Using and Misusing the Marital Deduction

Lauren J. Wolven, Julie Miraglia Kwon and Cynthia G. Lamar-Hart discussed the importance of the marital deduction in a session titled “Using and Misusing the Marital Deduction” at the 57th Annual Heckerling Institute on Estate Planning.

The speakers focused on planning for married individuals and the qualification for and utilization of the marital deduction, but also covered planning for those who anticipate divorce or who plan to marry or may never marry.

Discussion included how efficient use of the marital deduction can defer taxes and effectively use both spouse’s unified credits and GST exemptions.  Planning starts with the client: It is all about asking the right questions.  Planners don’t know what the estate tax will look like or whether circumstances will change by the first spouse’s death, let alone on the second spouse’s death.  Plus, every family is different.  There could be second or third marriages, partners with children from current and previous relationships, and couples without children.  Planners need to determine how law interacts with real life. 

The starting point for the marital deduction is IRC Sec. 2056(a).  In order to qualify for the marital deduction, the property must pass from the decedent to the surviving spouse, and be included in the decedent’s gross estate.  They then discussed each requirement and added that the property must also not be a nondeductible terminable interest.

Next followed a discussion of the pros and cons of relying on portability.  Portability is the surviving spouse’s ability to use the deceased spouse’s unused exemption (DSUE).

Pros of portability include:

1. Simplification (usually involves reliance on the DSUE)
2. No balancing of assets needed
3. Step-up in basis at second death
4. No trusts are needed

Cons include:

1. The DSUE can be lost. It only applies to the surviving spouse’s last post-2010 deceased spouse.  In other words, you only get one DSUE.
2. There is an estate tax return filing requirement. Fortunately, Rev. Proc. 2022-32 extends the time to file the return to five years but only if a return is not otherwise required.
3. The DSUE is a fixed amount. It does not grow.  A credit shelter trust on the other hand can grow outside of the surviving spouse’s estate.
4. GST exemption is NOT portable.

The speakers also pointed out that state tax planning should be considered especially in states that have an estate tax and the state estate tax exclusion is less than the federal exclusion. They also noted the reverse QTIP election is available and they warned to watch out for a simultaneous death clause that could invalidate the marital deduction.

Attention then turned to different ways of obtaining a marital deduction: outright, QTIP Trust, General Power of Appointment Trust, Estate Trust and QDOT (Qualified Domestic Trust).

Risks to leaving assets outright to a spouse include a potential loss of the spouse’s capacity, assets are subject to claims of creditors and loss of control.  These assets could be left to subsequent spouses or otherwise depleted in a way the decedent did not anticipate.  A discussion on the use of disclaimers then followed and emphasized how disclaimers could be used to add flexibility and take into consideration changed circumstances.

A QTIP trust is an effective way to use the marital deduction and retain control of the assets from the grave.  In order to qualify for the marital deduction as a QTIP Trust, there are four requirements that must be met under IRC Sec. 2056(b)(7):

1. the property must pass from the decedent;
2. the spouse must have a qualifying income interest for life;
3. there must be no other beneficiary during the spouse’s life; and
4. election must be made.

The QTIP election is essentially an agreement with the IRS that allows an estate to take the marital deduction now on this otherwise nonqualifying terminable interest property (because it ends at the surviving spouse’s death) if the surviving spouse agrees to include the trust property in his or her taxable estate.

Regarding the election, the speakers noted that because the government had so much trouble with returns that failed to properly make the QTIP election, QTIP treatment is now automatic unless there is an affirmative election out.  Simply report the trust or other property that qualifies for QTIP treatment accurately on the return (Form 706, Schedule M, for example) and compute the tax with the deduction reflected.

When planning with a larger estate, an advantage of the marital deduction is the deferral of estate tax until the surviving spouse’s death.  The surviving spouse can then deplete his or her estate by spending down the assets, making annual exclusion gifts or taking advantage of the educational or medical exclusion.  In addition, there might be other factors that come into play in the future like an increase in the estate tax exemption or elimination of the estate tax.  Potential estate tax law changes can also be  a disadvantage.  Rates may go up or the exemptions may go down.  Another big disadvantage of the marital trust is the timing of the non-spousal beneficiaries’ access to the trust.  With some second (or third) marriages, it is possible that the children from a first marriage are close in age to the surviving spouse so the requirement that they wait until the spouse’s death may seem unfair.

As mentioned, one of the disadvantages of portability is that there is no preservation of the GST exemption of the first spouse to die.  You don’t want to lose the GST exemption.  Therefore, a reverse QTIP election should be considered.  The speakers advise that the reverse QTIP election cannot apply to only a portion of a QTIP trust so include severance provisions in the trust. The speakers then gave drafting tips, like use a savings clause and include a statement of intent, and discussed funding formulas.