trusts created in wills are known as testamentary trusts. The portability of an unused lifetime estate and gift tax exemption from one spouse to another is the main reason testamentary trusts are used less often.

It used to be routine for the first spouse to pass away to leave in trust enough assets to use up his or her lifetime exemption. The trust primarily would benefit the surviving spouse for life.

The rest of the estate would pass outright to the surviving spouse.

If the first spouse to pass away didn’t make use of the lifetime exemption in this way, that spouse’s unused exemption would be lost forever.

But today the combination of the unlimited marital deduction and the portability of unused exemptions seems to make such trusts unnecessary.

The first spouse to pass away can leave his or her entire estate to the surviving spouse. The marital deduction ensures no estate taxes are imposed on the first spouse’s estate.

The first spouse’s unused lifetime exemption is transferred to the surviving spouse under the portability provision. The same amount of the joint estate can pass to the next generation free of estate and gift taxes without any of it having to pass through a trust first. There are more details about portability in the June 2022 issue of Retirement Watch.

But there are some potential hazards to relying on the portability provision, and there are benefits to trusts that are being ignored.

Portability of the lifetime credit between spouses isn’t automatic.

The executor of the first spouse to pass away must file an estate tax return and elect to transfer the unused credit to the surviving spouse.

Because of today’s high exemption amount, few estates are subject to estate taxes or required to file an estate tax return.

Many executors don’t know they have to file a return to transfer the credit. Others don’t realize the estate tax exempt amount might be cut in half after 2025. The value of the joint estate is well below the current lifetime exemption, so they don’t think portability is important.

Some executors simply don’t want to incur the cost and hassle of filing an estate tax return solely to transfer the unused credit.

Another potential problem is that there is no inflation indexing of the unused credit transferred to the surviving spouse. The amount of the credit is fixed at the current level. Its value could be eroded over time by inflation and asset appreciation.

In addition, there are non-tax reasons not to transfer the entire estate outright to the surviving spouse.

Putting some of the estate in a testamentary trust ensures those assets eventually go to the children of the first spouse to pass away, or any other objects of that spouse’s affection.

Without the trust, the surviving spouse might bequeath or give the assets to others.

This might be especially important when the marriage is a second one and there are children from a previous marriage of one or both spouses. A spouse with children might worry the surviving spouse would remarry or otherwise develop reasons to leave part of the estate to other people or to charities.

Also, a trust can protect the assets from creditors of the surviving spouse. Asset protection is a reason not to rely on portability.

There are three types of testamentary trusts for married people to consider.

The first is the classic bypass trust, also known as the credit shelter trust, A/B trust and sometimes by other names.

In the classic plan, the will says that assets equal to the remaining lifetime estate and gift tax exemption are transferred to the bypass trust. The rest of the estate is bequeathed to the surviving spouse, though portions might go to charity or children depending on the size of the estate.

After the second spouse passes away, the remaining trust assets are distributed to the trust’s contingent beneficiaries, who usually are the children of the first spouse to pass away.

Today, the will usually shouldn’t say the bypass trust will be funded with the full unused lifetime exemption amount, because that would be the entire estate and then some. The surviving spouse wouldn’t own any assets outright and would have to ask the trustee for money to pay all expenses.

Instead, the will should have a formula. For example, the bypass trust could be funded with the lesser of the unused lifetime exemption and 50% of the estate. You determine the appropriate percentage. Some estate planners prefer a dollar amount instead of a percentage.

You name the trustee, and the surviving spouse can be trustee without voiding the tax and asset protection benefits of the trust.

But a surviving spouse who is trustee could distribute the assets for the benefit of others during his or her lifetime and spend down the trust, leaving little for the contingent beneficiaries.

Some bypass trusts are set up to minimize the family’s lifetime income taxes. The trustee can distribute portions of the income each year to the surviving spouse, children, or grandchildren in whatever proportions minimize the family’s income taxes. This can be beneficial when the surviving spouse was likely to spend a portion of the money for the benefit of the children and grandchildren anyway.

The trust can liquidate after the surviving spouse’s death by making distributions to the contingent beneficiaries.

Or it can be set to last for another generation or two by making annual distributions to the beneficiaries. Some trusts are allowed to make loans of additional amounts to beneficiaries, which the beneficiaries are expected to repay. Such provisions enable the trust to last for many years while supporting the beneficiaries and teaching them financial responsibility.

Setting the trust up to last for another generation or two also ensures the assets are protected from divorces, creditors, and other problems of the succeeding generations.

The bypass trust may make charitable gifts, if you provided that in the trust agreement.

A variation is the qualified terminable interest property, or QTIP, trust.

The QTIP has special tax rules. The assets put in the trust qualify for the marital deduction of the estate of the first spouse to pass away. When the surviving spouse passes away, assets remaining in the trust are included in his or her estate for tax purposes. The tax bases of those assets then are increased to their current fair market value.

To qualify as a QTIP, 100% of the trust income must be distributed to the surviving spouse at least annually. “Income” is fiduciary accounting income, not taxable income. So, the income distributed to the surviving spouse probably will differ from the taxable income. The surviving spouse can receive distributions that exceed the annual income.

Trust income can’t be distributed to other beneficiaries while the surviving spouse is alive.

The QTIP trust provides the asset protection benefits of the bypass trust and ensures trust assets eventually go to the beneficiaries designated by the first spouse to pass away.

The executor of the estate must elect to have a trust treated as a QTIP. The election is made on the last estate tax return filed within the filing deadline. But if no estate tax return is filed, the election is made on the first estate tax return filed on a later date.

Because many estates aren’t required to file estate tax returns, this rule could allow the QTIP trust election to be made years after the first spouse passed away. That provides survivors a lot of flexibility in deciding how to treat the trust.

The third option is a variation known as the Clayton QTIP trust, named after the court case that permitted it.

Under the Clayton QTIP, the executor of the estate decides which property goes into the trust. To use this trust, someone other than the surviving spouse should be the executor.

These three types of trusts can be used in combination. You might decide to have both a bypass trust and a QTIP trust as part of your estate plan, in addition to leaving some assets outright to your surviving spouse.

The important step is to consider issues other than immediate estate taxes. Consider issues such as protection from creditors and the determination of who ultimately inherits the remaining property.