Your Estate Plan May Need a Band-aid

Posted on January 18, 2010 by Patti Spencer

Thanks to Congress’s failure to act to "fix" the estate tax by the end of 2009, your estate plan may have a serious problem. If your estate plan divides your assets by use of a formula that refers to the estate tax, your plan could be in trouble.

Many people have this type of plan. It goes by various names. Some call it an A-B Trust, some call it credit shelter trust planning, some refer to it as by-pass trust planning. Whatever you call it, the salient feature is a word formula that directs part of the decedent’s assets to a trust and part to the surviving spouse (or to a trust usually for his or her benefit). These formulae were put into your plan so that your plan could adapt to changes in the federal estate tax, like the increasing exemption amount, and to take account of gifts you may make in your lifetime.

The formula divides the assets by reference to the federal estate tax law. Since we don’t have a federal estate tax right now, these formulae don’t work - they are either meaningless gibberish or they produce a bad result. (Thank you Congress.)

On December 31, I sent out letters to all my clients who had such formula provisions in their wills or revocable trusts. Many of them have been in to sign codicils or amendments already. If your plan has a formula, you really should get it fixed up for 2010.

One example of a formula would direct the distribution of the maximum portion of your estate amount that can pass free of estate tax to the credit shelter (or by-pass) trust. Since there currently is no estate tax, the maximum amount that can pass free of estate tax is 100% of your estate. Thus, if you died now, all of your assets would go to that trust; and your surviving spouse would not receive anything (except that he or she may have some interest in that trust). This is probably not what was intended when you signed the document.

Another example of a formula is one which provides that an amount passes to the spouse which is the whole estate minus an amount equal to the amount the federal exemption equivalent which is directed to the credit shelter (or by-pass) trust. Using this formula, if you died now, since there is no estate tax in 2010, 100% of your estate would pass to the surviving spouse, and nothing would go to the trust. Again, this is probably not what was intended when you signed the document.

With neither formula do you get the result that was intended when you signed your estate plan. Thanks to our venerable Congress’s failure to act with regard to the estate tax prior to the end of 2009, your plan now has a serious problem.

Remember, this type of planning was done to save estate taxes, specifically to use both spouses’ exemptions from the federal estate tax. In most cases, the only purpose of including a by-pass or credit shelter trust was to save estate taxes. It would not be good to saddle your surviving spouse with a trust to administer when the trust was completely unnecessary to save taxes and was funded only because of Congress’s current shenanigans.

The solution is to amend the formula provision. There is not sufficient time to revisit your whole plan. As an immediate "band-aid" fix, if your plan contains a formula division, you should contact your attorney to make a simple codicil to your will or amendment to your trust. The codicil or amendment should provide that if you die in 2010 when the estate tax and generation-skipping tax do not apply to your estate and if these taxes are not retroactively reinstated by Congress, any computations required to apply the formulae in your plan shall be made as if the Internal Revenue Code in effect on December 31, 2009 is then in effect.

If you make a change like this, your plan will be the same as when you signed it. That may or may not be good for you. Depending on when you created the plan, the federal exemption may have been $600,000. In 2009 it was $3.5 million. That’s a big difference. Maybe you don’t really want to direct up to $3.5 million where you had directed $600,000 before. If that is the case, you need a complete review of your plan, not just a band-aid fix.

The objective is to make sure your plan works and makes sense in 2010 until Congress acts, if it does. Don’t delay. This needs attention.

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Gift Tax Paid Within 3 Years of Death

Posted on February 1, 2009 by Patti Spencer

In 1981 with the passage of the Economic Recovery Tax Act (ERTA), Section 2035 of the Internal Revenue Code was amended so that most gifts made within three years of death were no longer pulled back into the estate.  The 3-year rule was not eliminated completely, however.  Transfers of life insurance within three years of death can still cause inclusion of the death benefit in the estate and transfers of the "strings" under IRC Sections 2036, 2037 and 2038 that cause estate inclusion can cause a pull back. 

Also, any gift tax paid within three years of death is pulled back into the estate.   The reason for this gift tax rule is that the federal estate tax is a tax inclusive tax and the gift tax is a tax exclusive tax.  These examples illustrate the point:

Gift:         Donor has $150; transfer tax rate is 50%. Donor can give $100 to donee and pay $50 gift tax.

Bequest:       Decedent dies with $150; transfer tax rate is 50%. Decedent can leave $75 to beneficiaries and pay estate tax of $75. 

Without the 3-year pull back for gift tax paid with 3 years of death, one could cut the federal transfer tax payable by 1/3 simply by transferring everything days or moments before death.  OK.  So, decedent made taxable gifts and paid gift tax within three years of death.  Gift tax is brought back into the estate.  Who pays the estate tax on the gift tax?

See Gary Freidman's blogpost about  Matter of Rhodes, __ Misc.3d __, __ N.Y.S.2d __, 2008 NY Slip Op 28472 (Sur. Ct. Westchester Co. 2008), where the issue was whether donees of gifts made within three years of death are responsible for paying estate tax attributable to the inclusion of the gift tax paid on such transfers.

The Court held that the donees of the gifts made within three years of decedent's death are responsible for paying their ratable share of the estate tax attributable to the inclusion of the gift tax paid.  Ouch!  

Here is what the tax clause in the will said:

All inheritance, succession, transfer and estate taxes . . . payable by reason of my death in respect of all items included in the computation of such taxes which shall have passed under the provisions of this Will, shall be paid by my Executors as follows:
(A) All taxes with respect to property passing under this Will shall be apportioned in accordance with the law of New York, notwithstanding the foregoing, I direct that any such taxes resulting from the bequests under Clauses SECOND, THIRD and FIFTH of this Will shall be paid by my Executor out of my residuary estate, without apportionment or reimbursement from any beneficiary.
(B) I intend that all taxes described in paragraph (A) of this Clause with respect to property passing outside of the provisions of this Will shall be apportioned in accordance with the law of New York . . ..
(D) I wish to record that I have given great consideration as to how I have directed that the taxes described in paragraph (A) of this Clause are to be paid with respect to property passing under and outside my Will and to whom I have burdened with the payment of such taxes. I believe that the provisions which I have arrived at are equitable for all of my family members.

Looks like the decision is correct.  The gift tax paid certainly didn't "pass under the terms of the will."   Another reminder to be very careful with tax clauses.

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