married couple cooking

Marital Disclaimers and the Clayton Election: Last-Minute Estate Tax Planning

Deferring, minimizing, or avoiding estate taxes altogether is often an important estate planning goal for married couples. However, uncertainty surrounding what the estate tax laws and the value of their accounts and property will be 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.

Marital Deduction Planning and Marital Share Funding Formulas

Before diving into some of the particulars of using a disclaimer and the Clayton election, let us 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, transfers from a decedent spouse to a surviving spouse (provided the surviving spouse is a US citizen) are excluded from the decedent spouse’s estate and are not subject 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.

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, the exemption amount will be reduced to $5 million (adjusted for inflation) on January 1, 2026. Currently, a 40 percent tax is imposed 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 the their estate into two shares: (1) the marital share, which is the part of the decedent spouse’s estate that passes to the surviving spouse in a form that qualifies for the unlimited estate tax marital deduction, and (2) the nonmarital share, which is the part of the decedent spouse’s estate that does not qualify for the unlimited marital deduction but is instead sheltered by the decedent spouse’s remaining estate tax exemption amount.

Example without a marital share funding formula. Bill and his wife, Cindy, each own half of their $25 million estate. Bill dies in 2022, when the estate tax exemption amount is $12.06 million. Cindy dies in 2026, when the estate tax exemption amount is only $5 million, the inflation-adjusted amount then in effect. Their estate plan leaves the first decedent’s estate to the surviving spouse with everything going to their children at the surviving spouse’s death.

When Bill dies in 2022, his $12.5 million portion of the estate passes to Cindy estate-tax free under the unlimited estate tax marital deduction. Because all of Bill’s $12.5 million passes to Cindy under the marital deduction, when Cindy 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, Cindy’s estate would owe $8 million in estate tax.

Example with a marital share funding formula. The facts are the same as in the above example, except that Bill and Cindy’s estate plan uses a marital funding formula that divides Bill’s estate into marital and nonmarital shares. At Bill’s death, $12.06 million is apportioned in trust to the nonmarital share, using all of Bill’s estate tax exemption amount, and the remaining $440,000 is apportioned to the marital share. When Cindy 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. Cindy’s $5 million estate tax exemption amount in 2026 will protect $5 million of Cindy’s $12.94 million estate. Applying a 40 percent estate tax rate, Cindy’s estate would owe $3,176,000 in estate tax.

By using a marital share funding formula as part of their estate tax planning, Bill and Cindy can prevent their heirs (their children) from having to pay $4,824,000 in estate taxes.

Disclaimer

There are numerous 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 or 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.

Clayton Election

The Clayton election, named after the court case Estate of Clayton, Jr. v. Commissioner1, is another formula used 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.

An advantage of the Clayton election, in contrast to the disclaimer option, is that its technical requirements and timelines are less rigid. While a disclaimer must be made within nine months after the first spouse’s death, a Form 706 is not due until up to fifteen months (or possibly twenty-four months if the executor is not required to file an estate tax return but files to elect portability) after the first spouse’s death, allowing more time to grieve and for making a less emotion-driven decision. Another advantage of the Clayton election is that it allows someone other than the surviving spouse to objectively decide what property should be apportioned to the marital and nonmarital shares. In addition, because a Form 706 must be filed when using the Clayton election option, there is the opportunity to claim for future 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.

Footnotes

  1. Estate of Clayton, Jr. v. Comm’r,976 F.2d 1486 (1992).
grandparents with grandkids

Changes to the FAFSA Form and What It Means for Grandparents

For grandparents who want to leave a legacy to their grandchildren, the gift of a 529 college savings plan is an option. Not only can opening a 529 plan account help a grandchild with educational expenses, it can also help grandparents with their estate planning goals. 

In the past, grandparent 529 plans had the potential to reduce student aid eligibility. However, changes to student aid application rules mean that soon, 529 distributions from grandparents will not count toward a student’s income on the most-used financial aid form. This is welcome news for grandparents who want to help cover the ever-increasing costs of higher education without impacting a student’s need-based financial aid eligibility. 

About 529 Plans

College tuition costs and student loan debt keep going up, so much so that student debt has reached a crisis point. Student loan debt in the United States is approaching $2 trillion and grows six times faster than the national economy.1 The average annual cost of a private four-year college is more than $32,000—not including expenses such as housing, food, books, and supplies.2 Between 2005 and 2020, the average per-student debt level nearly doubled, from $17,000 to $30,000.3 

Student loan debt is an economic drag that can limit opportunities long after graduation. One of the most popular ways to save for an education is a 529 plan, also known as a qualified tuition program. These plans take their name from Section 529 of the Internal Revenue Code, but they are established and maintained at the state level. Every state except Wyoming has a version of the 529 plan.4 

Grandparent-Owned 529 Plans

A 529 plan is the most popular way for Americans to save for a child’s education.5 Grandparents may contribute to a 529 plan that has already been established by the parents, or they can open a separate plan. 

Until recently, there was a major disincentive for grandparents to open a 529 plan because, when a student received funds from it, they had to report the funds as untaxed income on their Free Application for Federal Student Aid (FAFSA) form. As a result, the income from a grandparent-owned 529 plan could reduce the amount of financial aid the student qualified for. The same was true of parent-owned 529 plans, but the maximum reduction amount was significantly lower than the one from grandparent-owned plans. 

FAFSA Changes and Grandparents 

The FAFSA Simplification Act, signed into law in late 2020, made several changes to the Higher Education Act of 1965, including changes to the FAFSA form. One of the changes is that students will no longer have to disclose cash support on their FAFSA form. 

The upshot for grandparents is that they no longer have to worry about the financial aid trap previously associated with grandparent-owned 529 accounts.6 They can use a 529 account to help pay for their grandchild’s education without concerns that it will harm financial aid eligibility. 

Importantly, income reporting changes are not yet in effect. Until they are, money from grandparent 529 plans may count as untaxed income on a student’s FAFSA form. The Department of Education announced in the summer of 2021 that full implementation of FAFSA changes, originally scheduled for the 2023–24 school year, will be delayed until the 2024–25 school year. 

This delay should not affect plans to fund a grandchild’s education, because the funds in a grandparent-owned 529 plan come into play only when they are released. Therefore, grandparents can continue to put money into a 529 plan without affecting student aid eligibility. 

In the meantime, grandparents will want to pay attention to when the new FAFSA rules take effect. They should also keep in mind that a grandparent 529 plan will still be considered on the College Scholarship Service Profile—an additional financial aid form used by a small number of private colleges. 

Other Benefits of 529 Plans

A 529 plan can fund more than just tuition. Qualified expenses include fees, books, supplies, equipment such as computers and printers, software, and internet access. In addition, students living off campus may use the funds to pay for rent, utilities, and food. And, a 529 plan does not even have to be for higher education: tuition for primary or secondary school qualifies as well. 

Leaving a legacy in the form of education funding is its own reward, but 529 plans provide financial benefits to both grandkids and grandparents, including the following: 

  • Investment earnings and withdrawals from a 529 plan are tax-free if they go towards qualified educational expenses. 
  • The money from a 529 plan can be used for non–education-related expenses. The money withdrawn is subject to a 10 percent penalty and taxes on the investment gain but the money can be tapped in an emergency. 
  • If the beneficiary (i.e., the grandchild) decides not to attend college, the grandparent owner can change the beneficiary. In fact, the beneficiary and the ownership can be changed at any time. 
  • Contributions to a 529 plan are removed from the owner’s taxable estate, lowering estate tax liability. 
  • While 529 contributions are considered gifts to the beneficiary and could be subject to the federal gift (and generation-skipping transfer) tax, this tax can be avoided by spreading a lump-sum contribution over a five-year period, a strategy known as “superfunding” a 529 plan.7 Superfunding can be done for an unlimited number of beneficiaries. 
  • Some states offer a tax break for contributing to a 529 plan.8 
  • State rules vary for 529 plans, including contribution limits, but you can pick a plan from any state. You are not limited to plans in the state where you live, and students can use the money to attend a qualified school in any state. 

It is important to remember that anytime you are dealing with the Internal Revenue Service, there are myriad rules and regulations that must be met, and 529 plans are no exception. State rules also apply to 529 plans. To get the most out of your plan, make sure you work with a knowledgeable professional. To learn more about ways you can help the next generation with their education and help yourself with a proper estate plan, call us.

Footnotes

  1. Melanie Hanson, Student Loan Debt Statistics, EducationData.org (Nov. 17, 2021), https://educationdata.org/student-loan-debt-statistics. 
  2. College Costs: FAQs, CollegeBoard, https://bigfuture.collegeboard.org/pay-for-college/college-costs/college-costs-faqs (last visited Dec. 27, 2021).
  3. Scholarship America, The Far-Reaching Impact of the Student Debt Crisis, Our Blog (Jan. 2021), https://scholarshipamerica.org/blog/the-far-reaching-impact-of-the-student-debt-crisis/.
  4. Though Wyoming stopped operating its own 529 plans around 2006, the state has partnered with other states to create similar plans established under the other state’s law and operated by that state’s treasury department.
  5. Hanson, supra note 1.
  6. See Joseph Hurley, Avoiding the financial-aid trap with grandparent 529s, Saving For College (Nov. 12, 2014), https://www.savingforcollege.com/articles/avoiding-the-financial-aid-trap-with-grandparent-529s.
  7. See Joseph Hurley, 10 Rules for Superfunding a 529 Plan, Saving For College (Feb. 25, 2021), https://www.savingforcollege.com/article/10-rules-for-superfunding-a-529-plan.
  8. Compare 529 Plans by Features, Saving for College, https://www.savingforcollege.com/compare-529-plans/state-tax-deductions (last visited Jan. 24, 2022).

Indiana Inheritance Tax Repeal (Actually a Phase Out)

On March 20, 2012, Governor Daniels signed into law a phase out of the Indiana inheritance tax.  First, a little background may be helpful.  For many, many years Indiana has had an independent inheritance tax. This tax is technically a tax on the heir/beneficiary when that person receives an inheritance. The actual amount of tax depends upon the relationship of the heir/beneficiary to the decedent.  Hopefully you will recall that there is no tax on any amounts passing to a spouse.  For lineal descendants (children, grandchildren, step-children, step-grandchildren, etc.) and for lineal ancestors (parents, grandparents, etc.) there was a $100,000 exemption. Amounts inherited above $100,000 would be taxed at rates ranging from 1% to 10%.  These lineal descendants and ancestors were called “Class A” beneficiaries by the Indiana Department of Revenue.

The new law does a few things.  First, it add a spouse, widow, or widower of a child or step-child as a Class A beneficiary.  Second, it increases the exemption for Class A beneficiaries to $250,000.  This change was made retroactive to decedents dying after December 31, 2011.  The third change is the gradual repeal of the inheritance tax.  This was done through a credit to the actual tax owed which credit increases by 10% each year beginning in 2013 through 2021.  Beginning in 2022 the inheritance tax would cease to exist.  As an example, if a parent dies in 2013 with a $1,000,000 estate which is divided equally between two children. Each inherits $500,000. The first $250,000 for each child would be exempt.  The other $250,000 inherited by each child would incur a tax of $7,250.  In 2013 there would be a 10% credit against this tax (which is $725) and thus the actual tax owing for each child would be $6,525.  If the person died in 2014 the law applies a 20% credit against the tax ($1,450) and thus the actual tax on each child would be $5,800.

Unfortunately this new law does not increase the paltry exemptions available to Class B beneficiaries (brothers, sisters, nieces, nephews, etc.) which is only $500 nor does it increase the exemption for Class C beneficiaries (everyone who is not a Class A or Class B beneficiary – such as a friend) which is only $100.

The fact that this legislation got passed is somewhat of a surprise. There have been proposals to repeal our state’s inheritance tax many times in the past and it never got anywhere.  This time was different although the full repeal will take many years to materialize.

The Death of a Billionaire – George Steinbrenner Owner of the NY Yankees

On July 13, 2010, George Steinbrenner, the owner of the New York Yankees, died.  It has been widely reported that 37 years ago he bought the Yankees for about $10 million.  The Yankees are now reported to be worth $1.6 billion.  He became the face of the Yankees, butted heads with several of his managers, other team owners and the commissioner of baseball through the years.  He was known as the “Boss” and moved the Yankee team from the “House that Ruth Built” to the “House that the Boss Built” as the team moved to a new Yankee Stadium in 2009.

Mr. Steinbrenner appears to also have been the fourth billionaire to die in 2010, joining Dan Duncan, Mary Janet Morse Cargill, and Walter Shorenstein as the U.S. billionaires who have died in 2010. So why is this significant?  Well, if you have been following this blog and the news on the federal estate tax you know that there is no federal estate tax on the wealth of those that die this year.  He is likely the most famous of the billionaires to have died this year and will add a public face to the estate tax debate.  For some, his death will represent a loss of hundreds of millions of dollars of tax revenue.  (For an analysis of Mr. Steinbrenner's estate issues see this Forbes entry).  For the opponents of the estate tax, his death illustrates the benefit many small business and family farms could receive if the estate tax was permanently repealed.
 
There was a recent Wall Street Journal article titled “Too Rich to Live?” which may be of interest to you.  A few years ago I heard a speaker jokingly talk about 2010 as being the “Push Mamma from the Train” year for wealthy individuals.  Hopefully this will remain a joke.  I hope we don’t hear a story about a family trying to decide if perhaps “daddy is just to rich to live beyond 2010.”

Will Congress Act on the Estate Tax?

Former Treasury Secretary Robert Rubin will join others in urging Congress to reinstate the estate tax before the August recess.  Apparently this event will be held on July 21, 2010 and Rubin is expected to discuss his reasons to support a permanent fix to the estate tax.  See more of this report at The Hill.

In 2009 the estate tax exemption was $3.5 million.  However, due to a quirk in the law that was passed in 2001 the estate tax expired in 2010.  Thus, anyone dying in 2010, even billionaires, will pay no federal estate tax.  However, like Cinderella’s carriage turning back into a pumpkin, on January 1, 2011 the estate tax is set to be reinstated with only a $1 million exemption.  Despite rumors and other information that Congress would fix this issue they have failed to do so.

Again, stay tuned.  I am sure there will be more to this story later.

Estate Tax Deal Falls Apart

It appears that a reported agreement between Senate Democrats and Republicans on an estate tax proposal has fallen apart.  It now appears even more likely that we may actually return to a 55 percent maximum estate tax rate and $1 million exemption beginning January 1, 2011.
 
The details of the reported agreement have not been made public.  However The Hill reports that there would be a 35 percent tax rate for estate in excess of $3.5 million, increasing to $5 million over time.

According to The Hill , Senator Jon Kyl (R-Ariz) said the deal broke down because of Senate Democrats' would not allow legislation to reach the floor that lacked the support of a majority of its members.
 
"We no longer have an agreement because the Democratic side has decided that unless a matter has a guaranteed majority of Democratic votes going in, they're not going to allow it on the floor, at least not voluntarily," Kyle said. "So we have to find a way to get a reasonable permanent estate tax reform to the floor where members can vote on it."
 
It now appears any estate tax reform will not happen any time soon and we face the very real possibility of a return to the $1 million exemption and 55 percent tax rates.  Again, stay tuned.
 
For more details on the breakdown in click here for another article.
 

More Rumblings About the Estate Tax

I subscribe to various list serve’s that are specific to estate planning, tax and elder law issues. Today a colleague of mine posted that he had recently heard Prof. Jeffrey Pennell, of Emory Law School, speak about this issue. Prof. Pennell is a very well respected law professor and his thoughts are not to be taken lightly. In any event, Pennell apparently opined that he did not think we would have any legislation on estate tax reform this year, that the estate tax law changes passed in 2001 would indeed sunset on January 1, 2011, and we would return to an estate tax exemption of only $1 Million.

If in fact we return to a planning world with only a $1 Million estate tax exemption, there appear to be many winners, and perhaps a few losers.

Winners:

Democrats – more money to help with the deficit and high priority (and costly) legislation

Republicans – a proven effective fund raising issue (eliminate or lessen the impact of the "death tax")

States – reinstitution of the state death tax (sponge or pick-up tax) provides states with much needed revenue

Insurance Companies (always a strong lobbying group) – increase use of ILITs to provide liquidity for payment of estate tax and preservation of estate

Charities – more motivation for charitable playing (CRTs, CLTs and private foundations)

Losers:

Heirs

Unfortunately, that means that my clients and their families could very well  be losers in this whole debate.  Again, stay tuned to see if we actually do get some legislation passed.

 

Possible Estate Tax Proposal Forthcoming?

Despite promises by our congress that estate tax reform would be a priority in the new year, as of yet, nothing has happened. It has been reported that Senate Minority Whip Jon Kyl (R-Ariz) is working on an estate tax proposal. This article from The Hill discussed that proposal which would set the estate tax exemption at $3.5 Million with increases up to $5 Million over time and tax rates of 35%. It was not clear how much success this would have of passing with the pay-go rules that may require corresponding "off-sets" to the proposal. Stay tuned.

They Said It Couldn’t Happen

Effort to Extend Estate Tax Fails

According to a Wall Street Journal article at http://online.wsj.com/article/SB126098351451293981.html the Senate has failed to pass a patch to the estate tax laws that would have kept the estate tax from expiring in 2010. Apparently the Democrats favored keeping the 2009 levels in place (a $3.5 million exemption and a 45% tax rate) whereas the Republicans favored a $5 million exemption and a 35% top rate. It is possible that passage of a new law in 2010 will be made retroactive to January 1, 2010.
 
It appears that issues such as whether College Football should institute a playoff system may be deemed more important by our Congress than trying to address the issue of estate taxes. See http://kdka.com/topstories/congress.bowls.playoffs.2.1358827.html

Stay tuned. Hopefully there will be some legislation early next year that will provide some certainty to the estate tax issue.