Unexpected Effects of the $5,000,000 Exclusion

     Now that the applicable exclusion amount for determining when the federal government assess estate taxes is $5,250,000, many clients believe that they no longer need to worry about updating their estate plan because their estate will never be large enough to pay estate taxes. However, the majority of estate plans prepared when the applicable exclusion amount was much lower than the current $5,250,000 never contemplated the exclusion reaching such a high value. Plans drafted as late as 2010 expected the exclusion to remain at $3,500,000 and plans drafted prior to 2001 were written when the exclusion was less than $1,000,000. Practitioners must now revisit these plans in light of the higher applicable exclusion amount, to determine whether the non-marital and marital shares created will leave the surviving spouse with sufficient assets on which to live comfortably. 

     There may be no need to amend a Living Trust that creates separate marital deduction and non-marital deduction shares if the provisions of the two shares provide the surviving spouse sufficient flexibility. This is particularly true where the clients have only common descendants and believe that the surviving spouse may need their entire combined wealth to maintain his or her accustomed standard of living. The increased applicable exclusion amount will have little effect on the surviving spouse in such an estate plan, because allocating the first $5,250,000 to the non-marital portion with little or none going to the marital portion will have little actual economic effect on the surviving spouse. Still, with the applicable exclusion now at $5,250,000, most if not all of the assets of most Living Trusts will be allocated to the non-marital share, leaving little flexibility for the spouse. Faced with this reality on the death of the first spouse, the surviving spouse will likely be very unhappy to be told that she is only entitled to income automatically and principal within the discretion of the trustee. 

     However, the increased applicable exclusion amount can create a serious problem if the marital and non-marital deduction shares do not both benefit the spouse or if they both benefit the spouse, but substantially different ways. An estate plan that creates a non-marital deduction share that benefits family members other than the surviving spouse can produce a particularly unfortunate result under the current law. If the trust provides that the non-marital share is equal to the available applicable exclusion amount and the total estate is less than that applicable exclusion amount, it will create a non-marital share that will disinherit a surviving spouse to a degree that the client never intended. 

     Even if the non-marital share benefits the surviving spouse, if the distribution provisions only allow for distributions of income to the spouse, with principal distributions only made within the discretion of the trustee then the surviving spouse has very little flexibility. Provisions such as these were common with a lower exclusion because the thought was that assets allocated to the Marital Portion would provide for more flexible distribution provisions, such as all income and all principal within the discretion of the spouse. Because the prior applicable exclusions were only $1,000,000, or at most $3,500,000, there would be sufficient assets allocated to the marital portion to provide the spouse with sufficient flexibility. 

     In our next post we will suggest some strategies that can protect the surviving spouse even considering the new law, yet protect family members after the death of both spouses.

Alan Ferrara