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Abstract: If one expects his or her estate to have a significant estate tax liability at death, he or she should pay attention to the tax apportionment clause in a will or revocable trust. An apportionment clause specifies how the estate tax burden will be allocated among beneficiaries. Omission of this clause, or failure to word it carefully, may result in unintended consequences. This article explains how an apportionment clause works and the pitfalls if it’s omitted.

Don’t overlook tax apportionment when planning your estate

If you expect your estate to have a significant estate tax liability at your death, pay attention to the tax apportionment clause in your will or revocable trust. An apportionment clause specifies how the estate tax burden will be allocated among your beneficiaries. Omission of this clause, or failure to word it carefully, may result in unintended consequences.

Apportionment options

There are many ways to apportion estate taxes. One option is to have all of the taxes paid out of assets passing through your will. Beneficiaries receiving assets outside your will — such as IRAs, retirement plans or life insurance proceeds — won’t bear any of the tax burden. Another option is to allocate taxes among all beneficiaries, including those who receive assets outside your will. Yet another is to provide for the tax to be paid from your residuary estate — that is, the portion of your estate that remains after all specific gifts or requests have been made and all expenses and liabilities have been paid.

There’s no one right way to apportion estate taxes. But it’s important to understand how an apportionment clause operates to ensure that your wealth is distributed in the manner you intend. Suppose, for example, that your will leaves real estate valued at $5 million to your son, with your residuary estate — consisting of $5 million in stock and other liquid assets — passing to your daughter. Your intent is to treat your children equally, but your will’s apportionment clause provides for estate taxes to be paid out of the residuary estate. Thus, the entire estate tax burden — including taxes attributable to the real estate — will be borne by your daughter.

One way to avoid this result is to apportion the taxes to both your son and your daughter. But that approach could cause problems for your son, who may lack the funds to pay the tax without selling the property. To avoid this situation while treating your children equally, you might apportion the taxes to your residuary estate but provide life insurance to cover your daughter’s tax liability.

Omission of apportionment clause

What if your will doesn’t have an apportionment clause? In that case, apportionment will be governed by applicable state law (although federal law covers certain situations). Most states have some form of an “equitable apportionment” scheme. Essentially, this approach requires each beneficiary to pay the estate tax generated by the assets he or she receives. Some states provide for equitable apportionment among all beneficiaries while others limit apportionment to assets that pass through the will or to the residuary estate.

Often, state apportionment laws produce satisfactory results, but in some cases they may be inconsistent with your wishes.

Consider this example:

Laura’s will provides for her $5 million residuary estate, which is subject to estate tax, to be divided equally between her daughter, Sara, and a charity. It doesn’t contain an apportionment clause. Laura’s estate takes a charitable deduction for the half that goes to charity, so the estate tax liability is 40% of $2.5 million, or $1 million. Under the state’s equitable apportionment statute, the entire amount is allocated to Sara, whose inheritance generated the tax liability. If Laura wants Sara to share the benefit of the charitable deduction, she should include an apportionment clause in her will that allocates a portion of the tax liability to the charity.

Avoid surprises

If you ignore tax apportionment when planning your estate, your wealth may not be distributed in the manner you intend. To avoid unpleasant surprises for your beneficiaries, be sure to include an apportionment clause that clearly spells out who will bear the burden of estate taxes.