June, 2008 Technical Newsletter
Provided by Leimberg Information Services
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other issues.
Fully Utilizing Credits of Both Spouses Creative Thinking
Jeffrey N. Pennell is the Richard H. Clark Professor of Law at
Emory University School of Law, author of nine books, including
WEALTH TRANSFER
PLANNING AND DRAFTING (West),
FEDERAL
WEALTH TRANSFER TAXATION (West), and
ESTATE PLANNING, the three volume treatise on estate planning originally
written by the legendary Harvard Professor A. James Casner.
Steven C. Davis is a partner at Hartzog Conger Cason & Neville
in Oklahoma City, and concentrates his practice in the areas of estate planning,
post-death administration, and transactional tax.
Len B. Cason is a partner at Hartzog Conger Cason & Neville in
Oklahoma City and a Fellow in both the American College of Tax Counsel and the
American College of Trust and Estate Counsel. He authored "Maximizing Funding of
Credit Shelter Trust with Non-IRA Assets" in the June 2002 issue of Estate
Planning magazine, and "IRS Ruling Approves Poorer Spouse Funding Technique' in
the May 2004 issue of Estate Planning. Len also has written in these pages on
the poorer spouse funding technique.
Jeff, Steve, and Len team up to tackle a most perplexing problem:
As the applicable exclusion amount increases (it will become $3.5 million for
2009, and potentially for the indefinite future), one of the hardest challenges
in planning for a married couple is sheltering the unified credits of both
spouses, regardless of the order of their deaths.
This objective is particularly difficult if the couple's aggregate wealth
exceeds one applicable exclusion amount (meaning there will be taxes at the
survivor's death under a plan that leaves everything to the survivor) but less
than double the applicable exclusion amount (meaning that sheltering both
credits is not so easy as simply dividing their wealth between the two spouses
and waiting to see who dies first).
Keep reading and you'll learn more about the problem and a most creative
solution.
EXECUTIVE SUMMARY:
By a series of private letter rulings, the government has blessed an approach
that entails creation of an inter vivos trust that gives the first spouse to die
a Section 2041 general power to appoint sufficient assets of the trust to cause
inclusion in the estate of the first to die and fully utilize that spouse's
unified credit, followed by a life estate in the surviving spouse that the
government concludes will not cause Section 2036 inclusion when the survivor
dies, even though property in the trust originated with that surviving spouse.
Recently,
Estate of Lee v. Commissioner gave planners pause about one conclusion in
these rulings, that death of the first to die causes a taxable gift by the
survivor that is offset by an available gift tax marital deduction the issue
being whether the testamentary lapse of a general power of appointment can
generate a gift tax marital deduction, because the donee spouse already is dead.
Creative drafters seek to avoid this concern by triggering the general power
taxation prior to the powerholder's death. But this can create control
issues.
This discussion addresses those considerations.
FACTS:
Estate planning for spouses with disparate wealth often leads to the
suggestion that the more wealthy spouse make a gift to the less wealthy spouse
to cover the contingency of "deaths out of order." More often a planning concern
in noncommunity property states, the tax-sheltering benefit of one unified
credit may be lost if the non-propertied spouse dies first and no inter vivos
intraspousal gifts were made.
Until the advent of the inter vivos QTIP trust, the only ways to address this
concern were by:
- outright lifetime gift to the less wealthy spouse,
- an inter vivos general power of appointment marital deduction trust (which
gave the donee spouse unfettered power to dispose of the transferred
property), or
- a Section 2513 inter vivos split gift to a third party (which took the
property out of the marital coffers entirely).
Section 2523(f) now allows the propertied spouse to create an irrevocable
inter vivos QTIP trust to pay income to the donee spouse for life, with the
remainder passing as the donor spouse originally designated in the trust, or as
the donee may appoint pursuant to a nongeneral testamentary power of
appointment, if granted by the trust.
The donor spouse may make an inter vivos QTIP election under Section
2523(f)(4), making the initial transfer free of gift tax and, on the donee
spouse's death, corpus will be includible in the donee spouse's gross estate,
thus utilizing the shelter of that spouse's unified credit and taking advantage
of the donee spouse's GST tax exemption all without giving the donee spouse
more control over the trust property than the donor chooses.
If control is not a concern, a different but equally effective alternative
was originally addressed in Private Letter Rulings 200210051 and 200101021, in
which spouses created joint settlor trusts, funded in the main with tenancy by
the entirety or joint tenancy property.
While both spouses were alive, either could revoke the trusts unilaterally,
in which case the property would be partitioned and delivered to the original
owner (or, for concurrently owned assets, to them in equal shares). The first
spouse to die was given a general power to appoint all of the trust property (in
the 2002 Ruling it was an inter vivos power; in the 2001 Ruling it was
testamentary, with no difference in the government's conclusions) and, in
default of exercise, the property was allocated first to a credit shelter trust
and any excess to the surviving spouse outright.
According to the government:
- their initial contributions to the trust were not taxable gifts
because of their retained powers to revoke;
- any inter vivos distribution to either spouse constituted a gift of the
distributed property by the non-recipient spouse to the recipient of the
distribution, which qualified for the gift tax marital deduction;
- when the first spouse died, all the trust property was includible in the
estate of that decedent, half under Section 2038 due to the transfer
with retained power of revocation and half under Section 2041 due to the
general power of appointment;
- when the first spouse died, the surviving spouse was deemed to make a gift
of the survivor's share of the trust corpus, which also was deemed to qualify
for the gift tax marital deduction; and
- the credit shelter trust was treated as passing from the deceased spouse,
meaning that the survivor would not suffer Section 2036(a)(1) retained
interest inclusion of any part of that trust when the survivor dies.
It is item (4) in this summary that generates some angst.
A refinement (inspired by but not identical to Private Letter Rulings
200604028 and 200403094) will be attractive to many clients because it does not
entail an irrevocable transfer to an inter vivos QTIP trust, nor a joint trust.
Furthermore, any control granted to the first spouse to die is limited to a
formula driven general power to appoint.
In this approach each spouse creates a separate revocable inter vivos trust,
and each spouse's trust grants a general inter vivos power of appointment to the
other spouse, exercisable at any time prior to the powerholder's death,
over only those assets in the settlor's trust that would qualify for the
gift tax marital deduction if transferred directly to the powerholder.
The amount subject to each power, determined by a formula, equals the excess
of the powerholder's remaining applicable exclusion amount over the value of the
powerholder's own taxable estate (determined without regard to the general
power). The power is exercisable only by written notice from the powerholder to
the trustee of the settlor's trust (usually this is the settlor, which raises
the same cautions as are appropriate in any credit shelter trust situation with
the surviving spouse as trustee, to preclude estate tax inclusion on the
settlor's subsequent death).
The written notice-to-exercise requirement guarantees that the time of
exercise precedes the powerholder's death, which addresses the most
controversial issue with respect to this planning whether a gift tax marital
deduction is available to the settlor for the property subject to the power of
appointment that is includible to the powerholder.
Without this element it might be argued that any gift occurred at the
powerholder's death, when the power lapses and causes estate tax
inclusion, and arguably a donor cannot make a marital deduction qualifying gift
to a deceased spouse. That was the message in the discussion that recently
spilled over to the planning discussed here. (In
Estate of Lee, discussed by practitioners in LISI's LawThreads commentary "Does
Recent Case Kill Poorer Spouse Technique?," the "surviving" spouse actually
died 46 days before the taxpayer/decedent, and the Tax Court rejected the
argument that a presumption of survivorship could salvage the section 2056
marital deduction.)
The inter vivos general power of appointment in the alternative discussed
here cannot be revoked after the effective date of its exercise (a practical
impossibility anyway), but the trust is revocable by the settlor and can be
amended prior to the powerholder's death.
The trust document articulates the settlor's intent that a completed gift to
the powerholder occurs on the effective date of exercise (immediately prior
to the powerholder's death), which ought to qualify for the gift tax marital
deduction because the powerholder is still alive at that time. Plus, assets that
satisfy any exercise of the power are valued on the date when any exercise of
the power becomes effective (again, immediately prior to the
powerholder's death).
Immediately upon creation of the revocable trust the powerholder executes a
Notice of Exercise with respect to the full amount subject to the general power,
stating that the effective date of the exercise is immediately prior to the
powerholder's death (as required by the power itself), but only if the
settlor is then living. (A variation on this requirement would make the power
itself conditional on the powerholder dying before the settlor.)
The power usually is exercised in favor of the powerholder's own revocable
trust (typically created at the same time as the settlor's trust although care
is required to avoid potential application of the reciprocal trust doctrine).
This appointee trust contains traditional marital deduction and credit
shelter formula language, with the expectation that exercise will fully soak up
the powerholder's unified credit and fill up the powerholder's credit shelter
trust, which will be held for the surviving spouse's overlife.
Although the powerholder could change that revocable trust without the
donor-spouse's knowledge, the donor of the power can avoid most problems by
remaining vigilant and altering the power granting trust if there are storm
clouds over the marriage or if the powerholder changes the appointee trust in an
unacceptable manner.
Thus far, most clients have not been unduly concerned with this risk. For
those clients who are concerned, however, an alternative is to have the
powerholder immediately release the general power, in lieu of the exercise just
described. This precludes a result that many may fear, if the settlor spouse
becomes incompetent or is simply unaware of the powerholder's activity.
The reason this immediate release of the general inter vivos power continues
to accomplish inclusion in the powerholder's estate of the formula-determined
amount that soaks up the powerholder's unused applicable exclusion amount is the
second clause of Section 2041(a)(2):
The value of the gross estate shall include the value of all property . .
. with respect to which the decedent has at any time . . . released [a general]
power of appointment by a disposition which is of such nature that if it were a
transfer of property owned by the decedent, such property would be includible in
the decedent's gross estate under sections 2035 to 2038, inclusive.
In plain English, what this means is that the powerholder is treated as
having made a lifetime withdrawal from the trust granting the general power and
then made a contribution of that withdrawn amount back into that trust.
If the powerholder's ongoing enjoyment in or control over that trust would
generate inclusion under any of the string provisions (for example, because the
powerholder has a life income interest in that trust), then estate tax inclusion
occurs at death notwithstanding the release. This inclusion is exactly what the
spouses want, if the powerholder dies first, with unused unified credit.
This approach precludes misuse of the general power, because it precludes the
powerholder from altering ultimate distribution of the property subject to the
power. (Note that this denial may be undesirable if, for example, circumstances
change after creation of the trust and the settlor is incompetent to alter the
power granting trust.)
To avoid confusion, it is important to segregate those assets that were
included in the powerholder's estate, during the overlife of the settlor of the
power-granting trust. These included assets must pass into a trust for the
overlife benefit of the surviving spouse and must be administered as would
property in the powerholder's own credit shelter trust for the survivor's
benefit.
This trust may provide the same enjoyment that any credit shelter trust would
provide and still avoid inadvertent inclusion in the surviving spouse's estate
on the second death. This is the key to the government's favorable rulings on
this planning by inclusion in the powerholder's estate and then exclusion from
the original settlor's estate, the effect is to soak up and shelter the full
unified credit of the first spouse to die.
Under the Notice of Exercise approach, this segregation occurs by the
exercise itself.
Under the release of power approach it occurs under a default-of-exercise
provision that applies by virtue of the powerholder's failure to exercise the
power (that is, by virtue of the release) and sends the property subject to the
power to a credit shelter trust created by the original settlor, essentially for
the settlor's own benefit.
Either way, with inclusion to the powerholder and thus a "cleansing" of the
wealth, the desired objectives continue to apply.
Segregation of the appointive property also makes it easier to identify any
property includible in the powerholder's estate that is entitled to Section 1014
new basis which raises an issue with respect to potential application of
Section 1014(e) that is controversial and unresolved but not the primary object
of the planning here under consideration (and thus not the subject of this
discussion). If new basis is available, the parties obtain a bonus on the
already very desirable objective of sheltering all the unified credit of the
first spouse to die.
COMMENT:
The two approaches outlined here address what many regard as the weakest link
in the analysis in the private letter rulings (the gift tax marital deduction),
which is the issue upon which some commentators have focused in the wake of
Estate of Lee (i.e., that it is illogical to treat a gift made to an
already deceased donee as qualifying for the gift tax marital deduction).
The Notice of Exercise or the release, either signed during the powerholder's
lifetime, may eliminate those concerns while accomplishing the spouses'
objectives.
The need to shelter both spouses' applicable exclusion amounts by using
both of their unified credits, no matter which spouse dies first, will
remain a significant planning objective unless Congress enacts portability of
the unified credit (by which deceased spouses could leave to their surviving
spouses the decedents' unused unified credits, which the survivors could use
along with their own credits on the second death).
Until the government issues a long-pending revenue ruling on this particular
planning, however, there will remain some risk that it may not succeed. And
planning of this ilk will remain relevant even if Congress enacts
portability, in cases in which portability is undesirable such as a deceased
spouse with intended remainder beneficiaries who the survivor is not likely to
benefit.
In any event, it makes sense to hedge our bets on the most uncertain aspect
of this credit sheltering approach.
HOPE THIS HELPS YOU HELP OTHERS MAKE A POSITIVE DIFFERENCE!
Len Cason,
Steve Davis,
Jeff Pennell
CITE AS:
LISI Estate Planning Newsletter # 1292 (May 7 , 2008) at
http://www.leimbergservices.com Copyright 2008 Leimberg Information Services,
Inc. (LISI). Reproduction in Any Form or Forwarding to Any Person Prohibited -
Without Express Permission.
CITES:
Estate of Lee v. Comm'r, 94 T.C.M. (CCH) 604 (2007); PLRs 200210051 and
200101021.
See Charles A. "Clary" Redd, "Sharing Exemptions? Not So Fast," Trusts and
Estates, April, 2008, Pg. 18; Andy DeMaio, "Does Recent Case Kill Poorer Spouse
Technique?" LISI LawThreads Discussion.
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