The Most Important Provision In Your Will May Be The Most Overlooked:  Understanding Estate Tax Allocation and Apportionment Provisions.

At Apexium, we take a comprehensive and holistic approach to estate planning.  This entails helping our clients understand who will inherit their assets, and how.  Moreover, we clarify what taxes will be attributable to each asset, who will pay such taxes, and craft a plan so that the cash will be available to the responsible party.   Our relationship managers pay careful attention to estate tax allocation provisions, which can be a vital component of your estate plan and necessary to ensuring your testamentary desires are fulfilled.

Clients, and sometimes professional advisors, focus on fancy estate tax saving formulas, disclaimer provisions, and the value of assets to be left in trust to beneficiaries. financial-planningAlthough these are important considerations, some attorneys do not spend adequate time and energy on the estate tax apportionment clause, which dictates who is responsible to pay the estate and other transfer taxes.   Additionally, planners may fail to look at the “big picture” and consider all of the client’s assets, including those passing outside the will, by so-called “operation of law” (such as to a joint owner or a named beneficiary).  This can result in an estate tax allocation clause being poorly drafted, incorporating inapplicable or antiquated boilerplate language, or ignored altogether. According to David Bruckman, an attorney and partner at Apexium, “We have seen instances where the estate tax allocation clauses in a client’s will and one or more trusts contradict each other.  Any of these mistakes or oversights can lead to delays, confusion, litigation, extra taxes, and/or unintended consequences.” Some examples of which are discussed herein.

In the absence of an apportionment or allocation clause, the governing state’s law will generally determine who will pay the taxes.  Taxes due upon death, or as a result thereof, include federal income tax; state estate, inheritance, and income taxes; and the federal estate and generation skipping transfer (“GST”) taxes.  There are typically two places where the money comes from to pay the applicable estate or GST tax.  One option is that the taxes are paid from the decedent’s residuary estate, before distributing the probate assets to beneficiaries under the will. The other option, which is generally perceived to be more equitable (and which is the statutory default in the State of New York), is that the estate taxes are paid by the person who receives the asset that resulted in the tax.

We urge our clients to review their wills and living trusts to see if they contain a tax apportionment provision.  Then we create a chart mapping which asset will pass to whom, when and how, what the taxes will be, who will pay such taxes, and with what money.  Consideration must be given to the client’s intent, the titling of assets, any powers of appointment, and assets passing by operation of law.

A well contemplated tax apportionment clause should address the following:

  1. State and federal apportionment statutes (do they apply or will they be overridden);
  2. Specify the taxes to which the clause applies, including federal estate tax, state estate tax, succession and inheritance tax, and the GST;
  3. Instructions regarding the fund or funds from which the above taxes are to be paid;
  4. Direction as to apportionment of non-probate (assets that pass by operation of law) assets; and
  5. Instructions as to the specific allocation of the GST exemption.

Examples of Poor Planning

  • Here is a fairly simple example of how things can go wrong. Assume a father has 3 children, one daughter and two sons, A and B, whom he wants to benefit equally. Furthermore, assume that the three primary assets include a family business that the father wants to leave for his daughter, an IRA, and a stock portfolio. Each asset is worth $6,000,000, so the estate will be subject to the federal estate tax (assume a 50% rate of tax for federal and state estate taxes). The IRA lists sons A and B as the beneficiaries. The stock portfolio will pass through probate under the father’s will. The family business will transfer, upon the father’s death, to his daughter pursuant to a shareholders’ agreement. Further assume that the father has no estate tax exemption remaining. His will, drafted by his matrimonial attorney, has a boilerplate provision that all estate taxes are to be paid from the residuary estate, and that the net probate estate should be divided equally between sons A and B, who happen to be the executors.

The good news is that the will named only the sons as beneficiaries, rather than all three children, as that would have unevenly benefited the daughter. The bad news, however, is twofold. The primary problem is that the IRA and the business pass by operation-of-law (outside the will). Let’s assume the estate taxes attributable to these assets are $6,000,000. The burden of paying the estate taxes on the entire estate, which total $9,000,000, is the responsibility of the residuary estate. Thus, the sons are saddled paying the $3,000,000 of estate taxes attributable to the daughter’s inheritance of the family business. The daughter receives $6,000,000 of value, free and clear, whereas the sons will have to apply the entire $6,000,000 of the stock portfolio to partially satisfy the $9,000,000 estate tax bill. They may need to liquidate the IRA to come up with the remaining $3,000,000, which happens to be what is left of the IRA after the sons have to pay income taxes on it. This means the sons are left with nothing- hardly the result the father intended! This is an extreme example, but illustrates the point.

  • Sometimes, having the tax follow the asset can backfire. Assume a grandmother, as part of her estate and wealth transfer planning, designated a so-called “IRA Trust” to be the beneficiary of her Roth IRA. Further assume that the Roth IRA has investments of $2,000,000, that she is not taking any distributions (as none are required during her life), that the rest of her estate is going to her children, that her estate will be subject to federal estate tax, that she has substantially all of her estate tax and GST exemptions remaining, and that her grandchild is the beneficiary of the IRA Trust. The purpose of leaving the Roth IRA to her grandchild is for a maximum stretch after she dies. This means that the IRA Trust can base its required minimum distributions over the grandchild’s life, and the trust will provide ongoing oversight and asset protection. Keep in mind that theestate-planning Roth IRA will pass outside the grandmother’s will, but is subject to estate tax and, because the money is going to a grandchild, the GST. If the will lacks an apportionment provision the IRA Trust will have to pay the estate taxes. Assume that when the grandmother dies the Roth IRA is worth $3,000,000 and the estate taxes attributable to it are $1,500,000. If the IRA Trust has no source of funds other than the Roth IRA, it will have to liquate the IRA to create the funds to pay the estate taxes-not the desired result. Better options include 1- having the parents of the grandchild pay the estate taxes, 2-having the grandmother’s residuary estate pay the taxes or 3-having trust-owned life insurance proceeds available to cover the taxes. The planner and the client also need to be certain that the executor/rix of the grandmother’s will is authorized to allocate the grandmother’s GST exemption to the Roth IRA.  Otherwise, the GST tax will have to be paid on the amount of the Roth IRA.
  • These sorts of problems happen in real life, not just on bar exam questions and in newsletters.   Recently, in August 2015, the Baltimore City Orphans’ Court ruled that the estate taxes attributable to the estate of Tom Clancy, the famous author, must be paid exclusively from a trust for the benefit of the adult children of his first marriage, thereby exempting the share going to his widow and their child from paying any estate tax. The judge held that none of Alexandra Clancy’s two-thirds share of the $83 million estate can be used to pay the almost $12 million estate tax bill. Instead, the taxes must be paid out of the approximately $28.5 million trust Clancy left to his four adult children from his first marriage. In so holding, the judge noted, in relevant part, that the controversy was due to the convoluted and “inartfully drafted” estate tax allocation provision in the will.

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