Estate Tax Apportionment Clauses

Take-Away: An estate tax apportionment clause is an important provision in a Will or Trust when there is a second marriage, children with different parents, or an extensive use of non-probate transfers techniques like ladybird deeds, TODs, PODs, and IRAs. Without careful allocation of federal and state estate taxes associated with these beneficiaries and non-probate transfer techniques, some estate beneficiaries can be penalized while other beneficiaries end up receiving a windfall which frustrates the decedent’s intent.

Background Rules: In general, with a couple of exceptions noted below, the federal tax law does not provide for the apportionment of federal estate taxes or direct the imposition of the burden of payment of estate taxes on beneficiaries. The allocation of federal estate taxes is left to the states. All the federal government really cares about is that the federal estate taxes are timely paid, not who pays the federal estate tax liability.

Michigan’s Tax Allocation: Michigan has a fairly elaborate statute that addresses the allocation or apportionment of estate taxes among beneficiaries who receive assets that were subject to a death tax. MCL 700.3920.
Direction in Governing Instrument: Michigan’s statute apportions all death taxes [state, federal or foreign] under a common set of rules if the governing instrument, e.g. a Will or Trust, does not allocate that death tax burden, or the instrument is silent on the question ‘who pays the death tax?’ In short, Michigan’s statute provides a set of default rules to allocate who pays the death tax when the governing instrument is silent.
Will: With regard to a Will the death tax is generally borne by the residuary beneficiaries of the decedent’s estate. MCL 700.3920(1)(a)
Trust: With regard to an intervivos Trust the statute allocates the death tax burden on property that passes through the Trust. That burden falls on the balance of the trust property, not on assets specifically bequeathed to a trust beneficiary; specific bequests of assets or devises or real estate avoid the estate tax burden when the default rules are applied. The statute reads, in part: If a portion of the trust is directed to pass or to be held in further trust by reference to a specific property or type of property, fund, money or other nonresiduary form, the net amount of the tax attributable to that portion shall be charged to and paid from the principal of the residuary share of the trust without requiring contribution from a person receiving or benefiting from the nonresiduary interest and without apportionment among residuary beneficiaries. If the residuary share of the trust is insufficient to pay the tax attributable to all nonresiduary interests, the balance of the tax shall be apportioned pro rata among the recipients of those interests generating the tax based on the value of those interests. MCL 700.3920(1)(b). Consider a fairly common situation where the parents devise the family cottage and 200 feet on Lake Michigan to the child who lives in Michigan (and who is more likely to regularly use and enjoy the cottage) and the balance or residue of their assets to the child who lives in California (who will seldom find the time or want to incur the expense to visit the Michigan cottage.) If the parent’s Trust (the governing instrument) is silent on the tax allocation, the Michigan child will inherit the cottage free from estate taxes, while the California child who inherits the residue of the Trust will have that residue depleted to pay the estate taxes on the value of the Michigan cottage. This result may, or may not, be an equitable result, depending on the value of the cottage or the size of the Trust estate’s residue.
Beneficiary Designations and Ladybird Deeds: With regard to death taxes imposed with respect to a property interest that passes by beneficiary designation, survivorship, intestacy or in an annuity form, those taxes will be apportioned pro rata among, and paid by, all the recipients and beneficiaries of those property or interests, based on the value of the interests that generate the death tax. MCL 700.3920(1)(c).
Exceptions: Excluded from Michigan’s general default rules on the allocation of death taxes are a series of estate tax allocation rules found in the federal Tax Code. These separate federal rules can create some surprises for those who are unfamiliar with them since they are not all applied in the same manner. Those federal tax recovery/reimbursement statues create a number of rights of reimbursement given to the personal representative (or the right to recover a tax amount already paid by the personal representative from a recipient) for federal estate taxes paid.
A. Life Insurance: A personal representative possesses the right to collect the pro rata estate taxes attributable to a life insurance policy (the death benefit actually paid) in which the insured-decedent held an incidence of ownership. Trap: This right of reimbursement given to the personal representative can be waived under the decedent-insured’s Will, but the right of reimbursement cannot be waived in the decedent-insured’s revocable Trust that becomes irrevocable upon the decedent-insured’s death. A waiver of this right of reimbursement must be in the decedent’s Will. IRC 2206.
B. General Powers of Appointment: A personal representative possesses a right to recover estate taxes attributable to recipients of property over which the decedent held a general power of appointment. This right to recover federal estate taxes is on a pro rata basis, based on the value of the assets actually received by those beneficiaries. An exception to this right of recovery is when a surviving spouse holds a general power of appointment over a trust that qualifies for the federal estate tax marital deduction under IRC 2056(b)(5). Trap: A waiver of this right of reimbursement over general power of appointment assets must be in the decedent’s Will. IRC 2207.
QTIP Property: A personal representative possesses a right to recover federal estate taxes attributable to qualified terminable interest property (QTIP). There are, however, three differences with the personal representative’s right to reimbursement associated with a QTIP property or a QTIP Trust. First, the reimbursement is for the incremental federal estate tax that is attributable to the QTIP Trust (the value of which is included in the surviving spouse’s taxable estate), not the pro rata estate tax paid that is reimbursable for the life insurance or a general power of appointment assets, the value of which are also included in the decedent’s taxable estate. Second, the waiver of this right of reimbursement given to the personal representative, unlike the waiver of recovery provisions for life insurance and general power of appointment assets, may be found in either the decedent’s Will or a revocable Trust. Trap: Third, if there is to be a waiver of this right of recovery of estate taxes associated with the QTIP Trust, a general waiver of the right to reimbursement is inadequate. Rather, an explicit waiver of the right of reimbursement must be used in the governing instrument. Example: “I direct that the personal representative of my estate waive any right of reimbursement my estate may possess for taxes attributable to a qualified terminal interest trust under IRC 2207A.
Retained Interests: The value of certain lifetime transfers of property are sometimes included in the transferor’s taxable estate. Examples include a Grantor Retained Annuity Trust (GRAT), a Qualified Personal Residence Trust (QPRT) or a Ladybird Deed (a lifetime transfer of real estate that is subject to a retained life estate.) The personal representative of the transferor’s estate, where there is a taxable retained interest held by the transferor, possesses a right to recover estate taxes attributable to the value of these lifetime transferred property interests much like IRC 2207A, but with one key difference. While IRC 2207A (QTIP Trust estate tax recovery) is for the incremental increase in federal estate taxes, the right of recovery for these taxable retained interests will be on a pro rata basis. But excluded from this right of recovery held by the personal representative is the retained interest held by a transferor in a Charitable Remainder Trust (CRT.)
Generation Skipping Transfers: The Tax Code directs that generation-skipping transfer taxes (GST) are to be charged to the property that constitutes such taxable transfer, (Trap) unless the governing instrument provides otherwise by specific reference to the GST tax. In other words, a general waiver of the right of recovery or reimbursement granted to the personal representative will be insufficient to protect assets that are subject to the GST. The liability of the GST tax rests on: (i) the transferee in the case of a taxable distribution by a Trustee from the Trust; (ii) the Trustee in the case of a taxable termination of the Trust; and (iii) the transferor in the case of a direct skip (other than a direct skip from a Trustee.)
IRAs and Retirement Accounts: The Tax Code is silent on a personal representative’s right to recover or be reimbursed for federal estate taxes that are associated with IRAs or 401(k) account balances which normally have a designated beneficiary, but Michigan’s default rules fills that void.

Practical Issues:

Unintended Windfall?: Father dies after his second marriage. Father leaves his IRAs to his children from his first marriage. Father leaves his remaining assets to his children from his second marriage. The apportionment clause used in Father’s estate planning documents determines who pays the estate tax on the IRA assets. If Father’s Will directs ‘pay all estate taxes from the residue of my estate’, the children from the first marriage will inherit all of the Father’s IRAs, and the children from the second marriage will pay the estate taxes associated with the IRAs their step-siblings receive, which will be paid from the assets Father intended the children from the second marriage to receive. The issue of the apportionment of the federal estate taxes must be coordinated with Father’s overall estate plan, or at least brought to Father’s attention, so that one set of children is not burdened with a disproportionate share of the entire federal estate tax bill.
GST Trust Allocations: Wife is the surviving spouse of a wealthy Husband. Most of Husband’s assets are allocated to Marital Trusts for Wife’s lifetime benefit, deferring federal estate taxes until Wife’s death. Two Marital Trust’s were created for Wife on Husband’s death: (i) a GST exempt marital trust [a reverse-QTIP election was made on Husband’s death to allocate his unused GST exemption to this Marital Trust}; and (ii) a nonexempt marital trust [which identifies skip persons who are its beneficiaries on Wife’s death, e.g. their grandchildren, from which each distribution from this nonexempt marital trust will be a taxable GST distribution- meaning two taxes will ultimately be paid, federal estate taxes on Wife’s death and the federal GST tax on distributions to the grandchildren from the nonexempt] Wife’s Will or Trust should specify that all federal estate taxes attributable to these two Marital Trusts on Wife’s death will be paid out of the nonexempt marital trust. As a result of that directive, the distribution of assets from the exempt marital trust will all be GST-free; depleting the assets that are subject to both estate and GST taxes held in the nonexempt marital trust is the most tax efficient way to transfer wealth to the grandchildren.
IRAs: Income tax deferred assets like IRAs or deferred compensation benefits need special attention when apportioning federal estate taxes. With an intact family, with one dispositive scheme, and one set of beneficiaries, it makes sense to waive a collection of federal estate tax from the IRA or deferred compensation benefits. The payment of the federal estate tax using taxable IRA funds will itself trigger another income tax on the IRA proceeds withdrawn and thus significantly reduce the benefit of income tax deferral available with a stretch inherited IRA. Recall that IRAs are subject to both federal estate taxes and federal income taxes when the inheritor takes distributions from the inherited IRA. There is, however, an IRC 691(c) deduction for estate taxes paid associated with income in respect of a decedent , e.g. IRA assets, which helps to mitigate the double taxation associated with distributions from IRAs. With children from two separate marriages, the allocation of estate taxes, or the IRC 691(c) deduction can distort the ultimate distribution of wealth among the children. If the IRA is left to the children from the decedent’s first marriage with no waiver of apportionment, the estate and income taxes will take a large bite out of the after-tax value of the IRA as an inherited asset, even using the IRC 691(c) income tax deduction for estate taxes paid on the IRA assets they inherit. On the other hand, a waiver of the right of apportionment of estate taxes from the IRA shifts the entire estate tax burden associated with the large IRA onto the children of the second marriage who receive the residue of their deceased parent’s estate, and they cannot use the IRC 691(c) income tax deduction.
Governing Instruments: The Michigan statute acts as a default set of tax apportionment rules. These rules apply unless the governing instrument directs otherwise. The definition of a governing instrument is much broader than just a decedent’s Will or Trust. The Michigan statute also defines a governing instrument to include: a deed, funeral representative designation {really?}, insurance or annuity policy, POD or TOD beneficiary designation account; pension, retirement or similar benefit plan; and an instrument that creates a power of appointment or power of attorney or a dispositive or appointive instrument of similar type. MCL 700.1104(m). Trap: It is important to avoid the temptation to only read the decedent’s Will or Trust in search of a tax apportionment provision before Michigan’s set of default tax allocation rules are applied. For example, a contract to leave a bequest or devise of real estate may exist that could meet the definition of a dispositive instrument of similar type. MCL 700.2514. Or, tax allocations or waiver provisions may be included in a prenuptial agreement for death-time transfers of wealth for a new spouse that may not satisfy the federal estate tax marital deduction, where the estate tax burden may be addressed.
Duty of Impartiality: Michigan’s set of default rules are mandatory, meaning if a governing instrument is silent on the tax allocation, then the statute directs how the death taxes will be apportioned. The federal statutes noted earlier, give to the personal representative of the decedent’s estate the right to be reimbursed, which carries with it the discretion to assert the right of reimbursement. The personal representative has a duty of impartiality to all beneficiaries. Obviously, a personal representative that exercises the right of reimbursement from beneficiaries who received some of the decedent’s assets has the effect of reducing the wealth that the beneficiary would otherwise receive. It is not hard to imagine that a beneficiary subject to a claim of reimbursement might claim that the personal representative’s decision to exercise the statutory right of reimbursement effectively treats that beneficiary unfairly, and violates the personal representative’s duty of impartiality. The more direction contained in the governing instrument of where to allocate the tax burden, or a direction given to the personal representative to ‘exercise any and all rights of recovery or reimbursement afforded by the federal tax code’ the easier it will be for the personal representative (or trustee) to avoid claims that it breached of fiduciary duty of impartiality.

Conclusion: It is critical to consider all assets, both probate and nonprobate, tax deferred and non-tax deferred, in creating a coherent and internally consistent estate plan to implement a client’s intent on how much wealth is to be transmitted to beneficiaries on the client’s death. Relying on a boilerplate Will or Trust provision is usually a mistake. A common directive to ‘pay all estate taxes from the residue of my estate’ can easily create many inequities, especially as we continue to see the popularity of nonprobate transfer mechanisms like ladybird deeds and TOD beneficiary designations that proliferate. While we continue to read about the promise to repeal the federal estate tax, tax allocation clauses are always going to be important, if for no other reason that many states have indicated that if the federal government abandons its estate tax as a source of revenues, the states are more than willing to fill that void in their eternal search for more tax revenues.