The Marital Deduction

A trust officer for upwards of twenty rears, LYNN LLOYD has been surprised to discorer how few people of wealth or moderate means have taken the trouble to revise their wills or to reconsider the gifts for their children in the course of the past year when the marital deduction has made such an immense difference to the sizable estate. Mr. Lloyd is a resident of Chicago and the Vice-President of the Harris Trust and Savings Bank.

by LYNN LLOYD

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THE Federal statutes, rather sober documents, have recently had in them something approaching sex appeal. The Revenue Act of 1948, enacted over the President’s veto by the much maligned Eightieth Congress, devotes over 70 per cent of its ponderous phraseology to enumerating new privileges and relationships between husband and wife. Strangely enough, the inducements there set out for a husband to do nice things for his wife by way of gifts, either during his lifetime or at his death, not only are inexpensive, but may save rather than cost money.

A well-to-do married man, worth $250,000, can now give his wife up to half of his estate — in this case $125,000 — and the net savings in taxes on both estates may increase his children’s inheritance by $20,000. In addition, the gift by increasing his wife’s estate would add to her income $1000 or more a year for as many years as she may survive him. This legalized privilege is called the “marital deduction,” a wholly new concept in the Federal tax laws.

In addition to reducing the aggregate taxes of individuals about $4,800,000,000, a fundamental purpose of the Revenue Act of 1948 was to equalize the burden of Federal income, gift, and estate taxes between residents of the eleven communityproperty states, whose substantive laws were of Spanish or French origin, and the residents of the thirty-seven remaining common-law states, whose laws derived from the common law of England. The disparity in income-tax payments was considerable. For instance, a married man living in a community-property state, such as Texas, whose net taxable income was $20,000 and whose wife had no separate income, could in effect divide his income with his wife on his tax return and, as a result of the lower surtax rate, would pay $4606 in Federal income tax. But a married man living across the state line in Arkansas (a common-law state) would have to pay a Federal tax of $6868 on the same amount of income.

To adjust this inequity, the Revenue Act now gives husbands and wives living in common-law states the privilege of “splitting’ their income, so that the amount of their income tax will be the same as if they lived in a community-property state. It should be noted that this does not change the ownership or control of property or its income, but is merely a fictional division for tax purposes.

In order to get the necessary votes to pass this law in both houses of Congress over the anticipated Presidential veto, it is reported that some inducement had to be given to certain Representatives and Senators from the community-property states. This was done by repealing the estate-tax provisions of the former law, which laxed the full value of all community property at the death of whichever spouse was the first to die, and by including in the new estate-tax law the provision for a “marital deduction” of up to 50 per cent of the estate. Thus the Federal estate tax on estates of married persons in all states is now substantially equalized, provided that this allowable marital deduction is in fact exercised.

Not only are Federal income and estate taxes affected by this new law, but gift taxes are also made subject to the principle of splitting between husband and wife. The gift tax is levied on gifts of property which you irrevocably bestow during your lifetime. As in the case of other Federal taxes, certain exemptions are allowed and the tax applies upon the excess.

The former Federal gift-tax law permitted two exemptions before gifts to individuals were subject to the tax. You were permitted to give a total of $30,000 during the course of your lifetime to any individual or group of individuals without incurring a tax. In addition, annual gifts up to $3000 to any one donee were not subject to tax.

Under the new law the specific or lifetime exemption of $30,000 is continued in the same amount, but one half of the property transferred from husband to wife, or vice versa, is regarded as already belonging to the donee spouse; hence, gifts of $6000 or less in any year from a married person to his spouse need not be reported and are not subject to tax under the new statute.

However, if each spouse already has a substantial amount of separately owned assets, further gifts between them may offer no economies which cannot be realized more simply by splitting income currently and by arranging to use the marital deduction at death.

The important application of the marital deduction in connection with gifts is in cases where a married person, with the consent of his spouse, makes a gift to a third person or persons, such as children. Since most parents expect eventually to bequeath most of their property to their children, many of them are willing to give them moderate amounts immediately. They may give $6000 a year to each child without tax, and thus relieve this much of their assets from the impact of the Federal estate tax which would otherwise apply at death. A gift of $6000 to a child, made by a father who has $1,000,000 taxable estate, if the mother consents to the gift, would mean a reduction of $1884 in Federal estate taxes at the father’s death. If the donor’s estate is only $200,000, such a gift would nevertheless save $1704 of estate taxes.

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THE Revenue Act of 1948 reduces individual income taxes for the first time since 1928, except for a minor reduction by the 1945 Act; it reduces gift taxes for the first time since the gift tax was enacted — on June 6, 1932; and it reduces Federal estate taxes for the first time since February 6, 1926. The reduction in income taxes applies both to rates and exemptions for individual taxpayers, including married persons, and gives the latter the privilege of splitting. The reduction in gift and estate taxes applies to married couples only, and involves no change in rates.

Since his inauguration in January of this year, the President has asked Congress for increases in income, estate, and gift taxes for individuals, for higher taxes on corporations, and for higher Social Security taxes, in the aggregate amount of about $6,000,000,000 per year. As yet he has not suggested that the principle of the marital deduction be removed. Many students of taxation believe that income splitting and marital deduction are now permanently in the law, and that only changes in rates will occur hereafter.

Taxpayers were practically forced to take advantage of the new income-tax reductions when they filed their final returns for the year 1948. The instructions which accompanied their returns were so explicit that the saving could scarcely be avoided. There is unfortunately no comparable means of forcing married persons to take advantage of the permitted reduction or deferment of Federal estate tax through the marital deduction.

While the canons of the legal profession may discourage lawyers from publicizing such matters sufficiently to get their clients to act, the banks and trust companies of the country are constantly drawing public attention to the importance of reviewing wills, trusts, and life insurance, and to the tax effects (often adverse) of joint ownership of real estate, securities, and bank accounts. The marital deduction can be of benefit only if used, and it can only be used intelligently and to the best advantage after you have thoroughly analyzed your assets, your will, your life insurance, and your entire estate plans — and the same for your spouse.

When you contemplate using the marital deduction, here are some of the most important considerations to have in mind: —

Where one spouse owns all or most of the assets, use of the marital deduction by that spouse will probably be of considerable advantage; but where assets are owned by both spouses, and have considerable disparity in value, use of the marital deduction by the spouse owning the smaller estate may result in little or no benefit.

In some states the Federal estate-tax reduction resulting from use of the marital deduction may be partly offset by an increase in state inheritance tax; therefore, the effect on the combined Federal and state death taxes should be considered in measuring the net result.

The portion of the estate relieved from Federal estate tax by use of the marital deduction by one spouse will be taxed at the death of the surviving spouse; thus the aggregate taxes on both estates might be unduly increased, instead of reduced, by the marital deduction. In such cases, non-use or only partial use (less than 50 per cent) may be advisable.

Annual income of the surviving spouse will be increased because of the tax saved (or deferred) by the marital deduction in the estate of the first spouse to die. Moreover, the surviving spouse will have the protection of a greater amount of principal, as well as greater income. Depending upon the size of the decedent’s estate and the probable period of survivorship, this factor may be more important than the possible decrease, or even increase, in the aggregate taxes on both estates.

A “marital-deduction trust” created by will for your wife, in preference to a direct bequest to her at your death, is permitted by the law, provided she gets all the income and the right to will the principal at her death. This trust is widely recommended by lawyers because it offers the important benefits of: eliminating probate expense and possibly state inheritance tax at the death of the surviving spouse; reducing income tax on future capital gains; and retaining the property in trust and protecting the widow and children through management by an experienced trustee.

The maximum lax saving will be accomplished only when the marital-deduction property is relieved from Federal tax in the estate of both spouses -the second as well as the first to die. Careful planning can often accomplish this result through:

1. Creating for one’s wife, by will, a maritaldeduction trust (including 50 per cent of the net estate) from which fixed monthly payments of predetermined amount will be paid to her as an annuity from both income and principal, thus gradually consuming the principal of this fund. The principal so received and consumed will not be taxed to her as income when received, nor will it be subject to Federal estate tax at her later death. Compensating provisions can be made for the children (and also for the wife’s protection) through a residuary trust including the remaining half of the estate, in which income could be accumulated. This plan can substantially increase both the wife’s spendable income and the amount of principal eventually going to children.

2. Creating a marital-deduction trust for one’s wife by will (including 50 per cent of the net estate) and giving her both the necessary right to will the principal of this fund at her death and the additional right to dispose of it in whole or in part during her life by outright gift or by restricted power of appointment. The outright-gift method could save the second death tax, but might incur a gift tax. The method of restricted power of appointment would permit her to transfer it by deed to any of a limited class of persons (descendants or their spouses) and could save the second death tax without incurring a gift tax.

Since 1946, the taxpayer has come out second-best to the government in every tax decision but one handed down by the United States Supreme Court. Against these odds and with further burdensome tax increases threatened, it should be obvious, to those who have acquired a taxable amount of properly, that they ought promptly to take intelligent advantage of the privilege still allowed by law to plan carefully for its future distribution.