Deferring, minimizing, or avoiding estate taxes altogether is often an important estate planning goal for married couples. However, uncertainty surrounding the estate tax laws and the value of their accounts and property at the first spouse’s death can leave a couple feeling that they need a crystal ball to make the right decisions. Using either a disclaimer or the so-called Clayton election as part of their estate plan can allow at least some hindsight and, consequently, peace of mind.
These are complex issues. You can save your partner and family a lot of stress during a difficult transition. As an estate planning attorney in Austin, I can help you find the best solutions for your family's specific needs. We can work through how marital disclaimers and the Clayton election might play out in your situation.
Before diving into some of the particulars of using marital disclaimers and the Clayton election, I'll first lay some conceptual groundwork. The main objective of using a marital funding formula in estate tax planning is to take advantage of both (1) the estate tax marital deduction and (2) the estate tax exemption to eliminate the federal estate tax due at the first spouse’s death and to reduce or eliminate federal estate tax due at the surviving spouse’s death.
What is the marital deduction? In general, as long as they meet the requirements under federal estate tax law, a decedent spouse can exclude transfers to a surviving spouse (provided the surviving spouse is a US citizen) from the decedent spouse’s estate. In this way, the IRS will not subject the transfers to estate taxes at the first spouse’s death. This is the unlimited estate tax marital deduction. The unlimited estate tax marital deduction essentially postpones the payment of any estate taxes until after the second spouse’s death. This provides the power behind the marital disclaimers and the Clayton election planning techniques.
The general concept of the estate tax exemption is that, if the value of your estate is less than the exemption amount, no federal estate tax is due. The 2022 exemption amount for an individual is $12.06 million. Under current law, Congress will reduce the exemption amount to $5 million (adjusted for inflation) on January 1, 2026. Currently, the IRS imposes a 40 percent tax on the estate to the extent that its value exceeds the exemption amount.
Marital share funding formulas use both concepts to eliminate federal estate tax to the greatest extent possible. In essence, because the unlimited estate tax marital deduction allows estate tax liability to be postponed until the second spouse’s death, the first decedent spouse’s estate plan should use a formula to divide their estate into two shares:
Keynes and his wife, Lydia, each own half of their $25 million estate. Keynes dies in 2022 when the estate tax exemption amount is $12.06 million. For this example, let's say that Lydia dies in 2026. That is when Congress has scheduled for the estate tax exemption amount to fall back to $5 million. It will be more than $5 million because it will include a yet-to-be-calculated inflation-adjusted amount then in effect). This couple's estate plan leaves Keynes' estate to Lydia with everything going to their children at Lydia’s death.
When Keynes dies in 2022, his $12.5 million portion of the estate passes to Lydia estate-tax free under the unlimited estate tax marital deduction. Because all of Keynes' $12.5 million passes to Lydia under the marital deduction, when Lydia dies in 2026, the applicable $5 million exemption amount will only protect $5 million of the $25 million estate. Applying a 40 percent estate tax rate, Lydia's estate would owe $8 million in estate tax.
The facts are the same as in the above example, except that Keynes and Lydia’s estate plan uses a marital funding formula that divides Keynes' estate into marital and nonmarital shares. At Keynes' death, $12.06 million is apportioned in trust to the nonmarital share, using all of Keynes' estate tax exemption amount, and the remaining $440,000 is apportioned to the marital share. When Lydia dies in 2026, her estate will be worth $12,940,000, consisting of her $12.5 million portion of the estate and the $440,000 apportioned to the marital share. Lydia's $5 million estate tax exemption amount in 2026 will protect $5 million of Lydia’s $12.94 million estate. Applying a 40 percent estate tax rate, Lydia's estate would owe $3,176,000 in estate tax.
By using a marital share funding formula as part of their estate tax planning, Keynes and Lydia can prevent their heirs (their children) from having to pay $4,824,000 in estate taxes.
There are different ways to divide a couple’s trust property into marital and nonmarital shares upon the first spouse’s death, but the disclaimer option gives the surviving spouse the most flexibility. Using the disclaimer option, the trustee or executor distributes all the decedent spouse’s trust property to the marital share. The surviving spouse may then exercise a qualified disclaimer (refusal to take ownership of money or property left to them by their deceased spouse) under Internal Revenue Code section 2518, and the trustee distributes any property disclaimed by the surviving spouse to the nonmarital share, which can be either held in trust for the benefit of the surviving spouse (and other beneficiaries if desired) or otherwise administered under the trust agreement’s residuary provisions.
With the disclaimer option, the surviving spouse can choose to give any amount of property they wish to the nonmarital share, depending on the estate tax law in effect at the time of the first spouse’s death, the value of the decedent spouse’s estate, and the surviving spouse’s financial needs.
The Clayton election, named after the court case Estate of Clayton, Jr. v. Commissioner, provides another formula to divide a couple’s trust property into marital and nonmarital shares. It also provides maximum flexibility to engage in marital deduction planning after the first spouse’s death. The way the Clayton election works is almost the opposite of the disclaimer option. Instead of distributing all the decedent spouse’s trust property to the marital share, the trustee distributes it to the nonmarital share. The trustee may then list any property on Schedule M—Bequests, etc., to Surviving Spouse (Marital Deduction) of the decedent spouse’s IRS Form 706 (the federal estate tax return) to allocate it to the marital share instead.
In contrast to the disclaimer option, an advantage of the Clayton election is that its technical requirements and timelines are less rigid. While a surviving spouse must make a disclaimer within nine months after the first spouse’s death, they need not file a Form 706 until up to fifteen months (or possibly twenty-four months if the executor files an estate tax return merely to elect portability) after the first spouse’s death. This allows the surviving spouse more time to grieve and for making a less emotion-driven decision.
In addition, with the Clayton election, the surviving spouse has the opportunity to have professionals (attorneys, CPAs, other advisors, etc.) help them objectively decide which property they should apportion to the marital and nonmarital shares. In addition, a surviving spouse must file a Form 706 when using the Clayton election option. Filing a 706 provides the opportunity for the couple's children to use any unused amount of the decedent spouse's estate tax exemption.
Finally, because the Clayton election sends the decedent spouse’s property into a nonmarital share trust by default, the surviving spouse automatically receives those accounts and property in a form that offers a degree of creditor protection.
Whether to use a marital formula in your estate plan, and which marital formula to use, requires considerable analysis of your estate, your goals, and the law. Contact us to put in place or review your plan to ensure that it will meet all your goals, including deferring, minimizing, or eliminating the estate tax that your heirs will pay.
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