A. Discuss Tax Apportionment
1. Because tax apportionment effectively changes the size of beneficiaries’ shares of a client’s estate, it is as important to discuss the tax
apportionment issues with the client as it is the dispositive provisions of her documents.
2. One commentator suggests, “because of the subtle but far reaching effects of the tax apportionment clause, more time may have to be spent
discussing that clause than any other will provision.” B. Always Include a Tax Apportionment Clause in the will
1. Even if the client wants to use the statutory provisions to direct
apportionment in his or her estate plan, the will should spell out the plan the client wants - inside, outside and/or equitable apportionment, etc. a. The client may move to another jurisdiction which has a different
statute.
b. The statute may be modified over time.
c. The client may own property in another jurisdiction at the time of her death. Including a provision in the client’s will increases the likelihood that the foreign jurisdiction will be bound by the client’s wishes.
2. It is generally prudent to include the tax apportionment clause in the will, even if it is also included in other documents, to ensure that it will be effective regardless of the state in which the client dies domiciled. Be sure all of the clauses are consistent!
C. Avoid Blanket Waiver of Outside Apportionment
1. As a general rule of thumb, it is dangerous to waive outside apportionment because the value of the nonprobate assets can be substantially higher than the decedent anticipated. As noted earlier in II.C.3, many of the types of nonprobate property which may be included in the decedent’s estate are assets which the decedent gave away, in one way or another. In addition, the decedent may have held powers as a trustee of a trust she did not even create which could make the trust property includible in her estate. As a
result, the decedent may not be aware of all of the assets that will be includible in her estate. Waiver of the right of apportionment under these circumstances may obliterate the decedent’s probate estate with the payment of tax on property the decedent did not expect to be included in her estate. See e.g., Estate of Farrell v. United States, 553 F.2d 637 (Ct. Cl. 1977) (because inter vivos trust decedent created for first wife many years earlier did not forbid him from serving as trustee of trust with powers that would make trust includible in his estate, trust was includible in his estate and tax was paid from residuary estate of which second wife was beneficiary).
2. If the client wants certain nonprobate property to pass without any tax burden (e.g., a pension plan), it can be specifically identified in the tax clause.
3. The tax clause would direct that the probate estate would pay all tax on property passing under the will and the specified additional nonprobate pieces identified in the tax clause. All other tax on nonprobate property would be born by the beneficiaries who received the property. This suggestion is, in effect, the reverse of many standard form tax
apportionment clauses which direct that all taxes be paid from the residue, excepting specific taxes from the definition of taxes.
D. Avoid Blanket Waiver of Inside Apportionment
1. One of the main reasons that people like to exempt specific bequests from the payment of tax is to avoid subjecting beneficiaries of tangible personal property to tax.
2. Again, however, it is possible for the estate tax value of certain items to vastly exceed the client’s expectations. For example, a piece of art may have an unexpectedly high value. This may be particularly true of specific bequests of particular business interests to a particular child. Under these circumstances, if inside apportionment is waived, the remaining children who are the residuary takers will bear the tax burden for their sibling’s bequest.
a. This situation often presents a quandary since the client probably does not want to force the child to liquidate the business interest in order to pay the tax. On occasion, the client will be faced with hard choices.
b. Consider that a section 303 redemption will not be possible to provide the estate with liquidity at the client’s death if the stock (or its recipient) is not charged with the tax.
3. This issue generally always requires care in analysis since the preresiduary specific legatees are often not the same people as the residuary legatees. 4. Moreover, when the client specifies a cash legacy for a friend or relative,
she often wants that person to receive the full amount, in which case such legacies should be exonerated from tax apportionment.
5. Consider exonerating the preresiduary bequests up to a specific value or percentage of the estate.
E. Apportion Taxes Where Payment Is Deferred
1. Where payment is deferred under section 6166 and tax is due from the residue, the personal representative may be reluctant to distribute the residue, to ensure that she can pay the tax when it comes due. It may be preferable to require the tax to be paid from the asset causing the deferral, if possible, or to apportion to all beneficiaries of the estate.
2. As a result, it is a good idea to thoroughly discuss this issue with your client.
F. Consider the Effect of Subjecting Marital or Charitable Bequests to Tax 1. As discussed above, the payment of tax from a bequest that generates a
deduction has the circular effect of not only reducing the bequest by the amount of tax paid, but also then decreasing the size of the deduction which requires payment of additional tax.
2. For example, for an estate taxed at the 55% rate, the effective rate of tax for payments made from a deductible interest is 122%.
3. A good example of a situation in which a client should be asked his or her preference with regard to this issue is when the residuary is divided on a percentage basis among several beneficiaries, one or more of whom are charitable. The actual dollar amounts that the beneficiaries receive will be dramatically affected by whether the shares are calculated as a percentage of the residuary before or after the payment of tax. Remember that sometimes this division of the residue between charitable and
not survive the client. The tax apportionment clause must address considerations raised by gifts to contingent beneficiaries.
G. Special Considerations Regarding Marital Property 1. QTIP Election.
a. A client who intends that the marital bequest held in trust will be deductible by reason of electing QTIP treatment should be cautious about the tax apportionment clause. Assume that the bequest was preresiduary with a direction that all taxes be paid from the residuary which is intended to pass to the client’s children from a prior marriage. Consider that if the election is not made, the entire amount of the estate passing to the trust will be subject to tax, and that tax burden will be shifted from the spouse’s estate (at the later death of the spouse) to the client’s residuary estate. If the client and the spouse each have children from prior marriages who are the beneficiaries of their respective estates, such an alternative is not entirely far-fetched, particularly if the spouse is serving as the personal representative. Since no QTIP treatment was elected, the client’s children will have no right of reimbursement under section 2207A.
b. Consider the alternative that the client’s personal representative would like to make a partial QTIP election, determining that it would be advantageous to pay some tax in each estate to reduce the applicable tax rates. Under these circumstances, the personal representative may not be able to make a partial QTIP election without seriously impacting the size of the shares of the estate passing to the client’s children.
c. Frequently, the best alternative will be to direct that if the election is not made, the tax will be paid from the share of the estate that passes to the spouse which does not qualify for the marital deduction. Note, however, that the drafting must make clear that the payment of tax from the share passing to the spouse is
contingent on the share not qualifying for the marital deduction independently of the direction to pay tax from the share.
2. Elective Share.
a. The law regarding the imposition of tax on a spouse’s elective share of course varies from state to state.
b. More recent case law has found that when the spouse elects against the will, he also elects not to be subject to the tax apportionment clause in the will. Rockler v. Sevareid, 691 A.2d 97(D.C. 1997). As a result, it seems unlikely that the size of a spouse’s elective share can be affected by the tax apportionment clause in the decedent’s will. The determination of whether the elective share bears tax is likely to be determined by applicable state law. Note that in the Rockler case, as a result of exempting the elective share from tax, the spouse received over 46% of the decedent’s estate. Brief for Appellant at 5, Rockler v. Sevareid, 691 A.2d 97 (D.C. 1997).
3. Sharing the Tax Rate Differential.
a. A client may choose to leave most of her estate to her spouse in a QTIP trust, despite that fact that if the tax were paid in the client’s estate and the property left to her children, the rate of tax that would be applicable to the property would be lower than the highest marginal rate allowed for reimbursement purposes under section 2207A.
(1) Section 2207A provides for reimbursement from the QTIP trust at the incremental rate of tax under the theory that the a surviving spouse’s probate estate should not be required to bear any portion of the tax associated with the property included in the QTIP trust.
(2) However, where a client and her spouse have agreed that the client will leave the property in trust for the benefit of the spouse, the client may wish to share the combined tax rate available at the death of the surviving spouse. In this case the surviving spouse’s will or revocable trust must waive the reimbursement right under section 2207A and provide simply for standard outside apportionment. 4. Allocation of Tax to Nonexempt Marital Trust.
a. Where a client plans to allocate her GST tax exemption to a marital trust (making a reverse QTIP election) and have the balance of her estate pass to an ordinary nonexempt QTIP trust, it is important for the drafter of the will creating the trusts to direct that the estate tax due at the surviving spouse’s death as a result of its inclusion in the surviving spouse’s estate should be paid first from the nonexempt QTIP trust, and only if the assets of the nonexempt QTIP trust are
exhausted, then paid from the exempt QTIP trust. This avoids the “wasting” the GST exempt funds in payment of tax.
b. The payment of the tax from the nonexempt marital trust is not deemed to be a constructive addition to the exempt marital trust. c. It is not clear that a direction in the surviving spouse’s will to
collect the tax due on both QTIP trusts from the nonexempt QTIP trust first would be effective. For this reason, the language should be included in the language creating the nonexempt QTIP trust in the will of the first spouse to die.
H. Nonprobate Takers as Interested Parties
1. Under state apportionment statutes or provisions in the will or revocable trust, takers of nonprobate property may be liable for tax due on the estate. As a result, they may be entitled to receive notice of actions and court orders. However, few states have addressed this issue or the procedures for satisfying it.
2. A simple way to resolve this issue is to direct that all taxes be paid from the probate estate. However, as should be apparent by now, that choice should also involve other considerations.
I. Require Apportionment for Taxable Terminations or Taxable Distributions 1. Federal law directs payment of generation-skipping transfer tax from the
property transferred unless otherwise directed by the governing instrument. However, in some cases, the client may prefer to provide that the tax on a direct skip be paid from the residuary, thus permitting a grandchild to receive her bequest free of tax. Remember that, to be effective, the language to override the apportionment of tax under section 2603(b) must specifically refer to the GST tax. However, as discussed in II. D.7 above, the client should be aware that this will result in a larger GST tax.
2. The will (or revocable trust) can carve out a specific direction to treat direct skips differently than taxable distributions or taxable terminations. a. Consider, however, that in the event that a child of the decedent
disclaims all or a portion of a bequest, the transfer will often be a direct skip which the decedent may not have expected. It may be preferable to direct that GST tax on direct ships under the will, other than those resulting from a disclaimer, will be paid from the residue.
b. Direction to pay the generation-skipping transfer tax on taxable terminations and taxable distributions from the residuary, while possible, would be extremely unwise from an administration point of view. The tax may not be due for many years and the residue probably could not be distributed until after the payment of the tax. J. Be Specific (Waivers)
1. It is critical to be specific about the client’s intention of how the taxes will be computed and paid and from what sources under what circumstances. However, the most important aspect of being specific relates to the state statutes and the federal reimbursement provisions: sections 2206, 2207, 2207A, 2207B and 2603(b).
2. These reimbursement rights may be extremely valuable to the estate and should not be waived carelessly.
3. As discussed above, sections 2207A and 2207B now require that the document (either the will or the revocable trust) demonstrate a specific intent to waive these provisions. Although several alternatives could probably meet this requirement, why take a chance? If the intent is to waive the reimbursement right under section 2207A, there is no reason why the document should not say so. Remember that the failure to exercise this right if it is not waived will be treated as a gift.
4. However, consider that apportionment is more reliable and effective than reimbursement. In addition, it may resolve liquidity issues by having the beneficiaries of illiquid assets pay their pro rata shares of the tax to the executor in order to receive distribution of their bequests.
V. TWO KILLER TAX APPORTIONMENT CLAUSES
A. Too Little. Consider the following relatively simple tax clause: “My executor shall pay all taxes imposed on my estate by reason of my death." The following are just a few of the questions raised by this language:
1. Does this language waive apportionment, or does this language merely direct the payment of these taxes which may then be apportioned? 2. What happens if the decedent's death is a generation-skipping taxable
generation-skipping taxes apply or does this clause attempt to shift this burden?
3. Is it possible that this clause intends to include additional estate tax that may be imposed under Section 2032A upon a recapture event?
4. What is intended by the reference to "my estate?" Does this mean the decedent's probate estate, gross estate or taxable estate? In any event, the final determination involves both equitable and outside apportionment issues which may need to be considered.
B. Too Much? The following sample tax apportionment clause was included in Jeff Pennell’s article, Tax Apportionment, ALI-ABA Course of Study, Planning Techniques for Large Estates, April 26-30, 2010 at pg. 1541. Even Professor Pennell concedes in his article that it is far more inclusive than the average estate would warrant. Nevertheless, it provides a flavor for all of the potential issues which may need to be addressed in the well-drafted tax apportionment clause. “Debts, Expenses, and Taxes: My personal representative shall pay from the residue of my estate all obligations of my estate, including expenses of my last illness and funeral, costs of administration (including ancillary), other legally enforceable charges and claims allowable against my estate, and (subject to apportionment as provided below) death taxes as defined next below. Payments may be deducted for income or other tax purposes in the discretion of my personal representative without regard to whether any other deduction otherwise allowable is reduced.
“VI. Death Taxes Defined: Death taxes means all estate, inheritance, succession, or transfer taxes and any income or similar taxes on appreciation (including interest, penalties, and any excise or supplemental taxes) imposed by the laws of any domestic or foreign taxing authority at the time of or by reason of my death, but shall not include:
A. Any additional estate tax incurred under § 2032A(c) or §2057(i)(3)(F) of the Internal Revenue Code (or any similar or corresponding state tax law or any successor provision to any such law, all as amended prior to my death, hereafter collectively referred to as the Code) because of the disposition of or failure to use qualified real property or family-owned business interests; and
B. Generation-skipping transfer taxes imposed by Chapter 13 of the Code [, except to the extent attributable to a direct skip of which I am the
transferor and that is not caused by a qualified disclaimer by a non- skip person (as those terms are defined in the Code), which shall be paid from the residue of my estate without apportionment or reimbursement
notwithstanding the provisions of §§ 2603(a)(3) and 2603(b) of the Code or any other provision of this will].
“VII. Apportionment: Except as otherwise provided herein, it is my intent that each recipient of property that is includible in my estate for death tax purposes (whether passing under this will or otherwise) pay the proportionate death taxes attributable to the property (s)he receives, determined as follows:
A. The death tax attributable to:
1. Appreciation is the full amount of income or similar taxes incurred by reason of my death.
2. Adjusted taxable gifts as defined by §2001(b)(I)(B) of the Code,