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opportunities for estate planning
IN LIGHT OF
CURRENT FEDERAL ESTATE TAX LAW
Under the 2001 law known as
"EGTRRA," the federal
estate and gift tax system has been in a state of short-term fluctuation and
long-term uncertainty. As of January 1, 2010,
the estate tax has finally been eliminated, but only for decedents dying in calendar year 2010.
The same law calls for
the estate tax to be reinstated, and at its 2001 levels, for deaths occurring
after December 31, 2010.
This article discusses the current rules governing the federal estate and gift
tax, and the planning opportunities arising from them.
FEDERAL ESTATE TAX EXEMPTION FOR 2009 AND THE ONE-YEAR REPEAL OF THE TAX
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For estates where
death occurred in calendar year 2009, the federal estate tax will still be imposed,
but with the availability of a $3.5 million exemption, i.e., only assets valued in excess of $3.5 million will be
taxed.
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The federal estate tax is eliminated for estates of decedents
whose deaths occur during the 12-month period starting January 1, 2010 and
ending on December 31, 2010.
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Some commentators believe that
Congress may yet take action this year to reimpose the estate tax at its 2009 levels and make the tax retroactive to
deaths occurring on or after January 1, 2010. However, the constitutionality
of any attempted retroactive tax legislation is unclear, and would likely be
tested in the courts.
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Federal Estate Tax EXEMPTION TO
REVERT BACK TO $1 MILLION for Deaths After December 31, 2010
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Regardless of what rules may
ultimately govern estates where death occurs in 2010, under the "sunset" provisions of
the EGTRRA law, the federal estate tax will be fully reinstated, and the exemption amount will revert back
to $1
million, for deaths occurring after
December 31, 2010. The maximum estate tax rate will increase to 55%.
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Again, commentators predict that
Congress will not allow this reversion to occur and will certainly "fix"
the estate tax rules before 2011. However, they also predicted that
Congress would never let the estate tax be repealed for one year in 2010.
There is thus a good chance that, come January 1, 2011, the
federal estate tax exemption will in fact be only $1 million.
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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 (other than to the surviving spouse), at rates that are based on the relationship between the beneficiaries and the
decedent. There is no exemption amount applicable to the Pennsylvania
inheritance tax.
Federal Gift Tax
Exemption Is Fixed, and the Gift Tax Will Not Be Repealed
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Unlike the federal estate tax
exemption, which has risen over the past several years, the federal gift tax exemption
has been fixed at $1 million
and is due to remain at that level for
all future years, with no repeal in 2010. 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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For those estates
where death occurs at a time when the federal estate tax is not in effect (e.g., during
calendar year 2010), the inherited assets passing to the beneficiaries, while
escaping the federal estate tax, will be subject to the carryover basis
rules. 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
(generally defined as any asset not used in a trade or business).
"Carryover" basis means that the beneficiary
of an inherited asset 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.
Carryover basis rules will likely be very burdensome to administer, since in
many cases it will be difficult if not impossible to ascertain
the decedent's basis in the asset.
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When the
federal estate tax
is in effect at the time of a decedent's death, there is a "step up" in
basis, which means that the beneficiary can use the date-of-death value of an
asset as his
or her basis upon its later sale. By that definition, any gain built up prior to death
will go 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.
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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
$90.00 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 only have been $20.00 per share (sales price of $110.00,
reduced by the date-of-death value of $90.00).
Of course, in the "real world" perhaps the biggest
problem for Andy will be to find out the actual price that Aunt Mary paid for the
stock way back in 1986!
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CURRENT ESTATE PLANNING OPPORTUNITIES
Given the
uncertainties of the federal estate tax law for 2010 and beyond, what are the
planning choices that married couples and individuals should now consider?
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MARRIED COUPLES SHOULD CONSIDER UPDATING THEIR ESTATE
PLANS that CONTAIN FORMULA BEQUESTS THAT ASSUME THE EXISTENCE OF A FEDERAL ESTATE TAX
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Some wills and
trusts of married couples define the bequests passing to
or for the benefit of the surviving spouse by a formula that is described in terms
of the
federal estate tax exemption (or unified credit) available in the year of death.
Typically the documents call for an amount equal to the federal exemption to pass into a "credit shelter"
trust, with any amount in excess of the exemption to pass either outright to the surviving spouse or into a
separate QTIP trust for their benefit.
However, if the
first spouse dies at a time when there is no estate tax and thus no
exemption, how will such bequests be construed?
To avoid such
uncertainty, these couples' wills could be updated in 2010 to clearly define
the bequest to the surviving spouse in the event that there is no estate tax applicable at the
first spouse's death.
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PLAN FOR CONTINGENCY OF FLUCTUATING EXEMPTION
AMOUNTS
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Looking towards 2011 and beyond, when the
exemption amount may be as low as $1 million (if there is no Congressional
action) or as high as $3.5 million, $5 million, or more (if there is), flexibility is
the key principle of good drafting. One such flexible solution
is to have an initial "all to
my spouse" bequest in each spouse's will, but then provide for 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,
if any, 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.
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Lifetime Giving
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Lifetime gifting should continue within the limits of the annual gift tax exclusion
(currently $13,000) 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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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 if the
federal estate tax exemption amount is permanently increased to an amount that
is well above the size of a couple's assets, 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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