Our Experts Explain the Estate Tax Marital Deduction, Section 2056

An unlimited deduction is allowed for property includable in the gross estate that passes in a qualifying manner to the surviving spouse of the decedent. The surviving spouse must be a U.S. citizen or the property must pass to a Qualified Domestic Trust (QDOT) for the benefit of the surviving spouse. No deduction is allowed, however, for certain nondeductible terminable interests, in general, interests which may terminate or fail to vest upon the lapse of time or upon the occurrence or nonoccurrence of a specified event or contingency. A spouse’s interest in life insurance proceeds is terminable and would be nondeductible if:

  1. there is any possibility that her interest will terminate upon the occurrence or nonoccurrence of a contingency or event;
  2. some other person or persons will receive the property as a result of the termination; and
  3. that other person or persons will receive the property interest without paying consideration in money or money’s worth.

If all three tests are met, the interest will not qualify for the marital deduction.

Form of Payment

Generally, proceeds will qualify for the federal estate tax marital deduction if they are paid in the form of a:

  • lump sum;
  • life annuity ending at spouse’s death;
  • life annuity with principal remaining paid to spouse’s estate;
  • payment to spouse (interest only or installments) and principal remaining paid to specified beneficiary coupled with surviving spouse given general power of appointment over principal;
  • payment to spouse of interest only, with remaining principal qualifying under QTIP rules; and
  • outright payment under insured’s will;
  • outright payment under state intestacy laws;
  • payment of proceeds to trust which itself qualifies for marital deduction.

Lump Sum or Life Annuity to Spouse

Life insurance will qualify for the federal estate tax marital deduction if payable in a lump sum to the decedent-insured’s surviving (U.S. citizen) spouse. Since the spouse will receive the entire interest in the proceeds rather than a nondeductible terminable interest, the marital deduction will be allowed even if the insured names secondary or other contingent beneficiaries in the event the noninsured spouse does not survive the insured. The marital deduction will also be allowed if the surviving spouse chooses to receive proceeds under a settlement option (life annuity) rather than take a lump sum, as long as the choice is hers.

Life Annuity to Spouse, Balance to Spouse’s Estate

A marital deduction will be allowed if the insured or the surviving spouse selects a settlement option with the insurer giving the surviving spouse income from the proceeds for her life with the balance of the proceeds going to her estate. This follows the principle that a nondeductible terminable interest is one in which someone other than the surviving spouse might take her interest with no consideration upon the occurrence or nonoccurrence of a specified event. Since no one other than the spouse will take an interest (payment to the spouse’s estate is equated to payment to the spouse), the interest is not a nondeductible interest. Therefore, a life annuity to the spouse with no refund or no period certain guarantee would qualify for the marital deduction. Likewise, a life annuity to the spouse coupled with a period certain guarantee (for example, a guarantee that at least fifteen years’ payments will be made) with the balance of any payments going to the spouse’s estate will qualify.

Income to Spouse, Power of Appointment

As another exception to the nondeductible terminable interests rule, the interest can be payable to the spouse and then to some other beneficiary and still qualify, if the surviving spouse is given a general power of appointment over the proceeds and certain other requirements are met.

There are five conditions that must be met:

  1. All income to spouse rule: There must be an agreement with the insurer that the proceeds (or a specified portion of the proceeds) will be paid in installments to the surviving spouse, or that the surviving spouse will receive all the income and no one else will receive installment or interest for as long as such spouse lives.
  2. Annually or more frequently rule: The installments or interest payable solely to the surviving spouse must be payable annually or more frequently. Payments must begin no later than thirteen months after the insured’s death. As long as payment can begin within thirteen months after the decedent’s death, and the only person with any choice in that decision is the surviving spouse, the thirteen month test is met even if, in fact, no payment is elected for more than thirteen months. This condition is satisfied even if the insurance contract requires the surviving spouse to provide proof of death before the first payment is made.
  3. Power to appoint rule: The surviving spouse must have the general power to appoint all or a specific portion of the amounts held by the insurer to either herself, her estate, her creditors, or the creditors of her estate. The power will be considered general if the surviving spouse can revoke the contingent beneficiaries the insured had named and substitute her estate. Likewise, if she can require the trustee to pay her principal for her own use, she will be deemed to have a general power.
  4. Alone and in all events rule: The power to make appointments of principal must be exercisable by the surviving spouse without the need to consult or obtain anyone else’s consent. This requirement will not fail merely because the insurer places administrative restrictions on withdrawal rights. For example, the requirement that the beneficiary give formal written notice, or that some reasonable time interval must be allowed between partial exercises of the surviving spouse’s powers, will not be considered to thwart the spouse’s right to withdraw in all events. The power can be exercised either by will or by an instrument during the spouse’s lifetime, but must be an unconditional right exercisable without limitations.
  5. No power except to provide for spouse rule: The amounts payable under the arrangement with the insurer cannot be subject to a power of appointment in anyone’s hands other than the surviving spouse, except for a power in the hands of another to appoint some or all of the insurance proceeds to the surviving spouse.

QTIP Rules

Another exception to the nondeductible terminable interests rule is Qualified Terminable Interest Property (QTIP). Under this exception, income only payments to the spouse with payments to a beneficiary following the termination of her interest can qualify for a marital deduction even if the surviving spouse is given no general power of appointment.

QTIP rules require that the proceeds pass from the decedent, that the surviving spouse be given a qualifying income interest for life, and that the original decedent’s executor make an irrevocable election on the federal estate tax return to have the marital deduction apply. Any principal left at the time the surviving spouse dies will be includable in her estate.

Payment under Insured’s Will or Intestacy Laws

In some instances, life insurance is payable to an insured’s estate. Most often, this occurs where the insured has neglected to name a specific beneficiary or contingent beneficiary or where the beneficiary named has predeceased the insured and the insured died before naming a new beneficiary. But even such payments can qualify for the marital deduction if assets in the estate pass outright by will to the surviving (U.S. citizen) spouse. Likewise, if the insured’s life insurance is payable to his estate and he dies intestate, the proceeds will qualify for the federal estate tax marital deduction even though passing under state inheritance tax laws to the surviving spouse rather than by will or through specific direction in the policy itself.

Payment to Estate Trust or Marital Deduction Trust

Payment of life insurance proceeds directly to a trust which otherwise qualifies for a marital deduction will qualify the proceeds for the marital deduction. Therefore, payments to an estate trust (income may be paid out to the spouse or may be accumulated at the trustee’s discretion, but principal remaining at the surviving spouse’s death is payable to her estate) or power of appointment trust (the surviving spouse receives all income annually or more frequently and has the general power to appoint principal to herself or her estate) will qualify for a marital deduction.

Time Delay Clause

To qualify for the marital deduction, property must pass to a surviving spouse. If the beneficiary spouse does not survive the insured, the marital deduction is not allowed. In some situations, the beneficiary spouse may survive the insured spouse and yet the proceeds will not pass to the surviving spouse and so the marital deduction is lost. Planners must therefore make sure when using a time delay clause or common disaster provision that—if the marital deduction is important—its requirements are met.

A time delay clause is a provision that can be inserted in an insurance company’s beneficiary form which provides that payment will be made to the surviving spouse of the insured, but only if such spouse is living at the end of a given period of time, typically thirty or sixty days after the death of the insured. If the surviving spouse does not survive the time delay clause period, the proceeds are paid to contingent beneficiaries. Such a clause is designed to assure that the proceeds don’t fall into the hands of a surviving spouse’s relatives or to avoid a needless probate in the surviving spouse’s estate (and perhaps needless state death taxes) if she doesn’t survive the specified period of time.

The problem with a time delay clause is that probate costs and state inheritance taxes may be saved at the expense of much higher federal estate taxes; the marital deduction is denied if the surviving spouse dies before the end of the specified time period, since the proceeds will not pass to her. For instance, if a client provides in his life insurance beneficiary designation that his wife must survive him by thirty days in order to receive the proceeds of his $1,000,000 policy and she dies eighteen days after he does, the money will not be paid to her or to her estate and will pass to the secondary beneficiary. The marital deduction will be lost.

Will a marital deduction be allowed even if the surviving spouse does survive the time delay period? The problem is that a time delay clause creates a condition which may terminate the surviving spouse’s interest and result in property passing to someone other than the surviving spouse’s estate and no consideration would be paid to her or her estate for the transfer. In other words, a time delay clause is a classic nondeductible terminable interest.

Fortunately, however, there is a specific statutory provision that enables the marital deduction to be obtained even if a time delay clause is used. There are two requirements:

  1. The delay period cannot exceed six months.
  2. The spouse must actually survive whatever period is specified.

If both requirements are met, the marital deduction will be allowed. On the other hand, if under the clause there is any possibility that the surviving spouse may have to survive longer than six months to receive the proceeds, no matter how remote that possibility is, the marital deduction will be disallowed. The deduction will be disallowed even if the spouse does survive the specified period and the proceeds in fact pass to her.

A good example of such a fatal clause is one that paid the proceeds to the insured’s wife “if she were living at the time the insurer received proof of the decedent’s death.” Proof of death was provided to the insurer within six months and payment of the proceeds was made to the widow. However, the IRS ruled that the marital deduction would not be allowed because proof of death might not have been made within the requisite six-month period.

A time delay clause must be carefully considered because it can result in a lose-lose situation: if the spouse lives longer than the minimum time, the clause is inoperative. If the spouse outlives the insured but does not survive the specified period, the marital deduction is forfeited. Selection by the insured of a settlement option that qualifies for the marital deduction or payment of proceeds to a trust qualifying for the marital deduction may be a better choice.

Common Disaster Clause

A common disaster clause provides a presumption as to the order of death. If both the insured and the beneficiary die in the same accident, the insured will be deemed to have survived the beneficiary. In other words, a common disaster clause is triggered, not by an arbitrarily specified length of time the survivor must live, but rather by whether or not the beneficiary died in a common accident with the insured. No matter by how long the beneficiary survives the insured, if the beneficiary subsequently dies as the result of the accident which killed the insured, the proceeds will pass to the contingent beneficiary (or the insured’s estate) and will therefore not qualify for the marital deduction.

A common disaster clause therefore would appear to cause a loss of the marital deduction; there is always a possibility that the surviving spouse’s interest may terminate. The marital deduction will be lost if at the final audit of the estate tax return “there is still a possibility that the surviving spouse may be deprived of the property interest by operation of the common disaster provision as given effect by the local law.”

But under a special exception to the normal rules disqualifying terminable interests, the deduction will be allowed if in fact the noninsured spouse does survive and receives the proceeds. Planners should not count on this occurrence if the federal estate tax marital deduction is important.

Uniform Simultaneous Death Act (USDA)

Almost all the states have adopted the USDA. This law provides that if the insured and the beneficiary die at so nearly the same time that the order of their deaths cannot be ascertained, there is a legal presumption that the beneficiary died first. This, of course, would cause the loss of the marital deduction with respect to the proceeds. Note that the cause of death is irrelevant. In fact, the insured and the beneficiary can be at the opposite ends of the earth; if they die about the same time and the facts don’t clearly indicate who died first, the presumption is that the beneficiary died first and therefore no marital deduction would be allowed.

In smaller estates, where federal estate taxes are not a major issue, this presumption would be favorable, since it would eliminate an unnecessary probate (and perhaps state taxation) of the proceeds in the beneficiary’s estate. In a larger estate, the USDA could be a disaster.

Fortunately, a client can reverse the presumption of order of deaths merely by stating that desire in the insurance policy application or in a separate beneficiary agreement. This so called reverse simultaneous death clause nullifies the effects of a statutory presumption that the noninsured died first. Specifically, a reverse simultaneous death clause would state that if it cannot be determined who died first, the beneficiary will be deemed to have survived. Such a clause will be recognized by the IRS. Of course, if the facts show that the beneficiary did die first, a reverse simultaneous death clause will be worthless and the marital deduction will be lost.

Reproduced with permission.  Copyright The National Underwriter Co. Division of ALM

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