If you've ever stretched something flexible, like a rubber band, beyond its intended maximum stretching point, you know what happens; it breaks if stretched so far that it becomes misshapen. Often the snap of the breaking rubber band can surprise us and hurt. Many estate planning techniques are like that. Flexibility is good; it serves a purpose. But when events change too dramatically, that flexibility can yield unintended results. So we encourage frequent revisiting of the plan to make sure the flexible tools we incorporate into a plan don't get stretched beyond what was intended.

In the traditional estate plan, a formula clause is employed to calculate an amount that will pass into a “credit shelter trust.” What goes into the credit shelter trust is property equal to the amount that can pass estate tax free at the first spouse's passing. The credit shelter trust can be for the benefit of a surviving spouse, with the assets of the trust avoiding estate tax on the death of that spouse. However, sometimes clients with children by prior marriages determine that this “tax- free” amount should pass directly to children, or to trusts for their benefit, when the first spouse passes. When the estate tax exemption amount ranged from $600,000 to $2,000,000 or even $3,500,000, this method of determining the gift to children may have achieved the result desired. Yet when the exemption amount was raised to $5,000,000 this year, would that be best?

Also the expected return on investments for the surviving spouse might have been higher years ago than it is now. What effect would that have on the outcome from the funding formula in the will or trust?

Consider the case of a husband and wife who both have children from previous marriages. Their community property assets are $5,000,000 with an additional $4,000,000 in life insurance–$2,000,000 on each person. To avoid the children from the first spouse having to wait until their step-parent passes away to receive any inheritance, each of the spouses left their respective “estate tax free amount” to their own children, with the excess going to the surviving spouse. If the plan was executed in 2007, when the exemption was $2,000,000, the result would be the children receiving $2,000,000 and the remainder passing to the surviving spouse. Consequently, the surviving spouse ends up with $7,000,000 in assets and the children with $2,000,000. However, in 2011, when the estate tax exemption is $5,000,000, the formula causes this “tax free” amount to go to the children, with the surviving spouse receiving $4,000,000.

In addition, current investment returns on the assets left to the surviving spouse are the lowest they have been in decades. The spouse may have received the house or other non-income producing assets as a part of his or her inheritance. As a result, not only is the surviving spouse receiving less of an overall inheritance, but his or her ability to earn income with the inherited assets is impaired as well.

The question is whether this is an unintended consequence from a flexible formula clause that is stretched so far that it is now broken. Call us if we need to help determine if your documents accomplish what you desire.