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A difficult estate planning problem often arises in the context of second marriages where there are children from prior marriages, especially where the married couple (the clients) wish to coordinate their estate plans and treat all of the children equally. The surviving spouse’s freedom to alter the estate plan after the death of the first spouse means that the survivor could presumably favor his or her own children at the expense of the deceased spouse’s children. The problem is compounded where one spouse is wealthy and the other spouse has only minimal assets in his or her own name. (See "Tax Risk on the Order of Deaths" elsewhere on this website.)

For example, assume Mr. and Mrs. Client have a child of their marriage and each has two children by a prior marriage. Assume further that Mr. and Mrs. Client have a typical estate plan which takes advantage of the exemption equivalent and the marital deduction. That is, the first to die passes the exemption equivalent (i.e., $1,500,000 which can be transferred tax-free in 2001, increasing per the new tax act to $2,000,000 in 2006-2008; and $3,500,000 in 2009; with repeal of the estate tax in 2010 and reinstatement of the estate tax in 2011) to a bypass trust (a.k.a. credit shelter trust) for the benefit of the survivor and the balance to a marital deduction trust. Finally, assume both trusts pass the assets remaining on the survivor’s death to all of the children equally.

Treating the Children Equally

Suppose Mrs. Client dies first. There is nothing keeping Mr. Client from changing his estate plan and gifting all of his assets to his children either during lifetime or at death, thus cutting out Mrs. Client’s children. Similarly, if Mr. Client dies first, Mrs. Client could cut out Mr. Client’s children.

A "solution", of course, is to provide in the bypass and marital trusts established on the first death that on the death of the survivor the shares of the children will be adjusted to take into account disproportionate transfers made by the survivor. But that "solution" is far easier said than done.

Put yourself in the shoes of the Trustee of the trusts established on the death of the first to die. After the death of the survivor, the Trustee must divide the trust assets in accordance with a formula contained in the trust documents. To be thorough, the formula must take into account the assets passing on the surviving spouse’s death via the surviving spouse’s will and trusts, as well as lifetime gifts made by the surviving spouse after the first spouse’s death.

There are tradeoffs. Suppose the surviving spouse lives for 20 years after the first spouse dies. Administrative expediency requires that the Trustee not be required to delve into the surviving spouse’s XMAS gifts over such a time period. Presumably, the drafting will eliminate the need to account for gifts unless some minimum threshold is attained. For example, the threshold might be that a gift would not count unless it exceeded the $10,000 annual exemption amount, but even then a drafting decision would have to be made about whether the Trustee had to look for unreported taxable gifts.

The tradeoff, of course, is that a regular gifting program involving small gifts could nevertheless transfer substantial wealth to the surviving spouse’s children without causing a later adjustment in the children’s shares on the survivor’s death.

What about the timing of the gifts? Should the adjustment take into account the fact that gifts were made long ago, and thus the donee also received the income and appreciation?

What about the problem of the "worthless" child? It seems appropriate to give the surviving spouse some ability to cut out a child who turns out to be a "bad apple." This is usually accomplished via granting the survivor powers of appointment. But it seems appropriate to limit the power so that the net effect is not an increase in the surviving spouse’s children’s receipts.

It should be obvious that there is no limit on how complicated the drafting can become in order to assure that the children are all treated equally. Good estate planning requires that the problem be addressed, but in a way that is in balance with other objectives.

©2007 Steven M. Chamberlain, Esq. All rights reserved. Republication with attribution is permitted.