How Estate Planning Is Changed by the New Tax Law

Credit Shelter Trusts Are Being Rewritten

By James L. Dam

Many estate planners are revising the way that "credit shelter trusts" are funded, as a result of the new tax law signed by President Bush.

Lawyers are making the funding more flexible, because the new law makes it harder to determine in advance how much property must pass to the trust in order to avoid tax on the spouse's estate.

A common method is to leave everything to the spouse and fund the credit shelter trust through a "disclaimer" of property by the spouse, rather than an automatic formula.

Alternatively, where property is left to a QTIP trust for the spouse, lawyers are providing that the credit shelter trust be funded by any property the executor does not elect to be treated as QTIP property.

Either way, the funding decision is postponed until after the client's death, when the fate of various provisions of the new law should be more clear – including increases in the "unified credit" during 2002 through 2009, repeal of the estate tax in 2010, and a "sunset" expiration of the entire new law in 2011.

Postponing the decision can be especially helpful in smaller estates – such as those under $3 million – because if the increases in the unified credit take effect, many of these estates will not need to fund the credit shelter trust at all in order to avoid tax on the spouse's estate, lawyers say.

However, both the "disclaimer" and the "QTIP" strategies have major disadvantages, experts warn. For example, there is the danger that a spouse will refuse to disclaim property even if doing so would reduce estate taxes.

Another strategy is to make it easier to "undo" the trusts once they are funded. This is generally done by giving a trustee the power to distribute all the property to the spouse if doing so would be unlikely to result in tax on the spouse's estate.

Many lawyers are also putting a "cap" on the amount that can be put into the trust. This is because standard funding formulas require that the trust be funded with the largest amount of the client's estate that can pass tax-free, and under the new law this amount will greatly increase and may be much greater than the client wants. If estate taxes are repealed, the formulas would require that the entire estate be put into the trust.

Here is a closer look at the strategies lawyers are using:

Disclaimers
Lawyers have used disclaimers in the past but expect to use them much more frequently now.

The strategy "is going to become the prevalent way to fund the credit shelter trust from now on," predicts estate planning attorney Andrew Willms of Thiensville, Wis.

In the past, the strategy was generally used only for couples with a combined estate of about $1 million or less, lawyers say.

With an estate of that size, and with the unified credit "exemption" under $700,000, it often would not be clear if a credit shelter trust would be necessary to avoid tax on the estate of the second spouse to die.

The client would be "on the cusp" of having a taxable estate, and the disclaimer strategy would be a way to "keep things simple," says Philadelphia attorney Daniel Evans, the author of How to Build and Manage an Estates Practice.

Now, because of the new law's scheduled increases in the unified credit and eventual repeal of the estate tax, and because of the uncertainty as to whether the changes will actually occur, there are many more estates in this category, and there may be a growing number of them over the next nine years, lawyers say.

The strategy is now useful for couples with combined estates of up to $2 million, says Evans.

Willms says he will use it for estates of all sizes, because with repeal of the estate tax possible, "to presume the existence of estate tax doesn't make as much sense."

The majority of clients don't want to fund a credit shelter trust if it won't be necessary for tax reasons, says Willms.

"They're couples who have been married for 35 years and just want to leave their property to each other," he says.

These clients don't want "the records, separate tax returns, and all the paperwork" of a trust, says Evans.

They also may not want the restrictions a trust imposes on a spouse's access to the trust property, he notes.

Typically, "the spouse is the trustee and can get to the property, but it's restricted, so it's not fun money. It can't be [used] for luxuries," says Charlottesville, Va., attorney Richard Howard-Smith.

With the disclaimer strategy, the credit shelter trust will not be funded unless the surviving spouse decides to do so "based on the tax realities and his or her comfort level at that time," says attorney Donald Baker of Bloomfield Hills, Mich.

Even if the spouse disclaims some amount to the trust, this amount might be less than the amount that would be put into the trust by a funding formula. As a result, the drawbacks of having the trust may be reduced as well.

In general, a spouse will probably want to disclaim at least as much as necessary to avoid any tax on his or her estate if he or she were to die the next day, says Evans.

Example: Husband dies in 2004, when the unified credit "exemption" is $1.5 million. He leaves his wife $2 million, and she has $500,000 of her own property. She would disclaim $1 million, so that she is left with a total of $1.5 million. That way, if she were to die the next day, there would be no tax on her estate.

Spouses should also consider their life expectancy, how much of the property they might use up before they die, and how the tax laws might change, says Willms.

For instance, if a husband dies in 2009 and the exemption then is $3.5 million, as scheduled under the new law, and if the new law still has a "sunset" provision under which the exemption after 2010 drops back to $1 million, the spouse would want to consider this potential drop in the exemption amount.

To provide for the disclaimer strategy in a will or revocable trust, you just need to state in the document that any disclaimed property of the estate will pass to the credit shelter trust.

You also need to make sure the disclaiming spouse is not given a "power of appointment" over the property in the credit shelter trust, because if the spouse has this power, the disclaimer would be invalid under the Tax Code.

However, if the spouse is given that power, the problem can be corrected by drafting the disclaimer to include a disclaimer of the power of appointment.

To be valid, a disclaimer must be made in writing within nine months of the transfer of the property, and before the spouse has received any interest in the property or any benefits from it. (Tax Code Sect. 2518).

In some cases, for the strategy to work, a client may also need to name the credit shelter trust as the secondary beneficiary of a life insurance policy or retirement plan, so that these assets can be disclaimed into the trust, says Evans.

"You have to look at all the assets and figure out, if there is a disclaimer, how are they going to get into the bypass trust," he says.

Disclaimer Drawbacks
The disclaimer strategy has the following drawbacks:

• Spouse might not cooperate.
One danger is that the surviving spouse might refuse to disclaim property, even if the disclaimer is necessary to avoid tax on the spouse's estate.

Some lawyers believe this danger is very great.

The disclaimer "is great in theory but horrible in practice," contends Rapidan, Va., attorney Howard Zaritsky, editor of Probate Practice Reporter.

It's a "risky approach," says Sarasota, Fla., attorney Renno Peterson, who is a co-author of Handbook of Estate Planning. "After one spouse dies, the other can change in a lot of ways, and it's unpredictable."

The spouse has to decide at "a very emotional time," says New York attorney John Dadakis, president of Attorneys for Family-Held Enterprises.

"I wouldn't use [the strategy], because I've found that the next most reliable thing besides, 'The check is in the mail,' is, 'I will disclaim,'" says San Francisco attorney Max Gutierrez, a past chair of the ABA's real property, probate and trust law section.

"I don't count on surviving spouses to do my planning for me," he says.

However, other lawyers contend that the danger is very small.

The view that the spouse can never be trusted "is ridiculous," says Willms. "It has absolutely no basis in fact."

If the spouse is the sole trustee and sole beneficiary of the trust and is given as much access to the trust property as possible without causing the property to be included in his or her estate, "There is no reason for the spouse not to be cooperative," he says. "I've used disclaimers for 15 years and never had a single client with such access refuse to disclaim."

If the trust is drafted that way, it is unlikely that the spouse will refuse, agrees Jerome Deener of Hackensack, N.J., author of Estate Planning Strategist.

But the spouse "is still going from outright ownership to having this animal called a trust that the spouse has never dealt with before, which can be daunting," says Dallas attorney Steve Akers.

Also, no matter how the trust is drafted, spouses might not disclaim if, upon the spouse's death, the trust property will pass to the client's children from a previous marriage, or to other beneficiaries the spouse would not want it to pass to, lawyers agree.

"If there are children from a previous marriage, then you don't use [the disclaimer strategy]," says Deener.

• Spouse gets "total control."
Even if spouses can be relied on to make appropriate disclaimers where they will have as much access as possible to the credit shelter trust property, they should not be relied on to do so if additional restrictions are imposed on this access, lawyers also agree.

As a result, another drawback of the disclaimer strategy is that it generally won't make sense if the client wants to impose such restrictions.

It only makes sense where the client "does not mind the surviving spouse having total control of the trust," says Hanover, N.H., attorney Willemien Dingemans Miller.

For example, it probably would not make sense if the client wants the spouse to share the income from the trust with their children, or wants to limit distributions to the spouse in the event the spouse remarries, says Willms.

However, this is generally less of a problem in small estates than in large ones, he says.

"As the estate gets larger, the desire to impose restrictions on the spouse's power over the property grows as well," says Willms.

• Spouse gets no power of appointment.
One power the surviving spouse cannot get is a power of appointment over the trust, or else the disclaimer would be invalid.

This is a drawback for couples who would prefer that the surviving spouse have this power.

Ordinarily, a surviving spouse can have this power over a credit shelter trust.

As a result, "You lose some flexibility," says Deener. "Say the spouse doesn't want the assets in the trust anymore or wants to give them to children, or maybe eliminate some children. She can't do that."

"If one of the kids runs into a problem or there is a grandchild with a special need," the spouse cannot say that more of the property goes to them at her death, says Alvin Golden of Austin, Texas, a past regent of the American College of Trust and Estate Counsel (ACTEC).

"She can't rearrange the plan," says Bethesda, Md., attorney Nancy Fax.

• Spouse might "blow" the disclaimer.
Another problem is that, for the disclaimer to be valid, the surviving spouse must not receive any interest in the property or benefits from it before making the disclaimer.

There is a danger that a spouse will inadvertently violate this rule by, for example, making withdrawals from a bank account, lawyers say.

"What often occurs is that by the time anyone contacts the surviving spouse, the disclaimer is already blown, because the spouse didn't know," says Peterson. "If you're relying on the disclaimer for planning, that's a disaster."

However, "the Service is pretty generous about that," says Golden. "They are not hyper-technical."

Also, it may be possible to avoid the problem by providing in a client's will or trust for a pecuniary bequest to the spouse, in addition to leaving the spouse the residue of the estate, says Edward Koren of Tampa, Fla., the chair of ACTEC's estate and gift tax committee.

Then, if the spouse uses some of the property, it can be argued that this use was just a means of funding the pecuniary bequest, says Koren.

There is also an argument that because the disclaimed property will go to a trust of which the spouse is a beneficiary, any use of the property by the spouse, even if it occurs before the disclaimer is made, should be treated as merely a distribution from the trust, says Willms.

QTIP Strategy
In many cases, attorneys are providing for the property to pass to a QTIP trust and allowing the executor to divide it up.

If the executor decides that it is unlikely that there would be tax on the spouse's estate even if the executor "elects" all the property for QTIP treatment, then the executor could do so and a credit shelter trust would not be funded.

The advantage of this strategy is that the executor is likely to be more trustworthy, especially where the spouse is not the sole beneficiary of the credit shelter trust.

"If you have the son or daughter as the executor, they may be a little more dispassionate about it," says Charlotte, N.C., attorney Mark Edwards.

Another advantage is that the decision as to how to divide the property is due in 15 months instead of nine, notes attorney Lawrence Katzenstein of St. Louis.

The drawbacks of the strategy are the cost and hassle of creating the QTIP trust. In addition, for many clients, the fact that property would not be left outright to the spouse would be a big disadvantage.

This strategy can be useful if the client already wants a QTIP trust for other reasons – such as preserving property for children of a prior marriage.

Creating a QTIP trust just to use the strategy would probably not be worthwhile, lawyers say.

"With smaller estates, I don't know that I want to get involved with the complexity of a QTIP," says attorney Howard Esterces of Garden City, N.Y.

Termination Clauses
Lawyers are also making it easier to "undo" credit shelter trusts once they are funded by including provisions authorizing the trustee to distribute all the property if the trust no longer serves a tax purpose.

"People are putting in provisions that say, in effect, that the credit shelter trust was created solely to minimize taxes, and if there is no tax, then I'd just as soon let my spouse have it," says Koren.

This discretion should not be given to a family member or a beneficiary of the trust, or else it may cause the trust property to be included in their estate, warns Evans.

It should be given instead to an independent trustee, or a "trust protector."

It's not clear, however, how the provision should be drafted.

On the one hand, you want to put conditions on the power, says Koren. "You had better give some pretty good guidelines for what you want to do," he says.

On the other hand, says Evans, if you make it black and white – providing, for example, that the trust be terminated "if at any time there is no federal tax on property passing as a result of death" – then there is a danger that the trust might be terminated in 2010, when the estate tax is repealed, even if the estate tax is still scheduled to be reinstated in 2011.

So the provision "should be kind of flexible," says Evans. It might be something like, "If the trustee should determine in his or her own discretion that the trust will not save taxes under any reasonably foreseeable circumstances, then the trustee has the power to terminate the trust," he suggests.

Formula Caps
To prevent a standard funding formula from putting much more property into a credit shelter trust than the client expected, some lawyers are "capping" the amount that can pass to the trust.

"This is something people will have to look at," says Zaritsky. Otherwise, as a result of increases in the unified credit and estate tax repeal, "You could end up with the non-marital portion of the estate growing dramatically."

The problem can be serious even if the spouse is a co-beneficiary, but not the primary beneficiary, of the credit shelter trust, says Willms.

To fix it, you can provide that, "no matter what the circumstances are, we don't want the exclusion amount to exceed 'x' dollars," says New York attorney Alan Halperin.

You can state the cap as a dollar amount or a percentage of the estate, says Golden.

Alternatively, you can impose a "floor" for the amount or percentage of the estate going to the spouse, says attorney George Gregory of Birmingham, Mich. That may be easier for the client to understand, he says.

You might also provide that the difference between the formula amount and the cap or floor amount will pass not to the spouse but to a second credit shelter trust, of which the spouse would be the primary beneficiary, says Gutierrez.

That way, there would be no risk of wasting any of the unified credit, he says.

Similarly, the difference could go to a "non-qualifying QTIP trust" for the spouse, says New York attorney Linda Hirschson.

Read the Law
The law is "The Economic Growth and Tax Relief Reconciliation Act of 2001," Public Law 107-16. You can read, print or download the full text in the "Important Documents" section of Lawyers Weekly USA's Internet site: http://www.lawyersweeklyusa.com/subscriber/usa/treas.cfm

Questions or comments can be directed to the writer at: mailto:jdam@together.net