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opportunities for estate planning
IN LIGHT OF
CURRENT FEDERAL ESTATE TAX LAW
Since 2001 the federal
estate tax system has been in a state of short-term fluctuation and long-term
uncertainty, which has made planning very difficult. A permanent solution
regarding the exemption amount and rate(s) of tax should be reached within
the next few years, as 2011 (when the exemption amount is due to revert to $1
million) approaches. This article discusses the current
rules governing the federal estate tax.
TIMETABLE FOR
INCREASES IN THE FEDERAL ESTATE TAX EXEMPTION AND TEMPORARY REPEAL OF THE TAX
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There is a now a
$3.5 million federal estate tax
exemption for estates of decedents whose deaths occur in calendar year 2009.
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This exemption
amount replaces the $2.0 million exemption for deaths occurring in
calendar years 2007 and 2008.
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The federal estate tax is then due to be repealed
altogether for
estates where death occurs during the 12-month period from January 1, 2010 to December 31, 2010.
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Federal Estate Tax EXEMPTION DUE TO
REVERT BACK TO $1 MILLION for Deaths After December 31, 2010
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Under the "sunset" provisions of the 2001
federal tax law known as EGTRRA,
starting in 2011 the federal estate tax will be reinstated and the exemption will revert back to its 2001 amount of $1
million for deaths occurring after
December 31, 2010. The maximum estate tax rate will also return to
its 2001 level of 55%.
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While "conventional wisdom" says that a return to the
pre-2002 estate tax rules will never be allowed to happen, there is certainly no
guarantee of that result, especially in the absence of a political consensus on
permanent estate tax repeal or, in the alternative, what an appropriate
exemption amount should be.
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NOTE ON Pennsylvania
inheritance tax: In any event, these changes in federal
estate law will not affect
the Pennsylvania inheritance tax, which will continue to be imposed on the
transfer of taxable property at death, at rates based on the relationship between the beneficiaries and the
decedent.
Federal Gift Tax
Exemption Is Fixed and the Gift Tax Will Not Be Repealed
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Unlike the rising exemption for federal estate taxes, the federal gift tax exemption
has been fixed at $1 million
and will remain at that level for
all future years, with no eventual repeal. Lifetime gifts in
excess of the $1 million exemption amount (and the annual exclusion amount of $13,000
for 2009) will thus continue to
be taxed.
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The annual gift tax exclusion
is indexed for
inflation and could increase in future years.
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Carryover Basis: The "Dark Side" of Estate Tax
Repeal
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If federal estate tax repeal would become permanent, carryover basis for inherited assets will
also become part of the law. This will be a decidedly mixed blessing.
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By way of explanation, the term "basis" is used in
the context of figuring taxable gains and losses on sales of capital assets.
"Carryover" basis means that the beneficiary must use the decedent's own basis
(usually the original cost of the asset) for each inherited asset to determine
gain or loss when the beneficiary later sells the asset -- in other words, the
decedent's basis is "carried over" to the beneficiary.
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With the estate tax, there is also a "step up" in
basis, which means that the beneficiary can use the date of death value as his
or her basis upon later sale. Any gain built up prior to death essentially
goes untaxed for capital gains tax purposes.
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Carryover basis, at least in larger estates, will result
in additional capital gains tax being paid by beneficiaries on the sale of inherited
assets. Moreover, the carryover basis rules will likely prove very
difficult to administer.
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EXAMPLE: Aunt Mary dies in 2010 leaving
her nephew Andy her 500 shares of ABC Corp. stock. Aunt Mary had purchased
this stock at $10.00 a share back in 1986, but at her death it was valued at
$100.00 per share. In 2012 Andy decides to sell the stock, which at
that time is worth $110.00 per share.
Under the carryover basis rules, Andy will have a
taxable gain of $100 per share (sales price of $110.00, reduced by Aunt Mary's
basis of $10.00). Had Aunt Mary died with the "step up in basis" rules in
effect, the taxable gain would have been only $10.00 (sales price of $110.00,
reduced by the date of death value of $100.00).
Of course, in the "real world" perhaps the biggest
problem for Andy will be to find out the actual price that Aunt Mary had paid for the
stock way back in 1986!
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CURRENT ESTATE PLANNING OPPORTUNITIES
How have traditional estate planning techniques been affected by
the increase in the federal estate tax exemption amount from $600,000, which had
been the fixed exemption amount back in the 1990's, to $3.5 million in 2009, and the
possible repeal of the tax?
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Preference for Disclaimer trust in Marital Deduction Planning
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Marital deduction planning for married couples whose
combined assets still
exceed the exemption threshold ($3.5 million in 2009) will likely shift away from the
"bypass trust" or "A-B trust" approach, which requires the full
funding of a credit shelter trust up to the maximum exemption amount. A more flexible solution
is to have an initial "all to
my spouse" bequest, but then provide a contingent credit shelter trust that the surviving spouse can fund by making a post-mortem disclaimer of all or a specific percentage or amount
of the outright bequest.
With the disclaimer approach, the surviving spouse can choose exactly how much
(if any) of the first spouse's estate to place into the credit
shelter trust in order to utilize some part or all
of the first
spouse's estate tax exemption. The surviving spouse would be the lifetime
beneficiary of this trust.
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Partial QTIP Trust
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As an alternative to the spousal disclaimer trust,
marital deduction planning could involve the creation of a single trust for the surviving spouse’s benefit, again avoiding the traditional “bypass trust” approach. The executor could elect how much of the single trust to qualify as QTIP property for the marital deduction. This partial QTIP election would take into account both the first spouse’s exemption amount, and the likelihood of
permanent estate tax repeal or an increased estate tax exemption at the surviving spouse’s death.
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Family Limited Partnerships and LLC
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Even if there is permanent estate tax repeal, there
will be good reasons, particularly with an active family business or
family investments that are closely managed, to shift existing
assets and future appreciation to younger family members while allowing the senior family members to retain control.
To the extent valuation discounts
can be created through lifetime gifts, families should continue using this strategy,
given the
unavoidable possibility of death occurring prior to 2010.
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Lifetime Giving
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Lifetime gifting should continue within the limits of the annual gift tax exclusion
($13,000 for gifts made in 2009) or the unlimited
exclusion for tuition or medical expense payments.
Donors who made large taxable gifts up to the
maximum exemption amount allowed in prior years now possibly
have additional amount to gift tax-free.
However, any gifts that
could trigger a gift tax liability (i.e., total lifetime gifts in excess of the $1 million exemption) should be
avoided.
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Simplify Estate Plans If Your Assets Will Be At or
Below the New Exemption Amounts
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Estate plans can be simplified as necessary to eliminate tax-related provisions that are deemed
no longer needed in light of the increased estate tax exemption. (A thorough analysis of
the your assets, including life insurance benefits and retirement
accounts, will necessary to ensure that the total value of your assets does
in fact fall below the exemption
threshold.)
Joint lifetime revocable trusts
for spouses will become more attractive when the couple’s combined assets fall below the increased
exemption amount.
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Charitable Remainder Trusts
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The charitable remainder trust (CRT) is primarily an
income tax planning vehicle, permitting you to transfer appreciated property
to a tax-exempt trust, which in turn sells the property and reinvests the proceeds
and pays you an annuity or unitrust amount each year thereafter. The
estate tax deduction for the
remainder interest passing to the charity when the trust ends is usually a secondary consideration. Thus the CRT should continue to be a valuable estate planning tool.
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Charitable Lead Trusts
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A charitable lead trust (CLT), on the other hand,
may not be as useful as the exemption amount increases, since the
advantage of the CLT is primarily to reduce estate taxes. (In any event, no income tax
deduction is available with the CLT.)
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Charitable Private Foundation
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The charitable private foundation is a vehicle
that serves important income and gift tax purposes, so its use should
continue under the new law.
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Role of Life Insurance
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Many clients will still need life insurance for purposes other
than paying federal estate taxes. For example, life insurance will still be needed to fund business buy-sell agreements, to serve as an income replacement for dependents of a
deceased family breadwinner, and as a means of leveraging annual exclusion gifts. These needs will not be reduced by estate tax repeal.
With the long delay and ultimate uncertainty of estate tax repeal, be careful about dropping or reducing existing life
insurance coverage.
The irrevocable life insurance
trust (ILIT) remains an important planning technique to exclude life insurance proceeds from the gross estate.
If you
want to
buy
new policies, the use of term insurance (including
decreasing
term) should be considered. (The utility of this kind of policy will
depend on the
age and
health of the client.)
The policy should be convertible term, since
permanent repeal of the estate tax is uncertain.
NON-TAX REASONS FOR ESTATE PLANNING
Even with the increased exemption amounts and possible
permanent repeal of the
federal estate tax,
there are still many non-tax reasons why you should have your estate plan periodically reviewed
and updated. At a minimum, you need to have documents in place that adequately
answer the following questions:
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"What will happen if during my lifetime I become
unable to take care of my own
personal and health needs"?
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"What will happen if during my lifetime I am no
longer
able to manage my property"?
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"Who will receive my property at my death"?
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"Who will wind up my affairs after my
death"?
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"How
can I lower the state inheritance taxes that my family will have to pay"?
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As to your intended beneficiaries, Congress obviously cannot
legislate away problem areas such as spendthrift
heirs,
handicapped children,
substance abuse,
divorce,
and immaturity. Protecting beneficiaries in these situations will
remain an important estate planning goal.
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