Apportionment Clause

Generally, a testator includes in his will a provision governing the method of imposing the burden of estate and inheritance taxes. Since death taxes can consume more than half of a person's estate, the tax clause can effectively dispose of more property than any other provision in the will. Obviously, such an important provision should be carefully drafted. Surprisingly, this aspect of estate planning is often handled hastily and not given enough attention. What a prime example of how to inadvertently distort a person's dispositive arrangement.

In the absence of an effective tax apportionment clause, state law will generally determine where the ultimate burden of the estate tax will fall. At one time, most states followed the common law rule which provided that death taxes, like administrative expenses, were to be paid from the residuary estate. However, a majority of states now require that the estate tax be equitably apportioned among the persons benefiting from their interests in the estate. Essentially, this means that each bequest must pay the tax which it generates. In order to avoid the payment of taxes in an equitable apportionment manner, the testator's will should clearly provide for the method of determining who will bear the tax burden. Historically, a favored approach of planners has been against apportionment. It depends greatly, of course, on the financial and family circumstances.

A testator's wishes can be frustrated when the tax clause is not well thought out. Assume hypothetically that Mr. Smith owns all of the stock in a closely held business. He has two sons, one who works in the business and another who does not. He wishes each of his sons to receive an equal share of his estate when he dies. His will provides for a pre-residuary bequest of his closely held stock to the son who is active in the business, with the residue, which is of equal value, to the other son. In addition, his will provides that all taxes are to be paid from the residuary estate. This means that the son with the residuary half will bear the burden of the total death tax! If the estate is large enough, it might mean that the residuary beneficiary will receive no property as a direct result of the tax apportionment clause. Where the preresiduary specific legatees are not the same persons who take the residue, it may be advisable to direct that the specific legatee bear the burden of the tax which their legacies generate. Another possibility would be for the will to provide a limit on the amount of tax on pre-residuary bequests which is to be paid out of the residue. This can be a percentage or an absolute dollar amount.

Problems concerning tax apportionment lurk in many areas. An apportionment that affects a marital deduction can create a revolving "tax on tax" scenario caused by an apportioned tax reducing the marital share. The failure of a qualified heir to maintain the ongoing circumstances concerning a special use valuation can trigger a recapture tax. In fairness, shouldn't this heir be responsible to pay such tax? The problem also lurks in all non-probate assets, such as Sec. 2036 remainder interests, GRITs and QTIP trusts.

There may be instances where a decedent does not want to burden beneficiaries who will receive property interests which pass outside of the will. For example, the testator may wish that family heirlooms, interests in a pension plan, life insurance proceeds, or jointly held property with rights of survivorship pass free of any death tax burden. The tax clause in the will should provide that the probate estate pay all taxes with respect to property passing under the will, as well as specifically identified non-probate assets. Taxes on "unexpected" non- probate assets should be apportioned to those assets.

A transfer to a surviving spouse which qualified for the estate tax marital deduction as QTIP property will be includible in such spouse's estate under IRC Sec. 2044, even though the spouse has no power to dispose of the property. Sec. 2207A provides relief to the surviving spouse's estate by entitling it to recover, from the person receiving the property, the incremental federal estate tax attributable to it, unless the spouse's will otherwise directs. A standard "pay all taxes from the residue" provision could inadvertently shift the burden of paying the incremental estate tax from the QTIP beneficiary to the spouse's probate estate. In order to insure that the estate tax on QTIP trust property is apportioned in accordance with the provisions of Sec. 2207A, a non-apportionment tax clause should specifically exclude tax from its scope taxes resulting from the QTIP disposition.

Many states have enacted statutes similar to Sec. 2207A to give a surviving spouse the same relief for state death taxes. In Estate of Gordon, 510 NYS 2d 815 (Sur. 1986), the court applied this statute against a decedent's form book nonapportionment clause. The court held that the clause did not otherwise provide as required by Sec. 2207A and NY EPTL Sec. 2-1.12 and apportioned the tax attributable to QTIP trust property against the beneficiaries of the trust fund. The decision indicates that express mention of the QTIP trust may be necessary in order for the tax clause to meet the "otherwise directs" requirement, which is based on the presumption that a testator does not normally intend to exonerate QTIP property from tax.

Another case Matter of Cord, 58 NY 2d 539 (1983) indicates the need to have a tax clause which is clear and unambiguous. The case involved conflicting tax clauses contained in decedent's inter-vivos trust and will. The court decided that the will, which included a non- apportionment clause, took precedence over contrary direction in a trust created 40 years earlier that provided that the trust pay its share of the estate tax. In 1986, New York amended its apportionment statute to provide that the tax clause in a later instrument must specifically refer to the tax direction provision in the earlier instrument in order to prevail.

A tax apportionment clause can often be the most important provision in the will. This is true today more than ever because of ever changing estate tax laws, new planning techniques and the continuing trend of state law to apply a testator's presumed intent in the absence of specific direction to the contrary. It is imperative that the attorney drafting a will not only be completely familiar with the federal and local tax apportionment statutes, but that he discuss with his client in great detail the impact of these rules on the client's dispositive plans.