Here Is Your Will – Do You Want Tax Planning To Go With That?

May, 2016  | By Carl E. Eastwick

These days only a few wealthy families will pay the federal estate tax. But for residents of Maryland, the state estate tax may perplex people planning to pass on more modest wealth. Since the federal and Maryland estate tax systems will be out of phase until 2019, estate planners should contemplate crafting special Maryland-only provisions into plans until the tax laws are again in synch.

For most people, the federal estate tax is dead! If you die this year, 2016, your family and friends will not have to deal with the IRS’s “Death Tax” unless you have more than $5,450,000 to leave to them. Only a handful of the U.S. citizens dying each year have taxable estates larger.

So much for the U.S. estate tax, such as it is. But what about that pesky Maryland estate tax which starts eating into estates of $2,000,000 or more if you die in 2016? Our State has written its own tax law which will persist no matter what the federal government does. Nevertheless, Maryland is on track to synch with the federal estate tax threshold on this schedule:

If you die during The Maryland tax hits estates above …
2016 $2,000,000
2017 $3,000,000
2018 $4,000,000
If you die after December 31, 2018, the Maryland tax threshold is the same as the federal in effect at that time.

Without planning, married couples with over $1,000,000 in combined assets expose the estate of the surviving spouse to an estate tax. However, the same couple may choose to limit the estate tax, or even eliminate it altogether, by making use of a “bypass trust” or a “credit shelter trust”. Let’s see how it is done.

The “Sweetheart Will” is a Tax Trap. A marital deduction is hard wired into the estate tax laws. That means that a married person can leave the surviving spouse an unlimited estate without having to pay an estate tax immediately. Thinking in the short term, one is tempted to sign a simple Will giving the entire estate to the surviving spouse. But in the long term couples who opt for these “Sweetheart Wills” unnecessarily play into the hands of the tax collector. A surviving spouse receives the assets of a deceased spouse free of estate tax, but the full tax on the spouses’ combined assets comes due when the survivor dies.

Example – “Romeo and Juliet”. Romeo and Juliet are married (forget about the end of Mr. Shakespeare’s tragedy) and together they own property worth $2,000,000. Conveniently, their property is evenly divided. Romeo and Juliet each owns property worth $1,000,000. Each of the lovebirds has a Will which leaves all of the property to the survivor. When the survivor dies, all of the property in the hands of the survivor will pass to the children under the survivor’s Will. If Romeo dies first, his property worth $1,000,000 will be transferred to Juliet. After she dies, all of the $2,000,000 concentrated in her hands will pass to the children. Using her federal estate tax credit she shelters all of the inheritance from U.S. estate tax. But her Maryland estate tax credit is only $1,000,000, leaving the other $1,000,000 unprotected. Her estate will pay $99,600 to the State of Maryland. The children’s legacy is reduced by 4.98% to $1,900,400.

What Happened? The couple incurred the Maryland estate tax because Romeo did not plan to use his $1,000,000 credit exemption amount. His Will forced all of his property to pass to Juliet. After the allowance of the marital deduction the taxable estate was reduced to $0! His estate produced no tax, hence no opportunity to apply his credit amount came to hand. Moreover, his credit amount is not portable. Romeo’s unused credit died with him. The estate tax on his $1,000,000 was simply deferred until Juliet’s death.

Let’s Fix It. Romeo must preserve his estate tax credit amount. The first idea which comes to mind is give $1,000,000 to somebody other than Juliet, for instance, the children. That works as a tax saving plan, but Juliet would not be pleased. Her financial nest egg following Romeo’s death would be reduced by 50%. The couple can permanently reduce the estate tax payout as well as provide Juliet with financial security: use a Bypass Trust.

Example – “Bonnie and Clyde”. Bonnie and Clyde, like Romeo and Juliet, each has $1,000,000 to his or her name. (Bonnie married Clyde after a career in banking and had children.) Bonnie and Clyde each has a Will which specifies that $1,000,000 will pass to a Bypass Trust. If Bonnie dies first, her $1,000,000 will be held for Clyde’s benefit. He will have access to the principal and income of the trust for his lifetime. When he dies, the remaining balance of the trust will be distributed to the children, in addition to Clyde’s own $1,000,000 which passes to them at Clyde’s death. Neither Bonnie’s nor Clyde’s estate pays any estate tax. The children receive all of the $2,000,000.

What Happened This Time? The $1,000,000 passing from Bonnie to her Bypass Trust is sheltered by the tax credit and is not taxed. The better news is that it will not be taxed at Clyde’s death because the amount in the trust “bypasses” his estate on the way to the children.

Tax planning can be 100% successful for an estate of a married couple with assets of more than $1,000,000 but less than $2,000,000. Let’s turn to an estate of a couple which comes in between $2,000,000 and $10,900,000.

Example – “Anthony and Cleopatra”. Anthony and Cleopatra are a wealthy couple (and have re-settled in Maryland after an extended stay in Egypt). Together, they have assets totaling $10,900,000. Each of them has a Will which gives a certain amount of his or her estate to a Bypass Trust. The amount going into the Bypass Trust is determined by a formula. The formula says, in effect, “give my Bypass Trust an amount equal to the amount of my available federal estate tax credit.” Anthony dies, and his entire $5,450,000 is used to fund his Bypass Trust. Nothing passes to Cleopatra. His estate pays no U.S. estate tax, but it pays $229,200 to Maryland. The same thing happens when Cleopatra dies.

The “Decoupling Problem”. Anthony and Cleopatra encountered the effects of the “decoupling” of the Maryland estate tax system from the federal. Decoupling presents a conundrum with two mutually exclusive solutions.

Solution #1. If the couple takes full advantage of the federal credit according to the funding formula, each would leave $5,450,000 to a Bypass Trust. Nothing is left to the surviving spouse. No marital deduction is applied. An estate that size is protected by the federal tax credit, but $2,500,000 is left exposed to the Maryland estate tax since the State credit is only $1,000,000. The $2,500,000 difference is the “gap amount”. If Anthony dies first, his estate for federal and Maryland purposes is $5,450,000. The estate pays Maryland tax of $229,200 at the first death. It avoids the U.S. tax because the tax credit wipes out the tax liability. When Cleopatra dies, Anthony’s Bypass Trust goes straight to the children avoiding her estate, while the balance of her estate is protected by her federal credit amount. For Maryland purposes, her estate is worth $5,450,000 and pays a tax of $229,200. The total tax paid is $458,400, all to Maryland.

Solution #2. The other solution is to rewrite the Bypass Trust formulas so that only the Maryland credit amount is funneled into the trust. The remaining $2,500,000 is given to the surviving spouse. The rewrite eliminates the tax at the first death, but the $2,500,000 “gap amount” passing to the surviving spouse is taxed when he or she dies. The bottom line is that the tax on the “gap amount” is deferred until the death of the surviving spouse. If Anthony dies first, the Bypass Trust is funded with only $1,000,000. The remaining $2,500,000 passing to Cleopatra is covered by the marital deduction, reducing his taxable estate to a mere $1,000,000. Anthony’s estate pays no Maryland or U.S. estate tax. Cleopatra then dies. Her estate consists of her $5,450,000 plus the $2,500,000 from Anthony, combining into a total estate of $6,000,000, all of which is taxed by the U.S. and Maryland. The tax collectors are the beneficiaries of $1,405,940, or 23.43%, of her estate. It pays $895,140 to the IRS and $510,800 to Maryland.

Neither of these solutions is pleasant to contemplate. The first results in a tax at the first death, and the second defers the tax at great price. Some help, albeit incomplete help, is at hand: the “Maryland-Only QTIP Trust”. It works like this.

The Maryland-Only QTIP Trust Solution. Let’s forget about Solution #2 and instead work with Solution #1 to eliminate the tax at the first death. Relief for the surviving spouse lies in a provision of Maryland law which allows us to use the full federal tax credit and, at the same time, treat the ”gap amount“ as being eligible for the marital deduction. The plan, with several variations, follows this basic pattern. First, put the Maryland exemption amount ($1,000,000) into a Bypass Trust and put the rest of the estate into a Marital Trust. The Marital Trust exists for the sole purpose of supporting the surviving spouse for life, but anything left in the trust when the spouse dies is taxed. Second, segregate the “gap amount” portion of the Marital Trust from the amount in excess of the “gap amount”. At this point we may have three trust portions, depending on the size of the estate. The first $1,000,000 goes in a Bypass Trust, the “gap amount” is segregated from the rest of the Marital Trust, and the excess amount is held separately for the surviving spouse’s sole benefit. Third, treat the “gap amount” part of the Marital Trust like it is a chameleon. For federal purposes it looks like a Bypass Trust and for Maryland purposes it looks like a deductible marital gift.

The Final Result. The estate of the first spouse to die pays no estate tax. No estate tax is paid to either the U.S. or Maryland at the first death. At the second death, no Maryland or U.S. tax is due on the Bypass Trust. No federal tax is payable on the “gap amount” portion of the Marital Trust. However, Maryland will collect its tax on the “gap amount” if the surviving spouse’s estate, including the “gap amount”, exceeds $1,000,000. Cleopatra’s estate would be worth $6,000,000 for estate tax purposes and would pony up $510,800 to Maryland, but nothing to the IRS.

Summing Up. The Maryland-Only QTIP Trust Solution offers a way to avoid all estate tax when the first spouse dies. That is a good outcome, especially for the surviving spouse. It also may eliminate or reduce the federal estate tax. That is an even better outcome for the family, especially the children. The cost of this technique for a couple with a combined estate of $10,900,000, compared to Solution #1, is a bit more Maryland estate tax, namely, $510,800 versus $458,400. But the couple avoids a $895,140 federal tax.

The “Portability Miracle”. A critical reader would have noted that, in each of the case studies, each spouse owned exactly one-half of the couple’s combined assets. In particular, the tax savings achieved by Anthony and Cleopatra are at a maximum only if each spouse owned one-half of the combined assets of the couple. Critically, the Bypass Trust for the purposes of the federal tax is most efficient if the level of its funding at the first death does not depend on which of the spouses dies first. The ideal is that each spouse owns half of the assets in order to assure the funding of the Bypass Trust at the same level no matter who dies first. Otherwise, the tax savings would be eroded if the “poorer” spouse died first and could not fund his or her Bypass Trust as fully as possible.

Starting in 2011, the federal estate tax was changed to make unbalanced ownership of assets less of a tax planning concern. It is now possible for the unused portion of the “poorer” spouse’s exclusion amount to be carried forward to the surviving spouse’s estate. Say the deceased spouse’s estate amounted to $3,000,000, and that the surviving spouse owned assets worth $7,900,000. The deceased spouse did not use all of the available exclusion amount, which in year 2016 is $5,450,000 (and will be indexed for inflation in future). He or she left $2,360,000 on the table. In years past, that amount would have been gone forever. Now, the surviving spouse may pick up that $2,360,000 and add it to the $5,540,000 in his or her pocket and shelter up to $7,900,000 in assets at his or her death.

The Maryland estate tax has no portability feature. Maryland residents who die before 2019 will not be able to pass on their unused exemption amounts to their surviving spouses. During this interim period married couples with a desire make maximum use of their Maryland exemption amounts should take steps to equalize the values of their estates.

Do I Need a Bypass Trust? With the introduction of portability even Anthony and Cleopatra’s “Sweetheart Wills” are not a tax disaster. For federal estate tax planning, they probably do not need a Bypass Trust if their combined estates are less than the federal exclusion amount and the other beneficial features of such a trust are not attractive. However, the answer may be “Yes” if they count on reducing Maryland estate taxes. Adding a Marital Trust also is desirable for the purpose of deferring Maryland estate taxes until the surviving spouse dies.