Funding the Marital Share
I. Proper drafting of the marital share is critical. The draftsperson must give the fiduciary clear directions as to the method to be employed in determining the amount of the marital bequest and how the assets to fund the marital share will be selected. A. Generally, the marital deduction bequest may be expressed in one of two ways: 1. A pecuniary amount. (Ex: I leave my husband $500,000.) 2. A fractional amount. (Ex: I leave one-half my residuary estate to my husband.) B. To ensure that estate taxes are minimized on both the first spouse’s death and the surviving spouse’s death, estate planners often express the marital deduction utilizing a formula. Proper drafting of the formula ensures full use of the credit shelter amount and minimizes the possibility of overfunding the marital bequest. The formulas utilized fall into two categories: 1. Fractional Share Formula: A fractional share formula is a gift of a fractional portion of each asset in the estate. An example of a fractional share formula is as follows: “I give to my spouse that fractional share of my residuary estate necessary to obtain the maximum federal estate tax marital deduction, the numerator of which shall be . . . and the denominator of which shall be. . .” This type of formula is similar to giving the spouse one-half of the residuary estate. The primary difference is that the amount of the bequest will be determined by a formula to obtain the optimum marital deduction. 2. A Pecuniary Formula is a gift of money. An example of a pecuniary gift is: “I give the smallest pecuniary amount of my residuary estate that, if allowed as a federal estate tax marital deduction, would result in the least possible federal estate tax being payable by reason of my death.” This type of formula is similar to a bequest of a specific sum of money to the spouse. Once again, to ensure flexibility, the amount of the bequest is being expressed as a formula. C. It is critical that the draftsperson gives the fiduciary clear guidance that a particular formula is a pecuniary amount or a fractional among. Unclear or ambiguous directions can produce unintended results. II. While there are only two basic formulas for expressing the amount of the marital deduction, there are variations in the funding formulas which can be used for either a pecuniary formula marital deduction or the fractional share formula marital deduction. It is critical that the instrument specify the method of funding to be used. The method of funding must be selected when the instrument is drafted. Granting the fiduciary the discretion to choose a method may result in disallowance of the marital deduction. While the type of formula (pecuniary vs. fractional) determines the amount of the marital transfer, the funding formula instructs the fiduciary as to how that amount will be achieved. A. In determining the funding of the pecuniary formula marital deduction, there are three approaches: 1. Funding based on date of distribution value, sometimes referred to as a true worth pecuniary. 2. Minimum worth pecuniary. 3. Fairly representative pecuniary. 4. There is also the reverse pecuniary formula, which makes a pecuniary gift to the credit shelter or by-pass trust. The marital gift is of the residuary estate. This method may employ as a funding formula for the credit shelter gift either date of distribution/true worth approach or the fairly representative approach. The minimum worth approach in this context could disqualify the marital deduction as it gives the fiduciary too much power to manipulate the funding of the marital share by permitting overfunding of the non-marital pecuniary bequest. B. The date of distribution value or true worth pecuniary method of funding has several advantages: 1. This type of provision allows the fiduciary broad discretion to pick and choose assets to fund the marital share. The fiduciary will not be limited to a fractional portion of each asset. Thus, the fiduciary can allocate property to the marital share which is not expected to appreciate, thereby minimizing estate taxes upon the surviving spouse’s death. 2. A second advantage of this method of funding is that it protects the spouse’s share against depreciation if estate assets decline in value during administration. Since the marital share is a fixed dollar amount, depreciation will be allocated to the non-marital share. 3. Another advantage is that the value of the marital share is frozen. This will prevent increasing estate taxes upon the surviving spouse’s death by overfunding the marital share. Appreciation in asset values since the date of death (or alternate valuation date if alternate valuation was elected) will be allocated to the non-marital share. 4. Finally, the true-worth pecuniary is easy to administer. Once the value of the marital share is determined, the fiduciary only has to choose the property to allocate to the trust which will equal that value on date of distribution. C. There are disadvantages to the true-worth pecuniary method of funding: 1. If the fiduciary uses appreciated property to fund the bequest, there will be a capital gain upon funding. (Rev Rul 60-87 1960-1 C.B. 286, Suisman v. Eaton, 15 F. Supp 113 (d.Conn 1935), Affd per curiam Suisman v. Hartford Connecticut Trust Co. 83 F2d 1019 2d 1936) cert dep 299 vs. 573 (1936).) If property has declined in value, then the entity which is funding the marital share may not be allowed to take the loss. Thus, if funding is being made from a “parent” trust to the marital share, pursuant to IRC Sec. 267(b), no loss will be allowed as the trusts will be deemed to be related parties. The loss is suspended and if certain conditions are met may be taken when the property is sold by the marital trust. The loss will only be allowed when the property is sold. To determine if there is a loss upon the sale requires the trustee to maintain two sets of tax costs for the same asset, one for gain purposes and one for loss purposes. In order to claim a capital loss the sale must be below the date of distribution values; for a gain the sale must be above the 706 values. This complicates record keeping for the trustee. A sale for an amount which is in between date of distribution values and 706 values has no tax consequences. To avoid this problem, assets with a loss should be sold in the parent trust so the loss can be recognized. If the funding of the marital share is directly from an estate (e.g., to a testamentary trust), then the loss will be recognized. Even though the Taxpayer Relief Act of 1997 added to IRC Sec. 267(b) an executor of an estate and its beneficiaries as related parties there is an exception for losses for a sale or exchange that satisfies a pecuniary bequest. Recently the IRS issued regulations under IRC Sec. 645. IRC Sec. 645 permits an executor of a will and a trustee of a revocable trust to make an election to treat a qualified revocable trust as part of the estate for fiduciary income tax purposes during the administration of the estate. It would seem that if this election is made, then the funding of a pecuniary formula date of distribution value marital deduction trust from a qualified revocable trust with depreciated property would permit recognition of losses. This is because the distribution, by value of the IRC Sec. 645 election, is deemed to be from the estate and thus not from a related party. 2. Another disadvantage is that a market decline before funding may wipe out the credit shelter disposition. Since depreciation is allocated away from the marital share, a market decline will affect the value of the credit shelter disposition. This may expose the fiduciary to liability if the fiduciary has delayed funding the marital share. A severe market decline prior to funding may not only eliminate the credit shelter disposition, but may also prevent the fiduciary from fully funding the pecuniary marital amount. 3. Also, as estate expenses and death taxes will be paid from the credit shelter disposition, this will reduce the credit shelter and, in some cases, deplete it entirely. 4. Distribution of property which is a right to receive income in respect of a decedent (IRD) to fund a pecuniary marital amount will accelerate recognition of income (IRC Sec. 691(a)(2)). This could present a serious problem if the right to IRD represents a stream of future payments (royalties, installment contract). 5. As with all marital fundings (except for gifts of specific dollar amount or bequest of specific property (Ex., I leave my husband $500,000 or I leave my husband Whiteacre), pecuniary or fractional funding will carry out Distributable Net Income (DNI). The true worth pecuniary is not covered by the exception contained in IRC Sec. 663(a)(1) for specific bequests. Therefore, unlike satisfaction of a specific bequest of property or sum of money, distribution to fund the marital will attract DNI. (Regulations Section 1.663(a)-1(b).) 6. To fund the marital bequest will require revaluation of those assets used to fund the marital share. This is not difficult if the asset is cash or marketable securities; however, if the asset is real estate or an interest in a closely held business, the task is more onerous. 7. If the estate consists largely of stock in a closely held business, then use of a pecuniary formula marital deduction may be inappropriate. As mentioned previously, the company will have to be revalued if the funding formula is based on date of distribution values. This will often be difficult and time consuming, and the value assigned may be debatable. If the value of the stock has appreciated since the date or death (or alternate valuation date), there will be a capital gain on funding. The obligation to pay this tax will create a problem if there are insufficient liquid assets with which to pay the tax. (This problem will occur any time
the estate consists largely of non-liquid assets, and not only with closely held stock.) Further, a redemption of stock to pay the tax will not qualify under the safe harbor created by IRC Sec. 303; therefore, the redemption will be treated as a dividend. A related issue is, if the decedent’s estate has as a substantial asset a majority interest in a closely held business, then if the marital trust will receive shares which represent a majority interest, those shares may be entitled to a control premium. In other words, in funding the marital trust rather than using a pro rata value based on estate tax values for the shares or appraisal value, a block of shares that represents control would be valued at a premium. This would decrease the amount of other assets allocated to the marital share. (See Chenoweth Est. v. Comp., 88 T.C. 1577 (1987).) This sword can cut both ways. If the estate has a majority interest in a closely held company, and a minority interest is allocated to the marital share, then the IRS position is the value of the shares should be discounted to reflect the fact they represent a minority interest (see TAM 9050004). This will increase the amount of other assets necessary to fund the marital bequest. 8. If there is a significant delay in funding, the IRS has successfully argued that there was a constructive funding that occurred within a reasonable time. Therefore, the value of the marital trust includible in the surviving spouse’s estate includes an allocable amount of appreciation from that time. (See Conn. Nat’l Bank vs. U.S. 937 Fed 90 (2d cir. 1991.) III. Utilizing a minimum worth or fairly representative funding formula may eliminate some of the disadvantages of utilizing the true worth pecuniary formula. A. Minimum worth 1. A minimum worth provision directs the fiduciary to value the property used to fund the marital share at the lower of its fair market value or its adjusted basis for income tax purposes. 2. The primary advantage of this method is it avoids triggering a capital gain upon funding since the value for funding is never greater than basis for income tax purposes. As with a funding formula based on date of distribution values, there is maximum pick and choose flexibility. 3. A major disadvantage of this approach is it may overfund the marital share. Thus, an asset with a fair market value of $600,000 on date of funding, but with a tax cost of $400,000, will be valued as $400,000 for purposes of satisfying the pecuniary amount. This provision may allow the fiduciary to favor the spouse by increasing the amount of the marital share by utilizing property that has a value in excess of its adjusted basis to satisfy the bequest. This type of provision makes it possible for the marital share to share in appreciation. However, the ultimate value of the marital share is protected from depreciation. Thus, unlike the true worth pecuniary, the minimum worth pecuniary is not frozen. This ability to favor the spouse could subject the fiduciary to liability. A fiduciary has a duty to act impartially toward beneficiaries and failure to do so would be considered a breach of fiduciary duty. A fiduciary utilizing such a formula must remember the overriding duty to act impartially toward beneficiaries. It is also the case that the minimum worth method will not meet the requirements for separate share treatment under the Generation Skipping Tax Regulations. See Treas. Reg. Sec. 26.2642-2(b)(2)(i). Thus, an allocation of GST exemption to a minimum worth pecuniary marital trust is ineffective. This is a significant drawback to the minimum worth method. Also, the credit shelter is at risk if assets that depreciated in value below their tax cost are used to fund the marital share. This will require additional assets to fund the marital share which could result in significantly reducing or eliminating the credit shelter share. This could expose fiduciary to liability. 4. The same issues concerning disallowance of a capital loss for funding between related parties, distribution of a right to receive IRD and attracting of DNI are present with the minimum worth formula as with the true worth formula. B. Another approach to avoiding the capital gains problem encountered with the true worth pecuniary method of funding is to utilize the approach outlined in Rev. Proc. 64-19. This approach is called the fairly representative pecuniary. 1. The fairly representative pecuniary allows the fiduciary to value assets for purposes of satisfying the pecuniary amount at their adjusted basis for income tax purposes. To avoid having the marital deduction disallowed pursuant to Rev. Proc. 64-19, the fiduciary must be directed in the instrument to select assets in a manner which fairly represents any appreciation or depreciation in assets on the date(s) of distribution. 2. The primary advantage to this approach is it avoids the capital gain/loss problem that may be encountered upon funding of a true worth pecuniary. 3. The income tax consequences concerning attraction of DNI and potential acceleration of IRD are present with this approach as with the minimum worth and date of distribution/true worth approach. 4. As with the true worth and minimum worth approaches to funding, there are disadvantages to the fairly representative approach. The primary disadvantage is this approach may overfund or underfund the marital share. Thus, an asset worth $500,000 on date of funding, but with an adjusted basis of $400,000, will only satisfy $400,000 of the pecuniary bequest. If the asset had declined in value to $300,000, then it would be valued at $400,000 for purposes of satisfying the marital share; therefore, this would underfund the share. Since the fiduciary is required to pick assets that are fairly representative of appreciation or depreciation, the fiduciary cannot allocate only depreciated assets to be the marital share to minimize estate taxes on the surviving spouse’s death. Once again, in selection assets fiduciary must be careful to act impartially to avoid liability. 5. A significant disadvantage is all assets must be revalued. This is because assets must fairly reflect appreciation and depreciation. The only way to do this is to revalue them. This can be a problem if the assets do not have a readily ascertainable market value. This provision limits the ability of the fiduciary to pick and choose assets. In this regard, the fairly representative approach is more restrictive than the true worth approach and the minimum worth approach. As with any pecuniary approach the credit shelter disposition and the marital share will be at risk in a falling market. IV. As an alternative to a pecuniary formula marital deduction, the draftsperson may employ a fractional share marital bequest. The numerator of the fraction is the amount of the marital deduction and the denominator is the value of the assets available to satisfy the bequest. A fractional share bequest does not trigger capital gains or losses upon funding. A. In drafting the denominator, the draftsperson must indicate if the denominator is to be the value of the assets available before (sometimes referred to as pre-residuary) or after payment of taxes, debts, legacies and expenses of administration, (sometimes referred to as a residuary bequest). A denominator that requires a reduction for taxes, expenses and debts will tend to increase the marital share. Conversely, a denominator which is not reduced by taxes, debts and administration expenses will decrease the marital share. The document should specify the calculation of the denominator to avoid any ambiguity. Note that the differences in expressing the denominator will not change the amount of the marital deduction, but can impact the actual amount that is distributed to the marital share. To illustrate, assume the numerator, the marital deduction, is $2,000,000. Assume the denominator is to take into account payment of taxes, debts and administration expenses. Based on this, assume the denominator is $4,000,000. Thus, the fraction is: 2,000,000 or 1/2 x 4,000,000 = 2,000,000 4,000,000 Now let’s assume the denominator does not take into account these items and is worth $5,000,000. The fraction becomes: 2,000,000 or 2/5 x 5,000,000 = 2,000,000 5,000,000 Thus, the difference in the expression of the denominator does not affect the marital deduction. However, as previously noted, it can affect the amount that will fund the marital share. So, if the value of the residue grows to $6,000,000, the marital share using a denominator that is the residuary estate the amount actually distributed to the marital share will be $3,000,000 (2,000,000/4,000,000 x $6,000,000) whereas if it is a pre-residuary denominator it will be $2,400,000 (2,000,000/5,000,000 x 6,000,000 = $2,400,000). 1. Unlike the pecuniary approach, the amount of the marital share will fluctuate such that it will share in any appreciation or depreciation. This is an advantage if there is an unhappy family (e.g., the spouse is a second spouse and there are children from the first marriage). However, this may result in overfunding or underfunding the marital share when compared with a true worth pecuniary. Unlike the pecuniary formula utilizing a date of distribution funding formula, the value of the marital share is not frozen. 2. A problem with the fractional share is it can be more difficult to administer. This can happen if values change on audit and there has been partial funding of the marital bequest prior to these changes. As the audit change will affect the fraction, this will impact future funding and will likely require adjustment to earlier funding of the marital share. Similarly, if there are non-pro rata distributions, the fraction will need to be adjusted. This is time-consuming and creates greater risk that the funding will be done incorrectly. B. There are two methods of funding
the fractional share marital deduction. One requires a pro rata division of each asset, which is determined by multiplying the fraction against each asset available for funding. The alternative is to employ a pick and choose approach. The pro rata approach is probably required if the instrument is silent as to the method of funding. 1. The pro rata approach has several advantages in addition to no gain or loss being recognized upon funding: a. No acceleration of IRD because distribution is not in satisfaction of a pecuniary bequest. b. There are no concerns with Rev. Proc. 64-19 because a fractional share ensures there is a ratable selection of assets. c. No revaluation of assets is required since the fraction is being applied against each asset. C. However, there are disadvantages to this approach: 1. The most significant disadvantage is the fiduciary has no ability to pick and choose assets. This may result in difficulty in allocating assets to or away from the marital share. 2. If the instrument does not allow the fiduciary to make non-pro rata distributions, a distribution that is not pro rata may result in a taxable exchange between recipients. (Rev. Rul 69-486, 1969 2 C.B. 159.) D. To eliminate the lack of flexibility required by a pro rata funding approach, the draftsperson should consider giving the fiduciary the ability to pick and choose assets when funding the marital bequest. Such a provision would allow the fiduciary to distribute assets in satisfaction of the marital bequest in whole or in part which would have a date of distribution value equal to the aggregate value of the marital share’s pro rata portion of each item of the residue. 1. As with a pro rata allocation, this provision will allow funding without any recognition of gain or loss. Further, there would be no acceleration of income upon distribution of items of IRD and there will be no Rev. Proc. 64-19 problems. Also, there would be no taxable exchange problems since the fiduciary has the power to make non-pro rata exchanges. 2. A disadvantage to the pick and choose approach is that assets will need to be revalued each time there is a distribution. This is not the case with a pro rata funding of a fractional share. V. Allocation of income between the marital share and the non-marital share A. When funding the marital share, the fiduciary must determine the amount of the income to be allocated to the marital and the non-marital share. This is true of both pecuniary formula maritals and fractional share maritals. Further, pursuant to Mass. Gen. Law Ch. 197 Sec. 26, a gift in trust entitles the income beneficiary to income earned from the testator’s date of death. If the bequest is a pecuniary amount and will not be held in trust, interest accrues in accordance with Mass. Gen. Law Ch. 197 Sec. 20. 1. When funding pecuniary formula marital trust, the fiduciary needs to determine the share of income the marital share is to receive on income earned by the estate or trust prior to the payment of debts, estate taxes and administration expenses and the share of income for income earned after these payments. Since payments of these items will generally come from the non-marital share, the ratio of the marital share to the residue will change after payment of these items. It is critical to review the instrument to determine the source of payment for the above items. a. Example: Assume the marital amount is $400,000 and that taxes are to be paid from the credit shelter share. When the taxes are paid, the amount to fund the credit shelter trust will be $400,000. When the marital share and non-marital share are funded, the fiduciary needs to determine the income to be allocated to each share. Until payment of taxes, the fraction for computing the income to be allocated would be: 400,000 or 40% 1,000,000 After payment of taxes, the fraction would be: 400,000 or 50% 800,000 2. With the fractional share formula, since the amount of property to be transferred to the marital share will be determined on date(s) of distribution, the fiduciary will need to recalculate the fraction. The fraction will be applied to income earned prior to funding. If there will be partial fundings, then the fraction will need to be recalculated. 3. If the surviving spouse is likely to receive the income from the marital and non-marital share, then exact allocation of income is less critical. However, if it is unlikely that the spouse will be receiving the income or it is an unhappy family, then proper allocation of income is critical. Improper allocation could result in surcharge of the fiduciary. VI. Conclusion Once the marital deduction formula has been chosen, it is incumbent upon the draftsperson to select the method of funding. Selection of the method to be employed in funding the marital share as with selection of the formula for the marital deduction (pecuniary vs. fractional) must be based upon a review of the estate owner’s objectives, the assets of the estate and the family situation. Use of a funding formula that is inappropriate to the estate owner’s situation, or no formula, may result in a marital bequest which does not truly meet the needs of the spouse or achieve the estate owner’s intent. Failure to properly implement the chosen funding formula may result in liability to the fiduciary and adverse tax consequences. (See Rev. Rul. 84-105 1984-2 C.B. 197). IRS held surviving spouse who did not object to underfunding of marital share made a gift of that amount.