9124 / What are some of the considerations that should be taken into account when deciding whether to use an inter vivos or a testamentary QTIP trust?

Planning Point: Note that with an inter vivos QTIP trust, the trust documents can provide that the funding spouse will actually become the trust beneficiary if the less wealthy spouse is the first-to-die spouse. This option, however, still requires that the grantor not be given the right to amend, alter, revoke or terminate the trust.¹ This strategy also carries the risk that the trust could be treated as a self-settled trust reachable by the grantor’s creditors.

An inter vivos trust can also provide asset protection to the couple while both spouses are still living. Further, an inter vivos QTIP trust is “defective” for income tax purposes for the lives of both spouses—this eliminates the need to file separate income tax returns for the trust.

Property held in the inter vivos trust is valued separately from property held individually by the surviving spouse for his or her benefit. This generally means that if, for example, a portion of a piece of property is held in the QTIP trust and a portion remains outside of the trust, each portion of the property could potentially be eligible for any applicable valuation discounts that may be available.²

One primary disadvantage to the inter vivos QTIP trust is that it is not revocable upon divorce. Therefore, once created, the divorced spouse remains entitled to the benefit of the QTIP trust assets if he or she survives the trust creator. Despite this, the trust document can limit the trustee’s power to invade the trust principal by providing that such a discretionary right is available only if the beneficiary was married to the trust creator at his or her death. Prior to 2018, after divorce, income from the trust was includable only in the income of the beneficiary spouse.³ Because the testamentary QTIP trust only becomes effective at death, the grantor is able to modify his or her will following a divorce so that a prior spouse does not receive the benefit of the QTIP trust.

Planning Point: The 2017 tax reform legislation repealed IRC Section 682. Generally, the legislation modified the treatment of alimony payments with respect to divorces that occur after December 31, 2018, so that alimony will no longer be included in the income of the payee and deductible by the payor. Prior to its repeal, Section 682(a) provided that if a divorced spouse received income from a grantor trust (which would otherwise be taxable to his or her former spouse), the income would be taxable to the spouse receiving the payments. New IRS guidance provides that this rule will continue to apply if the divorce occurred on or before December 31, 2018 (unless the relevant instrument is modified to provide that the post-reform rule will apply). For divorces that occur after December 31, 2018, the grantor will now be taxed on income paid to the former spouse through the grantor trust. Because of this, spouses who create grantor trusts prior to or during the marriage should consider this issue, and potentially provide that the grantor trust will terminate upon divorce (or that the payor spouse will otherwise be reimbursed for taxes through other assets of the donee spouse).

1. Treas. Reg. § 25.2523(f)-1(d).