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General Impact Of the 2001 Act

On June 7,2001, President Bush signed into law the 2001 Act. New-Section 2210 of the Internal Revenue Code ("IRC") provides that Chapter 11 (the estate tax law) does not apply to decedents dying after December 31, 2009. In addition, the 2001 Act lowers the estate tax top marginal rate to 50 percent as of January 1, 2002, and gradually decrease the rate to 45 percent in 2009. The per person applicable exclusion amount increased to $1M on January 1, 2002, and increases gradually to $3.5M in 2009.

The 2001 Act provides that all of the changes made by the Act themselves cease to have effect, or "sunset," after December 31, 2010. All of today's status quo laws will automatically be reinstated at that time. If nothing more is done, there will be no Federal Estate Tax and no Generation-Skipping Transfer Tax ("GST") applied to the estate of a decedent who dies in calendar 2010, regardless of the size of that person's state. However, if the individual is unlucky enough to pass away on January 2, 2011, the Federal Estate Tax is reinstated with a top rate of 55 percent on taxable estates in excess of $3 million. This result is not fair and is obviously not logical.

Will permanent repeal of the estate tax/GST tax ever in fact occur? The first thing to be said is, of course, that nobody really knows at this point. There will be congressional elections in 2004, 2006 and 2008, and there will be presidential elections in 2004 and 2008. No one knows what the political landscape will be between now and January 1, 2010. Most knowledgeable commentators, however, believe that complete and permanent repeal will not in fact occur. Could these commentators be wrong? Yes!

The budgetary squeeze is upon us already. The economic surplus is gone given the slowing economy and the tax cut. The Counter-War Against Terrorism will consume billions of dollars. In time, there will be pressure for increased spending in the future for items like prescription drug benefits for Medicare, or more aid to education, or missile defense, or infrastructure repair and maintenance (roads, bridges, etc.), or paying down the national debt. Regardless of your political affiliation, everyone agrees that there is a tremendous need for revenue.

The Republicans may attempt to repeal the "sunset" in the next Congress, given the results of the Fall 2002 elections. Given the possibility of a filibuster in the Senate where 60 votes would therefore be required, it is more likely than not that the Federal Estate Tax/GST Tax will not be repealed, but, instead, reformed. The need for revenue is too great, to justify a complete repeal. The revenue lost in the repeal of the transfer tax system will inevitably have to be made up somewhere else in the tax system, which will have an adverse effect on the rest of the taxpayers.

Clients pay lawyers ultimately for their judgment. We are currently advising clients that we do not believe that permanent estate tax repeal will ever in fact occur, but, that no one knows for sure at this point, and we certainly could be wrong. Since we believe, however, that permanent repeal will not in fact occur, continuing prudent estate planning for those individuals who have substantial wealth already today makes good sense.

All the techniques that made sense before the 2001 Act continue to make sense today, with the exception of any technique involving a deliberate annual payment of Federal Gift Tax. Clients continue to utilize techniques, however, that do not involve the payment of any significant annual gift tax, like Grantor Retained Annuity. Trusts, and/or sales to defective grant trusts, and/or a systematic annual gift program using the $11,000 per person per year present interest exclusion, typically involving discounted assets like limited partnership interests or membership interests in a family LLC.

Marital Planning After the 2001 Tax Act

Most Wills or Revocable Trust Agreements contain formula clauses that automatically take advantage of the gradual increases in the applicable exclusion amount. Under such a document, a Family Trust or Credit Bypass Trust of an individual dying in 2001 would be funded with $675,000, assuming no use of the applicable exclusion amount by that tax payer during her lifetime. That same trust, however, would be funded with $1M for an individual passing away in 2002, $1.5M for a demise in 2004, $2M for a death in 2006, and $3.5M for an individual dying in 2009, all as an effect of the 2001 Act. This result may or may not be in keeping with the goals of that taxpayer and her Family, depending upon the total wealth involved, and depending upon the identity of the beneficiaries of the Credit Bypass Trust.

Worst Case Example: Assume a net worth of $3,675,000, where the beneficiaries of the Credit Bypass Trust are the children and grandchildren, and where the amount in excess of the applicable exclusion amount passes to a Marital Trust or passes outright to the surviving spouse. The taxpayer/decedent is told in 2001 when the Will is prepared and executed that only $675,000 will be unavailable to the surviving spouse, and that the rest of the wealth in the approximate amount of $3M will be adequate to support and maintain the surviving spouse. No change is made in the document, and the taxpayer passes away in 2009 with no further growth in net worth. In 2009, $3.5M is allocated to the Credit Bypass Trust, and only $175,000 passes to or for the benefit of the surviving spouse.

The dynamic illustrated above is much more troublesome for families of moderate wealth than for families with very substantial wealth; if the husband is worth $20M, for example, it hardly matters to the support and maintenance of the surviving wife that the Marital Trust is depleted by an allocation of $3.5M in 2009 to the Credit Bypass Trust even if the latter is dedicated entirely to children and grandchildren.

Some marital planing techniques make sense only for the "extremes" of the modest estate or the very wealthy estates. Consider the following schematic:

Modest Estates - less than $2 million total net worth for husband and wife combined, including the face amount of life insurance death proceeds. Key planning fact with basic estate planning implemented correctly, this family will pay. no Federal Estate Tax. No inter-vivos gifts are recommended. 

Moderate Estates - between $2M and $4M. Key planning fact: after 1 / 1 /2006, when the exclusion rises to $2M per person, with basic estate planning implemented correctly, this family will pay no Federal Estate Tax. No inter-vivos gifts are generally recommended if clients in the normal course are expected to live to 1/1/2006; if clients are very old and/or in bad health with shortened life expectancy, then perhaps modest gifts of present interest exclusion amounts would be recommended.

Substantial Estates - between $4M and $7M. Key planning fact: this couple will pay federal transfer taxes unless they both live to 1 / 1 /2009 and provided that the applicable exclusion amount in fact increases to $3.5M per person as scheduled under the 2001 Act. Inter-vivos gifting is recommended for this couple.

Wealthy Estates-over $7M. Key planning fact: unless there is in fact permanent repeal, this family will end up paying federal transfer taxes. Aggressive inter-vivos gifting is recommended for this couple.

It is crucial for families of modest and moderate wealth to make sure that the surviving spouse is the primary beneficiary of the Credit Bypass Trust, which is usually the case already. In cases of modest wealth and moderate wealth, the Credit Bypass Trust typically provides the surviving spouse with an automatic right to income, plus a "5 and 5" invasion privilege, plus unlimited principal for "ascertainable standards," and a testamentary limited power of appointment, with the surviving spouse either serving as sole trustee (less often) or co-trustee with an individual (like a child) who is emotionally sympathetic to the surviving spouse (more often).

For cases involving substantial wealth, consider a dispositive pattern in the Credit Bypass Trust in which the surviving spouse and the Co-Trustee are given discretion to spray income and principal for "ascertainable standards" among the class consisting of the surviving spouse and all of the then living descendants; if the surviving spouse needs supplemental distributions from the Credit Bypass Trust because it, turns out to be funded with $15M because the taxpayer dies in 2009, that need can be accommodated, without at the same time mandating that all income necessarily be distributed to the surviving spouse.

Wealthy estates typically omit the surviving spouse entirely as a beneficiary of the Credit Bypass Trust when the Marital Trust becomes larger than $5M (depending, of course, on age, health and lifestyle needs of the surviving spouse may insist on receiving income from the Credit Bypass Trust, however). If the Marital Trust ever becomes exhausted, then the document would typically require that the surviving spouse receive from the Credit Bypass Trust thereafter a right to income, a 5 and 5 power, discretionary principal distributions for "ascertainable standards," and a testamentary limited power of appointment.

Postmortem Flexibility As Between Marital and Credit Bypass Gifts.

The set of concerns expressed above have led commentators to consider what methods exist to achieve postmortem flexibility with regard to the allocation of funding between the marital gift and the credit bypass gift. Three methods are generally used: disclaimer by the surviving spouse; partial QTIP election; and use of a Clayton QTIP.

Please note that you do not always need to preserve postmortem flexibility. This is especially true in the small estate (where one spouse will leave everything outright to the surviving spouse, with a contingent Residuary Trust in the estate of the surviving spouse for the benefit of the children), or in the very large estate (where the Credit Bypass Trust will be established and held for family members other than the surviving spouse). Postmortem flexibility becomes a more relevant inquiry for the in between estate from $2M to $7M, those involving moderate wealth and substantial wealth.

Disclaimer: Consider leaving everything outright to the surviving spouse in the Will, but providing a Disclaimer Trust in the event that the surviving spouse disclaims. The surviving spouse, would therefore consider the amount of the wealth, the status of the transfer tax law at that time, and his or her own economic needs, in terms of making that decision. A sufficient amount could be disclaimed, for example, to fully fund the credit bypass amount of the first spouse to die, passing that wealth into the Disclaimer Trust, or partially fund the same (because the amount not disclaimed which will still be owned outright by the surviving spouse is less than the applicable exclusion amount available to that surviving spouse).

This technique could also be used with jointly owned property, either joint tenants with right of survivorship or tenancy by the entireties, subject to the special rules with regard to bank accounts, etc. Some planners refer to this structure as the Survivor's Choice Trust. The use of a disclaimer can be problematic, however, for sever reasons. First, after the death of the first spouse, the surviving spouse may change his or her mind and be unwilling. to disclaim even though disclaimer is advisable for good family estate planning. Second, the surviving spouse might inadvertently accept benefits before disclaiming, thereby frustrating the attempt to disclaim. Third, disclaimer to a trust has the disadvantage of foregoing the use by the surviving spouse of a limited power of appointment over that trust property. Thus, the dispositive pattern formulated by the first spouse to die will necessarily control even though circumstances may have changed; an option is to give some other family member like a sibling the power to exercise a limited power of appointment which would take effect upon the demise of the surviving spouse. Fourth, the decision to disclaim must be made within 9 months after the first spouse's demise.

Partial QTIP Election: In this second method, the first spouse to die could leave 100 percent of the property into a QTIP Marital Trust, and there could be discussed with the fiduciary the desirability of possibly making a partial QTIP election, in order to create assets which would consume the applicable exclusion amount of the first spouse to die.

This is a good solution for both minimal wealth and moderate wealth because the non-elected QTIP still provides for mandatory income distribution to the surviving spouse, and the surviving spouse at these wealth levels typically needs all the income. There is, therefore, no ability to either accumulate the income or distribute the same to children and grandchildren. It is usually clear in this wealth context that the surviving spouse will require all income from all the assets owned by the first spouse to die.

The surviving spouse can be the fiduciary or one of the fiduciaries making this decision; all economic benefit stays with the surviving spouse. If the surviving spouse does not turn out to need a high level of income yield from the non-elected QTIP; one could invest the same for low income/high growth.

Clayton QTIP: A Clayton QTIP (the third method) provides that 100 percent of the decedent's wealth is eligible to pass into the QTIP Marital Trust, but only to the extent that the Personal Representative in fact makes the QTIP election; to the extent that the election is not made, the non-elected property passes in another fashion, typically to a Credit Bypass Trust in which the surviving spouse has no economic benefit, or at most, a right to receive a spray distribution of income and principal for "ascertainable standards."

The technique derives from Estate of Clayton v. Commissioner, 976 F.2d 1486 (5th Cir.1992) (rev'g 97 T.C. 327 (1991.)). The case held that eligibility of the property for QTIP is tested only with respect to property for which the election is actually made.

The marital deduction regulations were subsequently amended to reflect these planning possibilities. Regulation Section 20.2056(b)-7(d)(3)(i) now explicitly permits the Clayton QT1P as a planning technique.

The Clayton QTIP thus appears to offer a high degree of certainty and flexibility with regard to this complex dynamic, dependent as it is on the precise state of the wealth and the state of the law at the time of the first spouse's demise.

There is a "trap for the unwary" in the Clayton QTIP, however: it has been pointed out that if the surviving spouse alone is the individual who decides as Personal Representative whether to make the QTIP election, then the IRS has a good argument that a gift has been made by that surviving spouse in the sense of having released a general power of appointment. If the spouse is held to release a general power, then the spouse has made a gift measured by the amount passing away from the Marital Trust. Therefore, it is crucial (at this time, pending clarification of the "trap") that any such Clayton QTIP election be made by a fiduciary other than the surviving spouse.

The surviving spouse may be suspicious of this dynamic; we have found that naming the accountant, lawyer or sibling of the surviving spouse is usually more acceptable than naming a child (who has a conflict of interest because the child is a beneficiary of the Credit Bypass Trust).

Consider Use of Vanishing Marital Trust.

The old technique of the "vanishing marital trust" is receiving new enthusiasm as a result of the dynamic mentioned above. In this planning, a fully funded Credit Bypass Trust is used along with a QTIP Marital Trust. The income in the Credit Bypass Trust is accumulated until the day (if ever) on which the Marital Trust is totally exhausted; if that day ever comes, then from and after that date the surviving spouse is entitled automatically to all of the income generated by the Credit Bypass Trust, along with a "5 and 5" invasion privilege, etc.

The key feature of this technique is that the surviving spouse receives not only all of the income generated by the QTIP Marital Trust, but also automatically receives an amount of principal from the Marital Trust equal to the amount of net income after income taxes accumulated in the Credit Bypass Trust that quarter or year.

This feature causes the Marital Trust systematically to decrease in value, with the Credit Bypass Trust systematically increasing in value, while giving the surviving spouse the cash flow in effect from both funds. This approach can potentially save significant Federal Estate Taxes on the subsequent demise of the surviving spouse.

Using the Exclusion Amount of the Less Wealthy Spouse.

Estate planners have often faced difficulty in making sure there was sufficient assets in the name of each spouse to take advantage of the unified credit equivalent regardless of which spouse died first; this was sometimes difficult when the required level was $600,000 or $675,000.

This potential problem is now more difficult as the applicable exclusion amount has risen to $1M, let alone $1.5M, then $2M, and then $33M. If there is sufficient wealth in the family to justify this level of movement of assets from one spouse to another, it may be difficult to convince the wealthy spouse to implement this transfer to the less wealthy spouse.

Consider as a solution an irrevocable inter-vivos QTIP Marital Trust in this context, with the wealthy spouse retaining a contingent income interest for life in the event that the wealthy spouse survived the less-wealthy spouse. Even though the wealthy spouse is the donor, the contingent right to income after the death of the less-wealthy spouse can be retained without the risk of inclusion of that trust property in the wealthy spouse's estate under Section 2036. See Regulation Section 26.2623(f)-1(f), Examples 10 and 11. This favorable conclusion occurs whether or not the wealthy spouse actually survives the less-wealthy spouse.

Avoid the trap: the wealthy spouse must file a Federal Gift Tax return in a timely fashion, and affirmatively elect to treat the trust as QTIP. Otherwise, there is no QTIP, and the trust does not qualify for the marital deduction in the absence of a timely' election. If no marital deduction qualification is achieved, then the applicable exclusion amount of the wealthy spouse must be used instead. Ouch!

Drafting For Repeal of the Federal Estate Tax.

Many experienced commentators are apparently taking the position that they flatly will not prepare documents today which involve an appropriate estate plan in the event that the client dies at a time when there is no Federal Estate Tax or GST Tax. This position is taken on the grounds that 2010 is simply too far removed in time, and because that particular commentator does not believe in fact that repeal will ever occur. There is no obligation to draft with respect to a set of circumstances which the estate planner in good faith does not believe will ever exist. 

Other estate planners are worried about the possibility that their clients will become incompetent between now and 2010, but will not actually pass away, and that such clients will lose the ability to prepare and implement an alternative estate plan in the event that there actually is repeal. The risk mentioned above seems remote.

This is particularly the case if you discuss with your client the question of whether an alternative estate plan should be prepared because of the possibility that there will be a federal estate tax repeal, coupled with the remote possibility that the client will become disabled but still be alive, and then subsequently die, and the client as a result of that discussion tells you not to bother at your hourly rates from further spinning wheels in that regard. If such discussion has occurred, and the client has made that decision, the lawyer is certainly free from any criticism.

"Standard" Estate Planning for Clients of Substantial Wealth:

The "standard" estate plan utilizes a Revocable Trust for the purpose of avoiding probate, fully utilizes the applicable exclusion amount for estate tax purposes byway of a formula, and fully utilizes the GST exemption amount by formula. It was the starting point for comprehensive planting for clients of substantial wealth before the 2001 Tax Act, and is still used for that purpose today.

No reason can be perceived why some version or variation of this "standard" estate planning pattern should not continue to be used for the foreseeable future for clients whose personal value judgments and goals are compatible with the structure and who have sufficient wealth to justify using the same.

This article has been reproduced with the permission from the Maryland Bar Journal, published by the Maryland State Bar Association.