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Remarried with children: estate tax considerations of a significantly younger spouse.

Occasionally, an estate planner will encounter a family situation that requires special consideration in the development of an estate plan, for example, when one spouse is significantly younger than the other. A taxpayer who intends (whether via prenuptial agreement or otherwise) to dispose of his estate equally between a significantly younger second spouse and children from a previous marriage may inadvertently leave the children with considerably less than half of the estate if the impact of Federal estate taxes is not properly considered.

Traditional estate plans, which provide a spouse with support for life and a remainder interest passing to children on the spouse's death, are not appropriate when the children and spouse are approximately the same age; the spouse may outlive the children, thereby depriving them of their share of the estate. Therefore, the estate planner must consider methods that simultaneously provide for current, equitable distributions of estate property to the spouse and children while minimizing Federal estate taxes.

A simple stipulation in the taxpayer's will for the estate to be divided equally between the spouse and children would, on the surface, appear to be equitable to all estate beneficiaries. However, distributions to a spouse are afforded more favorable Federal estate tax treatment than distributions to a nonspouse. In computing Federal estate taxes (assuming the provisions of Sec. 2056 are met), an unlimited marital deduction is allowed for distributions made to the surviving spouse. A similar deduction is not available for distributions to a taxpayer's children. Since the children's share of the estate will be reduced by Federal estate taxes, the taxpayer's wish for an equal distribution of estate property is not achieved.

Example 1: T, age 68, has an estate valued at $5,000,000. He recently married a 25-year-old. T has a child from a previous marriage who is also 25. T's will provides for the equal distribution of his estate between his new spouse and his child. The Federal estate tax implications, along with the impact on amounts distributed to the estate beneficiaries, are:

Scenario 1: Gross estate value $5,000,000 Marital deduction, specific bequest 2,500,000) Taxable estate 2,500,000 Federal estate tax 1,025,860 Available unified credit (192,800) Net Federal estate tax $ 833,000

Gross estate value $5,000,000 Net Federal estate tax (833,000) Marital distribution (2,500,000) Distribution to child $1,667,000

Because Federal estate taxes were not taken into consideration when T's will was drafted, the estate beneficiaries do not share equally in the estate property. This is contrary to the decedent's wishes and could create animosity.

To achieve T's goal of distributing the estate equally between the spouse and child, the net amount of the estate, after Federal estate taxes, must be distributed equally between the spouse and the child. This essentially means that some of the Federal estate tax will be paid from the spouse's share of the estate. The estate planner must realize, however, that this method increases the taxable estate and the overall Federal estate taxes.

In order to achieve an equal after-tax distribution, the amount of the marital bequest must be reduced, which in turn increases the Federal estate tax. Since one variable (the Federal estate tax) is dependent on the calculation of the other variable (the marital deduction), use of an algebraic equation (not discussed herein) is necessary to solve for the amount of the marital deduction that will result in equalized after-tax distributions.

Scenario 2: Gross estate value $5,000,000 Marital deduction, to equalize distributions (1,932,414) Taxable estate 3,067,586 Federal estate tax 1,327,972 Available unified credit (192,800) Net Federal estate tax $1,135,172

Gross estate value $5,000,000 Net Federal estate tax (1,135,172) Marital distribution (1,932,414) Distribution to child $1,932,414

Here, the amounts distributed to the spouse and child are equal. However, the estate owes $302,172 more in Federal estate taxes than if the estate had been divided equally on a before-tax basis.

Establishing a lifetime gifting program reduces the taxpayer's gross estate, thereby reducing the Federal estate tax. Using the $10,000 per donee annual exclusion provided by Sec. 2503(b), gift-splitting as provided by Sec. 2513 and the unlimited marital deduction, a significant tax-free transfer of wealth can occur during the taxpayer's lifetime.

Example 2: Assume the same facts as in Example 1, Scenarios 1 and 2, except that the estate planner suggests that T implement a lifetime gifting program. T gives 20,000 per year to the child, which is excluded from gift tax by virtue of the annual exclusion and gift-splitting. In order to maintain equal distributions to the child and spouse, T also gives $20,000 per year to the spouse, which is excluded from gift tax by virtue of the annual exclusion and the unlimited marital deduction. Assuming 10 years of gifts can be completed prior to T's death:

Scenario 3: Gross estate value, beginning of gifting program $5,000,000 Lifetime gifts to child (200,000) Lifetime gifts to spouse (200,000) Gross estate value, at taxpayer's death 4,600,000 Marital deduction, to equalize distributions (1,805,442) Taxable estate 2,794,558 Federal estate tax 1,181,916 Available unified credit (192,800) Net Federal estate tax $ 989,116

Gross estate value $5,000,000 Net Federal estate (989,116) Cumulative marital distributions (2,005,442) Cumulative distributions to child $2,005,442

Under this scenario, implementation of the gifting program results in $146,056 less Federal estate tax at the taxpayer's death than under Scenario 2. This demonstrates the savings that can be obtained through effective use of both the $10,000 per donee annual exclusion and gift-splitting. Such a lifetime gifting program can be very effective in reducing Federal estate taxes. However, time is a constraint and may limit significant reductions in the taxable estate.

The use of an irrevocable life insurance trust can also help. When properly established and maintained, the death benefit from a life insurance policy held by the trust will not be includible in the taxpayer's estate. The proceeds received by the child as trust beneficiary can compensate for the reduced distribution received from the taxpayer's estate.

Using this strategy, the taxpayer would make annual lifetime gifts to the trust, sufficient to pay the insurance premium on a policy naming the taxpayer as the insured and the trust as policy owner and beneficiary. In order to ensure that these gifts qualify as present interests (thus enabling use of the taxpayer's annual exclusion to shield the maximum amount possible from Federal gift tax), a Crummey power should be included as part of the trust instrument. This gives the trust beneficiary the right to remove the annual gift made to the trust for the premium payment within a specified period of time. Obviously, if the beneficiary exercises this right, the objectives of the overall estate plan would not be met. Thus, it is important all parties understand and consent to the goals and objectives of the plan. In addition to the premium Cost, other expenses (such as legal and trustee fees) would be incurred. It is also conceivable the annual exclusion will not be sufficient to prevent some portion of the gift from being subject to Federal gift tax, thus reducing the taxpayer's unified credit.

Referring to Example 1, Scenario 1, assume T establishes an irrevocable life insurance trust to equalize the $833,000 difference between the amounts distributed to the child. T must weigh the cost of the insurance premium against the $302,172 increase in Federal estate taxes that occurs when distributions are equalized on an after-tax basis. If the anticipated lifetime cumulative premium exceeds the amount of Federal estate taxes that could be saved, this strategy is not attractive.

Planning to minimize Federal estate and gift taxes is always important. This is particularly true when a spouse is approximately the same age as a taxpayer's child and the taxpayer wants an equal distribution of estate property. Making equal distributions to the spouse and child on an after-tax basis can accomplish this, but at the expense of higher Federal estate taxes. A lifetime gifting program can help reduce the amount of Federal estate taxes ultimately due. The use of an irrevocable life insurance trust to equalize distributions while minimizing Federal estate taxes can also be an effective strategy, provided the premium cost is justified when compared to the additional Federal estate taxes that result. From Daniel P. Doiron, CPA, CVA, Albin, Randall & Bennett, Lewiston, Maine, and Barton D. Haag, Albin, Randall & Bennet, Portland, Maine
COPYRIGHT 1997 American Institute of CPA's
No portion of this article can be reproduced without the express written permission from the copyright holder.
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Author:Haag, Barton D.
Publication:The Tax Adviser
Date:Aug 1, 1997
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