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Estate Planning for the Second Marriage ©
Presentation by Richard W. Kuhn
Kuhn, Heap and Monson
552. S. Washington St. Naperville IL
630.420.8228
[email protected]
You receive a phone message from a long-time client “I have decided to marry Harry. I
will be giving up a lot so I am very concerned for my financial security in the future-Wilma.”
Moments later, you receive a text from Harvey, Harry’s son, “Our dad Harry is marrying his
wealthy, clingy companion Wilma and we are concerned about his hard-earned inheritance for us
being squandered-Harvey.” Thus, squarely presented is a primary challenge of estate planning
for second marriages: providing financial support for the surviving spouse while preserving a
reasonable inheritance for the children of the first to die.
40% of marriages are second marriages. There are many possible second marriage
scenarios including young vs. old, wealthy vs. less wealthy, children from both prior marriages
and finally, the blended family where the clients share children of their prior marriages as well as
a young child or children of their own. In this outline, we first will review some non-tax estate
planning considerations for the second marriage, including challenges, opportunities and ideas
for appropriate pre- and /or post-nuptial and estate planning documents and instruments with
appropriate beneficiary designations. We also will address tax considerations, including income,
capital gain and estate tax pitfalls and opportunities.
NON-TAX ISSUES
Accidental disinheritance is very common with second marriages—and there is no easy
answer on how to avoid this pitfall. Tremendous thoughtful planning is required not to mention
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the ethical dilemmas that arise with second marriage estate planning. A wise law professor of
mine said the family cabin will be the most complex legal issue that you will deal with as a
lawyer. For me, the family cabin is second to estate planning for the second marriage. The
following are some, but certainly far from all, of the issues you should keep in mind in any
second marriage estate planning.
Ethical Concerns-Whom do you Represent?
If you choose to represent both clients, you need a carefully drafted engagement letter.
The letter should also disclaim any representation for either party’s children. There is a model
engagement letter on the American College of Trust and Estate Counsel (ACTEC) website.
ACTEC first published its Commentaries in 1993 and has updated them four times since then.
The Commentaries are a tremendous resource for guidance in handling ethical issues arising
from estate planning and probate and trust administration. In this connection, keep in mind that
Supreme Court Rule 1.7 prohibits the lawyer from representing both clients if either the
representation of one will be adverse to the other or if there is significant risk that representation
of one will be materially limited by the lawyer’s responsibility to the other. Never attempt to
waive conflicts in a joint representation of parties to a prenuptial agreement.
Step one: Draft the estate plan to comply with obligations arising from the prior marriage
The estate planner must carefully review all divorce decrees. This is not simply an
academic consideration. The Wisconsin Supreme Court disciplined an estate planning attorney
for aiding and abetting his client’s fraud by failing to follow the court-ordered property
settlement agreement that guaranteed certain death benefits to the former wife of his client.
Tensfeldt v Haberman, 768 N.W. 2d 641 (Wis. 2009). Divorce property settlements often are
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vague or are not well thought out as they relate to life insurance and other security devices
designed to secure performance in the event of premature death. By way of example, many
divorce decrees require the former spouse to be the beneficiary and/or trustee of insurance
proceeds for the benefit of minor children of the first marriage. The estate planner must follow
the intentions of the client, yet at the same time, follow the spirit of the divorce decree, which is
often a very delicate balancing act. We oftentimes bifurcate the client’s trust and create a
separate trust document to receive life insurance proceeds in the exact amount required by the
divorce judgment. The estate planning attorney also might consider adding an additional trustee
with the former wife to serve for the minor’s trust.
Also, be certain to ask the widow[er] if a Federal Estate tax return (hereinafter “706”) was filed
so that you can measure the deceased spouses’ unused federal estate tax exemption (hereinafter
“DSUE”) if any. [More to follow on DSUE]
The raison d’etre of the second marriage—The Prenuptial Agreement 750 ILCS 10-1
Illinois along with 26 other states has adopted the Uniform Premarital Agreement Act.
Under the Act, the document must be in writing and must contain a complete disclosure of each
party’s assets and liabilities. Each party should have independent legal counsel (e.g., baseball
player Barry Bond’s prenuptial agreement was invalidated because his wife did not have separate
counsel). We insist on this and insist that the agreement be negotiated and executed well before
the wedding. We attach exhibits of all assets and liabilities and federal income tax returns for the
two preceding years.
Often overlooked in premarital contract planning are obligations, liens and judgments of
one party that might affect the financial future of the other, such as, tax liabilities, student loans,
health issues, child support obligations and obligations to support the former spouse.
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Because we want the estate plan documents and not the probate act to control the
distribution of assets at death, we typically include a waiver of spousal award and the spousal
statutory share. Optional items might include the waiver of the right to be named executor or
administrator. Also, a wealthy spouse likely to survive would negotiate a requirement of the
executor at the death of the first to die to elect portability and to establish the DSUE for the
surviving spouse. We will discuss this in more detail in the estate tax portions of this outline.
ERISA does not allow for a waiver of spousal rights for a retirement plan before the marriage;
rather, you might consider having the agreement itself contain mutual promises to execute
separate retirement waivers after the parties are married. Also, the pre-nuptial agreement should
impose the cost of preparing and defending the 706 on the family of the first decedent. If the
Qualified Terminable Interest Property Trust (hereinafter “QTIP”) has property that might be
subject to IRS audit such as aggressive discounts, the duty to defend the IRS audit will be on the
second family!
Also, as part of the discussion with clients regarding the prenuptial portability, counsel
should inform the widowed person that he or she will lose the DSUE if the new spouse dies.
Also, consider compensating the person who will forego gifting her or his DSUE should the new
spouse need funds that the widow otherwise would gift to his or her descendants. If the second
spouse has greater wealth than the first spouse, there should be a guarantee that the executor of
the less wealthy spouse will elect portability.
The marital residence is especially important in prenuptial agreements. If it is likely that
one party would not inherit the home outright or have lifetime use of the residence by QTIP, then
the prenuptial agreement should give the surviving spouse a reasonable time to reside in the
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home and the costs to maintain the home must be carefully identified and apportioned. (More on
this topic below.)
Remember that the federal gift tax’s marital deduction does not attach until marriage and
therefore, pre-marriage property transfers or expensive gifts are taxable. Therefore, asset
transfers should not be made until the marriage takes place.
Amendments to a prenuptial agreement do not require consideration. (10-6 of the Act)
The parties may contract to, among other things, eliminate spousal support, making a will or trust
or agree to complete certain death beneficiaries of life insurance. Contracts to make wills will be
discussed below. The requirements for a valid prenuptial agreement are actually defenses to
enforcement. For example, Section 10-7 provides that the agreement must be entered voluntarily
and the terms must not be unconscionable. Furthermore, there must be adequate disclosure of
financial obligations and assets. Also, an agreed upon waiver of spousal support can be
overturned if a party experiences undue hardship in light of circumstances not reasonably
foreseeable at the time of the prenuptial agreement. Therefore, never guarantee that a prenuptial
agreement will be effective in relieving one’s duty to support his or her spouse, which can be a
huge issue for funding long term care. Finally, keep in mind that the statute of limitations for
breach of the prenuptial agreement is tolled during the marriage.
Identify and prepare the estate plan to comply with existing pre- and post-nuptial
agreements including contracts to make wills.
Existing pre- or post-nuptial agreements are another potential source of ethical concerns.
As with divorce decrees, the attorney must carefully review all pre- and post-nuptial agreements
to be certain that such agreements are not compromised by the estate plan. While the couple can
amend their pre-nuptial agreement, ethical concerns are elevated should the attorney suggest that
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the parties consider mutual amendments to their pre- or post-nuptial agreement. The attorney
must insist that each seeks independent legal counsel as part of any amendment.
Don’t Forget About Personal Property
The very important issue of distribution of personal property as between the surviving
spouse and the children of the first to die is often overlooked. For example, comedian Robin
Williams’ third wife and his three children from a previous marriage are still in court fighting
over personal items such as artwork and his watches. Though Mr. Williams had a very detailed
estate plan and prenuptial agreement, important personal items such as rings and artwork
apparently were not included. Detailed lists of personal items that will or will not pass to the
surviving spouse must be included in both prenuptial agreements as well as in estate planning
documents themselves. Likewise, gifts and loans should be clearly identified and their treatment
explicitly addressed. Do not underestimate the potential strong emotional attachment to personal
property whether it be expensive or not.
Do not Overlook the Issue of Long-term Care. Which Family Funds Nursing Home Care?
We have had many meetings with our elderly clients and their adult children in order to
negotiate who will pay for 24/7 nursing home care if and when needed. If clients are willing to
open up and share their asset makeup and estate planning intentions with their children and if the
children are reasonable, post-nuptial agreements can go a long way to prevent permanent harm to
the relationship between the two families, not to mention potential malpractice claims.
Beware of the Doctrine of Reciprocal or Mutual Wills / Contracts to Make a Will
A Mutual or Joint will can create Contract to make a will. If so, the surviving spouse is
estopped from changing the dispositive provisions of the joint or mutual will. This is somewhat
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of an ancient doctrine but beware of it! In Curry v Cotton 356 Ill. 538 (1934), the Illinois
Supreme Court did not allow one spouse to revoke her will without her spouse’s consent and
held their joint will created a contract to make a will. The courts appear to have softened the
harshness of this result by holding the opposite in the more recent case of Estate of Martin, 2014
Ill App. 1st 131209-U, No. 1-13-1209 (Il. App. Mar. 7, 2014).
Whereas love and affection were considered sufficient consideration for a contract to
make a will in the older cases, newer cases look to five factors to determine the couple’s intent to
make joint and mutual wills: (1) labels used by the testators; (2) reciprocal provisions; (3)
pooling of testator’s interests into one fund; (4) common dispositive scheme; and (5) the use of
common plural terms such as “we” and “our.”
In Martin, both spouses signed the same will (identified as “The Joint Last Will of Daniel
and Florence Martin”) that provided that the home would pass to their two sons. The couple held
the home as joint tenants. After her husband died, Mrs. Martin adopted a living trust and deeded
the home to the living trust which in turn left the home to only one of the sons. Following Mrs.
Martin’s death, the son who was left out brought suit asserting the joint will was a contract that
precluded her from changing the terms. While the court went to great lengths to review the five
factors, in my view, the testimony of the drafting attorney that a contract was not intended at the
time of execution was determinative. He also testified that his practice always was to use a joint
will and that he got the form from a formbook. In other words, the clients never asked for a joint
will. Based upon the cases noted below, I believe Martin might have been decided in the
opposite manner but for the drafting lawyer’s testimony.
While the following cases follow Martin, do not rely on the trend of the courts finding no
contract. See In Re Briick, 24 Ill. App. 2nd 77 (Ill. App. 1959), Perino v Eldert 229 Ill. App.3rd
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602 (Ill. App. 1992) and In Re Estate of Schwebel 133 Ill. App. 3d 777 (Ill. App. 1985). These
cases, inter alia, stand for the proposition that ‘courts have expressed their reluctance to permit
the fact of joint execution alone to be conclusive and have looked to the provisions of the will
itself and to other proof for a contract. [Briik at 92, Perino at 604 and Schwebel at 786]
Other recent cases have held that the wills created a contract and rejected the widow’s
revised estate plan. See Erickson v Schackmann, no 4-05-0446, 4th Dist., Helms v Darmstatter 56
Ill. App. 2d 176, 205 NE 2d 478 (1965) and Rauch v Rauch 112 Ill. App. 3d 198, 445 NE 2d 77
(1983).
An actual contract to make a will can be a very effective tool where you encounter a
second marriage with clients who refuse to do QTIP/ Credit Shelter type planning and the
surviving spouse would need the support of the assets of both parties. Often, the surviving
spouse will not want to be looking over his or her shoulders while the children of the first to die
attempt to monitor the investing and spending habits from the QTIP/ Credit Shelter trust. The
key to the contract to make a will is being certain that the executors of each family know of the
contract’s existence and location. Notification is critical because there is no requirement to file
the contract and no known fiduciary duty to notify the contract beneficiaries. [Although a likely
ethical duty for the attorney to notify the beneficiaries of the contract’s existence!]
Know the Chemistry of the Family1) Recognizing Unresolved Emotional Issues
Be certain to carefully investigate and flush out unresolved emotional issues such as
resentment of the new spouse by the children of the previous spouse. Also, identify
emotional effects caused by the dissolution of the prior marriage, which can linger for many
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years. Planners need to understand that it is not uncommon for individuals to enter new
relationships before fully recovering from a previous one.
2) Dealing with the “Blended Family”
Remarried individuals often have children from a previous relationship as well as
from the current one. Younger children may not have received the same financial support
as the older children, such as for college. Therefore, in these situations, the plan likely
should be weighted in the younger children’s favor. Complicating this may be the
existence of a somewhat strained bond with the child[ren] from the previous relationship.
If there is a great age disparity between the children of the previous relationship and the
new child, we typically urge clients to leave gifts in their estate planning documents
directly to the older children even before the surviving spouse. I refer to this concept as
giving the children an “instant legacy” from their father or mother. I think that this is a
very important sign of love that can go a long way to promote harmony within the
blended family.
Another consideration is whether the children from the prior marriage will receive a
substantial inheritance from the ex-spouse’s family. Are there agreements in place that
obligate the former spouse to make specific provisions for the children in his or her estate
planning? Also, of course, what are the resources and prospects for financial success for
the children of the former marriage?
3) The “May-December” Romance
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Age differences between spouses in a second marriage can present a problem. If the
younger spouse is close in age to the elder spouse’s children, the children will not want to
wait for the younger spouse to die before receiving their inheritance.
Another issue is dealing with the IRA and the much younger spouse especially as it
relates to special rules for computing minimum required retirement plan distributions
when the participant is more than ten years older than the other spouse. (More on IRAs
below.)
Beware of the “trophy spouse” syndrome and “gold digger” resentment, especially
when the spouse is the same age as (or younger than) the other spouse’s children. Also,
be aware that there is a better chance of actual or unclaimed undue influence by the
children of the first decedent. An example was the 89-year-old billionaire Howard
Marshall, married to 26-year-old Vicki Lynn Marshall, AKA Ana Nicole Smith. In the
May to December romance, there is a much greater need to provide for the inheritance to
the next generation of the older spouse at his death-at least to the extent that funds are not
necessary for the reasonable comfort and support for the surviving spouse.
Remember to Pay Close Attention to Apportionment Clauses in Wills and Trusts
Most form documents provide that claims and taxes fall within the residue of the estate.
In a second marriage situation, this might result in unintended consequences causing either the
surviving spouse or the children of the first to die to be charged with these taxes or debts of the
estate. Therefore, taxes and expenses should be properly apportioned when planning the estate.
Warning signs might include where beneficiaries of large non-probate assets or large specific
bequests are not the same as the beneficiaries of the residue. Query – Can one argue that an
apportionment clause directing that all taxes be paid by the residuary preclude the executor of the
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surviving spouse to claim reimbursement on the taxes due and owing on the QTIP trust
otherwise available to the executor via IRC 2207A? (For example, if 20% of Husband’s estate
passes via the residuary provision solely to Wife.)
Thought is Required in Handling the Homestead Residence
Again, this is an attractive asset to leave to the credit shelter trust. The problem is the loss
of the $250K capital gain exclusion for post-death appreciation of the value of the residence.
This issue will be covered in more detail below.
Like the IRA, if there are other assets available to support the surviving spouse in the
QTIP it would be better to leave the home outright to the surviving spouse or to give the
surviving spouse the opportunity to reside in the home following death. An exclusive and
unrestricted right to use a residence qualifies for QTIP treatment. Treas. Reg. 20.2056[b]-7[h].
An interesting tidbit involves real estate taxes. If the home is left outright to the surviving
spouse, even if all taxes are to be paid by the residue in the estate planning document, Radley v.
Wolland held that the wife as devisee of the home had the burden of accrued real estate taxes.
895 N.E.2d 43 (Ill. App. 2008).
Most planners favor including terms in the trust for the surviving spouse’s lifetime use of
the residence as compared to the use of life estates. There are disadvantages to using a life estate.
The law is somewhat all over the board and thus a preferable approach is to clearly spell out the
duties and expenses to be apportioned between the spouse on the trust.
Examples of how life estate law in Illinois is “all over the board” include the following:
The children of the first to die lose the right to partition the property subject to a life estate.
Westerdale v. Grossman, 728 N.E.2d 67 (Ill. App. 2000). The life tenant must make ordinary
(but not extraordinary) repairs. Honeyman v. Heins, 268 N.E.2d 907 (Ill. App. 1971). The life
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tenant has the duty to prevent waste. In Sexton v. Marine Bank of Springfield, the court ruled that
the life tenant committed waste by not paying real estate taxes or mortgages. 617 N.E.2d 869 (Ill.
App. 1993). A life tenant is not required to carry fire insurance but must pay mortgages and
taxes. In Prettyman v. Walston, the life tenant was not responsible when the home burned. 1864
Ill. LEXIS 122** (Ill. April, 1864). In Chapman v. Epperson, the court allowed the life tenant to
harvest timber for repairs and firewood but not for resale. 101 Ill. App. 161 (Ill. App. 1901).
Non-Testamentary Beneficiary Designations and Renunciation
The Illinois Probate Act (at ILCS 5/2-8) gives the surviving spouse the power to
renounce one-third of the will of the first to die if the testator leaves a descendant and one-half if
not. Unlike most other jurisdictions, renunciation rights in Illinois apply only to probate assets
and not to assets controlled by a beneficiary designation.
Therefore, if an IRA beneficiary would be a child of the first marriage of the surviving
spouse cannot renounce the IRA unless the beneficiary were the participant’s estate. It is critical
to check on beneficiaries and tenancies after a client becomes divorced. Sections 755 ILCS 5-47(b) disinherits the divorced spouse from a will and removes any power of appointment or
appointment as fiduciary, and Section 760 ILCS 35-1 [a] and [d] disinherits the divorced spouse
from a revocable trust including powers of appointment and fiduciary appointment. Under these
provisions, the divorced spouse therefore, cannot serve as fiduciary of either the will or trust, nor
serve as a durable power of attorney under Section 755 ILCS 45-2-6 (b).
Extreme care also must be taken with other assets such as tenancy by the entirety that 765
ILCS 1005-1c converts to a tenancy in common upon divorce. Joint tenancies, land trusts and
irrevocable trusts are not affected by divorce. Courts often will often impose a constructive trust
for the intended beneficiary if the former spouse was not entitled to the assets per the divorce
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judgment. By way of example, in Laisner v. Beckhart, the court granted a constructive trust over
life insurance proceeds otherwise payable to the ex-wife for the benefit of the children. Laisner
v. Beckhart, 864 N.E.2d 1002 (Ill. App. 2007).
The estate planner also should be familiar with Johnson v LaGrange State Bank 73 Ill. 2d
342, 383 N.E.2d 185 (1978). Illinois appears to be the only state that allows a spouse to
disinherit his or her spouse without the use of a pre- or post-nuptial agreement—but we never
rely on this case alone. In this important case, Mrs. Johnson adopted a living trust redirecting her
assets to relatives, charities and a small support trust for Mr. Johnson. Mr. Johnson passed
shortly after Mrs. Johnson’s death. Thereafter Mr. Johnson’s children brought an action against
the estate of Mrs. Johnson for a constructive trust for his elective share of her estate. The court
decided the case of Havey v Patton, simultaneously. The issues in Havey were virtually identical
to Johnson, although Mr. Havey’s disinheritance was via joint tenancies that Mrs. Havey created
in favor of her son-in-law and not to her husband before she died. Havey v. Patton, 368 N.E.2d
728 (Ill. App. 1977). In both cases, the court held that so long as there was no fraud on the
marital rights of the surviving spouse, one spouse may effectively disinherit the other spouse and
defeat the surviving spouse’s right to impose a constructive trust on the lost renunciation. Fraud
can be proven by lack of donative intent. In both cases, the court felt that the husbands had
adequate estates and that the wives were not secreting their assets in any nefarious way.
QTIP Trusts
The 1981 Tax reform Act created Qualified Terminable Interest Property Trusts (QTIP
Trust). For the first time, this allowed an estate and gift tax marital deduction for restricted gifts
to surviving spouses. Prior to the advent of the QTIP trust, any restriction on the bequest to the
spouse disqualified the marital deduction. The 1981 Act also created the unlimited marital
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deduction, which was driven by the protests of many widows who had to sell the family farm or
business to pay the estate tax at the death of the first spouse. Prior to the QTIP trust, the parties
had to create contracts to make wills and/or joint of mutual wills that they hoped would be
construed to create a contract to make a will.
The obvious advantage of a QTIP Trust is the ability to control the assets so what is
necessary to support the surviving spouse passes back to the children of the first to die at the
survivor’s death. Also, the main advantage over a credit shelter trust is the second step up in
basis at the death of the second spouse.
QTIP disadvantages include:
1)
2)
3)
4)
5)
6)
The funds cannot be used for wife’s descendants.
The assets might experience a step down in basis.
Creditors of the wife might attach her income because it is guaranteed.
There will be federal estate tax on the appreciation.
The Illinois Estate tax exemption is wasted
The first spouse loses the GST exemption that he or she otherwise could apply to the
credit shelter trust.
Testamentary QTIP Requirements
The spouse must be a US citizen and must be paid income for life. Principal cannot be
distributed to anyone but the spouse. An election must be made to qualify the trust for estate law
marital deduction under IRC 2056(b)7. The trust is included in the surviving spouse’s gross
estate under Section 2044; however, the surviving spouse has the power under Section 2207A to
recover from the trust any estate tax due to the inclusion of the QTIP trust in the surviving
spouse’s estate. Notably, Illinois estate tax law does not contain the Section 2207A power for the
portion of the Illinois partial QTIP election passing to the credit shelter trust. Therefore, the
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children of the second to die bear the cost of a portion of the Illinois estate tax. (Discussed in
more detail below.)
Where there is no disparity in age, the QTIP can be a good fit for the second marriage
especially because the assets are stepped up in basis at the second spouse’s death and therefore,
the children of the first to die receive potentially significant capital gain savings. An example of
this fit is where much of the wealth for the couple involves assets sited in a state with no estate
tax. However, as will be discussed below, significant unfairness to the descendants of one party
can result if careful estate tax planning is not applied.
A very significant topic for the estate planner’s checklist to consider is whether to have
an independent trustee serve for the QTIP trust in order to manage the blend of investments
between income and growth. Again, the ethical concern for independent representation for the
surviving spouse is elevated here. Do not have a remainderman serve as the trustee of the QTIP
or credit shelter trust. In Faville v Burns, the court removed the son of the first to die as the QTIP
trustee, holding that the son had a personal interest in preserving principal and limiting income.
960 N.E.2d 99 (Ill. App. 2011). A trustee’s duties in this position can be difficult. A solution
might be to elect conversion to a total return trust in order to guarantee the widow[er] a
guaranteed income stream irrespective of income actually earned to free the trustee to invest for
the best total return. For example, the language of the QTIP could state the payment to the
surviving spouse be the greater of all income earned or 4% of the principal of the trust paid
annually.760ILCS 5/5.3[Total return trusts]
Query-does the Total Return statute override [b-1] of section 2 of 35ILCS 405/2? [Ill
estate tax statute]? [b-1] provides that the trustee may not retain non-income producing assets for
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more than a reasonable amount of time without the consent of the surviving spouse. Query #2
why is this located in the estate tax statute and not in the probate act? [!]
Credit Shelter Trusts vs. Portability
Credit shelter trust benefits include:
1) Asset protection.
2) Securing the Illinois Estate Tax exemption of the first to die.
3) Being a good fit where the surviving spouse is not capable of managing assets
(improvidence).
4) Ability to control assets in a second marriage or blended family.
5) Ability to allocate GST exemption.
6) Family line protection.
7) Lack of indexing makes the credit shelter trust a better choice.
Credit shelter trust disadvantages include the fiduciaries’ duty to manage money, trust income
tax returns 1041s are required to be filed, and assets need to be segregated between the credit
shelter trust and the survivor’s trust.
Portability benefits include:
1) Step-up in basis at the death of the second spouse.
2) It is simple.
3) Market decline will not impact the DSUE.
4) If you know the couple will be moving soon to a state without inheritance tax such as
Florida, it may be best not to use a Credit Shelter Trust to insure a larger DSUE.
Relying on porting does waste the Illinois Estate Tax Exemption of the first decedent and thus,
you typically would employ Credit Shelter Trust.
On balance, using portability in a second marriage is not likely the best choice. A credit
Shelter Trust ensures that the first decedent’s estate tax exemption will indeed be used for the
benefit of his or her own descendants. As will be discussed below, if all the assets go to a QTIP
and the DSUE is ported to the surviving spouse, he or she may decide to use it along with his or
her basic exception amount for the benefit of his or her own decedents. The QTIP will be
charged with the Federal Estate Tax under IRC 2207A unless the parties contract otherwise.
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Thus, even though the surviving spouse cannot divert the QTIP assets, he or she can deny the
remainder beneficiaries any of the benefits of the first decedent’s Estate Tax Exemption.
TAX ISSUES
The QTIP for the IRA is an attractive option. One can draft the QTIP to guarantee the
required minimum distributions for the surviving spouse’s lifetime and at death what is left in the
IRA, if any, will pass to the children of the first to die.
A QTIP trust can be drafted as a conduit or non-conduit form. The conduit trust requires
the trustee to pay all required minimum distributions to the surviving spouse. The advantage of
the conduit form is to insure “stretch treatment” of the IRA to the surviving spouse and not have
all the income tax payable in five years.
The disadvantage is the less favorable life expectancy computation versus the nonrecomputed life expectancy fixed in the year after the decedent’s death. For example, if the
surviving spouse is 70 the year after her husband dies and the IRA is “QTIP-ed” to a conduit
trust, her non-recomputed life expectancy is 17 years. Thus, if she lived to 87, the husband’s
children would receive nothing. If, on the other hand, if she were the sole beneficiary, the
deferral would be much greater.
Natalie Choate, a leading authority on the topic of IRAs, discussed the disadvantage of
using the QTIP for an IRA, stating:
Leaving retirement benefits to a QTIP is not tax bargain. Making benefits payable
to a marital trust as opposed to the spouse individually, often results in forced distribution
of the benefits sooner than would be the case if the spouse personally were named as
beneficiary. In addition to the loss of the deferral, income-taxable retirement plan
distributions to the trust [to the extent not passed out to the spouse as “distributable net
income”] are taxed to the trust. Trust income tax rates reach to top federal bracket at a
much lower level of taxable income than the individual rates do. Life and Death
Planning for Retirement Benefits (7th ed. 2011), p. 225.
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There is no option but to QTIP the IRA if the main asset is the IRA and the surviving spouse
needs the support from the benefits of that asset. However, where there are other assets to
support the surviving spouse, the IRA should be the last asset for QTIP-ing. If you do decide to
QTIP the IRA, the QTIP trust must contain language requiring the trustee to withdrawal the
greater of the net income of the trust or the minimum required distributions under IRC section
401(a)(9), otherwise all the income tax must be paid in five years.
Capital Gain Tax Concerns
A problem with leaving the home to a credit shelter trust is the loss of the IRC 121,
$250,000 capital gain exclusion otherwise available to the survivor per PLR 200104005. For
example:
Harry and Wilma bought a home for $100k. At Harry’ death the home was worth $200k.
More than two years later, Wilma sold the home for $500k. Rather than leaving Harvey’s
50 percent interest in the home outright to Wilma, he left it to a credit shelter trust for
Wilma’s benefit. Wilma has a split basis, with her basis at $50k and the credit shelter
portion at $100k. She has a $250k exclusion for her half of her $200k gain [$250k less
$50k basis =$200k], and thus while Wilma has no gain on her half of the home, the credit
shelter trust has a gain of $150k [$250k less the $100K stepped up basis at Harvey’s
death]. Had the home been left outright to Wilma, she could have used the $50k unused
portion of her $250k exemption to offset the gain from Harry’s half.
If the surviving spouse has adequate funds, one solution is to purchase the home from the credit
shelter trust. But if the credit shelter trust provides financing, be certain that the loan is
adequately secured so that the loan has real value to the children of the first marriage at the death
of the second spouse.
An often-overlooked tax provision is IRC 121 [b][4]. A surviving spouse can qualify for
the entire $500k exclusion if he or she sells the home within two years of her spouse’s death.
Had Wilma sold within two years of Harry’s death, there would have been no capital gain tax.
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Therefore, when counseling a recently widowed person in estate planning, this is one more topic
to consider.
Another major capital gain concern with second marriage planning is the loss of stepped
up basis at the second death when a credit shelter trust is used. A credit shelter trust is necessary
in order to secure the $4 million dollar Illinois Estate Tax exemption for the first to die. The
problem is that if the surviving spouse lives a long time, and the trust grows, the children of the
first to die will not get a step up in basis in those assets. However, the trust assets will be free
from the Illinois Estate Tax. On the other hand, assets left to a QTIP trust will receive a step up
in basis at the death of the second spouse. Therefore, the estate plan of the first to die should
include directions so that higher basis assets would first fund the credit shelter trust and lower
basis assets fund the QTIP trust, in order to maximize potential step up in basis at the second
death.
For obvious reasons, disclaimer trusts are not favored in second marriage planning
because of the potential loss of the assets if the surviving spouse fails to disclaim. Another
disadvantage is that the surviving spouse cannot have any powers of appointment in a disclaimer
trust.
A new technique for limiting the damage caused by the loss of step-up in basis at the
second death is to give a special power holder the right to grant the surviving spouse a general
power of appointment over trust assets that have significant appreciation, such as 25-50%. While
this may work in order to obtain a second basis step up, the control of the assets back to the
descendants of the first decedent is lost.
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The Estate Tax and the Importance of DSUE
Think of the DSUE as a very valuable asset for the wealthy surviving spouse. If the
surviving spouse is wealthy, the less wealthy spouse should agree in a post- or pre-nuptial
agreement that his or her executor will indeed file the 706 Estate Tax Return and elect
portability. Provisions can be made as to who can make the election although the IRS requires
that it be the executor, and if none, then those in charge of the assets. The cost of filing the
return- because simple returns are not allowed by the IRS as of this writing- perhaps should be
borne by the wealthier spouse who is seeking the DSUE.
To understand the value of the DSUE and table the Illinois Estate Tax for a moment,
consider the following example:
Harry husband dies with $10 million [consisting of Texas oil and gas interests] and is
survived by Widow Wilma who also has $10 million [consisting of Miami Florida
apartment buildings]. Each party has children from a prior marriage. Harry leaves his
$10 million to a QTIP trust for Wilma, which provides that at her death, the QTIP assets
revert to his descendants. If Wilma is Harry’s executor and files a 706 and elects
portability, she will have a DSUE of $5.49 million, as well as, her own Estate Tax
Exemption of $5.49 million. At her death, her estate grows to $11 million and her
descendants effectively will inherit her entire estate free of estate tax while (assuming
that her executor elects 2207A) Harry’s descendants will receive only $6 million
(because the surviving spouse elected to have the $4M estate tax due on the $10m QTIP
paid from the QTIP trust assets.
In this example, Harry should have had a Credit Shelter Trust so that Wilma did not get his
DSUE. Another area of concern is illustrated by the following example:
Harry husband dies with $1 million and is survived by Wilma wife who is worth $10
million. Harry’s son Harvey hates Wilma and is the named executor. Harvey refuses to
file the 706 and elect portability. Wilma loses $4.49 million in DSUE, which is worth
$1.796 million dollars to her children at her death!
In consideration of Husband agreeing to elect portability, Wilma could agree to waive
reimbursement rights under IRC Section 2207A.
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In the preceding example, if Wilma had $6 million of DSUE from her former spouse
before Harry and if Harry died with Harvey refusing to port his father’s unused exemption, then
Wilma would have lost out on her first husband’s $6 million of DSUE and Harry’s $4.49 million
and, therefore, her children lost $10.49 million of gift or estate tax exemption. Had Wilma lived
another 20 years and died with $15 million, the total loss to her children would have been
$4.196M dollars. Instead, widow Wilma after or before marrying Harry but before Harry’s death,
should gift her children the DSUE amount from her former husband [$6M] and in the prenuptial
require Harry’s executor to elect portability. [$4.49M]
Another fascinating consequence of the DSUE law is what is euphemistically known as
the “Black Widow Effect.” The DSUE is determined by the last spouse to die. Only the last-todie spouse’s DSUE is portable per IRC 2010 (c)(4)(b). This is illustrated by an albeit far-fetched
example:
Wealthy Wilma had $60 million and she went on within a period of 10 years to marry 10
impoverished, dying husbands back-to-back and had all their executors elect portability.
Before the final husband died, thus racking up $54.9M in DSUE so long as she gifted the
DSUE of $5.49 million dollars from each husband to her children before the next spouse
died. Wilma has now left virtually all $60 million to her children free of federal estate tax
by using her various DSUE[s] along with her own $5.49M exemption.
Do remember that the executor of the first decedent must file a form 706 to obtain the DSUE of
the first decedent.
Again, the DSUE is a valuable asset to the surviving spouse. In prenuptial counseling,
always ask a widowed person if a 706 was filed and if he or she has DSUE. If so, inform them
that they will lose that DSUE asset if the new spouse dies. His or her best way to save the DSUE
is to gift the assets to his or her children during the life of the new spouse. If the parties need to
live on the assets, the parties could agree in the prenuptial agreement to compensate the children
if the new spouse dies and he or she loses the DSUE. If, on the other hand, he or she has no
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DSUE, then the pre- or postnuptial agreement could be negotiated so that if the new spouse dies,
portability to the survivor will be guaranteed.
Another example of when to counsel a client to gift the DSUE is where a non-wealthy
spouse becomes terminally ill. If so, you should question the healthy spouse if she or he has
DSUE from the first marriage and that immediate gifting to his/her children should be
considered.
If the spouse does gift DSUE to his or her children, a current planning technique is to gift
to a grantor trust so that all future income taxes are charged to the grantor-donee thus further
reducing his or her estate. The trust thereafter would invest in low-basis assets so that his/her
children get a step up in basis at her death.
The existence of the Illinois Estate tax complicates DSUE planning. For the sake of the
children of the first marriage, that parent should establish a credit shelter trust to save the Illinois
Estate Tax and QTIP the rest and perhaps require the executor to file a partial Illinois QTIP
election for the difference between the $4 million Illinois Estate Tax exemption and the $5.49
million Federal Estate Tax exemption. The surviving spouse will get no DSUE, and there will be
Illinois Estate Tax due for her estate at her death for all QTIP, including the Illinois portion
passing to the credit shelter trust. The $1.49M in the credit shelter trust on which a partial Illinois
QTIP election was made does not enjoy the benefit of 2207A and therefore, her children and not
her husband’s children will pay the Illinois Estate Tax on the $1.49 million QTIP trust and its
growth, if any. (More on this topic below.)
For second marriage Illinois residents with Illinois assets exceeding the $4 million
Illinois Estate Tax Exemption, the following examples illustrate possible strategies.
1) Harry has $10 million and Wilma has $10 million. Harry’s and Wilma’s trusts
first should give outright distributions to their respective descendants because it
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appears that neither surviving spouse will need all of the first decedent’s assets.
The assets passing to Harry’s descendants should include IRD assets to ensure
longer “stretch treatment,” although each spouse should be counseled as to the tax
cost to his or her descendants. Other assets should include low-basis assets
because assets passing to the credit shelter trust will not receive a second basis
step up when the surviving spouse dies. Let’s assume each left $3M outright to
their children. The balance of their respective assets would be left in a credit
shelter trust [$2.49M], and a partial QTIP election for the Illinois Estate Tax
should be made within the credit shelter trust [$1.49M] with the balance of the
assets [$4.51M] passing to a QTIP for the survivor’s support. The home should
pass outright to the survivor, or if control is critical to the clients, then to the
QTIP. With the survivor electing 2207A, and a direction to have the first family
be responsible for the Illinois estate tax payable on Illinois QTIP within the credit
shelter trust, both families should be treated fairly overall after the death of the
second spouse.
2) Harry has $1 million and Wilma has $10 million. Wilma should gift her
descendants some amounts outright [IRD monies perhaps] with the balance
passing to a Credit Shelter Trust first, followed by a QTIP for Harry. If Wilma
does not need Harry’s $1 million, then Harry’s assets should pass to his children.
The home (if owned or partially owned by Harry) should be left outright to Wilma
or in a QTIP trust. If Harry passes first, Wilma must ensure that a 706 is filed so
that she captures the DSUE for her descendants. This requirement could be in a
pre-nuptial agreement or if none in Harry’s will giving direction to the executor to
port his exemption to Wilma.
To summarize, family [i.e., descendants’] concerns for the DSUE:
1) To the extent, a QTIP is used vs. a Credit Shelter Trust, the DSUE will be increased for
the second spouse.
2) The children of the second spouse will want the executor of the first decedent to elect
portability.
3) The QTIP affords the children of the first decedent a second step up in basis, but it can
come at the cost of losing Illinois or Federal Estate Tax Exemption.
4) The parties need to ensure that the children of the second to die not be required to pay the
Illinois Estate Tax on the Illinois QTIP within the credit shelter trust on which a partial
election was made.
Keep in mind to counsel the widow[er] to potentially use the DSUE before the second spouse’s
death, unless the second spouse needs the financial support. If so and if the second spouse is
poorer than the first, he or she will receive a greater DSUE in any event.
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An Apparent Problem with the Illinois Estate Tax Statute
35 ILCS 405-11 appears to grant IRC 2207A relief but not for the partial Illinois QTIP
election that passes to the credit shelter trust. The Illinois statute provides that the surviving
spouse is entitled to reimbursement when reimbursement is allowed under the Internal Revenue
Code. Section 2207A only applies to assets held in the QTIP trust and not the credit shelter trust.
The partial Illinois QTIP election is held by the credit shelter trust and not the QTIP trust and
therefore, is not governed by Section 2207A.
By way of example, Harry dies with $7 million. He leaves Wilma a Credit Shelter Trust
of $5.49 million and the balance in QTIP, and his executor also makes a partial Illinois
QTIP election for $1.49M which passes to the credit shelter trust [i.e., the difference
between the IL exemption of $4M and the federal at $5.49M]. At Wilma’s death, her
executor certainly has the power to have the QTIP trust pay its share of Federal Estate
Tax and the Illinois estate tax from the QTIP trust. At Harry’s death, the Credit Shelter
trust would be divided between the $4 million Illinois Estate Tax Exemption and then for
ease of tracing, we typically bifurcate the Credit Shelter Trust for the partial QTIP Illinois
amount of the difference between the state and federal exemption, i.e., $1.49 million.
Because 2207A applies only to federal estate tax due and only applies to the QTIP trust
and not the Credit Shelter trust, and because the partial Illinois QTIP is within the Credit
Shelter Trust, 2207A would not apply and therefore neither will 35 ILCS 405-1. This
issue does not appear to have gained any traction for a legislative amendatory solution.
Finally, there is a newly issued rev. proc. Between 2001 and the end of 2016, the IRS was
flexible in allowing an inadvertent QTIP election to be reversed. Specifically, a QTIP election
was considered to be void by the IRS if the election was not necessary to reduce the estate to
zero. This was allowable by the prior rev. proc. 2001-38. New rev. proc. 2016-49 (issued in
September of 2016) appears to make it difficult, if not impossible, to reverse an inadvertent
QTIP election. The IRS seems to be saying that if you were to port the DSUE, we will certainly
let you but once the 706 is filed, the election will be binding, which may lead to malpractice
claims for failing to obtain the maximum amount of federal estate exemption. The new rev. proc.
discusses two instances where the QTIP election is made in error: where sums passing to the
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surviving spouse were from an otherwise non-taxable estate or if the 706 incorrectly makes a
QTIP election for all or part of a credit shelter trust.
CONCLUSION
I hope that this presentation heightens the awareness of the complexity and options
relating to the tax and non-tax aspects of estate planning for second marriages. This is like
walking a tight rope. There are many competing (and sometimes conflicting) considerations that
need to be evaluated and harmonized based upon the particular facts of each case. Not only is
great thought and analysis required but also your intake forms, your request for existing estate
plan and divorce documents, your engagement letter and, in particular, your conclusion of
representation letter must be much more comprehensive than with the traditional marriage. Your
conclusion of representation letter should contain all of the options presented and discussed
during the engagement and the decisions the clients ultimately made. After all, the next
generation is often waiting in the background to see (and possibly second guess) the details of
the plan which you helped your clients adopt.
This presentation contains the opinion of the author and is for illustration only and is not
intended to provide professional advice to the reader and thus it is not to be relied upon for legal
advice.