Wills, Estates and Surrogate's Practice

Every attorney who drafts wills and trusts knows how important it is to draft an instrument’s tax apportionment clause carefully, both to avoid imposition of an inadvertent additional tax liability and to avoid a potentially unfair – or at least unintended – allocation of the tax burden among the estate’s beneficiaries. As two recent cases illustrate, a will’s tax apportionment clause can raise both expected and unexpected controversies.

In Matter of Rhodes, 22 Misc. 3d 766 (2008), a case of first impression in the Westchester County Surrogate’s Court but involving a more typical tax apportionment controversy nonetheless, the court found the decedent had clearly intended certain beneficiaries to be exempt from the payment of estate taxes on their bequests in all cases, even, as here, where the residue charged with payment of such taxes was insufficient. The result in Matter of Rhodes was that the beneficiaries who were not “favored” in the tax apportionment clause bore the entire shortfall.

The tax apportionment provision in Estate of Wu, NYLJ, May 4, 2009 at 19, Col. 3 (New York County Surrogate’s Court) charging all estate taxes to the residue was in no way ambiguous; it clearly relieved all beneficiaries, whether of probate or non-probate property, from the burden of payment they would otherwise have under New York’s estate tax apportionment statute, EPTL §2-1.8. In this unusual case the named beneficiary of two insurance policies on the decedent’s life was also one of the two witnesses to the will, and the court found that the apportionment provision was tantamount to a disposition to him, since it relieved him of a liability he would have if the tax apportionment statute applied.

Viewed in that light, the court determined that EPTL §3-3.2(a), which governs situations where a beneficiary under the will is also a witness, required him to forfeit the “beneficial disposition” deriving from the will’s tax apportionment provision. He therefore had to bear his share of the estate taxes attributable to the inclusion of those life insurance proceeds in the decedent’s estate.

‘Matter of Rhodes’

Silas Rhodes died in 2007 leaving a substantial estate to three surviving children, Anthony, David and Steven, and several grandchildren. Under his will and codicils, the decedent gave personal property to his issue under Article Second, specifically devised real property to certain issue under Article Third, and gave cash bequests to certain grandchildren and friends under Articles Third and Fifth. Under Article Fourth he gave certain business interests valued at $12 million (and representing the bulk of the estate) to his sons David and Anthony who had made contributions to the development of those businesses; he acknowledged giving them a disproportionate share of the estate in Article First. The decedent gave his residuary estate to his three sons in equal shares under Article Sixth.

Less than three years prior to his death, the decedent transferred real property to his son Steven and Steven’s wife, Karen, in exchange for their agreement to pay the gift tax due plus any transfer taxes associated with the transfer;¹ decedent also agreed to hold them harmless “from any claim thereof.” The decedent made numerous gifts in addition to the transfer to Steven and Karen during the three-year period prior to his death. Gift taxes in excess of $1.1 million were paid and were included in the decedent’s federal gross estate pursuant to §2035(b) of the Internal Revenue Code.

Article Eighth contained the tax clause, which provided that:

The decedent also expressly stated that he had given “great consideration” to his directions regarding the payment of estate taxes and that he believed the provisions he had made were equitable to all family members.

The residuary estate was not sufficient to pay the estate taxes due with respect to the bequests under Articles Second, Third and Fifth. David and Anthony argued that where the residuary estate is insufficient to pay the estate tax, the rule is that the shortfall must be apportioned among all of the beneficiaries of the estate. Steven and some of the other beneficiaries countered that this would be contrary to the decedent’s intent and asserted the shortfall should be charged solely to David and Anthony, the beneficiaries under Article Fourth.

The court affirmed the general rule that where the residuary estate charged with payment of taxes is insufficient, the shortfall must be apportioned against beneficiaries who would have been exonerated had the residuary estate been sufficient, but noted that the rule applies only where the decedent has not expressed a contrary intent. Thus, a construction of the will was required to determine the decedent’s wishes in this case, and the court found that the language the decedent used demonstrated his intent to exonerate the preferred dispositions under Articles Second, Third and Fifth and to impose the tax burden on interests disposed of under Article Fourth.

The court focused on what it determined was the decedent’s overriding intent that the preferred bequests not be reduced by estate taxes, as well as the fact that the Article Fourth bequests were always intended to bear their share of the taxes, which was understandable given the relative size of those bequests; based on the facts the Article Fourth bequests had to bear their share of taxes to avoid wiping out the residue. The court was clearly influenced by the fact that Anthony and David were much better able to shoulder the burden of additional estate taxes, and that “[h]aving transferred and bequeathed the majority of his estate to Anthony and David, it is clear that decedent did not intend to mock his remaining beneficiaries by further reducing their inheritance through the assessment of estate taxes.”

The court also focused on the “without apportionment or reimbursement from any beneficiary” language of the tax apportionment clause, finding the words “without reimbursement” particularly persuasive; the phrase was found to imply that the decedent foresaw the possibility that the residuary estate might be inadequate to pay the tax associated with the preferred bequests and nonetheless elected to provide that their recipients would not be required to reimburse the estate under those circumstances. While the equities of the case played an important role here, the court did have evidence of an intent to avoid a diminution of the preferred bequests.

The court next focused on whether the donees of the gifts made within three years of the decedent’s death were responsible for paying the estate tax attributable to inclusion of the gift taxes paid on those gifts in the decedent’s gross estate. Prior case law held that EPTL §2-1.8 did not authorize apportionment of estate taxes against the recipients of inter vivos gifts, since these gifts technically do not enter into the calculation of the decedent’s gross estate for estate tax purposes (the basis for the apportionment calculations) and are taken into account in a separate portion of the calculation of estate tax due.

By distinction, gift taxes paid on gifts made within three years of death clearly are comprised in the computation of the federal gross estate, and the court appropriately found that the donees of the decedent’s gifts made within three years of his death were responsible for paying their ratable share of the estate taxes attributable to the inclusion of the gift taxes paid. It left open for determination whether Steven and Karen were responsible for paying any additional gift tax imposed following the Internal Revenue Service audit of the gift tax return that reported the transfer to them. In light of the “hold-harmless” language that was included in the net gift arrangement, it would seem it was the decedent’s intent that they should not be.

Many wills include provisions requiring that estate taxes allocable to or paid in respect of property passing outside of the will are to be apportioned against and paid by the persons who benefit from such property, which is generally preferable to a provision that all taxes be paid from the residue. The latter can have surprising consequences.

What is clear from Matter of Rhodes and any number of other cases involving construction of a tax apportionment clause is that the ramifications of tax apportionment are critical to examine in each case. It may be a relatively simple matter to specify what constitutes “estate taxes” (or death taxes, as they may be defined) and whether these are deemed to include estate taxes on all property disposed of under the will or outside it, as well as on any other items that enter into the calculation of the gross estate, such as gift taxes paid on gifts within three years of death. This would eliminate any construction regarding the testator’s intent in a case where such gift taxes are so included. It is, however, less simple to review the consequences of the tax apportionment clause with the testator, and can become difficult indeed when one has to calculate and describe its effects in a case where gift taxes were paid. Nevertheless, appropriate steps must be taken to ensure that the testator’s wishes will be effectuated.

‘Estate of Wu’

The decedent’s brother was the beneficiary of over $3 million of insurance on the decedent’s life in Estate of Wu. He was also one of the two attesting witnesses. Under EPTL §3-3.2, a beneficial disposition under a will to an attesting witness is void unless there are at least two other attesting witnesses who receive no beneficial disposition. There was no third witness in this case (despite an unsuccessful attempt to characterize the notary as a third witness), and the central question was whether the brother had received a beneficial disposition via the tax apportionment clause.

Surrogate Kristin Booth Glen found he had. The court reasoned that if there was no tax apportionment clause in the will, EPTL § 2-1.8 would require the brother to bear his allocable share of estate taxes; in that event, the brother would not receive the benefit of the full amount of insurance proceeds. The tax apportionment provision thus clearly conferred a benefit on the brother and the tax apportionment clause/beneficial disposition was held ineffective with respect to him. Consequently, the brother was responsible for his proportionate share of the estate taxes. The court noted that the brother had fared better than the typical beneficiary ensnared by EPTL §3-3.2: while a bequest under a will would be forfeited entirely if the beneficiary was one of the two witnesses, here the beneficiary received the life insurance proceeds, albeit subject to estate taxes.

This case highlights the issues involved when charging all estate taxes to the residue, in particular when the non-probate estate may be substantial. It also suggests that the attorney supervising the execution of the will would be well-advised in all cases – and in particular where the will directs that all taxes be paid from the probate estate – to select at least two witnesses who are neither beneficiaries under the will, nor outside it. While this may seem difficult, as the client may have forgotten or not advised the attorney about insurance or other non-probate assets, it generally should not be. In perhaps most cases, the will is executed in the office of the attorney-drafter, and it should be relatively easy to find two disinterested witnesses. When in doubt, choosing witnesses who do not know the testator personally would appear to solve the problem.

Susan Peckett Witkin is a partner in the private client group of Blank Rome. Gregory K. Black, an associate at the firm, assisted in the preparation of this article. Regular columnist Peter C. Valente will return in July.

Endnote:

1. This is a “net gift” arrangement, and the amount of the gift reported by the donor is reduced by the tax liability assumed by the donee if the donee’s payment of the tax is a condition of the transfer of the property. Rev. Rul. 81-223, 1981-2 CB 189.