Is There a Fatal Flaw Lurking in Your Estate Plan?

Congress' failure to resolve the federal estate tax issue this year is more than just inconvenient for taxpayers and estate planning clients. It has transformed a once-common estate planning technique into a fatal flaw for many married couples.

This flaw could result in your unintentionally disinheriting your spouse, depriving your spouse income you envisioned he/she would live on after you're gone!

Let's examine how this fatal flaw might play out. Take the case of Gordon, age 71, and his wife Bernice, 70. This is a first marriage for both. Gordon and Bernice established their estate plan in 1996, when the estate tax exclusion was $600,000. To protect one another and leave the maximum amount of tax-free money to their children, Gordon and Bernice have separate trusts funded with different assets. Gordon's trust contains $2 million in stocks and cash; Bernice's trust contains their Florida condo and a second home, together worth about $900,00. Their estate plans say that when the first spouse dies, the "maximum amount of money that can be passed tax free" goes into a credit shelter trust, with the remainder going outright to the survivor. The survivor can derive income from the credit shelter, but cannot touch the principal. When the survivor dies, the principal from the credit shelter goes to the children.

This was common estate planning language at that time. And in 1996, it made sense. If Gordon had died in 1996, $600,000 (the maximum estate tax exclusion) would flow into the credit shelter trust. Bernice would be left with the rest of the funds in Gordon's trust, $1.4M, enough for her to live on for the remainder of her life.

But in 2010? Well, now it's a very different story. By 2010 standards, Gordon's plan is fatally flawed.

If Gordon dies today -- when there is no federal estate tax and no maximum on what can be passed tax free -- all his assets flow into the credit shelter. Bernice inherits nothing. Even if Gordon's trust specificies that she can derive income from the credit shelter, today's lower interest rates probably don't provide sufficient income to maintain her lifestyle. Bernice ends up with little to live on and she may be compelled to sell one or more of the homes to survive economically. She has been effectively disinherited.

And Bernice's plight would probably be even worse if this was Gordon's second marriage and he had children from a prior marriage. As is typical for these situations, Gordon's estate plan likely would have required the credit shelter to pass outright to his children, providing Bernice no income.

If you're a married couple whose estate plan was drafted many years ago, you owe it to yourselves to have your plans reviewed. Don't let Bernice's story become your story. The unfortunate fact is that most people don't fully understand the provisions of their trusts. I am often asked to review trust instruments drafted by other attorneys many years ago, and clients are often shocked when I explain how their lives will actually be impacted when one or the other passes away.