Funding Formulas for Revocable TrustsFunding Formulas for Revocable Trusts

Unlimited Marital Deduction.  This deduction allows transfers of unlimited amounts of assets between spouses at death.  The result is that the surviving spouse does not have to pay any tax on the estate of the first spouse to die.  In other words, the marital deduction postpones the federal estate tax.  As an example, Bill Gates can pass to Melinda Gates $50 billion in assets, so long as they are married at the time of the transfer, free of transfer tax until the passing of the last of them to die.

Funding Formulas.  Generally, two types of funding formulas exist, Pecuniary and Fractional.

Pecuniary Formulas.  Pecuniary formulas are easier to draft and administer than fractional share formulas, since they simply determine an amount to be distributed to one share, with the balance going to the other. If valuation changes occur during the postmortem administration period, the calculation is minimally affected, since the formula continues to place the defined amount in the share designated in the pecuniary formula.

Fractional Share Formula.  With a fractional share, it is impossible to determine the actual amount of either share until postmortem administration is complete, since the fraction itself is affected by non pro-rata distributions (such as the payment of estate taxes from the non-marital share), and changes in valuation.

Selecting the Correct Funding Formula.  The choice of marital deduction funding formula can affect (1) the amount passing to the surviving spouse (and therefore, additional tax may be due upon the surviving spouse’s death), (2) whether income tax will be triggered upon funding the marital and credit shelter bequests, and (3) the ease of administration.  A discussion of each of the major formula types is as follows:

Pecuniary Non-Marital (Reverse Pecuniary) Formula.  Pecuniary formulas come in two basic varieties: pecuniary non-marital (or “reverse pecuniary”), and pecuniary marital.  Using the non-marital or reverse pecuniary approach, a sum equal to the applicable exclusion amount, adjusted by any credits, deductions, and other non-marital bequests, goes to the non-marital share, with the balance remaining going to the marital share.

A few additional points regarding the Pecuniary Non-Marital Formula: (a) Intuitive.  This formula is one of the more intuitive ones and is quite easy to describe to clients. (b) Appreciation Transferred to Marital Share.  With this formula, any appreciation (or depreciation) occurring between date of death and the date of funding will be transferred to the marital share.  (c) Appreciation could increase tax on large estates.  Transferring appreciation to the marital share will increase the surviving spouse’s gross estate and may increase estate tax due upon death.  (d) Depreciation could decrease tax on large estates.  Transferring depreciation to the marital share will decrease the surviving spouse’s gross estate and may decrease estate tax due upon death.  (e) For small second estates could be beneficial.  If the surviving spouse doesn’t have an estate large enough to utilize all of the federal estate tax credit available on his or her estate, then use of the pecuniary non-marital formula is beneficial, since capital gains will be eliminated by a stepped-up basis at the time of the survivor’s death.

Pecuniary Marital Formula.  Using the pecuniary marital approach, the sum allocated to the marital share is the smallest amount that must qualify for the marital deduction in order to reduce, to the extent possible, federal estate tax due on the first spouse’s death, with the balance going to the non-marital share.

A few additional points regarding the Pecuniary Marital Formula: (a) Less intuitive.  The marital formula is not as intuitive as the non-marital formula, since the marital formula is circular.  (b) Appreciation Transferred to Non-Marital Share.  Appreciation or depreciation occurring between date of death and date of funding will be transferred to the non-marital share. Transferring this appreciation to the non-marital share removes the appreciation from the surviving spouse’s gross estate and is beneficial to the surviving spouse if his or her estate will exceed his or her applicable exclusion amount.  (c) Most useful where….  A pecuniary share formula is most useful in cases where the assets of the decedent will clearly exceed twice the applicable exclusion amount. In these cases, mandatory funding assures full use of the decedent’s credit without the risk that a disclaimer won’t get filed, or that benefits will be accepted by the beneficiary, thereby foreclosing the option to disclaim.

Fractional Share Formula.  Generally, the fractional share formula requires that the marital share and the non-marital share each have a proportional fractional interest in each asset. Thus, the value of the marital and the non-marital shares both change with appreciation or depreciation between the date of death and date of distribution.  Depending upon values of each spouse’s estate, and depending upon formulas used, this can be either beneficial or detrimental.

A few additional points regarding the Fractional Share Formula:  (a) Avoidance of Capital Gains Tax. One benefit of using a fractional share formula is the avoidance of potential capital gains tax recognition of appreciation occurring between date of death and date of distribution of assets, which can occur with pecuniary formulas. This fact reduces any pressure regarding timing of funding the shares.  (b) Less need to revalue assets.  In addition, revaluing assets at date of distribution would not be required, since a proportion of each asset will be allocated to each share. This, however, results in each share receiving its proportional share of any post-death appreciation.  (c) Fair to all beneficiaries.  With the fractional share formula no beneficiary should feel that another beneficiary received “better” assets since all beneficiaries share equally in all assets.  (d)  Disadvantages. Using fractional funding can create administrative difficulties related to the fractionalization of the assets themselves.

Some of these difficulties are as follows: (1) Everyone owns a piece of everything.  Co-ownership of assets can put fractionalized ownership in hands of individuals who don’t get along with each other.  What’s more, assets may not even be easily divisible.  Real estate or business assets may not lend themselves to being easily divided among beneficiaries.  If this formula is used, it is strongly advisable to include authorization for the trustee to distribute assets between beneficiaries in economically equal proportions, without being required to split ownership of tangible assets. (2) Cannot pick and choose particular assets.  Flexibility is lost in distributing assets to the most appropriate share for maximizing tax benefits.  With pecuniary formulas, the fiduciary has flexibility in picking and choosing assets to fund the marital and credit shelter trusts. Assets that appreciate in value would likely fund the credit shelter trust. Assets that depreciate in value or assets that the spouse desires (residence or investment assets), may be allocated to marital trust. Generally, fractional formulas do not permit pick-and-choose flexibility.  (3) Hard to adjust for income and growth.  It is much more difficult to adapt income and growth as appropriate for various beneficiaries.  (4) Complexity guaranteed. Similar to the potential problems with the pecuniary formula, a fractional share formula will still require funding of separate trust shares, even where values are low enough that estate taxes will not be paid.

David M. Grant