Preserving Asset Protection in Lifetime QTIP Trusts with Possible Reversions in the Settlor

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By I. Mark Cohen,
Esq.

Cohen & Burnett, P.C., McLean,
VA 

Several states have addressed
concerns relating to lifetime QTIP1 trusts
with reversions in the settlor. The increased interest in lifetime
gifting to minimize estate tax savings, that was no doubt spurred
on by the temporary two-year expansion of the gift tax exemption to
$5 million plus for 2011 and 2012, has continued thanks to the
"permanent" increase in the transfer tax exemptions under the
American Taxpayer Relief Act of 2012, P.L. 112-240.2

It is not uncommon for a wealthier
spouse to seek ways to use the gift or estate tax credit of the
less wealthy spouse. For many clients, the dilemma is whether and
to what extent to give up assets to further this goal. For example,
consider a Husband who has assets with a value of $10M and a Wife
(perhaps a second or subsequent wife, not the mother of Husband's
children) who has no estate of her own. Husband could give $5
million outright to Wife, with the hope that she would eventually
transfer it to his children, perhaps on her death. Some clients
either do not trust their spouses to leave assets to step children
or they fear exercise of elective rights by future spouses.

It is common in situations where
clients wish more certainty as to the ultimate outcome for Husband
to make a gift to Wife by means of an irrevocable living trust that
will benefit Wife for her life and then pass for the benefit of his
children and/or grandchildren. Where Wife is a U.S. citizen, the
trust can be drafted so that it qualifies for the gift tax marital
deduction as an inter vivos qualified terminable interest property
(QTIP) trust under §2523.

Under the provisions of the gift
trust, Husband would have no beneficial interest in the trust and
no access to the trust property. However, Husband may benefit
indirectly while married to Wife (particularly if the trust were to
use a "generic wife" definition). When Wife dies, the trust
property will be subject to estate tax in her estate, sheltered by
Wife's unified credit, not Husband's.

In the event Wife dies first, what
if Husband wants continued access to the trust funds? A possible
solution is to have the trust continue for Husband's benefit upon
wife's death. The continuing trust could be structured as a credit
shelter trust.  But because Husband was the settlor of this
trust, does this reversionary interest now give his creditors
access to the funds, perhaps also causing inclusion into his
taxable estate? The regulations under §2523 suggest not, as a
matter of federal transfer tax law.3

This is the context in which the
various UTC states' approach to lifetime QTIP trusts is examined.
In the last five years, Wyoming, Tennessee, North Carolina,
Arizona, Florida, Michigan and Virginia have all made amendments
modifying the asset protections afforded to these marital trusts.4

There are three variations among the
states: (i) decree that the donor spouse IS NOT the "settlor," or
that the property of such trust IS NOT contributed by the
"settlor;" (ii) treat amounts contributed to the trust as
originating from the settlor's spouse after her death rather than
from the settlor; or (iii) exempt the settlor's ability or power to

benefit from trust property from treatment as "distributable to or
for" his benefit after the spouse's death.5

Treatment as "settlor" after
spouse's death

Wyoming ,Michigan, and Arizona take
the first approach. Donor spouse is deemed not to be the settlor of
the eventual credit shelter trust for the Donor's benefit. But if
the donor spouse is not the settlor, who is? That question is,
pardon the pun, unsettled.  Wife, in the above example, is the
"deemed transferor" under the QTIP rules, but that is not the same
as settlor. Wyoming defines "settlor" as:"…a person, including
a testator, grantor or trust maker, who creates, transfers or
contributes property to, a trust. If more than one (1) person
creates, or transfers or contributes property to, a trust, each
person is a settlor of the portion of the trust property
attributable to that person's contributions or transfers, except to
the extent another person has the power to revoke that
portion."
6

Michigan defines "settlor"
as:"…a person, including a testator, who creates a trust. If
more than one person creates a trust, each person is a settlor of
the portion of the trust property attributable to that person's
contribution. The lapse, release, or waiver of a power of
appointment shall not cause the holder of a power of appointment to
be treated as a settlor of the trust."
7

Both these definitions clearly would
make the donor spouse the settlor, not the donee.

In addition to changing treatment of
settlors, Arizona also deems property of such trusts as not
contributed by the settlor. 8 This
begs the same question - who did contribute the property?
Additionally, Arizona expressly provides for the exception's
applicability to three other types of trusts not necessarily
qualifying for the marital deduction, including irrevocable trusts
created:

(i) inter vivos, for
the settlor's spouse, if the settlor is a beneficiary after the
spouse's death;

(ii) for the benefit of a person,
the settlor of which is the person's spouse, regardless of whether
and when the person was also a settlor of a similar trust for the
benefit of that spouse (reciprocal trusts); and

(iii) for the benefit of a person to
the extent that the trust property was subject to a general power
of appointment in another.9

Source of contribution after
spouse's death

Florida, Virginia, and North
Carolina do not leave us "unsettled" but instead decree that the
property, in our example, is treated as having been contributed by
Wife.10 The
exception provides that marital trust property is considered to be
contributed by the decedent spouse, and therefore primarily takes
aim at multi-settlor marital trusts.11 Florida
and North Carolina provide a "catch-all" provision extending
protection to trusts not explicitly comporting with §§2523(e)-(f),
but having property attributable to such trusts.12

Like Arizona, North Carolina goes on
to provide protection to irrevocable inter
vivos
 trusts that designate the settlor's spouse as the
sole life beneficiary, but that do not qualify for the federal gift
tax marital deduction.13

Distributions "to or for" the
settlor's benefit

The final approach is similar to the
first, but less unsettling. Tennessee alone adopts this approach in
its 2010 amendment to UTC §505, providing that, regardless of what
is actually distributed to the settlor, the distributions are
deemed not to be treated as "amounts distributzable to or for the
settlor's benefit" for purposes of UTC §505.14

For more information, in the Tax
Management Portfolios, see Lischer, 845 T.M.
, Gifts, and
Cohen, 864 T.M.
, Uniform Trust Code.

  1 §2523. 

  2 The expansion was made permanent in the early
hours of 2013 as a part of the Fiscal Cliff legislation. 

  3 See Regs. §25.2523(f)-1(d), (f),
Exs. 10 and 11; see also Mitchell M. Gans. Jonathan G. Blattmachr
and Diana S.C. Zeydel, "The Supercharged Credit Shelter Trust," 21
Probate and Property 52 (July/August 2007). 

  4 See generally, Wyo. Stat.
§4-10-505.1(e); Tenn. Code Ann. §35-15-505(d); N.C. Gen. Stat.
§36C-5-505(c); A.R.S. §14-10505(E); Fla. Stat. §736.0505(3);
M.C.L.S. §700.7506(4); Va. Code Ann. §64.2-747. 

  5 Compare Wyo. Stat. §4-10-505.1(e)
with Fla. Stat. §736.0505(3) and Tenn.
Code Ann. §35-15-505(d). 

  6 Wyo. Stat. §4-10-103(xviii). 

  7 Michigan §700.7103(i). 

  8 A.R.S. §14-10505(E). 

  9 Id. at (E)(3)-(5). 

  10 Fla. Stat. §736.0505(3); Va. Code Ann
§55-545.05B(3), [unintentionally omitted during a code renumbering
effort, will be reinserted and applied retroactively] N.C. Gen.
Stat. §36C-5-505(c). 

  11 UTC §505(a)(2). 

  12 Fla. Stat. §736.0505(3)(b); N.C. Gen. Stat.
§36C-5-505(c)(4). 

  13 Id. at (c)(3). 

  14 Tenn. Code Ann. §35-15-505(d).