Drafting a Bypass Trust (Applicable Exclusion Trust, A-B Trust, Credit Shelter Trust) After 2010 Tax Act

Drafting a Bypass Trust (Applicable Exclusion Trust, A-B Trust, Credit Shelter Trust) After 2010 Tax Act

By by Martin M. Shenkman, CPA, MBA, JD

Sample Will Clause Funding Federal Bypass Trust In the past, a formula clause may have been written to determine how much, in terms of value, would be paid to a bypass or credit shelter trust. “I give, devise, and bequeath the pecuniary sum which is the largest dollar amount which will not create a federal estate tax on my death, to the Trustee of my Applicable Exclusion Trust, in trust, (‘Applicable Exclusion Trust’) to be disposed of in accordance with the provision below  ‘Application of Applicable Exclusion Trust.’” Note that similar issues are raised by a marital (QTIP) trust funding clause approach, that states that “I give, devise, and bequeath the pecuniary sum which is necessary to avoid the creation of a federal estate tax on my death, to the Trustee of my Qualified Terminable Interest Property Trust, in trust, (‘QTIP Trust’) to be disposed of in accordance with the provision below  ‘QTIP Trust.’” This common scenario raises important issues:

  • Will the language in a will “the largest amount that will not trigger federal estate tax” be applied in a manner that accomplishes the taxpayer’s objectives with the new $5 million exclusion?
  • If Congress either takes no action or affirmatively acts to reconfirm a $1 million or other exclusion for 2013 and later years, what happens?
Scenario 1: Perhaps the following modifications might warrant consideration if the taxpayer’s dispositive scheme is such that the amount that can pass free of federal estate tax should always be used to fund this bequest: “I give, devise, and bequeath the pecuniary sum which is the largest dollar amount which will not create a federal estate tax on my death, to the Trustee of my Exclusion Trust, in trust, (‘Exclusion Trust’) to be disposed of in accordance with the provision below ‘Application of Applicable Exclusion Trust.’ I recognize that the Basic Exclusion Amount is presently $5 million, but that such amount may decline to $1 million in 2013, or that such amount may otherwise be changed by future legislation, and I intend in all events that this bequest remain set at whatever the Basic Exclusion Amount shall be.” Scenario 2: If instead the taxpayer’s dispositive scheme is such that a specified amount should pass to the children of a former marriage in trust, but without the desire to trigger estate tax on the first death, then the amount that can pass will be the lesser of the bequest amount or the Basic Exclusion Amount. An approach similar to the following might be considered to fund this bequest: “I give, devise and bequeath the pecuniary sum which is the smaller of:
  • The largest dollar amount which will not create a federal estate tax on my death, to the Trustee of my Exclusion Trust,
  • Two Million Dollars ($2,000,000) ( ‘Cap’), in trust, ( ‘Exclusion Trust’) to be disposed of in accordance with the provision below ‘Application of Applicable Exclusion Trust.’ I recognize that the Basic Exclusion Amount is presently $5 million, but that such amount may decline to $1 million in 2013, or that such amount may otherwise be changed by future legislation. I intend by this provision to make a bequest not greater than the Cap. However, it is not my intent to incur a federal estate tax on this bequest so that in any event this bequest shall not exceed whatever the Basic Exclusion Amount is that shall be available to my estate. I further recognize that, to the extent I utilize, some portion, or all, of the gift exemption during my lifetime the amount of this bequest may be reduced.”
Scenario 3: If instead the taxpayer’s dispositive scheme is such that a fixed minimum amount will pass to children of a prior marriage even if it results in causing federal estate tax to be paid (perhaps to comply with requirements of a divorce agreement), then an approach similar to the following might be considered to fund this bequest: “I give, devise and bequeath the pecuniary sum of Three Million Dollars ($3,000,000) (‘Amount’), in trust, (‘Family Trust’) to be disposed of in accordance with the provision below ‘Family Trust.’ I recognize that the Basic Exclusion Amount is presently $5 million, but that such amount may decline to $1 million in 2013, or that such amount may otherwise be changed by future legislation. I intend by this provision to make a bequest equal to the Amount. However, I recognize that my estate may incur a federal estate tax on this bequest and I have intentionally not limited this bequest understanding that the Amount may exceed the Basic Exclusion Amount available to my estate. I further recognize that to the extent I utilize some portion or all of the gift exemption during my lifetime the amount of estate tax incurred on this bequest may be increased. There are a myriad of approaches to address these types of bequests. Those above, are just presented for discussion only. Sample Pre-2010 Alternative Will Clause Funding Bypass Trust If the taxpayer is fortunate enough to be domiciled in a state that has its own estate tax that has decoupled from the federal estate tax, the decision process, and drafting should perhaps differ. In prior years, especially for an older couple, it may have been advantageous to fully fund the bypass trust at the first spouse’s death to maximize the federal estate tax savings on the second death, even if the full funding triggered a state estate tax on the first death. This analysis may have been dramatically altered by the TRA and every will with this type of plan should be revisited. The calculus prior to 2010 for a testator living in a high estate tax state was whether it was worth funding a bypass trust for the difference between the state estate tax exclusion and the federal exclusion amount. Planning Note: Decedent resided in a state with a $1 million state estate tax exclusion. In 2009, depending on the age and health of the surviving spouse, it might be advantageous to fully fund the bypass trust up to the larger federal exclusion of $3.5 million even at the cost of incurring a state estate tax. The avoidable state estate tax on the incremental $2.5 million funding to a bypass trust for a New York domiciliary in 2009 would have been approximately $230,000. This might well have been worthwhile to avoid a later and more substantial federal estate tax. Example: Husband and Wife were quite elderly when they implemented an estate plan. Husband’s estate is comprised of $3 million in assets and Wife’s estate of $3 million in assets. Husband died in a year when the estate tax exclusion was $2 million. The couple resided in a state that had decoupled from the federal estate tax and had only a $1 million exclusion. The tax cost on a $2 million taxable estate in that state was $100,000. The estate plan funded a bypass trust (exclusion trust) under Husband’s will with the full $2 million federal exclusion amount even though this triggered a 10% tax or $100,000 state estate tax cost on the additional $1 million in excess of the state exclusion. If instead, the Husband’s will only bequeathed $1 million to the bypass trust and the balance to Wife, no state estate tax cost would have been incurred. Wife died the next year when the exclusion was $3.5 million and the rate was 45%. Her estate was $4 million (her original $3 million plus the $1 million inherited from Husband that did not go to the bypass trust). Wife had a $500,000 taxable estate that paid a 45% tax of $225,000. If Husband had funded the bypass trust with only $1 million, Wife’s estate would have been $5 million (her original $3 million plus the $2 million that she would have inherited from Husband that did not go to the bypass trust), and her estate tax would have been $675,000 ($1.5 million taxable estate times a 45% rate). The federal estate tax savings from the fully funding the bypass trust at Husband’s death was $450,000 ($675,000 – $225,000).  This is offset by the additional $100,000 of state taxes paid at Husband’s death, for a net savings of $350,000 by fully funding the bypass trust at Husband’s death. The net tax saving was the marginal rate difference of 35% (the 45% federal tax rate less the state 10% tax rate) on the second million dollars funded to the bypass trust on Husband’s death, or $350,000. This type of planning will be counterproductive for millions of taxpayers with the new $5 million exclusion and portability. With federal portability, there is no need to incur a state estate tax to fund a bypass trust on the first death. However, since the portable exclusion is not indexed, it might still make sense to fund a bypass trust up to the state exclusion amount, especially if the surviving spouse is healthy and likely to live for many years. Planning Note: All wills should be reviewed that have a bypass or exclusion trust funded above the state limit and be reevaluated in light of portability and the higher exclusion. There may be no reason to fund beyond the state exclusion amount as there may have been under prior law. But just like with the late night cable infomercials, “There’s more!”. If, in 2013, the law reverts to pre EGTRRA rules the portability benefit disappears along with the higher exclusion and the advantage of funding a bypass or exclusion trust beyond the state limit reappears. Should this contingency be planned for in drafting? “I give, devise and bequeath the pecuniary sum which is the largest dollar amount which will not create a federal or state estate tax on my death, to the Trustee of my Applicable Exclusion Trust, in trust, (‘Applicable Exclusion Trust’) to be disposed of in accordance with the provision below ‘Application of Applicable Exclusion Trust.’” If this taxpayer was domiciled in the Garden State (that’s New Jersey for you non-Springsteen fans) and if those magic words “or state estate tax” appear in the will, New Jersey has only a $675,000 state exclusion so that would limit the funding. If, however, the taxpayer headed south to the land Miami Vice where there is no state estate tax, then the full federal bypass or Basic Exclusion Amount would fund the trust. With an increasingly mobile society, and considerable uncertainty as to how states will react (perhaps they won’t) to the federal estate tax changes, an assumption as to which state law may govern the provision could itself lead to problems. This will be further compounded by the possible dramatic change in the exclusion in 2013. Throughout the period of 2009-2010 with the tumult over the impact of estate tax repeal on formula clauses in wills and other instruments, great care must be taken to assure that if the beneficiaries of the different dispositive results are not identical that caps and floors and perhaps even statements of intent, as illustrated previously, be incorporated. The wild card, as noted, remains 2013. If, in 2011, the federal estate tax roars back with a measly $1 million exclusion and a 55 percent marginal rate, then it might be worthwhile to draft a bypass trust that also contemplates this scenario. However, how much detail and complexity will taxpayers accept?

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