Federal and State Estate Tax Apportionment: Planning Pitfalls and Best Practices

“Federal and State Estate Tax Apportionment: Planning Pitfalls and Best Practices,” that is the subject of today’s ACTEC Trust and Estate Talk.
This is ACTEC Fellow Margaret Van Houten of West Des Moines, Iowa.

When estate taxes come due, the question of who pays and from which assets can create unexpected consequences for families and fiduciaries. Federal and state estate tax apportionment rules do not always align. And without thoughtful planning, those differences can create inequities among beneficiaries and costly disputes.

ACTEC Fellow Mel Justak of Chicago will walk us through how these rules work, where the common pitfalls lie, and how planners can structure documents to better reflect a client’s intent. Welcome, Mel.

Mel Justak: Margaret, when we think of federal and state estate tax apportionment, often we treat that as a boilerplate provision in our will or revocable trust, and it’s seldom altered. However, how taxes are apportioned under the standard “burden on the residue” provision can have unintended consequences on certain beneficiaries who ultimately bear the tax burden. I think it’s important that we know not only the federal and state laws in this area, but also when we’re planning for our clients to know their specific situation because we have broad latitude in how we apportion these taxes in different scenarios.

Understanding the Federal Estate Tax Recovery Statutes

I’d like to start with the federal rules. There is no federal apportionment statute per se, however, there are four specific recovery statutes that are available to executors in certain instances.

Those begin with Internal Revenue Code Section 2206, which provides for recovery from recipients of life insurance proceeds that pass outside of a probate estate or revocable trust. That is typically based on a pro rata method of calculation – pro rata based on the value of insurance proceeds relative to the value of the taxable estate. All these recovery statutes may be waived. These are default rules, however, you can draft around them for specific situations.

The second statute is Internal Revenue Code Section 2207, which provides for recovery from recipients of property under a general power of appointment. Like the life insurance provision, it also provides for a pro rata method of calculating the recovery based on the value of the general power of appointment property relative to the taxable estate.

Third is Section 2207A, which deals specifically with QTIP property — the Qualified Terminal Interest Property — that’s includable in surviving spouses’ estates because a QTIP election was made in the first spouse to die’s estate resulting in a marital deduction. That, unlike the prior two statutes, is calculated on a marginal basis. So you calculate the value of the gross estate, or the taxable estate, and the tax due with the inclusion of the QTIP property, and then you do a secondary calculation with the value of the property, less the QTIP property, and that increase in the tax by inclusion of the QTIP property is the amount of the recovery.

The last category is Section 2207B, which would be property included under Internal Revenue Code Section 2036 – more generally property that would be in a revocable trust, for example, which would be outside of a probate of estate, but nonetheless includable in the gross estate for federal estate tax purposes. And, like Section 2206 and 2207, those are based on a pro rata method of calculation. So, we look at the overall value of the non-probate assets — the 2036 property — relative to the taxable estate, and that’s the amount of the recovery that would be owed.

Waiving Federal Recovery Rights Through Estate Planning Documents

As I said before, these statutes are default rules, and they can be waived. The way they may be waived is actually different among the statutes. In 2206 and 2207, the statutes there provide that the right of recovery for life insurance proceeds and general power of appointment property may be waived by an express provision in a decedent’s will. However, for Section 2207A and 2207B, the 2036 property and the QTIP property, those may be waived in the will or the revocable trust and the waiver must be specifically indicated. That’s actually language from the statute itself in those two. So, it seems like it’s a more precise and a more exact method of waving.

I think a best practice is that if you are looking to waive the right of recovery under any of these statutes, just be as specific as possible because you know that you won’t have any issue if you’re very specific as to the recovery right that’s being waived in any of these statutes.

Why State Apportionment Law Matters

We also need to look at what your state law provides. Now, a minority of states still provide for estate taxes at the state level. But, however, how we’re going to apportion federal estate tax paid within a certain state may differ from state to state and you have to see if there’s an actual statute that would be in effect for the state where you’re administering the estate.

So, for example, in my home state of Illinois, we have no statute governing tax apportionment. However, it’s governed under common law and its equitable apportionment between probate assets and non-probate assets. But within probate assets, it’s actually a “burden on the residue” rule. So, if you have only probate assets, it’s a burden on the residue, but if you have a combination of probate and non-probate assets, we look to equitable apportionment between those two classes of assets.

Many other states have specific statutes. For example, just to name a few, Florida, California, New York, and several other states have statutes that govern the apportionment of state taxes or federal estate taxes in their state. Many of the states provide for equitable apportionment by default. But, like the federal recovery statutes, the state apportionment statutes are default rules by nature and can be waived in the governing document, that being the will or the revocable trust.

Federal and State Rules Must Be Considered Together

We have to look at the federal rules. We then look at the state rules, and then how do we apply all this? There are some general considerations, I think, to keep in mind when applying this.

• I think the first one is – know what your state rule is because we want to look at, you know, if we’re going to be waiving what the state default rule is. We have to know what that rule is before we can proceed.
• I think it’s also important to understand the relationship between the federal recovery statutes and the applicable state law that’s in play. Does the state statute mirror federal law with respect to the types of property I mentioned earlier with the federal recovery statutes? Do they have similar requirements as to how one is to veer from those default rules?
• I think it’s also important to keep in mind, as I mentioned at the outset, that we do have broad latitude. And if we are going to veer from the default rules provided by the federal recovery statutes and your state apportionment law, that we understand what we’re trying to accomplish. And that could be very different depending on what the makeup of the estate plan is and what the family dynamics are.

Practical Example: Estate Taxes and IRA Beneficiaries

For example, let’s assume that we have an estate, it’s taxable for both federal – I’ll assume it’s a state without a state estate tax, keep it simple – the federal taxable estate, the major asset in this estate is an IRA. There are some other assets, and the other assets are barely sufficient enough to cover what the federal estate tax liability would be. If we are to assume, for purposes of this example, that the beneficiaries of the IRA and the beneficiaries of the estate are the same – the decedent’s children in the same proportion – then a so-called “burden on the residue” tax apportionment rule or language in the document, probably okay because you are taking the other assets outside of the IRA to pay the estate tax and thereby leaving the remaining estate assets, being the IRA, to transfer to the children. We don’t have to then sell assets or make a distribution out of the IRA, which would — if it’s a traditional IRA — would be not very efficient from an income tax perspective because if it were a traditional IRA, we would have income being carried out with that distribution in order to pay estate tax. Now, we would have a deduction against the income for the IRD, the so-called “IRD deduction.” However, if we can avoid having that situation all together, it would be better in this example.

But if we change the facts slightly and let’s assume that the beneficiaries of the IRA are different than the beneficiaries of the estate, then if you had the other estate assets pay the estate tax, then you would have one class of beneficiaries bearing the entirety of the estate tax that would benefit the IRA beneficiaries who are completely different, which could be an unfair result.

Best Practices for Estate Tax Apportionment Planning

So, we want to be sure that we’re discussing these things with our clients. I think it’s important that, we know the rules and then know that we can apply the rules differently depending on what the client situation is. I hope this was helpful and thank you for listening.

Margaret Van Houten: Thank you, Mel, for this very helpful talk about a very important topic.

 

You may also be interested in:

• Estate & Gift Tax and Charitable Contributions Under the OBBBA
• Use of Asset Protection Trusts for Estate Tax Planning Purposes

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