A cohesive Estate Plan focuses on the distribution of assets and the naming of fiduciaries to carry out the plan upon the death of the Grantor or Testator. I understand that taxes and the payment thereof play an important role as well. Often, even those individuals whose gross estate falls below the Applicable Exclusion Amount ($12.06 million in 2022) need to worry about taxes. In addition to the Federal Estate Tax, clients need to consider the impact of state estate or inheritance taxes, along with local taxes and cash flow to pull it all together. It’s important to understand how taxes will be allocated among your beneficiaries upon your death and to ensure that allocation honors your wishes. I attempt to control the allocation of taxes through the use of an apportionment clause. An apportionment clause specifies who among your beneficiaries will ultimately bear the burden of the taxes. Omission of this clause or inartful drafting may result in unintended consequences, or worse yet, litigation.
Tax apportionment clauses come in many varieties. For example, a Will or Trust may contain language that designates only those assets passing under the Will or Trust are to pay the taxes. Thus, beneficiaries who receive assets that pass outside the Will or Trust, such as beneficiary designated assets like Individual Retirement Accounts, life insurance, or Pay on Death or Transfer on Death Accounts, would not bear the burden of any taxes. That may or may not reflect the Grantor or Testator’s intent. Conversely, the Will or Trust may allocate taxes among all the beneficiaries, including those who receive the assets outside through a beneficiary designation. Alternately, the documents may direct payment of taxes from the residuary estate, after payment of all specific gifts, expenses, and liabilities. Of course, if the residuary lacks liquid assets sufficient to pay the taxes, that poses another problem altogether. Let’s review an example that highlights one of the potential problems with payment from the residue.
Assume that Ned has two children, Rob, and Sansa. Ned wants to leave his home, Winterfell, valued at $10 million to Rob and the other $10 million of his estate consisting of cash and stock to Sansa through his residuary clause. Ned was clear that he intended to leave equal amounts to his children; however, an inexperienced attorney included a tax apportionment clause that directed payment from the residue of Ned’s estate. Ned died in 2022 leaving an approximate estate tax liability of $3.2 million. Because Ned’s Estate Plan directs payment from the residuary estate, the taxes will diminish the residue, which was going solely to Sansa. Thus, after payment of taxes, Sansa will receive a mere $6.8 million, while Rob will receive $10 million. If the tax clause directed apportionment between the beneficiaries proportionately based upon their share of Ned’s estate, then each of Rob and Sansa would bear $1.6 million in taxes. If we assume that Rob had no assets other than Winterfell, then the attorney needs to consider other sources of payment for the tax or structure the plan in another way to prevent a sale of Winterfell to pay the taxes. Perhaps the best plan gives each of Rob and Sansa half of Winterfell and half of the cash and stocks to ensure equal treatment.
Let’s change the facts a bit to mimic those of a recent Nebraska Supreme Court case, Svoboda v. Larson, 311 Neb. 352 (2022). Now assume that Ned lives with Catelyn and has only one child, Jon. Ned and Catelyn have a business and personal relationship but remain unwed. Ned’s estate plan leaves half of Winterfell to each of Catelyn and Jon and half of his sword-making business to each of Catelyn and Jon. Ned gives his livestock along with the residue of his estate containing minimal assets to Catelyn. Ned’s documents directed payment of estate and inheritance taxes through the residuary estate. A state statute imposes inheritance taxes at different rates based upon the beneficiary’s relationship to the decedent. Catelyn’s portion of Ned’s estate produced an inheritance tax liability of approximately $2,000,000, while Jon’s portion of Ned’s estate produced a tax liability of approximately $70,000. Ned’s residuary estate lacked assets sufficient to bear the burden of these taxes. State law indicates that if the direction given in the Will or Trust results in insufficient funds to pay the tax liability, then such direction fails and the burden of payment falls where the law places such burden, unless the testator made contingent plans in the governing documents. In Ned’s case, Catelyn will be responsible for coming up with $2,000,000 resulting from her bequest, while Jon will be responsible for the much smaller amount of $70,000 because of his legal relationship with Ned. Of note, Catelyn and Jon received substantially similar amounts but because of insufficient planning and state statutes ended up with vastly different results.
As the above examples demonstrate, we always need to consider the tax implications of a plan carefully. It’s important that the Will and Trust coordinate to avoid any confusion. In addition, we consider what assets the Personal Representative or Trustee will use to pay the liability and provide for various contingencies, for example, an insufficient residuary. Finally, remember that state laws and a beneficiary’s individual circumstance will also impact the ultimate responsibility for payment of taxes.