ALI-ABA Course of Study Planning Techniques for Large Estates April 20-24, 2009 New York, New York

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1 273 ALI-ABA Course of Study Planning Techniques for Large Estates April 20-24, 2009 New York, New York Selected Issues in Planning for the Second Marriage By Virginia F. Coleman Ropes & Gray LLP Boston, Massachusetts

2 274 I. Introduction....1 II. Issues in pre-nuptial Planning....1 A. State law validity...1 B. Marital deduction for property passing to survivor per agreement...1 C. Alteration of property rights or discharge of support obligation...1 D. Issues on acquisition of a new principal residence...2 E. Income tax consequences of sale of residence and reinvestment...5 F. Transfer tax issues if trust discharges support obligation...6 G. Discharge of any and all support obligation...7 H. Trust may but is not required to discharge support obligation....7 I. Dealing with gift splitting in a pre-nuptial agreement....9 J. Dealing with income tax filings in a prenuptial agreement K. Dealing with qualified plans and IRAs in a prenuptial agreement L Gift Splitting...13 M. Income Tax Filings...13 N. Qualified Plans and IRAs...14 III. Planning issues subsequent to the Marriage...24 A. Legal status of a pre-existing will and testamentary substitutes...24 B. Tax Apportionment Issues, at first death C. Tax Apportionment Issues, at second death...33 D. Issues in Zero-Out Planning...35 E. The annuity marital trust...37 F. The statutory share (right of election)...37 G. The statutory share and Charitable Remainder Trusts..48 H. Compensating Spouse for Use of Unified Credit I. Providing for the Equalization and Timing of Inheritances of Different Sets of Children...50 J. The inter vivos QTIP K. The Tax Basis Revocable Trust or Joint Revocable Trust...63 L. The Remainder Purchase Marital Trust...76 M. Qualified plans N. Making QTIP Funding Dependent upon QTIP Election IV. Post-Mortem Planning...94 A. Disclaimers B. Partial QTIP election...95 C. Statutory share...95

3 275 Selected Issues In Planning for the Second Marriage Virginia F. Coleman Ropes & Gray One International Place Boston, MA I. The typical fact scenario is one in which each spouse has children from a prior marriage and wishes to protect his/her assets for the children, while at the same time providing for the survivor (if the marriage is successful) and limiting the disruption of divorce (if the marriage is not successful). Also, there are tax advantages available to married couples (gift splitting, joint income tax returns), which they will want to take advantage of in a way which will not hurt either one. A. Unless specified otherwise it will be assumed throughout that the spouses are in a common law state, and that both are U.S. citizens. II. If the client comes to you before the marriage you have the opportunity to recommend a prenuptial agreement. Even after the marriage a post-nuptial agreement may be entered into with much the same effect. A. The legal status of such agreements and the criteria applied to determine their validity vary from state to state and are beyond the scope of this outline. For a good discussion of the subject see Springs and Bruce, Marital Agreements: Uses, Techniques and Tax Ramifications in the Estate Planning Context, 21 University of Miami Institute on Estate Planning, Chapter 7 (1987). This outline will instead focus on federal tax aspects of such agreements which are frequently overlooked or not understood. B. To the extent that the spouses simply contract as to what each will leave the other at death from his or her own assets and waive statutory survivors rights, there should be no marital deduction issues assuming the forms of disposition specified qualify for the marital deduction. 1. A disposition to the surviving spouse pursuant to the terms of a prenuptial agreement will not, however, be deductible under Estate of Hermann v. Comm r, 85 F.3d (2d Cir. 1996). C. If, however, one spouse wishes to alter property rights which the other spouse would otherwise acquire or already has (other than marital rights described in 2043), or to satisfy via an inter vivos trust the obligation of support, the relinquishment of which by the other spouse constitutes consideration for federal tax purposes, unexpected tax issues may arise. -1-

4 276 D. The acquisition of a new principal residence, in particular, may raise difficult transfer tax issues. 1. For instance, suppose H (the wealthier spouse) agrees to take title to the principal residence in joint names, in return for W s undertaking, if she survives, to leave the residence to H s children and, if she sells it after H s death, to hold the principal intact for H s children. a. When H purchases the residence there is a gift by H to W under general gift tax principles, old IRC 2515 having been repealed. Assuming the purchase occurs after the marriage, does it qualify for the marital deduction? b. It would appear that W has acquired a terminable interest. There is ample authority that a restriction as to the disposition by the survivor of jointly owned property, if entered into by H and W after the property has been acquired, does not alter the nature of the joint ownership as such and does not transform the survivor s interest into a terminable interest for marital deduction purposes. The rationale is that the restriction on the survivor s ability to dispose of the property arose not from any action of the first to die but rather from the survivor s own act of entering into the contract. Rev. Rul , C.B. 274, citing U.S. vs. Ford, 377 F.2d 93 (8th Cir. 1967); McLean vs. U.S., 225 F. Supp. 726 (E.D. Mich. 1963), aff d (per cur.) 65-2 USTC 12,3266 (6th Cir.); Awtry vs. Commissioner, 221 F.2d 749 (8th Cir. 1955); Ltr. Rul Contra Wilcoxen vs. U.S., 310 F. Supp (D. Kan. 1969), applying California law. Qu. whether this authority is applicable where the restriction is a condition to the creation of the joint tenancy and restricts only the spouse who is not contributing to it. c. In this kind of situation, treating W s interest upon creation of the tenancy as QTIP, filing a gift tax return and making the appropriate election, should ensure that her interest will qualify for the marital deduction. d. Note that this in turn requires, if the property is sold during their joint lifetimes, that W s income interest in her share of the property be preserved. Thus the agreement cannot provide (as H would no doubt prefer) that if the property is sold he would be free to use the proceeds as he saw fit. e. If W survives H, another QTIP election would be necessary for the one-half interest in the property includable in H s estate and passing to W at H s death. -2-

5 277 f. If title is taken as tenants by the entirety and the tenancy is not subject to partition the fractions involved for any interspousal gift by H to W may be other than one-half. g. The transaction should not give rise to any gift by W under IRC 2702 because she has not furnished any consideration for her interest in the property. See Reg (c) and (d)(1) Example 5, discussed at II.J.6, below. 2. An alternate approach to acquisition of the residence, which will avoid the problems presented by joint ownership with strings, and which should give rise to highly desirable estate planning results is a split purchase in QPRT form. a. Under this arrangement, the property is bought by a QPRT lasting for the life of the survivor of H and W, terminating in favor of C H. Under the QPRT, H has a life estate, W has a successor life estate. H, W and C H each contributes to the QPRT an amount equal to his or her actuarial interest in the trust. b. Assuming the QPRT meets the applicable 2702 requirements, there should be no taxable gift upon acquisition of the property, and no inclusion in the estate of either H or W. The latter conclusion may be challenged on the basis of Gradow v. U.S., 897 F.2d 516 (Fed.Cir. 1990), aff g 11 Cl.Ct. 808, USTC 13,711, and its progeny (Pittman v. U.S., 878 F.Supp. 833 (E.D.N.C. 1994); Parker v. U.S., 95-1 USTC 60,199 (N.D.Ga.)), but subsequent (and to this author clearly correct) authority supports it. Wheeler v. U.S., 116 F.3d 749 (5th Cir. 1997), rev g 96-1 USTC 60,226 (W.D.Tex.); D Ambrosio v. Comm r, 101 F.3d 309 (3d Cir. 1996), Cert. den. (5/19/97), rev g. 105 T.C. 252 (1995); Estate of Magnin v. Comm r, 184 F.3d 1074 (9th Cir. 1999), rev g 71 T.C.M (1996). Furthermore, it has always been questionable how the Gradow rationale, even if correct, could apply to a split purchase as opposed to a sale of remainder interest. c. There are four PLRs blessing a similar technique from a gift tax point of view; the facts differed in that each one the property was already owned by H and W and they retained a joint and survivor life estate under the QPRT rather than successive life estates. PLRs , , , d. In all four rulings, the Service explicitly did not express an opinion on inclusion of the property in the estate of either H or W under

6 278 e. Interestingly, the trust to which the remainder was sold in PLR was a personal residence trust, not a QPRT. f. In PLR , there was a reversion in the grantor(s) rather than a GRAT if the arrangement ceased to qualify as a QPRT, and this feature formed the basis for the Service s ruling that there was no inclusion in the estate under 2039: the trust instrument does not provide for the conversion of the trust estate into an annuity. Presumably one need no longer have any worries about inclusion under Section 2039, and thus no need to require a reversion rather than a GRAT, since the issuance of Reg (e), applicable to estates of decedents dying on or after July 14, ( Section 2039 shall not be applied to include in a decedent s gross estate all or any portion of a trust... if the decedent retained a right to use property of the trust or retained an annuity, unitrust, or other income interest in the trust... Examples include a GRAT, QPRT and personal residence trust.) g. This technique is not appropriate in all situations. For instance, the remainderman should purchase the remainder with an independent source of funds, or at least with funds not immediately traceable to the parent who is also a party to the transaction. See PLR , in which it was represented that the trust which purchased the remainder in the QPRT had sufficient liquid funds to do so and had been previously funded in an independent transaction that is not related to the transaction that is the subject of this ruling request. This may not be possible. In addition, if the residence is sold and the proceeds not reinvested in a new residence, the QPRT will have to convert to a GRAT or return the contributions to the respective parties. (Note, however, in PLR , if the arrangement ceased to be a QPRT 100% of the property was to be distributed to the two life tenants (or the survivor), with nothing to the remainderman.) Thus, the technique is best suited for a residence which is likely to be retained. Finally, if H and W should be divorced, the transaction will be difficult to unwind and the tax consequences uncertain. Accordingly, this structure is best suited for the stable marriage and it is important that the parties be so advised. h. If one spouse (say H) already owns the residence, there are variations on the QPRT theme which might or might not be appropriate in any given case, keeping in mind especially the fact that each one involves the transferor spouse retaining no interest in the property. -4-