Time to Review of Estate Planning Documents?

Overview

The laws surrounding estate planning have changed significantly in recent years and have done so multiple times.  That means that it might be a good idea to review wills, trusts and associated estate planning documents to make sure they still will function as intended at the time of death. 

But, just exactly what should be looked for that might need to be modified?  One item is clause language in a will or trust that is now outdated because of the current federal estate tax exemption that is presently much higher than it has been in prior years. 

That’s the topic of today’s post – the need to review and modifying (when necessary) clause language in a will or trust that no longer will work as anticipated because of the increase in the federal estate tax exemption.

Common Will and Trust Language

Wills and trusts that haven’t been examined in the last five to seven years should be reviewed to determine if pecuniary bequests, percentage allocations and formula clauses will operate as desired upon death. For example, if will or trust  language refers to the “Code” and/or uses Code definitions for transfer tax purposes, or otherwise refers to the Code to carry out bequests, that language may now produce a result that no longer is consistent with the testator’s intent.

Common language used in wills and trust to split out shares to a surviving spouse in “marital deduction” and “credit shelter” amounts often refers to the “Code.”  In other words, the split of the shares is tied to the amount of the federal estate tax exemption at the time of the testator’s death.  This results in an automatic adjustment of the marital deduction portion of the first spouse’s estate (as well as the credit shelter amount) in accordance with the value of the federal estate tax exemption at the time of the decedent’s death. 

Why is such language an issue?  For starters, it could result in nothing being left outright to a surviving spouse.  For example, a clause that leaves a surviving spouse “the minimum amount needed to reduce the federal estate tax to zero” with the balance passing to the spouse in life estate form could result in nothing passing outright to the surviving spouse in marital deduction form.  That would be the case, for example, with respect to an estate that is not large enough to incur federal estate tax.  Presently, the threshold for estate taxability at the federal level is a taxable estate of $11.4 million which means that very few estates will be large enough to incur federal estate tax.  For nontaxable estates, the formula language that was designed to minimize estate tax by splitting the bequests to the surviving spouse between marital property and life estate property no longer works - surviving spouse would receive nothing outright.   

On the other hand, a beneficiary of an estate that is not subject to federal estate tax would receive everything under a provision that provides that the beneficiary receives “the maximum amount that can pass free of federal estate tax.” 

Formula clause language.  As can be surmised from above, a common estate planning approach for a married couple facing the possibility of at least some estate tax upon either the death of the first spouse or the surviving spouse has been for the estate of the first spouse to be split into a marital trust and a credit shelter (bypass) trust.  To implement this estate planning technique, the couple’s property is typically re-titled, if necessary, to roughly balance the estates (in terms of value) so that the order of death of the spouses becomes immaterial from a federal estate tax standpoint.  This necessarily requires the severance of joint tenancy property.  Estate “balancing” between the spouses is critical where combined spousal wealth is between one and two times the amount of the federal estate tax exemption.  For many years that range was between $600,000 and $1.2 million.  Then the ranged ratcheted upward to between $3 million and $6 million.  It then moved upward again to a range of $5 million to $10 million.  Now it is a range of $11.4 million to $22.8 million.  

What formula clause language does is cause the trusts to be split in accordance with a formula that funds the credit shelter trust with the deceased spouse’s unused exemption, and funds the marital trust with the balance of the estate.  As indicated above, the increase in the exemption can cause, a complete “defunding” of the surviving spouse’s marital trust and an “over stuffing” of the credit shelter trust.  That may not be what the decedent had planned to occur.  For instance, here’s a sample of language to be on the lookout for:

“To my Trustee…that fraction of my residuary estate of which the numerator shall be a sum equal to the largest amount, after taking into account all allowable credits and all property passing in a manner resulting in a reduction of the Federal Estate Tax Unified Credit available to my estate, that can pass free of Federal Estate Tax and the denominator of which shall be the total value of my residuary estate

For the purpose of establishing such fraction the values finally fixed in the Federal Estate Tax proceeding in my estate shall control.    

The residue of my estate after the satisfaction of the above devise, I devise to my spouse; provided that, any property otherwise passing under this subparagraph which shall be effectively disclaimed or renounced by my spouse under the provisions of the governing state law or the Internal Revenue Code shall pass under the provisions of paragraph…”.

To reiterate, while the above language typically worked well with federal estate tax exemption levels much lower than the current $11.4 million amount, the language can now result in an “over-stuffed” credit shelter trust (and related de-funding of the marital trust).

Consider the following example:

John and Mary, a married couple, had a combined spousal wealth of $3 million in 2001 at a time when the exclusion from the estate tax was $1 million.  As part of the estate planning process, they re-titled their assets and balanced the value of the assets between them to eliminate problems associated with the order of their deaths.  Assuming John dies first with a taxable estate of $1.5 million, the clause would result in $1 million passing to the bypass trust and $500,000 passing outright to Mary in the marital trust created by the residuary language.  Upon Mary’s subsequent death, her estate would consist of her separate $1.5 million (assuming asset values have not changed) and the $500,000 passing outright to her under the terms of John’s will.  With a $1 million exclusion, only $1 million would be subject to the federal estate tax.

With the present $11.4 million exclusion, the clause would result in John’s entire estate passing to the bypass trust, and nothing passing outright to Mary as part of the marital trust.  While the couple’s estate value is not large enough to trigger an estate tax problem, it would be better to have some of the property that the clause caused to be included in the bypass trust be included in Mary’s estate so that it could receive an income tax basis equal to the date of death value.  With the present $11.4 million exclusion, all of John’s property could be left outright to Mary and added to her separate property with the result that Mary’s estate would still not be subject to federal estate tax.  But, all of the property would be included in her estate at death and the heirs would receive an income tax basis equal to the fair market value at the time of Mary’s death. 

Charitable bequests.  The same problem with formula clause language applies to many charitable bequests that are phrased in terms of a percentage of the “adjusted gross estate” or establish a floor or ceiling based on the extent of the “adjusted gross estate.”

Conclusion

The standard advice has been to routinely revisit existing estate planning documents every couple of years.  Not only does the law change, but family circumstances can change and goals and objectives can change.  But, the rules surrounding estate planning have been modified several times in recent years which means that plan should be revisited even more frequently. 

One final thought.  The current rules sunset at the end of 2025 and then revert back to the rules in play in 2018.  That means that the estate tax exemption would go back to $5 million plus inflation adjustments.  So, just because federal estate tax might not be a problem for a particular estate, that doesn’t mean that estate planning can be ignored.  Reviewing wills and trusts for outdated language is important, but overall objectives should be reviewed and related documents such as financial and health care powers of attorney should be executed or modified as necessary. 

The bottom line - there remain numerous reasons for seeing an estate planning attorney for a review of estate planning documents.  Examining drafting language in older wills and trusts is just one of them.