By Dennis L. Voelkel, Esq.

Federal estate tax planning has become a less important planning objective for an increasing number estate planning clients due to a combination of the substantial increase in the federal estate exemption in recent years and the decline in the net worth of many clients due to the slide real estate and stock values.

The Estate Tax

As of the date this article is written, we continue to lack certainty regarding the structure of the federal estate tax, including the amount of the estate tax exemption and the rates for the current year — 2010. However, it appears likely that the federal estate tax will neither be eliminated (as many have hoped) nor return to the $1.0 million level in 2011 (as now provided by law). General consensus is that the federal estate tax exemption will find its new home in the ballpark of $3.5 million per person (the estate tax exemption for 2009). Estates over this amount were taxed at the rate of 45% in 2009.

Background of the Family Exemption Trust

Basic federal estate planning for a couple simply entails designing the estate plan to utilize the estate tax exemptions of both husband and wife. If the estate tax exemption is $3.5 Million per person then couples with the proper federal estate tax planning through Family Exemption Trusts (a/k/a A/B trust, family trust, bypass trust, credit shelter trust) potentially should be able to eliminate federal estate taxes on estates of $7 million or less.

Gifts to a spouse or charity are not subject to federal estate tax. Therefore, such gifts do not utilize a client’s federal estate tax exemption, which is lost if not used at death. Gifts to a spouse are added to the surviving spouse’s estate and taxed at his/her death if the surviving spouse’s total gross estate exceeds the exemption amount. Therefore, if each spouse is going to take advantage of the federal estate tax exemption, he/she needs to give the assets to someone other than a spouse or charity. One option is to simply pass the assets on to the next generation. Of course, surviving spouses in most situations are hesitant to do so because they would lose complete control over and access to the assets. And that is where the Family Exemption Trust comes in. Assets passing to the Family Exemption Trust are deemed to have passed on to the next generation for estate tax purposes, thus utilizing the first spouse’s exemption, while the surviving spouse continues to retain access to the assets as a beneficiary of the trust.

The Family Exemption Trust is often designed with the surviving spouse receiving all of the income from the trust for life along with the right to be paid principal pursuant to certain standards. A common standard for distributing trust assets to a spouse is for the spouse’s “health, education, maintenance and support.” These are magic words in estate planning because this “ascertainable standard” even enables the surviving spouse to serve as the trustee of the trust, capable of making distributions to him/herself without the trust being considered part of surviving spouse’s estate. There is no minimum access that the surviving spouse must be given, but there is a maximum access and control that if exceeded would result in the trust assets being deemed part of the surviving spouse estate for federal tax purposes, thus completely defeating the estate tax planning benefit of the Family Exemption Trust.

The Problem with Many Older Estate Plans

Many older estate plans, some of which were drafted when the estate tax exemption was below $1.0 Million, require the mandatory funding of the Family Exemption Trust, often through funding formulas that put all of the first spouse’s assets in the Family Exemption Trust. Now, when clients realize that they may no longer need a Family Exemption Trust for federal estate tax planning purposes, most instinctively want to eliminate it so that assets pass outright to the surviving spouse. Also, some clients are surprised to learn that their estate plans provide that at the death of the first spouse, all of the assets of the first spouse pass to Family Exemption Trust, with none of it going outright to the surviving spouse.

Asset Protection and the Elimination of the Family Exemption Trust?

Should the Family Exemption Trust be eliminated where it serves no federal estate tax planning purpose? It depends.

There are benefits to funding the Family Exemption Trusts other than federal estate tax planning. Family Exemption Trusts provide substantial asset protection benefits. They also increase the likelihood that the first spouse’s children (or other intended beneficiaries) ultimately receive the assets.

In most cases, assets in the Family Exemption Trust are protected against the surviving spouse’s creditors. Because the surviving spouse does not have the ability to withdraw the assets from the trust, the surviving spouse’s creditors generally cannot do so either.

Because the Family Exemption Trust becomes irrevocable at the death of the first spouse, the surviving spouse does not have the ability to change its terms. Therefore, the surviving spouse cannot disinherit a child following an argument. In addition, the surviving spouse does not have the right to give the trust assets to someone else. This may be an important consideration if the surviving spouse remarries, and the new husband or wife exercises influence over the surviving spouse. Once the assets leave the trust then they cease being protected.

In evaluating whether or not to keep or eliminate the Family Exemption Trust, you should ask yourself the following questions:

• Do you wish to achieve greater asset protection by keeping the assets out of the surviving spouse’s name? [This is especially important if the surviving spouse is or may someday be engaged in a potentially risky profession or business.]
• Do you wish to provide greater assurance that part of the marital assets will ultimately pass to the children (and not to the surviving spouse’s new husband or wife) by placing limits on the surviving spouse’s access to those assets? [This protects against influence from both the new spouse and certain children who seek to exclude other children.]
• Do you wish to protect the surviving spouse from potential loss if he/she remarries and then divorces? And, if you are the surviving spouse, do you want the ability to tell a future spouse that the assets are not yours to share?

In light of these important considerations, some clients will choose to partially fund the Family Exemption Trust even though it is unnecessary for federal estate tax purposes. In other instances, clients will choose to keep it simple and just leave everything outright to the surviving spouse.

Optional Funding of Family Exemption Trust via Disclaimer

In most estate plans, the surviving spouse should retain the option to fund the Family Exemption Trust through a disclaimer. A disclaimer is a formal statement that essentially causes the assets to bypass you and pass to the next beneficiary in line to inherit. In this case, that would be the Family Exemption Trust. Therefore, with disclaimer exemption planning the surviving spouse can decide whether or not to fund the Family Exemption Trust after consulting with advisors and weighing the facts that then exist, such as estate and income tax laws, the likelihood of remarriage, or the need for asset protection planning.

Second Marriages and Blended Families

The planning goals for first marriages are often different than those for subsequent marriages. In the case of first marriages, where the children belong to both the husband and wife, spouses are far more likely to leave the assets to the surviving spouse, knowing that their children are also the natural heirs of their spouse.

On the other hand, in blended families, couples are more likely to want to protect against the surviving spouse disinheriting children from a prior marriage. In such cases, clients may desire some level of mandatory funding of the Family Exemption Trust, and occasionally even leave some or all the assets directly to the children, thus bypassing the surviving spouse entirely.

Leaving Assets Directly to Children’s Trusts

Younger couples, recognizing the likelihood that the surviving spouse will remarry, sometimes desire to leave a portion of their assets to their children in trust instead of the surviving spouse. These couples seek the assurance that their children will not be deprived, especially in respect to the education of the child, as the result of influences exerted upon their surviving spouse by a new husband or wife.

Summary

Deciding whether and to what extent couples should use a Family Exemption Trust arrangement, even if they do not have federal estate tax planning concerns, requires an informed and thoughtful analysis. In addition to providing federal estate tax savings, Family Exemption Trusts provide important asset protection benefits and greater assurances that your assets ultimately pass to your intended beneficiaries.