Tennessee Estate Planning Law : Tennessee Estate Planning Lawyer & Attorney : Bryan Howard : Howard & Mobley Law Firm : Nashville, Chattanooga, Memphis

One of my clients has been diagnosed with a rare disease that will very likely end her life in 2010. Due to the peculiar estate tax laws that apply to decedents dying in 2010, there are some unusual planning steps that my client and her husband are taking.

As a general rule, you want to make sure that the first spouse to die has sufficient assets titled in their name so that they can take maximum advantage of federal and Tennessee estate and inheritance tax exemptions. In 2009, the magic number was $3,500,000. This year, the amount is unlimited.

We previously split assets between the husband and the wife with each of them owning assets worth approximately $6 million. The husband is in the process of transferring most of his assets to his wife.

Another change that we are making is to create a revocable trust for the wife that will replace her will. The wife’s revocable trust will own her assets so that it will be unnecessary to probate her will. The revocable trust will transfer $1 million to a typical credit shelter trust of which the husband and children are beneficiaries. The remaining $11 million of assets will be transferred to a marital trust for the husband’s sole benefit during his lifetime. Assuming the wife dies when there is no federal estate tax, it will not be necessary to claim a marital deduction for the marital trust for federal estate tax purposes. We will elect to qualify for the marital deduction for Tennessee inheritance tax purposes so that no Tennessee taxes will be owed.

The overall result of this plan is that all of the couple's assets are eligible for a basis step up. Since the combined built-in appreciation of their assets is $4 million and there is $4.3 million of basis step up available, they will receive a full basis increase. Since they own some significant rental properties, the higher basis will increase the husband’s depreciation deductions.

More importantly, the $11 million marital trust will not be subject to federal estate taxes upon the husband’s subsequent death. This will be a tremendous advantage to the family if they do not ever have to worry about paying federal estate taxes.

In summary, simple planning steps are needed to take full advantage of the absence of federal estate taxes in 2010.
 

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Making a lifetime gift of the $1,000,000 federal gift tax exemption amount can substantially reduce estate taxes. Appreciation and income from the gifted property between the date of the gift and the donor’s death can escape federal transfer taxes. My clients are generally unwilling to make such a gift because it would require the payment of Tennessee gift taxes. A second problem is that the donor loses access to the income from the gift.

A Tennessee QTIP Trust™ provides an opportunity for making a lifetime gift without paying Tennessee gift tax while retaining indirect access to the income through your spouse. A Tennessee QTIP Trust™ is a trust that would qualify for the federal gift tax marital deduction but for which the donor elects not to make a QTIP election on the federal gift tax return. The donor does make the QTIP Trust election on the Tennessee gift tax return.

The Tennessee QTIP Trust must make income available to the donee spouse. Rather than requiring income to be paid to the spouse, the spouse should be given the right to withdraw income. There are two benefits from using the right to withdraw income as opposed to the mandatory payment of income. First, to the extent that income accumulates in the trust, it will escape federal transfer tax. The second benefit is that either the donor spouse or the donee spouse will be required to pay federal income taxes attributable to trust income even though the income remains in the trust. Thus, the trust is able to grow in value on a pre-tax basis.

The donor spouse should not have a successor life estate or discretionary principal interest following the death of the donee spouse. This would cause estate tax inclusion for the donor spouse.

The downside with a Tennessee QTIP Trust occurs when the donee spouse predeceases the donor spouse. If the value of the trust upon the donee spouse’s death exceeds the $1,000,000 Tennessee inheritance tax exemption, the donee spouse’s estate will pay Tennessee inheritance tax. This means that some transfer tax will be paid prior to the death of the survivor. Because the lifetime Tennessee QTIP Trust will exhaust the donee spouse’s Tennessee inheritance tax exemption, the donee spouse’s Will should establish a testamentary Tennessee QTIP Trust (as opposed to a traditional credit shelter trust) for the donee spouse’s federal estate tax exemption amount.

Due to the potential Tennessee inheritance tax upon the death of the donee spouse, and the necessity of the donee spouse’s establishment of a testamentary Tennessee QTIP Trust, it may be advisable for the spouse with the shortest life expectancy to be the one who establishes the lifetime trust. Access to income will also be preserved if the survivor is the donee spouse. Nevertheless, the greatest benefit from accelerating the use of the federal gift tax exemption will occur if the trust is established by the spouse with the longest life expectancy.

A Tennessee QTIP Trust™ can reduce estate taxes while allowing the donee spouse to retain access to the income and corpus of the trust.

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The father of one of my clients is considering a move to Nashville in order to be closer to his daughter and grandchildren. He called me regarding the state tax consequences of moving to Tennessee.

The good news is that his income taxes will decrease slightly because Tennessee will not tax his IRA distributions. He will pay the Hall income tax on his dividends and interest, but he is already paying taxes on that income in the state where he currently lives.

The bad news is that Tennessee inheritance tax will apply to his estate when he dies. He currently lives in one of the many states that does not have a state inheritance tax. Based on his estate of $3.5 million, his Tennessee inheritance tax bill will be approximately $225,000.

Inheritance taxes would be much higher if his estate has to pay inheritance tax on the $6 million marital trust that his wife established upon her death. The marital trust will be taxable for federal estate tax purposes. However, Tennessee does not tax marital trusts that were established by residents of other states. Since the Tennessee inheritance tax rate is 9.5%, not having to pay Tennessee tax on the marital trust will reduce his estate’s Tennessee inheritance tax bill by $570,000. He told me that this tax reduction is good enough to allow him to move to Tennessee.  If the marital trust would be subject to Tennessee inheritance tax, he probably would not move.

The planning opportunity is to have a marital trust established for your benefit prior to moving to Tennessee. If you know friends or family members such as parents who are considering a move to Tennessee, encourage them to establish and fund a marital trust prior to moving to Tennessee. For example, a husband might establish a marital trust for his wife prior to moving. The marital trust will not escape federal taxes; however, it will escape Tennessee inheritance taxes because it was established by a non-resident of Tennessee.
 

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Federal and state lawmakers continue to pass laws that provide tax and non-tax benefits to trusts. I have often wondered why legislators love trusts so much.

Richard Johnson and I did a presentation to the Nashville Estate Planning Council titled “60 Trusts in 60 minutes.” We came up with 65 different types of trusts. Let me know if we forgot any.
 

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I discourage the use of a marital trust for a surviving spouse when the decedent’s children from a prior marriage will be the remainder beneficiaries. Such trusts have an inherent conflict of interest and should be avoided when possible.

Most marital trusts base the payments to the surviving spouse on the trust’s income. The surviving spouse wants the Trustee to purchase investments that produce a lot of income. Conversely, the stepchildren prefer the Trustee to invest in assets that will appreciate in value over time.

When a marital trust is the only practical solution, I recommend a marital unitrust, which works as follows: The surviving spouse receives the greater of the income earned by the trust or five percent (5%) of the value of the trust determined as of the beginning of each calendar year. In order to reduce volatility in the amount of the annual payments to the spouse, payments should be based on a 3 year average of the value of the trust.

The Trustee invests in a mixed portfolio of equities and fixed income investments. Principal assets will need to be liquidated each year to make the payments to the spouse because income will be significantly less than 5%.

The spouse wants growth because it will increase distributions in the future without reducing current distributions. The Trustee’s job will be much easier to accomplish because the spouse and the stepchildren will have the same goals.  
 

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A recent case (pdf) decided by the Tennessee Court of Appeals highlights the challenges of planning for spouses involved in a second marriage, especially when both spouses have children from a prior marriage. The children of the first spouse to die generally do not fair well.

The case involved Mr. and Mrs. Reinhart, who both had 2 children from a prior marriage. When Mr. Reinhart died, his entire estate went to his widow. Before her husband's death, Mrs. Reinhart had prepared a Will which left her estate in 4 equal shares to the children if her husband predeceased her. After her husband died, Mrs. Reinhart changed her Will to leave her entire estate to her two children. The stepchildren were not successful with their attempt to overturn the change that had been made to Mrs. Reinhart's Will.

I was not involved in the case, but I would venture a guess that the Reinharts had an "understanding" that the survivor would treat all 4 children equally. I have heard this plan many times before. It is a simple and beautiful estate plan when it works. Regrettably, what happened with the Reinharts occurs frequently. It is natural for a widow or widower to spend more time with their own children than with their stepchildren. The children are often successful in persuading their parent to change the parent's Will in their favor.

Another concern is the potential remarriage of the survivor followed by a significant transfer of assets to the next spouse. If this occurs, the children of the survivor can also lose their inheritance.

Estate planners are very well aware of the dangers of planning for couples in second marriages. The problem is that there are drawbacks to all potential solutions that we can recommend.

My preferred solution is to give the children of the first spouse to die a significant portion of their inheritance at the first death. In some cases, this benefit is funded by life insurance. The survivor can then leave all or most of their estate to their own children. This solution might generate estate taxes at the first death and may not be feasible if it does not leave enough assets to take care of the survivor for their remaining lifetime.

Another solution is to put a significant amount of assets in a marital trust for the survivor. There are a variety of safeguards that can be used to ensure that the trust is not depleted during the survivor's lifetime. These safeguards are often disliked by the survivor. The trust arrangement puts the stepchildren in the position of "waiting" for the survivor to die. I have been involved with a lot of these trusts where the survivor and the stepchildren were all unhappy with the arrangement.

My least favorite solution is for the spouses to enter into a contract that requires the survivor to treat the children equally. At best, this gives the children of the first spouse to die a chance to sue their stepsiblings if they are not treated as outlined in the contract.

Married persons who have children from a previous marriage must plan carefully if they want to provide for their children and spouse without pitting them against each other.
 

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