The choice of marital deduction clauses is important. It effects the amount passing to the surviving spouse (and therefore, the additional State tax due upon the surviving spouse's death), whether income tax will be triggered upon funding the marital and credit shelter bequests and the ease of administration. In addition, the expectations of beneficiaries must be considered since the estate may appreciate or depreciate from the date of death to the date of transferring the assets to the marital and credit shelter trust. All these factors must be addressed at the time you draft the documents. For example, assume your client dies with a $3,000,000 estate on September 15, 1994. His estate plan provides for a standard marital/credit shelter formula clause: $600,0001 would be directed to the credit shelter trust with the balance ($2,400,000) to the marital trust. You timely file the estate tax return and receive the closing letter from the Internal Revenue Service. Now you are ready to fund the trusts. During the period of administration, the value of the estate increases by $1,000,000 to $4,000,000.
Does the marital trust or credit shelter trust receive the benefit (or burden) of the $1,000,000 appreciation? Which assets do you select to fund each trust? Is there an income tax problem (capital gain) upon funding the trusts? The answer depends upon the marital deduction formula and the method selected to value assets distributed in kind.
Marital deduction formulas are divided into two types: pecuniary and fractional. A pecuniary formula funds a specific dollar amount. For example, a pecuniary formula would direct the trustee to distribute to the marital trust the smallest amount that, if allowed as a marital deduction, would result in the least possible federal estate tax. The credit shelter trust would receive the balance ($600,000).2
A fractional formula funds the marital and credit shelter trust proportionally with each asset. For example, a fractional formula would direct the trustee to allocate a portion of each asset to the marital trust ($2,400,00/$3,000,000 = 80%) and credit shelter trust ($600,000/$3,000,000 = 20%) in the proportion that each trust bears to the total value.
There are a variety of pecuniary formulas available. Some formulas fund the marital trust first -- the credit shelter is the balance ("up front marital"). Other formulas fund the credit shelter first -- the marital trust received the balance ("reverse marital").
Once you determine whether to draft a fractional or pecuniary marital formula and, if a pecuniary formula, whether the marital or credit shelter trust is funded first,3 you must then determine with respect to assets distributed in kind, which valuation approach satisfies the pecuniary amount: federal estate tax value,4 date of distribution value or a value which is fairly representative of appreciation and depreciation.5 These drafting decisions can make an enormous difference.
For example, assume a $3,000,000 estate is comprised of the following assets as of the date of death (9-15-94) and as of the date of distribution (9-15-96):
9-l5-94 Date of Death 9-l5-96 Date of Distribution
Cash $2,000,000 Cash $2,000,000
GM Stock 200,000 GM Stock 400,000
Ford Stock 200,000 Ford Stock 400,000
Land 600,000 Land 1,200.000
$3,000,000 $4,000,000
On the estate tax return, the marital deduction would be $2,400,000. The remaining amount of $600,000 would pass to the credit shelter trust and be covered by the $600,000 exemption equivalent. IRC 20l0. The result would be no estate tax.
The following chart illustrates the difference in funding methods:
UP FRONT
MARITAL:
FEDERAL ESTATE TAX VALUE
UP FRONT MARITAL: DATE OF DISTRIBU- TION
UP FRONT
MARITAL:
FAIRLY
REPRESENTATIVE
FRACTIONAL
ESTATE TAX RETURN
- MARITAL
$2,400,000
!cash
$2,000,000
!GM stock
$200,000
!Ford stock
$200,000
$2,400,000
same
$2,400,000
same
$2,400,000
same
- CREDIT
SHELTER
$600,000
!land
$600,000
$600,000
same
$600,000
same
$600,000
same
FUNDING
- MARITAL
$2,800,000
!cash
$2,000,000
!GM stock
$400,000
!Ford stock
$400,000
$2,400,000
!cash
$2,000,000
!GM stock
$400,000
$3,200,000
$1,000,000 )
$3,000,000 =
33% apprecia-tion
$2,400,000 marital x 1.33 = $3,200,000 to marital!GM stock
$400,000
!land
$1,200,000
!cash
$1,600,000
$3,200,000
!Each asset:
$2,400,000
marital deducttion)
$3,000,000 gross estate =
80% of
$4,000,000 =
$3,200,000 to marital
- CREDIT
SHELTER
$1,200,000
!land
$1,200,000
$1,600,000
!Ford stock
$400,000
!land
$1,200,000
$800,000
$600,000 credit shelter x 1.33 = $800,000
!cash
$400,000
!Ford stock
$400,000
$800,000
20% of
$4,000,000 to credit shelter
As the chart illustrates, significant differences exist among the marital deduction formulas. For example, using date of distribution values, only $2,400,000 would be included in the surviving spouse's estate (rather than $2,800,000 under the federal estate tax value or $3,200,000 under the fairly representative formula or fractional formula). If the surviving spouse died soon after the death of first spouse and the assets were funded at the federal estate tax value, there could be an additional estate tax of $220,000.6
OTHER CONSIDERATIONS
In addition to the size of the surviving spouse's estate, there are other important considerations in selecting the marital deduction formula:
1.Capital Gain. Using the date of distribution value would trigger capital gain on the difference between the value used for funding and the basis. For example, by using the GM stock to fund the pecuniary marital amount, there would be capital gain of $200,000 ($400,000 fair market value of GM stock less $200,000 basis). At a 28% rate, the tax would be $56,000. As a result, it is important to weigh the higher current income tax on funding the marital bequest against the lower deferred estate tax which would occur upon the death of the surviving spouse. (The higher current income tax can be minimized by funding the marital bequest before the assets appreciate).
2.Acceleration of Income in Respect of Decedent. Income earned prior to death but received after death (example: IRA received in installments) constitutes income in respect of a decedent ("IRD"). IRC 691(a)(1). Funding a pecuniary amount with IRD would trigger acceleration of gain. IRC 691(a)(2). If a pecuniary amount was funded with the right to receive $60,000 a year for 10 years, the entire income tax (assume: $600,0007 x 39.6% tax rate = $237,600) would be due in the year of funding although payments would be received over a period of 10 years.8 The result is avoidable, however, by making a specific bequest of the IRD either to or away from the pecuniary share, since disposition as a specific bequest does not accelerate the income represented by the IRD. Fractional formulas also avoid the problem.
3.Expectations of Beneficiaries. If the marital trust is funded first, the risk of appreciation or depreciation would fall to the credit shelter trust. For example, assume the value of the estate appreciates. If the beneficiaries of the credit shelter trust (children) are different from the beneficiary of the marital trust (spouse), the surviving spouse should be apprised at the drafting stage that the entire appreciation benefits the children only. If the estate depreciates, however, the spouse is protected against diminution.
4.Pick and Choose Flexibility. With all pecuniary formulas, the fiduciary has flexibility in picking and choosing assets to fund the marital and credit shelter trusts. Assets that appreciate in value would likely fund the credit shelter trust. Assets that depreciate in value or assets that the spouse desires (residence or investment assets), may be allocated to marital trust. Generally, fractional formulas do not permit pick and choose flexibility.
5.Ease of Administration. Fractional formulas are considered more difficult to administer since it generally requires fractionization of each asset and requires a change in the fraction for non-simultaneous distributions. Pecuniary formulas are considered easier to administer, although some pecuniary formulas (date of distribution) require revaluation of all assets as of the date of funding.9
CONCLUSION
While the choice of marital deduction funding formulas does not receive significant attention, the selection can have a dramatic effect on the client's estate. Care should be taken in selecting a pecuniary or fractional formula; if a pecuniary formula, whether to use an up front marital or reverse marital; and whether to value the assets distributed in kind at the federal estate tax value, date of distribution value or fairly representative value.
FOOTNOTES
1.$600,000 is the exemption equivalent of the $192,800 credit. IRC 2010.
2.Taking into account the state death tax credit, the credit shelter amount increases to $642,425.
3.Funding the credit shelter trust first is sometimes viewed as more appropriate when the credit shelter trust will be smaller than the marital trust because it minimizes capital gain on funding.
If the credit shelter trust is funded first, only a date of distribution value or a fairly representative value should be used. If funding occurred at the federal estate tax value, the credit shelter trust could be overfunded, the marital trust could be underfunded, with the attending concern about marital deduction qualification.
4.This formula sometimes funds the marital bequest at the lesser of the federal estate tax value or date of distribution value with an added requirement that the total value of the distribution be equal to the size of the deduction.
5Revenue Procedure 64-19.
6.$2,800,000 federal estate tax value - $2,400,000 date of distribution value = $400,000 x 55% maximum estate tax rate = $220,000 additional estate tax.
7.The tax rate would be applied against the present value of the annuity as determined under IRC 7520.
8.While IRC 691(c) permits an income tax deduction for the estate taxes attributable to a right to receive IRD, when there is no estate tax with an optimum marital deduction formula, the IRC 691(c) deduction would be lost.
9.Other factors include the taxation of distributable net income and the pass through of losses and deductions. A disadvantage to all pecuniary formulas is that distributions carry out distributable net income. IRC 662. The net result is that a pecuniary bequest (date of distribution value) may incur gain at the distributing entity level and constitute taxable income to the surviving spouse or marital trust.
Another disadvantage to all pecuniary formulas is that unused losses and deductions do not carry out under IRC 642(h). As a result, losses and deductions should be used in the distributing entity before it terminates or it will be lost.
Drafting decisions are usually not made with respect to distributable net income and carry out of losses and deductions.