TAX APPORTIONMENT WHAT WOULD THE TESTATOR WANT?
Barbara A. Sloan
McLaughlin & Stern, LLP
New York, New York
I.
INTRODUCTION
A.
B.
The Issue
1.
Thinking through how the taxes will fall in a client’s estate plan is often
one of the most challenging aspects of developing the plan. The tax
apportionment clause may be the most complex provision in a client’s
will. Moreover, even where the issue of tax apportionment has been raised
with the client, many drafting pitfalls may impact the manner in which
taxes are apportioned in surprising and unwelcome ways.
2.
Estate planning attorneys often select the tax apportionment clause in a
client’s will without consulting the client. In some cases, this may be
tantamount to determining the client’s dispositive plan.
.
Scope of this Outline
1.
This outline will review:
a.
the sources of law regarding apportionment of federal1 and state
death taxes in general,
b.
the basic alternatives with regard to apportionment of estate taxes;
and
c.
selected drafting considerations regarding apportionment clauses to
be included in wills and other estate planning documents.
1
Although no federal estate taxes are imposed this year, 2010, it seems certain at this time
that the federal estate tax will return for 2011 and the years thereafter, albeit at rates and with
exemption amounts that cannot be predicted with certainty.
©Copyright 2010 by Barbara A. Sloan
2.
C.
It is the intent of this outline to address practical planning issues related to
apportionment of death taxes, rather than to undertake a complete analysis
of all issues related to tax apportionment. For a thorough presentation of
the topic of tax apportionment, see Pennell and Danforth, 834 T.M.,
Transfer Tax Payment and Apportionment.
Significance of Tax Apportionment
1.
2.
Everybody Has One.
a.
Estate planners often say that if an individual does not have a will,
she nevertheless has an estate plan -- one that the state has written
for her.
b.
Similarly, if a will or revocable trust does not include a tax
apportionment clause, applicable law will fill the gap. The only
question is whether the applicable provisions are what the client
would want.
c.
Each client with a taxable estate deserves to have the unique tax
apportionment issues of her estate thought through carefully, fully
explained and meticulously drafted.
Tax Apportionment Affects the Size of Bequests.
a.
Most estate planners take great pains to explain thoroughly the size
and nature of federal and state death taxes which are likely to be
imposed on the client’s estate.
b.
Unfortunately, many planners do not the explain to the client that
these taxes can be allocated among their beneficiaries in a variety
of ways.
c.
As a result, the drafting of the tax apportionment clause (or the use
of a form clause) may substantially affect the distribution of the
client’s estate in ways that the client does not expect and would not
choose.
d.
Unfortunately, the case law is rife with examples where the client
(and the client’s beneficiaries) would have been better off if the
estate planning attorney had not included any tax apportionment
clause at all.
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3.
Tax Apportionment Is Not Applicable in Many Estate Plans.
a.
Generally, tax apportionment will not raise serious issues in estates
where:
(1)
(2)
4.
no tax is due because:
(a)
the estate does not exceed the federal and state
applicable credit exemption amounts or
(b)
the will (or revocable trust) is drafted using a credit
shelter/marital deduction formula that ensures no
federal and state estate tax will be due and the
spouse survives or
all of the property, both probate and nonprobate, passes to
the same people in the same shares.
b.
Under these circumstances, burdening any one source (e.g., the
residue) with the tax or apportioning the tax between probate and
nonprobate property will probably result in all of the beneficiaries
receiving the same shares in either case.
c.
To the extent that we draft frequently for these types of estates, it is
easy to embrace a standard tax clause and neglect to think through
and discuss the tax apportionment issues with the client, although
even in some of these cases, the tax apportionment clause as it
would apply to the contingent beneficiaries, if the spouse and/or
children do not survive the client, may need close attention.
Estates Which Require Tax Apportionment Analysis.
a.
In simplistic terms, careful consideration of tax apportionment
issues is necessary whenever:
(1)
The estate is likely to generate a state or federal death tax;
(2)
Different instruments direct property to different
beneficiaries in different shares;
(3)
Substantial credits or deductions are likely to be available
to reduce a portion of the tax due; or
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(4)
b.
II.
A substantial portion of the estate is composed of
nonprobate property.
Unfortunately, it is not always obvious whether an estate will meet
any of these criteria. In addition, as a result of post mortem
alternatives (e.g., disclaimers or partial QTIP elections), an estate
that is not expected to fall into one of these categories may. Thus,
the better course is to attend to the tax apportionment clause as a
matter of habit.
GENERAL RULES AND CONSIDERATIONS
A.
Imposition of Federal Estate Tax
1.
Section 2001(a) of the Internal Revenue Code of 1986, as amended,2
imposes a tax on the transfer of the taxable estate of every decedent who is
a citizen or resident of the United States.
2.
The executor of the decedent’s estate is personally liable for the tax,
whether on probate or nonprobate property. § 2002.
3.
If no executor is appointed, any person in actual or constructive possession
of the decedent’s property is required to pay the entire tax to the extent of
the property in her possession. Treas. Reg. § 20.2002-1.
4.
“Executor” is defined to mean the executor or administrator of the
decedent’s estate. § 2203.
5.
To ensure that the liability for the tax is clear, any recipient of nonprobate
property who pays tax has a right of reimbursement from the estate. §
2205.
a.
Section 2205 provides that, subject to a direction under the will of
the decedent, taxes shall be paid out of the residue of the estate
before its distribution.
b.
However, Riggs v. Del Drago, 317 U.S. 95 (1942), clarified that
this provision does not preempt state law apportionment statutes.
Rather, it simply provides that payment of tax is to be made from
the estate. As a result, section 2205 is applicable only if the
2
Unless otherwise provided, all references herein to section numbers will be to the
Internal Revenue Code of 1986, as amended (the “Code”).
-4-
decedent’s will does not express a contrary direction and state law
does not direct some form of tax apportionment.
B.
6.
In addition, if the executor distributes the property of the estate prior to
paying the tax, the transferee is also personally liable for payment of taxes
up to the amount of the property the transferee received. § 6901(a)(1) and
(h).
7.
The liability for unpaid estate tax is secured by a lien, under section 6321
for the personal representative and under section 6324(a)(2) for a
transferee.
8.
Procedures for discharging personal liability for tax are available under
section 2204(a) for personal representatives, section 2204(b) for
fiduciaries other than personal representatives and section 6325(c) for
transferees.
Taxes and Tax Benefits to Be Apportioned
1.
Death Taxes. Following 2010 when the federal estate and generationskipping transfer taxes will be reinstated, tax apportionment planning will
be just as challenging as ever due to the number and complexity of taxes
which must be considered.
a.
The Federal Estate Tax. This is likely to be the lion’s share of the
death taxes. As a result, apportionment of this tax should be
addressed first.
b.
State Death Taxes.
(1)
Starting in 2011, in states where the pick-up tax will be
revived, like New York, the state estate tax is based on the
amount of the state death tax credit available under federal
estate tax law and the state death taxes should be
apportioned in the same manner as the federal estate tax.
(2)
However, in states which impose a separate system of
taxation for death taxes, the apportionment of these taxes
must be considered separately. This is particularly true for
states that impose different tax rates based on
consanguinity.
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(3)
(a)
For example, in a state where bequests to linear
descendants are exempt from inheritance tax and
bequests to non-related persons are subject to
inheritance tax, a division of the residue among
them will yield differently sized shares, depending
on how the inheritance tax is apportioned. See
Pfeufer v. Cyphers, 919A.2d 641 (Md 2004)
(holding that inheritance tax can be charged to
residue at testator’s discretion even if residue passes
in part to individuals not subject to inheritance tax,
but shifting of burden of tax is additional gift to
beneficiary subject to inheritance tax).
(b)
The effect of paying inheritance tax which is
imposed differentially on different beneficiaries
from the residue is to equalize the rate of tax
applied to all beneficiaries, although it increases the
amount of tax due by increasing the gifts to the
beneficiaries subject to the higher rate of tax.
(c)
If the testator would like for beneficiaries in
different categories for purposes of inheritance tax
to receive equal shares, an alternative the client may
want to consider is simply to increase the size of the
shares passing to higher tax rate beneficiaries to
offset the higher rate of tax and to apportion the tax
among those beneficiaries whose bequests generate
the tax. Of course, this solution will also increase
the inheritance tax to be paid.
Under current law, after the sunset provision of the
Economic Growth and Tax Relief Reconciliation Act of
20013 becomes effective,4 the federal estate tax law will
3
P.L. 107-16 (“EGTRRA”).
4
Section 901 of EGTRRA provides:
“(a) IN GENERAL. All provisions of, and amendments made by, this Act
shall not apply --(1) to the taxable, plan, or limitation years beginning after December 31,
2010, or
(2) in the case of Title V, to estates of decedents dying, gifts made, or
generation skipping transfers, after December 31, 2010.
-6-
return to its 2001 structure, including a $1 million
applicable exclusion amount and a 55% rate of tax, and
many states, like New York, will once again have estate tax
laws that are coordinated with the federal law. In this case,
the apportionment of state estate taxes imposed in these
states will not need as much separate attention as has been
warranted in recent years. However, in circumstances
where the applicable exclusion amount for federal purposes
is not the same as the amount for a particular state, for
example, in New Jersey where the applicable exclusion
amount will remain at $675,000, then planning for
apportionment of state estate taxes in such a state will
continue to require separate attention from apportionment
of federal estate taxes.
c.
2.
Generation-Skipping Transfer Tax.
(1)
Starting again in 2011, because of the flat 55 percent rate of
the generation-skipping transfer (“GST”) tax, it is
imperative to plan for these taxes.
(2)
Unfortunately, many generation-skipping transfers may not
be intended or, in some cases, may not even be anticipated
as when a child disclaims in favor of grandchildren.
(3)
Chapter 13 contains its own rules for apportionment of the
GST tax liability which are discussed below.
Property Which Receives Special Tax Treatment. The allocation of tax to
special types of property must also be considered in analyzing the
apportionment of taxes.
a.
QTIP Property.
(1)
Because QTIP property is includible in the surviving
spouse’s estate under section 2044 even though it is
distributed to the beneficiaries as directed by the terms of
(b) APPLICATION OF CERTAIN LAWS. The Internal Revenue Code of 1986
and the Employee Retirement Income Security Act of 1974 shall be applied and
administered to years, estates, gifts, and transfers described in subsection (a) as if
the provisions and amendments described in subsection (a) had never been
enacted.”
-7-
the QTIP trust, it is critical to think through who should
bear the tax, from where the funds should come to pay the
tax and all of the places in which the tax apportionment
language should appear.
(2)
b.
c.
In addition, a federal apportionment statute will apply to
apportion taxes directly to the QTIP at the highest marginal
rate unless it is specifically waived. This requirement will
be discussed further below.
Special Use Valuation Property
(1)
The ability to make a special use valuation election under
section 2032A provides a substantial benefit to the estate.
(2)
The section also requires recapture of the tax benefit in the
event that the special use is discontinued prior to 10 years
or the property is disposed of in a nonqualifying manner.
(3)
Since the qualified heir who receives the property is
responsible for the recapture tax, notions of fairness
indicate that he or she should receive the benefit of the tax
savings. See e.g., Estate of Nevius 172 P.3d 1221, 2007
WL4577908 (Kan. Appp.) (Raising the issue of whether the
benefit of the $870,000 reduction in estate tax caused by
the §2032A election made by beneficiaries receiving certain
property should benefit those beneficiaries making the
election).
Qualified Plan Benefits
(1)
More and more frequently, qualified plan assets constitute a
substantial portion of a client’s estate.
(2)
Substantial estate tax and tax due on income in respect of a
decedent may be generated by these assets. However, due
to the unique tax character of qualified plan assets,
apportionment of the pro rata share of tax attributable to the
value of these assets may not be possible or desirable.
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d.
3.
Family-Owned Businesses
(1)
Under the Taxpayer Relief Act of 1997, a new tax benefit
was created for certain estates where a substantial portion
of the assets are comprised of family-owned businesses. §
2057.
(2)
Under EGTRRA, this provision was made inapplicable to
estates of decedents dying after December 31, 2003.
However, with the “sunset” provisions of EGTRRA taking
effect on December 31, 2010, this provision will apparently
revive.
(3)
Like section 2032A, section 2057 provides for the tax
benefit to be recaptured under certain circumstances.
Liability for the additional tax will be imposed on those
who received the property since the Internal Revenue
Service is likely to collect the tax from the assets. Again,
this argues for allocating the tax benefit under section 2057
to the beneficiaries who receive the property.
Tax Credits. In addition to identifying the taxes which will need to be
apportioned, it is equally important to identify the credits that may be
available to offset the taxes.
a.
State Death Tax Credit - Section 2011
(1)
In a pick-up tax state, the state death tax credit generally
should be allocated to the beneficiaries who will bear the
state death taxes and should thus be allocated in the same
manner as the federal estate tax.
(2)
In situations where the state imposes death taxes in excess
of or in lieu of the state death tax credit, it would seem fair
to allocate the credit to those beneficiaries who bear the tax
on a pro rata basis.
(a)
However, where the state death tax rates applied to
bequests to different beneficiaries differ based on
consanguinity, the client should consider how she
prefers to allocate the credit, given the rate
differential.
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(b)
b.
c.
i)
For example, where bequests are made to
children and stepchildren, in some states the
stepchildren’s share will bear a higher rate
of inheritance tax.
ii)
Consider that the determination of each
beneficiary’s pro rata share of the tax, taking
into account the rate differential in
allocating the credit, may be complex.
In addition, consideration should be given to
ensuring that any marital share is protected from the
allocation of such taxes, if possible.
Foreign Tax Credit - Section 2014
(1)
The foreign tax credit, if any, can be applied to benefit all
takers of the estate.
(2)
Alternatively, the credit can be allocated to the person who
receives the property which generates the credit. Under
these circumstances, apportionment of the foreign tax to
that property would be appropriate.
Previously Taxed Property Credit - Section 2013
(1)
Commentators differ with regard to the question of whether
to allocate this credit to the benefit of the estate as a whole
or to allocate it to the individuals who receive the property
that generates the credit.
(2)
Consider first that the actual property that generated the
credit may not be included in the decedent’s estate, thereby
making apportionment of the credit to those receiving the
property impossible.
(3)
Consider also that the decedent may not have had any tax
due on the transferor’s estate allocated to his or her share,
in which case the credit simply represents a windfall to the
decedent’s estate.
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d.
C.
Credit for Gift Tax - Section 2012
(1)
Although Section 2012 does not permit a credit on any gift
made after December 31, 1976, it is still possible that an
estate may include gifts made prior to that date.
(2)
Assuming the property gifted during life is not includible in
the decedent’s estate under sections 2035 through 2038,
2040 or 2042, generally the credit for gift tax paid will
inure to the benefit of the estate as a whole.
(3)
However, consider the results if the property is subject to
estate tax in the decedent’s estate. The client should
consider whether the donee should be required to bear a pro
rata share of the estate tax allocable to the includible gifted
property, keeping in mind the fact that the value of the
gifted property may be substantially higher in the
decedent’s estate than it was for purposes of calculating the
gift tax (e.g., life insurance). Under these circumstances,
the client may wish to allocate the credit for gift tax
previously paid to gifted property which is subject to estate
tax in his estate.
Apportionment Alternatives
1.
The Common Law Rule. The common law rule is that all taxes are borne
by the residue. This is surely the simplest and easiest form of
apportionment from a drafting and administration perspective, albeit not
always the most desirable.
a.
The effect of this form of apportionment is that all taxes are paid
out of the residuary estate before its division into shares. If the
residue is insufficient, taxes would then be borne by general and
specific bequests under the will on a pro rata basis up to the
amount necessary to make up the shortfall.
b.
The biggest advantage of this type of apportionment is that the
executor has access to and control over the assets to be used to pay
the tax.
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2.
Inside Apportionment.
a.
Inside apportionment relates to the issue of whether taxes will be
allocated among all classes of bequests within or inside the probate
estate, including marital or charitable bequests.
b.
If inside apportionment is selected, each beneficiary under the will
bears a pro rata share of the taxes which are due from the estate.
(1)
3.
Basically, there are two opposing views with respect to
inside apportionment, both of which have merit.
(a)
First, to the extent that preresiduary bequests are
nominal or minor, the testator probably would not
choose to protect them over the residuary bequests
to his or her family. Under this analysis, inside
apportionment acts to protect the family’s interests
by allocating tax to all bequests on a pro rata basis.
(b)
Second, often preresiduary bequests are bequests of
specific interests or property which the decedent
wanted to be distributed intact, without a forced
liquidation to pay tax. Typical of this type of
bequest are preresiduary bequests of tangible
personal property, real estate and business interests.
Under these circumstances, inside apportionment
may defeat the decedent’s intent to pass specific
property to particular individuals by requiring them
to liquidate the bequeathed property to pay the pro
rata share of tax generated by the value of the
property.
Outside Apportionment.
a.
Outside apportionment determines the burden of tax that will be
allocated to property passing under the will and property passing
outside of the will which is includible in the decedent’s estate for
estate tax purposes.
b.
As the proportion of nonprobate assets that are includible in a
decedent’s estate has generally increased in recent years, this
concept has become increasingly important. Numerous
unfortunate circumstances have occurred where the entire residuary
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estate has been paid over in tax due primarily on nonprobate assets.
Since the testatrix’s family (spouse and children) are usually the
residuary beneficiaries, such a result is unlikely to be what the
testator would have wanted.
c.
To counteract the common law rule, state apportionment statutes
typically direct outside apportionment. In addition, the few federal
rules which address apportionment apply to outside apportionment.
d.
However, outside apportionment of taxes may add substantial
complexity to the administration of an estate. Of course, the
greatest difficulty with outside apportionment, whether ir not the
result is fair, is that the executor does not have control over the
property and may not be able to collect the tax due on the property
from the current owner. If the will directs outside apportionment
and the executor is unable to collect the tax (for example, where a
gift is pulled back in the estate, but the donee has already spent the
money), then the will should direct a secondary source for the
payment of the tax. Due to these potential complexities, in most
cases, the determination of whether and how to apportion taxes
will involve a balancing of simplicity and ease of administration
with equitable results.
e.
Classes of property which may be subject to outside apportionment
include:
(1)
Property transferred or powers relinquished within three
years of decedent’s death and includible in her estate for
estate tax purposes under section 2035, including gift taxes
paid on gifts made within three years of death on property
not pulled back into the estate;
(2)
Gifts of property in which the decedent retained the right to
income or possession of the property includible in her
estate under section 2036(a)(1);
(3)
Gifts of property over which the decedent retained the right
to control who will enjoy the principal or income of the
property under section 2036(a)(2);
(4)
Gifts of property in which the decedent retained a
reversionary interest includible in her estate under section
2037;
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f.
(5)
Property held in a revocable trust created by the decedent
includible in her estate under section 2038(a)(1);
(6)
Annuities includible in the decedent’s estate under section
2039;
(7)
Jointly owned property includible in the decedent’s estate
under section 2040;
(8)
Property over which the decedent held a general power of
appointment includible in her estate under section 2041;
(9)
Life insurance on the life of the decedent for which the
decedent held one or more incidents of ownership
includible in her estate under section 2042;
(10)
QTIP trust of which the decedent was the income
beneficiary includible in her estate under section 2044; and
(11)
Property includible in the decedent’s estate under Chapter
14 (a suspense account under section 2701(d); a deemed
transfer under section 2704(a)(1); an increase in value of a
business interest over the specified sale price in a buy-sell
agreement under section 2703).
The primary issue here is whether the client wants to have the
probate estate bear the burden for the tax due on the nonprobate
assets.
(1)
A key factor in making this determination is whether the
client has actually identified all of the nonprobate property
which will be subject to tax at her death. If the client
chooses not to apportion tax to nonprobate assets, a surprise
asset could dramatically change her estate plan. Consider,
for example, Lurie v. Com’r, 425 F.3d 1021 (7th Cir.
2005). In this case, the decedent created irrevocable inter
vivos trusts valued at approximately $40,500,000 through
the exercise of powers of appointment contained in other
trusts (“Notice Trusts”). These Notice Trusts were
determined on audit to be included in his estate. The court,
after reviewing the tax apportionment language in the
decedent’s revocable trust and applying Illinois law,
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determined that the tax must be paid from the marital trust
created under the decedent’s revocable trust. The court
stated, “It is clear that the decedent did not anticipate that
the Notice Trusts would be included in his gross estate, and
it is very likely that the decedent would have laid out his
estate plan differently had he or his attorneys considered
this possibility. We cannot, however, rewrite the
decedent’s will or trust agreement to give effect to what the
decedent would have done.”
4.
(2)
In addition, some nonprobate assets represent property over
which the decedent does not have any control (e.g., QTIP
property) and for which she may thus prefer not to have
probate assets bear the burden of the tax.
(3)
Qualified plans and IRA’s may represent sizeable
nonprobate assets to which the client does not want to
allocate tax in order to preserve the income tax benefits
otherwise available to the funds in them. In addition, funds
withdrawn from a plan will have an immediate income tax
liability, requiring that the amount withdrawn from the plan
be grossed up to cover both the estate tax liability for which
the funds were withdrawn and the income tax liability due
on the withdrawn funds. If the plan will not be distributed
in a lump sum at the decedent’s death, the client should
consider whether the beneficiary will have the funds to pay
the tax. In addition, consideration should be given to
whether the plan permits apportionment of tax against the
plan itself or the withdrawal of funds from the plan to be
used to pay the tax.
Equitable Apportionment.
a.
Equitable apportionment deals with the issue of whether a bequest
of property which generates an exemption or deduction should
enjoy the full benefit of the exemption or deduction.
b.
If taxes are equitably apportioned, then bequests which generate a
deduction are not required to contribute toward the payment of the
tax due. Thus, the value of a marital or charitable bequest will be
determined without regard for any decrease due to the payment of
estate taxes.
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c.
This is an area which can be a source of real controversy among
beneficiaries of an estate and has spawned much litigation.
Common instances in which equitable apportionment may be an
issue are:
(1)
Whether a spousal intestate share is determined before or
after the reduction in the value of the estate for estate taxes.
See Estate of Collins, 269 F.Supp. 633 (D.D.C. 1967)
(holding that decedent’s husband’s one-half intestate share
of estate should not bear burden of any tax).
(2)
Whether a spousal elective share is calculated based on the
value of the estate before or after taxes are paid. See e.g.,
Rockler v. Sevareid, 691 A.2d 97 (D.C. 1997); c.f., Herson
v. Mills, 221 F.Supp. 714 (D.D.C. 1963).
(3)
Whether a fractional residuary bequest of an interest to
charity is determined based on the gross value of the
residuary or the net value after taxes are paid.
d.
Although apportioning taxes without equitable apportionment will
increase the total tax due, in many cases it may be the result the
testator would want because it generally will increase the size of
the shares passing to the non-charitable or non-marital
beneficiaries.
e.
Two issues should be considered in determining whether a marital
or charitable bequest should bear any portion of the death taxes due
on an estate.
(1)
First, does the client want to minimize the total estate tax to
be paid? If that is the client’s goal, equitable
apportionment will achieve the result.
(2)
Alternatively, does the client want to equalize the shares
passing to the spouse or charity with those of other
beneficiaries of the estate (e.g., one-half to charity and onehalf to the client’s brother)? If so, the client would
probably prefer to have the tax deducted first and then
divide the remaining estate.
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(a)
Under these circumstances, the total tax paid will be
higher, but so will the share passing to the client’s
brother.
(b)
The tax is increased because the portion of the
deductible share which is used to pay the tax then
decreases the amount of property passing to the
deductible beneficiary, again increasing the tax in a
circular calculation. § 2055(c). The marital
deduction is subject to a similar effect. See §
2056(b)(4)(A). See also, Martin v. United States,
923 F.2d 504 (7th Cir. 1991)(addressing decrease in
marital share as result of payment of tax from it).
(c)
For example, for a $4.4 million estate where 10% of
the gross estate is paid in administration expenses
other than estate tax:
Elective Share Bears Tax
Elective Share Does Not
Bear Tax
Tax Paid
$1,506,000
$1,430,000
Surviving Spouse's
Elective Share as a
Percentage of
Distributable Estate
$ 968,000
(33%)
$1,380,000
(46%)
Children's Share
$1,926,000
$1,590,000
See Rockler v. Sevareid, 691 A.2d 97, 97-98 nn. 2, 4 (D.C. 1997).
5.
Tools for Collection of Tax.
a.
In the case where a will directs outside apportionment of tax, it is
imperative that the executor be given as many tools as possible to
assist with the collection of tax from assets outside her control. Of
course, the same is true for the trustee of a revocable trust who
must attempt to collect tax from assets not under her control.
b.
At a minimum, the fiduciary should have the express right to offset
the amount of tax due on nonprobate assets from any bequest
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passing to the same beneficiary under the will or trust. In addition,
the client should be asked whether the fiduciary can have a right to
sell an illiquid asset passing to a beneficiary who does not
contribute the required share of tax on a nonprobate asset.
6.
c.
In line with the powers described above, the fiduciary should be
empowered to delay distribution of a bequest to a beneficiary from
whom a share of tax on a nonprobate asset is due until payment of
the tax due or some other method for paying the tax is secure,
including the use of a bond.
d.
The real difficulties arise when the fiduciary must collect the tax
on a nonprobate asset from a beneficiary who does not have an
interest passing to her under the will. Certainly the fiduciary
should be authorized to pursue enforcement in a foreign
jurisdiction. Under these circumstances, the client should be
consulted about a secondary source from which to pay the tax if it
cannot be collected. Should it be apportioned among other
beneficiaries? Charged to the residue? Only the client can anser
this question.
Apportionment Coordination Among Multiple Documents of an Estate
Plan.
a.
For an estate plan which establishes several entities using a variety
of documents, the apportionment of taxes on the property passing
under each document must be considered in relation to the whole
estate plan.
b.
For example, where a client has executed a will, a revocable trust
and an irrevocable insurance trust, the determination of how taxes
are to be apportioned in the total estate will be affected not only by
the provision within each document, but also by the interrelation of
the tax apportionment directions within each document. Again,
this is a fertile area for litigation. For example, see Leavenworth v.
Nat’l Bank & Trust Co, Inc. v. United States, 1996 WL 225193
(D.C. Kan. 1996) (where pourover will directed all taxes be paid
from decedent’s “estate,” and revocable trust, which created a
bypass trust and a marital bequest, permitted trustee to pay any part
of all of death taxes imposed, probate assets were subject to tax
prior to pourover to trust, thus diminishing marital share and
increasing tax due).
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c.
Needless to say, the provisions in each document should
implement portions of a coordinated tax apportionment plan.
d.
An area of caution to consider is to what extent each document is
capable of authorizing the payment of taxes out of any property
other than the property passing under that document. See, e.g.,
Riggs v. Commissioner, 945 F.2d 733 (4th Cir. 1991) (applying
Virginia law, finding that decedent could not shift burden for tax
due on probate property from probate to nonprobate property by
use of provision in his will where nonprobate property otherwise
qualified for the marital deduction).
e.
Some of the possibilities for ways in which the tax apportionment
issues could be allocated among the documents are:
(1)
Each document could provide that all taxes will be paid
from the probate estate. The issues of inside and equitable
apportionment would then need to be addressed within the
probate estate. If this plan were used, it would be prudent
also to include in the documents and the will some alternate
source for paying the tax in the event that the probate estate
is inadequate. See, e.g., In re Estate of Williams, 835 N.E.
2d 79 (Ill. App. Ct. 2006) (holding that where decedent’s
will directed payment of all taxes from residue without
apportionment or reimbursement and was silent as to
source of payment of tax if residue was inadequate, will
was ambiguous and court determined to apply equitable
apportionment to collect tax from nonprobate general
power of appointment marital trust included in decedent’s
gross estate).
(2)
The will and revocable trust could provide that all taxes
will be paid from the revocable trust. Again, inside and
equitable apportionment would need to be addressed and
the provisions in these two documents should direct the
same forms of apportionment. Even if all taxes are directed
to be paid frm the revocable trust, it is important to attend
to the tax apportionment clause in the will since many
statutes require that tax apportionment direction be made in
the will.
(3)
The will and revocable trust could provide that the taxes
will be paid from the trust only to the extent that the
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probate assets are insufficient to pay the tax but again the
forms of apportionment selected in the provisions of the
two documents should be the same.
(4)
f.
7.
D.
The irrevocable trust could authorize the trustee to purchase
assets from the probate estate or from the revocable trust or
to lend money to either of them and should include a
direction regarding the payment of tax in the event that the
assets of the trust are determined to be includible in the
decedent’s assets for estate tax purposes (e.g., a life
insurance policy transferred within three years of death).
In determining how the taxes will be apportioned among the
different entities in the estate, the drafter should bear in mind the
potential for conflicts of interest and the effect of having different
fiduciaries serving under different entities.
Coordination of Tax Apportionment Provisions between Estate Plans for
Husband and Wife.
a.
Just as tax apportionment provisions among multiple documents
for the same client should be reviewed to ensure coordination of
provisions, as will be discussed more fully below, a similar review
should be undertaken to ensure that the documents for a husband
and wife coordinate the tax apportionment provisions.
b.
In cases where the estate planner represents only one of the
husband and wife, it is nevertheless important to consider the effect
of the tax apportionment provisions of each of their estate plans
and to coordinate them, if possible.
Federal Reimbursement Rules
1.
Governing Law. Four federal statutes provide the estate of a decedent
with a right of reimbursement for estate tax paid from nonprobate
property. Although Riggs v. Del Drago, 317 U.S. 95 (1942), provides that
state law governs tax apportionment for property passing under the
decedent’s will (or revocable trust), to the extent that federal law expressly
provides for apportionment of taxes attributable to nonprobate property,
federal law governs. These federal statutes were enacted on a piecemeal
basis, as changes in the estate tax law developed. As a result, the four
statutes are not consistent in their scope or their requirements. Note that
all of sections 2206, 2207, 2207A and 2207B apparently deny
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reimbursement for taxes deferred under sections 6161, 6163 and 6166 and
not yet paid.
2.
3.
These rights of reimbursement or the waiver of them have been likened to
property rights.
a.
In an interesting case, the court in Estate of Boyd v. Commissioner,
819 F.2d 170 (7th Cir. 1987), determined that the waiver of the
right to reimbursement under section 2206 in the decedent’s will
was a property right the beneficiary of the insurance policy could
disclaim. As a result of the disclaimer, the full marital deduction
was preserved in the decedent’s estate.
b.
In an even more interesting analysis, the court in Estate of Wu, 877
N.Y.S.2d 886 (Sur. Ct. 2009) held that the waiver under the
decedent’s will of the right to reimbursement for the tax due on
two insurance policies was a beneficial disposition to the
beneficiary of the insurance policies. In that case, since the
beneficiary of the insurance policies was an attesting witness
whose testimony was necessary to prove the decedent’s will, this
beneficial disposition to him was void under New York law.
Insurance Proceeds - Section 2206.
a.
Under section 2206, unless the decedent directs otherwise in her
will, the personal representative of the estate is entitled to
reimbursement from the beneficiaries of any life insurance policy
includible in the decedent’s estate of a proportionate share of the
estate tax due attributable to the policy. Multiple beneficiaries of a
policy are liable on a pro rata basis. Note that this right of
reimbursement does not include the trustee of a revocable trust.
b.
Unless the decedent waives this right of reimbursement, an
executor is likely to have an obligation to make the effort to collect
the pro rata share of tax from each beneficiary of life insurance
includible in the decedent’s estate.
c.
The statute expressly selects equitable apportionment with respect
to the marital deduction, providing that it does not apply to the
extent that the marital deduction is allowed for proceeds receivable
by the decedent’s spouse, but does not mention any exemption for
charitable beneficiaries. For this reason, an express provision in
the tax apportionment clause in the decedent’s will providing for
equitable apportionment should resolve this issue and prevent
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imposing any duty on the executor to collect tax from the
charitable beneficiary of a life insurance policy includible in the
decedent’s estate.
4.
d.
The right of reimbursement does not extend to insurance
companies, even if the proceeds have not been paid to the
beneficiaries. See Annot., Remedies and Practice Under Estate
Tax Apportionment Statutes, 71 A.L.R.3d 371, 409 (1976).
e.
Given the size of proceeds of many insurance policies, this right of
reimbursement should not be waived carelessly. Note, however
that the statute merely provides “Unless the decedent directs
otherwise in his will,” and does not require an express reference to
it in order to waive it. See Estate of Fagan, T.C. Memo 1999-46
(1999)(holding that language in tax apportionment clause in
decedent’s will which provided all taxes assessed on property
included in gross estate be paid from residuary estate and that
executor should not require any part of such taxes be recovered
from recipients of property was adequate to waive reimbursement
right under section 2206).
f.
Preservation of the right of reimbursement is particularly important
for a client whose estate planning includes an irrevocable insurance
trust which is not intended to be included in the client’s taxable
estate.
(1)
In addition to careful preservation of this reimbursement
right in the tax apportionment clauses in the client’s will
and/or revocable trust, the insurance trust also should
include a provision which directs allocation from the shares
of the trust of that portion of the taxes due in the event that
the trust is includible in the client’s estate.
(2)
To avoid inadvertent inclusion of the trust in the client’s
estate, however, this tax clause included in the insurance
trust should clearly be made contingent on the prior
determination that the trust is includible in the client’s
estate.
Powers of Appointment - Section 2207.
a.
This provision is the twin of section 2206 and grants a right of
reimbursement to a personal representative for taxes attributable to
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property subject to a general power of appointment included in the
decedent’s estate under section 2041.
5.
b.
Recovery may be had from the person “receiving such property by
reason of the exercise, nonexercise or release of a power of
appointment.”
c.
Again, if a marital deduction is allowed for the interest passing to
the spouse, no right of reimbursement is created, but this
application of equitable apportionment does not mention charitable
beneficiaries.
d.
Again, no specific reference to the Code section or type of
reimbursement is required in order to waive the right and the right
can be waived only in the decedent’s will.
e.
This provision also provides that to the extent the marital
deduction is inadequate to protect both the life insurance proceeds
and the power of appointment property passing to the spouse, the
life insurance proceeds are protected first from the right of
reimbursement and then the power of appointment property. Given
the current unlimited marital deduction, this provision should no
longer be relevant.
QTIP Property - Section 2207A.
a.
Section 2207A gives the personal representative of the decedent’s
estate the right of reimbursement from a QTIP trust for federal
estate taxes due at the highest marginal tax rate as a result of the
inclusion of the QTIP trust in the decedent’s estate.
b.
Section 2207A differs from sections 2206 and 2207 in several
important respects:
(1)
First, it can be waived under the decedent’s will or
revocable trust.
(2)
Second, to prevent an inadvertent waiver of this right, the
Code section was amended to provide that the right of
reimbursement can be waived only by specific indication
of the intent to waive reimbursement. The legislative
history of the Taxpayer Relief Act of 1997, which amended
section 2207A, provides that a specific reference to QTIP,
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the QTIP trust, section 2044 or section 2207A will suffice
to meet the requirements of the statute.
(3)
To ensure that no tax due to the inclusion of the QTIP trust
in the decedent’s estate will be payable from the decedent’s
assets, the tax is recoverable from the QTIP on an
incremental basis. It also includes the right to recover
interest and penalties attributable to the additional taxes.
c.
Note that although in many jurisdictions, the state estate tax will
follow the federal estate tax, the federal reimbursement provisions
apply solely for the purpose of reimbursing the estate for federal
estate tax. See, Forrester v. Forrester, 914 So.2d 855 (AL
2005)(determining that § 2207A did not preempt Alabama estate
tax statute directing nonapportionment of Alabama estate tax
which charged decedent’s residue for Alabama tax due on QTIP
trust includible in decedent’s estate).
d.
To facilitate the administration of the surviving spouse’s estate, a
provision should be included in the QTIP trust directing that,
following the surviving spouse’s death, the incremental amount of
estate tax due to the inclusion of the QTIP in the surviving
spouse’s estate be paid over to the personal representative of the
surviving spouse’s estate. This provision may need to include an
apportionment provision, directing how the taxes should be
apportioned among the beneficiaries of the QTIP trust. See,
Proceeding of Feil, 894 N.Y.S.2d 837 (Sur. Ct. 2009)(determining
whether cash bequest to children from QTIP trust following death
of surviving spouse should bear tax imposed on QTIP or tax should
be paid from residue of QTIP trust passing to charity)
e.
A trap for the unwary is that if the surviving spouse’s will or
revocable trust does not waive the right of recovery from the QTIP
trust, the failure of the surviving spouse’s personal representative
to recover the tax will be treated as a gift from the beneficiaries of
the surviving spouse’s estate from whose share the tax was paid to
the remaindermen of the QTIP trust. Treas. Reg. § 20.2207A1(a)(2). The gift is deemed made when the right of recovery is no
longer enforceable and the failure to recover the tax is treated as a
gift even if recovery is impossible.
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6.
7.
Retained Life Estate - Section 2207B.
a.
Like sections 2206 and 2207, section 2207B authorizes the
personal representative of the decedent’s estate to be reimbursed
from property included in the decedent’s estate under section 2036
for a proportionate share of the tax attributable to the inclusion of
the property in the decedent’s estate. However, unlike sections
2206 and 2207, the right of reimbursement includes penalties and
interest attributable to the tax, like section 2207A.
b.
Section 2207B provides that the right of reimbursement can be
waived “to the extent that the decedent in his will (or revocable
trust) specifically indicates an intent to waive any right of recovery
under this subchapter.” Under the Taxpayer Relief Act of 1997,
the standard for specificity of the waiver was reduced to
correspond to that required for section 2207A.
c.
Section 2207B also provides specifically that no right of
reimbursement is available from a charitable remainder trust, but
does not mention any other form of equitable apportionment.
Generation-Skipping Transfer Tax Apportionment - Section 2603.
a.
Section 2603(a) provides that the transferor (or the transferor’s
estate) pays the tax in the case of a direct skip, the distributee pays
the tax in the case of a taxable distribution and the trustee pays the
tax in the case of a taxable termination.
b.
The GST tax on a direct skip is tax exclusive, meaning no GST tax
is charged on the amount required to pay the GST tax, but, an
estate or gift tax is charged on the amount required to pay the GST
tax. In the case of a testamentary bequest, the GST tax is charged
on the amount of the bequest, but net of GST tax paid out of the
bequest, and the estate tax is charged on the amount of the bequest,
the GST tax paid and the estate tax paid. See, Danforth, “GST Tax
Computation, Payment and Apportionment,” 29 Estates, Gifts and
Trusts Journal 82 (2004) (short but very clear explanation of
calculation of GST taxes).
c.
Section 2603(b) provides that, unless the governing instrument
directs otherwise “by specific reference to the tax imposed by this
chapter,” the tax will be charged to the property constituting the
generation-skipping transfer.
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(1)
The direction in the governing instrument to pay the tax
from another source must be made with “specific reference
to the tax imposed.” Estate of Monroe v. Commissioner,
104 T.C. 352 (1995), rev'd on other grounds, 124 F.3d 699
(5th Cir. 1997). See, In re Estate of Denman, 270 S.W.3d
639 (Tex Ct. App. 2008)(finding that reference to “any
transfer, estate, inheritance, succession and other death
taxes” did not refer specifically to GST tax and did not shift
burden to pay tax from property subject to bequest).
(2)
This right to have the tax paid from the property
constituting the generation-skipping transfer should be
waived only with great care since generation-skipping
transfers can be inadvertent and unanticipated. Given the
anticipated 55% rate of tax, an unexpected imposition of
the tax on the residue of the client’s estate may
substantially change her testamentary plan.
(3)
Treas. Reg.§ 26.2662-1(c)(2)(iii) requires the personal
representative to pay generation-skipping transfer tax on the
proceeds of insurance policies of less than $250,000 and to
seek reimbursement from the insurance company or the
beneficiary, depending on whether the proceeds of the
policy have been distributed at the time. However, for
policies where the proceeds are in excess of $250,000, the
insurance company is liable for the tax. A fiduciary may
prefer to ask the insurance company to pay the tax in all
cases to avoid inadvertently failing to do so in cases where
the proceeds exceed $250,000.
d.
In the case of a direct skip made under the transferor’s will, where
no contrary intent is expressed, sections 2603(a) and 2603(b) act to
require that the tax be paid from the amount bequeathed to the skip
person, but no generation-skipping transfer tax is imposed on the
amount used to pay the tax. The tax would be computed as: .55 X
([amount of bequest] / 1.55). If this result is not the client’s intent,
then the will or revocable trust must clearly override the statutory
direction to pay the tax from the amount transferred to the skip
person.
e.
Example
(1)
Decedent dies in 2011 (assuming the 2001 transfer tax
regime is applicable), having used his entire GST tax
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exemption on other transfers. In his will he leaves a
$1,000,000 bequest to a grandchild.
E.
(2)
Unless the will directs otherwise by specific reference to
the GST tax, the tax will be charged against the bequest.
Since the tax is assessed on the amount actually received by
the transferee, the tax (at 55%) is $354,839, and the
grandchild receives $645,161.
(3)
If the will directs that the GST tax be paid out of the
residue, the grandchild will receive the full $1,000,000, but
the GST tax will be $550,000.
Gift Tax Includible in Gross Estate Under Section 2035
1.
An additional very difficult issue may be raised with regard to the
application of the section 2035 gross up rule where the decedent has paid
substantial gift tax within three years of death. The difficulty with
apportioning the tax due on this value is that the recipient of the property
is the federal government, and, needless to say, it is not going to pay its
share of the tax generated by the inclusion of the gift tax paid on gifts
made within three years of death in the taxable estate. It may also be
difficult or unfair to apportion the tax to the donees of the gifts giving rise
to the inclusion of the gift tax because they may have already spent or
consumed the gifted property, never suspecting they might be liable for tax
related to the gift. But see, Application of Rhodes, 868 N.Y.S. 2d 513
(Sur. Ct. 2008) (applying New York tax apportionment statute to
determine that donees of gifts are responsible for their pro rata shares of
the estate tax attributable to the inclusion of the gift tax paid on their gifts).
Finally, apportionment of the tax on the includible amount may cause
significant inequities in the decedent’s estate.
2.
For example, where gift tax of over $1.8 million is paid on a gift made
within three years of the decedent’s death, the additional tax generated by
the gross up rule will be $900,000, assuming for simplicity an estate tax
rate of 50%. If the residuary probate beneficiaries are not the same
individuals who received the gifted property (or do not take in the same
shares), the imposition of the additional $900,000 of tax on the residuary
will substantially decrease the shares of the residuary beneficiaries of the
probate estate in favor of the gift beneficiaries.
3.
Alternatively, if the individuals who received the gifted property are also
beneficiaries of the probate estate, allocation of the additional tax to their
probate shares would probably be the most equitable solution.
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4.
F.
III.
Of course, it is usually not known that a client will die with three years of
paying gift tax. As a result, this is an apportionment provision which
should be included in a will on an anticipatory basis and should be
discussed with the client when the client pays the gift tax, if not before.
Freedom to Choose
1.
Within certain limitations, a decedent is permitted by her will to select the
method of tax apportionment which results in the allocation of tax
consistent with her intention.
2.
In addition, she may expressly specify the bequests or property which are
to bear the burden of the tax.
3.
By contrast, the decedent is also permitted by her will to override state
apportionment statutes and to provide that certain nonprobate property will
not bear the burden of any tax.
4.
Finally, the decedent by her will can also direct that specific nonprobate
property bear the burden of tax. The testatrix may not be able, in her will,
however, to increase the tax burden on nonprobate property over what it
otherwise would have been if apportioned.
UNIFORM TAX APPORTIONMENT ACTS
A.
The National Conference of Commissioners on Uniform State Laws (“NCCUSL”)
has adopted three versions of the Uniform Tax Apportionment Act - in 1958,
1964 and 2003. A fourth version was included in the Uniform Probate Code in
2002. Many states have adopted the 1964 act, albeit in forms somewhat modified
from the original. Others have adopted the Uniform Probate Code version and a
few have adopted the 2003 version. The general substantive provisions of the
1964 Act and the 2003 Act are described below. For an excellent review of the
2003 Act, see the article by Douglas A. Kahn, the reporter of NCCUSL’s draft of
the Act at 38 Real Property, Probate and Trust Journal 613 (2004).
B.
Inside and Outside Apportionment. Both Acts provide for inside and outside
apportionment, meaning that taxes are apportioned among all persons interested in
the estate, unless the will provides otherwise. Within the probate estate, taxes are
apportioned based on the proportionate share that each beneficiary receives
relative to the value of all interests in the estate. Thus, preresiduary bequests are
charged with a pro rata share of the tax. In addition, beneficiaries of nonprobate
interests pay a pro rata share of estate tax. However, the 2003 Act has an entirely
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new section addressing the manner of apportionment by will or other dispositive
instrument which requires that the provision in the decedent’s documents must
apportion the tax “expressly and unambiguously ” and establishes an order of
priority in the event that the directions in different revocable trusts conflict (the
most recent controls). The 2003 Act also limits the amount of tax a decedent can
apportion to property over which she had no power of disposition at her death.
C.
Both Acts include federal and state estate tax, together with interest and penalties
imposed in addition to tax as part of the amount apportioned. The 2003 Act also
includes any foreign tax imposed as the result of an individual’s death. The 2003
Act expressly does not include inheritance, income or generation-skipping transfer
taxes other than a generation-skipping transfer tax incurred on a direct skip taking
effect at death.
D.
In the absence of a contrary direction in the will (or other dispositive document
under the 2003 Act), both Acts provide for equitable apportionment, giving the
benefit of any reduction in rate of tax or exemption or deduction to the person
bearing that relationship or receiving the gift. However, the 2003 Act adopts a
concept called the “apportionable estate” which excludes from the gross estate the
value of marital and charitable interests, any gift tax paid on gifts within three
years added back to the estate, and the amount of any claims and expenses for
which a deduction is allowed. The tax is then equitably apportioned among
persons with interests in the apportionable estate. By subtracting out any gift tax
added back into the estate, the Act avoids the mathematical problem that less than
100% of the tax would be apportioned if the donees of the gifts generating the tax
were not included as persons interested in the estate. It also avoids the difficulties
associated with including the donees of completed gifts as persons interested in
the estate. The end result is that the tax is allocated to the persons interested in
the apportionable estate on a pro rata basis.
E.
Both Acts apportion tax related to a time-limited interest to the principal of the
interest.
F.
Both Acts also provide a number of mechanisms to assist the fiduciary with
collecting the tax due from beneficiaries, including withholding the tax from
property in the fiduciary’s possession and authorizing the fiduciary to recover any
additional amounts due from the person interested in the estate. The fiduciary
may also require a distributee to provide a bond or other security for the portion of
the estate tax due from the distributee. Finally, the 2003 Act provides an order of
priority of persons from whom the tax can be collected if the fiduciary cannot
collect it from the person who is obligated to pay: (i) any person having an interest
in the apportionable estate which is not exonerated from tax; (ii) any person
having an interest in the apportionable estate; (iii) any person having an interest in
the gross estate (which adds back in the marital and charitable bequests).
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IV.
GENERAL GUIDELINES IN DRAFTING TAX APPORTIONMENT CLAUSES
A.
B.
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.”
Always Include a Tax Apportionment Clause in the will
1.
2.
C.
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.
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!
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
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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).
D.
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.
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.
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b.
E.
F.
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.
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.
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
noncharitable beneficiaries only occurs if the spouse and/or children do
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not survive the client. The tax apportionment clause must address
considerations raised by gifts to contingent beneficiaries.
G.
Special Considerations Regarding Marital Property
1.
2.
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.
Elective Share.
a.
The law regarding the imposition of tax on a spouse’s elective
share of course varies from state to state.
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b.
3.
Sharing the Tax Rate Differential.
a.
4.
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).
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.
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
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exhausted, then paid from the exempt QTIP trust. This avoids the
“wasting” the GST exempt funds in payment of tax.
H.
I.
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.
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.
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.
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b.
J.
V.
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.
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.
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
termination or creates a direct skip? Does the normal imposition of the
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generation-skipping taxes apply or does this clause attempt to shift this
burden?
B.
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.
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
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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.
B.
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,
any gift taxes includible in my gross estate by §2035(b) of the
Code, any recaptured inter vivos transfer subject to §529(c)(4)(C)
of the Code, or any comparable inclusion (hereafter collectively
referred to as completed lifetime gifts) is the difference between (a)
the total death taxes incurred by my estate, less those death taxes
described in paragraph B.1.a and (b) the death taxes that would
have been incurred if there were no completed lifetime gifts. For
apportionment purposes, the recipient of property that produced
gift tax includible by §2035(b) of the Code shall be treated as
having received the amount of that gift tax, and the recipients of
completed lifetime gifts will pay the tax attributable thereto.
3.
The death tax attributable to all other property is the difference
between (a) the total death taxes paid by my estate and (b) those
death taxes described in paragraphs B.1.a. and B.1.b. that actually
are collected by my personal representative.
Multiple Recipients: If there is more than one recipient of property
separately described in paragraphs B.1. each recipient shall pay a
proportionate share of the death tax attributable to all of the property
described in that separate paragraph based on the value of the property
received by the recipient as finally determined in the death tax
computation as compared to the same value of all property described in
that separate paragraph that is not excluded from apportionment under
paragraph B.6.
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C.
Tax Benefits: Credits, deductions, exclusions, exemptions, and similar
benefits shall be reflected as follows:
1.
In computing the death tax paid by my estate for purposes of
paragraph B.1.b. and determining the proportionate share of such
tax to be paid by any individual recipient, any gift tax allowed as a
credit by §2001(b)(2) of the Code that was paid by the recipient
shall inure to the benefit of that recipient.
2.
In computing the death tax paid by my estate for purposes of
paragraph B.1.c. and determining the proportionate share of such
tax to be paid by any individual recipient, the credit granted by
§2001(b)(2) of the Code for gift taxes that were not paid by any
individual recipient, the unified credit granted by §2010 of the
Code, the credit for gift taxes granted by §2012 of the Code, the
credit for property previously taxed granted by §2013 of the Code
(but only to the extent attributable to property that cannot be
identified specifically as includible in my estate at death), and any
other credit the benefit of which is not allocated by paragraph
B.3.c. because it is not possible to identify the property passing to a
recipient that produced the credit shall inure to the benefit of all
recipients of property described in paragraph B.1.c.
3.
The benefit of any other credit shall inure to the recipient of
property that produced the credit (e.g., the recipient of property that
generates a state death tax shall enjoy the benefit of the credit
granted by §2011 of the Code or the deduction granted by §2058 of
the Code with respect to payment of that tax, the recipient of
property subject to foreign death tax shall enjoy the benefit of the
credit granted by §2014 with respect to the taxation of that
property, and the recipient of specifically identifiable property that
is includible in my estate and that previously was taxed shall enjoy
the benefit of any credit granted by §2013 of the Code with respect
to that property).
4.
The benefit of any reduction in tax attributable to an election under
§2032A of the Code shall inure to the qualified heir who receives
the property that is the subject of the election.
5.
The benefit of any reduction in tax attributable to property
qualifying for the marital or charitable deduction shall inure to the
recipient of that property. Any increase in death taxes attributable
to a disclaimer of such property or a failure to elect to qualify any
part of a bequest that otherwise could constitute QTIP property
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under §2056(b)(7) of the Code shall be charged to the disclaimed
or non-elected property without the benefit of any marital or
charitable deduction otherwise available to my estate.
6.
The benefit of any tax rate differential in computing death taxes
attributable to the relation of the recipient to me shall inure to that
beneficiary.
7.
The benefit of any other entitlement directly attributable to
identifiable property shall inure to the beneficiary who receives
that property.
D.
Temporal Interests: Death tax attributable to property held in temporal
interests (e.g., a life estate, annuity, or term of years, followed by a
remainder) shall be paid from corpus to the extent the effect thereof is to
amortize the cost over the respective interests but otherwise shall be
apportioned between the respective interests based on their respective
values. Apportionment to a lead interest may entail a loan from principal
or recomputation of an annuity or other guaranteed payment, but neither
this paragraph nor any provision of state law shall apply to the extent the
effect is to reduce a deduction otherwise allowable for any part of the
property.
E.
QTIP Property: Notwithstanding paragraph B.3.e. with respect to property
includible in my estate under §2044 of the Code, all taxes attributable to
all §2044 property shall be determined on a pro rata rather than the
incremental basis provided by §2207A of the Code and shall be
apportioned to the §2044 property with the highest inclusion ratio to the
extent doing so will not constitute a constructive addition with respect to
any §2044 property with a lower inclusion ratio.
F.
Exoneration: Notwithstanding any other provision of this will, the
recipient of property described in this paragraph shall not be subject to
apportionment and the taxes attributable to this property shall be paid by
the remaining recipients of property includible in my estate according to
the computation of attributable tax described in paragraphs B.1. and B.2.
1.
To the extent apportionment of the attributable tax would violate
federal law relating to employee benefits and deferred
compensation.
2.
To the extent apportionment of the attributable tax would cause an
acceleration of income taxation or to the extent the property
otherwise would be eligible for exclusion from my estate by
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§2039(c) or §2039(e) of the Code pursuant to the transition rules in
§§52.5(b)(2) through 525(b)(4) of the Tax Reform Act of 1984 as
amended.
3.
Proceeds of life insurance that are exempt from inheritance or
similar death taxes to the extent not subject to apportionment
because paid to a beneficiary other than my personal
representative.
4.
Property not passing under this will to the extent the total tax
attributable thereto is less than *% of the total death taxes
described in paragraph A.
5.
Property passing under * of this will (relating to personal property)
to the extent the total tax attributable thereto is less than *% of the
total death taxes described in paragraph A.
6.
“VIII. Reimbursement: Because it is my intent to apportion death taxes as described
above, it is unnecessary to assert the rights to reimbursement provided by §§2206,
2207, 2207A, 2207B, and 2603 of the Code (and any similar provisions hereafter
adopted) and, except to the extent inconsistent with the foregoing, I hereby waive
those entitlements.
“IX.
Interest and Set Offs: In the discretion of my personal representative death taxes
attributable to property not passing under this will may be paid out of the residue
of my estate prior to recovering the attributable tax from the recipient of that
property.
A.
Attributable tax that has not been paid by the recipient before my personal
representative pays death taxes or that is not yet due because my personal
representative made a valid deferral election under §6161, §6163, or
§6166 of the Code shall bear interest equal to that imposed by the Code on
my personal representative.
B.
In the discretion of either my personal representative or a beneficiary
under this will, as a form of payment by that beneficiary to my personal
representative, any entitlement of a beneficiary under this will may be
applied in payment of that beneficiary's share of the taxes and interest
attributable to other property received by that beneficiary.
C.
In its discretion my personal representative may distribute my estate in
whole or in part prior to final audit and settlement of the tax liability of my
estate, notwithstanding that attributable taxes may be altered thereafter.
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D.
XII.
My personal representative shall not be personally liable for withholding
an insufficient amount as a set off against the liability of a recipient or for
failing to recover attributable taxes or interest following reasonable efforts,
and shall not be required to litigate to enforce apportionment unless
indemnified against the costs thereof.
“X.
Adjustments: My personal representative's selection of assets to be sold to pay
death taxes, and the tax effects thereof, shall not be subject to question by any
beneficiary. My personal representative is hereby indemnified against any
liability it may incur to any recipient of property not passing under this will for the
effect of any action taken in the computation or payment of death taxes that
directly or indirectly affects any recipient's liability under this provision.
Elections or allocations authorized under the Code may be made by my personal
representative in its discretion without regard to or liability for the effect thereof
on any beneficiary or any tax consequence thereof. No adjustment shall be made
between income and principal, in the relative interests of the recipients, or in the
amount or selection of assets allocated to any trust under this will to compensate
for the effect of any such action or for the effect on the amount of any tax
attributable to any recipient of property includible in my estate for death tax
purposes.
“XI.
Conflict of Laws: For all purposes of interpreting this provision and ascertaining
the rights of any recipient of property includible in my estate for death tax
purposes the law of the state of my domicile at death shall govern notwithstanding
the nature or location of the property or the domicile of the recipient.”
CONCLUSION
Having read this outline, the reader is now no doubt in agreement with the author that tax
apportionment is fun and that apportionment will be added as a new topic to be addressed
in the vast majority of client interviews. In all truth, a standard clause directing that all
taxes on probate assets and retirement assets be paid from the residue will all other tax
ratably apportioned will probably suffice in many situations; however, having addressed
the topic with the client as a matter of course, the estate planner will have notes from the
client meeting supporting the decision to apportion taxes in that manner (or whatever
other manner carries out the client’s intent).
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