Taxes have been and seemingly always will be an issue, especially when developing an effective estate plan. Estate planning is essential since the largest tax bill often comes in the form of estate taxes after your death.
One of the biggest questions people have when setting up their estate plan is how to pass on the estate to their surviving spouse with the minimum tax burden. The first way to avoid taxes altogether is to take advantage of the marital deduction.
Use the Marital Deduction
The marital deduction allows one spouse to transfer an unlimited amount of property to their spouse upon death without incurring estate or gift taxes. Most gifts or transfers to a spouse, regardless of the amount, qualify for the marital deduction.
At first glance, the marital deduction may look like an IRS blunder or, at the very least, a tax giveaway! The truth is that it is neither. The advantage of the marital deduction is not complete avoidance of estate tax on the transferred property. Instead, it is merely a deferral of estate tax. The marital deduction requires that the transfer of your assets to your spouse be made in such a way that those assets are exposed to estate tax liability in the surviving spouse’s estate.
If the marital deduction only defers the tax, then why do people use it at all? The obvious advantage of using the marital deduction is that your spouse will have the use of the tax dollars that would otherwise have been paid to satisfy the tax liability of your estate. This deferral may also postpone the potential need to sell off assets in order to satisfy the tax liability.
As with everything, there is a downside to the marital deduction. The disadvantage is that, although you can transfer any amount that you want to your spouse, if your spouse survives you (and does not remarry), there will be no marital deduction available to lessen the estate tax liability at his or her later death. For this reason, it’s often a good idea not to give everything to your spouse outright, but to use a Trust.
Transferring Assets Through a Trust
The marital deduction law permits, with no loss of the deduction, the transfer of assets to the surviving spouse through a Trust. There are two basic types of Trusts that have become the standard means for taking advantage of this deduction.
The first type of Trust is known as a “Power of Appointment” Trust. The property is placed in Trust, and your spouse is given a life interest in the income generated by the Trust and the power to give the assets in question to anyone, including to himself or herself or to his or her estate. This power can be restricted so as to be exercisable by your spouse only by a Will and still qualify for the marital deduction.
The second type of Trust, rather than giving your spouse the power to ultimately dispose of the assets, permits you to designate the ultimate recipients of the property qualifying for the marital deduction. This Trust is known as the Qualified Terminable Interest in Property (QTIP) Trust. Your spouse must receive a lifetime income interest in the property. No one other than your spouse may have any claim to the Trust assets during your spouse’s lifetime. Your personal representative must elect QTIP treatment on the estate tax return. The crucial feature of the QTIP Trust is that you retain the ability to control who eventually gets the assets qualifying for the marital deduction after your spouse’s death.
Coordinating the Unified Credit and the Marital Deduction
It has become standard estate planning practice to coordinate the estate tax marital deduction with the applicable exclusion amount. The applicable exclusion amount allows an individual to pass a certain amount of assets free from estate tax liability regardless of the identity of the recipients. For people who die in 2017, the amount that can pass tax-free is $5.49 million. The amount allowed to pass tax-free is normally transferred under what is known as a “Credit Shelter,” “Family,” or “By-Pass” Trust. Then, the transfer under the marital deduction rules is made so as to prevent the taxation of the remaining assets.
Clearly, in the case of a married couple owning sufficient assets to make estate taxation an issue, estate planning must take into account the marital deduction rules and the associated tax savings. Given the complex nature of the many rules involved, you should always seek the guidance of a qualified estate planning attorney.