Tax Apportionment Games (Alternatively: The Hunt for the Tax Apportionment Clause)

After author/novelist Tom Clancy died in 2013, the terms of his Will and a Codicil were disputed by his current wife and adult children from a previous marriage. The dispute related to the Will’s tax apportionment provision, a “boilerplate” provision found in most wills.  A tax apportionment provision tells the personal representative how taxes owed at death will be paid. A decedent’s estate will owe federal estate or generation-skipping transfer tax only if it has a taxable estate over the applicable exclusion amount ($5,490,000 in 2017, plus a deceased spouse’s unused exclusion, if applicable).  Assuming tax is owed, the tax apportionment provision will determine who (or what property) will pay the tax.

There are two common ways to apportion estate or GST taxes. The first is to apportion the taxes proportionately to the beneficiaries who receive the decedent’s property that generates the estate tax. (Estate assets left to a surviving spouse, either outright or in a marital trust, are not considered part of your estate and estate taxes are not levied against them. Similarly, gifts to charities are not taxable.) Using this approach, if your spouse inherits 50% of your estate and your three children inherit the other 50%, each child will pay 1/3 of the estate tax due. Your spouse would pay none of the estate tax. Colorado has adopted the Uniform Estate Tax Apportionment Act (C.R.S. § 14-12-401 et. seq.) that takes this approach.  It is also common to use this “Colorado apportionment” method but exclude out particular gifts. For example, if you leave a $10,000 bequest to a friend, you may want to exclude that gift from paying its proportional share of estate tax because doing so reduces the total gift.

The less common method is “non-apportionment.” That is to say, the provision does not apportion estate tax to the beneficiaries proportionate to their gift, but rather the total amount due is paid out of the residuary of the estate. The residuary beneficiaries shoulder the burden of the estate tax liability. This has the potential to lead to unfair results. If you leave a percentage of your estate as a gift to your children and the remainder to your spouse, your children will pay $0 in estate tax and the entire estate tax will be levied against your spouse even though any gift to her is not taxable. Similarly, if the bulk of your estate is in non-probate assets (e.g., retirement accounts), the non-probate beneficiaries will not pay any of the estate tax.

Back to Tom Clancy. Clancy died leaving behind a wife (his second marriage), a minor child from that marriage, and adult children from a previous marriage. His Will left his estate in thirds: 1/3 to a marital trust, 1/3 to a family trust for his wife and minor child, and 1/3 in trusts to his adult children. The tax apportionment provision in his Will stipulated that estate taxes should be apportioned proportionately against estate assets that did not have a corresponding marital devise.

In this case, the marital trust would not incur estate tax, while the family trust for his wife and minor daughter would. Given this structure and his tax apportionment provision, at his death estate taxes would have been paid as follows:

Marital rust Receives: $21.25M

Tax Apportioned: $0

Family Trust Receives: $15.7M

Tax Payment: $13M

Adult Child Trusts Receive: $15.7M

Tax Payment: $13M

Total Tax Paid: 26M

Under this scenario the results are roughly equitable, with the Family and Adult Child Trusts paying the same amount of tax and receiving the same amount of funding. In reality, though, two months before his death Clancy executed a codicil to his Will.  The Codicil essentially altered the terms of the Family Trust to make it a second marital trust. He did not change his tax apportionment provision. The codicil also included a “Savings Clause,” the terms of which were subject to dispute. The question became: does the Family Trust, now that it is a qualifying marital trust, still pay a portion of the estate tax?

Whether or not the Family Trust was apportioned estate tax would lead to very different results. If the Family Trust did not pay any estate tax, it would be funded with $28.7M dollars, while the Adult Trusts would receive just $16.7M and pay all of the resulting $11.8M in taxes. If the Family Trust was subject to a pro rata share of estate tax, it would receive $20.8M in funding and pay $7.85M in tax. The Adult Trusts would receive $20.8M in funding and its estate tax share would be reduced to $7.85M.

The Court ultimately found that the Family Trust was exempt from paying a pro rata share of the estate tax, to the determinant and disappointment of Clancy’s adult children. (Many argue the Court was wrong in this instance, and in fact there was a spirited dissent of the majority opinion.) Whether the Court got this one right, the case serves as an important reminder that tax apportionment provisions, buried in the backs of wills, have a dispositive effect on taxable estates.

Specific information regarding this case was provided by Estate Planning Newsletter #2512 (February 2, 2017) by L. Paul Hood, Jr.