As an estate planning attorney, I find it extremely frustrating to not know what the estate tax law will be when my client eventually passes away, since this makes the very idea of “planning” problematic. The window between when an estate plan is created and when it goes into effect can be several decades long. Since the 1990’s, when many existing estate plans were created, the entire estate tax scheme has undergone two major transformations, numerous alterations, and is due for another complete overhaul at the end of 2012. Accordingly, estate plan provisions and actions – originally taken for useful and effective purposes – have now become meaningless, and, in some cases, may create negative unintended consequences when the “settlor” (the person who makes an estate plan) passes away.
History of Estate Tax Law
There was a period, before the year 2000, when the estate tax law had been fairly consistent for a long period of time, and certain estate planning devices had become standardized. In those days, estate taxes were high (55%), and estate tax exemptions were low ($600K from 1986 to 1995; raised to $675K by 2000), so that the estates of many middle income people were subject to estate tax.
The Classic Estate Tax Scheme
Since most people’s estates were subject to tax, estate plans for most people required provisions to avoid taxes. The method generally used was to segregate the settlors’ property into several piles, with each pile governed by particular tax rules, in order to minimize and avoid taxation.
One such tax rule is that, for the most part, death transfers to a spouse are not taxable. Another rule was that each spouse has to use their tax exemption when they died or it would be lost. As a consequence, if the entire estate of the first spouse to die (“decedent spouse”) was passed to the “surviving spouse” (second spouse to die) – tax free because transfers to a spouse are tax free – then, when the surviving spouse died, and property passed to children or other third parties, all of the assets would pass, but there would be only one exemption remaining. The children would have to pay a heavy estate tax.
For example, lets say a couple – we’ll call then “Mr. X and Mrs. X” – had $2M dollars. When “decedent spouse” Mr. X died, he left everything to Mrs. X, the surviving spouse. No tax was due at that time, since an inter-spousal transfer is tax free. However, when Mrs. X, died, the entire amount of the estate, the whole $2M, would be passed to the children. Since only one $600K exemption would be available, the difference between that amount and $2M – $1.4M – would be taxable. At 55%, the tax on $1.4M would be $770K, leaving the kids only $1,230,000. Ouch.
Mr. X’s exemption was not used when he died, and was not available to use when the estate is passed to the children. Wouldn’t it have been better if there was some way to use that exemption?
Well, Mr. X could have given some of the money directly to the children at his death. The problem with that is that surviving spouse Mrs. X needs that money to live on during her lifetime. Normally, a surviving spouse hopes to live on the income from the assets, and not the principal, during their lifetime, so as not to deplete the amount going to the beneficiaries. For example, if Mrs. X could earn 5% annually by investing her $1.4M, she would have $70K a year. That’s OK, but it would be even better if she could have the interest on the entire $2M: at 5%, this would be $100K. Unfortunately, Mr. X gave the kids the 600K difference when he died. What was needed was some way that the 600K could go to the kids when Mr. X dies, but yet still be available for Mrs. X to invest and to live off the income.
The solution was something called the Bypass Trust. In this type of trust, as long as the principal will eventually go to the children, and Mrs. X doesn’t have any ability to change that, she would be able to use the income from the trust during her lifetime. The principal “bypasses” her estate for tax purposes, but she is allowed to obtain the income. Thus, when Mr. X dies, an amount, up to the amount of his $600K exemption, could be deemed for tax purposes to pass directly to the children instead of to Mrs. X by being immediately put into a trust for the children. The terms of the trust are that Mrs. X could have the income from the trust, during her lifetime, and the principal would go to the children when she died.
It worked like this: $600K went into the kids trust while a $1.4M “marital trust” was funded for Mrs. X. She would have the income from all $2M but only $1.4M is deemed to be in her estate. Then, at her death, her $600K exemption would be deducted from her $1.4M, so that only $800K ($1.4M – $ 600K) would be taxable, instead of $2M. Since 55% of $800K is $440K, there would be a net tax savings of $330K ($770K – $440K). Furthermore, at her death, the kids would receive both the proceeds of the trust established by Mr. X ($600K) – tax free since it was already charged against Mr. X’s deduction- as well as Mrs. X’s estate. The children would receive a total of $1,560,000, instead of only $1,230,000, without the Bypass Trust.
And remember that Mrs. X had all $2M to use for income during her lifetime, giving her an extra $30K a year.
The Use of Formulas Instead Of Dollar Amounts
So, some money would go to the surviving spouse, in a “marital trust”, and some would go to the children, in a “bypass trust”. But how much should go into each? At the time the estate plan was created, no one could know exactly how much would be in the estate when Mr. X would happen to die. If the document simply said “put $600K into the bypass trust and put $1.4M in the marital trust” there would be a problem if the eventual amount of the estate was less than $1.4M. If, for example, there was only $1M was in the estate at the time of Mr. X’s death, the gifts would fail. There would not be enough money to fund both gifts.
So, because the amount could not be known ahead of time, estate plans did not specify an amount for each trust; instead a formula was used. The formula was that as much money as possible would go into the “bypass trust”, up to the amount of $600K, while the remainder would go into the “marital trust”. Or, it could be the other way around.
And this system worked pretty well until the millennium.
Congress Changes the Numbers And Creates Uncertainty
Congress passed the Economic Growth and Tax Relief Reconciliation Act of 2001, under which the amounts of the estate tax would gradually decrease, and the estate tax exemption would increase, each year, until the tax was would be only 45% and the exemption would be $3.5M by 2009. The estate tax would phase out entirely in the year 2010: there would be no estate tax. However, unless congress passed something to replace the Act by the end of 2010, the law would end, and the tax would revert to 35%, and the exemption credit would be $1M thereafter.
Since the amount of tax and exemption was going to change every year, it became impossible to state the dollar amount limit of how much should go into the bypass trust. Therefore a new type of formula was used: assets would go into the “bypass trust” up to the amount of whatever the exemption would happen to be when the decedent spouse (Mr. X) died, and the rest would go into the “marital trust”. That was not a difficult change, and many estate plans were already written that way, since the amount of exemption was subject to some change even in the 1990’s, although more infrequently.
But there was still a problem. By 2009, the amount of the exemption would be so large – $3.5M – that provisions for funding the marital and bypass trusts would become meaningless. There would simply be no tax on most estates. In fact, in 2010, there would actually be no estate tax. Many clients did not want to pay extra for a more complex estate plan which included provisions to avoid taxes, when they might not have to use them. If their estate was only $1M or $2M, why should they have to have a complicated trust, when the likelihood was they would have no estate tax?
The answer was that there was great uncertainty about what would happen in 2010, since, unless a dysfunctional congress acted, the exemption would revert to $1M. In many states, like California, it was not unusual for a middle class estate to exceed $1M since, during the real estate boom of the mid 2000’s, even average homes could cost that much. Given that, you would still want the marital/bypass trust formula to be in your estate plan.
So, weighing the cost of have to pay for a more complicated bypass/martial trust estate plan, with the risk that portions might become meaningless, against that cost of what would happen if they were not in place and the exemption was reduced to $1M – which could result in negative tax consequences – clients faced a dilemma. Pay more now or risk having a higher estate tax. My advice was that if the estate was likely to be more than $1M, it was preferable to create the more complex trust. Not everyone accepted that advice.
The Current Tax Law Situation- And More Uncertainty
Despite Washington gridlock, Congress managed to enact a new estate tax law in 2010, known as TRA 2010 (“TRA 2010?). The essential feature of TRA 2010 was that it created the largest estate tax exemption ever – $5M, while reducing the estate tax rate to the lowest ever – 35%. Furthermore, the law created “portability” for the estate tax exemption. This means that in an estate plan for both spouses, the decedent spouse’s exemption can be freely transferred (by filing an IRS Form) to the survivor spouse, so that he/she may use all of the couple’s combined exemption. Portability ended the need for the traditional bypass trust to accomplish the same result.
However, this tax law will “sunset” out of existence on December 31, 2012, and unless something is done by Congress, once again the tax will revert, this time to 45% with the exemption amount of $1M, and no portability.
Some practitioners argue that Congress can do nothing since this is an election year, and so this reversion is the likely scenario. Others think that a $3.5M exemption and 35% tax is likely, since that is the position of the Obama administration. Others are sure that the Estate Tax will finally be repealed once and for all. Whether portability will survive is another unknown.
With all of the uncertainly, the practice of leading estate planners has now become to include optional and discretionary tax saving devices which allow the surviving spouse to determine, at the death of the decedent spouse, whether to use a bypass trust, and how much to put in it, based upon the tax law in effect at the time. Once such device is called the “disclaimer trust”, under which all of the estate assets go in the surviving spouse’s marital trust, but the survivor can decide to “disclaim” a portion, which would go into a bypass trust. Otherwise, the bypass trust would not be used.
This seems like the prudent way to go for couples with more than $1M, and crucial for those with estates of $3.5M or more. This still has the drawback of requiring the creation of a more expensive complex estate plan which might end up not being necessary if the exemption remains high. Also, it puts a burden on the surviving spouse, who has to engage attorney and accountant to help make tax and estate planning decisions, soon after the death of their spouse. But the alternative is that the estate might end up being drastically reduced by taxes.
Until Congress finally does what is right and creates an estate tax system that is rational and can be relied upon, and which cannot be changed for decades at a time, or, provides that the law in effect when an estate plan is made will be the law that rules it’s implementation, then it will be necessary to have estate plans periodically reviewed and amended to account for changes in the state of the law.
If you have an estate plan that was created prior to 2010, and/or does not have any provision allowing for options which can be used by the surviving spouse to allocate the decedent spouse’s estate for tax purposes, it might be a good idea to have the estate plan looked at by an estate planning attorney. This is imperative if there is a good chance that one spouse might pass away in this year. And, I would urge everybody to have their estate plan checked in 2013 once it is clear what the new law will be.
 Normally, her estate would be placed into a trust called the “marital trust”, which ensured that she would get the income, and have some right to take the principal as well, but the remaining principal would go the beneficiary children. In the bypass trust, only income goes to the surviving spouse, and the children get all of the principal.
 For a fuller discussion of TRA 2010, please see my article “Estate Tax Law Changes: 2011, 2012 and Beyond” (ã Terry Traktman, 2011), available elsewhere on this website. The instant article is not intended as a complete treatment of the subject, and does not contain discussion of all aspects of that law.
© Terry J. Traktman, July, 2012, all rights reserved.