Estate Plan Building Blocks: Estate Tax, The Marital Deduction and Trusts

Many people have procrastinated about Estate Planning. They delayed making or updating plans because of uncertainty over the tax law or turmoil in asset values. People naturally procrastinate because estate planning is complicated and full of unfamiliar terms and concepts.

Most of you will have or at least consider the same basic tools and strategies for your estate plans. These tools are the foundation of most estate plans, regardless of the amount of wealth and types of assets in the estate. Other concepts can be introduced as wealth increases or there are complications in the assets or family situation. But these basic strategies are key elements of many plans. Become familiar with these concepts and you will be able to discuss estate planning options intelligently with your financial planner.

First remember this basic concept. The estate tax is based on the value of all assets owned. Taxes are reduced by excluding assets from the estate, reducing their value, taking estate tax deductions, and using credits against the estate tax. Now, let’s look at the key strategies for many estate plans.

Marital deduction. Estate taxes can be avoided entirely by a married person simply by leaving the entire estate to the spouse. The value of all the property in the estate is known as the gross estate. The value of all property left to the surviving spouse is deducted from the gross estate as the marital deduction.

Name the spouse as the sole beneficiary of the estate, and there are no estate taxes.

There are risks to using the marital deduction to reduce or eliminate estate taxes. The marital deduction only defers taxes. All the property is included in the surviving spouse’s estate, and he or she will not be able to use the marital deduction without remarrying. In addition, each person has a lifetime estate and gift tax credit, which effectively excludes $3.5 million from estate taxes in 2009. When the first spouse to pass away makes full use of the marital deduction, that spouse’s lifetime credit is wasted. All the burden of planning to reduce taxes is on the second spouse, who has no marital deduction and only one lifetime credit.

This is not a problem with a relatively modest estate that is not likely to be taxed. For that estate, tax planning is secondary. For other estates full use of the marital deduction can be a problem.

Another potential problem with full use of the marital deduction is some or all of the ultimate beneficiaries of the assets might not be your first choice. Your spouse might remarry and leave some or all of the assets to the new spouse or members of the new family. A charity might attract the attention of the surviving spouse. Or the spouse might favor some of the children or grandchildren in a way you would not. The surviving spouse also might not be able to manage the assets.

Finally, the spouse might not be able to manage the assets.

Marital deduction trust. This trust takes advantage of the marital deduction while reducing the asset management risk. The spouse receives income from the trust as needed and also potentially all the principal over time. The spouse also can appoint the successor beneficiaries of the trust, those who receive trust assets after him or her.

The trustee manages the assets and can be given discretion to distribute the principal and income. You can provide guidelines for the distributions. The entire value of this trust is included in the estate of the surviving spouse and qualifies for the marital deduction.

QTIP trust. Qualified Terminable Interest Property (QTIP) is property that qualifies for the marital deduction. Leaving assets to a QTIP trust is another way to use the marital deduction while limiting some of its risks. To qualify for the marital deduction, the trust must distribute all of its income to the spouse at least annually. The spouse also can have access to the principal to pay for medical expenses and other living expenses, at the trustee’s discretion. You can give the trustee guidelines for making the distributions.

The spouse has no right to designate successor bene-ficiaries. You name the beneficiaries in the trust agreement. So, the QTIP trust provides management of the assets and lets you determine who eventually receives the remaining property. The QTIP trust is especially popular in second marriages.

The QTIP trust assets are included in the estate of the surviving spouse. So, that spouse still must plan to reduce taxes on the property.

Bypass trust. This trust allows you to take advantage of the lifetime estate and gift tax credit, provide for a surviving spouse, provide management of the property, and retain some control over the property.

Property that does not qualify for a deduction has the lifetime credit applied against it. The credit in 2009 allows each person to pass up to $3.5 million free of estate taxes. To make use of the lifetime credit, you could leave property outright to someone other than your spouse, such as your children. But you might not want to give full ownership of the property right away. For example, the beneficiaries might be children. Also, your estate might not be large enough to give the property to your children and still provide for your spouse.

The bypass trust solves most of those problems. Your will leaves property to the trust (also known as an AB trust). The property passes tax free to the extent you have not used the estate and gift tax credit. The terms of the trust can be very flexible. In the standard case, the trust pays income and principal to the surviving spouse for life to the extent needed. You can set a formula or specific amount for the payments or give the trustee discretion. After the spouse passes away, the trust property goes to the children or other beneficiaries you named. As I said, the trust is very flexible. You can leave the property to the children in equal or unequal amounts, have them take direct ownership or keep it in the trust, or leave it to someone else.

The trick with the bypass trust these days is how much to put in it. Before 2001, the standard will provision was to leave the estate and gift tax exemption amount. Then, the amount was $650,000. For 2009, the exempt amount is $3.5 million. Most estates are not big enough to put that much in the bypass trust and leave enough to the surviving spouse for him or her to be independent. In addition, the value of the estate might fluctuate wildly. As we have seen $3.5 million might be a minority of an estate at one point and be the entire estate a year or so later.

A better solution now is to use a formula to fund the bypass trust. The will can state that the trust receives the lesser of the exempt amount or another stated amount, say $1 million. Or the bypass trust can receive only a percentage of the gross estate. Again, this can be limited by a stated amount.

Equalize estates. The lifetime estate and gift tax credit of each spouse can be maximized only if each spouse owns enough property. If one spouse owns title to all the property and the other spouse dies first, the lifetime exemption of that first spouse to pass away is lost. The exemption can be used only to the extent the person has title to property.

To avoid losing a lot of one spouse’s exemption and to make planning more flexible, it is best to equalize the assets owned by each spouse or at least make sure each owns a significant portion of the estate.

Equalizing estates is fairly easy, since unlimited gifts can be transferred between spouses free of gift taxes. There can be difficulties when a significant part of the estate is in certain types of assets, such as retirement plans or a small business. In other cases, an estate planner first wants titles adjusted so that each spouse owns some of the estate.

Here is how these tools can be combined in a typical estate plan. The estate owner first decides how much to leave in the bypass trust to avoid all estate taxes. Under the will this amount will be placed in a bypass trust that first benefits the surviving spouse and then the children and perhaps the grandchildren. (Some estate owners will have the trust benefit the children of their first marriage.)

The remainder of the estate is left to the spouse either directly or in a QTIP trust. It qualifies for the marital deduction.

Through this arrangement, all estate taxes are avoided. The estate of the second spouse might incur some taxes, depending on how much property he or she has. The objects of the estate owner’s affection are protected, and if necessary the assets can be managed professionally through trusts.

There are many other estate planning tools to fit different situations, but most estate plans begin with this basic model. If you understand these concepts, you will be able to engage in intelligent discussions with an estate planner and develop a good estate plan.