It is obvious to say — but vital to understand — that your customers and mine only benefit from what they keep, not necessarily from what they have. As brokers and advisors, you naturally concentrate on maximizing investment results. But as your business becomes closer to mine and you get more involved in issues of wealth management, it makes sense to pay attention to how seemingly arcane tax rules can make a huge difference in what clients keep and what they send to federal and state tax collectors.
Take, for example, this recent twist, which the Internal Revenue Service explained in Technical Advice Memorandum 200132004 (April 25, 2001). It shows how clients who don't fit the common married-with-children mold can wind up in a legal thicket. The case involved a man and woman who cohabited for 33 years and held themselves out publicly as married. The woman suffered a stroke and entered a rehabilitation home. When she was ready to return to her mate, he denied her access to their residence. She then suffered a second, disabling stroke.
Ironically, the man died, but she survived. Since the man made no provision for her in his will, the woman's guardian sought a share of his estate under state law that allows a spouse who is excluded from the will of a deceased spouse to make such a claim. Since the woman was not a legal spouse, that didn't wash. The woman's counsel fared better by filing a claim against the estate for “intentional infliction of mental distress.” The estate reached a settlement, agreeing the estate would make certain payments to the woman for four years.
That, however, was not the end. The next legal issue became whether the amount of the settlement would be deductible from the estate as a marital gift. (Since 1982, you can make unlimited gifts to a spouse during lifetime or at death and pay no tax on the gift when made.) The IRS said this settlement was not deductible because the survivor was not the spouse. So, every dollar of the settlement was subject to estate taxes.
Such situations are actually not that uncommon. Advisors should bear in mind that it is critical to understand that if their customers are not legally married, results such as this — or even worse — can apply to them.
Even clients who make careful plans for preserving their assets can run into trouble. In another case, a man left $1.5 million in a trust for the benefit of his wife (they were, in fact, lawfully married), with the remainder of the trust (what was left when the spouse's interest terminated) going to Columbia University. The widow was to receive $100,000 per year for life. The question then was whether the amount of principle necessary to produce that income for the wife would be deductible from the $1.5 million as a marital deduction gift to the spouse, which would not be taxed.
The IRS ruled that about $1 million of the $1.5 million would be deductible as a marital gift, but the balance would not. This shocked the executors of the estate because the will stipulated that the $100,000 annuity would be adjusted for inflation. This led them to expect a larger marital gift deduction. The service pointed out correctly that, under its own regulations, inflation adjustments are simply not taken into account, so the executors paid a tax on property actually passing to the spouse but not deductible for these technical reasons.
The sadness of this situation is that there were at least two ways to make the trust work as intended. Both of these cases illustrate that one can work a lifetime to accumulate property, seek professional guidance and still wind up losing far more to the taxman than they have to. The bottom line is that what we have been calling “investment-driven estate planning” should be a vital part of the advice you give your clients. You can't be a full-time estate planner, but you need to know enough about estate planning to spot potential problems and help your clients hold onto the wealth that you are helping them build.
Roy M. Adams is a partner in Sonnenschein Nath & Rosenthal in New York, where he serves as senior chairman of its trusts and estates practice group.