Teresa Bush, JD., InterActive Legal
A television show in the early 2000's had a frequently-used bit where a popular guy would introduce his somewhat shy friend to women at the neighborhood bar with the quick line “Have you met Ted?” It’s likely that the women otherwise never would have had the opportunity to meet Ted, as he was a bit of a wallflower. I feel the same way about the Clayton QTIP.
Before joining InterActive Legal (ILS) in 2007, I practiced estate planning law for sixteen years, and I never once drafted a document using a Clayton QTIP. Nor, to my knowledge, did any of the attorneys with whom I practiced. Honestly, we didn’t pay much attention to the Clayton decision back then. Only when I began working with ILS documents did I learn what a great option the Clayton QTIP can be for flexibility in estate planning, as an alternative – or in addition to – a disclaimer plan. Had I not started working with ILS, I probably never would have taken the opportunity to understand this planning tool.
To understand Clayton, think about a disclaimer plan. Ted can leave all his property to his wife outright – or in a QTIP trust – and provide in his Will that if she disclaims, the disclaimed property passes to a credit-shelter trust (the “bypass” trust). In that way, if Ted’s net worth increases, or the estate tax exemption decreases (so that a bypass trust makes sense) his widow can create it post-mortem. This makes for a document that is easier for the client to understand – no potentially cryptic formula gifts – and lets the surviving spouse take action to minimize taxes, if necessary.
We’ll consider the drawbacks of the disclaimer approach in a moment. But first, let’s meet Clayton.
The Clayton QTIP works very much like a disclaimer, because both are post-mortem tools for funding a bypass trust. In a Clayton QTIP plan, Ted leaves all of this property to a trust for his wife (this won’t work with an outright gift), which will qualify as a QTIP trust if Ted's executor makes the QTIP election. The document then provides that if Ted’s executor doesn’t make the QTIP election, or makes only a partial election, the non-QTIP property passes to a bypass trust. Hence, the result is the same under a disclaimer plan or a Clayton QTIP plan: property that would have otherwise passed for the spouse’s benefit, in a form that qualified for the estate tax marital deduction, and been included in the surviving spouse’s taxable estate at death, passes instead to a bypass trust that avoids estate taxation in both spouses' estates.
But wait – how can this possible re-directing of property work and still allow the QTIP to qualify for the marital deduction?
We all know that no one can have the power to direct property away from the spouse, or the marital deduction is lost. That was the issue faced by the court in the Clayton case, in which the concept was approved – the marital deduction remains available for the QTIP to the extent the election is made, even if the document provides for non-QTIP property to pass to the bypass trust – and specifically addressed by regulation in 1997 (Treas. Reg. §20.2056(b)-7(d)(3)).
The disclaimer and Clayton QTIP plans differ in one important way – the identity of the party who decides whether to fund the bypass trust.
With a disclaimer, the surviving spouse makes the decision – presumably with the assistance of her advisors who will evaluate whether a bypass trust is advisable. With a Clayton QTIP, the decedent’s executor makes the decision.
If the spouse is serving as executor, does that mean the party making the decision is the same? Usually not. Most practitioners require that a decision to act under a Clayton provision can only be made by a disinterested executor. ILS documents include this restriction, and for good reason - it prevents the spouse from making a gift, which would occur with the shift of property from a trust in which the beneficiary is entitled to all income to a trust where income distributions are discretionary. It also allows someone other than the spouse to be the decision-maker, which can be important in Medicaid planning. Indeed, one major advantage of Clayton over disclaimer is that a spouse who disclaims might be considered to have made a transfer for Medicaid purposes. If the (non-spouse) executor makes the call, then there should be no transfer made by the spouse.
Another advantage Clayton has over the disclaimer approach is that putting the decision in the hands of another party – a disinterested fiduciary who needs to make the best decision for all beneficiaries – can make it more likely that a bypass trust will be created when needed. I’ve heard both Jonathan Blattmachr and Howard Zaritsky say that one of the world’s biggest lies, apart from “the check is in the mail,” is that the surviving spouse will disclaim. Even if it makes sense to do so, the spouse may not want to give up control (in an outright gift situation) or rights to all income (in a QTIP), but if the Clayton option is available, the executor can make the decision.
I’ve come to appreciate the Clayton QTIP as a great alternative for contingency planning particularly in the current political climate. Back when I was actively practicing, we did more formula gift planning (and much less wait-and-see planning), because the estate tax exemption was much lower – just over 5% of what it is now – and most clients clearly needed a bypass trust. But today, with larger exemptions and the potential for major tax law changes as administrations change, having a flexible plan, where the executor can implement the best tax planning when the time comes, makes a great deal of sense. And Clayton’s advantages make it the preferred choice, either alone or in addition to a disclaimer.
So, have you met Clayton? It may be time to do so.