Estate Planning for California Residents, Chapter 9 – last updated April 28, 2000
Many married couples start their estate planning by assuming that all property will be left to the surviving spouse, who will then leave all remaining property to the children. Unfortunately, this well-intentioned estate plan could result in a substantial estate tax that could easily have been avoided.
“Unnecessary” Estate Taxes
Assume that Mr. and Mrs. Jones have assets of $1 million. Their goal is to use the income from that money for retirement, with the balance to pass to their adult children and grandchildren when both die.
Next, assume that Mr. Jones dies, leaving all his property to his wife. His $500,000 estate is not subject to any estate tax (both because it is less than $675,000 and because bequests to a spouse are tax-free). Mrs. Jones retains complete control over the $1 million estate.
However, when Mrs. Jones dies, leaving $1 million to her children and grandchildren, there will be an estate tax of $125,250, leaving only $874,750 for her heirs.
Capturing Both Exemptions
To avoid this large tax, Mr. Jones should have left part or all of his property to an “exemption trust,” with his wife as trustee. His wife could then use the money in that trust for her “health, education, maintenance, and support.” If Mrs. Jones wanted to do something not authorized by that broad standard, she could dip into her half of the $1 million.
When Mrs. Jones died, the “exemption trust” would not be considered part of her estate, so her estate would be valued at only $500,000. No estate tax would be due. The children could receive the entire $1 million estate tax-free.
Problems in “Exemption Equivalent” Planning
In the above examples, we have assumed that the $1 million estate remains constant after the first spouse’s death. However, imagine the difference if Mrs. Jones survived another 10 years and the $1 million estate grew to $2 million. Her estate taxes would be $560,250 if she retained all this property. But if she owned only half, the estate tax would be only $125,250.
Alas, the reverse could also happen. If Mrs. Jones had high expenses or medical problems during her remaining years, her estate might drop from $1 million to $500,000 or even to nothing. This unpleasant possibility leads many couples to leave everything to the survivor, rather than making bequests to children or charity when the first spouse dies.
Benefits of Using An Exemption Trust
These planning considerations become less important when you realize that it is possible to create an “exemption trust” that can be used by the surviving spouse for “health, education, maintenance, or support” during his or her lifetime, and then passes to the children free of any additional estate taxes. For estate tax purposes, the exemption trust is treated as if it were taxed at the first spouse’s death (although the exemption trust usually contains $675,000 or less, to avoid actually paying any tax).
Whether you think of this as a “technical rule” or a “loophole” or a “lawyer’s trick” or anything else, it is important to recognize the importance of this option. It can save some estate taxes for any couple with assets expected to be worth more than $675,000 at the time of the second spouse’s death.
For clients who are reluctant to place any limits on the survivor’s inheritance, it is possible to draft a “wait and see” estate plan that allows the survivor to re-evaluate their financial situation after the first spouse dies. If the use of an exemption trust seems justified, the survivor can “disclaim” property (which then passes into the exemption trust); absent a disclaimer, all property passes directly to the surviving spouse. The main drawback of this approach is that the survivor might fail to act wisely after the first spouse’s death, or the survivor might be incapacitated and thus unable to “disclaim” property at the appropriate time.