Without planning, married couples with over $1,000,000 in
combined assets expose the estate of the surviving spouse to an estate tax.
However, the same couple may choose to limit the estate tax, or even
eliminate it altogether, by making use of a "bypass trust" or a "credit
shelter trust". Let's see how it is done.
The "Sweetheart Will" is a Tax Trap. A marital deduction
is hard wired into the estate tax laws. That means that a married person can
leave the surviving spouse an unlimited estate without having to pay an
estate tax immediately. Thinking in the short term, one is tempted to sign a
simple Will giving the entire estate to the surviving spouse. But in the
long term couples who opt for these "Sweetheart Wills" unnecessarily play
into the hands of the tax collector. A surviving spouse receives the assets
of a deceased spouse free of estate tax, but the full tax on the spouses'
combined assets comes due when the survivor dies.
Example – "Romeo and Juliet". Romeo and Juliet are
married (forget about the end of Mr. Shakespeare's tragedy) and together
they own property worth $2,000,000. Conveniently, their property is evenly
divided. Romeo and Juliet each owns property worth $1,000,000. Each of the
lovebirds has a Will which leaves all of the property to the survivor. When
the survivor dies, all of the property in the hands of the survivor will
pass to the children under the survivor's Will. If Romeo dies first, his
property worth $1,000,000 will be transferred to Juliet. After she dies, all
of the $2,000,000 concentrated in her hands will pass to the children. Using
her federal estate tax credit she shelters all of the inheritance from U.S.
estate tax. But her Maryland estate tax credit is only $1,000,000, leaving
the other $1,000,000 unprotected. Her estate will pay $99,600 to the State
of Maryland. The children's legacy is reduced by 4.98% to $1,900,400.
What Happened? The couple incurred the Maryland estate tax
because Romeo did not plan to use his $1,000,000 credit exemption amount.
His Will forced all of his property to pass to Juliet. After the allowance
of the marital deduction the taxable estate was reduced to $0! His estate
produced no tax, hence no opportunity to apply his credit amount came to
hand. Moreover, his credit amount is not portable. Romeo's unused credit
died with him. The estate tax on his $1,000,000 was simply deferred until
Juliet's death.
Let's Fix It. Romeo must preserve his estate tax credit
amount. The first idea which comes to mind is give $1,000,000 to somebody
other than Juliet, for instance, the children. That works as a tax saving
plan, but Juliet would not be pleased. Her financial nest egg following
Romeo's death would be reduced by 50%. The couple can permanently reduce the
estate tax payout as well as provide Juliet with financial security: use a
Bypass Trust.
Example – "Bonnie and Clyde". Bonnie and Clyde, like
Romeo and Juliet, each has $1,000,000 to his or her name. (Bonnie married
Clyde after a career in banking and had children.) Bonnie and Clyde each has
a Will which specifies that $1,000,000 will pass to a Bypass Trust. If
Bonnie dies first, her $1,000,000 will be held for Clyde's benefit. He will
have access to the principal and income of the trust for his lifetime. When
he dies, the remaining balance of the trust will be distributed to the
children, in addition to Clyde's own $1,000,000 which passes to them at
Clyde's death. Neither Bonnie's nor Clyde's estate pays any estate tax. The
children receive all of the $2,000,000.
What Happened This Time? The $1,000,000 passing from
Bonnie to her Bypass Trust is sheltered by the tax credit and is not taxed.
The better news is that it will not be taxed at Clyde's death because the
amount in the trust "bypasses" his estate on the way to the children.
Tax planning can be 100% successful for an estate of a
married couple with assets of more than $1,000,000 but less than $2,000,000.
Let's turn to an estate of a couple which comes in between $2,000,000 and
$7,000,000.
Example – "Anthony and Cleopatra". Anthony and Cleopatra
are a wealthy couple (and have resettled in Maryland after an extended stay
in Egypt). Together, they have assets totaling $7,000,000. Each of them has
a Will which gives a certain amount of his or her estate to a Bypass Trust.
The amount going into the Bypass Trust is determined by a formula. The
formula says, in effect, "give my Bypass Trust an amount equal to the amount
of my available federal estate tax credit." Anthony dies, and his entire
$3,500,000 is used to fund his Bypass Trust. Nothing passes to Cleopatra.
His estate pays no U.S. estate tax, but it pays $229,200 to Maryland. The
same thing happens when Cleopatra dies.
The "Decoupling Problem". Anthony and Cleopatra
encountered the effects of the "decoupling" of the Maryland estate tax
system from the federal. Decoupling presents a conundrum with two mutually
exclusive solutions.
Solution #1. If the couple takes full advantage of the
federal credit according to the funding formula, each would leave $3,500,000
to a Bypass Trust. Nothing is left to the surviving spouse. No marital
deduction is applied. An estate that size is protected by the federal tax
credit, but $2,500,000 is left exposed to the Maryland estate tax since the
State credit is only $1,000,000. The $2,500,000 difference is the "gap
amount". If Anthony dies first, his estate for federal and Maryland purposes
is $3,500,000. The estate pays Maryland tax of $229,200 at the first death.
It avoids the U.S. tax because the tax credit wipes out the tax liability.
When Cleopatra dies, Anthony's Bypass Trust goes straight to the children
avoiding her estate, while the balance of her estate is protected by her
federal credit amount. For Maryland purposes, her estate is worth $3,500,000
and pays a tax of $229,200. The total tax paid is $458,400, all to Maryland.
Solution #2. The other solution is to rewrite the Bypass
Trust formulas so that only the Maryland credit amount is funneled into the
trust. The remaining $2,500,000 is given to the surviving spouse. The
rewrite eliminates the tax at the first death, but the $2,500,000 "gap
amount" passing to the surviving spouse is taxed when he or she dies. The
bottom line is that the tax on the "gap amount" is deferred until the death
of the surviving spouse. If Anthony dies first, the Bypass Trust is funded
with only $1,000,000. The remaining $2,500,000 passing to Cleopatra is
covered by the marital deduction, reducing his taxable estate to a mere
$1,000,000. Anthony's estate pays no Maryland or U.S. estate tax. Cleopatra
then dies. Her estate consists of her $3,500,000 plus the $2,500,000 from
Anthony, combining into a total estate of $6,000,000, all of which is taxed
by the U.S. and Maryland. The tax collectors are the beneficiaries of
$1,405,940, or 23.43%, of her estate. It pays $895,140 to the IRS and
$510,800 to Maryland.
Neither of these solutions is pleasant to contemplate.
The first results in a tax at the first death, and the second defers the tax
at great price. Some help, albeit incomplete help, is at hand: the
"Maryland-Only QTIP Trust". It works like this.
The Maryland-Only QTIP Trust Solution. Let's forget
about Solution #2 and instead work with Solution #1 to eliminate the tax at
the first death. Relief for the surviving spouse lies in a provision of
Maryland law which allows us to use the full federal tax credit and, at the
same time, treat the "gap amount" as being eligible for the marital
deduction. The plan, with several variations, follows this basic pattern.
First, put the Maryland exemption amount ($1,000,000) into a Bypass Trust
and put the rest of the estate into a Marital Trust. The Marital Trust
exists for the sole purpose of supporting the surviving spouse for life, but
anything left in the trust when the spouse dies is taxed. Second, segregate
the "gap amount" portion of the Marital Trust from the amount in excess of
the "gap amount". At this point we may have three trust portions, depending
on the size of the estate. The first $1,000,000 goes in a Bypass Trust, the
"gap amount" is segregated from the rest of the Marital Trust, and the
excess amount is held separately for the surviving spouse's sole benefit.
Third, treat the "gap amount" part of the Marital Trust like it is a
chameleon. For federal purposes it looks like a Bypass Trust and for
Maryland purposes it looks like a deductible marital gift.
The Final Result. The estate of the first spouse to die
pays no estate tax. No estate tax is paid to either the U.S. or Maryland at
the first death. At the second death, no Maryland or U.S. tax is due on the
Bypass Trust. No federal tax is payable on the "gap amount" portion of the
Marital Trust. However, Maryland will collect its tax on the "gap amount" if
the surviving spouse's estate, including the "gap amount", exceeds
$1,000,000. Cleopatra's estate would be worth $6,000,000 for estate tax
purposes and would pony up $510,800 to Maryland, but nothing to the IRS.
Summing Up. The Maryland-Only QTIP Trust Solution offers
a way to avoid all estate tax when the first spouse dies. That is a good
outcome, especially for the surviving spouse. It also may eliminate or
reduce the federal estate tax. That is an even better outcome for the
family, especially the children. The cost of this technique for a couple
with a combined estate of $7,000,000, compared to Solution #1, is a bit more
Maryland estate tax, namely, $510,800 versus $458,400. But the couple avoids
a $895,140 federal tax.
Standard Tax Opinion Disclaimer. We are obliged to bring
to your attention that this tax advice and conclusions are not intended or
written to be used, and in fact they cannot be used, by anyone for the
purpose of avoiding tax penalties imposed by the U.S. Internal Revenue Code
or for promoting, marketing, or recommending a matter or a transaction to
another party.
For most people, the federal estate tax is dead! If
you die this year, 2009, your family and friends will not have to deal with the
IRS's "Death Tax" unless you have more than $3,500,000 to leave to them. Only a
handful of the U.S. citizens dying each year have taxable estates larger. Even
wealthy people dying in 2010 will be excused from paying a federal estate tax
unless Congress mixes and matches several pending proposals to make the current
federal tax permanent. The conventional wisdom, which is far from infallible,
has the U.S. estate tax being extended into 2010 and beyond with the proviso
that estates with assets at the $3,500,000 to $5,000,000 level will not enter
into the estate tax system. For the moment, we have $3,500,000 to work with
until the end of 2009. 
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