Let’s set the stage. You are a professional service provider and are concerned about professional liability exposure. Or you are engaged in a business that is high risk and you are worried about being sued.
So your lawyer said put all your assets in your spouse’s name.
Well, that generally works. But the solution creates its own problem, which is shown by the following example of a married couple.
Joe and Jane have a combined net worth of $4 million. Joe places all assets in Jane’s name, so the balance sheet is $4 million for Jane and $0 for Joe. This solves the liability problem for Joe because Jane is not liable for Joe’s debts so, as long as she has all the assets and Joe has nothing, Joe is judgment-proof
So what and where is the problem? It is an estate tax problem.
By way of background, here in Connecticut each spouse has a $2 million exemption from estate taxes and it behooves a married couple to make sure that they can each use their exemption if it’s needed to eliminate estate taxes. So let’s take a look at a scenario.
If Jane dies first
If Jane dies first, she can leave $2 million in a special type of trust known as a QTIP trust that qualifies for a marital deduction as long as Joe gets all the income for his life—a deduction from her $4 million gross estate in arriving at her taxable estate, which would be $2 million.
The QTIP trust would be protected from Joe’s creditors because he was only a beneficiary of the trust—he did not own the assets outright. For that remaining $2 million taxable estate, Jane can place that also in a trust for her husband that is protected from Connecticut tax by her $2 million exemption. No tax if Jane dies first because the QTIP is a deduction for her and the other $2 million is protected by her exemption.
Assuming a nuclear family, both trusts are likely drafted so that the remaining assets of both trusts will pass to the children at Joe’s death. But the QTIP trust, because Jane received a deduction for it, means it must be included in Joe’s estate, even if Joe was merely the beneficiary.
As an aside, estate taxes are like income taxes: if someone gets a deduction somewhere (Jane at her death for the QTIP trust), someone must have to pick something up on the other end (Joe will have the remains of the QTIP included in his estate at his death). But Joe has his own $2 million estate tax exemption, so, as long as the remains of the QTIP are less than $2 million, there is not estate tax due at his death. If the QTIP has grown since Jane’s passing and has more than $2 million, only the excess over $2 million will be exposed to tax.
Not a bad result. The assets are protected from Joe’s creditors and no estate tax is due when either Jane or Joe die.
So you ask again, where and what is the problem?
Answer: What if Joe dies first?
If Joe dies first, which is likely based on life expectancies, he has no need to worry about estate taxes due at his death because he has no estate. H gave all his assets to Jane so, when he dies, there is no estate tax.
But then Jane dies later on and she has all of the $4 million. With no spouse to pass the assets to at her death, there is no marital deduction and, consequently, her gross estate is the same as her taxable estate. With a $4 million gross estate and a $2 million estate tax exemption, $2,000,000 will be exposed to Connecticut estate tax resulting in a tax due at her death of about $146,200. Oops.
What we say, at this point, is that by trying to avoid any potential creditors of Joe, we have created an estate tax problem of $146,200 for Jane if her husband dies before her.
The solution is a QTIP
While she is still living, Jane places $2 million into a QTIP trust for Joe. There will not be any gift tax on the assets that are placed in the QTIP Trust. Joe is the sole income beneficiary of the QTIP trust for his lifetime (a requirement of any QTIP Trust) and, if he dies first, the assets then remaining in the QTIP trust will be included in his estate.
BUT, because Joe has a $2 million estate tax exemption of his own, the $2 million of QTIP assets included in his estate for estate tax purposes are protected from any estate tax up to the $2 million amount. And while the assets are in the QTIP they are protected from Joe’s creditors.
Now it does not matter who dies 1st or 2nd because both spouse’s will be able to use their $2 million estate tax exemptions. But, you ask, when Joe dies, do the assets in the QTIP still go to the children? And is Jane left to survive on only her $2 million, a situation that she might find unacceptable?
The answer is no. Jane can draft the QTIP to provide that if Joe dies first, the assets remain in further trust her HER benefit until she dies, and then the assets will pass to the children. Jane can draft the QTIP trust to provide her, after Joe’s death, with income and principal. She will, in fact, have the full benefit of all $4 million.
Creditor protection and no estate tax – no matter what the order of deaths may be.