2010 Tax Act Impact on Matrimonial Matters

Major changes were made to the federal transfer tax laws with the Dec. 17, 2010 enactment of “The Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010,” the “2010 Tax Act.” These changes will have a significant impact on certain matrimonial matters. They also make it essential for all matrimonial practitioners to exercise caution with respect to their clients' existing estate plans and documents. Certain asset transfers in particular may raise issues for matrimonial property settlements.

Key Law Changes

The gift, estate and generation skipping transfer (“GST”) exclusion will be $5 million in 2011 and 2012. But these generous changes are still only temporary. They end in 2012 and in 2013, a $1 million exclusion and 55% rate return. Many matrimonial plans and agreements use estate tax references and terminology in definitions. These wide swings in the estate tax rules could result in commensurate gyrations in the economic consequences under your matrimonial documents. Practitioners should contact any client who may have formula clauses in matrimonial documents to review and clarify them in light of these estate tax law fluctuations.

Large Gifts May Have Matrimonial Impact

Many clients will be encouraged by their estate planners to make large gifts in 2011 and 2012 to reduce their estate in the event that 2013 will bring the return of a low estate tax exclusion and high estate tax rates. For taxpayers with moderate wealth (perhaps $3 million to $12 million), these transfers may take the form of simple outright gifts or gifts to irrevocable trusts. For high net-worth clients, these transfers may use more sophisticated techniques, such as note sales to grantor dynasty trusts, to leverage tens or even hundreds of millions of dollars outside their estates. Before any such major gift or estate tax motivated transfers are consummated, practitioners should caution clients to have the matrimonial implications of these carefully evaluated. Most estate planning for a couple is handled by one attorney who cannot advise either spouse as to the matrimonial problems that might result from a transfer. Given the substantial incentive the 2010 Tax Act creates for ultra high-net worth clients to shift wealth, the consequences of these steps will likely reverberate in the matrimonial arena for many decades.

If large gift transfers are desirable, any prerequisites contained in prenuptial or other matrimonial agreements should be addressed. Although many estate planners endeavor to address these issues, too often they are overlooked, or the clients will not authorize the requisite work.

Insurance Coverage May Be Affected

Many taxpayers have already begun contemplating, or even planning to reduce life insurance coverage that is viewed as superfluous in light of the 2010 Tax Act's dramatic increases in the basic exclusion amount to $5 million. This is the amount that can be passed to heirs free of federal estate tax. Before canceling any life insurance coverage, they should carefully evaluate the matrimonial implications of those actions, requirements under prenuptial or other matrimonial agreements and other ramifications. If life insurance is cancelled and needed at a later date as part of a divorce settlement, health issues may make replacement coverage prohibitively expensive, or even impossible to obtain. Also, life insurance is often held in irrevocable trusts. Many of these trusts are planned and implemented with specific consideration to an overall matrimonial plan. Terminating the insurance coverage could undermine important safeguards clients previously negotiated.

Estate-Planning Documents (Wills) Will Change

Every client should be advised to review all existing estate planning documents now that the estate tax laws are clear to determine what revisions are advisable. The manner in which distributions and bequests under client documents were written may need to be updated to reflect the new law and other changes. Many taxpayers will opt for simple, inexpensive “I love you” wills that do not include any trusts. After all, with a $5 million exclusion, many may view estate tax planning as an unnecessary costly waste. While this might in fact provide some up-front cost savings, and the superficial benefit of “simplicity,” this approach could prove disastrous from a matrimonial perspective. Trusts were rarely only used to save estate taxes. Protecting assets for children from a current or prior marriage, protecting a surviving spouse from a new opportunistic spouse, and so on, were always vital objectives met by the use of trusts in estate planning. This has not changed. While the formulas that may be used to fund estate planning trusts may change, the matrimonial considerations should not. Matrimonial practitioners should endeavor to communicate this point to clients. Further, as the use of trusts will likely wane, matrimonial practitioners will face more opportunities to address matrimonial considerations in prenuptial agreements when the surviving spouse remarries without the protection of the traditional bypass trust.

Portability Concepts Should Be Addressed in Prenuptial Agreements

The 2010 Tax Act introduced an entirely new estate planning concept that could have tremendous ramifications for client estate and matrimonial planning. The concept, called “portability” permits a surviving spouse to use the remaining or unused exclusion (the amount that can be gifted or bequeathed gift- or estate-tax free) to the surviving spouse. This raises a host of important matrimonial implications, none of which could have been addressed in any matrimonial planning or
documents that preceded the 2010 Tax Act. Matrimonial practitioners should coordinate with clients' estate planners to be certain that the appropriate safeguards and steps are taken.

If portability is made permanent (it is presently scheduled to end in 2013 unless Congress extends the 2010 Tax Act changes), then planning for the use of estate tax exclusions will become a significant factor in marital planning. The numbers could be simply too large to ignore. Perhaps the new meaning given to the phrase “marriage of convenience” will be to refer to a couple who married so that the wealthy spouse, for a fee, could avail himself or herself of the estate tax exclusion of the new impoverished spouse. Imagine the want adds:

“Elderly, preferably terminally ill, female spouse needed. Will provide $100,000 bonus to your heirs for the use of your basic exclusion amount. Must be poor and remain poor throughout the marriage.”

If in fact the position posited by some tax experts, that the gift use of unused exclusions is not limited to only one prior spouse, Henry VIII syndrome could really become common as wealthy clients seek out marriages of convenience to accumulate other taxpayers' unused estate tax exclusions.

It will become de rigueur in negotiating prenuptial agreements for second and later spouses to obtain confirmation of the remaining portable estate tax exclusion. This representation should specifically address whether any prior taxable gifts were made, whether gift tax returns were filed (and, if so, copies should be attached as an exhibit), and whether any audits of those returns occurred.

Pre-marital due diligence should include a review of all prior gift tax returns to ascertain if the adequate disclosure rules were met and the statute of limitations on audits indeed tolled. If the items reported on a gift tax return were reported with sufficient specificity and disclosures, then the period during which the IRS can audit that return will run out (toll). When the audit period has expired, the IRS cannot revisit the returns and audit them. This will be an important consideration for the surviving spouse.

Perhaps for open gift tax return years (i.e., returns for periods that the IRS can still audit the returns), the prenuptial agreement should provide a readjustment of the negotiated financial arrangements if the audit of those returns depletes the remaining exclusion of the spouse being represented.

Matrimonial counsel should also evaluate having an estate planner transfer assets to an irrevocable trust for the client prior to marriage. Since it appears that portability of the estate exclusion can be applied to inter-vivos gifts by the surviving spouse as well, this transfer may secure the benefit of that exclusion without the risks discussed above. The transfer, however, may not be a simple task if the surviving spouse has to use her own exclusion (basic exclusion amount) first, or simultaneously. At present there is no clarity in the law as to whether some type of ordering rule will be required.

Disclaimers

There is a potential issue with disclaimers under the 2010 Tax Act that might present interesting planning opportunities or challenges for matrimonial practitioners. As a general matter, most practitioners are familiar with a disclaimer of interests in an inheritance by a client, or the client's ex-spouse to be, to avoid having those assets added to the marital estate. Section 301(d)(1) of the 2010 Tax Act presents some interesting twists on this common planning tool that might be essential to certain matrimonial cases. First a quick overview of the tax law requirements for a disclaimer before the 2010 Tax Act changes.

Disclaimers, or renunciations, are a time-honored powerful post-death (post-mortem) estate-planning technique. The donee or beneficiary of a gift or bequest may be able to refuse to accept (disclaim) that gift or bequest. The property then passes to whoever would have received it if the disclaiming person had not survived the decedent. Compliance with any state law mandate is required for a disclaimer to be valid. Such requirements might include a filing with the court, notice to the executor, or some other action. Some states require that this be done within nine months of the decedent's death. For a disclaimer to be valid under federal estate tax rules it must comply with the requirements of Code Section 2518. These include:

• The disclaimer must be in writing.
• The disclaimer must be made on a timely basis that is generally nine months from the date of transfer for a gift or the date of death for a bequest. This is the one provision for which TRA has provided some leniency.
• The person disclaiming cannot have accepted benefit from the property.
• The property must pass without the direction of the person making the disclaimer (although a special rule is provided for a spouse).

If assets were distributed to beneficiaries, or the beneficiaries benefited from the property involved, it may no longer be feasible to file a disclaimer (renunciation) with respect to those assets.

The 2010 Tax Act extended the time during which a disclaimer can be made for federal estate tax purposes for decedents dying from Jan. 1, 2010 to the Dec. 17, 2010 date of enactment for nine months. This may give those involved in a matrimonial matter a substantially longer time frame in which to plan a disclaimer to impact their matrimonial situation. But many questions are unanswered: Will the extension of the time to make disclaimers still have hurdles to face under the language of governing documents or state law? Will states have to create disclaimer extensions to enable executors to take advantage of this leniency? What will the legal impact be to the disclaimer of real estate in a state that has a nine month statutory deadline? If the statutory deadline is passed, the disclaimer would still be valid under federal estate tax law so long as it is within the extension period provided by the TRA. But if the disclaimer does not comport with state law, will the disclaimer then be invalid to affect the transfer of real estate or other asset as desired? Code Section 2518(c)(3) may help. It says that a transfer that does not qualify as a disclaimer under local law may still constitute a qualified disclaimer for federal tax purposes if the disclaimer operates to transfer property to the persons who would have received the property had it been a qualified disclaimer under local law. But what will it mean in a matrimonial context?

So the bottom line on disclaimers is that clients who have an inheritance and are now embroiled in a matrimonial matter, may have a longer period in which to disclaim to reduce their marital estate. The flip-side of this is that practitioners involved in matrimonial matters performing due diligence on their client's soon-to-be ex-spouse should endeavor to ascertain if a disclaimer was filed during this federal extension period as it may be feasible to challenge that disclaimer as not binding on the matrimonial estate if it does not comport with state law disclaimer requirements.

Conclusion

Although matrimonial practitioners have always considered estate taxes and planning to some degree, the significant changes made by the 2010 Tax Act should be evaluated in the context of all client documents and current planning.

Martin M. Shenkman, CPA, MBA, PFS, AEP, JD, a member of this newsletter's Board of Editors, is an estate planner in private practice in Paramus, NJ. He is author of “Estate Planning After the 2010 Tax Act,” published by the American Institute of CPAs and available through www.cpa2biz.com.

Major changes were made to the federal transfer tax laws with the Dec. 17, 2010 enactment of “The Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010,” the “2010 Tax Act.” These changes will have a significant impact on certain matrimonial matters. They also make it essential for all matrimonial practitioners to exercise caution with respect to their clients' existing estate plans and documents. Certain asset transfers in particular may raise issues for matrimonial property settlements.

Key Law Changes

The gift, estate and generation skipping transfer (“GST”) exclusion will be $5 million in 2011 and 2012. But these generous changes are still only temporary. They end in 2012 and in 2013, a $1 million exclusion and 55% rate return. Many matrimonial plans and agreements use estate tax references and terminology in definitions. These wide swings in the estate tax rules could result in commensurate gyrations in the economic consequences under your matrimonial documents. Practitioners should contact any client who may have formula clauses in matrimonial documents to review and clarify them in light of these estate tax law fluctuations.

Large Gifts May Have Matrimonial Impact

Many clients will be encouraged by their estate planners to make large gifts in 2011 and 2012 to reduce their estate in the event that 2013 will bring the return of a low estate tax exclusion and high estate tax rates. For taxpayers with moderate wealth (perhaps $3 million to $12 million), these transfers may take the form of simple outright gifts or gifts to irrevocable trusts. For high net-worth clients, these transfers may use more sophisticated techniques, such as note sales to grantor dynasty trusts, to leverage tens or even hundreds of millions of dollars outside their estates. Before any such major gift or estate tax motivated transfers are consummated, practitioners should caution clients to have the matrimonial implications of these carefully evaluated. Most estate planning for a couple is handled by one attorney who cannot advise either spouse as to the matrimonial problems that might result from a transfer. Given the substantial incentive the 2010 Tax Act creates for ultra high-net worth clients to shift wealth, the consequences of these steps will likely reverberate in the matrimonial arena for many decades.

If large gift transfers are desirable, any prerequisites contained in prenuptial or other matrimonial agreements should be addressed. Although many estate planners endeavor to address these issues, too often they are overlooked, or the clients will not authorize the requisite work.

Insurance Coverage May Be Affected

Many taxpayers have already begun contemplating, or even planning to reduce life insurance coverage that is viewed as superfluous in light of the 2010 Tax Act's dramatic increases in the basic exclusion amount to $5 million. This is the amount that can be passed to heirs free of federal estate tax. Before canceling any life insurance coverage, they should carefully evaluate the matrimonial implications of those actions, requirements under prenuptial or other matrimonial agreements and other ramifications. If life insurance is cancelled and needed at a later date as part of a divorce settlement, health issues may make replacement coverage prohibitively expensive, or even impossible to obtain. Also, life insurance is often held in irrevocable trusts. Many of these trusts are planned and implemented with specific consideration to an overall matrimonial plan. Terminating the insurance coverage could undermine important safeguards clients previously negotiated.

Estate-Planning Documents (Wills) Will Change

Every client should be advised to review all existing estate planning documents now that the estate tax laws are clear to determine what revisions are advisable. The manner in which distributions and bequests under client documents were written may need to be updated to reflect the new law and other changes. Many taxpayers will opt for simple, inexpensive “I love you” wills that do not include any trusts. After all, with a $5 million exclusion, many may view estate tax planning as an unnecessary costly waste. While this might in fact provide some up-front cost savings, and the superficial benefit of “simplicity,” this approach could prove disastrous from a matrimonial perspective. Trusts were rarely only used to save estate taxes. Protecting assets for children from a current or prior marriage, protecting a surviving spouse from a new opportunistic spouse, and so on, were always vital objectives met by the use of trusts in estate planning. This has not changed. While the formulas that may be used to fund estate planning trusts may change, the matrimonial considerations should not. Matrimonial practitioners should endeavor to communicate this point to clients. Further, as the use of trusts will likely wane, matrimonial practitioners will face more opportunities to address matrimonial considerations in prenuptial agreements when the surviving spouse remarries without the protection of the traditional bypass trust.

Portability Concepts Should Be Addressed in Prenuptial Agreements

The 2010 Tax Act introduced an entirely new estate planning concept that could have tremendous ramifications for client estate and matrimonial planning. The concept, called “portability” permits a surviving spouse to use the remaining or unused exclusion (the amount that can be gifted or bequeathed gift- or estate-tax free) to the surviving spouse. This raises a host of important matrimonial implications, none of which could have been addressed in any matrimonial planning or
documents that preceded the 2010 Tax Act. Matrimonial practitioners should coordinate with clients' estate planners to be certain that the appropriate safeguards and steps are taken.

If portability is made permanent (it is presently scheduled to end in 2013 unless Congress extends the 2010 Tax Act changes), then planning for the use of estate tax exclusions will become a significant factor in marital planning. The numbers could be simply too large to ignore. Perhaps the new meaning given to the phrase “marriage of convenience” will be to refer to a couple who married so that the wealthy spouse, for a fee, could avail himself or herself of the estate tax exclusion of the new impoverished spouse. Imagine the want adds:

“Elderly, preferably terminally ill, female spouse needed. Will provide $100,000 bonus to your heirs for the use of your basic exclusion amount. Must be poor and remain poor throughout the marriage.”

If in fact the position posited by some tax experts, that the gift use of unused exclusions is not limited to only one prior spouse, Henry VIII syndrome could really become common as wealthy clients seek out marriages of convenience to accumulate other taxpayers' unused estate tax exclusions.

It will become de rigueur in negotiating prenuptial agreements for second and later spouses to obtain confirmation of the remaining portable estate tax exclusion. This representation should specifically address whether any prior taxable gifts were made, whether gift tax returns were filed (and, if so, copies should be attached as an exhibit), and whether any audits of those returns occurred.

Pre-marital due diligence should include a review of all prior gift tax returns to ascertain if the adequate disclosure rules were met and the statute of limitations on audits indeed tolled. If the items reported on a gift tax return were reported with sufficient specificity and disclosures, then the period during which the IRS can audit that return will run out (toll). When the audit period has expired, the IRS cannot revisit the returns and audit them. This will be an important consideration for the surviving spouse.

Perhaps for open gift tax return years (i.e., returns for periods that the IRS can still audit the returns), the prenuptial agreement should provide a readjustment of the negotiated financial arrangements if the audit of those returns depletes the remaining exclusion of the spouse being represented.

Matrimonial counsel should also evaluate having an estate planner transfer assets to an irrevocable trust for the client prior to marriage. Since it appears that portability of the estate exclusion can be applied to inter-vivos gifts by the surviving spouse as well, this transfer may secure the benefit of that exclusion without the risks discussed above. The transfer, however, may not be a simple task if the surviving spouse has to use her own exclusion (basic exclusion amount) first, or simultaneously. At present there is no clarity in the law as to whether some type of ordering rule will be required.

Disclaimers

There is a potential issue with disclaimers under the 2010 Tax Act that might present interesting planning opportunities or challenges for matrimonial practitioners. As a general matter, most practitioners are familiar with a disclaimer of interests in an inheritance by a client, or the client's ex-spouse to be, to avoid having those assets added to the marital estate. Section 301(d)(1) of the 2010 Tax Act presents some interesting twists on this common planning tool that might be essential to certain matrimonial cases. First a quick overview of the tax law requirements for a disclaimer before the 2010 Tax Act changes.

Disclaimers, or renunciations, are a time-honored powerful post-death (post-mortem) estate-planning technique. The donee or beneficiary of a gift or bequest may be able to refuse to accept (disclaim) that gift or bequest. The property then passes to whoever would have received it if the disclaiming person had not survived the decedent. Compliance with any state law mandate is required for a disclaimer to be valid. Such requirements might include a filing with the court, notice to the executor, or some other action. Some states require that this be done within nine months of the decedent's death. For a disclaimer to be valid under federal estate tax rules it must comply with the requirements of Code Section 2518. These include:

• The disclaimer must be in writing.
• The disclaimer must be made on a timely basis that is generally nine months from the date of transfer for a gift or the date of death for a bequest. This is the one provision for which TRA has provided some leniency.
• The person disclaiming cannot have accepted benefit from the property.
• The property must pass without the direction of the person making the disclaimer (although a special rule is provided for a spouse).

If assets were distributed to beneficiaries, or the beneficiaries benefited from the property involved, it may no longer be feasible to file a disclaimer (renunciation) with respect to those assets.

The 2010 Tax Act extended the time during which a disclaimer can be made for federal estate tax purposes for decedents dying from Jan. 1, 2010 to the Dec. 17, 2010 date of enactment for nine months. This may give those involved in a matrimonial matter a substantially longer time frame in which to plan a disclaimer to impact their matrimonial situation. But many questions are unanswered: Will the extension of the time to make disclaimers still have hurdles to face under the language of governing documents or state law? Will states have to create disclaimer extensions to enable executors to take advantage of this leniency? What will the legal impact be to the disclaimer of real estate in a state that has a nine month statutory deadline? If the statutory deadline is passed, the disclaimer would still be valid under federal estate tax law so long as it is within the extension period provided by the TRA. But if the disclaimer does not comport with state law, will the disclaimer then be invalid to affect the transfer of real estate or other asset as desired? Code Section 2518(c)(3) may help. It says that a transfer that does not qualify as a disclaimer under local law may still constitute a qualified disclaimer for federal tax purposes if the disclaimer operates to transfer property to the persons who would have received the property had it been a qualified disclaimer under local law. But what will it mean in a matrimonial context?

So the bottom line on disclaimers is that clients who have an inheritance and are now embroiled in a matrimonial matter, may have a longer period in which to disclaim to reduce their marital estate. The flip-side of this is that practitioners involved in matrimonial matters performing due diligence on their client's soon-to-be ex-spouse should endeavor to ascertain if a disclaimer was filed during this federal extension period as it may be feasible to challenge that disclaimer as not binding on the matrimonial estate if it does not comport with state law disclaimer requirements.

Conclusion

Although matrimonial practitioners have always considered estate taxes and planning to some degree, the significant changes made by the 2010 Tax Act should be evaluated in the context of all client documents and current planning.

Martin M. Shenkman, CPA, MBA, PFS, AEP, JD, a member of this newsletter's Board of Editors, is an estate planner in private practice in Paramus, NJ. He is author of “Estate Planning After the 2010 Tax Act,” published by the American Institute of CPAs and available through www.cpa2biz.com.