by: Prof. Beckett G. Cantley
Atlanta’s John Marshal Law School

Note: Currently, the Applicable Exclusion allows for $5 million (indexed for inflation) in assets to be transferred during life per person without paying transfer taxes.   For married couples, it is not necessary for one spouse to use all of his or her $5 million+ during life to get the full benefit of the Applicable Exclusion.  Instead, the surviving spouse can make use of the deceased spouse’s remaining Applicable Exclusion even after the deceased spouse has passed.  Since the rules related to portability of Applicable Exclusion are somewhat recent, I have left the below article unedited to provide an example of a non-portable system.  

The Federal Transfer Tax System

The Federal Estate Tax (“Estate Tax”) and the Federal Gift Tax (“Gift Tax”) are both transfer taxes.  The Gift Tax taxes the amount of wealth transferred by a donor during life, while the Estate Tax taxes the amount of wealth transferred by a decedent at the time of his or her death.  Each donor is permitted to transfer an amount per donee on an annual basis (known as the “Annual Exclusion”) without being subject to Gift Tax or consuming any of his or her Applicable Exclusion” (formerly known as the “unified credit”).  Each decedent is permitted to transfer property without paying Estate Tax at death equal to the decedent’s remaining Applicable Exclusion.

Without any estate planning, the amount of property transferred at death which exceeds the Applicable Exclusion will be taxed at very sizable marginal rates.  However, married individuals have an unlimited marital deduction available to them.  Thus, when the first spouse dies, all of the property of the decedent spouse may pass (if their Wills are properly drafted) to the second spouse without paying any Estate Tax.  But, this does not solve their Estate Tax problem because the first spouse will not have used his or her Applicable Exclusion.  Therefore, when the second spouse dies, all of the first spouse’s property and all of the surviving spouse’s property will be included in the surviving spouse’s estate.

An example may clarify this problem.  Assume the Applicable Exclusion is $5,000,000.  If the first spouse dies with $6,000,000 and leaves it all to the surviving spouse, who has $1,000,000 in separate property, then, when the surviving spouse dies, in the absence of any available credits or exclusions, his or her estate will be subject to Estate Tax on the full $6,000,000 at a high marginal tax rate.

Tax-Oriented Wills

If a tax-oriented Will is properly drafted, a trust can be set up to shelter the property of the first spouse to die equal to that spouse’s then remaining Applicable Exclusion.  This trust is often referred to as a “Bypass Trust”.  Then, because married individuals have an unlimited marital deduction available to them, the first spouse’s property which exceeds his or her then remaining Applicable Exclusion may pass to the second spouse without paying any Estate Tax.  This technique will permit the first spouse to die to use his or her Applicable Exclusion. Next, when the second spouse dies, the second spouse will have his or her own Applicable Exclusion available as well to pass property to his or her children.  Thus, both spouses’ Applicable Exclusions are fully used to transfer property to the natural objects of their bounty.

An example of the structure of a typical tax-oriented Will may be of assistance to the reader.  If the first spouse dies with a $6,000,000 estate and with all of the $5,000,000 Applicable Exclusion remaining, then a Bypass Trust can be created under his or her Will containing $5,000,000.  The remainder of the first spouse’s estate ($1,000,000) will pass to the surviving spouse outright, and no Estate Tax will be paid on the first spouse’s death.  If the surviving spouse has $1,000,000 of separate property in his or her name, then the surviving spouse will potentially have $2,000,000 ($1,000,000 + $1,000,000) in his or her taxable estate.  Since the second spouse has $5,000,000 of Applicable Exclusion, his or her death will also result in no Estate Tax due.

As the above example illustrates, it is very important for married couples to have properly drafted tax-oriented Wills as part of their combined estate plan.  Failure to take advantage of this estate planning technique can result in a dramatic shift in benefit from the couples’ children to the U.S. government.