Should a tax apportionment clause be in your estate plan?
Even though the Tax Cuts and Jobs Act doubled the gift and estate tax exemption to $10 million beginning this year (when indexed annually for inflation, the amount is $11.18 million for 2018), there are many families that still have to content with significant federal estate tax liability. Plus, there may be taxes levied on your estate by your state. If that’s the case with your estate, it’s important to consider a tax apportionment clause in your will or revocable trust.
How to apportion estate tax
An apportionment clause specifies how the estate tax burden will be allocated among your beneficiaries. Omission of this clause, or failure to word it carefully, may result in unintended consequences.
There are many ways to apportion estate taxes. One option is to have all of the taxes paid out of assets passing through your will. Beneficiaries receiving assets outside your will — such as IRAs, retirement plans or life insurance proceeds — won’t bear any of the estate tax burden. Another option is to allocate taxes among all beneficiaries, including those who receive assets outside your will. Yet another is to provide for the tax to be paid from your residuary estate — that is, the portion of your estate that remains after all specific gifts or requests have been made and all expenses and liabilities have been paid.
There’s no one right way But it’s important to understand how an apportionment clause operates to ensure that your wealth is distributed in the manner you intend. Suppose, for example, that your will leaves real estate valued at $5 million to your son, with your residuary estate — consisting of $5 million in stock and other liquid assets — passing to your daughter. Your intent is to treat your children equally, but your will’s apportionment clause provides for estate taxes to be paid out of the residuary estate. Thus, the entire estate tax burden — including taxes attributable to the real estate — will be borne by your daughter.
One way to avoid this result is to apportion the taxes to both your son and daughter. But that approach could cause problems for your son, who may lack the funds to pay the tax without selling the property. To avoid this situation while treating your children equally, you might apportion the taxes to your residuary estate but provide life insurance to cover your daughter’s tax liability.
Without a clause, state law rules
What if your will doesn’t have an apportionment clause? In that case, apportionment will be governed by applicable state law (although federal law covers certain situations). Most states have some form of an “equitable apportionment” scheme. Essentially, this approach requires each beneficiary to pay the estate tax generated by the assets he or she receives. Some states provide for equitable apportionment among all beneficiaries while others limit it to assets that pass through the will or to the residuary estate.
Often, state apportionment laws produce satisfactory results, but in some cases they may be inconsistent with your wishes.
Talk to your advisor
If estate tax liability remains a concern, consult with your estate planning advisor about the need to address tax apportionment in your estate plan. Without including an apportionment clause, your assets may not be distributed as you wish and heirs may be burdened with paying tax.