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Protecting your children’s interests after a divorce: the usefulness of QTIP trusts

Sam is young and in love. He marries and has children, but eventually the marriage fails. He ends up in a second marriage with Trina, who already has two children of her own. After Sam’s death, the children from his first marriage learn that their father’s estate will pass to their stepmother and then to her children. What went wrong?

The short answer is that Sam failed to protect the interests of his children from his first marriage. Had I been his attorney, I would have advised him to set up a Qualified Terminable Interest Property trust, more commonly referred to as a QTIP trust. QTIP trusts basically ensure the financial security of a surviving spouse while also providing for the children from a first marriage.

Getting back to our example, this is how things ideally would play out: Taking the advice of a good estate planning attorney, Sam sets up a QTIP trust that grants Trina a so-called life estate if she survives him. Upon Sam’s death, his property is transferred to the trust. Trina, as the surviving spouse, receives any income that the assets in the QTIP trust generate, and she is entitled to using the real estate in the trust. But — and this is the important point — Trina doesn’t own the assets in the QTIP trust and can therefore neither sell nor bequeath them. After Trina’s death, the property in the QTIP trust goes to the people Sam originally designated as “final beneficiaries,” i.e. to the children from his first marriage.

What are the tax implications with this setup? A QTIP will not help you avoid estate taxes, it only delays them. When Sam dies, the assets in the trust become subject to the unlimited marital deduction which allows for the property to pass to Trina as the surviving spouse without the IRS cashing in. (This applies only if Trina is a U.S. citizen.) After Trina’s death federal estate taxes come due on her property as well as on the assets in the QTIP trust. Will Sam’s children have to pay taxes? Well, the federal estate tax exemption for 2015 is set at $5.43 million, and Trina can also use any unused portion of Sam’s exemption from estate taxes. (This tool is commonly referred to as “portability.”) As I have written before less than one percent of all estates exceed the $5.43 million limit. Chances are, Sam’s heirs are off the hook.

By Kevin J. Moore