The eighteen month period from April 2000 to September 2001 was a horrible year for the stock markets. Most stock portfolios declined by about 30%, and some declined much further. During that time, the bear market called to mind one of the dangers of a pecuniary marital deduction formula: when a decedent’s will or living trust uses such a formula, a market decline may dramatically reduce or totally eliminate the credit shelter trust. But the good news is that by timely post-mortem planning, practitioners can totally restore the credit shelter trust. A properly worded disclaimer, coupled with electing the alternate valuation date, will save the credit shelter trust.
The pecuniary marital formula is a wonderful thing in a rising market. The formula fixes the amount of the marital deduction at a certain dollar amount as of the date of death. Then, until funding occurs, the credit shelter amount floats with the post-death increase or decrease in the value of the entire estate. Using leverage, the pecuniary marital formula often dramatically increases or decreases the value of the credit shelter share. For example, in a $3 million estate, a 10% increase in value between death and funding results in a $975,000 credit shelter trust under a pecuniary marital formula. The marital amount is fixed at the date of death at $2.325 million and remains that amount even when the portfolio has increased to $3.3 million. The entire $300,000 of appreciation inures to the benefit of the credit shelter trust.
Playing the odds that, in most periods, markets are appreciating, many practitioners use the pecuniary marital deduction formula as their standard wording in wills and trusts. But what happens when markets turn against us, as in 2000? The leverage that was such a friend in an appreciating market turns into our worst enemy in a depreciating market. Returning to our $3 million estate, let us assume a 20% decrease between date of death and date of funding. In this instance, the value of the estate is down to $2.4 million. The marital deduction, which was fixed at death, is still $2.325 million. Only $75,000 is left for the credit shelter trust. At this point, we remember the old Wall Street expression: “Bulls make money, bears make money, but pigs get slaughtered.” The leverage that was designed to enrich the credit shelter trust has instead impoverished it.
Or has it? What about making use of alternate valuation under Code § 2032? At first, this seems beyond our reach, since alternate valuation applies only when tax is due and our formula marital deduction has been carefully crafted to ensure that no tax is due. How can we come within § 2032?
The answer is to make use of a qualified disclaimer under Code § 2518. Here is the strategy: on or before the six month alternate valuation date, the surviving spouse disclaims a fractional or percentage amount of the marital share sufficient to generate federal estate tax using date of death values. Now we can meet the two requirements of Code § 2032(c), which are that the alternate valuation election (1) will decrease the value of the gross estate and (2) will decrease “the sum of the tax imposed by this chapter and the tax imposed by chapter 13 with respect to property includible in the decedent’s gross estate (reduced by credits allowable against such taxes).” Return to our example in which a $3 million estate of a decedent who dies in 2001 declines by 20%, and suppose that the surviving spouse disclaims 2.3656% of the pecuniary marital devise. At date of death values, the disclaimer increases the taxable estate by $55,000 to $730,000 and produces a tentative tax of $20,350, a state death tax credit of $19,440, and a net federal estate tax of $910. Then, when we elect the alternate valuation date, because the gross estate is now worth only $2.4 million, the marital deduction drops from $2.27 million (the original $2.325 million less the $55,000 disclaimed) to $1,684,193 (computed by subtracting the disclaimed 2.3656% from the new marital share amount of $1.725 million). On the other hand, the credit shelter trust, which had been reduced to $75,000, has now been reinflated to its full $675,000 value plus the amount disclaimed, which, because of the 20% decline in the value of the total estate, is now $40,807.
Continuing with the 20% decline example, our gross estate has been reduced to $2.4 million, and the federal estate tax has been reduced from $910 to zero. The net taxable estate is $675,000 plus the disclaimed amount of $40,807, or $715,807. The total tax is $15,099, all of which is paid to the state, because it is less than the maximum allowable state death tax credit of $18,759 on the taxable estate of $715,807.
The end result is that at a tax cost of a little more than $15,000, we have totally restored the $600,000 that otherwise would have been lost from the credit shelter trust. Furthermore, if we again assume a death in 2001, the tax that we have paid has been paid at only 37%, instead of the rate that would have applied in the surviving spouse’s estate. That rate could be as high as 50% or even 55% to 60%, if the spouse also dies in 2001. It seems to be money well spent.
The above example assumes a state that has only a “soak up” inheritance tax. In states that have a tax greater than the state death tax credit, the cost of doing the disclaimer, rather surprisingly, may actually be lower. For example, in a state with a straight 2.5% inheritance tax, the state tax on our estate of $715,807 is $17,895, versus $16,875 on our original taxable estate of $675,000, a difference, or “cost,” of only $1,020. In addition, because of the phase out of the credit for state death taxes that begins in 2002, the cost of this procedure will be less for 2002 decedents and will continue to drop, because the estate will need to pay less state death tax before reaching actual federal estate tax liability.
For this strategy to be available, the surviving spouse must disclaim at least enough to generate federal estate tax; it is apparently not sufficient under Code § 2032(c)(2) to disclaim merely enough to generate estate tax that is solely covered by the state death tax credit. Obviously, the disclaimer must be of either a fraction or a percentage, and it must generate at least the targeted taxable amount of approximately $730,000, if we assume a 2001 death. It cannot be a pecuniary amount: lower estate tax would not result if alternate valuation were elected, because it would not be affected by value changes in the estate as a whole.
It is also extremely important, if one wishes to use this strategy, that the disclaimant can meet the other rules for a qualified disclaimer, particularly the no acceptance of benefits requirement. Therefore, if we think we may have to use this gambit, no income should be distributed to the surviving spouse before the alternate valuation date.
For the more sophisticated and wealthy clients who do not mind paying a substantial amount of tax at the first death, or in cases where the surviving spouse has a large individual estate and has an actual (but preferably not actuarial) life expectancy of only a few years, a variation of the plan can be beneficial. The surviving spouse can disclaim considerably more than the percentage that would result in an approximate taxable estate for the decedent of approximately $730,000 (assuming death in 2001). For example, the surviving spouse may wish to disclaim a percentage that would result in an alternate valuation date taxable estate of $2 million. This provides a “run up the rates” in the decedent’s estate, up to a maximum of 45%, as opposed to the 50% (or even 55% or perhaps 60%) tax rate that might apply in the surviving spouse’s estate. Further, if the surviving spouse is the sole initial beneficiary of the credit shelter trust and that trust requires all income to be paid currently to the surviving spouse, the credit for tax on prior transfers can also result in the surviving spouse’s estate in effect paying part of its estate tax bill using the government’s own money.
Nothing in life is free: the disclaimer/alternate valuation plan has two costs. One is a relatively small amount of estate tax. The other is the possibility of future higher capital gains tax. One of the consequences of electing alternate valuation is a lower basis in all of the estate assets, if the current step-up in basis at death rules are in effect. The importance of this consideration will vary from case to case. For example, if the surviving spouse is elderly and does not intend to sell any of the marital assets before his or her death, the problem becomes moot. In addition, nothing prevents the credit shelter trust from being funded with assets that have not declined in value since the decedent’s death. In fact, allocating the depreciated assets to the surviving spouse and the undepreciated assets to the credit shelter trust is, all other things being equal, usually the preferred approach. The capital gains tax rate on a future sale will probably be the same whether the credit shelter trust or the surviving spouse sells the asset, and if the value of a depreciated asset in the marital share recovers so that the surviving spouse now has an appreciated asset, there is at least the possibility of a basis step-up on his or her death. On the whole, however, trading a possible 20% capital gains tax for estate tax savings of 50% (or more) seems to be a good trade. Nonetheless, the size of the decedent’s and the spouse’s estates and the amount of depreciation will make the income tax cost and estate tax benefit of this strategy vary, so the potential cost and benefit should be computed in each case. And, of course, the rules for carryover basis with limited step-up provisions under the Economic Growth and Tax Relief Reconciliation Act of 2001, Pub. L. No. 107–16, 115 Stat. 38, add a new wrinkle to consider.
A hypothetical case can illustrate the interplay of the income tax cost of this strategy and the estate tax savings. Let us assume that Mr. Diversification dies in March 2000, owning nothing but $1.5 million worth of stock in TechBubble.com, a company that provides high speed wireless Internet access to motorcycles. At the date of his death the stock is worth $150 a share, giving it a market capitalization slightly greater than that of AT&T. By the six month anniversary of Mr. Diversification’s death, in September 2000, investors are beginning to see that this particular emperor has no clothes, and the stock is down to $90 a share, for a total value of $900,000. At this point, using date of death values, the marital share for Mrs. Diversification is still $825,000, but the credit shelter share has declined to only $75,000. If we assume that during the entire period Mrs. Diversification has a potential taxable estate of $5 million, then electing alternate valuation and resurrecting the credit shelter trust eliminates what would otherwise be a 55% estate tax on $600,000 in Mrs. Diversification’s estate, saving $330,000 ($300,000 if Mrs. Diversification were to die in 2002 and slightly less each succeeding year). In addition, the tax paid on the disclaimed amount is only 37% instead of the highest marginal rate, thus saving still more future estate tax. At the same time, the step-up in basis lost by electing the alternate valuation date may be as much as $600,000. If we assume that Mrs. Diversification or the credit shelter trust could have sold the stock and benefited from the step-up in basis before Mrs. Diversification’s death, the amount saved could have been worth $120,000 in saved capital gains tax. The net savings will be $210,000 if Mrs. Diversification dies in 2001, $180,000 if she dies in 2002. In this case, we would want to use the disclaimer/alternate valuation date gambit.
Now assume that at the decedent’s death, Mrs. Diversification’s entire portfolio consists of $2 million worth of Crater Technology, Inc., an online retailer of nuclear power plants. Investors are a little quicker to have serious doubts about the business plan and long-term viability of Crater Technology, Inc., and by September Mrs. Diversification’s stock is worthless, leaving her with no taxable estate. Under these facts, the disclaimer/alternate valuation maneuver would not be cost effective. As noted before, Mr. Diversification’s stock decline results in a potential capital gains income tax cost of $120,000 if we elect alternate valuation. The benefit in this particular case would be the estate tax that would have been saved had we fully funded the marital deduction to Mrs. Diversification with $825,000, which would have generated an estate tax at her death of only $55,000, assuming she also died in 2001, and no tax if she died in 2002. In this case, the income tax cost of $120,000 far outweighs the estate tax benefit, so we would probably not want to elect alternate valuation. In addition, we would have to factor in the possibility that Mrs. Diversification might die in 2010, when the estate tax is scheduled to be repealed.
If the alternate valuation strategy is to be used, funding should take place immediately on the alternate valuation date, in order to prevent re-exposure to market risk. Electing the alternate valuation date merely resets the clock to zero. If time is allowed to run after that and before funding takes place, a decline in the market after the alternate valuation date will irrevocably erode what can be passed to the credit shelter trust. Returning to Mr. Diversification’s estate will illustrate this. At the six month anniversary of his death in September 2000, his stock of TechBubble.com has dropped in value to $900,000. Mrs. Diversification elects to disclaim 6 2 /3% of what at the date of death would have been a marital share of $825,000. By September, with the value of TechBubble.com at $900,000, this disclaimer percentage is applied to the new $225,000 marital share, with the result that the marital share is now worth $210,000 ($225,000 minus 6 2 /3% of $225,000, or $15,000), and the credit shelter share is worth $690,000. Now suppose that the stress of witnessing the annihilation of so much wealth has thoroughly exhausted the personal representative of Mr. Diversification’s estate, so he goes on a six week vacation, not having funded the shares in the meantime. By the time he returns, the value of TechBubble.com has declined another $200,000 to $700,000. The marital share is still $210,000, since the pecuniary formula keeps this amount fixed. As a result, the credit shelter share, which had been $690,000 at the alternate valuation date, is now worth only $490,000. The entire $200,000 depreciation has fallen onto the credit shelter share. To an extent, the personal representative has managed to snatch defeat from the jaws of victory. As a result, it might be best to use the “elective” alternate valuation date: the date that an asset is sold or distributed. In other words, shortly before the six months is up, the personal representative or trustee could fund both shares. The date of distribution of the assets is the alternate valuation date for those assets under Code § 2032(a)(1), so their values are determined at the same time that funding occurs.
One other factual pattern should be borne in mind. What if the estate depreciates to less than the unified credit effective exemption amount? If this occurs, we should immediately disclaim and fund the credit shelter share. Once the value of the estate drops to the exemption amount, we cannot save any more of the tax generated by the disclaimer, since the tax has (assuming the decedent lived in a soak-up state) declined to zero. Allowing the estate to decline further before fixing the alternate valuation date value will only make the basis of the assets less.
Returning to Mr. and Mrs. Diversification, let us change the facts slightly. Let us assume that by August 2000, Mr. Diversification’s stock in TechBubble.com has dropped in value to $675,000. By the six month anniversary of his death in September, the stock has further declined to $400,000. In each case, it would make sense to elect the alternate valuation date, but ideally the election should be made the moment the value of Mr. Diversification’s TechBubble.com stock drops to $675,000. Compare the results of electing the alternate valuation date by making a distribution of the stock to the credit shelter trust in August with electing the alternate valuation date on the six-month anniversary of Mr. Diversification’s death. In both cases, all estate taxes on the disclaimed amount have been eliminated, but if the funding occurs in August, the basis of the stock in the credit shelter trust will be $675,000, while waiting until September results in the basis being only $400,000. Again, the lesson is that if the value of the decedent’s estate declines to the exemption amount, funding should take place immediately in order to lock in the higher basis.
One further benefit of immediately disclaiming and funding once the value of the estate drops to the exemption amount is the possibility of performing the estate tax equivalent of putting a ship in a bottle. Suppose that in August 2000, Mr. Diversification’s TechBubble.com stock is worth $675,000, but by September, the share price has rallied so that it is worth $900,000. If Mrs. Diversification disclaims and we fund in August instead of September, we still end up with no estate tax, but with $900,000 instead of $675,000 in the credit shelter trust.
Return a moment to the question of how much the surviving spouse should disclaim. In a case in which the decedent’s entire net estate has now declined to the exemption amount or less, prudence dictates that the surviving spouse still only disclaim an amount that, using date of death values, would have resulted in a small amount of federal estate tax being due. Although it would appear perfectly safe for the surviving spouse in this instance to make a full disclaimer of the marital share, the danger is that on audit the values may be changed or the personal representative or the IRS may discover that the decedent had made taxable gifts during his life or had additional assets. If either of these events occurs, the taxable estate may be considerably more than we had planned. Using a partial disclaimer sufficient only to generate federal estate tax at date of death values provides good insurance against the unknown. Another example using the hapless Mr. Diversification can illustrate this potential pitfall. Suppose that everyone believes that Mr. Diversification’s estate has declined from $1.5 million to $675,000 by the alternate valuation date when Mrs. Diversification does her disclaimer. If she does a full disclaimer of the marital share and later learns that Mr. Diversification made taxable gifts during his life of $200,000, then estate tax of $76,500 will be due, instead of the zero tax she expected. Prudence dictates a disclaimer of only enough to generate federal estate tax using date of death values. In this example, a disclaimer of 6 2 ⁄ 3 % would be sufficient, and the additional $200,000 of gross estate would generate additional estate tax of only $4,933.
Is the strategy described in this article merely a device to save estate tax that the IRS might attack as having no economic substance? Such an argument should not be successful. The 1984 amendment to Code § 2032, Pub. L. No. 98-369, 98 Stat. 1030, which introduced the requirement that both the gross estate and the amount of tax must be decreased by the election, was designed to prevent a tax-free increase in basis, accomplished by electing alternate valuation in a zero tax estate in which the value had increased after the date of death. In contrast, this strategy is not at variance with Code § 2032’s underlying policy of relief from decreases in the value of the estate. Thus this approach should fall within the general rule that a person may arrange his or her affairs in a way that reduces tax.
In summary, through a disclaimer and the use of the alternate valuation date, we can completely restore a depreciated credit shelter trust. In a declining market environment, any good news is welcome.
Robert A. Dawkins is a shareholder with the law firm of Fisher, Tousey, Leas & Ball, in Jacksonville, Florida.
The alternate valuation strategy also can be employed by having the personal representative not elect QTIP treatment for a corresponding fractional or percentage portion of the marital share, but only if the marital share passes to a QTIP trust. The advantage of having this alternative available is that it can still be done even if the surviving spouse has received income from the estate or trust during administration, which would disqualify the surviving spouse from disclaiming. But this secondary method requires that the marital share pass to a QTIP trust. Further, even in the case in which the marital share passes to a QTIP trust, in most cases it will be cleaner to use a disclaimer. Under most documents, the amount disclaimed is simply added to the credit shelter trust. By contrast, in the case of a partial QTIP election, we may be faced with a partially includable and partially excludable marital trust in the spouse’s estate, or it may be necessary to sever the non-QTIP portion of the marital trust from the remaining portion of the marital trust. Unless the will, the living trust, or state law provides for severance and combination of separate trusts, and unless the dispositive provisions of the marital trust are substantially identical to those of the credit shelter trust, it may not be possible to combine the taxed portion of the QTIP trust with the credit shelter trust. In that case, use of this strategy will result in three trusts to administer instead of simply two. A further advantage of a spousal disclaimer, as opposed to an intentional failure to elect QTIP treatment for part of the marital trust, is that there may be fiduciary liability issues in the failure to elect full QTIP treatment. Unlike the personal representative, the surviving spouse, acting on her own behalf, is not a fiduciary and can do as he or she sees fit, without having to answer to any other beneficiaries. Thus, when possible, the disclaimer route is usually preferable, but a partial QTIP election can also work if for any reason the surviving spouse cannot disclaim.