A formula for estate planning success?

An important goal of many estate plans is to optimize use of the unlimited marital deduction, which allows you to leave any amount of assets to your spouse estate-tax free, so long as he or she is a U.S. citizen. In many cases, however, leaving too much to your spouse can cause you to waste your estate tax exemption amount ($3.5 million for 2009) and overpay estate taxes.

To achieve the best tax result regardless of what the future holds, many people incorporate a marital deduction formula into their estate plans. But bear in mind that formulas aren’t right for every situation, and their impact can change over time, such as when net worth or tax laws change. If your plan includes a formula, it’s a good idea to periodically review it to ensure that it won’t produce unexpected results.

How do formulas save taxes?

Let’s say, for example, that your estate is worth $7 million. If you die this year — when the exemption amount is $3.5 million — and leave your entire estate to your spouse, there’s no estate tax because of the unlimited marital deduction. But now your spouse has an estate worth $7 million (or more). If your spouse dies and the exclusion amount remains at $3.5 million, his or her estate will owe at least $1.575 million in estate taxes (assuming a 45% marginal rate).

By leaving everything to your spouse, you’ve wasted your exemption amount. You could have avoided this result by placing your exemption amount ($3.5 million in this case) in a credit shelter — or bypass — trust, which provides your spouse with benefits for life and, on your spouse’s death, transfers the remaining assets to your children or other beneficiaries. This trust would take full advantage of your exemption amount and would bypass your spouse’s estate, eliminating the $1.575 million tax hit.

Because it’s difficult to predict what the exemption amount will be years or even decades down the road, a formula may be desirable to ensure the optimal tax result. Essentially, a formula provides that the largest amount that can pass tax free by virtue of the exemption goes into a bypass trust. That way, you make the most of your exemption amount, whether it’s $1 million or $5 million.

Which formula is best?

There’s no easy answer to that question. Marital deduction formulas generally fall into two categories: pecuniary and fractional. A pecuniary formula calls for your estate to go to your spouse and to a bypass trust in amounts that will make the most of your exemption amount and minimize estate taxes. A fractional formula distributes assets between your spouse and a bypass trust according to a fraction in which your spouse receives the smallest fraction of your estate (as of your date of death) that minimizes estate taxes.

A full discussion of the tax and planning issues raised by these formulas is beyond the scope of this article. But, in general, pecuniary formulas offer greater flexibility to distribute assets through postmortem planning in a manner that achieves your estate planning goals. On the other hand, fractional formulas allow your spouse and children to share in any postdeath appreciation or depreciation in the value of your estate. This may result in higher taxes, but may be better for family harmony.

Who needs a formula?

A formula can be an effective tool for minimizing estate taxes, but not everyone needs one. For example, a formula may not be appropriate if you have other estate planning goals that are more important than saving taxes, such as ensuring that control of a family business or other assets is maintained by particular family members.

If your estate plan includes a formula, review it with your advisors to be sure it continues to meet your estate planning needs. •