Understanding and Manipulating Estate and Gift Taxes

After that title, who doesn’t want to read this post? Any practitioner in the Estate Planning world considers the impact that estate, gift, generation-skipping transfer, and inheritance taxes will have on a plan. Clients inquire about tax impact during consultation and beneficiaries wonder not only if taxes will result from their inheritance but also who will bear the burden of paying said taxes. Generally, the individual making the gift bears the responsibility of paying any taxes on the transfer during life or at death. Certain provisions of the Code may change that result. This first part in a two-part series will focus on understanding the basics of the Estate and Gift Tax.

Let’s start with the basics. The Internal Revenue Code (“Code”) levies an estate tax on the value of the assets of an estate that exceed the Applicable Exclusion Amount (“AEA”) at the rate of 40%. In 2023, each U.S. citizen / resident has an AEA of $12.92 million, meaning that an individual can transfer up to $12.92 million either during life or at death without worrying about incurring a tax on the transfer. For most of the population, that’s enough to remove the worry of estate tax from their mind. For some of the population, however, that’s not enough. Thankfully, in addition to the AEA, Section 2056 of the Code provides an unlimited deduction for property passing to the surviving spouse. Thus, married individuals may pass an unlimited amount of assets between one another during life and at death. Section 2056(b)(1) prohibits the deduction, however, for property passing to the surviving spouse that qualifies as a “terminable interest” meaning that the spouse’s interest in the property will terminate or fail on the lapse of time or occurrence of an event or contingency, or will terminate upon the failure of an event or contingency to occur, and upon such termination the interest will pass to someone other than the surviving spouse.

You may be wondering what that means. Let’s review an example. Assume that Howard and Bernadette have been married for several years but have no children together. Howard has children from a prior relationship, Halley and Neil. Over the years as an astronaut, Howard has amassed an estate of $25 million. Bernadette has her own assets of $25 million from her successful job as a microbiologist at a pharmaceutical company. Howard and Bernadette live a lavish lifestyle, flying all over the world to visit their friends, Sheldon and Amy, now living in Switzerland, along with their friend, Raj, and his wife Riva, living in India. After his death, Howard wants to make sure that Bernadette can continue this lifestyle but also wants to ensure that his children have adequate funds as well. He wants to pay as little as possible in taxes but worries that if he gives Bernadette everything outright that she will spend it all or fail to leave his children any of his wealth.

With these competing interests in mind, Howard makes an appointment to see his attorney who suggests that he structure his estate plan to create a Family Trust that will consist of his unused AEA with the remainder going into a Marital Trust for Bernadette’s benefit. The terms of the marital trust allow the Trustee of the Trust to make distributions of income or principal for Bernadette for life for her health, education, maintenance, and support. Howard does not want Bernadette to alter the plan and therefore excludes both a limited power of appointment and a general power of appointment. At Bernadette’s death, the assets in the marital trust will pass to his children, Halley and Neil. Howard likes the plan and signs it.

A few months later, Howard dies unexpectedly. Bernadette sees her attorney who advises her that Howard’s attorney structured the plan improperly. Howard’s estate cannot avail itself of the unlimited marital deduction for the assets passing to her in the marital trust. The attorney explains that Bernadette’s marital trust consists of a terminable interest, but an inappropriately structured terminable interest. He indicates that the Code allows a decedent spouse to leave assets in a trust for the benefit of a surviving spouse during that spouse’s life and obtain the benefit of the unlimited marital deduction provided that said trust has been properly structured and that Bernie’s trust was not. The lawyer goes on to advise Bernadette that two types of marital trusts will produce an unlimited marital deduction. The first is one in which the surviving spouse has a life estate coupled with a general power of appointment. While Bernie’s marital trust gave her a life estate, it did not contain a general power of appointment. The second is a trust that meets the requirements set forth in Code Section 2056(b)(7).

Code Section 2056(b)(7) requires the trustee to distribute all income from the trust to the surviving spouse. In addition, the trust gives the surviving spouse the power to make any unproductive property income-producing. Finally, no payment may be made to any other person during the surviving spouse’s lifetime. If the trust meets these requirements, it will qualify as a “Qualified Terminable Interest Property” (“QTIP”) Trust and allow the decedent spouse’s estate an unlimited marital deduction for the assets passing to the trust. The decedent spouse’s fiduciary need only file Form 706, United States Estate (and Generation-Skipping Transfer) Tax Return and elect QTIP treatment thereon, and that forces inclusion of the value of the QTIP Trust at the surviving spouse’s death in the surviving spouse’s estate, pursuant to Code Section 2044.

The surviving spouse’s estate bears the burden of paying tax on assets that the surviving spouse cannot control. In fact, the surviving spouse may have never had the benefit of any distribution of principal, yet it’s the principal amount included in that surviving spouse’s estate. This realization undoubtedly has frustrated many a surviving spouse. Adding insult to injury, the decedent spouse controls disposition of the assets upon the death of the surviving spouse. Talk about a homerun for the decedent spouse and a recipe for a tense relationship between the surviving spouse and the stepchildren. If only there were a solution… we should be shouting “Code Section 2207A.” It provides relief to the surviving spouse’s estate.