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When a Former Spouse is Responsible for Estate Tax of Ex

Posted on: July 9th, 2015
estate taxA particular oversight in estate planning can cause several problems when distributing the estate. The problems include passing assets to an ex-spouse, failing to provide for a current spouse or loved ones, and related tax consequences. The oversight that causes these errors is the failure to update beneficiary designations.

Beneficiary designations on retirement accounts, life insurance policies, and other assets allow the respective assets to pass directly to the named individual(s) upon the account owner’s death. Fortunately, up-to-date beneficiary designations allow the transfers to occur immediately without the delay of probate. Unfortunately, when the account owner fails to keep designations current, there is a risk that an ex-spouse might receive the assets or that children born since the documents were last updated will not be provided for, among other issues. No matter how often an individual updates their will or how clearly they outline their wishes—beneficiary designation forms are followed by law, even if they are outdated.

A few other risks are associated with simply naming an individual on a beneficiary designation form. Since the assets pass directly to the individual, they could be subject to creditor or divorce claims, judgments, and subject to certain taxes. 

For retirement accounts, account owners can mitigate these risks by establishing a Standalone Retirement Trust. The owner can name the individuals as beneficiaries of the trust, and name the trust as beneficiary of the retirement account(s). Upon the account owner’s death, the assets pass directly in trust, shielded from creditors, free from tax (until distributed), and have the potential for futher tax-deferred growth. For life insurance policies, an ILIT (Irrevocable Life Insurance Trust) can provide similar protections. 

Recent case Smoot v. Smoot involved an estate without these asset protection tools where an ex-spouse was named as beneficiary. Life insurance proceeds are included when calculating the decedent’s taxable estate, unless they pass directly to an ILIT. In Smoot v. Smoot, Dianne Smoot (the ex-wife of Thomas Smoot II) received proceeds from several life insurance policies. She did not pay estate tax on the proceeds, which prompted her ex-husband’s son (the executor) to sue her for the tax portion that resulted from her life insurance payout. The court ruled that an ex-spouse is legally obligated to pay the portion of tax related to insurance benefits, as per Internal Revenue Code Section 2206. The code provides:

Unless the decedent directs otherwise in his will, if any part of the gross estate on which tax has been paid consists of proceeds of policies of insurance on the life of the decedent receivable by a beneficiary other than the executor, the executor shall be entitled to recover from such beneficiary such portion of the total tax paid as the proceeds of such policies bear to the taxable estate.

The decedent had not instructed otherwise in his will. Providing for his ex-spouse was intentional, according to Wealth Management, which expressed that he had confirmed his ex-wife as the beneficiary two months prior to his death.

Special planning might be required depending on the tax laws in the state where a testator resides, as well as the laws in the jurisdictions where assets are held. For example, New York imposes a tax on out-of-state trusts. Failing to address issues like this could result in a lengthy and expensive legal burden on surviving family members. Learn more about legislation changes that affect estate planning in the states our attorneys serve: New York, Florida, North Carolina and Tennesee.

By Attorney Samantha Reichle
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