What happens in 2013, when the federal estate tax exclusion goes back to $1 million if Congress does nothing? What are the implications of decoupling Illinois' estate tax from the federal exclusion, so that any taxable estate over $2 million generates Illinois estate tax? This article explores these and other questions and helps you advise estate-planning clients, especially married couples, in these uncertain times.

Estate planning for married couples with assets in excess of $1 million has been marked with uncertainty. The uncertainty continues with the passage of Tax Act 2010¹ and recent amendments to the Illinois estate tax.² The $5 million federal estate tax exclusion for years 2011 and 2012 is good news.³ The $2 million Illinois estate tax exclusion is not.

But what happens in 2013 when the estate tax exclusion is scheduled to go back to $1 million? What tax traps arise from decoupling the Illinois exclusion from the federal exclusion? How does the new concept of "portability" affect planning?

Practitioners need to consider which types of marital deduction/bypass trust estate plans or alternate plans to draft to provide the most flexibility to minimize estate tax under the current uncertain estate tax law. Practitioners also need to consider which existing plans may need revision to avoid unintended or unexpected tax and distribution consequences for deaths during 2011 and 2012.

First, this article describes the relevant changes made by Tax Act 2010 and Illinois estate tax law amendments. Second, it identifies the common estate planning techniques used for married couples. Third, it analyzes some basic examples of which estate planning arrangements work best under the new tax law and those that have potential pitfalls. Finally, it reviews some alternative drafting approaches to consider.⁴

Tax law changes

Federal estate tax changes. Before the Tax Act 2010, the gift and estate tax rules were governed for nine years by EGTRRA.⁵ EGTRRA increased the estate tax exclusion from $1 million in 2002 to $3.5 million in 2009 with outright repeal of estate tax for decedents dying in 2010. In 2011 EGTRRA was to sunset and the previous $1 million estate tax exclusion and top tax rates of 55 percent were to apply.

In December 2010 Congress hurriedly passed Tax Act 2010. Tax Act 2010 is a temporary law that sunsets at the end of 2012. Just like EGTRRA, when Tax Act 2010 expires on December 31, 2012, the pre-Bush era estate tax law will apply if Congress does nothing: $1 million lifetime gift and death exclusion with top tax rate of 55 percent. Executors of decedents who died during 2010 have a choice to use the new $5 million estate tax exclusion with stepped-up basis or to elect Bush-era estate tax repeal in 2010 with modified carryover basis rules for underlying assets.⁶

For decedents who die during 2011 and 2012, the federal estate tax exclusion is $5 million with assets receiving a stepped-up basis to fair market value on date of death. The estate tax and generation skipping tax top rate is 35 percent. There are new portability rules of unused estate and gift tax exclusion between husband and wife discussed below.

During 2011 and 2012 a significant lifetime gifting opportunity exists when the lifetime gift exclusion is $5 million instead of $1 million as previously has been the law.⁷

Also significant is what Tax Act 2010 did not change. Sophisticated estate planning techniques such as grantor retained annuity trusts (GRATs), valuation discounts through family limited partnerships, installment sales, sales to defective grantor trusts, and self cancelling notes were unaffected by Tax Act 2010. Also, the gift tax annual exclusion remains $13,000.⁸

Illinois estate tax changes. For deaths in 2010, Illinois followed the Bush-era federal tax law and repealed the Illinois estate tax. For 2011 and future years, the Illinois tax law decouples from the federal estate tax.

The Illinois estate tax is calculated based on the state death tax credit previously repealed by EGTRRA. The calculated state death tax credit amount arbitrarily uses a $2 million exclusion and not a $5 million exclusion. (See table below.) There continues to be no Illinois tax on lifetime gifts. Illinois has no portability rule for unused Illinois estate tax exclusion for married couples.

The table entitled "Federal and Illinois estate taxes for a decedent dying in 2011 or 2012" shows that Illinois estate tax will be significant for many clients who own appreciated farmland and other assets.

Estate planning for married couples

Estate plans for married couples fall within two general types of arrangements. First are those stable marriage arrangements where, absent tax consequences, the married couple wants the surviving spouse to have control of all assets during the surviving spouse's life. Second are all those other arrangements where the surviving spouse is expressly intended not to be the sole beneficiary after the death of the first spouse.

In second marriage situations, the deceased spouse often names both the second marriage surviving spouse and the children from the first marriage as income and principal beneficiaries under trust documents. Sometimes the second marriage surviving spouse is omitted as a beneficiary under certain trusts established in the estate plan.

Surviving spouse sole beneficiary during life. Where the surviving spouse is the sole beneficiary during life, the goal is to use each spouse's death tax exclusion amount regardless of order of death and defer any estate tax until the second spouse's death. The planning results in zero tax on death of the first spouse and the minimum estate tax on the death of the second spouse.

To accomplish this goal the assets are divided between the spouses. The strate­gy for each spouse is to have assets of at least the tax exclusion amount in that spouse's name to avoid the possibility of wasting unused tax exclusion. The estate planning documents establish a "marital deduction/bypass trust" arrangement. Through the use of tax formula clauses, the bypass trust is funded with assets up to the estate tax exclusion amount in the year of death of the first spouse to die.

The bypass trust is generally designed to benefit the surviving spouse for life but not have the bypass trust assets be includible in the taxable estate of the surviving spouse. The bypass trust often names the surviving spouse as the sole beneficiary during the surviving spouse's life. That is, the surviving spouse as lifetime beneficiary is entitled to all trust income and to principal distributions.

If the surviving spouse is the trustee of the bypass trust, principal distributions must be limited to an ascertainable standard relating to health, support, maintenance, or education of the surviving spouse.⁹ If a third party is trustee over the principal distributions of the bypass trust, the right to distribute principal can be broadened beyond the ascertainable standard limitation. A third party trustee can have broad discretionary rights to distribute trust principal to the surviving spouse without causing the trust assets to be includible in the surviving spouse's taxable estate.

The marital deduction qualifies any assets in excess of the first spouse's exclusion for deferred taxation until the second spouse's death. The marital deduction can be an outright gift or a gift to a trust that qualifies as a so-called "QTIP" (qualified terminable interest property) trust under IRC 2056(b)(7).¹⁰ To qualify as an eligible QTIP trust, the surviving spouse in question must be a US citizen and receive all income and principal distributions during the surviving spouse's life.¹¹ This makes the trust "QTIP eligible."

Since the Illinois estate tax has now decoupled from federal estate tax, two often-used tax formula clauses to fund the bypass trust generate different funding amounts:

1. Marital deduction/bypass trust - federal exclusion. This tax clause funds the bypass trust with the greatest amount that will not generate federal estate tax (under Tax Act 2010 that amount would be $5 million). The marital deduction is most often structured either as a QTIP marital trust or outright gift to the surviving spouse.¹²

2. Marital deduction/bypass trust - lesser of federal exclusion or Illinois exclusion. This tax clause funds the bypass trust with the greatest amount that will not generate either federal or Illinois estate tax (under the Illinois estate tax law changes that amount would be $2 million). Again, the marital deduction is most often structured either as a QTIP marital trust or outright gift to the surviving spouse.

Spouse not the sole beneficiary. Estate plans where the spouse is not the sole beneficiary need to be reviewed. With the exclusion increased to $5 million, a bypass trust favoring non-spouse beneficiaries may be overfunded unless a cap is imposed in the trust documents.

As discussed in the following examples, the post-death options available to minimize estate taxes on the first spouse to die are limited if the surviving spouse during life is not the sole beneficiary. The bypass trust will not qualify for partial Illinois QTIP treatment. Accordingly, Illinois estate tax may be incurred on the first spouse's death or the federal estate tax exemption may be wasted. One alternative drafting technique to address the Illinois estate tax is to use the three-trust arrangement discussed below.

Portability - fools gold? Tax Act 2010 introduces a new estate tax concept of "portability." The statute calls it "deceased spousal unused exclusion amount."¹³ The new law allows the surviving spouse to use the unused federal estate tax exclusion of the first spouse to die.¹⁴

At first glance, this portability concept seems to render unnecessary the strategy of dividing title ownership of assets between spouses. But portability appears to be "fools gold" for the following reasons.¹⁵

First, the law is temporary. It will only apply if both spouses die after December 31, 2010 and before January 1, 2013.

Second, an election will need to be filed with the IRS at the first spouse's death to preserve the unused exclusion. This election will be a pitfall for those who are not getting sophisticated legal advice, because the second spouse will not be thinking of filing any election with the IRS if no estate tax return is required.

Third, any possible asset protection for trust property in the bypass trust will be lost.

Fourth, in the event of remarriage, a future spouse may have or seek to assert rights to property outright owned by the surviving spouse.

Fifth, Illinois has no corresponding provision to allow portability of the $2 million Illinois exclusion.

Example 1 illustrates the "portability" problem. H and W are married and are Illinois residents. While at the beauty salon, W overheard a conversation about portability and the increased $5 million exclusion. H and W hold all assets in joint tenancy to avoid attorney fees and probate costs. They are confident their property will pass free of all death taxes.

H dies in 2011. W dies in 2012 leaving $4 million to their only child. What are the estate tax consequences?

On H's death there is no federal or Illinois tax owed since the unlimited marital deduction applies to the joint tenancy transfer. Upon the death of the second spouse, W, in 2012, there is a $4 million tentative taxable estate. Under portability, for federal estate tax purposes W has her $5 million exclusion plus H's $5 million exclusion for a total exclusion of $10 million. There would be zero federal estate tax owed and there would be stepped-up basis for the underlying assets received by the child.

For Illinois estate tax, however, there would be tax owed by the estate of W, the second spouse to die. Since there is no portability of the Illinois exclusion, the Illinois estate tax at W's death on $4 million would be $253,986. All of the Illinois estate tax could have been avoided by dividing assets between spouses during their lifetime and using a marital deduction/bypass trust estate plan.

Planning with decoupled Illinois estate tax. Since Illinois now has a $2 million exclusion that is below the federal estate tax exclusion of $5 million, any taxable estate over $2 million will generate Illinois estate tax. Thus, there is a $3 million difference that carries with it a potential $352,158 Illinois estate tax.

Example 2: H and W are married and are Illinois residents. H dies in 2011 with a $5 million tentative taxable estate in H's name alone. H's estate planning docu­ments use an outright marital/bypass trust arrangement previously described. The bypass trust is based on the largest amount that can pass free without federal estate tax.

Since the federal exclusion in 2011 is $5 million, the bypass trust will be funded with $5 million of assets. However, the Illinois exclusion is only $2 million and there will be $352,158 of Illinois estate tax incurred at H's death.

Is there a way to avoid the Illinois estate tax on the first spouse's death in this example? Yes, as described in examples 3, 4 and 5 below.

Example 3: Outright marital/bypass trust - federal exclusion. Same facts as Example 2, except H's executor makes an Illinois-only QTIP election on 60 percent of the assets of the bypass trust. No federal QTIP election is made.

This partial Illinois QTIP election is expressly authorized under 35 ILCS 405/2(b-1).¹⁶ As a result of the partial Illinois QTIP election, there is zero estate tax owed on H's death for both federal and Illinois purposes. The $5 million federal taxable estate is covered by the 2011 exclusion of $5 million. The $5 million Illinois estate is covered by the $2 million Illinois exclusion and the $3 million marital deduction from the Illinois QTIP election ($5 million x 60 percent partial QTIP election).

To achieve this result, the bypass trust must qualify for Illinois QTIP. Under 35 ILCS 405/2(b-1), the bypass trust must meet the federal QTIP requirements. The trust must designate a U.S. citizen surviving spouse as beneficiary who is entitled to all of the income and principal during life. No person can have the power to appoint any part to any person other than the surviving spouse.¹⁷ However, after the death of the surviving spouse, the trust can designate any beneficiary to receive the remaining trust property.

If the bypass trust names the surviving spouse as the sole income beneficiary and recipient of principal, the bypass trust should qualify as an Illinois QTIP trust. However, if the bypass trust contains: (i) provisions directing income or principal be sprinkled to beneficiaries other than the surviving spouse during the spouse's life, (ii) provisions excluding the surviving spouse as a beneficiary of the bypass trust, (iii) a disqualifying lifetime power of appointment or (iv) other power that disqualifies the trust from eligibility as a QTIP,¹⁸ the bypass trust will not qualify for Illinois QTIP. In that case, Illinois estate tax will be incurred if the bypass trust is funded with more than $2 million.

Successfully qualifying for the Illinois QTIP election may do more than just defer the Illinois estate tax. If the surviving spouse moves to a state that has no state estate tax, the deferred Illinois estate tax on the Illinois QTIP property may be avoided.¹⁹

In Example 3, if a QTIP marital deduction is used where the bypass trust qualifies for QTIP treatment, the same outcome of avoiding Illinois estate tax on the first spouse's death can be achieved.

Example 4: QTIP marital/bypass trust - lesser of federal or Illinois exclusion. Same facts as Example 2 except the tax formula used to fund the bypass trust is based on passing tax free the largest amount without federal and Illinois estate tax.

Here the bypass trust would be funded with $2 million, the Illinois exclusion. The excess $3 million would pass to the marital trust. If the plan uses a QTIP marital trust, no election would be made for federal estate tax to elect QTIP because the $5 million federal exclusion would cover the $2 million bypass trust and the $3 million marital trust. The executor would, however, need to elect Illinois only QTIP over the $3 million in the marital QTIP to avoid the Illinois estate tax.

Example 5: Outright marital/bypass trust - lesser of federal or Illinois exclusion. Same facts as Example 2 except the tax formula used to fund the bypass trust is based on passing tax-free the largest amount without federal and Illinois estate tax. Under this formula, the bypass trust would be funded with $2 million. The additional $3 million would pass as an outright gift to the spouse.

This example results in wasted $3 million federal exclusion of the first spouse to die if Tax Act 2010 sunsets. The wasted exclusion would not occur if both spouses die in 2011 and 2012 so that the federal portability rules apply carrying over the unused exclusion to the surviving spouse.

Alternative planning techniques

There are alternative drafting techniques that may be considered to address the decoupled Illinois exclusion issue.

Single fund QTIP. An alternative to drafting a marital deduction bypass trust arrangement is to draft a single trust that is QTIP eligible. At the first spouse's death, the trustee is directed to divide the trust into separate shares to use the federal estate tax exclusion, elect partial QTIP for Illinois estate tax, and elect QTIP as needed for the federal marital deduction. The single fund QTIP assumes the surviving spouse is to be the sole bene­ficiary during the surviving spouse's life.²⁰

Disclaimer based estate planning. Some plans for estates under $5 million leave all property outright to the surviving spouse. The plan further provides that if the surviving spouse disclaims all or a part of the property the disclaimed property passes to a bypass trust. Thus, the bypass trust can be triggered post death to use the federal estate tax exclusion of the first spouse to die.

There are risks with this approach. First, the surviving spouse may have second thoughts and decide not to disclaim even though there would be tax benefits. Second, the requirements of a qualified disclaimer under IRC 2518 are technical and susceptible to unintentional violation. For example, if the surviving spouse accepts any benefits from the disclaimed property (like income from interest and dividends) after the death of the first spouse, the disclaimer is not qualified.²¹

Contingent QTIP trust - Clayton trust. A contingent QTIP trust (sometimes called a "Clayton" trust) is allowed under regulation.²² In a Clayton trust the personal representative can elect a portion of trust assets to be used to give the surviving spouse a lifetime income interest. That lifetime income interest and restrictions on principal distributions qualifies for QTIP treatment. The nonelected portion can be used for the benefit of the surviving spouse and the other family members or just for the other family members. The personal representative making the election should not be the surviving spouse. The Clayton trust avoids the disadvantage of relying on the surviving spouse to make a qualified disclaimer.

Drafting with three-trust plan. Another way for the estate planning documents to address the Illinois estate tax decoupling issue is by using a three-trust approach. In addition to the marital trust and bypass trust, the third trust would be established with a tax formula clause to create a separate Illinois QTIP that meets the eligibility requirements.²³

Nontraditional marital plans need review

Nontraditional plans that leave the bypass trust to beneficiaries other than the surviving spouse need to be reviewed in light of these tax law changes. If the bypass trust contains sprinkling or spray provisions which allow distributions to someone other than the surviving spouse, the trust will not qualify as an Illinois QTIP to the extent the bypass trust receives more than $2 million in assets. If Illinois tax is to be deferred in that case, the planning documents need to be revised to provide for a third trust containing a tax formula clause establishing an Illinois QTIP trust.²⁴

Conclusion - flexibility remains the key

Naming the surviving spouse as the trust beneficiary to receive all income and principal during life offers the most flexibility to minimize estate tax. As long as the trusts are QTIP eligible, the often-used marital deduction/bypass trust arrangement should minimize federal and Illinois estate tax under whatever tax law exclusion applies. Indeed, any trust that is QTIP eligible provides post-death flexibility to use partial federal or Illinois QTIP elections. The decoupling of the Illinois estate tax from the federal estate tax means the tax exclusion for clients subject to the Illinois tax is really $2 million and not $5 million. The new federal concept of "portability" is too uncertain to rely on and does not apply for Illinois estate tax purposes. (See the table entitled "Comparing federal and Illinois estate tax 2011 and 2012 with 2013.")

In many cases, tax minimization is not the only goal of estate planning for married couples. Second marriages, children from the first marriage, and other factors can come into play. Those plans where the surviving spouse is not the sole beneficiary need to be examined so that the possible federal and Illinois estate tax and distribution consequences can be identified and addressed with the client.

Other options to preserve flexibility, such as drafting single fund QTIPs, disclaimer trusts, Clayton trusts, and three trust arrangements, deserve consideration if consistent with the client's property distribution goals.

 

Steven E. Siebers <ssiebers@slpsd.com> is a partner with Scholz, Loos, Palmer, Siebers & Duesterhaus LLP in Quincy and a graduate of the University of Illinois College of Law.

Federal and Illinois estate taxes for a decedent dying in 2011 or 2012

Tentative taxable estate	Federal estate tax	Illinois estate tax	Total
$2 million	0	0	0
$3 million	0	167,279	167,279
$4 million	0	253,986	253,986
$5 million	0	352,158	352,158
$6 million	190,375	456,071	646,446

Comparing federal and Illinois estate tax 2011 and 2012 with 2013

Deaths in 2011 and 2012		Deaths in 2013
Federal estate tax	Illinois estate tax		Federal estate tax	Illinois estate tax
$5 million estate tax exclusion	$2 million estate tax exclusion		$1 million estate tax exclusion	$1 million estate tax exclusion
$5 million lifetime gift exclusion	No tax on lifetime gifts		$1 million lifetime gift exclusion	No tax on lifetime gifts
Top estate tax rate 35%	Credit calculation of tax		Top estate tax rate 55%	Credit calculation of tax
Portability of unused exclusion to surviving spouse	No portability of unused Illinois exclusion to surviving spouse		No portability	No portability
QTIP election available	QTIP election available for IL estate tax regardless of federal election		QTIP election available	QTIP election available for IL estate tax regardless of federal election

 

 

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1. Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 Pub L 111-312, 111th Cong 2d Sess (2010); (hereafter "Tax Act 2010").

2. Illinois Taxpayer Accountability and Budget Stabilization Act; 35 ILCS 405/2(b).

3. The exclusion amount is technically a credit against estate and gift tax but for ease of discussion in this article will be referred to as an "exclusion."

4. Generation skipping tax issues are beyond the scope of this article.

5. The Economic Growth and Tax Relief Reconciliation Act of 2001, Pub L No 107-16, 107th Cong, 1st Sess (2001), 115 Stat 38 (hereafter "EGTRRA").

6. IRS Form 8939 is to be issued for reporting under modified carryover basis rules. Notice 2011-66, 2011 IRB____. See also Rev Proc 2011-41, 2011-35 IRB ----.

7. The potential federal estate tax downside of making gifts in excess of $1 million relates to the sunset of the 2010 Tax Act after 2012. Assume in 2013 (and years later) the $1 million estate tax exclusion goes back into effect. If this occurs, the estate of a decedent who dies in 2013 (or years later) and who made lifetime gifts in 2011 or 2012 in excess of $1 million will arguably have additional estate tax liability. This is called the "clawback" effect. The "clawback" issue is unresolved and will need to be addressed by Congress or the IRS. See Howard Zaritsky, Practical Estate Planning in 2011 and 2012, WG&L Fed Tax Treatises § 4.02(1)(a) (Thomson Reuters 2011).

8. Subject to possible inflation adjustment after 2011.

9. Because principal distributions are subject to an ascertainable standard, the bypass trust principal is not included as taxable property at the death of the surviving spouse even if the surviving spouse is named the trustee. IRC § 2041.

10. There are other types of trusts that can qualify for the marital deduction such as the power of appointment trust under IRC 2056(b)(5). The QTIP for flexibility and control is the most popular. Jeffrey N. Pennell, 843-2nd T.M., Estate Tax Marital Deduction VII, A 1 (BNA Washington DC).

11. Other requirements include that trust income cannot be terminated by remarriage or otherwise during the surviving spouse's life and the surviving spouse must have the power to require non-income producing assets be made income producing. See Robert J. Kolasa, The Illinois QTIP Election to the Rescue, 97 Ill Bar J 612, 614 (December 2009).

12. If the bypass trust is subject to an Illinois QTIP election (See Example 3), other forms of marital trust planning (such as a general power of appointment marital trust) may be utilized.

13. Tax Act 2010, § 303(a) amending IRC § 2010(c).

14. If a spouse remarries, the unused exclusion of the last deceased spouse is the unused exclusion for portability purposes.

15. The "real gold" opportunity of portability arises for enhanced lifetime gifts for larger estates. If one spouse dies during 2011 or 2012 with unused estate tax exclusion, the surviving spouse can use the unused exclusion of the first spouse to die to make lifetime gifts during 2011 and 2012 rather than having to wait to use the first spouse's unused exclusion for future estate taxes of the second spouse.

16. See Kolasa, 97 Ill Bar J at 614 (cited in note 11).

17. IRC 2056(b)(7).

18. The disqualifying power of appointment would have to be disclaimed under IRC 2518 to make the bypass trust eligible under the QTIP rules.

19. See Kolasa, 97 Ill Bar J at 615 (cited in note 11).

20. See Zaritsky, WG&L Fed Tax Treatises at § 3.06(3) (cited in note 7).

21. IRC § 2518(b)(3).

22. Treasury Reg 20.2056(b)-7(d)(3)(i).

23. See Zaritsky, WG&L Fed Tax Treatises at § 3.02(3)(c) (cited in note 7).

24. Id at § 3.05(2).