A, B, C...What is a Gap Trust?

With the federal estate tax exemption rising to $5.34 million in 2014, many people in the D.C. metro area mistakenly believe they will not owe any estate taxes on their passing. If you live in Maryland or D.C. and have in excess of $1.0 million in your estate on your passing, you would be incorrect.

Maryland and Washington, D.C. each a have $1 million state estate tax exemption level. That means that if a person dies with an estate in excess of $1.0 million that excess would have a state estate tax liability. Virginia currently does not have a state estate tax. In estate planning trade lingo, Maryland and D.C. have "decoupled" their exemption levels from the higher federal estate tax exemption. Because of this decoupling, additional estate planning is required through what is known as A/B/C, "Gap" estate trust funding or making the "state QTIP election." You can read more on QTIP trusts here. Unfortunately, making a state QTIP election is only applicable to Maryland decedents. D.C. does not let you make such an election.

Like most other estate planning a "gap" trust is an attempt to defer or reduce the payment on the state and federal estate taxes owed until after the surviving spouse has passed away. To understand how an A/B/C trust works, a brief explanation of how an A/B trust works in conjunction with the unlimited marital deduction. Pursuant to 26 U.S.C. 2523, a married couple can gift an unlimited amount to their spouse. See the recent Windsor v. U.S. Supreme Court decision demonstrating the importance of the unlimited marital deduction.

In a normal A/B trust, at the first spouse's death, the decedent's assets will be divided into two trusts. The amount equal to the decedent's federal estate tax exemption (which is currently $5.34 million in 2014) would fund the "B" trust, or bypass trust. The label "bypass" is used because these assets "skip over" the surviving spouse's estate. The amount in excess of the decedent's federal estate tax exemption would be placed in the "A" trust. Thus, if the first spouse to die had an individual estate worth $7.34 million, $5.34 million would be placed into the B trust consuming the decedent's federal estate exemption. $2.0 million would be placed into the A trust at the first spouse's deathi.

The surviving spouse would then be able to leave an amount equal to the surviving spouse's federal estate tax exemption as the surviving spouse wishes. The assets in the A trust would be included in the surviving spouse's estate but payment of the taxes owed on the value of the assets in the A trust would be deferred. But, the assets in the B trust would not be taxed at the surviving spouse's death because it was protected by the first spouse's federal estate tax exemption.

Now, enter the need for A/B/C trust for those residents that live in states with a state estate tax. Using the same facts from above, upon the first spouse's death, $5.34 million would go into the B trust. But, the A trust would not receive the same $2.0 million.

Why?

The A trust's value greatly exceeds the Maryland state estate tax exemption of $1.0 million and it is not afforded the marital deduction. Thus, only $1.57 million would go into the A trust because a Maryland state estate tax liability in the amount of $430K will be incurred and it needs to be paidii.

However, if a married couple establishes an A/B/C trust, the couple effectively defers the payment of both the Maryland estate tax and the federal estate tax until the death of the second spouse. And here is how it is done:

  • $1.0 million, under the Maryland estate tax exemption will go into the B trust and is exempt from state and federal estate taxes.
  • $4.34 million will go into the C trust. It is a state QTIP trust only but still exempt for federal purposes.
  • $2.0 million will go into the A trust and a state and federal QTIP election is made.
A QTIP trusts places some restrictions on what can be done with the trust assets upon death and restrictions on distributions, ability to invade the principle of trust assets and the like, but, it defers estate taxes until the second spouse's passing. Thus, the amount in the C trust will not be taxed until the surviving spouse's death. Plus, the surviving spouse will still be able to use the entire amount of his or her federal exemption.

Basics of Estate Planning: Is My Will Valid if I Move to Another State?

Living in a transient area, like Washington, D.C., I am frequently asked by clients is whether their will, executed in one state, will be valid if they move to another. The answer, broadly speaking, depends on two things:

  1. 1) whether the will's execution conformed to the testamentary laws in the state in which it was executed, and
  2. 2) the degree of similarity between those laws and the laws of the new state to which the client moves.

As to the first issue, if the will's execution did not conform to the original state's laws, it will be invalid, regardless of the laws of the second state. This should not be surprising in the least. Virginia law generally requires two legally competent persons to serve as witnesses to the execution, who must sign the will in addition to the testator (the person who makes the will). The law does not require a will to be notarized, but doing so is strongly recommended, because courts will then endorse a presumption that the will was properly executed, and will not require witness testimony in order to accept it as valid. Finally, Virginia recognizes holographic wills. This is an exception to the witness requirement which deems legitimate a will written out by a person in his or her own handwriting (as proved by at least two disinterested witnesses), then signed and dated. Note that holographic wills are not recognized in the vast majority of states.

Maryland has similar witnessing requirements: two or more witnesses (in addition to the testator), at least 18 years of age, must sign the will in the testator's presence. Like Virginia, Maryland does not have a notarization requirement. These same rules apply to those executing wills in the District of Columbia. Provided that a person complies with these basic formalities (and assuming that the will was not holographic), they should have little difficulty moving between these three jurisdictions - and many others - and maintaining legal recognition of their will.

However, the second issue, the degree of similarity between two states' testamentary laws, is a bit more nuanced. While the basic requirements for will execution are straightforward, the standard language used in wills varies from state to state. It is thus important that the new state's laws recognize each provision as having the same legal effect as it would have had in the original state. For example, if the decedent's will is validly executed in another state but does not meet the Virginia requirement, it may, upon proper authentication, be probated in Virginia for the purposes of disposition of personal property but would not meet the requirements for probate in Virginia regarding disposition of the decedent's Virginia real property.

Moreover, since estate taxes and the probate process differ between states, a person who has moved should consult an estate planning attorney to ensure that the testator's estate planning goals are carried out in his new state. For example, someone moving from a jurisdiction with no state estate tax, or a high exemption cap, might decide to reallocate his assets if his destination state has a low cap, and his current plan would subject him to higher penalties. The testator may also want to consider whether the person he has named as his estate executor is legally allowed to serve in that capacity under the laws of the new state. (Some states are more lenient with regards to this determination, while others are more restrictive - requiring, for example, Virginia requires the personal representative be a Virginia resident or a bond is required.

When you move, some portion of your will may need to be updated to ensure that it is in compliance with the laws of your new state. However, note that these changes will not have legal effect unless they comply with certain formalities - merely crossing out and adding to your will won't do the trick. You may either sign a document amending the will, known as a codicil, or execute a new will entirely. Both of these avenues to amendment must comply with the state's will execution requirements.

Estate of the Month: Maybe Disney is not the Happiest Place on Earth?

It seems the magic of Walt Disney's legacy has been lost on his own family, which is currently in the midst of ongoing litigation over the fate of enormous (upwards of $400 million) trust funds left to Disney's twin grandchildren, Michelle and Brad Lund. The Disney family's estate battle was first triggered in 2009, when Michelle was hospitalized after suffering a brain aneurysm.

But the story goes back much farther, when Walt Disney died in 1966, he was survived by two daughters. You can read Walt Disney's Last Will and Testament by clicking here. One of Disney's daughters, Sharon, married and divorced a real estate developer Bill Lund who assisted in purchasing what later become Disney World. Michelle and Brad are Sharon and Bill's children and the beneficiaries of a testamentary trust that was created in Sharon's will. Sharon passed away back in 1993 giving live to the Walt's grandkid's trust and it also named Bill as a trustee of Sharon's trust along with 3 other trustees.

Returning to more recent history, during Michelle's hospitalization, a fierce disagreement broke out within the family about whether Michelle should be relocated from California to Arizona, where her father, Bill, lives, in order to undergo rehabilitative treatment. When Bill continued to insist that it was in Michelle's best interest for her to leave California, the estate's trustees, acting as Michelle's legal representatives, filed suit to prevent him from following through on the move.

Like many litigations, the initial reasons for the trustees lawsuit quickly spiraled out of control and escalated to bring in many other topics. The trustees ceased making the annual distributions from Brad's trust to Brad citing a clause in Sharon's trust instructing the withholding of payment if a child had not "demonstrated the maturity and financial ability to manage and utilize such funds in a prudent and reasonable manner." The trustees cited Brad's financial incompetence, immaturity and a developmental disability as appropriate grounds for withholding the payments. While Brad was told he did not meet this standard, his sister received her 40th birthday payment because she was "98% back to normal" from her brain aneurysm.

The preparation for a showdown between the two sides - Michelle and the trustees on one; Brad and the twins' father, Bill, on the other - lasted nearly four years, with the trial on the underlying issues finally beginning on December 5, 2013. Each side has made accusations regarding the other including: Brad accusing Michelle of buying numerous multi-dollar homes, never holding a job and throwing lavish parties and the Trustees alleging financial mismanagement on the part of Bill as trustee and Bill controlling Brad.

While the focus of the litigation will be on Brad's capacity to receive the trust payments and adequately manage his financial affairs, the answer to this question is anything but clear-cut. The California trial court will have to wade through a mess of complicated back stories dating all the way back to the twins' father's business dealings in land development while he himself was acting as a co-trustee of their trusts. The deals apparently made a significant amount of money for Michelle's and Brad's trusts, but it is also alleged that Bill personally profited from secret land deals involving the trusts. Personal gain while acting in a fiduciary capacity is prohibited by law.

Bill agreed to step down as a co-trustee in exchange for settlement payments (for health reasons, according to Bill; for misconduct, according to the other trustees). But, if this type of back-door dealing were shown to be true, it would strengthen Michelle and the trustee's argument that Brad is being manipulated by his father, who has a personal interest in profiting off of his son's trust. This theory of Bill's motives is particularly important in light of Michelle and the trustee's concern that Brad, who lived for years with other relatives next door to his father, was being isolated and taken advantage of by self-interested family members.

Unfortunately, the Disneys' legal situation demonstrates that even with careful financial planning, unforeseen events can affect family unity. Allegations of undue influence, incapacity to manage assets, and back-door dealing combined with divorces of interested parties are common occurrences in large estates of this kind, where motives for non-beneficiaries to profit personally are high. And, this issues are just as common in smaller estates.

Regardless of the size of a person's estate, the discord present in the Disney family illustrates the importance of creating and maintaining an up-to-date medical directive that reflects the maker's wishes in case of a medical emergency; wisely choosing trustees, maintaining clear lines of communication with them, and ensuring that they have good working relationships with each other in the case of co-trustees; and for those themselves acting in a fiduciary capacity, duly recording and making available all financial transactions related to the assets managed.


iThis is based on assumption that the decedent did not use up any of the decedent's lifetime gift exemption or took other steps that could alter a decedent's estate for federal estate tax calculation purposes.

ii The $430K amount is based on the Maryland Estate Tax website stating that for most estates the tax rate is 9.9%.

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