Tax Apportionment 101: Planning with Retirement Assets

Sep 3, 2021 10:00:00 AM



When the federal estate tax exemption is high, the issue of how to apportion death taxes is of less concern to many families. But this issue can cause controversy with taxable estates, blended families, and certain types of assets. If the decedent’s will or trust is silent on the issue of tax apportionment or the decedent died intestate, state law provides default rules that determine which interests or assets in a decedent’s estate bear the burden of paying death taxes. If a certain interest is insufficient to pay the net tax attributable to property passing under the terms of the trust, state law often also provides an order of priority for payment of the balance of the tax owed. However, the terms of the decedent’s will or trust can override these rules; that is, everyone has the opportunity to direct how taxes (and expenses, for that matter) will be paid. In a taxable estate, this may be the most important provision in the testamentary instrument.

Options for Apportionment of Death Taxes

The term death taxes generally includes any taxes imposed by reason of a decedent’s death by federal, state, or local authorities, including estate, inheritance, gift, and direct-skip generation-skipping transfer (GST) taxes (but not GST taxes other than direct-skip GST taxes). Assume an unmarried decedent’s estate plan includes a will that pours over to a revocable living trust (RLT). The trust agreement directs the trustee to make a specific distribution of $12 million to the grantor’s niece and to distribute the residue to the grantor’s nephew. The grantor dies in 2021 with an estate valued at $24 million. The following are the most common options for how to apportion death taxes: 

  • No apportionment. Using this option means that the trustee of the RLT will pay all death taxes from the trust residue; that is, death taxes will be paid from the administrative trust just like any other expense of administration. Death taxes will not be allocated to or paid from any assets that
    • are not included in the decedent’s gross estate for federal estate tax purposes, 
    • are exempt for GST tax purposes,
    • qualify for the federal estate tax marital deduction, or
    • pass to an organization that qualifies for the federal estate tax charitable deduction or to a split-interest charitable trust (unless the trustee has first used all other assets available to pay the taxes).

Under this option, residuary beneficiaries bear the burden of all death taxes and administrative expenses. Based on the facts above, if the trust agreement directs the trustee to pay death taxes from the trust residue, the grantor’s niece will receive her entire share of $12 million while the grantor’s nephew will not receive the other $12 million, but will receive a remainder portion greatly reduced by death taxes. Assuming $4,920,000 of death taxes, the grantor’s nephew will receive a net of $7,080,000. 

Consider how this option may work in the context of a blended family. If a married grantor’s trust agreement creates a qualified terminable interest property (QTIP) trust for the benefit of his surviving spouse with the nonmarital share passing to the residuary beneficiaries who are the grantor’s children from a prior marriage, this tax apportionment option will preserve the estate tax marital deduction. However, the children may be unreasonably penalized in favor of their stepparent depending on the method used for determining the marital and nonmarital shares (specified percentages, fractional to reduce death taxes to zero, or some other method). 

  • Equitable apportionment. Taking this approach means that the trustee will apportion death taxes among the property generating the tax. Based on the same facts, if the trust agreement uses this option, beneficiaries share the burden of death taxes. If the grantor’s trust agreement instead provides for equitable apportionment, the shares of the grantor’s niece and nephew will each be reduced by $2,460,000 ($4,920,000 ÷ 2), and each beneficiary will receive a net of $9,540,000.
  • State apportionment. This option means that the trustee will apportion death taxes in accordance with the applicable state apportionment statute, so results can vary.

Income Tax Considerations When Planning With Retirement Assets

In addition, the nature of the assets included in the decedent’s gross estate can significantly affect these outcomes. For example, a beneficiary who inherits a qualified retirement plan may face certain income tax consequences, unlike with other types of assets. In this case, the term qualified retirement plan means a plan qualified under Internal Revenue Code (I.R.C.) § 401, an individual retirement arrangement §§ 408 or 408A, or a tax-sheltered annuity under § 403. The term qualified retirement benefits generally means the amounts held in or distributed pursuant to a qualified retirement plan. These benefits, less nondeductible contributions made by the deceased participant, are deemed income in respect of a decedent (IRD), or income that was owed to a decedent at the time of the decedent’s death. Other than qualified retirement benefits, IRD also includes uncollected salary and wages, accrued dividends and interest, and uncollected rents. These are income interests earned by a decedent or property that a decedent would have recognized as income if he had lived long enough to receive or report it. The I.R.C. provides that, because the decedent did not include the income on the decedent’s personal income tax return, the successor in interest to the income must report it on theirs. Another characteristic that distinguishes qualified retirement plans from many other assets is that it retains the same character when taxed to the beneficiary who inherits it. While most assets included in the decedent’s gross estate receive a basis adjustment or a step up in basis as of the decedent’s death, retirement assets have the same basis in the hands of the beneficiary as they did in the hands of the decedent. Consequently, retirement assets inherited by a beneficiary are potentially subject to both estate taxes and income taxes. 

Assume a widowed decedent dies in 2021 with an estate valued at $24 million, half of the estate is held in an individual retirement account (IRA), and the IRA beneficiary designation names the decedent’s RLT, which directs the trustee to divide the residue equally to be held in further subtrusts for the benefit of the decedent’s three children. Absent additional planning, and regardless of whether the RLT calls for no apportionment or equitable apportionment, these are the tax consequences upon the decedent’s death if the benefits are withdrawn from the plan and paid to the subtrusts established under the RLT in equal lump sums:

Date-of-death balance of IRA $12,000,000

Estate taxes ($2,460,000)

Income in respect of a decedent $12,000,000

IRD deduction (I.R.C. § 691(c)) ($2,460,000)

Income taxable amount   $9,540,000

Income taxes (at 37%) ($3,529,800)

Net to beneficiaries   $6,010,200

The IRA loses almost half its value! This result can be altered by the terms of the decedent’s estate plan. Specifically, the tax apportionment provision of the decedent’s trust agreement may have an exception for qualified retirement benefits payable to the RLT. If the trustee is prohibited from using these benefits for payment of estate, inheritance, or similar transfer taxes due because of the grantor’s death, the benefits will be segregated from other assets for the satisfaction of death taxes, and the reduction for estate taxes above will be avoided. It is worth mentioning that this language, together with the presence of several other important provisions within the trust agreement, will also cause the RLT to qualify as a designated beneficiary for purposes of the distribution of the benefits from the retirement plan. 

Retirement Assets Passing Outside of the Trust

But what if the IRA beneficiary designation names the decedent’s three children directly and the benefits therefore pass outside of the RLT? Absent additional planning, recipients of property that passes outside of the trust will usually be required to pay the property’s proportionate share of death taxes. As a result, qualified retirement plans passing directly to named beneficiaries might require income-taxable distributions from the qualified retirement plans to pay those death taxes. If the children—like the RLT—are also in the highest income tax bracket and each takes a lump sum distribution, the calculation is the same as above. In addition to its adverse tax consequences, this arrangement is not ideal for practical reasons: Under I.R.C. § 2203, the term executor means “the executor or administrator of the decedent, or, if there is no executor or administrator appointed, qualified, and acting within the United States, then any person in actual or constructive possession of any property of the decedent.” Further, the Internal Revenue Service Instructions to Form 706, United States Estate (and Generation-Skipping Transfer) Tax Return, mimic this definition, adding that, if an executor is not appointed, “every person in actual or constructive possession of any property of the decedent is considered an executor and must file a return” (emphasis added). I.R.C. § 2205 stresses the Code’s intent that death taxes should be paid as administrative expenses by the estate before its distribution unless the decedent’s estate plan contains a contrary direction. However, the Code sections that immediately follow grant rights of recovery to the executor for death taxes paid that are attributable to life insurance proceeds includable in the decedent’s gross estate (and not covered by the marital deduction) but passing directly to a beneficiary (I.R.C. § 2206), to property passing to a recipient over which the decedent had a power of appointment (I.R.C. § 2207), to certain marital deduction property (I.R.C. § 2207A), and to other property included in the gross estate by reason of § 2036 (I.R.C. § 2207B). This tax apportionment arrangement places fiduciaries in the awkward position of seeking contribution (or recovery) from outside sources and either coming up deficient or unfairly burdening remaindermen. 

Avoid Postdeath Administration Issues With Careful Planning

Practitioners wishing to change this result often include a provision in the trust agreement directing that taxes on qualified retirement plans that pass outside of the trust estate be paid as an expense of administration without apportionment. Before including this provision, it is important to consider whether the beneficiaries of an RLT are the same as the beneficiaries of the IRA. If they are the same, the outcome is usually desirable: The IRA will not be reduced by estate taxes nor will income-taxable distributions from the IRA be forced for the payment of those estate taxes. If they are not the same, however, the outcome is usually unfair: The beneficiaries of the RLT bear the burden of paying the estate taxes attributable to the IRA for the benefit of other beneficiaries. It is arguable whether the terms of the trust agreement legally control as to assets passing outside of the RLT, but practitioners often include the provision prohibiting apportionment of death taxes to retirement accounts passing outside the RLT out of caution if the circumstances warrant it. Estate planners should carefully consider the issues surrounding tax apportionment and retirement assets. Their drafting choices and advice to clients regarding funding can help avoid adverse income tax consequences, unfairness, and litigation in postdeath administration.

Wealth Docx®—the intelligent automated drafting software for estate planning attorneys—can assist with trust design and tax planning, including marital share funding, generation-skipping transfer tax, and tax apportionment, by offering a variety of drafting options and educational resources so that you can best meet your clients’ objectives. Learn more by scheduling a software demo today.

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