Overview of Applicable Exclusion

By Michael S. Whalen and Edmond R. Davis

Reproduced from commentary in Lawgic's California Wills & Trusts

Applicable Exclusion Amount

The "applicable exclusion amount" is a new term found in I.R.C. §2010, and is the amount which a person may transfer, either in taxable gifts during life or at death, without any transfer tax being payable. To take advantage of the applicable exclusion amount, that portion of the deceased spouse's estate should not be given to the surviving spouse. If the applicable exclusion amount is given to the surviving spouse, although there will be no estate tax, this merely serves to increase the size of the surviving spouse's estate and his or her potential estate tax liability. By funding the applicable exclusion amount in a separate non-marital deduction trust, that trust will not be included in the estate of the surviving spouse upon his or her death. The applicable exclusion amount is $650,000 in 1999 and increases until reaching $1,000,000 in the year 2006 and thereafter. If the combined estates of the spouses is less than one applicable exclusion amount, and that fact is likely to continue to be the case when the surviving spouse dies, there may be no reason to fund a separate trust. One alternate plan available, if the spouses are uncertain whether a separate trust will be used, is the disclaimer trust concept. Under this plan, a separate trust is set forth in the settlors trust but there is no mandatory requirement to fund the separate trust when the first spouse dies. However, there is express authorization for the surviving spouse to disclaim a portion of the deceased spouse's estate, and the portion disclaimed funds the disclaimer trust. The benefit of this plan is that the decision covering funding can be made as late as nine months after the death of the first spouse. I.R.C. §2518.

The balance of the deceased spouse's estate will go to the surviving spouse in a transfer that is subject to the marital deduction under I.R.C. §2056. This transfer can be outright or by a general power of appointment trust. Another marital trust concept is the qualified terminable interest property trust (QTIP trust). This trust, like the general power of appointment trust, qualifies for the marital deductions under I.R.C. §2056. The difference with the QTIP trust is that the surviving spouse has no power or control over the disposition of the remaining trust estate upon the surviving spouse's death. To qualify, the surviving spouse, and no one else, must have the right to all income from the trust for his or her lifetime. I.R.C. §2056(b)(7).

In the QTIP trust, the first spouse to die directs the disposition of the remaining trust estate upon the death of the surviving spouse. The QTIP trust is used often in situations where there are multiple marriages and multiple families. Also, the QTIP trust must be used if a reverse QTIP election for generation-skipping tax purposes is included in the plan. I.R.C. §2652(a)(3).

Following is a summary explaining funding by a pecuniary formula and by a fractional share. As will be noted, the use of a pecuniary formula can result in a realization of taxable gain, if assets used to fund have increased in value after the date of death. That issue does not exist if a fractional share is selected. Many attorneys have concluded that a pecuniary formula is simpler in practical application. Also, if assets are increasing in value, and if a pecuniary marital share formula is used, this limits the value of the assets used in funding the marital share, thus allowing appreciation to be allocated to the bypass trust.

PECUNIARY MARITAL SHARE

This is the most commonly used form of optimal marital deduction pecuniary formula. Once the amount of the marital deduction is determined, the trustees must value the assets to be used to fund it. Because the marital deduction is funded at its full value determined under the formula, any appreciation or depreciation of assets between the date of death and the date of funding shifts to the bypass or credit shelter trust (or wherever else the applicable exclusion amount is allocated). Because the marital deduction amount is stated as a pecuniary amount, if the assets used to fund the marital deduction increase in value after the deceased spouse's date of death and before funding, the estate or trust will realize a taxable gain on the amount of the increase for federal income tax purposes. Treas. Reg. § 1.1014-4(a)(3); Kenan v. Commissioner, 114 F.2d 217 (2nd Cir. 1940); Rev. Rul. 86-105, 1986-36 IRB 15. In large estates, the taxable income could be significant since the marital deduction amount could be any amount up to the entire estate. In addition, the full amount of any IRA account (to the full extent of its value) or other income in respect of decedent used to fund the pecuniary amount will be subject to income tax as of the date of funding.

PECUNIARY APPLICABLE EXCLUSION AMOUNT

Under the reverse pecuniary formula, all growth in the value of the assets after the death of the deceased spouse and before funding is shifted to the marital deduction bequest or trust. If the assets used to fund the pecuniary amount increase in value after the deceased spouse's date of death and before funding, the estate or trust will realize taxable gain on the amount of the increase for federal income tax purposes. The amount of the realized gain would be limited, however, by the applicable exclusion amount.

FRACTIONAL SHARE

The entire residue of the trust estate is allocated by this formula between the marital deduction portion and the bypass trust. The formula allocates an undivided interest in each asset to each trust. Because this formula is not pecuniary, Rev. Proc. 64-19 does not apply. The purpose of Rev. Proc. 64-19 was to provide guidance in situations where the executor is satisfying a marital bequest with assets at their value as finally determined for federal estate tax purposes. Fractional share bequests will include net appreciation or depreciation and avoid the issue of this revenue procedure. All growth will be allocated proportionately under the fractional formula, and no growth shifting will be available. In addition, because no pecuniary amount is to be funded, no gain will be realized upon the funding of the separate trusts. Note that changes to the denominator of the fraction during the course of administration prior to full funding will cause the fraction to change. See Kurtz, "Allocation of Increases and Decreases to Fractional Share Marital Deduction Bequests," 8 Real Property Probate and Trust Journal, 450 (1973).