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Exit Planning: Marital Deduction

19 Jan Exit Planning: Marital Deduction

Smart use of the marital deduction is essential in the design of most exit plans. It’s the tool that eliminates any estate tax bite on the death of the first spouse, deferring all taxes until the survivor’s death. Although rationales are sometimes spouted for paying some taxes at the first death, they’re always based on problematic assumptions that ignore the simple reality that nearly all business owners have no stomach for paying taxes any sooner than absolutely necessary. In most situations, the game plan for the marital deduction is to use a qualified terminable interest property trust called a QTIP.

Now, this is a special trust that qualifies for the marital deduction but does not give the surviving spouse carte blanche control of the stock. Although it adds complexity on the death of the first spouse, in most cases, the QTIP will be far superior to the alternative of leaving stock directly to the surviving mate. The QTIP trust is an essential element of most transition plans. It bridges the gap between the deaths of the parents, eliminates estate taxes on the death of the first parent, ensures that each parent can control the ultimate disposition of his or her property, provides management and creditor protection benefits, and preserves precious valuation discounts. In short, it can quell at least some of the issues inherent in having multiple mouths at the trough. The challenge is to customize each spouse’s QTIP to meet the parent’s objective and to avoid technical traps that compromise the all-important marital deduction.

To qualify for the marital deduction, that is to make it work tax-wise, the QTIP must mandate that during the life of the surviving spouse all income generated in the QTIP trust will be currently paid to the surviving spouse and no person other than the surviving spouse may receive property distributions from the trust. Also, an election must be made to claim the marital deduction benefits for the trust. A closely held business interest that comprises the bulk of the parent’s estate can sometimes trigger problems with one of these valuable QTIPS. Here are a few key traps to avoid:

Minority Discount QTIP 

This trap surfaces when a controlling interest in a business is included in the estate of the first spouse to die, thus the stock has a high value. But only a minority interest in the business stock is transferred to fund the QTIP and the balance of the stock passes either to a credit trust to other family members. The same specific shares from the estate are given a high value for gross estate valuation purposes but a lower discounted minority interest value for marital deduction purposes. This whipsaw nets a marital deduction that is just too low. The estate of the first spouse to die ends up paying an unanticipated estate tax liability along with various other tax problems.

The key to avoiding this whole mess is to make certain that if the estate owns a controlling interest in the stock of the business, that the QTIP is funded either with other assets of the estate or with stock in the business that clStevey also represents a controlling interest in the business.

Buy-Sell QTIP 

The buy-sell QTIP trap may be triggered when a QTIP is funded with corporate stock that is subject to a buy-sell agreement that gives another family member, Dave for example in our case, the right to buy the stock pursuant to a price established under the agreement and that price is not controlling for estate tax purposes. If the value of the stock for estate tax purposes, as ultimately determined, is greater than the price paid by Dave under the buy-sell agreement, then Dave may be deemed to have received an economic benefit from the QTIP during the life of the surviving spouse, Betty, by virtue of his right to buy the stock for less than its full value. The result, the entire QTIP marital deduction may be blown triggering a huge estate tax on Steve’s death. It’s a bombshell.

There are 2 ways to avoid this trap. Ensure compliance with the section 2703 requirements we previously described so that the buy-sell agreement will be deemed to control for estate tax purposes or make certain that any stock passing to the QTIP is not subject to any buy-sell agreement.

QTIP Trap

Assuming our case study that at Steve’s death, his estate owns 45% of the stock and Betty owns 45% of the stock. The 45% owned by Steve’s estate would constitute a minority interest for estate tax purposes. Assume that Steve’s will or living trust mandates that his stock pass directly to Betty in order to secure the marital deduction to eliminate any estate tax liability. Betty now would end up directly owning a controlling interest in the company which would be valued at a very high value for estate tax purposes at her death.

In contrast, assume that Steve have left all of his stock to a QTIP trust to ensure the marital deduction, not directly to Betty. The QTIP’s income would be paid to Betty every year and the trust could be structured to provide Betty with any other distributions needed to maintain her lifestyle. Both Betty and the QTIP would own minority stock interest, 45% a piece. Even though both of these interest would be subject to estate taxes at Betty’s death, they would be valued for estate tax purposes as two separate minority interests, not one controlling interest, so big estate taxes would be saved. The estate tax over valuation nightmare at Betty’s death is gone. The lesson is that smart use of a QTIP in designing any gift or marital deduction components of the plan often is the key to preserving valuable discounts that otherwise would be lost with direct inter-spousal transfers of stock at the death of one parent.

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Nate Nead
Nate Nead is a licensed investment banker and Principal at Deal Capital Partners, LLC which includes InvestmentBank.com and Crowdfund.co. Nate works works with middle-market corporate clients looking to acquire, sell, divest or raise growth capital from qualified buyers and institutional investors. He is the chief evangelist of the company's growing digital investment banking platform. Reliance Worldwide Investments, LLC a member of FINRA and SIPC and registered with the SEC and MSRB. Nate resides in Seattle, Washington.
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