For family law practitioners, marital and pre-marital estate planning can be key in protecting clients in the event of divorce. Here are three sets of critical considerations that could be worth millions to your client.
By Sharon L. Klein, Family Wealth Strategist, Trusts & Estates Attorney
Key Considerations in Pre-Marital Estate Planning
1. The “Hidden” Asset that Could be Worth Millions
The federal estate and gift tax, imposed at a top bracket of 40% in 2019, generally does not apply to transfers between US spouses. In addition, each person has an exemption from federal estate, gift, and generation-skipping transfer (GST) taxes. The GST tax is a tax, in addition to the estate or gift tax, payable on transfers in excess of the exemption that skip a generation (for example from a grandparent to a grandchild), and is imposed at the top estate or gift tax rate.
On December 22, 2017, the Tax Cuts and Jobs Act (the Tax Act) was signed into law. This sweeping legislation made significant changes to the tax landscape. As of January 1, 2018, the amount exempt from federal estate, gift and GST taxes doubled from $5 million per person to $10 million per person, indexed for inflation from 2010. In 2019, each person can transfer $11.4 million (or $22.8 million per married couple) free of federal gift, estate, and GST taxes. As with most of the changes made by the Tax Act, the doubling of the exemption amount is slated to sunset at the end of 2025.
Before 2010, the federal estate/gift exemption amount was a “use-it-or-lose-it” proposition. To give a simple example, assume a married couple both died in 2009 when the exemption amount was $3.5 million, and they each owned assets worth $3.5 million. If they each used their $3.5 million exemption amounts, with trust planning, for example, zero federal estate tax would have been due on the death of the survivor. Assume, however, that the first spouse to die did not use her exemption amount and instead left everything to the survivor. If the survivor died with a $7 million estate, the exemption of the first spouse to die would have been wasted and federal estate taxes of up to $1.575 million would potentially have been payable.
Portability, a concept introduced in 2010, and made permanent since 2012, obviates the use-it-or-lose-it nature of the federal estate and gift exemption amount. If one spouse does not use the entire exemption amount, it is possible to transfer or “port” the unused portion – called the Deceased Spouse’s Unused Exemption Amount, or “DSUE” Amount – to the surviving spouse. Unused GST exemption is not portable.
DSUE is a valuable asset to consider when drafting prenuptial agreements, particularly in light of the doubling of the federal exemption amount. Consider a prospective husband (H) and wife (W) who are negotiating their pre-marital agreement. H has assets totaling $24 million, while W has assets of only $1 million, which would pass to her heirs other than H, leaving $10.4 million of DSUE based on the 2019 $11.4 million federal exemption amount. Generally, H would not ask for any financial considerations from W because of the imbalance in the assets tilted in his favor. However, if W predeceases H and her executor (who could be H) elects to use portability, her $10.4 million DSUE would pass to H. Assuming H dies in 2019, with a top 40% federal estate tax rate and a $11.4 million exemption, having W’s additional exemption amount to shield estate taxes in his estate could save his heirs about $4 million in estate taxes! Accordingly, the wealthier spouse (H in this example) could view the DSUE as an important asset, and the less wealthy spouse (W in this example) could use the DSUE as a negotiating tool.
Federal Estate Tax Return Filing Required: Regardless of the size of the decedent’s estate, DSUE can only be preserved by a timely-filed federal estate tax return (Form 706), which is due nine months from the date of death, 15 months on extension. This means that estates under the federal filing threshold ($11.4 million in 2019) must still incur the cost of filing a federal return, although the standards for Form 706 filing have been relaxed if the return is necessary solely for the portability election. The return can be filed only by the executor, who may or may not be the surviving spouse. Accordingly, the requirement to file the return should be negotiated in prenuptial agreements to avoid a hostile executor spitefully refusing to file. Although it might be possible to bring a petition to request that a court grant someone other than the executor temporary executorial powers solely for the purpose of filing a return, and although there has been at least one reported case in which the court required the recalcitrant executor to file a return and elect portability, it is much better practice to plan ahead for this important matter. The case involving the recalcitrant executor was recently decided by the Oklahoma Supreme Court In re Matter of the Estate of Anne S. Vose v. Lee. The court required the personal representative (decedent’s son from a prior marriage) to make the portability election requested by the surviving spouse, even though the surviving spouse waived all of his rights to the decedent’s estate in a prenuptial agreement.
It is also important to consider the consequences if a return not otherwise required to be filed must be filed solely to protect the DSUE. In that case, the cost of filing the return – and costs associated with any audit proceedings – might logically be apportioned to the surviving spouse benefiting from the election. If a return must be filed because the estate is over the filing threshold in any event, consider whether the total cost should be borne by the estate. It will be prudent to memorialize who should bear the costs of filing Form 706 in the prenuptial agreement, along with the obligation to file to secure portability.
2. Pre-Marital Estate Planning: The Delaware Advantage
A. Another Pre-Marital Agreement Option: Asset Protection Trusts
A Delaware Asset Protection Trust (DAPT) is an irrevocable trust created under Delaware law, with a Delaware trustee. Neither the trust creator not any of the beneficiaries need to live in Delaware in order to create a Delaware trust. In most jurisdictions, it is not possible for a person to create a trust for himself and protect the assets from his creditors. Under Delaware law, however, the DAPT generally limits the ability of an individual’s creditors to reach the trust assets, while allowing the creator of the trust to remain a trust beneficiary. The creator can retain the right to receive current income distributions, the right to receive a 5% annual unitrust payout and the ability to receive income or principal at the discretion of an independent trustee. While 19 jurisdictions have enacted some form of asset protection legislation, it is very common for clients to look outside their home states in setting up these trusts: a driving reason to create an asset protection trust is to build obstacles creditors must overcome. Having to initiate an action in a different jurisdiction, rather than the settlor’s home state where the creditor is likely situated, creates additional hurdles to bringing suit. When selecting a trust jurisdiction, Delaware is often the jurisdiction of choice because of its attractive laws. Additionally, while legislation in some states is very new, Delaware has the distinction of being the first jurisdiction in the country that enacted domestic asset protection laws over two decades ago.
Delaware requires a creditor to bring an action against a DAPT in the Delaware Court of Chancery. For claims arising after an individual creates a DAPT, there is a four-year statute of limitations. For claims arising before an individual creates a DAPT, a creditor must bring suit within four years after creation of the trust, or, if later, within one year after the creditor discovered (or should have discovered) the trust. For all claims, the creditor must prove by clear and convincing evidence that the creation of the trust was a fraudulent transfer as to that creditor. A very limited number of creditors can pursue claims against a DAPT. In the family context, a spouse, former spouse, or minor child who has a claim resulting from an agreement or court order for alimony, child support, or property division incident to a judicial proceeding with respect to a separation or divorce may reach the assets of a DAPT, but a spouse whom the client marries after creating the trust may not take advantage of this exception. Accordingly, since future spouses cannot generally assert claims against a DAPT, a client’s children can establish these trusts to protect assets from such claims, without providing the financial disclosure that ordinarily is required for enforceable prenuptial agreements.
Giving an independent corporate trustee broad discretion to make distributions to a class of beneficiaries, instead of predicating distributions on an ascertainable standard, is also recommended since a court would be less likely to find such a discretionary interest reachable in divorce. Some practitioners also recommend inserting provisions in the documents that require a beneficiary’s spouse to waive marital rights to trust assets each time the beneficiary is eligible to receive a principal distribution before making the distribution. Others prohibit the trustee from making distributions to any beneficiary who is married without a prenuptial agreement.
B. Silent Trusts
Delaware permits the creation of so-called “Quiet” or “Silent” Trusts, which allows the trust creator to restrict beneficiary access to information under certain circumstances – even if that information would be required under the laws of other jurisdictions. This might be an effective tool to use in blended marriage situations. A Silent Trust could minimize friction by restricting information access to children of a prior marriage for the life of a second spouse. This is particularly so if the family members know that the trustee administering the trust is a corporate, impartial trustee, with fiduciary obligations to treat beneficiaries fairly within the context of a specific trust agreement.
3. Other Lifetime Estate Planning Considerations
A. Marital Trust Planning
With a portability election, it is possible to transfer one spouse’s unused federal exemption amount to the survivor. However, in second marriage situations, the ported exemption would be available for the surviving spouse to dispose of as she pleased – including for the benefit of her children from another marriage. In order to utilize the federal exemption amounts of both spouses, but continue to control the disposition of assets after the death of the first to die, the wealthier spouse could consider creating a lifetime marital trust – a so-called Qualified Terminable Interest Trust (QTIP). If properly structured, the QTIP would not have any gift tax consequences when established, would utilize the exemption amount of the less wealthy spouse, and the trust terms would insure that the trust’s assets passed to the trust creator’s intended beneficiaries after the death of the surviving spouse. Another advantage of this technique is the ability to utilize the survivor’s GST exemption by allocating it to the trust, which could then grow free of GST taxes. Using portability alone only transfers the unused estate tax exemption; it does not apply to the unused GST tax exemption, which otherwise would be lost.
B. Formula Planning
One common plan in second marriage situations is for the spouses to each waive rights in the other’s estate in exchange for the surviving spouse receiving assets in excess of the federal exemption amount. Assets up to the federal exemption amount can pass free of federal estate taxes to children of a previous marriage. Estate tax on the balance of the assets passing to the surviving spouse would be deferred until the death of that spouse due to the marital deduction. If that plan was effectuated with a formulaic disposition to the children of the “federal exemption amount“and the federal exemption amount was $5 million at the time, $5 million is presumably the amount that was intended to pass to children of a prior marriage. That plan might be distorted with the higher exemption amounts now in effect: in 2019, the children of a prior marriage would receive $11.4 million, leaving much less for a surviving spouse. Accordingly, it is generally advisable to avoid formulaic dispositions based on tax exemptions amounts in prenuptial agreements and estate planning documents. In the planning context, most practitioners now opt to use provisions designed to be very flexible in adapting to changes in family situations and tax laws.
The Bottom Line: Collaboration is Key Throughout the Marital or Pre-Marital Estate Planning Process
Clients can benefit when matrimonial, trusts & estates, accounting, and investment professionals partner to integrate considerations that cross disciplines at every stage of the marital or pre-marital planning process. Advisors who take a collaborative approach can most advantageously position their clients in the event of a future divorce for them or their children.
Sharon L. Klein is President of Family Wealth, Eastern US Region, for Wilmington Trust, where she also heads the National Matrimonial Advisory Solutions Group. She is a Fellow of the American College of Trust and Estate Counsel and a member of its Family Law Task Force, she chairs the Domestic Relations Committee of Trusts & Estates magazine, and is a member of the New York City Bar Association’s Matrimonial Committee. Beginning her career as a trusts & estates attorney, Sharon has over 25 years’ experience in the wealth advisory arena and is a nationally recognized speaker and author. www.wilmingtontrust.com/divorce
This article is for general information only and is not intended as an offer or solicitation for the sale of any financial product, service or other professional advice. Wilmington Trust does not provide tax, legal or accounting advice. Professional advice always requires consideration of individual circumstances. Wilmington Trust is a registered service mark. Wilmington Trust Corporation is a wholly-owned subsidiary of M&T Bank Corporation (M&T). © 2019 Wilmington Trust Corporation and its affiliates. All Rights Reserved.
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