The “typical” American family of the 21st century involves step-relations in some form or fashion. Innumerable books and articles have been written on the so-called “blended family,” composed of a married couple with different sets of children. From an estate planning point of view, challenges exist in “fairly” dividing an estate in such a situation. These challenges are manageable with proper planning, but disastrous without thoughtful attention to one’s objectives.
At Farner & Perrin, L.L.P., we encourage the married couple to assess, and possibly agree formally, as to the character of their properties. As a community property state, Texas favors the creation of community property in a marriage. In other words, Texas law places the burden on the party asserting separate property character to prove the same. When a couple marries bringing significant separate estates to the marriage, we believe they do their heirs a favor by defining what is to be maintained as separate property, which can be addressed in a pre- or post-nuptial agreement.
When one spouse dies, that person’s demise controls his or her separate estate and one-half of the community estate. It is up to the surviving spouse and the executor of that estate to divide and dispose of the properties accordingly. If the surviving spouse is named as the executor, he or she has a potential conflict of interest, with a fiduciary responsibility to the heirs of the deceased spouse in dividing the properties. If both members of the couple die together, then the separate sets of heirs must address these matters, which could involve compromise or litigation. Farner & Perrin, L.L.P., believes that both pre-nuptial and post-nuptial agreements can avoid unnecessary disagreements in such cases.
Next is the matter of how to bequeath that part of the properties one owns. Many of our clients in second marriages utilize trusts for the benefit of the surviving spouse and the children of the first to die. As current beneficiary, the spouse may be entitled to some or all of the income and may or may not be entitled to use the principal of the trust assets, based on some defined standard. Typically, the children are not entitled to receive distributions until the surviving spouse’s death. If the estate of the first to die exceeds the Federal estate tax exemption, his or her Will may include two spousal trusts in fact. One of those is the “bypass trust,” which captures the estate tax exemption and is more fully discussed in the Trust Planning article you may refer to on our Firm’s website; the other spousal trust is the so-called “qualified terminable interest property” trust (QTIP trust), which generally serves no tax purpose, but allows the first to die to control the ultimate disposition of his or her estate even in excess of the estate tax exemption. The QTIP trust entitles the first estate to a “marital deduction,” meaning its corpus is not subject to estate tax until the second spouse’s death.
Not surprisingly, a trust structure can set the “blended” family up for conflict, especially if the surviving spouse is the sole trustee of the trust, in charge of making the investment and distribution decisions. In some cases, a child of the first to die is appointed to serve as co-trustee with the surviving spouse to jointly administer the trust during such spouse’s lifetime. Alternatively, some families prefer to “split the baby,” by dividing the estate (if large enough) between the spouse and children at the first death. If this is not feasible, then life insurance or some other means of bequeathing the children a substantial amount at their own parent’s death is appealing, since most children dread having to wait for their step-parent to die to receive their inheritance.
Special assets require special planning. For example, a married person is generally precluded by “ERISA” (Federal law) from bequeathing his or her qualified plan such as a 401(k) to anyone other than his or her spouse without the spouse’s explicit written consent. This consent may be granted graciously or can be addressed in a pre-nuptial or post-nuptial agreement, so that the plan-participant spouse may leave such qualified plan in trust. While individual retirement accounts (IRAs) are not subject to this Federal requirement, many IRA-custodian firms include a required spousal consent on their beneficiary designation forms. They do this to avoid being in the middle of possible post-death litigation over marital property characterization, with the surviving spouse arguing for example that some or all of such IRA was community property, one-half of which he or she is entitled to by Texas law. It may be possible for the IRA-participant spouse simply to move the IRA to another custodian to avoid the spousal consent requirements of a particular custodian. In addition to addressing the spousal consent issue, it is critical that special provisions be included in the trust. First, certain provisions are required in order to achieve post-death income tax deferral. Secondly, additional provisions are necessary to achieve the “marital deduction” for Federal estate tax purposes, if the estate is large enough for a QTIP trust to be involved.
Married taxpayers should understand that leaving a qualified plan or IRA outright to a surviving spouse allows more post-death income tax deferral than leaving it in trust for the spouse. However, the challenge is not to have the ‘tax tail wag the dog,’ since leaving it outright may result in the surviving spouse disinheriting the children of the first spouse to die ultimately. That is not to say that the surviving spouse would do so out of maliciousness, but the realities of step-relationships are that they may well wane after the death of the natural parent. This may well be a case to “split the baby,” leaving the IRA to one’s spouse and other assets directly to one’s children. We can craft other creative solutions, depending on your personal circumstances.
Finally, some couples express a joint objective to “treat each set of children equally” at the second death, but we caution our clients to be realistic in this regard. Take the example of A & B, each of whom has two children 1A and2A, and 1B and 2B. A dies first with a Will leaving all of A’s estate to B in trust and the remainder at B’s death equally to the four children. Many years transpire after A’s death, and for reasons sufficient to B, B changes B’s Will to bequeath all of B’s estate to 1B and 2B. This result is far from equitable, and A would have done well to have anticipated this in A’s planning. That does not mean A should have left A’s estate directly to 1A and 2A (though possibly so, depending on circumstances), but A’s trust could have included a “renege” provision such that if B changes B’s ultimate disposition, then all ofA’s trust goes to 1A and 2A. This is not a perfect solution, but may well be the best alternative, depending on the level of wealth involved. Additional protections could be drafted into A’s trust, such as making 1A the trustee, or co-trustee, with B.
Suffice it to say that estate planning for the blended family takes time and effort, as well as an openness to communication. Most well-considered books* and articles analyzing blended families agree that there is no magic pill. Success is a process, and plans and relationships evolve with time if they are to be blended.
*Recommended reading: Estate Planning for Blended Families, Providing for Your Spouse and Children in a Second Marriage, Richard E. Barnes (2009).