October 24, 2012

Marital Deduction - Estate Tax

One of the key terms used when discussing the estate tax is the "marital deduction." The Internal Revenue Code provides an enormous deduction for transfers to  the surviving spouse from the deceased spouse. This post will provide a brief overview of the marital deduction.

The estate tax is applicable to all U.S. citizens and permanent residents when they die. Still, the estate tax is levied upon only certain estates that exceed a monetary threshold. The threshold figure for 2012 is $5.12M. This means that if a person's estate is valued over $5.12M, an estate tax of 35% will be levied upon the amount over $5.12M. For example, if a person's estate is worth $6M, a tax would levied upon 880,000. If a person's estate is under the threshold, there is no estate tax.

The value of a person's estate is basically the computation of all assets the person owns worldwide. Hence, if a person is a U.S. citizen but owns property abroad, e.g. a London flat, this flat would count towards the estate tax calculation. However, deductions from the value of the person's estate are permissible and therein the marital deduction comes into play.

A deceased spouse may transfer to a surviving spouse an unlimited amount of assets so as to reduce the value of their estate for estate tax purposes. IRC §2056(a). Although in practice the size of the transfer is typically carefully calculated to avoid future problems. For instance, if an affluent husband transfers his entire estate worth tens of millions of dollars to his surviving wife, the wife will probably have an estate tax issue down the line. This is due to the fact that the wife, assuming she does not re-marry, will not have the marital deduction at her disposal when she passes away. The upshot is that if a wealthy spouse blindly leaves everything to the surviving spouse, the estate tax issue is not really addressed but delayed. 

The common arrangement when dealing with marital deduction is to utilize the estate tax exemption of the deceased spouse by sheltering or disclaiming said amount and leaving the remainder to the surviving spouse. This sounds perplexing at first blush but is not conceptually difficult.  Assume John Doe has an estate worth $8.12M. He marries Jane Doe in 2012 in a May-December wedding. Jane is a U.S. citizen. Prior to John's passing, the couple write a marital deduction trust. The trust says that upon John's death, the trustee shall allocate to the marital deduction trust the maximum amount allowed to pass tax-free under the estate tax, i.e. the applicable exclusion amount. The remainder shall be allocated to Jane's trust. When Jane passes away, both trusts are to be distributed to John's neighbor Wilbur Wright. When John passes away in 2012, the trustee allocates $5.12M to the marital deduction trust and $3M to Jane's trust. Shortly thereafter in 2012, Jane passes away. Since Jane's estate is less than the estate tax threshold, $3M is less than $5.12M, and John's estate is held by a marital deduction trust, the estate of $8.12M passes to Wilbur estate tax-free. In short, since the couple wrote a marital deduction trust, the couple was able to utilize the unique advantages couples have in regards to the estate tax. That is, the couple was able to shield millions of dollars in assets from the estate tax due to drafting a marital deduction trust.     

There are caveats for utilizing a marital deduction trust however. The primary concern is that the recipient spouse must be a U.S. citizen. Conversely, there is no requirement that the deceased spouse be a U.S. citizen or a resident. 

Another key caveat is that marital deduction is not available to same-sex couples or domestic partners. While the Internal Revenue Code defers to state law for the definition of a spouse, the Defense of Marriage Act ("DOMA") prohibits the IRS from relying on a state law definition of spouse when the state law treats a same-sex couple or domestic partners as spouses. 1 USC §7. Although various courts have invalidated DOMA on constitutional grounds. Furthermore, here in California, the 9th Circuit affirmed a district court ruling that struck down Prop 8, the California constitutional amendment to ban same-sex marriage that passed in 2008. Going forward, the Prop 8 case, along with other DOMA cases, makes the future of DOMA uncertain.