Deciding how your assets will be distributed after you are gone is certainly an important estate planning goal; however, it should not be the only goal. Among the other important considerations in your estate plan should be the impact state and federal taxes, including gifts and estate and inheritance taxes, will have on your estate. Not only do you need to know what taxes will be incurred, but you should also consider how they will be paid and who will be responsible for paying them. With that in mind, the Los Angeles estate planning attorneys at Schomer Law Group, APC discuss how a tax apportionment clause can benefit your estate plan.
Estate and Inheritance Taxes
Simply amassing assets and deciding who will inherit what is left of those assets when you die is not sufficient for estate planning purposes. You must also consider how the transfer of assets will be taxed and plan accordingly. Every estate is subject to federal gift and estate taxes at the rate of 40 percent. Currently (as of 2022), the lifetime exemption allows you to transfer up to $12.06 million in assets before the tax is levied. This includes both qualifying lifetime gifts and assets transferred at the time of death. Some states impose a separate estate tax in addition to the federal estate tax while a handful of estates impose an inheritance tax on heirs and/or beneficiaries. Estate taxes are paid by the estate while an inheritance tax is paid by the beneficiaries. Collectively, these taxes can dramatically diminish the value of the assets passed down to loved ones without careful planning. When taxes cannot be avoided, you may also wish to decide who will be responsible for paying the tax bill.
How Can a Tax Apportionment Clause Help?
A tax apportionment clause specifies which beneficiary, or beneficiaries, will be responsible for paying taxes due to local, state, or federal governments. You can include an apportionment clause in either a Last Will and Testament or a trust agreement. Moreover, the language used in an apportionment clause can be tailored to structure your wishes regarding how the tax burden is allocated in various ways.
A common reason to include an apportionment clause is to ensure that the ultimate value of the inheritance you leave to beneficiaries is as intended. If all taxes are paid out of your probate estate assets, it may significantly diminish the value of the assets eventually passed down to beneficiaries while the value of assets passed outside of probate will remain the same. That means that assets gifted in your Will, for example, may lose value while assets gifted through a trust will not. Another related concern is to make sure that inheritance taxes are paid. Although inheritance taxes are the responsibility of the beneficiary, failing to pay them can result in litigation. Moreover, the beneficiary’s relationship to the decedent often determines if an inheritance tax is due and/or the rate of the tax. Once again, seemingly equal gifts can end up with dramatically different values after taxes are imposed. Finally, in the absence of an apportionment clause, state/federal law determines who pays taxes and how they are paid. Typically, this means they are paid out of your residuary probate estate assets. If sufficient liquid assets are not designated for the payment of those taxes, assets intended to be passed down to loved ones may need to be sold.
How Does an Apportionment Clause Work?
An apportionment clause can work in several ways. For example, if you want to ensure that all taxes are paid using cash assets from your probate estate, you will include language directing your Executor to do just that. In that case, taxable assets that pass outside of probate (such as life insurance, retirement accounts, and Payable on Death accounts) would not be responsible for contributing to the tax bill. If you do that, you need to ensure that your probate estate has sufficient liquid assets to pay the taxes. Failing to do so could force the sale of assets.
Alternatively, you might make it clear that taxes are to be allocated equally among all beneficiaries but paid by your estate. While this strategy sounds fair, it can also create problems if it is not clear how the taxes are to be paid. Imagine that you own a home valued at $10 and a life insurance policy worth $10 million. You leave the house to your spouse and the life insurance to your adult child. Assuming state and/or federal taxes are levied, how will your spouse pay his/her share if no additional assets are available?
Finally, you could place the tax burden directly on beneficiaries to pay inheritance taxes; however, be aware that the tax could impact the value of the gift. Assume, for instance, that you left your $10 million house to your spouse and your $10 million life insurance policy to a favored niece. Your intent was to leave equal gifts; however, your spouse (under current Maryland law) could not be required to pay inheritance taxes whereas your niece would be required to pay the tax at the rate of 10 percent. While your spouse receives a $10 million gift, the value of the gift to your niece is reduced by $1 million, making its value $9 million.
Contact Los Angeles Estate Planning Attorneys
For more information, please join us for an upcoming FREE seminar. If you have additional questions or concerns about how to incorporate a tax apportionment clause into your estate plan, contact the experienced Los Angeles estate planning attorneys at Schomer Law Group APC by calling (310) 337-7696 to schedule an appointment.