TAX APPORTIONMENT - WHAT WOULD THE TESTATOR WANT?

Transcription

1 TAX APPORTIONMENT - WHAT WOULD THE TESTATOR WANT? Barbara A. Sloan McLaughlin & Stern, LLP New York, New York I. INTRODUCTION A. The Issue 1. Thinking through how the taxes will fall in a client s estate plan is often one of the most challenging aspects of developing the plan. The tax apportionment clause may be the most complex provision in a client s will. Moreover, even where the issue of tax apportionment has been raised with the client, many drafting pitfalls may impact the manner in which taxes are apportioned in surprising and unwelcome ways. 2. Estate planning attorneys often select the tax apportionment clause in a client s will without consulting the client. In some cases, this may be tantamount to determining the client s dispositive plan.. B. Scope of this Outline 1. This outline will review: 1 a. the sources of law regarding apportionment of federal and state death taxes in general, b. the basic alternatives with regard to apportionment of estate taxes; and c. selected drafting considerations regarding apportionment clauses to be included in wills and other estate planning documents. 1 Although no federal estate taxes are imposed this year, 2010, it seems certain at this time that the federal estate tax will return for 2011 and the years thereafter, albeit at rates and with exemption amounts that cannot be predicted with certainty. Copyright 2010 by Barbara A. Sloan

2 2. It is the intent of this outline to address practical planning issues related to apportionment of death taxes, rather than to undertake a complete analysis of all issues related to tax apportionment. For a thorough presentation of the topic of tax apportionment, see Pennell and Danforth, 834 T.M., Transfer Tax Payment and Apportionment. C. Significance of Tax Apportionment 1. Everybody Has One. a. Estate planners often say that if an individual does not have a will, she nevertheless has an estate plan -- one that the state has written for her. b. Similarly, if a will or revocable trust does not include a tax apportionment clause, applicable law will fill the gap. The only question is whether the applicable provisions are what the client would want. c. Each client with a taxable estate deserves to have the unique tax apportionment issues of her estate thought through carefully, fully explained and meticulously drafted. 2. Tax Apportionment Affects the Size of Bequests. a. Most estate planners take great pains to explain thoroughly the size and nature of federal and state death taxes which are likely to be imposed on the client s estate. b. Unfortunately, many planners do not the explain to the client that these taxes can be allocated among their beneficiaries in a variety of ways. c. As a result, the drafting of the tax apportionment clause (or the use of a form clause) may substantially affect the distribution of the client s estate in ways that the client does not expect and would not choose. d. Unfortunately, the case law is rife with examples where the client (and the client s beneficiaries) would have been better off if the estate planning attorney had not included any tax apportionment clause at all

3 3. Tax Apportionment Is Not Applicable in Many Estate Plans. a. Generally, tax apportionment will not raise serious issues in estates where: (1) no tax is due because: (a) (b) the estate does not exceed the federal and state applicable credit exemption amounts or the will (or revocable trust) is drafted using a credit shelter/marital deduction formula that ensures no federal and state estate tax will be due and the spouse survives or (2) all of the property, both probate and nonprobate, passes to the same people in the same shares. b. Under these circumstances, burdening any one source (e.g., the residue) with the tax or apportioning the tax between probate and nonprobate property will probably result in all of the beneficiaries receiving the same shares in either case. c. To the extent that we draft frequently for these types of estates, it is easy to embrace a standard tax clause and neglect to think through and discuss the tax apportionment issues with the client, although even in some of these cases, the tax apportionment clause as it would apply to the contingent beneficiaries, if the spouse and/or children do not survive the client, may need close attention. 4. Estates Which Require Tax Apportionment Analysis. a. In simplistic terms, careful consideration of tax apportionment issues is necessary whenever: (1) The estate is likely to generate a state or federal death tax; (2) Different instruments direct property to different beneficiaries in different shares; (3) Substantial credits or deductions are likely to be available to reduce a portion of the tax due; or - 3 -

4 (4) A substantial portion of the estate is composed of nonprobate property. b. Unfortunately, it is not always obvious whether an estate will meet any of these criteria. In addition, as a result of post mortem alternatives (e.g., disclaimers or partial QTIP elections), an estate that is not expected to fall into one of these categories may. Thus, the better course is to attend to the tax apportionment clause as a matter of habit. II. GENERAL RULES AND CONSIDERATIONS A. Imposition of Federal Estate Tax 1. Section 2001(a) of the Internal Revenue Code of 1986, as amended, 2 imposes a tax on the transfer of the taxable estate of every decedent who is a citizen or resident of the United States. 2. The executor of the decedent s estate is personally liable for the tax, whether on probate or nonprobate property If no executor is appointed, any person in actual or constructive possession of the decedent s property is required to pay the entire tax to the extent of the property in her possession. Treas. Reg Executor is defined to mean the executor or administrator of the decedent s estate To ensure that the liability for the tax is clear, any recipient of nonprobate property who pays tax has a right of reimbursement from the estate a. Section 2205 provides that, subject to a direction under the will of the decedent, taxes shall be paid out of the residue of the estate before its distribution. b. However, Riggs v. Del Drago, 317 U.S. 95 (1942), clarified that this provision does not preempt state law apportionment statutes. Rather, it simply provides that payment of tax is to be made from the estate. As a result, section 2205 is applicable only if the 2 Unless otherwise provided, all references herein to section numbers will be to the Internal Revenue Code of 1986, as amended (the Code )

5 decedent s will does not express a contrary direction and state law does not direct some form of tax apportionment. 6. In addition, if the executor distributes the property of the estate prior to paying the tax, the transferee is also personally liable for payment of taxes up to the amount of the property the transferee received. 6901(a)(1) and (h). 7. The liability for unpaid estate tax is secured by a lien, under section 6321 for the personal representative and under section 6324(a)(2) for a transferee. 8. Procedures for discharging personal liability for tax are available under section 2204(a) for personal representatives, section 2204(b) for fiduciaries other than personal representatives and section 6325(c) for transferees. B. Taxes and Tax Benefits to Be Apportioned 1. Death Taxes. Following 2010 when the federal estate and generationskipping transfer taxes will be reinstated, tax apportionment planning will be just as challenging as ever due to the number and complexity of taxes which must be considered. a. The Federal Estate Tax. This is likely to be the lion s share of the death taxes. As a result, apportionment of this tax should be addressed first. b. State Death Taxes. (1) Starting in 2011, in states where the pick-up tax will be revived, like New York, the state estate tax is based on the amount of the state death tax credit available under federal estate tax law and the state death taxes should be apportioned in the same manner as the federal estate tax. (2) However, in states which impose a separate system of taxation for death taxes, the apportionment of these taxes must be considered separately. This is particularly true for states that impose different tax rates based on consanguinity

6 (a) (b) (c) For example, in a state where bequests to linear descendants are exempt from inheritance tax and bequests to non-related persons are subject to inheritance tax, a division of the residue among them will yield differently sized shares, depending on how the inheritance tax is apportioned. See Pfeufer v. Cyphers, 919A.2d 641 (Md 2004) (holding that inheritance tax can be charged to residue at testator s discretion even if residue passes in part to individuals not subject to inheritance tax, but shifting of burden of tax is additional gift to beneficiary subject to inheritance tax). The effect of paying inheritance tax which is imposed differentially on different beneficiaries from the residue is to equalize the rate of tax applied to all beneficiaries, although it increases the amount of tax due by increasing the gifts to the beneficiaries subject to the higher rate of tax. If the testator would like for beneficiaries in different categories for purposes of inheritance tax to receive equal shares, an alternative the client may want to consider is simply to increase the size of the shares passing to higher tax rate beneficiaries to offset the higher rate of tax and to apportion the tax among those beneficiaries whose bequests generate the tax. Of course, this solution will also increase the inheritance tax to be paid. (3) Under current law, after the sunset provision of the Economic Growth and Tax Relief Reconciliation Act of becomes effective, the federal estate tax law will 3 4 P.L ( EGTRRA ). Section 901 of EGTRRA provides: (a) IN GENERAL. All provisions of, and amendments made by, this Act shall not apply --- (1) to the taxable, plan, or limitation years beginning after December 31, 2010, or (2) in the case of Title V, to estates of decedents dying, gifts made, or generation skipping transfers, after December 31,

7 return to its 2001 structure, including a $1 million applicable exclusion amount and a 55% rate of tax, and many states, like New York, will once again have estate tax laws that are coordinated with the federal law. In this case, the apportionment of state estate taxes imposed in these states will not need as much separate attention as has been warranted in recent years. However, in circumstances where the applicable exclusion amount for federal purposes is not the same as the amount for a particular state, for example, in New Jersey where the applicable exclusion amount will remain at $675,000, then planning for apportionment of state estate taxes in such a state will continue to require separate attention from apportionment of federal estate taxes. c. Generation-Skipping Transfer Tax. (1) Starting again in 2011, because of the flat 55 percent rate of the generation-skipping transfer ( GST ) tax, it is imperative to plan for these taxes. (2) Unfortunately, many generation-skipping transfers may not be intended or, in some cases, may not even be anticipated as when a child disclaims in favor of grandchildren. (3) Chapter 13 contains its own rules for apportionment of the GST tax liability which are discussed below. 2. Property Which Receives Special Tax Treatment. The allocation of tax to special types of property must also be considered in analyzing the apportionment of taxes. a. QTIP Property. (1) Because QTIP property is includible in the surviving spouse s estate under section 2044 even though it is distributed to the beneficiaries as directed by the terms of (b) APPLICATION OF CERTAIN LAWS. The Internal Revenue Code of 1986 and the Employee Retirement Income Security Act of 1974 shall be applied and administered to years, estates, gifts, and transfers described in subsection (a) as if the provisions and amendments described in subsection (a) had never been enacted

8 the QTIP trust, it is critical to think through who should bear the tax, from where the funds should come to pay the tax and all of the places in which the tax apportionment language should appear. (2) In addition, a federal apportionment statute will apply to apportion taxes directly to the QTIP at the highest marginal rate unless it is specifically waived. This requirement will be discussed further below. b. Special Use Valuation Property (1) The ability to make a special use valuation election under section 2032A provides a substantial benefit to the estate. (2) The section also requires recapture of the tax benefit in the event that the special use is discontinued prior to 10 years or the property is disposed of in a nonqualifying manner. (3) Since the qualified heir who receives the property is responsible for the recapture tax, notions of fairness indicate that he or she should receive the benefit of the tax savings. See e.g., Estate of Nevius 172 P.3d 1221, 2007 WL (Kan. Appp.) (Raising the issue of whether the benefit of the $870,000 reduction in estate tax caused by the 2032A election made by beneficiaries receiving certain property should benefit those beneficiaries making the election). c. Qualified Plan Benefits (1) More and more frequently, qualified plan assets constitute a substantial portion of a client s estate. (2) Substantial estate tax and tax due on income in respect of a decedent may be generated by these assets. However, due to the unique tax character of qualified plan assets, apportionment of the pro rata share of tax attributable to the value of these assets may not be possible or desirable

9 d. Family-Owned Businesses (1) Under the Taxpayer Relief Act of 1997, a new tax benefit was created for certain estates where a substantial portion of the assets are comprised of family-owned businesses (2) Under EGTRRA, this provision was made inapplicable to estates of decedents dying after December 31, However, with the sunset provisions of EGTRRA taking effect on December 31, 2010, this provision will apparently revive. (3) Like section 2032A, section 2057 provides for the tax benefit to be recaptured under certain circumstances. Liability for the additional tax will be imposed on those who received the property since the Internal Revenue Service is likely to collect the tax from the assets. Again, this argues for allocating the tax benefit under section 2057 to the beneficiaries who receive the property. 3. Tax Credits. In addition to identifying the taxes which will need to be apportioned, it is equally important to identify the credits that may be available to offset the taxes. a. State Death Tax Credit - Section 2011 (1) In a pick-up tax state, the state death tax credit generally should be allocated to the beneficiaries who will bear the state death taxes and should thus be allocated in the same manner as the federal estate tax. (2) In situations where the state imposes death taxes in excess of or in lieu of the state death tax credit, it would seem fair to allocate the credit to those beneficiaries who bear the tax on a pro rata basis. (a) However, where the state death tax rates applied to bequests to different beneficiaries differ based on consanguinity, the client should consider how she prefers to allocate the credit, given the rate differential

10 i) For example, where bequests are made to children and stepchildren, in some states the stepchildren s share will bear a higher rate of inheritance tax. ii) Consider that the determination of each beneficiary s pro rata share of the tax, taking into account the rate differential in allocating the credit, may be complex. (b) In addition, consideration should be given to ensuring that any marital share is protected from the allocation of such taxes, if possible. b. Foreign Tax Credit - Section 2014 (1) The foreign tax credit, if any, can be applied to benefit all takers of the estate. (2) Alternatively, the credit can be allocated to the person who receives the property which generates the credit. Under these circumstances, apportionment of the foreign tax to that property would be appropriate. c. Previously Taxed Property Credit - Section 2013 (1) Commentators differ with regard to the question of whether to allocate this credit to the benefit of the estate as a whole or to allocate it to the individuals who receive the property that generates the credit. (2) Consider first that the actual property that generated the credit may not be included in the decedent s estate, thereby making apportionment of the credit to those receiving the property impossible. (3) Consider also that the decedent may not have had any tax due on the transferor s estate allocated to his or her share, in which case the credit simply represents a windfall to the decedent s estate

11 d. Credit for Gift Tax - Section 2012 C. Apportionment Alternatives (1) Although Section 2012 does not permit a credit on any gift made after December 31, 1976, it is still possible that an estate may include gifts made prior to that date. (2) Assuming the property gifted during life is not includible in the decedent s estate under sections 2035 through 2038, 2040 or 2042, generally the credit for gift tax paid will inure to the benefit of the estate as a whole. (3) However, consider the results if the property is subject to estate tax in the decedent s estate. The client should consider whether the donee should be required to bear a pro rata share of the estate tax allocable to the includible gifted property, keeping in mind the fact that the value of the gifted property may be substantially higher in the decedent s estate than it was for purposes of calculating the gift tax (e.g., life insurance). Under these circumstances, the client may wish to allocate the credit for gift tax previously paid to gifted property which is subject to estate tax in his estate. 1. The Common Law Rule. The common law rule is that all taxes are borne by the residue. This is surely the simplest and easiest form of apportionment from a drafting and administration perspective, albeit not always the most desirable. a. The effect of this form of apportionment is that all taxes are paid out of the residuary estate before its division into shares. If the residue is insufficient, taxes would then be borne by general and specific bequests under the will on a pro rata basis up to the amount necessary to make up the shortfall. b. The biggest advantage of this type of apportionment is that the executor has access to and control over the assets to be used to pay the tax

12 2. Inside Apportionment. a. Inside apportionment relates to the issue of whether taxes will be allocated among all classes of bequests within or inside the probate estate, including marital or charitable bequests. b. If inside apportionment is selected, each beneficiary under the will bears a pro rata share of the taxes which are due from the estate. (1) Basically, there are two opposing views with respect to inside apportionment, both of which have merit. (a) (b) First, to the extent that preresiduary bequests are nominal or minor, the testator probably would not choose to protect them over the residuary bequests to his or her family. Under this analysis, inside apportionment acts to protect the family s interests by allocating tax to all bequests on a pro rata basis. Second, often preresiduary bequests are bequests of specific interests or property which the decedent wanted to be distributed intact, without a forced liquidation to pay tax. Typical of this type of bequest are preresiduary bequests of tangible personal property, real estate and business interests. Under these circumstances, inside apportionment may defeat the decedent s intent to pass specific property to particular individuals by requiring them to liquidate the bequeathed property to pay the pro rata share of tax generated by the value of the property. 3. Outside Apportionment. a. Outside apportionment determines the burden of tax that will be allocated to property passing under the will and property passing outside of the will which is includible in the decedent s estate for estate tax purposes. b. As the proportion of nonprobate assets that are includible in a decedent s estate has generally increased in recent years, this concept has become increasingly important. Numerous unfortunate circumstances have occurred where the entire residuary

13 estate has been paid over in tax due primarily on nonprobate assets. Since the testatrix s family (spouse and children) are usually the residuary beneficiaries, such a result is unlikely to be what the testator would have wanted. c. To counteract the common law rule, state apportionment statutes typically direct outside apportionment. In addition, the few federal rules which address apportionment apply to outside apportionment. d. However, outside apportionment of taxes may add substantial complexity to the administration of an estate. Of course, the greatest difficulty with outside apportionment, whether ir not the result is fair, is that the executor does not have control over the property and may not be able to collect the tax due on the property from the current owner. If the will directs outside apportionment and the executor is unable to collect the tax (for example, where a gift is pulled back in the estate, but the donee has already spent the money), then the will should direct a secondary source for the payment of the tax. Due to these potential complexities, in most cases, the determination of whether and how to apportion taxes will involve a balancing of simplicity and ease of administration with equitable results. e. Classes of property which may be subject to outside apportionment include: (1) Property transferred or powers relinquished within three years of decedent s death and includible in her estate for estate tax purposes under section 2035, including gift taxes paid on gifts made within three years of death on property not pulled back into the estate; (2) Gifts of property in which the decedent retained the right to income or possession of the property includible in her estate under section 2036(a)(1); (3) Gifts of property over which the decedent retained the right to control who will enjoy the principal or income of the property under section 2036(a)(2); (4) Gifts of property in which the decedent retained a reversionary interest includible in her estate under section 2037;

14 (5) Property held in a revocable trust created by the decedent includible in her estate under section 2038(a)(1); (6) Annuities includible in the decedent s estate under section 2039; (7) Jointly owned property includible in the decedent s estate under section 2040; (8) Property over which the decedent held a general power of appointment includible in her estate under section 2041; (9) Life insurance on the life of the decedent for which the decedent held one or more incidents of ownership includible in her estate under section 2042; (10) QTIP trust of which the decedent was the income beneficiary includible in her estate under section 2044; and (11) Property includible in the decedent s estate under Chapter 14 (a suspense account under section 2701(d); a deemed transfer under section 2704(a)(1); an increase in value of a business interest over the specified sale price in a buy-sell agreement under section 2703). f. The primary issue here is whether the client wants to have the probate estate bear the burden for the tax due on the nonprobate assets. (1) A key factor in making this determination is whether the client has actually identified all of the nonprobate property which will be subject to tax at her death. If the client chooses not to apportion tax to nonprobate assets, a surprise asset could dramatically change her estate plan. Consider, th for example, Lurie v. Com r, 425 F.3d 1021 (7 Cir. 2005). In this case, the decedent created irrevocable inter vivos trusts valued at approximately $40,500,000 through the exercise of powers of appointment contained in other trusts ( Notice Trusts ). These Notice Trusts were determined on audit to be included in his estate. The court, after reviewing the tax apportionment language in the decedent s revocable trust and applying Illinois law,

15 determined that the tax must be paid from the marital trust created under the decedent s revocable trust. The court stated, It is clear that the decedent did not anticipate that the Notice Trusts would be included in his gross estate, and it is very likely that the decedent would have laid out his estate plan differently had he or his attorneys considered this possibility. We cannot, however, rewrite the decedent s will or trust agreement to give effect to what the decedent would have done. (2) In addition, some nonprobate assets represent property over which the decedent does not have any control (e.g., QTIP property) and for which she may thus prefer not to have probate assets bear the burden of the tax. (3) Qualified plans and IRA s may represent sizeable nonprobate assets to which the client does not want to allocate tax in order to preserve the income tax benefits otherwise available to the funds in them. In addition, funds withdrawn from a plan will have an immediate income tax liability, requiring that the amount withdrawn from the plan be grossed up to cover both the estate tax liability for which the funds were withdrawn and the income tax liability due on the withdrawn funds. If the plan will not be distributed in a lump sum at the decedent s death, the client should consider whether the beneficiary will have the funds to pay the tax. In addition, consideration should be given to whether the plan permits apportionment of tax against the plan itself or the withdrawal of funds from the plan to be used to pay the tax. 4. Equitable Apportionment. a. Equitable apportionment deals with the issue of whether a bequest of property which generates an exemption or deduction should enjoy the full benefit of the exemption or deduction. b. If taxes are equitably apportioned, then bequests which generate a deduction are not required to contribute toward the payment of the tax due. Thus, the value of a marital or charitable bequest will be determined without regard for any decrease due to the payment of estate taxes

16 c. This is an area which can be a source of real controversy among beneficiaries of an estate and has spawned much litigation. Common instances in which equitable apportionment may be an issue are: (1) Whether a spousal intestate share is determined before or after the reduction in the value of the estate for estate taxes. See Estate of Collins, 269 F.Supp. 633 (D.D.C. 1967) (holding that decedent s husband s one-half intestate share of estate should not bear burden of any tax). (2) Whether a spousal elective share is calculated based on the value of the estate before or after taxes are paid. See e.g., Rockler v. Sevareid, 691 A.2d 97 (D.C. 1997); c.f., Herson v. Mills, 221 F.Supp. 714 (D.D.C. 1963). (3) Whether a fractional residuary bequest of an interest to charity is determined based on the gross value of the residuary or the net value after taxes are paid. d. Although apportioning taxes without equitable apportionment will increase the total tax due, in many cases it may be the result the testator would want because it generally will increase the size of the shares passing to the non-charitable or non-marital beneficiaries. e. Two issues should be considered in determining whether a marital or charitable bequest should bear any portion of the death taxes due on an estate. (1) First, does the client want to minimize the total estate tax to be paid? If that is the client s goal, equitable apportionment will achieve the result. (2) Alternatively, does the client want to equalize the shares passing to the spouse or charity with those of other beneficiaries of the estate (e.g., one-half to charity and onehalf to the client s brother)? If so, the client would probably prefer to have the tax deducted first and then divide the remaining estate

17 (a) (b) (c) Under these circumstances, the total tax paid will be higher, but so will the share passing to the client s brother. The tax is increased because the portion of the deductible share which is used to pay the tax then decreases the amount of property passing to the deductible beneficiary, again increasing the tax in a circular calculation. 2055(c). The marital deduction is subject to a similar effect. See 2056(b)(4)(A). See also, Martin v. United States, 923 F.2d 504 (7th Cir. 1991)(addressing decrease in marital share as result of payment of tax from it). For example, for a $4.4 million estate where 10% of the gross estate is paid in administration expenses other than estate tax: Elective Share Bears Tax Elective Share Does Not Bear Tax Tax Paid $1,506,000 $1,430,000 Surviving Spouse's Elective Share as a $ 968,000 $1,380,000 Percentage of (33%) (46%) Distributable Estate Children's Share $1,926,000 $1,590,000 See Rockler v. Sevareid, 691 A.2d 97, nn. 2, 4 (D.C. 1997). 5. Tools for Collection of Tax. a. In the case where a will directs outside apportionment of tax, it is imperative that the executor be given as many tools as possible to assist with the collection of tax from assets outside her control. Of course, the same is true for the trustee of a revocable trust who must attempt to collect tax from assets not under her control. b. At a minimum, the fiduciary should have the express right to offset the amount of tax due on nonprobate assets from any bequest

18 passing to the same beneficiary under the will or trust. In addition, the client should be asked whether the fiduciary can have a right to sell an illiquid asset passing to a beneficiary who does not contribute the required share of tax on a nonprobate asset. c. In line with the powers described above, the fiduciary should be empowered to delay distribution of a bequest to a beneficiary from whom a share of tax on a nonprobate asset is due until payment of the tax due or some other method for paying the tax is secure, including the use of a bond. d. The real difficulties arise when the fiduciary must collect the tax on a nonprobate asset from a beneficiary who does not have an interest passing to her under the will. Certainly the fiduciary should be authorized to pursue enforcement in a foreign jurisdiction. Under these circumstances, the client should be consulted about a secondary source from which to pay the tax if it cannot be collected. Should it be apportioned among other beneficiaries? Charged to the residue? Only the client can anser this question. 6. Apportionment Coordination Among Multiple Documents of an Estate Plan. a. For an estate plan which establishes several entities using a variety of documents, the apportionment of taxes on the property passing under each document must be considered in relation to the whole estate plan. b. For example, where a client has executed a will, a revocable trust and an irrevocable insurance trust, the determination of how taxes are to be apportioned in the total estate will be affected not only by the provision within each document, but also by the interrelation of the tax apportionment directions within each document. Again, this is a fertile area for litigation. For example, see Leavenworth v. Nat l Bank & Trust Co, Inc. v. United States, 1996 WL (D.C. Kan. 1996) (where pourover will directed all taxes be paid from decedent s estate, and revocable trust, which created a bypass trust and a marital bequest, permitted trustee to pay any part of all of death taxes imposed, probate assets were subject to tax prior to pourover to trust, thus diminishing marital share and increasing tax due)

19 c. Needless to say, the provisions in each document should implement portions of a coordinated tax apportionment plan. d. An area of caution to consider is to what extent each document is capable of authorizing the payment of taxes out of any property other than the property passing under that document. See, e.g., Riggs v. Commissioner, 945 F.2d 733 (4th Cir. 1991) (applying Virginia law, finding that decedent could not shift burden for tax due on probate property from probate to nonprobate property by use of provision in his will where nonprobate property otherwise qualified for the marital deduction). e. Some of the possibilities for ways in which the tax apportionment issues could be allocated among the documents are: (1) Each document could provide that all taxes will be paid from the probate estate. The issues of inside and equitable apportionment would then need to be addressed within the probate estate. If this plan were used, it would be prudent also to include in the documents and the will some alternate source for paying the tax in the event that the probate estate is inadequate. See, e.g., In re Estate of Williams, 835 N.E. 2d 79 (Ill. App. Ct. 2006) (holding that where decedent s will directed payment of all taxes from residue without apportionment or reimbursement and was silent as to source of payment of tax if residue was inadequate, will was ambiguous and court determined to apply equitable apportionment to collect tax from nonprobate general power of appointment marital trust included in decedent s gross estate). (2) The will and revocable trust could provide that all taxes will be paid from the revocable trust. Again, inside and equitable apportionment would need to be addressed and the provisions in these two documents should direct the same forms of apportionment. Even if all taxes are directed to be paid frm the revocable trust, it is important to attend to the tax apportionment clause in the will since many statutes require that tax apportionment direction be made in the will. (3) The will and revocable trust could provide that the taxes will be paid from the trust only to the extent that the

20 probate assets are insufficient to pay the tax but again the forms of apportionment selected in the provisions of the two documents should be the same. (4) The irrevocable trust could authorize the trustee to purchase assets from the probate estate or from the revocable trust or to lend money to either of them and should include a direction regarding the payment of tax in the event that the assets of the trust are determined to be includible in the decedent s assets for estate tax purposes (e.g., a life insurance policy transferred within three years of death). f. In determining how the taxes will be apportioned among the different entities in the estate, the drafter should bear in mind the potential for conflicts of interest and the effect of having different fiduciaries serving under different entities. 7. Coordination of Tax Apportionment Provisions between Estate Plans for Husband and Wife. a. Just as tax apportionment provisions among multiple documents for the same client should be reviewed to ensure coordination of provisions, as will be discussed more fully below, a similar review should be undertaken to ensure that the documents for a husband and wife coordinate the tax apportionment provisions. b. In cases where the estate planner represents only one of the husband and wife, it is nevertheless important to consider the effect of the tax apportionment provisions of each of their estate plans and to coordinate them, if possible. D. Federal Reimbursement Rules 1. Governing Law. Four federal statutes provide the estate of a decedent with a right of reimbursement for estate tax paid from nonprobate property. Although Riggs v. Del Drago, 317 U.S. 95 (1942), provides that state law governs tax apportionment for property passing under the decedent s will (or revocable trust), to the extent that federal law expressly provides for apportionment of taxes attributable to nonprobate property, federal law governs. These federal statutes were enacted on a piecemeal basis, as changes in the estate tax law developed. As a result, the four statutes are not consistent in their scope or their requirements. Note that all of sections 2206, 2207, 2207A and 2207B apparently deny

21 reimbursement for taxes deferred under sections 6161, 6163 and 6166 and not yet paid. 2. These rights of reimbursement or the waiver of them have been likened to property rights. a. In an interesting case, the court in Estate of Boyd v. Commissioner, 819 F.2d 170 (7th Cir. 1987), determined that the waiver of the right to reimbursement under section 2206 in the decedent s will was a property right the beneficiary of the insurance policy could disclaim. As a result of the disclaimer, the full marital deduction was preserved in the decedent s estate. b. In an even more interesting analysis, the court in Estate of Wu, 877 N.Y.S.2d 886 (Sur. Ct. 2009) held that the waiver under the decedent s will of the right to reimbursement for the tax due on two insurance policies was a beneficial disposition to the beneficiary of the insurance policies. In that case, since the beneficiary of the insurance policies was an attesting witness whose testimony was necessary to prove the decedent s will, this beneficial disposition to him was void under New York law. 3. Insurance Proceeds - Section a. Under section 2206, unless the decedent directs otherwise in her will, the personal representative of the estate is entitled to reimbursement from the beneficiaries of any life insurance policy includible in the decedent s estate of a proportionate share of the estate tax due attributable to the policy. Multiple beneficiaries of a policy are liable on a pro rata basis. Note that this right of reimbursement does not include the trustee of a revocable trust. b. Unless the decedent waives this right of reimbursement, an executor is likely to have an obligation to make the effort to collect the pro rata share of tax from each beneficiary of life insurance includible in the decedent s estate. c. The statute expressly selects equitable apportionment with respect to the marital deduction, providing that it does not apply to the extent that the marital deduction is allowed for proceeds receivable by the decedent s spouse, but does not mention any exemption for charitable beneficiaries. For this reason, an express provision in the tax apportionment clause in the decedent s will providing for equitable apportionment should resolve this issue and prevent

22 imposing any duty on the executor to collect tax from the charitable beneficiary of a life insurance policy includible in the decedent s estate. d. The right of reimbursement does not extend to insurance companies, even if the proceeds have not been paid to the beneficiaries. See Annot., Remedies and Practice Under Estate Tax Apportionment Statutes, 71 A.L.R.3d 371, 409 (1976). e. Given the size of proceeds of many insurance policies, this right of reimbursement should not be waived carelessly. Note, however that the statute merely provides Unless the decedent directs otherwise in his will, and does not require an express reference to it in order to waive it. See Estate of Fagan, T.C. Memo (1999)(holding that language in tax apportionment clause in decedent s will which provided all taxes assessed on property included in gross estate be paid from residuary estate and that executor should not require any part of such taxes be recovered from recipients of property was adequate to waive reimbursement right under section 2206). f. Preservation of the right of reimbursement is particularly important for a client whose estate planning includes an irrevocable insurance trust which is not intended to be included in the client s taxable estate. (1) In addition to careful preservation of this reimbursement right in the tax apportionment clauses in the client s will and/or revocable trust, the insurance trust also should include a provision which directs allocation from the shares of the trust of that portion of the taxes due in the event that the trust is includible in the client s estate. (2) To avoid inadvertent inclusion of the trust in the client s estate, however, this tax clause included in the insurance trust should clearly be made contingent on the prior determination that the trust is includible in the client s estate. 4. Powers of Appointment - Section a. This provision is the twin of section 2206 and grants a right of reimbursement to a personal representative for taxes attributable to

23 property subject to a general power of appointment included in the decedent s estate under section b. Recovery may be had from the person receiving such property by reason of the exercise, nonexercise or release of a power of appointment. c. Again, if a marital deduction is allowed for the interest passing to the spouse, no right of reimbursement is created, but this application of equitable apportionment does not mention charitable beneficiaries. d. Again, no specific reference to the Code section or type of reimbursement is required in order to waive the right and the right can be waived only in the decedent s will. e. This provision also provides that to the extent the marital deduction is inadequate to protect both the life insurance proceeds and the power of appointment property passing to the spouse, the life insurance proceeds are protected first from the right of reimbursement and then the power of appointment property. Given the current unlimited marital deduction, this provision should no longer be relevant. 5. QTIP Property - Section 2207A. a. Section 2207A gives the personal representative of the decedent s estate the right of reimbursement from a QTIP trust for federal estate taxes due at the highest marginal tax rate as a result of the inclusion of the QTIP trust in the decedent s estate. b. Section 2207A differs from sections 2206 and 2207 in several important respects: (1) First, it can be waived under the decedent s will or revocable trust. (2) Second, to prevent an inadvertent waiver of this right, the Code section was amended to provide that the right of reimbursement can be waived only by specific indication of the intent to waive reimbursement. The legislative history of the Taxpayer Relief Act of 1997, which amended section 2207A, provides that a specific reference to QTIP,

24 the QTIP trust, section 2044 or section 2207A will suffice to meet the requirements of the statute. (3) To ensure that no tax due to the inclusion of the QTIP trust in the decedent s estate will be payable from the decedent s assets, the tax is recoverable from the QTIP on an incremental basis. It also includes the right to recover interest and penalties attributable to the additional taxes. c. Note that although in many jurisdictions, the state estate tax will follow the federal estate tax, the federal reimbursement provisions apply solely for the purpose of reimbursing the estate for federal estate tax. See, Forrester v. Forrester, 914 So.2d 855 (AL 2005)(determining that 2207A did not preempt Alabama estate tax statute directing nonapportionment of Alabama estate tax which charged decedent s residue for Alabama tax due on QTIP trust includible in decedent s estate). d. To facilitate the administration of the surviving spouse s estate, a provision should be included in the QTIP trust directing that, following the surviving spouse s death, the incremental amount of estate tax due to the inclusion of the QTIP in the surviving spouse s estate be paid over to the personal representative of the surviving spouse s estate. This provision may need to include an apportionment provision, directing how the taxes should be apportioned among the beneficiaries of the QTIP trust. See, Proceeding of Feil, 894 N.Y.S.2d 837 (Sur. Ct. 2009)(determining whether cash bequest to children from QTIP trust following death of surviving spouse should bear tax imposed on QTIP or tax should be paid from residue of QTIP trust passing to charity) e. A trap for the unwary is that if the surviving spouse s will or revocable trust does not waive the right of recovery from the QTIP trust, the failure of the surviving spouse s personal representative to recover the tax will be treated as a gift from the beneficiaries of the surviving spouse s estate from whose share the tax was paid to the remaindermen of the QTIP trust. Treas. Reg A- 1(a)(2). The gift is deemed made when the right of recovery is no longer enforceable and the failure to recover the tax is treated as a gift even if recovery is impossible

25 6. Retained Life Estate - Section 2207B. a. Like sections 2206 and 2207, section 2207B authorizes the personal representative of the decedent s estate to be reimbursed from property included in the decedent s estate under section 2036 for a proportionate share of the tax attributable to the inclusion of the property in the decedent s estate. However, unlike sections 2206 and 2207, the right of reimbursement includes penalties and interest attributable to the tax, like section 2207A. b. Section 2207B provides that the right of reimbursement can be waived to the extent that the decedent in his will (or revocable trust) specifically indicates an intent to waive any right of recovery under this subchapter. Under the Taxpayer Relief Act of 1997, the standard for specificity of the waiver was reduced to correspond to that required for section 2207A. c. Section 2207B also provides specifically that no right of reimbursement is available from a charitable remainder trust, but does not mention any other form of equitable apportionment. 7. Generation-Skipping Transfer Tax Apportionment - Section a. Section 2603(a) provides that the transferor (or the transferor s estate) pays the tax in the case of a direct skip, the distributee pays the tax in the case of a taxable distribution and the trustee pays the tax in the case of a taxable termination. b. The GST tax on a direct skip is tax exclusive, meaning no GST tax is charged on the amount required to pay the GST tax, but, an estate or gift tax is charged on the amount required to pay the GST tax. In the case of a testamentary bequest, the GST tax is charged on the amount of the bequest, but net of GST tax paid out of the bequest, and the estate tax is charged on the amount of the bequest, the GST tax paid and the estate tax paid. See, Danforth, GST Tax Computation, Payment and Apportionment, 29 Estates, Gifts and Trusts Journal 82 (2004) (short but very clear explanation of calculation of GST taxes). c. Section 2603(b) provides that, unless the governing instrument directs otherwise by specific reference to the tax imposed by this chapter, the tax will be charged to the property constituting the generation-skipping transfer

26 (1) The direction in the governing instrument to pay the tax from another source must be made with specific reference to the tax imposed. Estate of Monroe v. Commissioner, 104 T.C. 352 (1995), rev'd on other grounds, 124 F.3d 699 (5th Cir. 1997). See, In re Estate of Denman, 270 S.W.3d 639 (Tex Ct. App. 2008)(finding that reference to any transfer, estate, inheritance, succession and other death taxes did not refer specifically to GST tax and did not shift burden to pay tax from property subject to bequest). (2) This right to have the tax paid from the property constituting the generation-skipping transfer should be waived only with great care since generation-skipping transfers can be inadvertent and unanticipated. Given the anticipated 55% rate of tax, an unexpected imposition of the tax on the residue of the client s estate may substantially change her testamentary plan. (3) Treas. Reg (c)(2)(iii) requires the personal representative to pay generation-skipping transfer tax on the proceeds of insurance policies of less than $250,000 and to seek reimbursement from the insurance company or the beneficiary, depending on whether the proceeds of the policy have been distributed at the time. However, for policies where the proceeds are in excess of $250,000, the insurance company is liable for the tax. A fiduciary may prefer to ask the insurance company to pay the tax in all cases to avoid inadvertently failing to do so in cases where the proceeds exceed $250,000. d. In the case of a direct skip made under the transferor s will, where no contrary intent is expressed, sections 2603(a) and 2603(b) act to require that the tax be paid from the amount bequeathed to the skip person, but no generation-skipping transfer tax is imposed on the amount used to pay the tax. The tax would be computed as:.55 X ([amount of bequest] / 1.55). If this result is not the client s intent, then the will or revocable trust must clearly override the statutory direction to pay the tax from the amount transferred to the skip person. e. Example (1) Decedent dies in 2011 (assuming the 2001 transfer tax regime is applicable), having used his entire GST tax

27 exemption on other transfers. In his will he leaves a $1,000,000 bequest to a grandchild. (2) Unless the will directs otherwise by specific reference to the GST tax, the tax will be charged against the bequest. Since the tax is assessed on the amount actually received by the transferee, the tax (at 55%) is $354,839, and the grandchild receives $645,161. (3) If the will directs that the GST tax be paid out of the residue, the grandchild will receive the full $1,000,000, but the GST tax will be $550,000. E. Gift Tax Includible in Gross Estate Under Section An additional very difficult issue may be raised with regard to the application of the section 2035 gross up rule where the decedent has paid substantial gift tax within three years of death. The difficulty with apportioning the tax due on this value is that the recipient of the property is the federal government, and, needless to say, it is not going to pay its share of the tax generated by the inclusion of the gift tax paid on gifts made within three years of death in the taxable estate. It may also be difficult or unfair to apportion the tax to the donees of the gifts giving rise to the inclusion of the gift tax because they may have already spent or consumed the gifted property, never suspecting they might be liable for tax related to the gift. But see, Application of Rhodes, 868 N.Y.S. 2d 513 (Sur. Ct. 2008) (applying New York tax apportionment statute to determine that donees of gifts are responsible for their pro rata shares of the estate tax attributable to the inclusion of the gift tax paid on their gifts). Finally, apportionment of the tax on the includible amount may cause significant inequities in the decedent s estate. 2. For example, where gift tax of over $1.8 million is paid on a gift made within three years of the decedent s death, the additional tax generated by the gross up rule will be $900,000, assuming for simplicity an estate tax rate of 50%. If the residuary probate beneficiaries are not the same individuals who received the gifted property (or do not take in the same shares), the imposition of the additional $900,000 of tax on the residuary will substantially decrease the shares of the residuary beneficiaries of the probate estate in favor of the gift beneficiaries. 3. Alternatively, if the individuals who received the gifted property are also beneficiaries of the probate estate, allocation of the additional tax to their probate shares would probably be the most equitable solution