In my last post, I noted that readers should review their estate planning documents to determine if and how the sweeping new federal tax law impacts their planning. One likely effect that will require married readers to reconsider their estate plans is the common use of formula clauses in wills. A formula in a will is just what it sounds like: instructions relating to the disposition of the estate that are based on some particular formula.
But now, under the new law, this sort of thing in your will could be a formula for disaster!
Let’s consider an example. To minimize the estate tax, many wills provide that the largest amount that can pass tax-free be left to a “credit shelter” or exempt trust…and the balance left either outright to the spouse or to a marital trust, thus deferring any estate tax until the death of the surviving spouse.
Under prior law, the amount to be left in such an exempt trust was $5 million (or the indexed amount which, in 2017, was $5,490,000). Let’s assume our benefactor has an $11 million estate and wants to leave to his children from a prior marriage the amount equal to the federal exemption. To accomplish this, his will provides that such amount (using the formula) be left to the exempt trust.
But now, under the new law, that exempt amount has been increased to $10 million (indexed to $11,180,000 in 2018) and, if our benefactor does not change his will and he dies this year, his children will receive all $11 million, resulting in his wife being disinherited—not his intention! To avoid this, he must have his will revised to limit the funding of the exempt trust to a lesser amount.
Another byproduct of using the higher federal exemption amount may be a state estate tax liability at the first spouse’s death if the state estate exemption is not linked to the federal exemption. To avoid this result, residents of the 17 states that have an inheritance or estate tax should consider revising their wills to limit the funding of the exempt trust to the largest amount that can pass free of both federal and state estate taxes.
Other alternatives to using a formula provision can provide post-mortem flexibility. They include partial qualified terminable interest property (QTIP) elections…Clayton trusts (where property passes to a marital trust only if the executor makes a QTIP election)…and disclaimer trusts where the decedent leaves his estate to the surviving spouse outright who can then disclaim a portion thereof to an exempt trust considering the lower state exemption at that time. These alternatives, however, depend on the surviving spouse or executor making timely elections, which may not always be possible.
Another consideration is whether to use a formula at all where the size of the estate is not likely to exceed the federal exemption. If, for example, the value of a couple’s assets is less than $11 million, it may be better to leave all to the surviving spouse (or a marital trust) so that upon that surviving spouse’s death all remaining assets obtain a step-up in basis to date-of-death value. This would eliminate capital gains tax if the assets were sold shortly thereafter—a tax savings that would not be obtained in a case where the assets funded an exempt trust at the first spouse’s death.
One final suggestion to consider, if you are married, is to review how assets are currently titled between you and your spouse. Unless you reside in a community property state, it will generally be best to separate marital property so that each spouse has at least the equivalent of the exemption amount to be able to take advantage of it at each spouse’s death. Although the ability to transfer the unused exemption still exists (known as portability), it does not generally apply in states that have an estate tax and is also not effective for generation-skipping exemption purposes. So now, with the exemption doubled, each spouse should separately own at least the exempt amount in his/her own name (not including IRA or pension assets that are likely payable to the surviving spouse).