Matrimonial Issues and Estate Tax Repeal

Congress left the estate tax law in a state of complete confusion at the end of 2009. Even if the bigger question of whether we will have an estate tax is resolved by the time you read this article, many issues that affect matrimonial practitioners, not just estate planners, will still remain unresolved. However the estate tax repeal situation resolves itself, for the future, practitioners who negotiate matrimonial settlements and draft matrimonial documents should endeavor to address the lessons learned from these events.

Estate Tax Repeal: Is It Real?

The estate tax was repealed at the end of 2009. Tax experts expected Congress to continue the $3.5 million exclusion (how much you can bequeath without incurring a federal estate tax) and 45% rate from 2009 into 2010 while debating the future of the tax. In 2011 the exclusion drops to $1 million and the tax rate increases to 55% unless Congress acts. Tax advisers expect Congress to reinstate the estate tax in a manner similar to 2009 rules (it is uncertain if this will be retroactive, but as we get later into tax year 2010 retroactivity seems more unreasonable and more unlikely), and to eliminate the draconian rules that would otherwise come into effect in 2011. But, since all the experts were wrong on what happened once, practitioners have to plan flexibly and cautiously. Even if these uncertainties are resolved, important lessons remain for practitioners from the estate tax repeal situation, and issues will remain to be resolved for some time to come.

2010 Rules (Maybe?) in a Nutshell

The estate tax is gone (perhaps temporarily), but the gift tax remains. If your client makes large gifts to children or other heirs, a 35% tax can be assessed once the client has used up his available exclusions. In place of the estate tax is a complex new tax regime called “carryover basis.” When your client dies, his or her heirs will generally have the same tax basis (cost) for an asset they inherit that their benefactor had. This means a potentially greater capital gains tax when they sell. And since most tax people anticipate income and capital gains taxes to increase because of the deficits, these rates will be higher still. For example, the HIRE Act provides for a new 3.8% tax on investment income of wealthier tax payers. This and other changes will skew the system toward higher marginal rates and continue to introduce more complexity into the projections necessary to negotiate a settlement. The law (until they change it again) permits your client to increase tax basis by $1.3 million on death. This means your client can effectively eliminate the inherent appreciation for tax purposes to this extent. Spouses can qualify for an additional $3 million adjustment. But alas, not even Nostradamus could predict the outcome of all this. What does it mean? If carryover basis actually remains law, the need to ascertain and document the tax basis of assets when negotiating a matrimonial settlement will be even more important, and dramatically more difficult.

Securing a Percentage of the Gross Estate of the Monied Spouse

There are myriad objectives contained in property settlement, prenuptial and postnuptial agreements that can be aided by referencing tax law definitions. The advantage of this approach is that with a relatively short and simple provision, the detailed definitions and rules of a particular tax law provision can be effectively incorporated into the testing or implementation of the matrimonial agreement. Tax laws tend to be quite detailed. Luckily, the regulations, case law and other materials often provide considerable guidance so that uncertainty or disputes under the agreement can hopefully be minimized. Unfortunately, the sea change in the estate tax that occurred on New Year's Day 2010 now mandates a more comprehensive approach that clarifies the intent of the parties in the event the “rug is pulled out” from the tax provisions referenced. The following discussion illustrates the application of one such section.

An Example

An example can illustrate some of the issues that can arise. The language has been adapted and simplified from two recent client prenuptial agreements reviewed as part of an estate plan.

Example: New Spouse has modest assets and is marrying Monied Spouse, who has a substantial estate. The negotiations of the prenuptial agreement resulted in a compromise that New Spouse would receive 25% of the estate of Monied Spouse after two years of marriage. New Spouse's counsel wanted to be certain that Monied Spouse could not employ deception to distort what assets were included in the estate so the pre-nuptial agreement provided in part:

New Spouse shall receive Twenty Five Percent (25%) of the gross estate of Monied Spouse as defined for federal estate tax purposes under Code Section 2031 of the Internal Revenue Code as amended.

This might have seemed a rather cautious means of drafting the clause in light of the tax laws' historic paradigm defining the estate in the broadest sense. However, effective Jan. 1, 2010, the estate tax was repealed. What if Monied Spouse died on Jan. 10? At that time, it might be argued that 25% of the adjusted gross estate would be zero, since no gross estate existed at the time of death. Might the inclusion of the phrase “as amended” imply that it should be the estate tax law at the time of death and that these otherwise superfluous terms would counter an argument that it should be the gross estate as such term was defined in the context of the estate tax law at the time of the prenuptial agreement was executed?

'Gross Estate'

For the second illustrative clause below, the key phrase “gross estate” was clearly taken from the estate tax laws. However, it was not a defined term because it was neither in quotations, nor did it reference any particular Section of the Internal Revenue Code. Does this omission make the phrase less susceptible to the challenge to which the prior clause may be susceptible? And what paradigm is used to interpret the phrase in the second illustrative clause?

Matrimonial practitioners have often resorted to using tax law paradigms and definitions. However, just as estate planners may forever modify their drafting techniques in light of the estate tax repeal episode, matrimonial practitioners will do the same as it pertains to tax clauses in their documents. For example, had the first example been drafted as follows, perhaps the likelihood of someone arguing for a zero inheritance by New Spouse would be substantially lessened:

New Spouse shall receive Twenty Five Percent (25%) of the gross estate of Monied Spouse. It is the intent of the parties that the phrase “gross estate” be broadly interpreted to include all property rights and interests, real or personal, tangible or intangible, probate or non-probate. Should any issue arise as to whether a particular asset should be included in the phrase “gross estate” the broad definitions of “gross estate” as defined under Code Section, and Treasury Regulations thereunder, shall be applied to assure inclusion. The parties recognize that modifications may occur to such Code Section or the Treasury regulations thereunder, and in such event the utilization of such modified Code and/or regulations shall be done in a manner to carry out the intent of the parties as specified herein.

Whatever the ultimate resolution of the estate tax, practitioners are henceforth advised to incorporate a default definition anytime tax law references or terms are utilized, and provide a clear statement of the intent of any provision that cross-references any tax code definitions.

Prenuptial, Postnuptial and Divorce Agreements

Is there a quick fix to address the estate tax uncertainty? While quick fixes are always subject to some uncertainty and risk, the following language might suffice to amend a prenuptial or postnuptial agreement that includes references to estate tax law definitions ' .

WHEREAS, at the time that the Postnuptial Agreement was executed, a Federal estate tax (the “estate tax”) existed under the Internal Revenue Code of 1986, as amended (the “Code”), and the Postnuptial Agreement incorporated several terms and concepts relating to the estate tax; and

WHEREAS, as of January 1, 2010, the estate tax was repealed (albeit temporarily, at least at this point in time); and

WHEREAS, the parties now wish to modify and clarify the terms of the Postnuptial Agreement to take into account the repeal of the estate tax; and

'

TAX TERMS. If upon the death of either party the estate tax is not then in existence, then the Prenuptial Agreement and Postnuptial Agreement shall be read and interpreted as if the Federal estate tax laws in effect as of December 31, 2009 remained in effect on the date of such party's death. As a result, any provisions in the Prenuptial Agreement and/or Postnuptial Agreement (specifically including Paragraph XX) referring to the “federal gross estate,” Section 2031 of the Code, the IRS Form 706, or similar terms, ' then in effect” shall all be read and interpreted as if the Federal estate tax laws in effect as of December 31, 2009 remained in effect on the date of the spouse's death requiring application of said provision.

What Impact Does Carryover Basis Have?

Matrimonial practitioners are well versed in the concepts of tax basis and the art of negotiating the division of assets with differences between tax basis and fair value at the time of the settlement. If the carryover basis rules continue to be law, the same concepts applied to property settlement negotiations will have to be applied to negotiating and drafting agreed-upon distributions from an estate. Although few tax experts believe carryover basis will remain law, it is always “Better to be safe than sorry.” Ignoring this reality or possibility could be problematic. In the past, assets received by a surviving spouse were generally received with a step-up in tax basis so that there would be no capital gains tax on selling those assets after inheriting them. Under the new law, the executor of the estate can allocate up to $1.3 million of basis adjustment to assets inherited by anyone, and up to an additional $3 million in assets bequeathed to a surviving spouse. Perhaps all wills drafted before 2010 were silent as to this matter. Likely most wills continue to be drafted in that manner.

Consider the Matrimonial Impact

Example: Husband's will provides for a bequest to a trust for the children from a prior marriage and the balance of his estate to his second wife. Son from the prior marriage is executor. The will is silent with regard to how state laws that addressed tax allocation would be applied or interpreted to address the allocation of this special basis increase. So son allocates all assets that have no appreciation to the children's trust and all appreciated assets to fund the wife's bequest. The result is a substantial built-in capital gains tax that substantially reduces the net economic benefit of the estate rights for which the surviving wife had negotiated. This situation could be further exacerbated by future increases in capital gains rates, increases most tax experts believe almost assured as the country grapples with growing deficits.

It would now appear that if an agreement requiring a division of one spouse's estate is currently being negotiated, the parties should address how appreciated versus non-appreciated assets are allocated. For example, the agreement could at least in broad terms require a pro-rata or equitable allocation of appreciated and non-appreciated assets to the different heirs. The problem with this approach is that if the spousal bequests are permitted to benefit from a $3 million basis adjustment on estates with less built-in gain or appreciation, there may be no harm to the surviving spouse for receiving appreciated assets. But this presents several additional issues, all of which should be considered in matrimonial agreements. If the bequest to the surviving spouse does not meet the requirements of “Qualified Spousal Property” (“QSP”) then that property will not qualify to benefit from the $3 million basis adjustment. Thus, the manner in which practitioners structure such bequests needs to contemplate these rules as well.

Since no one can know who will be the surviving spouse, a planning objective under the new post-estate tax system, similar to the objective under the old law, will be to divide assets between spouses. This is meant to assure the greatest likelihood of maximizing the basis increase regardless of who is the first to die. But the task of dividing assets is actually somewhat different, and more complex, from planning under prior law (i.e., the estate tax system in place through 2009). Under pre-2010 law the planning is based on dividing the value of assets between spouses. Under the post-2009 modified carry- over basis system you will need to divide assets based on appreciation. This is not only more complex, but it will require more careful monitoring. Thus, taxpayers who divided assets to maximize funding of bypass trusts under prior law will have to re-evaluate that planning.

These rules, if carryover basis remains, will require rethinking how many matrimonial/estate distributions are structured, and how the new paradigm for titling assets may affect matrimonial agreements.

Conclusion

Regardless of the outcome of the estate tax uncertainty, practitioners will need to rethink drafting techniques to protect clients properly. If the uncertainty remains, any documents that have not been drafted should be revisited.

Martin M. Shenkman, CPA, MBA, JD, a member of this newsletter's Board of Editors, is an estate planner in New York City and Teaneck, NJ. His Web site, www.laweasy.com, has information on matrimonial, investment and related matters.

Congress left the estate tax law in a state of complete confusion at the end of 2009. Even if the bigger question of whether we will have an estate tax is resolved by the time you read this article, many issues that affect matrimonial practitioners, not just estate planners, will still remain unresolved. However the estate tax repeal situation resolves itself, for the future, practitioners who negotiate matrimonial settlements and draft matrimonial documents should endeavor to address the lessons learned from these events.

Estate Tax Repeal: Is It Real?

The estate tax was repealed at the end of 2009. Tax experts expected Congress to continue the $3.5 million exclusion (how much you can bequeath without incurring a federal estate tax) and 45% rate from 2009 into 2010 while debating the future of the tax. In 2011 the exclusion drops to $1 million and the tax rate increases to 55% unless Congress acts. Tax advisers expect Congress to reinstate the estate tax in a manner similar to 2009 rules (it is uncertain if this will be retroactive, but as we get later into tax year 2010 retroactivity seems more unreasonable and more unlikely), and to eliminate the draconian rules that would otherwise come into effect in 2011. But, since all the experts were wrong on what happened once, practitioners have to plan flexibly and cautiously. Even if these uncertainties are resolved, important lessons remain for practitioners from the estate tax repeal situation, and issues will remain to be resolved for some time to come.

2010 Rules (Maybe?) in a Nutshell

The estate tax is gone (perhaps temporarily), but the gift tax remains. If your client makes large gifts to children or other heirs, a 35% tax can be assessed once the client has used up his available exclusions. In place of the estate tax is a complex new tax regime called “carryover basis.” When your client dies, his or her heirs will generally have the same tax basis (cost) for an asset they inherit that their benefactor had. This means a potentially greater capital gains tax when they sell. And since most tax people anticipate income and capital gains taxes to increase because of the deficits, these rates will be higher still. For example, the HIRE Act provides for a new 3.8% tax on investment income of wealthier tax payers. This and other changes will skew the system toward higher marginal rates and continue to introduce more complexity into the projections necessary to negotiate a settlement. The law (until they change it again) permits your client to increase tax basis by $1.3 million on death. This means your client can effectively eliminate the inherent appreciation for tax purposes to this extent. Spouses can qualify for an additional $3 million adjustment. But alas, not even Nostradamus could predict the outcome of all this. What does it mean? If carryover basis actually remains law, the need to ascertain and document the tax basis of assets when negotiating a matrimonial settlement will be even more important, and dramatically more difficult.

Securing a Percentage of the Gross Estate of the Monied Spouse

There are myriad objectives contained in property settlement, prenuptial and postnuptial agreements that can be aided by referencing tax law definitions. The advantage of this approach is that with a relatively short and simple provision, the detailed definitions and rules of a particular tax law provision can be effectively incorporated into the testing or implementation of the matrimonial agreement. Tax laws tend to be quite detailed. Luckily, the regulations, case law and other materials often provide considerable guidance so that uncertainty or disputes under the agreement can hopefully be minimized. Unfortunately, the sea change in the estate tax that occurred on New Year's Day 2010 now mandates a more comprehensive approach that clarifies the intent of the parties in the event the “rug is pulled out” from the tax provisions referenced. The following discussion illustrates the application of one such section.

An Example

An example can illustrate some of the issues that can arise. The language has been adapted and simplified from two recent client prenuptial agreements reviewed as part of an estate plan.

Example: New Spouse has modest assets and is marrying Monied Spouse, who has a substantial estate. The negotiations of the prenuptial agreement resulted in a compromise that New Spouse would receive 25% of the estate of Monied Spouse after two years of marriage. New Spouse's counsel wanted to be certain that Monied Spouse could not employ deception to distort what assets were included in the estate so the pre-nuptial agreement provided in part:

New Spouse shall receive Twenty Five Percent (25%) of the gross estate of Monied Spouse as defined for federal estate tax purposes under Code Section 2031 of the Internal Revenue Code as amended.

This might have seemed a rather cautious means of drafting the clause in light of the tax laws' historic paradigm defining the estate in the broadest sense. However, effective Jan. 1, 2010, the estate tax was repealed. What if Monied Spouse died on Jan. 10? At that time, it might be argued that 25% of the adjusted gross estate would be zero, since no gross estate existed at the time of death. Might the inclusion of the phrase “as amended” imply that it should be the estate tax law at the time of death and that these otherwise superfluous terms would counter an argument that it should be the gross estate as such term was defined in the context of the estate tax law at the time of the prenuptial agreement was executed?

'Gross Estate'

For the second illustrative clause below, the key phrase “gross estate” was clearly taken from the estate tax laws. However, it was not a defined term because it was neither in quotations, nor did it reference any particular Section of the Internal Revenue Code. Does this omission make the phrase less susceptible to the challenge to which the prior clause may be susceptible? And what paradigm is used to interpret the phrase in the second illustrative clause?

Matrimonial practitioners have often resorted to using tax law paradigms and definitions. However, just as estate planners may forever modify their drafting techniques in light of the estate tax repeal episode, matrimonial practitioners will do the same as it pertains to tax clauses in their documents. For example, had the first example been drafted as follows, perhaps the likelihood of someone arguing for a zero inheritance by New Spouse would be substantially lessened:

New Spouse shall receive Twenty Five Percent (25%) of the gross estate of Monied Spouse. It is the intent of the parties that the phrase “gross estate” be broadly interpreted to include all property rights and interests, real or personal, tangible or intangible, probate or non-probate. Should any issue arise as to whether a particular asset should be included in the phrase “gross estate” the broad definitions of “gross estate” as defined under Code Section, and Treasury Regulations thereunder, shall be applied to assure inclusion. The parties recognize that modifications may occur to such Code Section or the Treasury regulations thereunder, and in such event the utilization of such modified Code and/or regulations shall be done in a manner to carry out the intent of the parties as specified herein.

Whatever the ultimate resolution of the estate tax, practitioners are henceforth advised to incorporate a default definition anytime tax law references or terms are utilized, and provide a clear statement of the intent of any provision that cross-references any tax code definitions.

Prenuptial, Postnuptial and Divorce Agreements

Is there a quick fix to address the estate tax uncertainty? While quick fixes are always subject to some uncertainty and risk, the following language might suffice to amend a prenuptial or postnuptial agreement that includes references to estate tax law definitions ' .

WHEREAS, at the time that the Postnuptial Agreement was executed, a Federal estate tax (the “estate tax”) existed under the Internal Revenue Code of 1986, as amended (the “Code”), and the Postnuptial Agreement incorporated several terms and concepts relating to the estate tax; and

WHEREAS, as of January 1, 2010, the estate tax was repealed (albeit temporarily, at least at this point in time); and

WHEREAS, the parties now wish to modify and clarify the terms of the Postnuptial Agreement to take into account the repeal of the estate tax; and

'

TAX TERMS. If upon the death of either party the estate tax is not then in existence, then the Prenuptial Agreement and Postnuptial Agreement shall be read and interpreted as if the Federal estate tax laws in effect as of December 31, 2009 remained in effect on the date of such party's death. As a result, any provisions in the Prenuptial Agreement and/or Postnuptial Agreement (specifically including Paragraph XX) referring to the “federal gross estate,” Section 2031 of the Code, the IRS Form 706, or similar terms, ' then in effect” shall all be read and interpreted as if the Federal estate tax laws in effect as of December 31, 2009 remained in effect on the date of the spouse's death requiring application of said provision.

What Impact Does Carryover Basis Have?

Matrimonial practitioners are well versed in the concepts of tax basis and the art of negotiating the division of assets with differences between tax basis and fair value at the time of the settlement. If the carryover basis rules continue to be law, the same concepts applied to property settlement negotiations will have to be applied to negotiating and drafting agreed-upon distributions from an estate. Although few tax experts believe carryover basis will remain law, it is always “Better to be safe than sorry.” Ignoring this reality or possibility could be problematic. In the past, assets received by a surviving spouse were generally received with a step-up in tax basis so that there would be no capital gains tax on selling those assets after inheriting them. Under the new law, the executor of the estate can allocate up to $1.3 million of basis adjustment to assets inherited by anyone, and up to an additional $3 million in assets bequeathed to a surviving spouse. Perhaps all wills drafted before 2010 were silent as to this matter. Likely most wills continue to be drafted in that manner.

Consider the Matrimonial Impact

Example: Husband's will provides for a bequest to a trust for the children from a prior marriage and the balance of his estate to his second wife. Son from the prior marriage is executor. The will is silent with regard to how state laws that addressed tax allocation would be applied or interpreted to address the allocation of this special basis increase. So son allocates all assets that have no appreciation to the children's trust and all appreciated assets to fund the wife's bequest. The result is a substantial built-in capital gains tax that substantially reduces the net economic benefit of the estate rights for which the surviving wife had negotiated. This situation could be further exacerbated by future increases in capital gains rates, increases most tax experts believe almost assured as the country grapples with growing deficits.

It would now appear that if an agreement requiring a division of one spouse's estate is currently being negotiated, the parties should address how appreciated versus non-appreciated assets are allocated. For example, the agreement could at least in broad terms require a pro-rata or equitable allocation of appreciated and non-appreciated assets to the different heirs. The problem with this approach is that if the spousal bequests are permitted to benefit from a $3 million basis adjustment on estates with less built-in gain or appreciation, there may be no harm to the surviving spouse for receiving appreciated assets. But this presents several additional issues, all of which should be considered in matrimonial agreements. If the bequest to the surviving spouse does not meet the requirements of “Qualified Spousal Property” (“QSP”) then that property will not qualify to benefit from the $3 million basis adjustment. Thus, the manner in which practitioners structure such bequests needs to contemplate these rules as well.

Since no one can know who will be the surviving spouse, a planning objective under the new post-estate tax system, similar to the objective under the old law, will be to divide assets between spouses. This is meant to assure the greatest likelihood of maximizing the basis increase regardless of who is the first to die. But the task of dividing assets is actually somewhat different, and more complex, from planning under prior law (i.e., the estate tax system in place through 2009). Under pre-2010 law the planning is based on dividing the value of assets between spouses. Under the post-2009 modified carry- over basis system you will need to divide assets based on appreciation. This is not only more complex, but it will require more careful monitoring. Thus, taxpayers who divided assets to maximize funding of bypass trusts under prior law will have to re-evaluate that planning.

These rules, if carryover basis remains, will require rethinking how many matrimonial/estate distributions are structured, and how the new paradigm for titling assets may affect matrimonial agreements.

Conclusion

Regardless of the outcome of the estate tax uncertainty, practitioners will need to rethink drafting techniques to protect clients properly. If the uncertainty remains, any documents that have not been drafted should be revisited.

Martin M. Shenkman, CPA, MBA, JD, a member of this newsletter's Board of Editors, is an estate planner in New York City and Teaneck, NJ. His Web site, www.laweasy.com, has information on matrimonial, investment and related matters.