Apportionment Clauses for California Clients (Who will pay the Estate Tax?)
California law dictates that if the will or trust instrument is silent as to payment of estate tax, then equitable apportionment will apply. This simply means that taxes will be paid proportionately by each beneficiary receiving an asset which is subject to estate tax. For example, any joint tenant beneficiary, any IRA beneficiary and any trust beneficiary will be liable for their share of taxes, on the assets they receive, if the trust/will is silent as to who pays the death taxes.
Seems like a fair way to allocate the tax burden proportionately among the beneficiaries who received the assets which caused the tax. As an example, say you have a 2020 estate with 4 beneficiaries, each to receive $5 million, one is an IRA beneficiary, one is a surviving joint tenant in a broker account, one is a life insurance beneficiary and one is a beneficiary of the living trust. Each will receive five million and each will pay their share of the estate tax which will be about ($20M <$11,580,000 exemption> X 40% estate bracket = $3,368,000 x ¼ each). All four take their money, pay their ¼ share of the tax, and live happily ever after.
What happens when the trust isn’t silent? About 50% of the trusts that I see have some kind of language addressing the payment of the estate taxes. Some trusts say the trust estate (i.e. usually the surviving spouse beneficiaries in the case of a married couple) will pay all estate taxes without apportionment among beneficiaries and some say all taxes as a result of death will be paid out of the residue of the trust. Now we have a problem, using the above fact pattern, the beneficiary of the trust ($5M) will pay 100% of the estate tax, or $3,368,000, and only receive a net of $1,632,000. The other beneficiaries will each receive $5M undiminished by the estate tax, they will not pay a dime in estate tax. Is there some possibility that the one beneficiary (usually a sibling) who paid all the estate tax himself may resent the other three beneficiaries?
The above example emphasizes the importance of considering non-trust assets when doing the pre-death estate work for clients. This is currently a growing problem as IRA’s and Pensions, in many cases, are now the biggest assets in an estate. After death, if apportionment applies, the trustees will need to collect estate tax from the non-trust beneficiaries.
The above rules apply to almost all assets in an estate or trust. One exception to the above rules is the apportionment of estate tax for QTIP trust assets. A QTIP trust is a marital deduction trust originating at the first death, sometimes called a C trust. If the living trust document has language saying the trust estate (i.e. usually the surviving spouse beneficiaries in the case of a married couple) will pay all estate taxes without apportionment among beneficiaries or says all taxes as a result of death will be paid out of the residue of the trust. Then, like above, we have a major problem. The trust estate will pay all the estate taxes, including the entire tax on the QTIP assets. The QTIP trust will pay zero taxes.
Let me emphasize the trust estate will pay 100% of the tax in the above situation. The trust estate usually represents the surviving spouse’s share of the assets. Her beneficiaries will pay 100% of the estate tax and the QTIP (usually children of the 1st to die) beneficiaries pay zip. Many times, I have seen the surviving spouse beneficiaries receive nothing and the QTIP beneficiaries receive everything as a result of the will/ trust language. This results in a truckload of misery.
If you have a QTIP trust and the trust is silent as to who pays the tax (i.e. no apportionment clause) then in California you revert to the incremental method of apportionment. With incremental apportionment, the QTIP will pay its share of estate tax, at the incremental rate, i.e. the highest estate tax bracket. At least this way, each set of beneficiaries will pay some of the estate tax and the burden will not fall on only one set of beneficiaries.
As you can see it is very important to understand the impact of apportionment clauses when designing an estate/trust plan.
Written by Robert Manton, CPA January 2020.
Reason to Fund the B Trust (Exemption Trust) after the first spouse dies
Our California clients and other professionals often ask me the following question. If someone doesn’t feel they will ever have enough assets to pay an estate tax at the second death, why should they bother funding the B trust after the first death? In my classes I offer the following response: Although below the threshold now, there are many reasons estates can grow. One is the life expectancy of the surviving spouse, typically 20 plus years, look at appreciation of real estate and stock over the last 20 years! Remarriage can also result in wealth expansion. Inheritance is another factor, it is not uncommon at all for a surviving spouse to inherit assets.
Not funding the B trust can cost you hundreds of thousands of dollars and sometimes millions in additional estate tax.
Funding the B trust also provides a mechanism for asset protection for half of the couple’s assets. Funding a B trust with a high exposure asset, such as a real estate rental provides a great degree of legal protection to the surviving spouse in the event of a lawsuit relative to the rental.
Another reason to fund the B trust is to help the surviving spouse avoid litigation (or her estate) where a B trust wasn’t funded properly. Very typical in situations where the surviving spouse remarries and forgets about the children from the first marriage (i.e. doesn’t fund the B trust).
In smaller estates qualifying for Medicare or medical may also be a good reason to fund the B trust. This strategy must be structured properly.
With the funding of the B trust you now have the opportunity to deduct more expenses which with the new tax law are severely limited on the personal tax return. A trust has its own state and local $10,000 cap deduction and a trust can deduct legal, accounting and trustee fees, which are not deductible on a personal tax return. The recent tax law changes now limit personal tax deductions making it extremely beneficial to fund the B trust in order to maximize deductions on the trust return.
Another important reason to fund the B trust is the unknown future estate tax exclusion. There is always the possibility congress could lower the current exclusion.
You should seek an attorney’s advice if you chose not to fund the B trust. A court petition is required with a sign off from all ultimate beneficiaries in order to properly void the B trust (and stay out of legal trouble).
Written by Robert Manton, CPA January 2020.