The Importance of the Terminable Interest Rule and QTIPs in Estate Planning

A qualified terminable interest property (“QTIP”) trust is an estate planning tool designed to provide for a surviving spouse while preserving assets for other beneficiaries. A QTIP provides a lifetime interest in the assets held in trust. QTIP trusts are typically irrevocable testamentary trusts. A testamentary trust is a trust that is established in a will that takes effect after the person (the grantor dies) who created it dies. A trustee, named in the will, manages the trust assets according to the grant’s wishes. Under the terms of the trust, the income generated by the trust’s assets is generally paid to the beneficiary spouse. The principal or remainder in the trust is distributed according to the wishes of the grantor.

QTIP trusts are often created to defer or avoid the estate and gift tax. Federal law imposes a transfer tax upon the privilege of transferring property by gift, bequest or inheritance. This transfer tax takes the form of a gift or estate tax. Gift and estate taxes are computed on the progressive unified rate schedule set forth in Section 2001 of the Internal Revenue Code with the rates ranging from 18% to 40% on the value of a gift or the value of an estate. A unified credit is available to minimize the impact of the transfer tax. The unified credit gives a set dollar amount that an individual can gift during their lifetime and pass on to beneficiaries before a gift or estate taxes apply. U.S. citizens and resident individuals are permitted a unified credit that exempts $13.99 million (for the 2025 calendar year) from the estate and gift tax. This means that U.S. citizens and residents can pass $13.99 million (in 2025) to their heirs without being assessed a gift or estate tax.

An unlimited deduction is allowed in computing the value of the taxable estate for the value of all property included in a decedent’s gross estate passing from the decedent to the decedent’s surviving spouse. This is the most important deduction available to married couples wishing to minimize estate taxes on their property. Not every interest in property that passes from a decedent to a surviving spouse qualifies for the martial deduction. For a trust to qualify for the marital deduction and thus be exempt from the estate tax, the surviving spouse must have control over the trust and the disposition of the trust assets. It should also be understood that a terminable interest will not qualify for a martial deduction. A terminable interest is one that ends at some specified time. For example, if a wife leaves her husband an interest in a house, but the house will pass to her children at the time the husband dies, the value of the house is a terminable interest which does not qualify for a marital deduction.

Section 2056(b)(5) of the Internal Revenue Code makes an exception to the terminable interest rule to permit the martial deduction with respect to life interests passing to a surviving spouse, even though contingent interests pass to others, if the spouse enjoys other controls over the property that, in general effect, make the spouse the complete owner of the property.

In order to qualify as a QTIP trust, the following must apply:

1) The Surviving Spouse Must be Entitled for Life of the Income From the Entire Interest or a Specific Portion of the Entire Interest, or a Specific Portion of All the Income from the Entire Interest

The surviving spouse should get “substantially that degree of beneficial enjoyment of the trust property during her life which the principles of the law of trusts accord to a person who is unqualifiedly designated as the life beneficiary of a trust.” See Treas. Reg. Section 20.2056(b)-5(f)(1). Within this concept discussed in the regulations promulgated under Section 2056, the exception to the terminable interest rule is not likely to be defeated by trust provisions; 1) requiring stock dividends or the proceeds from the conversion of trust assets to be treated as corpus or 2) prohibiting assignment or alienation of the spouse’s right to income. Neither is the exception lost merely because the survivor will not receive the income from the trust property for the period before distribution of the property by the executor, unless there is a will provision authoring or directing unreasonable delay in such distribution. Even if the trustees are given the discretionary power to retain cash without investment and to allocate receipts between income and principal, the marital deduction is permitted if local law imposes upon the trustees a duty to use the degree of care a prudent person would use if the person owned the trust assets. See Treas. Reg. Section 2056(b)-5(f)(4). However, a general provision for accumulation of trust income or for income accumulation at the discretion of someone other than the surviving spouse leaves the spouse without the current right that is a prerequisite to the exception to the terminable interest rule. See Treas. Reg. Section 20.2056(b)-5(f)(7).

A phrase “specific portion” is located in Internal Revenue Code Section 2056(b)(5). This phrase has been subject to significant controversy in tax litigation. While a surviving spouse’s interest in a portion of a trust can qualify for the martial deduction, the portion must be identified. The Treasury took the position that a trust as to which a spouse has an income interest expressed in a fixed dollar amount or a general power of appointment (a power of appointment is a right granted to an individual to designate who will receive property or assets) over a fixed dollar amount will not qualify for the specific exception to the terminable interest rule, because likely variations in trust income or corpus makes it impossible to express the spouse’s income interest or power in terms of a “fractional or percentile share.”  Eventually, Section 2056(b)(10) was added to the Internal Revenue Code. Section 2056(b)(10) provides that the term “specific portion” includes a portion based on a fractional or percentage basis. Thus, if the surviving spouse is entitled to only one half (or some other fraction) of the income (or the relevant fraction of the trust corpus, even if the surviving spouse has larger powers over the corpus.

Please find Illustration 1 which provides examples of partial QTIP Election Language for a trust.

Illustration 1.

Pursuant to section………of the Last Will and Testament of Decedent, the residue of the Estate of Decedent passes to the (QTIP) Trust, established under section…… of said will. (Surviving Spouse) has a qualifying income interest, as defined in Internal Revenue Code Section 2056(b)(7) and regulations thereunder, in such trust, and thus the trust is able to be qualified as a Qualified Terminable Interest Property trust. This election is being made with respect to a part of the trust, as defined by a fraction or percentage of the entire trust. This fraction or percentage is defined by the following formula, as allowed by regulation Section 20.2056(b)-7(b)(2):

1 – (x divided by y)

Where x = the greatest amount that can pass free of federal estate tax in Decedent’s estate, taking into account all relevant tax credits (including, but not limited to, (i) the unified credit provided by Internal Revenue Code Section 2010, (ii) the credit for state death taxes provided by Internal Revenue Code Section 2011, and (iiii) any credit or reduction in adjusted taxable gifts provided by Chapter 14 of the Internal Revenue Code) and other factors pertinent to the computation of the federal estate tax in Decedent’s estate (including, but not limited to, any transfers of property, including in the gross estate, to specific beneficiaries other than the surviving spouse, by will or otherwise), but only to the extent that the use of any such credit or the consideration of any such factor does not increase the amount of death taxes otherwise payable to any taxing authority by reason of Decedent’s death; and

Where y = the total gross estate, less the sum of expenses of administration, indebtedness and taxes; losses; transfers for public, charitable and religious uses; and all property interests including in the gross estate transferred to specified beneficiaries, including the surviving spouse, by will or otherwise.

For the estate of Decedent, based upon the amounts as reflected in this United States Estate (and Generation-Skipping Transfer) Tax Return, Form 706, the fraction is …….

2) The Income Payable to the Surviving Spouse Must be Payable Annually or More Frequent Intervals

In order to qualify as a QTIP trust, the surviving spouse must receive all of the income, and there must be a distribution of that income at least once a year. See Rev. Rul. 72-283, 1972-1 CB 311.

3) The Surviving Spouse Must Have the Power to Appoint the Entire Interest or the Specific Portion to Either Surviving Spouse or Spouse’s Estate

If the property passing from the decedent passes in form such that 1) the spouse is entitled to all of the income from the property, or a specific portion thereof, for payable at least annually, 2) the spouse has a power to appoint the property either to herself or to her estate which is exercisable alone and in all events and 3) no person, except the spouse, has a power to appoint the property to any person other than the spouse, the property passing from the decedent qualifies for the marital deduction. See IRC Section 2056(b)(5).

To illustrate, below, please find Illustration 2.

Illustration 2.

Suppose Sue creates a $100,000 trust to pay income to Tom for life, remainder to such persons, including Tom’s estate, as he appoints by will and in default of appointment to Craig. Sue’s estate is entitled to a marital deduction in the amount of $100,000. The marital deduction would be allowable even though Tom had a special inter vivos power of appointment exercisable in favor of his issue, in addition to his testamentary general power. The trust would qualify for a $100,000 marital deduction even if the trustee of the trust could invade the trust corpus for Tom. However, if the trustee could invade the corpus for the benefit of another person, other than Tom’s dependent and in satisfaction of his legal obligation of support the trust would not qualify for the marital deduction.

Property qualifying for the marital deduction under the life estate/power of appointment (a power of appointment is a legal mechanism where one person (the donee) is granted the authority to decide who will receive a specific asset or assets) exception will be included in the surviving spouse’s estate tax base either because the spouse exercises the general power (a general power of appointment means the holder has the right to decide who will receive assets subject to the power, including themselves) at the time of his death. See IRC Section 2041.

4) The power in the Surviving Spouse Must be Exercisable by the Spouse Alone and (Whether Exercisable by Will or During Life) Must be Exercisable in All Events

Under Section 2056(b)(7) qualified terminable interest property passing from the decedent to the surviving spouse qualifies for the marital deduction. Qualified terminable interest property is property in, or with respect to, which (1) the spouse is entitled to all of the income for life payable at least annually, (2) no person, including the spouse, has the power to appoint any of the property to someone other than the spouse during the spouse’s lifetime and 3) the executor has made an election that the property should qualify for the marital deduction.

To illustrate, below, please find Illustration 3.

Illustration 3.

A transfer from Tom to Lisa for life, remainder to Craig qualifies as a QTIP so long as no one can appoint the property to someone other than Lisa during her life.

To assure that a QTIP enters into the surviving spouse’s transfer tax base either under the gift or the estate tax, Section 2519 and Section 2044 were enacted. If a person with a qualifying income interest for life in QTIP transfers that income interest to another, the person is deemed to also have transferred the remainder interest. Whether or not the transfer of the income interest is a transfer for less than adequate and full consideration in money or money’s worth, a transfer of that interest also results in a transfer of the remainder under Section 2519.

5) The Entire Interest or the Specific Portion Must Not be Subject to a Power in any Other Person to Appoint Any Part to Any Person Other Than the Surviving Spouse

A power in another to appoint only to the surviving spouse need not defeat the exception to the terminable interest rule, because if it is exercised the power subject to the power simply becomes property subject to the power simply becomes property owned outright by the spouse subject to usual gift or estate tax consequences depending upon the spouse’s disposition of the property. Thus, as the statute indicates and the regulations provide, “a power in a trustee to distribute corpus to . . . a surviving spouse will not disqualify the trust.” See Treas. Reg. Section 20.2056(b)-5(j). On the other hand, if another person had a special power to appoint to the decedent’s children, which could be exercised in order to defeat a spouse’s inter vivos or testamentary power, property might be released from the surviving spouse’s estate free of tax, and such a power would disqualify the trust. If the other person’s power is exercisable only after the death of the surviving spouse, the trust is not disqualified because such a power is not “in opposition to that of the surviving spouse.”

An example in the regulations dealing with this point is set out below.

Assume that the decedent created a trust, designating his surviving spouse as income beneficiary for life as donee of a power to appoint by will will be the entire corpus. The decedent further provided that the trustee could distribute 30 percent of the corpus to the decedent’s son when he reached the age of 35 years. Since the trustee has a power to appoint 30 percent of the entire interest for the benefit of a person other than the surviving spouse, only 70 percent of the interest placed in trust are satisfied…If, in this case, the surviving spouse had a power, exercisable by her will, to appoint only one-half of the corpus as it was constituted at the time of her death, it should be noted that only 35 percent of the interest placed in the trust would satisfy [the exception to the terminable interest rule]. See Treas. Reg. Section 20.2056(b)-5(j) Ex. (2).

When the spouse who possesses a qualifying interest in QTIP dies, the QTIP is included in the spouse’s gross estate under Section 2044 unless during the spouse’s life a Section 2519 transfer occurred.

If the spouses follow certain guidelines, a QTIP trust allows the surviving spouse to benefit from the trust and be able to use the marital deduction. The QTIP trust must only benefit the surviving spouse during their lifetime, and this must be specifically provided for in the trust document and unchanged by the spouse or trustee. Otherwise, the QTIP trust will not receive the marital deduction. After the benefiting spouse passes, the QTIP trust assets pass to the beneficiaries as set by the granting spouse, not the benefiting spouse. For estate tax purposes, the QTIP trust assets apply to the benefiting spouse’s applicable exclusion amount.

The Qualifying income Interest Requirement

The “qualifying interest” requirement involves two prongs. The surviving spouse must have, first, a right to all the income from the property for the spouse’s life, payable annually or more frequently (or have a usefruct interest for life in the property).

See IRC Section 2056(b)(7)(B)(ii)(I). The surviving spouse’s income interest must generally commence at the decedent spouse’s death and extend for the surviving spouse’s life. Second, no one may have a power to appoint any part of the property during the spouse’s lifetime except for the spouse’s benefit.

Conclusion

The foregoing discussion is intended to provide the reader with a basic understanding and tax considerations of a QTIP. It should be evident from this article, however, that this is a relatively complex subject. As a result, it is crucial that anyone considering establishing a QTIP consult a qualified tax attorney.

Anthony Diosdi is an international tax attorney at Diosdi & Liu, LLP. Anthony focuses his practice on domestic and international tax planning for multinational companies, closely held businesses, and individuals. Anthony has written numerous articles on international tax planning and frequently provides continuing educational programs to tax professionals.

He has assisted companies with a number of international tax issues, including Subpart F, GILTI, and FDII planning, foreign tax credit planning, and tax-efficient cash repatriation strategies. Anthony also regularly advises foreign individuals on tax efficient mechanisms for doing business in the United States, investing in U.S. real estate, and pre-immigration planning. Anthony is a member of the California and Florida bars. He can be reached at 415-318-3990 or adiosdi@sftaxcounsel.com.

This article is not legal or tax advice. If you are in need of legal or tax advice, you should immediately consult a licensed attorney.