Advice: Estate Planning

Marital Deduction Dos and Don'ts

The marital deduction is perhaps the best-known estate tax reducer. It also is among the most misused planning devices. While powerful, the mari-tal deduction also can trigger higher taxes or other headaches.

The marital deduction is straightforward. The estate executor totals the value of all assets owned by the deceased to arrive at the gross estate. From this is subtracted the value of all property left to the surviving spouse. The marital deduction and the charitable contri-bution deduction are the major deductions in determining the taxable estate.

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There is no limit to the amount of the marital deduction. A married person easily can eliminate estate taxes by leaving the entire estate to his or her surviving spouse. Many people do just that, and it can be a mistake.

In addition to the deductions, every person has a lifetime credit, also called the estate tax exemption equivalent. The credit allows an individual in 2006-2008 to avoid estate taxes on up to $2 million of property left to non-spouses. The amount rises to $3.5 million for 2009.

The marital deduction only defers taxes, it does not eliminate them. All the property that was transferred to the surviving spouse is taxed at that spouse's death if it remains in his or her estate.

When the entire estate is left to the surviving spouse, the lifetime exemption amount of the first spouse is lost.

It was not used by the estate of the first spouse to die, and it cannot be transferred to the surviving spouse. The surviving spouse has only one lifetime exemption to shield what is now the combined estate of both spouses. The surviving spouse also must do all the estate and tax planning for the combined estates.

Loss of the life exemption is not a problem is if the combined estates are less than $2 million, but it can create unnecessary taxes for larger estates. Remember the value of the estate at the time of the surviving spouse's death determines the tax burden. An estate might be less than the exempt amount when it is inherited but be above the exempt amount when the surviving spouse passes away. Also, the estate tax law will change in coming years. In 2010, it is eliminated. But in 2011, if there is no additional legislation, the pre-2001 estate tax will be restored with a lifetime exemption of only $650,000 per person.

Another problem with making full use of the unlimited marital deduction is the person you ultimately want to have property might not receive it. Many people assume their surviving spouses will leave their estate to the children of the marriage. Other people desire that some or all of the wealth eventually be given to certain charities.

Those wishes might not be fulfilled if property is left outright to the surviving spouse. To qualify for the marital deduction, property generally must be given to the surviving spouse without restrictions. While the spouses might have been in agreement when the will was signed, things can change. The surviving spouse might remarry and change priorities. He or she might decide the children can take care of themselves and the wealth is better left to other relatives, friends, or charities. The surviving spouse also might favor one child over the others.

Another problem is that the surviving spouse might not be able to manage the estate. While professional advisors can help, the surviving spouse might terminate them, be unable to evaluate whether they are doing a good job, or come under the influence of an undesirable manager.

There are several ways to deal with these potential problems without impoverishing the surviving spouse.

A popular solution we have discussed in past visits (see the April 2005 and August 2006 issues) is the QTIP trust, or qualified terminable interest property trust. The trust qualifies for the marital deduction.

In a QTIP trust, the surviving spouse must receive all income generated by the trust property for life, paid at least annually. The surviving spouse also is allowed to receive distributions of principal if needed to pay for necessities. After the surviving spouse's death, the property passes to the remainder beneficiaries of the trust, who usually are the children of the couple.

The QTIP trust only defers taxes. The amount remaining in the trust is included in the estate of the surviving spouse. Using the trust, however, ensures that the estate of the first spouse is not taxed, the trust remainder will be disposed of as the trust creator intended, and the surviving spouse will have sufficient assets.

Another solution is the credit shelter or A/B trust.

This trust normally has the surviving spouse as beneficiary for life. The spouse who created the trust can set lifetime payments however is desired. The surviving spouse can receive primarily income, supplemented by principal payments for specific purposes. Or payments can be a fixed amount or a percentage of the trust. The trustee can be given discretion to set or increase the distributions.

Payments to the remainder beneficiaries also are flexible. The trust property can be distributed to them after the surviving spouse passes, or the annual payments can continue under a formula or at the trustee's discretion.

The credit shelter trust is offset by the lifetime estate tax exemption amount. The remainder of the estate can be left to the surviving spouse under the marital deduction. This ensures that the entire estate can be used to support the spouse, the estate escapes estate taxes, the exempt amount is used, and the amount in the trust eventually is disposed of as desired.

These days it is important not to put too much property in the credit shelter trust. It used to be that the trust automatically was funded with assets equal to the estate tax exemption amount. With today's higher exempt amount, the trust could take all or most of many estates. The result is that the surviving spouse would receive few or no assets outright and have to depend on the trust for income. It is better to state either a specific amount or a percentage of the estate to fund the credit shelter trust.

These strategies and others can be combined to make good use of the marital deduction as in this example.

Max Profits has a $5 million estate, is married to Rosie, and has several children. Max's leaves $2 million to a credit shelter trust with Rosie as the lifetime beneficiary and the children as remainder beneficiaries. Another $500,000 is left outright to Rosie, and the remaining $2.5 million is put in a QTIP trust with Rosie as beneficiary for life and the children as remainder beneficiaries. This arrangement uses most of Max's lifetime exemption, leaves Rosie adequate income and access to capital, and ensures the property eventually goes where Max intended.

The marital deduction is a valuable and flexible estate planning tool, but should not be overused. The deduction can be combined with other tools to maximize the after-tax amount left to heirs and to ensure the heirs eventually receive the wealth.

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