Estate planning opportunities under the Tax Relief Act of 2010, Pt. 2Article added by Julius Giarmarco on January 25, 2011
Julius Giarmarco

Julius Giarmarco

Troy, MI

Joined: July 07, 2008

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The Tax Relief Act of 2010, signed into law on December 17, 2010, unexpectedly and profoundly changed the rules governing wealth transfer.

In part one, I discussed some of the planning opportunities for wealth transfers under the 2010 Tax Relief Act. This article will offer further examples, including potential impacts on portability and charitable planning.

Portability
Prior to the Tax Relief Act, for a married couple to take full advantage of both spouses’ estate tax exemption, the predeceased spouse’s exemption had to be held in a credit shelter or family trust, thus requiring some advanced planning. Now, however, the legislation allows the executor of a deceased spouse's estate to transfer any unused exemption to the surviving spouse without creating a family trust. Portability applies for the gift tax exemption as well as the estate tax exemption. But the portability provision only applies to the last deceased spouse of the surviving spouse, thus eliminating "serial marriages" for the purpose of accumulating unused estate tax exemptions. The portability option is only available if a deceased spouse's estate files an election on a timely filed estate tax return (Form 706), even if a return is not otherwise required to be filed because of the size of the estate.

Family trust vs. portability — Despite the relative simplicity of just letting the surviving spouse use the predeceased spouse’s unused estate tax exemption in 2011 and 2012, there are several reasons for still using family trusts, including the following:
  • The predeceased spouse’s unused exemption is not indexed for inflation.

  • The first predeceased spouse’s unused exemption will be lost if the surviving spouse remarries and survives his/her next spouse.

  • The appreciation in the assets in the family trust is removed from the surviving spouse’s estate.

  • The predeceased spouse (as opposed to the surviving spouse) controls the management and distribution of the assets in the family trust.

  • There is no transfer to the surviving spouse of the predeceased spouse’s unused GST tax exemption.

  • The portability provision sunsets on December 31, 2012.
Disclaimer trusts — A family trust does have some disadvantages. The surviving spouse’s access to the assets in the family trust, albeit broad, is restricted. And there is no stepped-up basis at the surviving spouse’s death for the assets in the family trust. The family trust also adds complexity to the surviving spouse’s life in that separate records for the family trust must be maintained, and annual income tax returns (Form 1041) must be filed for the remainder of the surviving spouse’s lifetime. Finally, if the first spouse to die has little or no assets other than an IRA, then for income tax reasons, it’s generally not advisable to use an IRA to fund a family trust (and forego a spousal rollover).
Many couples with nontaxable estates, particularly those with children from the same marriage, will prefer to simply leave their estate to the surviving spouse. But for the reasons mentioned above such couples may still want the ability to utilize a family trust. The solution could be a disclaimer trust. With a disclaimer trust, a married couple’s revocable living trusts leave the deceased spouse’s entire estate to the surviving spouse. The family trust is funded only if the surviving spouse then disclaims (refuses) part of the deceased spouse’s estate. This enables the surviving spouse to decide how much to keep outright (to be taxed at the second death) and the amount to be allocated to the family trust (which is shielded from estate tax at the second death).

For married couples who live in states that have their own estate tax, postponing the federal estate tax until the death of the surviving spouse (by using a family trust) could result in generating a state death tax at the first spouse’s death. This can occur if the state’s estate tax exemption is less than the federal estate tax exemption. Another consideration is whether state law provides for an unlimited marital deduction against the state death tax. By using a disclaimer trust, the surviving spouse, upon the advice of counsel, will be able to determine whether it is more or less advantageous to fully fund the family trust and pay any state death tax.

In making an informed decision to disclaim and how much to disclaim, one must examine the size of the combined estate, the surviving spouse’s age and health (which impacts the spouse’s needs for funds), whether minor children will be beneficiaries of the family trust, the potential appreciation of the assets not disclaimed, the status of the estate tax exemption and the applicability of a state death tax.

The actual disclaimer must meet certain legal and filing requirements, and the surviving spouse must not accept any benefits from the assets disclaimed before filing the disclaimer.

Optional retroactivity for 2010 decedents
For decedents dying in 2010, the estate tax is retroactively reinstated, with an exemption of $5 million; a top rate of 35 percent; and a stepped-up income tax basis for appreciated assets. The decedent's executor, however, can elect to opt out of the estate tax, in "exchange" for modified stepped-up basis ($1.3 million for non-spousal beneficiaries and an additional $3 million for property passing to a surviving spouse). For those decedents who died during 2010 with very large estates, the option to elect out of the estate tax may be an easy decision. For those decedents with estates under $5 million, no election will be necessary. But considerable analysis may need to be done for estates above $5 million to decide which path to choose for the lowest overall tax consequences. This is particularly true where the estate owns fully-depreciated real estate because of the recapture rules. The election is revocable only with the consent of the IRS.
Impact on charitable planning
The higher estate tax exemption (at least for 2011 and 2012) will have an impact on charitable planning. Fewer persons will need to take advantage of the unlimited charitable estate tax deduction, particularly those who were not that charitably inclined to start with. However, for those persons no longer concerned about estate taxes, their emphasis is likely to shift to the income tax incentives of charitable giving, which were all left in place by the Tax Relief Act. In particular, charitable remainder trusts (CRTs) will become more popular.

A CRT is a tax-exempt irrevocable trust that will ultimately terminate in favor of one or more charities while first making payments to the donor (and the donor's spouse) for life. The CRT can create a source of lifetime income, reduce the donor's taxable estate, provide a charitable income tax deduction, defer tax realized by the donor on a sale of property, and secure a future gift to the donor's favorite charities. Moreover, by using the income tax savings to fund a wealth replacement trust (for the benefit of the donor's heirs) with a life insurance policy, the donor is able to replace the wealth that eventually passes to charity.

Review formula clauses
Applying the new $5 million estate and GST exemption in 2011 and 2012 could result in unintended financial consequences for a decedent's spouse and heirs. For example, allocating to the family trust "the maximum amount that can pass free of estate tax" now means $5 million (for 2011 and 2012). This could result in underfunding the marital gift (or marital trust), especially in those cases where a portion of the decedent's estate tax exemption was earmarked for children from a prior marriage. Another example is where the decedent's will or trust carved out the decedent's "available GST exemption" to pass to grandchildren. This now means $5 million (for 2011 and 2012) and could result in overfunding the grandchildren's bequest. Finally, formula bequests where the taxable portion of a decedent's estate was earmarked for charity could result in the charity now receiving nothing or much less than initially intended. Now, more than ever, estate planners must carefully review estate planning documents with their clients.

Closing
With a $5 million estate and gift tax exemption per person and $10 million per couple, the 2010 Tax Relief Act has effectively eliminated the estate tax for over 99 percent of Americans. Unfortunately, the bill only does this for two years, ending on December 31, 2012. On January 1, 2013, the estate and gift tax exemptions revert to $1 million per person, with a top rate of 55 percent. It will be up to Congress to determine whether the Tax Relief Act’s provisions will become permanent after 2012 or if additional changes will be made. Thus, there will continue to be uncertainty in planning for federal estate, gift and generation skipping transfer taxes in 2011 and 2012. And we will again face the prospect of much higher rates and lower exemptions in the near future, depending upon the political climate. Nevertheless, the $5 million/$10 million gift tax exemption provides a two-year window of opportunity for enhanced gifting by donors.
In making gifts, keep in mind that donors should use their gift tax exemptions sooner rather than later so that the future income and growth on the gifted assets will not be included in their taxable estates. In addition, to make the most of one’s gift tax exemption, the gifted assets should have strong return potential and, if possible, the gifted assets should also qualify for valuation discounts. Moreover, the best assets to gift are those with higher cost basis because the donee receives the donor’s cost basis. Additionally, by making gifts to grantor trusts, the trust assets essentially grow income tax free (because the grantor is responsible for paying the trust’s income taxes).

Finally, the increased estate tax exemption may encourage some people to cancel their life insurance. But it's important to keep in mind that the tax cuts are temporary, particularly considering the government’s likely need to raise taxes in the future. In fact, it’s likely that many high-net-worth individuals will use all or part of their increased gift tax exemptions to fund new irrevocable life insurance trusts.

In summary, the 2010 Tax Relief Act brings opportunity, complexity and uncertainty that can only be managed with good planning. But, because the provisions of the measure are scheduled to sunset on January 1, 2013, this may very well be a “use it or lose it” opportunity. With proper planning, perhaps now more than ever, it is possible to “disinherit” the IRS.

THIS ARTICLE MAY NOT BE USED FOR PENALTY PROTECTION. THE MATERIAL IS BASED UPON GENERAL TAX RULES AND FOR INFORMATION PURPOSES ONLY. IT IS NOT INTENDED AS LEGAL OR TAX ADVICE AND TAXPAYERS SHOULD CONSULT THEIR OWN LEGAL AND TAX ADVISORS AS TO THEIR SPECIFIC SITUATION.
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