Rethinking: “That’s the way we’ve always done it” and a Surviving Spouse’s Elective-Share [Estate Planning]

The provisions in this Will for my husband are in lieu of any statutory share, including, but not limited to, any forced share, minor’s allowance, surviving spouse allowance, year’s support, or otherwise.

The above provision for 40+ years has been included in most Last Wills and Testament. It centers on the law in most states that generally does not allow a spouse to cut the other spouse out as an estate beneficiary. Even if a spouse is purposely left out of a Will, the surviving spouse under most state laws has a right to a portion or all of the deceased spouse’s estate. This surviving spouse right is called, for example, an “elective share” or “widow’s allowance”. Georgia law refers to this surviving spouse right as “year’s support”.  A court generally has to approve the surviving spouse’s request for an elective share, and the request allows the court to consider objections from other estate beneficiaries and creditors.

The above in-lieu-of provision has the effect of forcing a surviving spouse to decide and choose (i) whether to take whatever is provided for him under the deceased spouse’s Will or (ii) to seek a state-law elective share. My point is that this forcing-of-a-choice is no longer a preference in many cases. For reasons I do not cover in this blog post, this forced-choice approach has been used most often to protect against an inadvertent loss of the marital deduction for estate tax purposes. An elective share typically does not qualify for an estate marital deduction.

Practitioners need to rethink whether to include this longstanding forced-choice provision in a Will. Here are the four points to consider:

·       One. For most clients the marital deduction is not a material concern due to the inflation-adjusted $5.43 million estate exemption. And, with good tax counsel a surviving spouse can avoid chilling the marital deduction even without this in-lieu-of provision, if the marital deduction is essential.

·       Two. The elective  share in many cases is an award of property to the surviving spouse that is superior to unsecured creditor estate claims, such as if the first spouse dies with a substantial amount of unpaid bills and credit card debt (including unpaid property taxes in some cases). In other words, the elective share property can pass to the surviving spouse without the property being otherwise used to pay the deceased spouse’s unsecured debts.

·       Three.  This is important.  If for some reason the court does not allow the full amount of the elective share sought by the surviving spouse, without this in-lieu of provision the surviving spouse still retains the fallback of getting property under the provisions of the deceased spouse’s Will. By contrast, the in-lieu-of provision can have the adverse result of a surviving spouse failing to obtain the elective share and, having made the choice, losing his benefits under the Will.   Remember, the in-lieu-of provision mandates a choice.

·       Four. In some situations this elective share approach can help protect against Medicaid estate recovery, again, as property passing to the surviving spouse is generally superior to debts.

The QTIPable By-Pass Trust; A Crystal-Ball Perspective

Estate planning documents that include built-in flexibility enabling an opt-in / opt-out approach to future changes in the law or circumstances are products of excellent work. The drafter needs to keep a crystal-ball perspective as to what might reasonably occur in the client’s future in order to move in the direction of this kind of excellent work. On the other hand, it is much easier to prepare an average, static, mediocre document.

There are dozens of reasons to maintain this crystal-ball perspective, and here is simply one important example:

As a broad proposition, I find no reason for using the old “By-Pass Trust” design for a married couple’s estate planning. This is the garden-variety “By-Pass Trust” that has been part of a married couple’s A-B trust estate plan for the past 30-plus years.

Rather, I prefer a QTIPable By-Pass Trust that provides essential income tax planning options not available with the above old By-Pass Trust design.

Why this importance of income tax options?

Because I am convinced our estate tax regime is continuing to move in the direction of the Canadian system where property gains will be taxed at death for income tax purposes, regardless of whether a person is over or under the threshold for estate tax. The QTIP trust likely will provide an optimal, effective response to reducing this income tax exposure.

As an example of these income tax headwinds we face, the federal government’s February 2015 “General Explanation of the Administration’s Fiscal Year 2016 Revenue Proposals” includes dozens of possible changes in the income tax law at death for certain taxable “deemed realization” events. Click here to see these 2016 revenue proposals.

Some practitioners by personality are simply not comfortable with the notion of change. Some also will continue to argue for the old-style By-Pass Trust as being necessary so that the surviving spouse’s children and descendants are included with the surviving spouse as beneficiaries of the trust. But, as an important aside, my 20+ years of lawyering make me conclude most children and descendants try and overreach whatever is available to them from the By-Pass Trust, especially when their mother is the surviving spouse. To the contrary, I prefer that the surviving spouse possess the utmost in independence and financial autonomy without this kind of overreaching.

But, again, my predominant objection to this 30-year old By-Pass Trust approach is that it simply does not provide income tax planning options.

$1 Million Income Tax Savings for a $4 Million Credit-Shelter Trust

This modest illustration demonstrates how the typical credit-shelter trust can be very costly to a large number of married couples if the trust is not purposely designed as a defective trust for income tax purposes.  Income tax planning now is a mandate for estate planning.

In this example, a $4 million beneficiary defective credit-shelter trust during the surviving spouse’s 20-year remaining lifetime saves approximately $1 million of income tax.

This income tax savings over the surviving spouse’s 20-year lifetime (in this example) has two components:

$541,000 in income tax savings. This is 20 years of avoiding the more compressed top marginal income and capital gain tax rates for trusts, including the 3.8% Medicare investment tax; and

$357,200 in income tax savings. This is at the end of the 20-years getting a second stepped-up cost basis for the credit-shelter trust assets at the surviving spouse‘s death.

This John / Jane Credit-Shelter Trust Example

John Smith dies at age 77 with $4.0 million of his own property. His wife Jane, age 68, has $1.5 million of her own property, plus social security and a modest source of her own income. Jane is in excellent health and expected to live at least 20 years following John’s death. She would like ideally to preserve the credit-shelter trust for the children and grandchildren.

John’s $4.0 million estate passes into his credit-shelter trust for Jane’s benefit. This credit-shelter trust is designed purposely as a beneficiary defective trust as to Jane during her remaining lifetime.

Assume the $4.0 million credit-shelter trust produces a $320,000 annual return of 8%, consisting of $256,000 capital gains and $64,000 ordinary interest income [roughly an 80 / 20 asset allocation].

Income Tax Illustration 1:  A Non-Defective Credit-Shelter Trust

The annual $64,000 ordinary interest income and $256,000 capital gains for a non-defective credit-shelter trust produce the largest amount of annual income tax: $86,478. This each year includes $11,695 of 3.8% Medicare investment tax. The ordinary income and capital gains are taxed at the credit-shelter trust tax rates. [Computed using 2013 rates.]

Income Tax Illustration 2:  A Beneficiary Defective Credit-Shelter Trust 

By contrast, this beneficiary defective credit-shelter trust results in the interest income and capital gains being taxed at Jane’s own personal income tax rates, including her less-costly threshold for the 3.8% Medicare tax. The higher marginal trust rates do not apply.

This defective trust status reduces the annual tax to $59,405 (compared to the $86,478 trust income tax above). This defective status saves Jane $27,073 in income tax each year [$59,405 annually compared to the more costly $86,478].

This annual income tax savings includes $7,135 less each year for the 3.8% Medicare tax compared to the above non-defective trust approach.

This annual income tax savings over Jane’s 20-years will enhance the credit-shelter trust value by $541,460 [20 times $27,073].

Additional Income Tax Saving for a Second Stepped-Up Basis

For a typical credit-shelter trust there is no stepped-up basis for the trust assets when the surviving spouse dies.  But, by contrast, it is this purposeful beneficiary defective trust design in this example that results in John’s credit-shelter trust assets getting a second stepped-up basis at Jane’s subsequent death. This is an additional level of income tax savings.  [The first stepped-up basis was at John’s death.]

Assume, for example, the market growth of the $4.0 million credit-shelter trust assets during the 20 years following John’s death increases 2% each year (in addition to the above annual 8% return). This results in a compounded increase in the trust assets from $4.0 million to approximately $5.9 million. This $1.9 million increase is the unrealized gain growth during the 20-year period at Jane’s death.

At Jane’s death this $1.9 million growth will get the benefit of a stepped-up basis. Thus, no taxable gain to the children. This saves an additional $357,200 of capital gains tax [18.8% tax rate times $1.9 million; using a 15% capital gains rate plus the 3.8% Medicare tax].

“Don’t get mad” or “I’m afraid that will make them mad” are Ruinous Notions for our Kids

The following web item caught my eye this morning and the subject matter is so important to all of us that I am providing the link.  Click here.  This piece is titled “Here’s a Ridiculous Thing We Teach Girls that Ends Ups Ruining Their Relationships”.

As a father of two girls I consistently give them the fullest opportunity to accept and express their anger, rather than quashing it on the idea society wants us all to be little good, nice, suppliant individuals.  This idea of being good little boys and girls is an insidious, ruinous notion for our kids.  I also admit, if I have erred with this parental guidance, my preference has been that my girls tilt more in the direction of giving someone the proverbial finger rather than moving in the direction of deferential servility.

Two more side comments:

One. I tell my girls never to let other people frame their (my girls) response to any situation, whether it be a boss, teacher, or even me.  Rather, first they should examine a situation or comment from someone only within their own (my girls) frame of reference.  Then, next, determine how that other person’s perspective or comment fits within their (my girls) own framework.  This means sometimes a conclusion that other person might be 100% right, maybe that other person is 100% wrong, or somewhere in between.   The key point is to assess all situations first from your own framework.  Not first from the other person’s framework.

Two.   As a lawyer I am persistently in the midst of anger, disagreement, fighting, acrimony, others trying to force a view or comment on me, etc.   I remind myself (and my girls) that one of my favorite statements attributed to Gandhi is: “Be truthful, gentle, and fearless.”

“Don’t Bogart that Exemption ($5.34M estate), My Friend.”

What if you could apply – to your own tax-savings advantage — your parents’ or divorced spouse’s $5.34 million estate exemption that otherwise will likely end up unused?  That is, pass their exemption to you.   This topic centers on tax planning with the Delaware Tax Trap.

Click here for my March 20, 2014 email alert.

What $$$ Will Your Credit-Shelter Trust Cost You?

Most married couples are not aware of the unnecessary income tax exposure that likley exists within their present core estate planning documents.   This stems from Congress’s early 2013 tax legislation that in a steath manner converted our death tax into an income tax system.  Click here for my recent newsletter about this situation.

Part 1. Congress is Brilliant: Why 99% of “Poor” Taxpayers Now Hold the Short End of the Stick

Congress has converted our federal death tax to an income tax system.   Why income tax planning is now paramount and this important blog topic applies to the 99% of taxpayers who will pay no federal estate tax.

Click here for my recent email alert.