The unlimited marital deduction allows a spouse to give an unlimited amount of property to the other spouse, either as an inter vivos gift or as a transfer from a deceased spouse's estate to the surviving spouse, free of federal gift or estate taxes. However, the marital deduction may not be available under state tax laws or it may be limited.
The marital deduction provides support for the surviving spouse by deferring — but not eliminating — the estate tax that may be due on the decedent's property. The actual deduction claimed on the tax return equals the value of the property when transferred as a bequest, but as a gift, the deduction is reduced by the annual exclusion that applies in the year of the gift.
The original purpose of the marital deduction was to equalize the treatment of married couples living in community property states and separate property states in regard to gift or estate taxes. Before 1948, for a couple where one spouse made most or all of the money, a couple in a community property state would pay considerably less in estate taxes when the breadwinner died first than a couple in a separate property state, because in a community property state, all of the earnings of the spouse is considered community property and owned equally by the 2 spouses, regardless of who actually earned the money. When the breadwinner died in a community property state, only half of the community property would be includable in his estate and subject to estate tax. In a separate property state, the entire breadwinner's property would be included in his estate.
The Revenue Act of 1948 amended the tax code to reduce the tax advantages of a community property state by allowing couples to file joint returns, where the breadwinner could split his earnings with a non-earning spouse, and by allowing a 50% marital deduction where the breadwinner could leave 50% of his property to his spouse free of estate taxes. This eliminated the advantage of community property states over other states with respect to the wealth transference taxes.
With the Economic Recovery Tax Act (ERTA) of 1981, Congress amended the federal estate tax law again by incorporating a new principal – that a married couple should be considered as one economic unit and that, therefore, any transfers of property between them should be free of wealth transfer taxes. The new law provided an unlimited marital deduction for any transfers between spouses, and for transfers from the deceased spouse's estate to the surviving spouse, and also introduced the concept of qualified terminal interest property (QTIP). The unlimited marital deduction would apply to any property where the surviving spouse received at least a life estate in the property.
The marital deduction has 6 requirements, to ensure that the property actually transfers to a spouse:
- there is a surviving spouse;
- the decedent and the surviving spouse must be legally married under state law and under federal law;
- Although marriage has traditionally been the state's jurisdiction, the Republicans have passed the Defense of Marriage Act to restrict federally recognized marriages as between a man and a woman. However, DOMA was overturned by the Supreme Court on 6/26/2013.
- the property must pass to a surviving spouse who is a U.S. citizen or to a qualified domestic trust (QDOT) that provides support to the surviving spouse;
- the property for which the marital deduction has been claimed must be includable in the surviving spouse's gross estate unless the property has been consumed or disposed of before the surviving spouse's death;
- by whatever means, the property interest must unambiguously pass from the decedent to the surviving spouse, whether by inheritance, trust, right of survivorship, by dower, curtesy, or elected share, by the exercise, extinction, or release of a power of appointment held by the decedent, as the beneficiary of a life insurance policy on the decedent, or by any other transfer; §2056(c)
- If there is any ambiguity as to whether the property passes to the spouse or to some other person, then the property will be treated as if it was transferred to the other person, and the property will not qualify for the marital deduction.
- the property interest cannot be a §2056(b) nondeductible terminal interest; otherwise, the interest will probably transfer to someone other than the surviving spouse without benefiting the spouse nor would the interest be includable in her estate.
That the property be includible in the surviving spouse's estate and that the property is held either by a surviving spouse who is a U.S. citizen or by a QDOT comports with the legal objective of the marital deduction, which is to delay, but not eliminate, the estate tax on the property. The United States citizenship requirement was predicated on the belief that if the surviving spouse is a foreigner, then the property may not be includible in her estate if she dies in another country. Nonetheless, there is a marital deduction for noncitizen spouses that is limited to $134,000 per year, which is adjusted annually for inflation using the same rules used to adjust the annual exclusion for the gift tax but where the amounts are multiplied by 10. IRC §2523(i)
The nondeductible terminal interest rule basically states that there can be no contingency that would allow the property to pass to someone other than the surviving spouse or her estate, since the deduction only applies to transfers to a spouse, not to anyone else. However, 5 exceptions exist:
- estate trusts,
- limited survivorship provisions,
- life estate with power of appointment,
- life insurance with power of appointment,
- qualified terminal interest property (QTIP).
Estate trusts are a special type of marital deduction trust where, when the surviving spouse dies, all remaining trust principal must go into the surviving spouse's estate, allowing the surviving spouse to choose the final beneficiaries. This type of trust is used to hold property, such as a business, where the income must be reinvested or to hold real estate that does not currently earn income, but is being held for appreciation. The occasional need for an estate trust arises from the following rules:
- Treasury Regulation §20.2056(b)-5(f)(1) requires that property that is transferred in trust will only qualify for the marital deduction if the surviving spouse either receives income or receives beneficial enjoyment from the property.
- Treas. Reg. §20.2056(b)-5(f)(5) stipulates that if the surviving spouse does not receive a substantial income from all or part of the trust and if the surviving spouse cannot compel the trustee to sell the trust assets for income producing assets, then it will not qualify for the marital deduction.
- But, a logical consequence of IRC §2056(b)-1(A) is that property is not a nondeductible terminal interest if it at least passes to the estate of the surviving spouse.
Therefore, an estate trust can be set up without satisfying the 1st 2 rules above and still qualify for the marital deduction, as long as the last rule is satisfied. In this case, the surviving spouse cannot demand that the trust assets be sold for income producing property, and when it does produce income, it does not have to be paid to the spouse. At the trustee's option, the income can be accumulated. Although trust income is taxed at a higher rate than income for individuals, the trustee can grow a business held by the trust by reinvesting the income, since such reinvestments are tax deductible.
Most wills and trust documents have provisions that require beneficiaries to survive the donor of the property by a specified amount of time, usually 30 to 60 days. For the marital deduction to apply to the property, IRS rules require that the survivorship provision must be for no longer than 6 months and the surviving spouse must actually survive the contingency period. If the surviving spouse does not actually survive long enough to satisfy the contingency, then the property never actually passes to her and the marital deduction will not be applicable.
A life estate plus power of appointment (aka marital deduction power of appointment trust) will qualify for the marital deduction if the spouse has the right to appoint the trust corpus to herself or to her estate. However, the following requirements must be satisfied: §2056(b)(5)
- the trust property must be either income producing or the spouse must have the power to compel the trustee to exchange unproductive property for income-producing property;
- the surviving spouse must be paid, at least annually, all income from the trust for life;
- the power of appointment must be exercisable in favor of the spouse or her estate;
- the surviving spouse can be the only one who has any power of appointment over the property, although it can be a testamentary power that is exercisable only through her will.
Life insurance with power of appointment has similar rules to the life estate exception but that applies to the proceeds of life insurance, endowments, or annuity contracts. §2056(b)(6)
The final exception is for qualified terminal interest property (QTIP), which gives the surviving spouse unrestricted power over the property but the beneficiaries of the qualified terminal interest cannot be changed. The QTIP is most often used when the donor has children from a previous marriage or if there is a good possibility that the surviving spouse will remarry and favor the new spouse or additional children.