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Estate Planning Tools for Married Couples

Introduction
If you are a couple who has over $675,000 in assets, a hefty tax bill will often result after your death. Your intended heirs will be left with less of an inheritance and Uncle Sam will walk away with more of your money than you would probably like him to have. Fortunately, there are estate planning techniques that can be utilized to reduce, or in some cases eliminate entirely, the estate taxes due upon your death.

The tax problem may not be present upon the death of the first spouse due to something called the marital deduction. The IRS allows the decedent’s estate to take a deduction from estate taxes for the value of any assets passing to the surviving spouse (with certain limited exceptions). Therefore, any assets that pass to the surviving spouse are estate tax free. This seems like a great solution; however a problem arises when the second spouse dies. The second spouse now has a huge estate (due to the inheritance from the first-to-die spouse) and the accompanying huge tax bill. This outcome can be avoided by ensuring that each spouse gets to take advantage of their Unified Credit.

What is the Unified Credit?
In 2001, the government passed legislation exempting a certain amount of each person’s estate from estate taxes. This exemption is called the Unified Credit. The amount of the Unified Credit changes every year according to the following schedule:

2008: $2,000,000
2009: $3,500,000
2010: federal estate tax is repealed

In December 2010, the Legislature passed the Tax Relief Act of 2010 which reinstates the estate tax for a period of two years. For 2011 and 2012, the estate tax is a flat tax at the rate of 35% with a Unified Credit of $5,000,000 per person. However, this Act is set to expire in 2013 unless Congress passes new estate tax legislation in the interim. Special rules may apply to estates of decedents who died in 2010, which exceed the scope of this article. If you would like more information about this topic, please contact our office.

Under the old tax laws, the marital deduction interfered with the ability of both spouses to utilize their Unified Credit. This is because under the old law, the Unified Credit could not be “rolled over” from one spouse to another. Therefore, when the first spouse died and left everything to the survivor, it all passed via the marital deduction (with few exceptions). Since the deceased spouse’s estate was essentially reduced to zero through the marital deduction, the Unified Credit did not come into play and was wasted. The surviving spouse then had a huge estate, and when he or she died, his or her Unified Credit may not have been enough to offset all the estate taxes due. In other words, only one spouse would have been able to make use of the Unified Credit.

Under the new tax law, the outcome would be different because the Unified Credit can now be “rolled over” to the surviving spouse. Therefore, if a husband dies and all of his assets pass to the wife via the marital deduction, the wife can use both her Unified Credit and her husband’s unused Unified Credit upon her death (for a total exemption of up to $10,000,000).

However, as favorable as the new federal estate tax law seems, it does nothing to change state estate tax laws- and many states still have exemption amounts which are significantly less than the federal Unified Credit and which cannot be rolled over between spouses. New Jersey’s exemption amount is only $675,000; therefore, couples with assets that exceed this threshold may still need advanced estate planning techniques in order to reduce or eliminate estate taxes. In addition, if the new estate tax law is allowed to expire in 2013, then the Unified Credit returns to $1,000,000 and tax rates will go up to 41%-55% depending on the size of the estate.

Fortunately, there are several trusts that can be drafted into your will, either individually or in combination, that can reduce or eliminate any federal or state estate taxes that may be due upon your death. The most commonly used trusts are the Disclaimer Trust and the Credit Shelter Trust.

What is a Disclaimer Trust?
The disclaimer trust serves to hold assets in the estate of the deceased spouse so that the applicable exemption (either state or federal) may be utilized effectively. It may seem counterintuitive to keep assets in the deceased spouse’s estate at first glance; however, the tax consequences to the surviving spouse will be much less by doing so. The surviving spouse can disclaim an amount up to that of the applicable exemption into a trust set up by the will. That trust amount will remain in the deceased spouse’s estate for tax purposes; however the applicable exemption will exempt that amount from estate taxes. The surviving spouse will receive the income from the trust for life, and the trustee will be able to use the principal for his or her support and maintenance if the need arises. The trust is then excluded from the surviving spouse’s estate upon his or her death.

How the Disclaimer Trust works is best explained through the use of an example. Suppose a couple, Jack and Jill, have $2 million in assets. Jack dies in 2011, and the Unified Credit amount for that year is $5 million. Jack’s estate is $1 million (half of their total assets) and passes to Jill through a simple will, federal and state tax-free due to the marital deduction. Jack now has nothing left in his estate and therefore cannot use his New Jersey applicable exemption. Jill dies later that year with an estate of $2 million (because she now owns all of their assets after her inheritance from Jack). Jill’s estate is tax-free for federal estate tax purposes, because it is under the Unified Credit amount of $5 million dollars. However, $1,325,000 of Jill’s estate will be subject to the New Jersey estate tax (i.e. the amount of her estate that exceeds $675,000).

Now let’s say that the couple above each had a Disclaimer Trust set up in their wills. Jack dies. Jill disclaims $675,000 of her inheritance into the Disclaimer Trust and receives the rest of his estate ($375,000) through the tax-free marital deduction. Jack’s estate is now $675,000 instead of zero, as it was above. Jack can use his applicable exemption to exempt his estate from New Jersey estate taxes. Jill then dies later that year; however the amount in the Disclaimer Trust is not included in her estate. Therefore, Jill now has an estate of $1,325,000, instead of $2 million as in the example above. The New Jersey applicable exemption will exempt the first $675,000 million from Jill’s estate, leaving only $650,000 subject to New Jersey estate taxes. Even though Jill still had estate taxes due, that amount was greatly reduced through the use of the Disclaimer Trust.

Obviously the variables in the example above will change depending on the tax laws in effect at the time and the size of your estates at your deaths, however, the Disclaimer Trust will function in the same way. This type of trust is unique in that is gives you a great deal of flexibility. If your estates are small enough, or if the tax laws in effect at your death are such that the Disclaimer Trust is not needed, then the surviving spouse can inherit all of the deceased spouse’s assets outright if he or she so desires. The surviving spouse can also disclaim more than the amount of the applicable exemption if splitting the tax bill between the two spouses would be more beneficial.

The Disclaimer Trust is a unique estate planning tool because it allows you to wait and see what the most beneficial course of action will be before making a decision. This type of trust is useful for medium sized estates because at present it is harder to predict whether tax-saving tools will be necessary many years from now when the first spouse passes.

What is a Credit Shelter or Bypass Trust?
The Credit Shelter Trust, also known as a Bypass Trust, is essentially the same as a Disclaimer Trust, except that the option of whether or not to use the trust is taken away. With a Credit Shelter Trust, the trust is automatically funded up to the amount of remaining Unified Credit (or the amount of the state estate tax exemption if that is preferred) at the death of the first spouse. The surviving spouse does not have the option of choosing to inherit all the assets from the deceased spouse outright, and must take at least a portion of his or her inheritance through the Credit Shelter Trust.

This type of trust is useful for estates that are large because it is almost certain that tax saving tools will be needed when the first spouse dies. Even though the surviving spouse’s choice is taken away, this trust has its advantages. With a Disclaimer Trust, the surviving spouse must disclaim within nine months of the deceased spouse’s death. This can be a very confusing and traumatic time, and there is a risk that the survivor may not disclaim within the allowed time period, or may not disclaim enough to render the trust fully effective. A Credit Shelter Trust will be automatically funded with the appropriate amount when the first spouse dies, and the survivor will not have the burden of making the decisions required by the Disclaimer Trust.

The disadvantage of the Credit Shelter Trust is that the surviving spouse will not get a large portion of the assets free and clear. This can be a problem when most of the assets in the deceased spouse’s estate are illiquid (such as real estate, tangible items, or other property that is not money and/or does not produce income). The surviving spouse may not have enough liquid assets (actual money) with which to adequately support himself or herself. With a Disclaimer Trust, the surviving spouse has the option to take the assets outright if they are needed even though it may result in a higher tax burden in the long run.

Conclusion
For medium- to large-sized estates, a simple will is not enough to prevent the government from taking a large part of your estate in the form of taxes when you die. The Disclaimer Trust and the Credit Shelter Trust are two tax-saving tools that will allow you to pass on more of your assets to your loved ones upon your death. If your estate is larger than $675,000 and you are interested in estate planning, please contact our office to discuss your options.

 

The articles on this web site are not intended as a substitute for legal advice and are distributed for general informational purposes only. While every precaution has been taken to ensure the accuracy of this document, Mattleman, Weinroth & Miller assumes no responsibility for any errors, omissions or damages resulting therefrom. If this web site is inaccurate or misleading, you may make a report to The Committee on Attorney Advertising, Hughes Justice Complex, CN 037, Trenton, New Jersey 08625.