Marital Deduction Trap

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ESTATE TAX MARITAL DEDUCTION--BLESSING OR TRAP FOR THE UNWARY?

In this next article in this series on Estate Planning, I will discuss the most used -- and for many families, the most useful -- tool in estate planning, namely the unlimited marital deduction. This tool applies in gift tax planning as well. The basic rule is that any amount given to your spouse is not subject to estate or gift taxation. This is true no matter how large the amount.

THE BLESSING. For many families, this is a blessing. For instance, let's consider the situation of husband and wife, married for many years, whose property is nearly all community property (that is, each has a vested one-half interest in all of the property), and who have lived on this property, either literally or from the "fruits" of that property (e.g., interest and dividends) during the husband's retirement. If one spouse dies, and the family community property is less than $700,000 or so and not likely to appreciate, it makes for easy estate planning for the decedent spouse's interest in the community property, and any of his or her separate property to go to the surviving spouse. In the San Francisco Bay area particularly, it could easily require an estate of that size for the surviving spouse to live comfortably and have an adequate cushion for medical expenses.

Under these circumstances, the best plan may be for the spouses to set up their wills or trusts so that their separate property and their share of the community property simply goes to the surviving spouse either directly or in a living trust, the latter giving the surviving spouse sole discretion and power over the property. This has the merits of giving the surviving spouse complete control over the property, which he or she may expect, and of simplicity in management, since no additional fiduciary income tax returns will be necessary. So these are the blessings.

THE TRAP. I have been told that Mae West said that too much of a good thing was simply wonderful. True in many cases; not true here. What if the families' estate is a bit over a million dollars, say $1.2 million? And what if the will or living trust was written so that the surviving spouse (whom we will call S.S. hereafter) receives all the decedent's interest in property at his or her death. Thus S.S. has an estate then of $ 1.2 million. Let us say, that S.S. has no catastrophic illness, but on the other hand, uses all the income of the property to live on, and the value of the property does not appreciate. Thus when S.S. dies, his or her estate is still $1.2 million. Under current tax law, the estate tax on S.S.'s estate would be approximately $230,000.

This could be a nasty surprise for heirs who, relying on popular tax planning that says that each person is entitled to up to a $600,000 exemption from estate tax, believed that no estate tax would be due at all. What you must do in this case is use specific tax planning maneuvers to use the $600,000 exemption and still place the property at the disposal of the surviving spouse, should he or she need it.

THE WAY OUT OF THE TRAP. The essence of what you should do is to leave the property to S.S. in terms of income and access to principal should he or she need it, but not for estate tax purposes. Would you believe that we can do that? We can.

This can be done through the use of a trust. There are several different names for this type of Trust. It is sometimes called a "bypass" trust, or a "B" trust, or is sometimes referred to as the family trust. They all do the same thing, usually in exactly the same way. They take advantage of a specific provision in the tax law that says that although a person such as surviving spouse has the income interest and access to the principal of the trust should he or she need it, the property that S.S. has such power over will not be included in his or her estate, and subjected to estate tax at his or her death (which is what we are trying to avoid), if his or her rights to withdraw principal from the trust are subject to an "ascertainable standard." The U.S. Dept of Treasury regulations indicate just what words are needed in order to provide a trust with the limits of the "ascertainable standard." If you need further information, let me know. Attorneys who work in this area know these regulations very well and how to apply them.

FINE-TUNING THE WAY OUT. This trust with the "ascertainable standard" provision needs to be provided for in a person's will or living trust before he or she dies. However, the will or trust does not need to specify how much is to go into the trust. The will or trust can provide that the "bypass" trust will be funded with whatever amount S.S. "disclaims," so that S.S. receives whatever amount is not "disclaimed." Thus, if it turns out that a families' estate is only $700,000 when the first spouse dies, S.S. will not "disclaim" but will receive everything outright. But if it is closer to $1.2 million, then $600,000 can be "disclaimed" to go into the "bypass" trust. Please note that the will or trust needs to be specially written so as to provide for the ability to fund the "bypass" trust through the use of a "disclaimer." Again, attorneys who work in this area know how to draft the necessary wording in the will or trust.

THE DISADVANTAGES TO THE WAY OUT. There are a few disadvantages to the "bypass" trust with the "ascertainable standard." The following appear to be seen as the most significant problems:
1. If the assets or property in the trust produce income, then a separate income tax return must be prepared and filed. The trust is a separate taxpayer and will pay tax on capital gains (net of capital losses). In the "bypass" trusts I usually see, all the regular or ordinary income passes (like a partnership) to the beneficiary, in this case, S.S. So there is no trust tax other than the tax on net capital gain income.
2. Where the withdrawals of principal that S.S. can make are limited to an ascertainable standard, he or she can be held accountable for withdrawing more than he or she was entitled to by the beneficiaries who will inherit after he or she dies. This may be viewed as too much of an administrative and legal burden by S.S.

In many cases, the will of the first spouse to die provides that one or more of the children be named trustee, or co-trustee with S.S., of the "bypass" trust. This usually works out fine. However, a family would probably want any trustee or co-trustee to be sensitive to the question of what is adequate support for S.S. given his or her prior lifestyle. You normally would not want to see a child using this as an opportunity to teach his or her parent thriftiness.

If you would like to discuss any of these issues in the light of your own families' estate or gift tax situation, let me know. I will be pleased to discuss any of these matters with you.

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