Estate Planning For Married Couples: The Basics

Married couples who are U.S. citizens have estate planning options available to them that are not available to unmarried couples. Opportunities arise upon the death of the first spouse which, if proper planning is done, can protect assets from estate taxes, creditors, and long term care costs.

The following is a massive oversimplification of the estate planning process as it relates to estate taxes for U.S. citizen spouses (the rules for non citizens spouses are different and will not be addressed in this article). The purpose of this article is to help married couples understand some of the basic estate planning and estate tax concepts that we typically cover in an initial estate planning meeting. Without this basic understanding, important estate planning decisions are frequently postponed or, too often, ignored.

Although I refer primarily to Wills in this article, it should be noted that, for estate tax purposes, the planning techniques described below can be implemented through the use of Wills or Will substitutes such as Revocable Trust Agreements.

Estate Taxes

The Internal Revenue Service imposes a tax on certain transfers made for less than fair market value. If the transfers are made during life (i.e. gifts) the IRS imposes a gift tax. If the transfers are made upon death either through the terms of our Wills or through the laws of intestacy, the IRS imposes an estate tax. To keep things simple, I will limit our discussion to transfers at death and the estate tax. However, it is important to note that the two taxes are related and gifts made during life may have an impact on estate taxes payable upon death.

For the last few years, we have been writing about the uncertainty of the federal estate tax laws. Will the estate tax be repealed? Will the estate tax exemption be $1,000,000 or $5,000,000 or something in between? Will the portable exemption law become permanent or was it just a flash in the pan? Thanks to some last-minute decisions made by Congress, as of January 1, 2013, we now have some “permanent” federal estate tax laws (whatever permanent means). The federal estate tax exemption is now $5 million, indexed for inflation, which means that each U.S. citizen has a $5,250,000 estate tax exemption in 2013. In addition, portability has become a permanent fixture. I will discuss the portable exemption law later in this article.

Congress was not the only one keeping us on our toes – state estate tax laws have also fluctuated drastically over the years. Within the last decade, the Connecticut estate tax laws have changed numerous times and the Connecticut estate tax exemption has recently swung from $2,000,000 to $3,500,000 and back to $2,000,000.

As a result, for at least the time being, we are facing a $5,250,000 federal estate tax exemption and a $2,000,000 Connecticut estate tax exemption. New York has a $1,000,000 estate tax exemption which, unlike the Connecticut and federal exemptions, has remained relatively consistent over recent years.

Planning Considerations for Married Couples

At the core of estate tax planning for married couples is the concept that transfers between spouses who are U.S. citizens occur free of gift or estate tax because there is an unlimited marital deduction. Accordingly, if our focus was merely on estate tax exposure upon the first spouse’s death, our job as estate planners would be pretty easy: “Just leave everything outright to your spouse and you have no estate tax issues! (Now here’s our invoice).”

Instead, our focus is on the surviving spouse’s estate and what happens at the surviving spouse’s subsequent death. If the first spouse to die gives everything outright to the surviving spouse, there may not be any estate tax issues upon the first spouse’s death, but the surviving spouse may end up with an estate that is larger than the applicable estate tax exemptions and may be exposed to estate tax upon the surviving spouse’s death.

For example, let’s say that Gracie and Dunkin are married U.S. citizens (in reality Gracie and Dunkin are our family dogs, but for the purposes of this article they are a happily married human couple). Dunkin dies (sorry dad) owning an estate worth $4,000,000 which passes outright to Gracie according to the terms of Dunkin’s Will. Now Gracie has Dunkin’s $4,000,000 in addition to her own assets worth $2,000,000 leaving her with a total estate of $6,000,000. When Gracie passes away, if the federal estate tax exemption is $5,250,000, then (ignoring the impacts of the portable exemption law discussed below) $750,000 could be exposed to federal estate tax. In addition, if Gracie was a Connecticut resident when she died, $4,000,000 could be exposed to Connecticut estate tax ($6,000,000 – $2,000,000 (the Connecticut exemption)).

If Gracie and Dunkin had taken certain steps in their estate planning, their estate tax liabilities could have been eliminated or significantly reduced. The most common way to do so is through the use of trusts which would be established through the terms of the Wills (or Will substitutes). For a discussion about the basics of trusts, including factors to consider regarding the use of trusts, please see: The Benefits of Trusts and Avoiding the Trustee’s Worst Nightmare.

The Wills would allow for a portion of the first spouse’s estate to pass to a trust for the benefit of the surviving spouse (frequently called a “credit shelter trust,” “bypass trust” or “exemption trust;” for the purposes of this article, we will call it an “exemption trust”). Property passing to the exemption trust would not qualify for the marital deduction because it is not property passing to the surviving spouse (unless the trust is drafted in a way which would qualify for the marital deduction). Instead, the property passing to the exemption trust would use part of or all of the first spouse’s exemption. The exemption trust would then be shielded by the first spouse’s exemption and would not be subjected to an estate tax when the surviving spouse dies (again, this is an oversimplification, intended to highlight the basic concepts).

There are two techniques which are frequently used to reduce or eliminate estate taxes for the surviving spouse through the use of exemption trusts – the Disclaimer Option and the Formula Option.

The Disclaimer Option

The Disclaimer Option would look like this: Dunkin’s Will provides that, upon his death, all of his estate will pass to Gracie outright, but it would give Gracie the option to “disclaim” (refuse to accept) all or a portion of the property. The “disclaimed property” would pass to a trust for Gracie’s benefit (the “Disclaimer Trust”). The Disclaimer Trust is a type of exemption trust which would use a portion of or all Dunkin’s estate tax exemption and would not be subject to estate tax on Gracie’s subsequent death.

[Note: A “disclaimer” is the irrevocable refusal to accept a gift of property. The general rule is that for a disclaimer to be effective for tax purposes the disclaiming party cannot have any interest in the disclaimed property following the disclaimer. There is, however, a special exception which allows a surviving spouse to disclaim property passing into a trust created under the deceased spouse’s Will for the benefit of the surviving spouse. Such a trust must, however, be narrowly drafted because the surviving spouse may not have any powers over trust principal.]

The Formula Option

The Formula Option would look like this: Dunkin’s Will provides that, upon his death, a fraction of his estate equal to the applicable estate tax exemption at the time of his death (either the federal exemption or the state exemption) will pass to a trust (the “Formula Exemption Trust”) for Gracie’s benefit. The Formula Exemption Trust would use a portion of or all Dunkin’s estate tax exemption and would not be subjected to estate tax on Gracie’s death. The rest of Dunkin’s estate would pass either outright to Gracie or to a trust for Gracie’s benefit which could qualify for the marital deduction.

Which Works Best?

The Disclaimer Option and the Formula Option can produce almost identical estate tax results but in different ways; and there are pros and cons associated with both options.

Under the disclaimer option, the surviving spouse has flexibility to make the planning decisions at the time of the first spouse’s death. No trust is created unless the surviving spouse decides that it makes sense from a tax perspective (with some help from advisors). The surviving spouse would have the option to disclaim any portion (or none) of the deceased spouse’s property. This is typically viewed as a good thing – allowing the decision to be made when all the facts are available (applicable exemptions, value of estate assets, surviving spouse’s needs, etc.).

The Formula Option also has advantages. The most significant advantage is that the surviving spouse can have broad power over the principal of the trust in the Formula Exemption Trust but not in the Disclaimer Trust. For example, the surviving spouse can have unlimited authority to appoint principal to other family members (typically descendants) both during life and at death through the terms of the surviving spouse’s Will.

This can be particularly beneficial in situations where a child falls on hard times (drug addiction, creditor issues, bad marriage, etc.) after the death of the first spouse. The surviving spouse would have the flexibility to change how the assets in the Formula Exemption Trust will be distributed when the trust terminates. For example, the surviving spouse’s Will could direct that assets in the Formula Exemption Trust will not pass outright to the child dealing with problems, but would be held in a separate trust which would protect the assets from creditors, divorcing spouses, or the beneficiary’s addictions. The surviving spouse can not have this authority over assets in the Disclaimer Trust.

Another potential advantage with the Formula Option is that the terms of the Will already provide the amount (based on the formula) that will pass to the Formula Exemption Trust. With the Disclaimer Option, the decision to disclaim assets is left to the surviving spouse and must made within nine months of the first spouse’s death. This can be challenging for a surviving spouse who is grieving and may have trouble focusing on estate tax planning issues soon after the first spouse’s death.

On the other hand, if assets or estate tax exemptions change significantly and documents are not updated to reflect the changing circumstances, the Formula Option has the potential to “disinherit” a surviving spouse. For example, if the formula is based on the federal exemption (currently $5,250,000), and the value of the first spouse’s estate is less than $5,250,000, all of the assets could pass to the Formula Exemption Trust and nothing would pass outright to the surviving spouse. This may not have been the couples’ intent back when the federal exemption was $1,000,000 (when the Wills were prepared).

Each couple will need to determine which option is best suited to their unique situation. If you prefer the “wait and see” approach and are not concerned about your spouse’s ability to make the decision in the future, then perhaps the Disclaimer Option would be your best bet, even though the Disclaimer Trust is a less flexible trust. On the other hand, you may decide that the Formula Option is better suited for your situation since it will provide your spouse with greater control over the property in the Formula Exemption Trust.

Portable Exemption Law

The now “permanent” federal estate tax laws have introduced another layer to our estate planning discussions. This added layer is referred to as the portable estate tax exemption law. The portable estate tax exemption law is applicable to married couples and provides that, when the first spouse dies, the surviving spouse may elect to take the unused portion of the deceased spouse’s federal estate tax exemption.

For example, if Dunkin dies and leaves everything outright to Gracie, we’ve already established that the assets pass free of estate tax due to the unlimited marital deduction. This means that Dunkin has not used any of his $5,250,000 federal estate tax exemption. The portable exemption law allows Dunkin’s executor to elect to allow Gracie to add Dunkin’s unused exemption ($5,250,000) to Gracie’s own estate tax exemption ($5,250,000), leaving Gracie with a total federal estate tax exemption of $10,500,000 (in this example) at her death.

The new portable exemption law has led many estate planners to encourage clients to consider simplifying their documents and eliminate complex trust provisions. However, trust provisions, like the ones described above, are still applicable in many cases.

For instance, the portable exemption does not change the state estate tax obligation. The fact that the portable exemption law may allow $10,500,000 to be sheltered from Gracie’s federal estate tax, does not mean that the same amount would be sheltered from Gracie’s Connecticut or New York estate tax. She would only have her $2,000,000 Connecticut estate tax exemption (or her $1,000,000 New York exemption if she moved to New York). Accordingly, for Connecticut and New York residents, planning techniques described above are still an important tool in reducing or eliminating estate taxes.

Factors unrelated to estate taxes such as asset management, young beneficiaries or beneficiaries dealing with special problems, may also warrant the use of trusts and other complex provisions in our Wills. For more on this issue, see: Simplify Your Estate Plan Maybe.

In addition, many people are worried about nursing home costs and are interested in protecting assets from the costs of long term care. Married couples have a unique opportunity to shelter assets upon the death of the first spouse through the use of trusts established under the terms of their Wills. For more information about protecting assets from long term care costs, please see our other posts:

Special Needs Trusts

Elder Law – Basics of Planning for Incapacity

Posted on 4/28/2013 by Kasey S. Galner, Associate, Chipman, Mazzucco, Land & Pennarola, LLC.

We frequently post articles relating to estate planning, estate settlement and elder law issues to this blog. We also post notices about our client seminars here. When we do, we send out notices to clients and friends of the firm. If you would like to get our notices, please join our mailing list by clicking below.

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Notice: To comply with U.S. Treasury Department rules and regulations, we inform you that any U.S. federal tax advice contained in this communication is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction, tax strategy or other activity.

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