By: Christopher Ha, Attorney, TCV Law Group

Introduction to the QTIP Election

The “Qualified Terminable Interest Property” (QTIP) election is a name only an IRS attorney could love.

The purpose of this blog post is to show how the QTIP Election (sometimes called a Clayton Election) could save the beneficiaries of your estate plan (e.g., children) from having to pay thousands of dollars in capital gains taxes.

Facts for Example Case

Assume you and your spouse last did your estate planning back in 2002 and have not done an estate plan update since then.

Summary of your estate tax planning information with simplifications and rounding:

  1. Net worth in 2002: $3,000,000
  1. Estate tax exemption in 2002: $1,000,000 (per person)
  1. Possible estate tax exposure: $2,000,000 (assume no estate tax planning)
  1. Potential estate tax due at 40% estate tax rate: $800,000.

Your attorney expertly designed your estate plan to prevent you from owing estate taxes as in effect in 2002.

Part of your estate tax planning involved a BYPASS Trust (also commonly called a B Trust).

What Is a Bypass Trust And How Does It Help Me?

A Bypass Trust (also commonly called a B Trust) is a trust entity that is designed to be exempt from estate taxes.

A properly drafted Bypass Trust can (potentially) hold an unlimited amount of assets and shield all those assets from estate taxes when you or your spouse die.

However, what Uncle Sam gives with one hand, Uncle Sam takes with the other.

While a properly drafted and funded Bypass Trust is exempt from estate taxes, it does NOT (by default) provide a stepped up income tax basis for beneficiaries.

Recap of Bypass Trust’s tax traits:

  1. Estate taxes – very good result. Exempt from estate taxes.
  2. Income taxes – bad result. Assets in Bypass Trust are NOT eligible for a stepped up income tax basis when the assets flow to your beneficiaries (e.g., children)

Why Does Stepped Up Income Tax Basis Matter to My Beneficiaries?

Assume you bought Apple shares back in the early days.

Sample facts:

  1. You bought Apple shares for $10,000
  2. The Apple shares are now worth $310,000.

If you sold the Apple shares during your lifetime, you capital gains tax would be calculated as:

  1. Gross Proceeds from sale of Apple shares: $310,000
  2. Minus Cost Basis (what you paid for the Apple shares): $10,000
  3. Equals Capital Gain of $300,000

The tax rate on capital gains can be changed by Congress, but for simplicity, lets use a capital gains tax rate of 20%.

Income tax owed = capital gain of 300,000 multiplied by capital gains tax rate of 20% = $60,000.

Your author humbly posits that most clients would prefer not to write a check to IRS for $60,000.

The “Stepped Up Income Tax Basis Rules” solve this capital gains tax problem for your children.

If you hold the Apple shares until your death and leave the Apple shares to your children, they are treated as though they bought the Apple shares from you on your date of death for their fair market value.

Result = if your children sell the Apple shares, they only pay income taxes on capital gains starting from the date of your death and NOT from the date of your purchase. This could substantially reduce the income tax liability for your children.

Stepped Up Income Tax Basis – Example of How Stepped Up Income Tax Basis Saves Your Beneficiaries Capital Gains Taxes

Lets use the same Apple shares as above:

Sample facts:

  1. You bought Apple shares for $10,000
  2. The Apple shares are now worth $310,000.

For purpose of this example, the owner has to pass away. The author apologizes for being morbid.

  1. You pass away.
  2. On your date of death, your Apple shares are worth $310,000
  3. You leave all your Apple shares to one child.
  4. That child sells your Apple shares at $320,000.

How much of a capital gain does your child have?

  1. Child’s gross proceeds from sale of Apple shares: $320,000
  2. Child’s stepped up income tax basis in shares: $310,000
  3. Child’s capital gain on sale of shares: $10,000
  4. Child’s income tax owed at 20% capital gains tax rate: $2,000

Result: if you had sold the shares during your lifetime, you would have incurred a capital gain of $300,000. However, because of the Stepped Up Income Tax rule, your child incurred a capital gain of only $10,000.

Child’s Tax Savings:

Capital Gains Prevented for Child: $300,000

Cash Saved at Capital Gains Tax Rate of 20%: $60,000

However, this Stepped Up Income Tax rule is one of the items on the Congressional chopping block which may mean your child will pay estate and income taxes at your death.

Wait, So How Does Stepped Up Income Tax Basis Relate to the Qualified Terminable Interest Property (QTIP) Election?

Recall your estate tax planning from 2002!

Summary of your estate tax planning information (with simplification and rounding):

  1. Net worth in 2002: $3,000,000
  1. Estate tax exemption in 2002: $1,000,000 (per person)
  1. Possible estate tax exposure: $2,000,000 (assume no estate tax planning)
  1. Potential estate tax due at 40%: $800,000.

Your attorney expertly designed your estate plan to prevent you from owing estate taxes as in effect in 2002.

Part of your estate tax planning involved a BYPASS Trust (also commonly called a B Trust).

Tax Traits of a Bypass Trust:

  1. Estate Taxes – very good. Bypass Trust is exempt from estate taxes.
  2. Income Taxes – bad result. Assets in a Bypass Trust are NOT eligible for a stepped up income tax basis at death and are your children are exposed to capital gains taxes at your death.

Back in 2002 this was a very good plan. Avoiding a 40% estate tax rate at death outweighed the tax inefficiency of missing out on the stepped up income tax benefit on the assets in the Bypass Trust.

But fast forward to 2021 – and the default estate tax exemption per person is $11,700,000.

Assume your net worth held steady at $3,000,000 and will stay at this level for the foreseeable future in this example for simplicity. With standard estate planning tools you and your spouse are not at risk of owing estate taxes at death.

However, the Bypass Trust in your estate plan from 2002 prevents your children from getting a stepped up income tax basis on your assets at your death.

This could result in your children owing substantially more in capital gains taxes than necessary when you die.

What should be done about this situation?

How the Qualified Terminable Interest Property (QTIP) Election Lets Your Beneficiaries Qualify for Stepped Up Income Tax Basis When Estate Taxes Are Not an Issue

For this example, your attorney back in 2002 built in a safety valve.

When your attorney drafted your Bypass Trust she built in an optional Qualified Terminable Interest Property Trust (QTIP) election (also commonly called a “Clayton Election”).

The QTIP election was specifically designed for your situation:

  1. Bypass Trust no longer needed for estate tax protection
  2. You want your Bypass Trust to become eligible for Stepped Up Income Tax basis treatment to shield your children from capital gains taxes at death.

The QTIP election in your estate plan allows the executor of your estate to file an estate tax return which causes your Bypass Trust to:

  1. Lose its estate tax protection features (which you don’t need in this example)
  2. And in exchange your Bypass Trust get stepped up income tax basis treatment (which you want for your children in this example because you do not have an estate tax problem in 2021)

Using the figures from the example above, the QTIP election saves your children a capital gain of $300,000. If the capital gains tax rate is 20%, avoiding a capital gain of $300,000 equates to savings $60,000 income taxes.

Is The QTIP Election Available for All Bypass Trusts?

No. The QTIP election is not available for all Bypass Trusts because it requires certain provisions in your Will or Trust to become available.

The QTIP requirements are the responsibility of the drafting attorney but typically requires that all income of the Trust be distributed to your surviving spouse for his or her lifetime.

How Does This Information Help Me and My Beneficiaries?

Many estate plans older than 10 years call for mandatory Bypass Trusts because back in those days the potential harm from estate taxes outweighed the tax inefficiency of missing out on stepped up income tax basis by using a Bypass Trust.

Under the current 2021 estate tax rules, many clients may no longer need Bypass Trusts in their estate plans.

Some of those estate plans had a QTIP election safety valve that allows clients to cause their Bypass Trusts to lose their estate tax protection (which may no longer be needed) and in exchange gain stepped up income tax basis treatment (which can save children taxes in avoided capital gains).

However, some clients may have estate plans that do not have the QTIP election safety valve and may be binding their children with unnecessary capital gains taxes at death.

Conclusion

The author appreciates you reading this far and hopes this has been helpful in understanding some of the more arcane features of estate tax planning in Wills and Trusts!

The author notes that the example is generic in nature for illustration purposes and your case most likely requires an individual consultation for your specific situation (e.g., exceptions to general rule, non-tax considerations).

Call to Action

If your estate planning documents are more than 3 years old, you may benefit from an estate planning check-up with one of our estate planning attorneys.

In many cases, the initial consultation is free.

You can contact our firm at (512) 263-5400 or info@tcvlaw.com