such election that is made would have to be binding for both federal and Vermont estate tax purposes. Some questions con- cerning the viability of a “regular” QTIP election under Vermont law have arisen as a result of the fact that, with the significant- ly higher federal exemption, many estates subject to Vermont estate tax are not re- quired to file federal estate tax returns. In those cases, Vermont estates are required to file a “pro forma” federal estate tax re- turn (IRS Form 706), for the purpose of cal- culating the Vermont estate tax. Although Vermont law incorporates federal estate tax laws and rules (as they existed in 201114
) for
the purpose of completing the pro-forma 706, some Vermont estate tax practitioners have expressed concern that such a “hypo- thetical” QTIP election may not be allow- able under Vermont law. As noted above, officials at the Vermont Department of Tax- es have stated informally that the Depart- ment will respect such elections made on pro-forma federal returns. Until that posi- tion becomes “official,” anyone intending to rely on a partial QTIP election would be well-advised to seek an advance ruling from the Department before making the elec- tion. 15
Effect of Federal Exemption “Portabil- ity” or “Vermont QTIP” on “Bypass Trust” Funding Formulas for Vermont Estate Plans As noted earlier, Federal law current-
ly provides that a decedent’s estate may apply the unused exemption of a prede- ceased spouse against the decedent’s es- tate tax liability, provided that a timely fed- eral estate tax return was filed for the pre- deceased spouse and a proper election was made on that return. Unfortunately, the provision is due to sunset at the end of 2012.16
Income Tax Considerations—Funding and Management of the Bypass Trust As if the discontinuity between the fed- eral and Vermont exemptions and tax rates doesn’t make planning complicated enough, there are income tax consider- ations as well. Take the following example. James and Molly have $5 million in as-
sets, which they have divided equally be- tween themselves as part of the execution of a “standard” bypass trust estate plan tied to the amount of the federal exemp- tion. At the time the plan was executed, their income tax basis in the assets was $1 million. Upon James’ death, under the fund- ing formula the bypass trust is funded with his entire half of the assets: $2.5 million. No federal or Vermont estate tax is due at that time because the value of James’ assets is less than the federal and Vermont exempt amounts. All of James’ assets will have their tax bases adjusted to their fair market val- ues as of the date of his death. When Molly dies ten years later, all of
Molly’s assets and the assets in the bypass trust have appreciated in value to $4 million each (by 60% overall). If all of the assets are sold upon Molly’s death, the tax scenario would look something like this:
VT Estate Tax
Bypass Trust -0- Molly's Estate $286,640
Fed Estate Tax
-0- -0-
Fed/VT Income Taxes17
$720,000 -0-
Now, let’s look at what would have hap- pened had James’ bypass trust been fund- ed with $2 million,19
million in the bypass trust and $4.8 million in Molly’s estate upon her death:
It is worth pointing out that in the event that exemption “portability” is made permanent at the federal level, fund- ing formulas for bypass trusts could then be drafted to fund the maximum amount that would result in no Vermont estate tax lia- bility, without running the risk of “wasting” the federal exemption of the first spouse to die. In many cases, the need to draft by- pass trusts allowing partial QTIP elections would diminish considerably, although the income tax considerations we will be dis- cussing next would still have an impact on the decision. Similarly, if the Vermont legislature were to pass a law specifically allowing a sepa- rate “Vermont QTIP” election to be made with respect to assets in the bypass trust, the trust could be funded with assets up to the full value of the federal estate tax ex- emption without incurring Vermont estate tax upon the first spouse’s death, thus giv- ing trustees more flexibility in planning to minimize the overall tax burden on both spouses’ estates.
28
VT Estate Tax
Bypass Trust
Molly's Estate
-0- $375,920 Fed
Estate Tax -0-
-0-
Fed/VT Income Taxes
-0- "Savings" $528,000 $192,000 -$89,290 Overall Savings: $102,720
As we can see, as long as Molly’s estate has sufficient exemption to avoid federal es- tate taxes, the cost of additional Vermont estate tax on Molly’s estate resulting from reducing the funding of the bypass trust is more than offset by the income tax savings achieved by the basis step-up at Molly’s death attributable to the additional assets. A couple of observations should be made about this example. First, the benefits of this strategy disappear if the assets are not already substantially appreciated at the time of the first spouse’s death, due large- ly to the way the Vermont estate tax mar- ginal rates apply and the fact that the es- tate tax is imposed on all of the assets, not
THE VERMONT BAR JOURNAL • SUMMER 2012
merely the gain. Second, if federal estate tax exemption portability becomes perma- nent, and there is no need to use any of the exemption of the first spouse at the time of their death, even greater overall tax savings can be achieved in situations like this be- cause more of the appreciated assets can be transferred to be taxed in the estate of the surviving spouse (and qualify for the ba- sis step-up). The problem for estate planners in these situations is, of course, the fact that it is not possible to know with any degree of cer- tainty any of the following: (a) which spouse will die first; (b) whether there will be signif- icant asset appreciation after the death of the first spouse; (c) whether there will be a change in estate tax exemptions and rates; and (d) whether there will be a change in capital gains tax rates. Despite all of this, a client may be willing to take those risks and pursue one or more of the following options: 1. If the bypass trust has been proper- ly drafted so as to qualify for a par- tial QTIP election, then as discussed above it should be possible under Ver- mont law to use the election to “dial down” the “bypass” amount to an ap- propriate level based upon the cir- cumstances at that time, although as discussed, a certain amount of “crys- tal ball gazing” would still be required regarding future events leading up to the surviving spouse’s death.
appreciating to $3.2
2. If circumstances change in the years subsequent to the first spouse’s death, the trustee could make discretionary distributions for the surviving spouse’s support out of the bypass trust first, rather than the “marital” share, or vice versa, depending upon the situation. Some trust agreements provide that the marital trust assets must be ex- hausted before distributions of prin- cipal can be made to the surviving spouse; estate planners who want to make this option available to trustees will need to omit such provisions.
3. Some estate planners have suggest- ed drafting trust agreements autho- rizing the trustee or a special trust- ee who is unrelated to the surviving spouse to give the surviving spouse a general power of appointment over all or a portion of the bypass trust, which could be exercised at a time the trustee determines appropriate. This would allow some or all of the assets in the bypass trust to qualify for the basis step-up at the surviving spouse’s death, at the expense of the exposure to federal and Vermont estate taxes. While including such a provision in trust agreements might at first appear to be a “no brainer,” there are rea- sons to be cautious about employing
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Planning for the Vermont Estate Tax
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