A recent New York Surrogate’s Court decision illustrates the importance of proper apportionment of estate taxes.

In re Walrod, Slip Copy, 2009 CL 3030727 (N.Y. Sur.), decided Sept. 21, 2009, turned on the interpretation of three provisions in William A. Walrod’s will and revocable living trust as to how estate taxes should be apportioned.

Determining which beneficiaries bear the brunt of estate taxes in a particular estate is among the most difficult aspects of structuring an effective estate plan. Should the default state law apply? Or should the estate-planning attorney draft specific instructions regarding tax apportionment that override state law?

The answer depends on two things:

(1) determining the testator’s intent about whose share should be reduced by estate taxes and whose should not; and

(2) the drafting capabilities of the attorney.


THE FACTS

The facts in In re Walrod make interesting reading:

In December of 1992, William Walrod executed a will that made specific bequests to family members and created a trust for the benefit of his wife, Ruth, and son, Robert.

In December of 1997, William executed a revocable trust that made pre-residuary bequests to family members with the residue passing to a marital trust. At the time, William was worth about $10 million.

In April of 2001, William executed a second irrevocable trust that included pre-residuary bequests to Robert and a marital trust for Ruth, a portion of which would pass on her death to a charitable lead trust (CLT) for the benefit of two local charities. At that time, William was worth about $19 million.

In February of 2002, William executed a third revocable trust that upon his death left the trust property to his family, primarily a marital trust for his wife Ruth that went to Robert after Ruth died. At this time, because of a significant investment in Enron, William’s net worth had declined to about $3 million.

In September of 2006, William signed a final version of the trust. This one provided for certain pre-residuary dispositions to Robert and other family members with the residue passing to a $3 million CLT for the benefit of two local charities. At this time, William had a net worth of about $5 million.

It is interesting (as well as unusual) to note that the law firm that drafted William’s 1992 will was different from the law firm that drafted the four revocable trusts. As such, it was a freestanding will with substantive dispositive provisions rather than the more typical, simple will that pours any assets over to the revocable living trust. This disconnect created some of the confusion regarding the relevant tax apportionment clause.

The 1992 will directed that all taxes be paid from the residuary estate “with no right of reimbursement from any such property.”

The first three trusts directed that estate taxes be paid from the trust principal before funding any residuary dispositions and gave the trustee complete discretion in this area.

The final trust contained the same provisions, but also contained a second tax clause directing that taxes be paid from the residuary “with no right of reimbursement from any recipient or beneficiary” (which was later determined to be the result of a drafting error).

After William died in 2007, Robert became the executor under the will and successor trustee under the trust. He retained the attorney who had drafted the trusts, Dale C. Robbins of Burgett & Robbins in Jamestown, N.Y., to administer the estate. Dale informed the charities that they were the recipients of the $3 million CLT.

(The court noted that although William had no connection during his lifetime with either of the charities, Dale C. Robbins and his law partner, Dalton J. Burgett were intimately involved with the charities, which are the WCA Hospital, a cancer center, and the Robert H. Jackson Center, an educational facility devoted to the former U.S. Supreme Court justice. Both charities are located in Jamestown, N.Y.)

In January of 2008, Dale directed Robert, as executor, to transfer $3 million to the trustee of the CLT.

Robert balked and retained new estate counsel—who commenced a voluntary accounting proceeding that proposed to pay the pre-residuary bequests and taxes first. But such an approach would result in little or nothing to fund the CLT.


THE STATE AG SUES

Unsurprisingly, the two charities along with the New York attorney general (as protector of all charitable gifts) filed objections to the accounting.

Each side argued that the other should be wholly responsible for about $1.5 million in estate taxes.

All parties agreed that taxes should first be paid from the residuary probate estate, as directed by William’s will. The problem was that there was only $125,000 in the residuary probate estate that was insufficient to pay the estate taxes. The bulk of the estate property was in the trust. The parties did not agree on the interpretation of the tax apportionment clauses in the trust.

Robert, as executor, contended that the language in the will, the language of the trust, and his father’s intent controlled how the rest of the taxes should be paid. Under this view, the pre-residuary bequests to family are funded first, taxes come out of the remaining assets, and the CLT is funded with whatever is left.

The charities and William D. Maldovan, the assistant attorney general in charge of the case, contended that the state default apportionment statute should apply—not the provisions in the will or trust. The result of this approach would be that the CLT receive the full $3 million, taxes then would be paid, and any remainder would go to the family.

Alternatively, the charities and the attorney general allow that a possible reading of the tax clause in the will could result in apportioning the taxes among all beneficiaries, including the charities.

If neither of these claims was persuasive, the charities argued that the trust should be reformed to provide for William’s “charitable intent.”

Obviously, the charities were throwing out any arguments they could come up with to get the money. Unfortunately for them, Judge Larry M. Himelein of the Cattaraugus County Surrogate's Court would have none of it. The court found for the executor on all counts, holding that the testator’s intent was clear that his family was to benefit first, taxes would be paid next, then the charities would get whatever was left. In this case, that turned out to be almost nothing.

YOU MUCH REMEMBER THIS

So what lessons can we derive from In re Walrod?

The first, and most important is for all estate-planning attorneys to spend the necessary time in a particular estate plan to determine which beneficiaries should bear the burden of the estate tax.

Too often, estate-planning attorneys rely on state apportionment statutes or boiler plate tax apportionment clauses that can result in the sometimes tragic results of disinheriting the spouses and children the testator wanted to benefit most.

Finally, it’s important to remember that if a charity is a beneficiary of the residuary estate and taxes are to be paid from the residue, not only will the charity’s share of the estate be reduced, but also the estate will be subject to a higher-than-necessary estate tax because, by reducing the charitable deduction, the estate tax is increased. That further reduces the charitable deduction, which in turn again increases the estate tax. This is something known as a circular tax calculation under Internal Revenue Code Section 2055(c).

The circular tax calculation can typically be avoided by structuring the charitable bequest as a pre-residuary rather than a residuary bequest.