Wisconsin: An Estate Planning Paradise

By Andrew J. Willms and Dean T. Stange

Wisconsin is well known for its great vacation opportunities. It also can be an estate planning paradise for Wisconsin citizens who benefit from a variety of advantageous laws. This article describes various aspects of Wisconsin law that attorneys should consider and emphasize to their estate planning clients who are contemplating a change of domicile.

Wisconsin has no state inheritance tax

Most clients are surprised that Wisconsin no longer has an inheritance tax. As of Jan. 1, 1992, Wisconsin replaced its inheritance tax with an estate "pick up" tax that is limited to the credit allowed for state death taxes under the federal estate tax system. ¹ If a federal estate tax is imposed on the estate of a deceased Wisconsinite, the state receives the amount of the credit for state death taxes and the IRS receives the remainder. If there is no federal estate tax to pay, then there also is no Wisconsin estate tax. Thus, Wisconsin's estate tax results in no additional taxes.

Wisconsin does not recognize the common law rule against perpetuities

The rule against perpetuities is an English law principle that has been carried over to the United States. It requires a person's interest in property to vest (or become absolute) within a certain period, typically within a life or lives in being plus 21 years. When the rule applies, restrictions placed on the transfer of property beyond that period will be invalid.

The rule against perpetuities can be an obstacle in estate planning in connection with trusts that are intended to continue for many generations. These trusts (sometimes called "Dynasty Trusts") will not be effective in states that still follow the old English law rule. Wisconsin is one of only a few states that does not recognize the rule against perpetuities in its common law form. Instead, Wisconsin statutes provide for a rule against suspending a power of alienation that voids a future interest or trust if it suspends the power of alienation for longer than the "permissible period," which is set by statute as a life or lives in being plus 30 years.² The statute also provides that a violation of the rule is avoided for trusts if the trustee has the power to sell trust assets, or there is an unlimited power to terminate the trust in one or more persons in being. Therefore, a trust established in Wisconsin can continue indefinitely as long as the grantor grants the trustee the power to sell trust assets.

Wisconsin Marital Property law

In 1986 Wisconsin adopted the Marital Property Act, which essentially changed Wisconsin from a common law property state to a marital property state.³As complicated as the marital property law can be, it provides the foundation for significant estate planning benefits for Wisconsin residents.

Transferring assets at death: will substitute agreements. The Wisconsin Marital Property Act provides that married persons may agree that upon the death of either spouse, either or both spouse's property, including any after-acquired property, may be transferred without probate to a designated person, trust, or other entity.⁴ As a result, a marital property agreement that directs how a married person's assets are to be distributed can protect those assets from probate, if the asset is located in Wisconsin.

Perhaps the most effective way to use this type of provision (sometimes called "Washington Will Provisions" because a more limited version of the concept originated in Washington state) is to direct that such assets be transferred to a living trust upon death. Wisconsin is the only state that permits a living trust to be funded after the grantor's death while still avoiding probate.⁵

However, will substitute provisions in a marital property agreement often are not appropriate as the primary asset transfer document at death. Section 766.58(3)(f) of the Wisconsin Statutes essentially provides a mechanism for transferring legal title of an asset to those persons named in the marital property agreement. Therefore, the statute offers no procedure for postmortem tax or other planning that usually occurs within the guidelines and protections of the probate process or a trust. Furthermore, absent specific provisions in the agreement to allow unilateral amendment by one spouse, the will substitute provisions may be revoked only by mutual consent of both spouses in a subsequently executed marital property agreement.⁶ This raises potential gift tax issues.⁷ By using the will substitute provisions as the primary asset transfer document at death, planners inadvertently may be locking one spouse into a nontestamentary disposition that cannot be changed unless the other spouse consents.

"Double step-up" in capital gains tax basis. Under the Internal Revenue Code, the basis of property received from a deceased person receives an adjustment in basis (called a "step-up" if the value of the asset has increased from the date of acquisition to the date of death) equal to the property's fair market value at the date of death.⁸ When a married person who is a resident of a common law state dies, assets titled in the name of the decedent will receive a new basis, but the basis of property belonging to the surviving spouse is not adjusted, and the basis of property owned jointly between spouses only receives a step-up in basis equal to one-half of the fair market value of the asset on the date of the decedent's death.⁹

By comparison, in community property states all community property receives a full adjustment equal to the value of the property on the death date of either spouse.¹⁰ Since marital property is treated as community property by the Internal Revenue Code, all marital property receives a full step-up in basis upon the death of either spouse.¹¹ Furthermore, Wisconsin statutes also provide this same "double step-up" result for state tax purposes.¹² Accordingly, marital property can help a surviving spouse avoid both state and federal capital gain taxes.

Unfortunately, this double step-up in basis is not automatic for Wisconsinites by mere fact of residence; spousal assets actually must be classified as marital property or survivorship marital property. Wisconsin's marital property law took effect on Jan. 1, 1986.¹³ Property owned by a married couple prior to that date is not necessarily classified as marital property.¹⁴Likewise, property owned prior to marriage or received after marriage by gift or inheritance may not be treated as marital property.¹⁵However, Wisconsin's Marital Property Act allows married persons to reclassify all assets titled in either spouse's name as marital property in a marital property agreement.¹⁶ As a result, in many cases a properly drafted estate plan will include a marital property agreement classifying the assets of the married couple as marital property to ensure the adjustment in basis on all marital property at the death of the first spouse.¹⁷

Equalizing the spousal estates. Under the Internal Revenue Code, every individual is entitled to an "Applicable Unified Credit Amount" which can shelter a specified amount of assets from federal transfer taxes for gifts during lifetime and transfers at death.¹⁸This credit can shelter $650,000 of assets in 1999, but is scheduled to increase to $1,000,000 of assets for persons dying in 2006 and beyond.¹⁹ If a married couple uses both spouse's unified credits, the amount protected from federal transfer taxes can be effectively doubled. For example, assume a married couple living in a common law state has a combined net worth of $1.25 million. Assume further that $1 million of these assets are held in the husband's name. The remaining assets are held in both spouse's names as tenants by the entirety. If the wife dies first, then the assets held in the husband's name will not be available to fund the wife's unified credit. Likewise, the joint assets will pass outright to the husband by right of survivorship. As a result, the wife's unified credit will not be used. Instead, all of the assets will be includable in the husband's estate for federal estate tax purposes at his death.²⁰ In comparison, if the couple lived in Wisconsin and had executed a marital property agreement that classifies all of their assets as marital property, then half of the assets held in the husband's name would be includable in the wife's estate for federal estate tax purposes. As a result, those assets could be used to fund the wife's applicable unified credit amount.

Often, a significant portion of a married person's assets will have been accumulated inside an employer-sponsored qualified retirement plan. Even though the assets inside such retirement plans may be classified as marital property and owned equally by the spouses, federal law under ERISA²¹, which preempts state law, may prohibit a married couple from using a surviving spouse's retirement benefits to fund a deceased spouse's unified credit. ²² As a result, if one spouse has significantly greater qualified retirement benefits than the other, it may be preferable in the marital property agreement to classify some nonretirement plan assets (such as the couple's home) as the individual property of the spouse who has fewer retirement benefits in order to promote estate equalization.

Qualifying for the Family-owned Business Deduction. Newly created I.R.C. section 2057 provides estate tax relief for "qualified family-owned business interests" (Qualified Interests). If the deduction applies, the estate tax liability is calculated as if the estate were allowed a maximum family-owned business deduction of $675,000 and a unified credit exemption equivalent of $625,000 regardless of the year in which the individual dies. For a decedent's estate to be eligible for the deduction, the amount of the qualified interests transferred by the decedent's death to "qualified heirs,"²³ both during life and at death, must be greater than 50 percent of the decedent's gross estate.²⁴

Wisconsin's Marital Property Act can be very helpful to ensure that a married couple receives the maximum tax savings possible from the family-owned business deduction. If the owner of a qualified interest is married, and the qualified interest is classified as marital property, then both estates are potentially eligible for the family-owned business exclusion. By the same token, however, if both spouses own one-half of the qualified interest because the qualified interest is classified as marital property, it may be more difficult for either spouse's estate to satisfy the requirement that the adjusted value of the qualified interest included in a decedent spouse's estate (plus qualified interest gifted by the decedent during life to family members) exceed 50 percent of the decedent's adjusted gross estate.

Therefore, the classification of family-owned business interests should be considered carefully. If the value of the couple's marital property interest in the family-owned business is worth greater than 50 percent of the sum of the couple's interest in all marital property assets plus each spouse's interest in individual property, then consider classifying the family-owned business as marital property so that both estates will be potentially eligible for the family-owned business exclusion. If the foregoing is not true, then consider classifying part or all of the family-owned business as the individual property of one of the spouses.²¹

Valuation discounts for marital property. The federal transfer tax is imposed on the fair market value of assets that are transferred either during life or at death for less than full or adequate consideration (that is, on gifts and inheritances). When determining fair market value, a willing buyer/willing seller test is used.²⁶That is, in a sale between unrelated parties, what would be the sale price for the interest being transferred?

Applying the willing buyer/willing seller test to a partial interest in property can result in a significant discount in the value of that interest for federal estate and gift tax purposes. As a result, if a married person dies owning a partial interest in an asset, the value of the deceased spouse's interest should be reduced for federal estate tax purposes. For example, the U.S. Court of Appeals for the Fifth Circuit approved a 45 percent discount for estate tax purposes when valuing the husband's portion of properties that were owned jointly by the decedent husband and a marital trust that had been created for his benefit upon his wife's earlier death.²⁷

Applying this rationale to marital property can mean big estate tax savings for Wisconsin residents. Since marital property is considered to be owned equally between husband and wife, one-half of marital property is transferred at each spouse's death.²⁸ As a result, the value of most or all of the assets that belong to a married or widowed Wisconsin resident may be eligible for discounts when determining the amount of federal estate taxes that are payable.²⁹

Estate planning with FLPs and LLCs

Because the willing buyer/willing seller test can result in significant valuation discounts for federal estate and gift tax purposes, Family Limited Partnerships (FLPs) and Limited Liability Companies (LLCs) have become increasingly important tools when developing estate plans for affluent individuals.³⁰When FLPs or LLCs are used in connection with estate planning, senior family members contribute assets to the entity. Limited interests in the FLP or LLC are then gifted to children or other family members. Giving limited interests in the FLP or LLC generally removes the asset from the donor's estate for federal estate tax purposes, while the donor can continue to maintain control of the property. If properly structured, the value of FLP or LLC interests that a donor gives to family members can be discounted significantly for gift tax purposes to reflect: 1) a lack of marketability for those interests³¹, 2) the inability of a limited partner or member to control the FLP or LLC investments and distributions³², and 3) restrictions that may be contained in the FLP or LLC agreement on the ability to transfer the limited interests.³³

Restrictions contained in FLP or LLC agreements are disregarded by the IRS for valuation purposes if they are more restrictive than state law.³⁴ For example, if state law allows a limited partner or member to withdraw easily from an FLP or LLC, regardless of the agreement terms, the IRS will not readily accept valuation discounts for those interests since the membership units can be converted to cash at the option of the limited partner or LLC member. In addition, the IRS may be able to disregard restrictions imposed by an agreement that is more restrictive than state law.³⁵ Wisconsin's partnership law and limited liability law both impose restrictions regarding the transferability of FLP and LLC interests and do not allow a limited partner or member to withdraw easily from the entity.²¹ As a result, it should be more difficult for the IRS to challenge valuation discounts claimed in connection with FLPs and LLCs established in Wisconsin as compared to many other states.

Conclusion

Wisconsin residents often flock to warmer climates when they retire. Many think that by moving they will not only enjoy warmer weather, but a better estate planning climate. However, Wisconsin is hard to beat when it comes to state laws that benefit estate planning.

Endnotes

¹Wis. Stat. § 72.02.

²See Wis. Stat. § 700.16(5).

³The Wisconsin Legislature adopted 1983 Wisconsin Act 186, known as the "Wisconsin Marital Property Act," in April 1984. It became effective on Jan. 1, 1986.

⁴Wis. Stat. § 766.58(3)(f).

⁵Washington and Idaho provisions are limited to transfer of assets between spouses only. Section 867.046(1m) of the Wisconsin Statutes allows for the court to issue a certificate confirming the transfer of the property interest under section 766.58(3)(f).

⁶ Wis. Stat. § 766.58(4).

⁷The inability of a spouse to unilaterally amend the disposition of property at death may be analogous to the use of joint and mutual wills, which has been held to incur gift tax liability under I.R.C. section 2501. See Estate of Jessie L. Grimes v. Comm., 851 F.2d 1005 (7th Cir., 1988).

⁸I.R.C. § 1014(a). Date of death valuation or alternate value under section 2032. Under I.R.C. section 1014(c), the basis adjustment rule applies to capital appreciation only. There is no basis adjustment for items considered income in respect of a decedent.

⁹I.R.C. §§ 1014(a), 1014(b)(9).

¹⁰I.R.C. § 1014(b)(6).

¹¹Id. and Wis. Stat. section 766.01(2), which states the Wisconsin Legislature's intent that marital property is a form of community property.

¹²Wis. Stat. § 71.05(10)(e).

¹³1983 Wis. Act 186.

¹⁴Wis. Stat. § 766.03(1).

¹⁵Wis. Stat. § 766.31(7).

¹⁶Wis. Stat. § 766.03(1).

¹⁷Planners need to discuss the full impact of reclassifying assets with clients. They also should consider the possible impact of I.R.C. section 1014(e), which allows a basis adjustment at the death of the donee, when the gifted property returns to the donor under the donee's estate plan, only if the gift is completed more than one year before the donee's death.

¹⁸I.R.C. § 2010.

¹⁹I.R.C. § 2010(c).

²⁰In accordance with the final Treas. Regs. issued under I.R.C. section 2518, within nine months of the death of the wife the husband could potentially disclaim at least a one-half interest in the jointly held property that is passing to him by right of survivorship. TD 8744 62 Fed. Reg. 68183 (12/31/97). See Pratt and Hauser, Estate Planning With Tenancy by the Entireties Property, Vol. LXXII, No. 7, Fla. B. J. p. 46 (1998). See also, Scholtes, Final Disclaimer Regulations Offer Estate Planning Opportunities, Vol. 12, No. 3, Prac. Tax Law. (Spring 1998).

²¹The Employee Retirement Income Security Act

²²See Boggs v. Boggs, 117 S. Ct. 1754 (1997). See also Wis. Stat. §§ 766.62(5) and 766.31(3).

²³ "Qualified Heirs" are defined as: 1) a member of the decedent's family, or 2) any individual who has been actively employed by the business for at least 10 years prior to the date of the decedent's death. I.R.C. § 2057(i)(1)(B).

²⁴The IRS Restructuring and Reform Act of 1998 converted what originally was an "exclusion" into an estate tax deduction.

²⁵For example, if one spouse has significant qualified retirement plan benefits, consideration should be given to classifying the family-owned business interest as individual property of the spouse without retirement benefits.

²⁶Treas. Regs. 20.2031-1(b).

²⁷Estate of Louis F. Bonner v. U.S., 84 F.3d 1005 (5th Cir. 1996). But see Estate of Wayne Utiynnk, 110 T.C. 24 (1988).

²⁸Id. The court in Bonner rejected the IRS position that assets in the marital trust of the first spouse to die and the estate of the second spouse to die had merged and therefore no discount should apply for the second spouse's estate.

²⁹If a fractional interest in marital property is used to fund a credit shelter trust at the first spouse's death, the amount of assets protected by the applicable unified credit amount should be increased by the amount of the discount that can be claimed with respect to that fractional interest. Likewise, discounts should apply when valuing the surviving spouse's marital property interest at his or her death and when valuing marital trust assets includable in the surviving spouse's estate to the extent the marital trust was funded with a partial interest in marital property at the first spouse's death.

³⁰See Willms, Family Limited Partnerships and Limited Liability Companies: New Estate Planning Tools for the 90s, Vol. 67, No. 3, Wis. Law., 16 (March 1994).

³¹Rev. Rul. 59-60, § 4.02(g), 1959-1 C.B. 237; Estate of Little v. Comm'r, 51 T.C.M. (P-H) 73 (1982); Hooper v. Comm'r, 41 B.T.A. 114 (1940); Bardahl v. Comm'r, 34 T.C.M. (P-H) 673, 918 (1965); South Carolina National Bank v. McLeod, 256 F. Supp. 913 (D. S.C. 1966).

³²Id.

³³Estate of Little v. Comm'r, 51 T.C.M. (P-H) 73 (1982); MacDonald v. Comm'r, 230 F.2d 534 (7th Cir. 1956). But see I.R.C. § 2703(a); Treas. Reg. § 25.2703-1(a)(1).

³⁴I.R.C. § 2704(b).

³⁵I.R.C. § 2704(b)(3)(B).

³⁶Wis. Stat. §§ 179.53(2), 183.08024.

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