The non-deductible terminal interest rule is an important tax rule in estate planning. Typically, gifts to a spouse are not taxable because of the unlimited marital deduction. The unlimited marital deduction allows a person to gift any amount of property to a spouse without incurring gift or estate tax liability.
However, if the recipient spouse’s interest in the gifted property will terminate for any reason, such as after a specified period of time or upon the occurrence of an event, then it is a terminable interest. The gift of a terminable interest is typically taxable and is not subject to the marital deduction described above.
For example, suppose H gifts to his wife, W, a life estate in certain property, with the remainder to go to his children. This gift would not generally receive the benefit of the marital deduction because W’s interest will terminate at her death. Therefore, the gift would generally be subject to taxation.
Because of the terminable interest rule, almost any gift to a spouse that does not transfer outright ownership is potentially a taxable gift if it exceeds the annual exclusion amount.
Here it is important to note two tax concepts: 1) the annual gift tax exclusion amount; and, 2) the unified credit, or estate tax exemption amount.
For 2018, the annual exclusion amount for gift tax purposes is $15,000 per donor per recipient. This means an individual can give up to $15,000 to a person without incurring any tax liability. For gifts above that amount, a gift tax return is required.
The unified credit offsets the estate tax on a certain amount of a person’s property, known as the exemption amount. For 2018, this exemption amount is $11.2 million per person, or $22.4 million for a married couple. This means that a single person with a total estate of $11.2 million or less can pass to his beneficiaries all of his property tax free (at least as far as federal estate tax is concerned), or $22.4 million for a married couple.
The gift and estate taxes work together. This means that lifetime gifts above the annual exclusion amount will reduce the person’s estate tax exemption amount at death. So, for example, suppose an individual made taxable gifts in the amount of $5.6 million during her lifetime but used her unified credit with respect to those gifts to shelter them from taxation. Suppose the person then passed away in 2018. She then would be able to pass property to her beneficiaries in the amount of $5.6 million free of any estate tax. This is because she used $5.6 million of her exemption amount during her lifetime, thus reducing the amount of property she could transfer tax free after death.
A gift or bequest that is a terminable interest, even to a spouse, will likewise use up the exemption amount, up to the value of the property.
However, there are exceptions to the non-deductible terminal interest rule. One of these exceptions is a general power of appointment trust. Under this exception a surviving spouse must be entitled to all of the income from the property for life and have the power to determine who will receive the property at his or her death (a general power of appointment).
Another exception to the non-deductible terminable interest rule is a Qualified Terminable Interest Trust, or a Q-Tip Trust.
A Q-Tip Trust allows an individual to give a lifetime interest in property to a spouse and still designate who will receive the remainder interest on the spouse’s death. This is often preferable to a general power of appointment trust, particularly for spouses with children from a prior marriage.
A Q-tip qualifies for the marital deduction if it meets certain requirements. Among these requirements: It must state that the income of the trust property must be paid to the surviving spouse during his or her lifetime. The surviving spouse must be paid the income at least annually. No one can have power to distribute the principal of the trust property to anyone other than the surviving spouse during his or her lifetime. The spouse must be a U.S. citizen (for non-citizens, a qualified domestic trust, or QDOT, is often used).
A QTip trust is especially useful for blended families, such as a subsequent marriage where one or both of the spouses have children from a prior marriage. A QTip trust allows a person to make sure his or her spouse is taken care of during their lifetime, but still make sure that their property ultimately passes to their chosen beneficiaries, such as their children from a prior marriage.
This material should not be construed as legal advice for any particular fact situation, but is intended for general informational purposes only. For advice specific to any individual situation, an experienced attorney should be contacted.