What part of the estate should pay the estate expenses? A post-Hubert analysis.

• Author: MacGrady, Glenn J.

Estate planners have long faced the question of whether to pay estate expenses and state taxes out of the marital deduction part of the estate, the unified credit shelter part, or perhaps out of some other part such as a charitable deduction gift. The Supreme Court's March 18, 1997, plurality decision in Commissioner v. Estate of Hubert, 117 S. Ct. 1124 (1997), approves another alternative--charging expenses to estate income. To the extent this estate income is otherwise payable to a spouse or charity, the "Hubert technique" can result in more favorable tax effects than pre-Hubert techniques, and hence can offer planning opportunities.

Mr. Hubert's estate was valued at about $30 million. The estate was split about 50-50 between the surviving spouse and charities, thereby qualifying for both a marital deduction(1) and a charitable deduction.(2) Estate expenses were $2 million. The Supreme Court made no finding as to the amount of estate income.(3) The executor was authorized to pay estate expenses out of either the corpus or income of the marital and charitable gifts, and he in fact charged $500,000 to corpus and $1.5 million to income. The marital and charitable deductions were reduced in amount dollar-for-dollar by the $500,000 of expenses charged to corpus. All parties and all nine Justices agreed this was the law.(4) No reductions were made to the marital or charitable deductions for the $1.5 million charged to estate income, which became the issue in the case. The IRS took the position that marital and charitable deductions must be reduced dollar-for-dollar by any estate expenses charged to income otherwise payable to the spouse or charity. The Tax Court and Supreme Court disagreed with the IRS and approved the taxpayer's technique. The case holds that estate expenses charged to estate income will not reduce the size of a marital (or charitable) deduction even though that income would have been payable to the spouse (or charity).

This article offers some simple scenarios and calculations to demonstrate estate planning opportunities both before and after Hubert, and ends with some caveats about the Court's opinion and some drafting suggestions. Although the Hubert opinion applies equally to the marital and charitable deductions, the focus will be on marital deduction planning, both for simplicity and because the charitable deduction planning advantages are fewer.(5)

The first four scenarios assume the following facts:(6) H dies with a $1 million gross estate; there is $100,000 of estate income and $100,000 of estate expenses; H is in a 60 percent estate tax bracket; the estate is in a 40 percent income tax bracket; the joint objective of H and W is to get the principal of H's $1 million estate to C at the least tax cost possible after W enjoys the income of H's marital deduction gift to her; W dies later in a 60 percent estate tax bracket, having preserved the principal of her marital deduction gift from H and leaving by her will the remainder of that gift to C. The fifth scenario increases the gross estate to $1.1 million.

The law that applies to the scenarios and calculations is that estate expenses can be taken as a deduction against the estate tax(7) or as a deduction against the estate's income tax(8) but not as a deduction against both.(9) If an estate expense is paid out of the corpus of a marital deduction gift, the marital deduction amount is pro tanto reduced,(10) because a marital deduction is given only for the amount that actually "passes" from a decedent to the surviving spouse.(11) The taxable estate, accordingly, is pro tanto increased. Subject to the caveats at the end of this article, Hubert holds that there is no such reduction in the marital deduction when an estate expense is charged to the income of a marital deduction gift.

The scenarios calculate the alternative effects of paying the estate expenses out of the marital deduction gift corpus, the unified credit shelter gift corpus (if any), and the estate income--plus the further alternative effects of taking the expense deduction against the estate tax versus the estate's income tax.

Scenario I: H Leaves All $1 million to W

This scenario assumes the unified credit,(12) which can shelter up to $600,000 of estate tax and which will be explored in the subsequent scenarios, is not available. The marital deduction here is potentially $1 million, which would reduce the $1 million gross estate to a taxable estate of $0, resulting in a potential $0 estate tax. The potential income tax is ($100,000 x 40 percent =) $40,000. How are these potential taxes affected by expense payment out of different estate sources and by applying the expense deduction against different tax regimes?

* Pay the $100,000 expenses out of the $1 million marital deduction gift corpus. This reduces the marital deduction by $100,000 from $1 million to $900,000 and increases the taxable estate from $0 to $100,000. Prior to the expense deduction, this results in a potential estate tax of ($100,000 x 60 percent =) $60,000, plus the potential income tax of $40,000, for a total potential tax liability of $100,000. How the expense deduction is applied dramatically affects this potential tax liability.

1) Take the $100,000 expenses as an estate tax deduction. The taxable estate is reduced from $100,000 to $0, resulting in no estate tax. The income tax remains at $40,000.

Total taxes = $40,000

2) Take the $100,000 expenses as an income tax deduction. Taxable income is reduced from $100,000 to $0, resulting in no income tax. The estate tax remains at $60,000.

Total taxes = $60,000

Thus, in this sub-scenario, it is better to use the $100,000 expense as an estate tax deduction. This is because the estate tax rate (60 percent) is higher than the income tax rate (40 percent), and the same quantitative deduction will naturally deflect more tax when applied in the tax regime having higher effective rates. But is paying the expense out of the marital gift corpus the best tax strategy? How would the Hubert technique affect this scenario?

* Pay the $100,000 expenses out of the $100,000 estate income. Per Hubert, the marital deduction is not reduced, and hence the taxable estate remains at $0. Prior to the expense deduction, this results in a potential estate tax of $0, plus the potential income tax of $40,000, for a total potential tax liability of only $40,000. Proper use of the expense deduction can reduce this potential tax liability even further.

1) Take the $100,000 expenses as an estate tax deduction. This would be a complete waste of the deduction because the taxable estate is already $0 and no estate tax already is owed. The income tax remains at $40,000.

Total taxes = $40,000

2) Take the $100,000 expenses as an income tax deduction. Taxable income is reduced from $100,000 to $0, resulting in no income tax. The estate tax remains at $0.

Total taxes = $0

In Scenario I, where there is no gift other than to W, Hubert offers a substantial tax advantage. If expenses are paid out of estate income and deducted against the estate's income taxes, the total tax liability can be reduced by $40,000 vis-a-vis the pre-Hubert alternative. More generally, the Hubert savings will be an amount equal to the estate expenses multiplied by the estate's effective income tax rate.

What happens to the calculations if H, in addition to a marital deduction gift to W, makes a gift to C using the shelter of the unified credit--i.e., where H uses a so-called "optimal marital deduction"?

Scenario II: H Leaves $600,000 to C via a Credit Sheltered Gift and $400,000 to W via a Marital Gift

The marital deduction is potentially $400,000 and the unified credit shelter is $600,000, the combined subtractive effects of which would reduce the $1 million gross estate to what I will call a "tax generating estate"(13) of $0, resulting in a potential estate tax of $0. The potential income tax is ($100,000 x 40 percent =) $40,000. Let's look again at how the sources of expense payment and deduction alternatives affect these potential taxes.

* Pay the $100,000 expenses out of the $400,000 marital deduction gift...