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Beware of Formula Clauses and Estate Tax Uncertainty

Uncertainty with estate tax can cause many problems when it comes to drafting estate planning documents.

These issues might not always be directly tax-related, though. Take the estate of Eileen Tweten, writes Reuters. The estate tax lapse of 2010 caused her estate plan to go to court, due to something called a "formula clause."

The Twetens gained their fortune through Magnolia Audio Video. If you’ve ever been to Best Buy, you’ve seen Magnolia’s products, because the Twetens sold their chain to Best Buy in 2000.

In their trusts, their estate planning attorneys used a formula clause. These are fairly typical in many revocable living trusts. These clauses divide the estate and then apportion it among various sub-trusts, in such a way as to avoid estate tax, generation-skipping transfer tax and make maximum use of the marital tax deduction.

In simpler terms, upon the death of the first spouse, the revocable trust divides into two or more sub-trusts. These sub-trusts become irrevocable. The amounts given to each sub-trust is based on a formula. The amount subject to the estate tax exclusion is allotted to the childrens’ trust and the remaining amount, subject to the marital tax deduction is subject to one of the surviving spouse’s trusts (usually the marital trust).

These amounts aren’t described in the estate planning documents by any dollar value. Rather, they are described in terms of a formula, i.e. “in the amount of the estate tax exclusion for the year of trustor’s death.”

The problem for many, which is the problem that came up in Eileen Tweten’s estate, was that in 2010, there was no estate tax exclusion amount because there was no estate tax, due to a legislative oversight on the part of Congress.

So, her kids got everything and her husband was cut out of his late wife’s community property share of the estate, despite the fact that she tried to make some last minute changes on her death bed.

The California judge sided with the husband, despite the fact that the last minute amendments were deemed not valid. The judge focused on the intent of the parties when drafting the original trust.

Nevertheless, with the possibility of the estate tax exclusion dropping to $1 million in a few months, these types of problems could become a lot more commonplace.

If you’re planning your estate, think twice about how to draft any formula clauses.

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