SC Lawyer, September 2010, #5. Construing Wills and Trusts During the Estate Tax Hiatus in 2010.

• Author: By F. Ladson Boyle, S. Alan Medlin and Howard M. Zaritsky

South Carolina Lawyer

2010.

SC Lawyer, September 2010, #5.

Construing Wills and Trusts During the Estate Tax Hiatus in 2010

South Carolina LawyerSeptember 2010Construing Wills and Trusts During the Estate Tax Hiatus in 2010By F. Ladson Boyle, S. Alan Medlin and Howard M. Zaritsky In 2001, Congress passed tax legislation that included a temporary repeal of the federal estate tax in 2010. Economic Growth and Tax Relief Reconciliation Act of 2001, Pub. L. 107-16, 115 Stat. 38, amending IRC section 2001. Early on, many estate planners believed that the federal estate tax would be permanently repealed before 2010, but that legislation did not pass. In more recent years, the mood shifted and most believed that Congress would act and not permit a year in which there was no estate tax, but that legislation has not passed either.

The 2010 federal tax surprise-no estate or generation-skipping transfer (GST) tax-has many tax implications. Articles may be found in the tax literature that discuss the problems. See, for example, Congressional Inaction Yields One-Year Repeal of the Estate and GST Taxes: Hiatus Planning for Drafters and Fiduciaries, 22 Probate Practice Reporter 1 (January 2010), and The Impossible Has Happened: No Federal Estate Tax, No GST Tax, and Carryover Basis for 2010, 112 J. of Taxation 68 (February 2010).

In addition to the tax issues, nontax state law concerns arise because there is no federal estate tax in 2010. One particular issue has the potential to cause significant problems for estates of decedents who die while there is no federal estate tax. Many tax-sensitive wills and revocable trusts divide a decedent's estate between a surviving spouse or a trust for a surviving spouse (hereinafter collectively described as a devise to the surviving spouse) and a bypass or credit shelter trust or a gift to someone other than the surviving spouse (hereinafter collectively described as a devise to the bypass trust).

The controlling document's division between the surviving spouse and the bypass trust is often worded with formulas that use estate tax terms to describe the division. For example, such a formula simplistically might give the bypass trust "the maximum amount of property of the decedent's estate that may pass free of estate taxes." Alternatively, the formula might give the surviving spouse an amount equal to the maximum marital deduction-that is, 100 percent of the estate, but reduced by the most property that may pass free of estate taxes. When these formulas use terms that refer to federal estate taxes, the unified credit, the applicable credit amount, the applicable exclusion amount, the exemption equivalent or other such similar estate tax-derived terms that have no tax meaning in 2010, the state law question becomes: how is the property of the decedent's estate or revocable trust divided? To answer this question, it is first necessary to examine the variations in wording of the formulas that produced the same result when there was an estate tax, but potentially very different results when there is no estate tax.

Types of formulas

Formulas that divide a decedent's estate between a devise to a surviving spouse and the bypass trust to maximize estate tax savings usually can be divided into one of two categories: pecuniary formulas and fractional share formulas. A pecuniary formula may be used to define the marital devise to the surviving spouse or to define the non-marital, bypass trust devise. When a fractional share formula is used for the division between the surviving spouse and the bypass trust, it is usually a division of the residue of the decedent's estate or remainder of the property in the decedent's revocable trust.

A typical pre-residuary marital deduction formula might leave the surviving spouse an amount equal to the maximum marital deduction-that is, all of the decedent's estate, but reduced by the most that may pass free of estate taxes, after taking into account the unified credit or the applicable credit amount, as well as other possible adjustments such as prior taxable gifts. Alternatively, the devise to the surviving spouse might be described as the maximum marital deduction, less the applicable exclusion amount. Another alternative might be a devise to the spouse of the minimum amount of property necessary to reduce the estate tax to zero or the least amount of estate tax possible.

A pre-residuary, pecuniary bypass trust formula might devise to the bypass trust the most property that might pass free of federal estate taxes, after various adjustments, with the residue devised to the surviving spouse. Alternatively, the devise to the bypass trust might be described as an amount equal to the applicable exclusion amount or applicable credit equivalent.

The wording of each of these pecuniary formula examples, or similar wording, may be used to define the numerator of a fractional share division of the decedent's residuary estate or the remainder of the decedent's revocable trust, with the denominator of the fraction being defined as the residue of the decedent's estate or the remainder of the trust estate for a revocable trust.

When an estate tax is in effect, all variations of the pecuniary formulas and the fractional share formulas result in a division of the decedent's property that was anticipated by the decedent and was likely clear under the terms of the controlling document. For example, in 2009 each of the various formulas would have produced a $1.5 million devise to the surviving spouse and a $3.5 million bypass trust devise for a $5 million estate (ignoring debts, expenses and other possible deductions such as charitable devises). After the decedent's death in 2009, the various formulas potentially result in differing divisions of estate income and appreciation or depreciation in estate assets, but there is no difference as of the date of death allocation of the decedent's assets.

In 2010, however, it is possible to assert that one or more of these formula devises result in no property passing to the surviving spouse and all of the decedent's property passing to the bypass trust because there is no estate tax and the technical tax terms used in the formula have no meaning. For example, a formula that devises the surviving spouse the maximum marital deduction less the most that can pass free of estate taxes seems to leave the surviving spouse nothing because the entire estate passes free of estate taxes: the cutback provision takes everything away from the surviving spouse. Alternatively, some of the formulas may produce a 100 percent devise to the surviving spouse. For example, a formula that leaves the bypass trust an amount equal to the applicable exclusion may be a devise of nothing because there is no such amount in 2010. Another possible interpretation that may be argued is that the formula does not direct the disposition of the decedent's property at all because the division is based on tax terms that have no meaning in 2010 so that the estate eventually passes by intestacy.

Similar issues arise when the decedent's estate or revocable trust is divided between GST exempt and non-exempt trusts. Often formulas are used for this division based on the GST exemption amount as defined in section 2631(c). But section 2631(c) refers to the "applicable exclusion amount under section 2010(c) for such calendar year," and for 2010 there is no applicable exclusion amount.

In addition, some testators make charitable devises that limit non-charitable devises to the most that may pass free of estate taxes with the balance passing to charity. For those documents, there may be no charitable devise in 2010 although the decedent clearly intended for the charity to receive something.

Possible elective share concerns

The lack of an estate tax during the hiatus had potential spousal elective share implications. In South Carolina, the offset to a spousal share is based in part on whether an interest to a surviving spouse qualifies for the federal estate tax marital deduction. When there is no federal estate in 2010, the reference to the federal estate tax marital deduction is meaningless for this purpose. The General Assembly fixed this problem with an amendment to § 62-2-207 that now references the federal estate tax marital deduction as in effect on December 31, 2009. See Act No. 181, R220, S372 (signed by Gov. Sanford and effective on May 28, 2010).

A matter of construction

For decedents dying while there is no estate tax, the nontax state law question about disposition of the decedent's assets, by will and by revocable trust, becomes a matter of construction. The dispute will often be between the surviving spouse and the beneficiaries of the bypass trust; for GST issues, the pool of litigants could be broader. Assuming the decedent anticipated that Congress would not act to prevent the 2010 hiatus, the intent is likely to be stated clearly in the document, and construction is not a problem. However, for those decedents who did not express an intention in the documents, construction becomes more problematic. Underlying the traditional notions of the construction of wills and revocable trusts is the goal of determining what the decedent intended to do about a certain situation that is not clearly explained in the documents. Nevertheless, the traditional application of construction rules is predicated on the principle that the decedent had an intention about a particular issue but did not clearly express it. While it may be possible that the decedent had an intention about a division of assets during the estate tax hiatus but failed to express it in the documents, it is also possible, and perhaps likely, that the decedent did not even consider that possibility. Had the decedent considered the possibility of dying during the 2010 hiatus, the documents would probably express an intent about that prospect.

So when the decedent's documents do not express an intent about the hiatus because the decedent did not even speculate about the lack of a federal estate tax, construction becomes more of a stretch. In that case, the determiner of fact is not trying to discover what the decedent actually considered and intended, but rather what the decedent would have intended if the decedent had thought about a hiatus death. Although this may appear to be guesswork rather than construction, probate courts do engage in similar speculation in other cases. For example, the doctrine of dependent relative revocation allows a court first to determine that a decedent revoked a will by mistake and then to decide whether to leave the will revoked. This process is akin to guessing what the decedent would have wanted if the mistake had not been made-guessing is necessary because it is likely the decedent never considered what should occur if the mistake were made or else the mistake would not have been made. See S. Alan Medlin, Wills and Trusts in South Carolina § 312 (S.C. Bar 2002).

South Carolina legislation

In 2010, the S.C. General Assembly passed legislation that provides:

The personal representative, trustee, or any affected beneficiary under a will, trust, or other instrument of a decedent who dies or did die after December 31, 2009, and before January 1, 2011, may bring a proceeding to determine the decedent's intent when the will, trust, or other instrument contains a formula that is based on the federal estate tax or generation-skipping tax. The proceeding must be commenced within twelve months following the death of the decedent. See Act No. 251, R 314, S 1348 (signed by the governor and effective on June 11, 2010, for decedents who die in 2010). The statute will be codified as section 62-2-612 and referenced with a note in Chapter 7, Title 62.

The purpose of this legislation is to permit affected parties to petition the probate court for a construction of documents that use federal estate tax terms to define devises. It does not provide a preferred construction, as legislation in other states have done. See, for example, Va. H 755 enacting § 64.1-62.4. The South Carolina statute does appear to assure that probate courts will hear the petitions and that extrinsic evidence will be admissible.

Common law construction: resolving ambiguities

South Carolina courts will have to resort to common law construction methods to resolve ambiguities. Arguably, the failure to express an intention about dying during the hiatus could be a patent or a latent ambiguity. The modern trend appears to allow a court to consider extrinsic evidence to resolve either. See, for example, Holcombe-Burdette v. Bank of America, 371 S.C. 648, 640 S.E.2d 480 (S.C. App. 2006) (allowing use of extrinsic evidence to resolve ambiguity in will); In re Estate of Prioleau, 361 S.C. 627, 606 S.E.2d 769 (S.C. 2004) (similar); In re Estate of Fabian, 326 S.C. 349, 483 S.E.2d 474 (S.C. App.1997) (similar); Garcia v. Celstron, 2 So. 3d 1061 (Fla. App. 2009) (using extrinsic evidence to construe testator's intent about parameters of devised life estate); In re Stull Living Trust, not reported in Cal.Rptr.3d (Cal. App. 2008) (2008 Westlaw 217622) (allowing extrinsic evidence to resolve question of settlor's intent as to allocation of expenses and fees); Estate of Zahrobsky, 731 N.W.2d 385 (Wis. App. 2007) (allowing extrinsic evidence to define "applicable exemption amount" reference for state estate tax purposes); Berry v. Ford, 829 N.E.2d 1052 (Ind. App. 2005) (explaining difference between latent and patent ambiguities and the use of extrinsic evidence to resolve them); Estate of Herceg, 747 N.Y.S.2d 901(Sur. 2002) (using clear and convincing standard to offset concerns about reliability of extrinsic evidence); and Estate of Klauzer, 604 N.W.2d 474 (S.D. 2000) (finding will unambiguous and therefore construing without extrinsic evidence, yet allowing extrinsic evidence to support its conclusion).

In such cases, absent some testimony or other proof about statements by the decedent about dispositions during a hiatus death, the extrinsic evidence will likely focus on relationships, especially in the estate tax cases, between the decedent and the surviving spouse on one hand and the bypass beneficiaries on the other. Based on those relationships, would the decedent want to exclude the spouse or the beneficiaries, or make devises to both the spouse and the beneficiaries? For those courts that are stricter about the use of extrinsic evidence, a reasonable result seems doubtful. In those cases, if the documents are silent about the possibility of a hiatus death, determining the decedent's intentions will be difficult if not impossible: the formula language in the documents will make no sense.

Family settlements

A surefire way to avoid the risks of an unwelcome court determination is to reach a family settlement agreement. These agreements are widely accepted. See S.C. Code Ann. § 62-3-912. Moreover, courts are typically allowed, but not required, to accept the terms of a family settlement agreement. See S.C. Code Ann. §§ 62-3-1101, -1102, and 62-7-411. Hopefully, courts, which usually favor family settlements, will recognize the special exigency of clarification during the hiatus. See, for example, the discussion of Osterneck v. Osterneck, 649 S.E.2d 127 (S.C. App. 2007) (recognizing validity of family settlement). But see Internal Revenue Technical Advice Memorandum 201004022 (demonstrating potential tax ramifications of family settlements).

Possible precedent from tax history

In construing the intent of hiatus decedents, it may be possible to analogize to the transition to an unlimited marital deduction under the Economic Recovery Tax Act of 1981 (ERTA) section 403(e). Prior to 1981, the marital deduction was limited to the greater of $250,000 or half the estate. ERTA contained a transitional rule that construed a formula clause calling for the maximum marital deduction to mean the pre-1981 limited marital deduction unless the testator amended the will post-ERTA or a state enacted a statute construing such clauses as providing the liberalized marital deduction. The purpose of the transitional rule was ostensibly to protect the testator's intent and the interests of non-spousal beneficiaries, although one might conjecture that a hidden agenda was to increase estate tax collections. See Estate of Bruning v. Commissioner, 888 F.2d 657 (10th Cir. 1989). For some other transitional rule cases indicating that the rule's purpose was to preserve intent, see Estate of Pouser, 975 P.2d 704 (Ariz. 1999), and Liberty Nat. Bank and Trust Co. v. U.S., 867 F.2d 302 (6th Cir. 1989).

Unlike the 2010 hiatus, however, Congress thought about the impact of the transition to the unlimited marital deduction as evidenced by its transitional rule. Of course, no such transitional rule exists for the 2010 hiatus. Analogies to what Congress may have intended by not providing a transitional hiatus rule with its provision of the transitional rule in ERTA seem speculative at best. Unlike the transitional rule cases, inferring that Congress' inaction was intended to preserve a testator's intent will be problematic.

However, some cases dealing with the transitional rule may be instructive for a methodology in construing hiatus documents. For example, in Estate of Klein v. Commissioner, 946 F.2d 1218 (6th Cir. 1991), the court refused to be bound strictly by the terms of the transitional rule and instead looked to the testator's intent as evidenced by the entire document. See also Hall v. United States, 39 F.3d 102 (6th Cir. 1994) (construing Tennessee "opt-out" statute).

While the transitional rule experience may consequently not provide airtight analogies for hiatus constructions, the methods of determining the testator's intent in some transitional rule cases may be helpful as arguable precedent.

Probable intent

Perhaps the most appropriate theory for dealing with hiatus construction cases is the doctrine of probable intent, which uses "common human impulses" in construing a will by filling in gaps in the dispositive plan. See, for example, Estate of Payne 895 A.2d 428 (N.J. 2006). Hiatus formula divisions issues fall within the dispositive gap genre, so probable intent could be an operative construction tool. However, this doctrine has so far seen limited application.

Conclusion

What is clear about hiatus deaths is that the decedent's documents are likely to be based on formula divisions that rely on tax terms of art for an estate tax that currently does not exist. Although the potential problems are fairly certain, the resolutions are not. Perhaps one of the construction tools discussed above will suffice, but if not, a remedy will have to be found some way.

F. Ladson Boyle and S. Alan Medlin are professors of law at the USC School of Law. Howard M. Zaritsky is an attorney in Rapidan, Virginia.