Interplay of State Formula Clauses, State Patches, and Estate Tax Relief
A formula clause is used to address the uncertainty of what dollars will be in an estate and what the law will be when a particular taxpayer dies. If a will bequeathed $2 million to a trust for children from a prior marriage and $2 million to a second spouse, that might work reasonably well if the estate was $4 million when the will was drafted, and $4 million on death. But, what if the estate grew to $8 million? How would the new $4 million of the estate be distributed? What if the $2 million to the children was based on the fact that at the time of the will was written $2 million could be left to the children without an estate tax? What if the amount that could be bequeathed without an estate tax (the exclusion) increased to $5 million as it did with the TRA? What if it decreased to only $1 million, as it almost did in 2011 and is on the books to do again in 2013? To address this type of risk estate planning, attorneys often drafted distribution provisions for wills using formulas. For example, “I devise and bequeath the largest amount that won’t create a federal estate tax to my children and the balance to my surviving spouse.” This was done to take advantage of the maximum amount that could be given to a non-spouse without triggering estate tax.
Planning Note: Consider a will that was written when the estate tax exclusion was $600,000 and bequeathed the largest amount that would not trigger a federal estate tax to children from a prior marriage. The balance, which was the bulk of the estate, was to pass to a new spouse. In 2011, that will mean $5 million to children and whatever is left to the spouse. Does that still reflect the individual’s intent? Formula clauses need to be carefully reviewed and stress tested for several possible future estate tax scenarios.
Formula clauses can work great, but the problem arises when the assumptions they are based upon get thrown out the window. The simple, and not uncommon, approach, suggested in the preceding paragraph, becomes problematic when, in 2010, to every tax expert’s surprise, the estate tax actually disappeared. So, in 2010, the entire estate would have been bequeathed to the children under that formula, since there was no tax.
To help address the problems of estate tax repeal based on formula clauses, many states enacted legislation that provided a Band-Aid to afford some relief. These patches often took the approach of stating that the federal estate tax rules of 2009 would apply to formula clauses in wills that provided that a distribution would be made based on, for example, “the largest amount that can pass free of federal estate tax.” With a state patch saying to apply 2009 law; the $3.5 million estate tax exclusion, in 2009, would have been a cap on the distributions to the children.
If this all wasn’t confusing enough, now the impact of the TRA on those state tax patches for the 2010 year of repeal have to be considered. Some state tax patches provide that they will only be effective for a year in which there is no federal estate tax. That means that if a taxpayer wrote a will in 2001 with a $1 million formula bequest to children of a prior marriage, in 2011 $5 million will be bequeathed to those children under a formula similar to that illustrated earlier. These issues, including possible effects of the carryover basis election on how these state patches might be interpreted, are discussed further in Chapter 3 in the section “Estates of Taxpayers Dying in 2010.”
Planning Note: This may be as problematic as the year of repeal and result for many estates in the entire estate being bequeathed to the children and nothing to the spouse. This is the same dramatic problem that affected many wills and estates in 2010. Every taxpayer must review and revise his or her will. Everyone. Many taxpayers have already breathed a sigh of relief when President Obama penned his signature on the TRA. That sigh may well have been premature, and it may turn into a moan and a groan if planning is not updated.
Subscribe to our email list to receive information on consumer webcasts and blogs, for practical legal information in simple English, delivered to your inbox. For more professional driven information, please visit Shenkman Law to subscribe.