QTIP Trusts and California’s Total Return Trust
A qualified terminable interest property trust (QTIP) is often included as a subtrust for a married couple. When combined with bypass subtrust that captures the amount of the first deceased spouse’s lifetime exemption, the QTIP allows the assets be used for the income benefit of the surviving spouse while preserving the principal for the remainder beneficiaries, usually the couple’s children.
For example, John and Mary have two children named Bob and Joe. When John passes away, their estate is worth $5 million. The current lifetime exemption for estate taxes is $3 million, so the first $3 million is placed by their joint trust into a bypass trust, with the other $2 million placed in the QTIP trust. The bypass trust pays out income to Mary and the principal can also be used for limited purposes such as maintenance and health. The QTIP trust terms require the income to be distributed to the spouse and the principal left for the children in order to qualify for the marital exemption from estate taxes.
But here’s the problem: does the trustee manage the assets in the QTIP trust for income or growth in principal? The trustee is required by law to treat all beneficiaries equally, and so cannot favor one or the other with the investment decisions. But the original intent may have been to prioritize income over growth to provide for the surviving spouse. Prudent investing guidelines require diversification, also creating conflict for the trustee. California resolved this problem in 2005 with the creation of a trust called a ‘total return trust’.
In this special type of trust, the current beneficiary (Mary, the surviving spouse in our example) receives a specific percentage of the trust’s total assets every year. The amount must be from 3% to 5% of the total assets to qualify, and can include distribution of principal assets.
Now Bob and Joe (the children) are happy - the assets can be invested to maximize total return. And Mary the surviving spouse is happy, as the trust’s assets grow her distributions increase because they are tied to a percentage of the total value. And the trustee is no longer caught in the middle.
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