Many wills drafted prior to EGTRRA employ “formula” clauses eliminating estate tax on the death of the first spouse by creating a “credit shelter” trust funded with assets equal to the unused applicable exclusion amount (AEA), and then distributing the remainder of the residuary estate to the surviving spouse outright or in a marital deduction trust, such as a QTIP. The combination of the unified credit and marital deduction result in no tax at the first death.
Anyone, including the surviving spouse, may be a beneficiary of the credit shelter trust, but to qualify for the QTIP marital deduction, only the surviving spouse may possess rights to income or principal. In fact, the surviving spouse must alone have the right to receive all income from the QTIP trust, paid at least annually, and no other person may be a beneficiary of that trust during the surviving spouse’s life.
With the AEA reaching new levels far exceeding previous amounts, and with many states, including New York, “decoupling” their own estate tax and retaining lower threshold levels for the imposition of estate tax, older formula clauses may produce unintended results.
The AEA rose to $2 million on January 1, 2006, and will increase to $3.5 million in 2009. The danger exists that by funding the nonmarital (credit shelter) trust with the maximum amount that can be shielded by the AEA, the surviving spouse might be unintentionally disinherited. Particularly in cases where the estate is less than $4 million and the surviving spouse is not granted distribution rights to the nonmarital trust, consideration should be given to capping the formula clause allocation to the nonmarital trust at a level substantially below the AEA, perhaps at an amount no greater than the amount that can pass free of New York estate tax.
Nevertheless, by capping the nonmarital share and increasing the marital share, a new problem arises: The estate of the surviving spouse might become subject to estate taxes. Fortunately, this problem can be avoided by funding a second nonmarital trust with the excess of the applicable exclusion amount over the cap placed on the first nonmarital trust. The surviving spouse could even be the sole beneficiary of this trust, the assets of which would remain outside of her taxable estate since no QTIP election will have been made.
To illustrate, assume decedent dies in 2009 with a taxable estate of $5 million at a time when the AEA is $3.5 million. Nonmarital Trust #1 is funded with $1 million, the maximum amount that can pass free of New York estate tax. Nonmarital Trust #2 with $2.5 million, and the QTIP Trust with $1.5 million. Nonmarital Trust #1 and Nonmarital Trust #2 make full use of the AEA. The surviving spouse is granted the same distribution rights to Nonmarital Trust #2 as she is to the QTIP. Nonmarital Trust #2 will not, however, be included in her taxable estate because no QTIP election will have been made.
Now consider New York estate tax consequences: New York’s AEA is $1 million, frozen at pre-EGTRRA levels. Nonmarital Trust #1 therefore makes full use of New York’s excludible amount. Does this mean that Nonmarital Trust #2 will attract New York estate tax? Not necessarily. Even though no federal QTIP election will be made for Nonmarital Trust #2, since New York has “decoupled” its estate tax from the federal estate tax regime, that trust might still qualify for the unlimited marital deduction for New York state estate tax purposes. If this strategy succeeds, Nonmarital Trust #2 would be includible in the surviving spouse’s estate for New York, but not for federal, estate tax purposes.
This plan would (i) eliminate New York (and federal) estate tax completely on the death of the first spouse without overfunding the federal QTIP which will be subject to federal estate tax at the death of the surviving spouse; while (ii) providing maximum benefits to the surviving spouse. Even if no New York marital deduction is allowed for estate tax purposes, the assets in Nonmarital Trust #2 — a trust over which the surviving spouse will have substantial rights — will not be included in her federal taxable estate, because no QTIP election will have been made with respect to it.
New basis rules to take effect in 2010 eliminate basis step-up in favor of a transferred basis regime. However, a $3 million basis increase will be allowed for property passing to a surviving spouse outright or in a QTIP trust; and a $1.3 million basis increase will be allowed for assets passing to any beneficiary, including the surviving spouse. Once these two permitted basis increases are exhausted, beneficiaries will receive assets without any basis increase. To avoid conflict among beneficiaries, the will could provide that assets should be allocated to the nonmarital share in a manner fairly reflecting the appreciation and depreciation in all assets available for allocation.
Property passing to the surviving spouse in a general power of appointment trust will not be treated as an asset of that spouse for purposes of her estate’s own $1.3 million aggregate basis increase. Therefore, if such a trust is used, the surviving spouse should be given $1.3 million in appreciated assets outright, or the trustee should distribute sufficient principal so that her estate can make full use of her own aggregate basis increase.