Making a QTIP Election on a Portability Return

by Abby C. Boyd

Given the current IRS rules, most individuals today will not face a federal estate tax. (In 2017, an individual will pay the federal estate tax only if he or she has assets at death and lifetime taxable gifts that exceed $5,490,000.) With “portability returns,” a married couple can avoid paying estate tax with assets at death and lifetime taxable gifts of up to $10,980,000. And unlike many East Coast states, Colorado does not have a state estate tax.

Many families opt to leave assets at death to a family trust. A family trust permits distributions to multiple beneficiaries, i.e., the surviving spouse, children, and grandchildren. A family trust provides asset protection from creditors and from claims of a new spouse. It also avoids inclusion in the estate of the surviving spouse. This is important if the exemption is lower, but less significant today because so few families will face an estate tax. The major downside to a family trust is that the assets inside the trust lose the “second step-up” in basis that would otherwise occur at the death of the surviving spouse. The second step up allows appreciated assets to reset income tax basis twice: at the death of the first spouse and again at the death of the second spouse.

If a family wants asset protection along with that “second step-up” in basis, they may consider leaving assets outright to a surviving spouse or utilizing a QTIP or Clayton QTIP trust.  Leaving assets in trust to a QTIP or Clayton QTIP structure would provide additional asset protection that you lose in leaving assets outright to your spouse.

The IRS recently issued Revenue Procedure 2016-49, which stated that QTIP elections would be permitted even if made on a portability-only estate tax return. This marks a change from a previous ruling which disallowed “unnecessary” QTIP elections, i.e., one in which an estate tax was not due.  Now that QTIP elections on a portability return have been allowed by the IRS, leaving assets to a QTIP trust is worth considering by families who may not face an estate tax but who want both asset protection and the second step up at the death of the surviving spouse.

In a QTIP trust, assets are held for the benefit of the surviving spouse during his or her lifetime and pass to other beneficiaries (i.e., children and grandchildren) at the second death. The surviving spouse receives mandatory annual distributions of income. In a Clayton QTIP, there is even more flexibility. Here, the personal representative of the second spouse’s estate may choose to devote some portion of trust assets to a QTIP and the remainder to the family trust. A Clayton QTIP allows flexibility to determine the most useful type of trust for the surviving spouse and family at the time the trusts would be created, rather than at the time the first spouse’s Will is prepared.

With fewer families subject to the estate tax and more filing “portability-only” returns, the issuance of Rev. Proc. 2016-49 means that a QTIP or Clayton QTIP may be considered by families who seek asset protection while also seeking to obtain a second step up in basis for appreciated assets.