Many states apportion estate taxes among beneficiaries of an estate and revocable trusts in proportion to the assets received by them that are subject to estate taxes, absent contrary language in the dispositive instruments. This is known as “equitable apportionment.” Thus, when assets pass to a surviving spouse in a manner that qualify for the marital deduction, equitable apportionment avoids such marital assets being reduced for estate taxes relating to the passage of other assets. This is usually a good thing since it reduces the overall estate tax bill – if the marital deduction property bears estate taxes, an interrelated computation of the tax arises that reduces the marital deduction (since not all the marital deduction property ends up with the surviving spouse).
Oftentimes, surviving spouses receive a residuary interest in estate and trust assets. In such cases, draftsmen must be careful to specifically provide that the marital assets so received do not bear estate taxes – either by allowing a state’s default equitable apportionment statute to apply or via drafting. Oftentimes, standard language (or statutory language) will allocate estate taxes to the residuary assets (and thus the marital deduction assets) by default – so this default language has to be overridden.
For example, if you were reading a revocable trust that left the residuary assets to the surviving spouse, and the trust also contained this language:
The Trustee shall pay from the residue of the trust estate prior to any distributions provided for herein, all of the Settlor's debts, expenses of last illness, expenses of disposal of remains, all expenses of administration and trust termination, including attorneys' fees, and shall pay all estate taxes, if any, attributable to Settlor's entire taxable estate,
you would assume there is a problem here – estate taxes are being allocated to the residuary (and thus the assets passing to the spouse), and that equitable apportionment would not apply. In a recent Tax Court case, the IRS thought the same. However, for some unknown reason, the Tax Court went through a numerous contortions to find that the clause did NOT require that the residuary marital gift bear estate taxes, and that Utah’s equitable apportionment statute applied to allocate the taxes to other gifts. This was done, even though it appears from the case that the other gifts were not other residuary gifts, but were specific gifts to other beneficiaries.
It is true that there were some slight ambiguities and inconsistencies in the trust that could be used to challenge the above express language, but I would not have expected the taxpayer to prevail. For example, the court read the above reference to the “residue of the trust estate” to refer to the residue of the probate estate – quite a stretch. Further, the Court drew a distinction between allocation and apportionment. That is, the Court believed that even if the testator/settlor intended that the taxes be allocated to and paid out of the residuary, the testator/settlor did not intend to also apportion the taxes among the residuary beneficiaries – that is, the taxes should still nonetheless be apportioned among the beneficiaries in proportion to the TAXABLE assets they received.
What lessons can be learned (other than sometimes, against all odds, the Tax Court will pull the draftsman’s fat out of the fire for him or her)? Depending on which result is desired, be very specific with allocation and apportionment language. For example, if apportionment among taxable assets only is desired, use language such as “with apportionment.” Or if apportionment is not desired so that the entire residuary should bear taxes, use language such as “without apportionment.” When no apportionment is desired, one can go the further step of expressly providing that no right of reimbursement exists – that is, to use language such as “without apportionment and with no right of reimbursement from any recipient of any such property.”
John D. McCoy, et ux. v. Commissioner, TC Memo 2009-61