Estate Planning 2016 and Beyond
What’s new in the world of estate planning? Well, not much really, and that’s good news. What’s happened is that Congress has done nothing of consequence since passing the American Taxpayer Relief Act of 2012 (“ATRA”), which went into effect in 2013. So, the general Federal1 estate tax regime that ATRA created remains in effect.
Recap: American Taxpayer Relief Act of 2012 (“ATRA”)
The basic outline of the estate tax provisions of the ATRA law were:
• The combined Estate Tax/Gift Tax Exemption was raised to $5 Million, with an annual inflation adjustment.
• The Estate Tax rate was “permanently” set at 39.6%
• The Estate Tax Exemption was “permanently” made “portable” between spouses
• The Generation Skipping Tax rate, and exemption amount, were set at the same levels as the Estate Tax Exclusion/Gift Tax Exemption, but are not subject to portability.
Prior to ATRA, the Unified Estate Tax/Gift Tax Exemption (hereinafter “exemption”) had been subject to a series of increases, and then uncertainty about what the amount would be. This made planning difficult and included many estates within the reach of the Federal estate tax. Setting the rate at the relatively high rate of $5 Million with inflation adjustment meant that the complex estate tax saving trust provisions in use before 2013 were rendered no longer necessary for the majority of estates. (For 2016 the inflation adjusted rate is $ 5.45 Million).
Before passage of ATRA, the estate tax rate changed with the whim of congress. It was as high as 55% in 2001, and as low as 35% in 2012. The change to a “permanent” figure of 39.6% (most people call it 40%) makes planning easier. (Of course, they could change it, again.)
“Portability” of the exemption also simplified estate planning. With portability, any unused portion of the exemption available to the first spouse to die (“decedent spouse”) would be made available to the “surviving spouse”, thus eliminating the need for complex trust arrangements which were aimed at “using” the decedent spouse’s exemption. In theory, this doubles the available exemption for a couple at the death of the surviving spouse, assuming the estate assets would have passed tax free to the surviving spouse at the death of the decedent spouse, by means of the “marital deduction” (whereby one spouse may make an unlimited transfer to the other with no tax owed). However, use of the portability feature requires that the surviving spouse file a tax election with the IRS.
One exception to the rule of portability is the Generation Skipping Tax – the distinct tax on estate gifts which go to beneficiaries more than a generation removed from the giver. This means that, as to generation skipping gifts, each spouse must ensure that the $5.34 limit is not exceeded at their own death.
What do the new rules mean in practice? Well, for starters, it means that, for most small to medium size estates, estate tax is no longer the problem it had been, which had required extensive estate tax planning. Recall that, as recently as 2001, an estate of $675,000 was subject to estate tax – and many people’s net worth exceeded this. Now, with an exemption of $5.45 million, estate tax affects far fewer people. And remember that, with portability, a couple’s exclusion is effectively double that amount. So, for many people, a basic trust which simply gives all of the deceased spouse’s property to the surviving spouse, and then passes it all on to their descendants at the death of the surviving spouse, is all that is needed.
However, whether or not the estate may conceivably exceed the limits is not the only consideration in estate planning. There might be other reasons to create additional trusts.
Uses for QTIP, Bypass and Disclaimer Trusts
Consider the case where there are children of a former marriage and/or a chance of remarriage by the surviving spouse. A simple trust which gives all the property and control to the surviving spouse would take away from the deceased spouse any control over whether the assets will be distributed as they wanted – to their own heirs. Accordingly, other trusts may be employed to limit the surviving spouse’s control over what happens to the assets.
A Qualified Terminal Interest Trust (“QTIP”) is generally employed for this. Under this trust, the surviving spouse does not obtain the assets directly, but they are held for his/her benefit by a Trustee. There are rules and limitations in the trust about how the assets are to be distributed, which the Trustee must follow. The primary limitation is that the surviving spouse does not have the power to leave the assets to anyone else but the beneficiaries named by both spouses in the Trust. Although in many cases the surviving spouse is the Trustee, they cannot deviate from the requirements of the Trust.
Another type of trust which may be useful is the “Bypass (Credit Shelter) Trust”. This actually removes assets from the estate of the surviving spouse, entirely, while still allowing him/her to obtain interest from the assets until death. With this trust, the property is legally transferred to the children, but in trust, and not actually paid out to them until the death of the surviving spouse. While this type of trust has important application in estates which are above the exemption amount, it also has application in smaller estates. If the surviving spouse has debts or liabilities, for example, the Bypass Trust removes assets from the reach of those creditors. Another good use for a Bypass Trust is where there are appreciating assets which might cause the estate to later exceed the exemption amount. If you place the assets in a Bypass Trust, the estate tax (and necessary exemption amount) on them would be calculated at the death of the first spouse, rather tha at the death of the surviving spouse, when appreciation will have made them far more valuable.
Using a Bypass Trust also has capital gains tax implications. Assets allocated to the trust “step-up” in basis upon the death of the decedent spouse, whereas assets passing to the surviving spouse will only “step up” at the time of the surviving spouse’s death. This can cut both ways. Where an appreciated asset is to be sold prior to the death of the surviving spouse, it may be beneficial to have a step-up occur at the death of the first spouse, so that the tax hit will be less upon the sale. On the other hand, if it is not be sold prior to the survivor’s death, it may be beneficial to wait for the “step up” to occur later, when the asset has appreciated even more. Also, as recent history has shown, there is the possibility of a “step-down” to consider.
It is often unclear at the time that the estate plan is made whether or not a Bypass Trust would be helpful. As a result, many people use a “disclaimer trust”. This basically gives the surviving spouse the ability to decide – at the time the deceased spouse passes away, and with the advice of attorney and accountant – whether to accept all of the decedent’s property or to “disclaim” (give up) a portion and put it into a Bypass Trust. The advantage is that the status of the estate and need for special planning will be much clearer at the time of the first death, than when the Trust instrument was originally drafted. This flexibility would protect against changes in the estate law (in tax land “permanent” may only mean until the next time Congress needs money), or where the estate has grown more than anticipated, or to determine whether the income tax capital gains “step up” is more useful than not.
Other Useful Trusts: QDOT, Asset Protection and Special Needs Trusts
There are numerous other types of Trusts which may be useful even for smaller Estates.
One important trust is called the Qualified Domestic Trust (“QDOT”). Where one spouse is not a citizen of the US, they are not entitled to all of the estate tax protections afforded to citizens. One benefit not afforded is the “marital deduction”, whereby one spouse may make an unlimited transfer to the other with no tax owed or needed to be reported. Most couples use the marital deduction for a tax free transfer of all of their property to the other at death, for the survivor’s use during their lifetime. Then, both spouse’s exemption can be used at the survivor’s death to shield the full estate for transfer to the next generation. Non-citizens cannot use this deduction.
The QDOT affords the non-citizen spouse a similar right to a “marital deduction” as the citizen spouse. (For more complete discussion, see “Estate Planning and the Non-Citizen Spouse”). The QDOT ensures that the trust qualifies for the deduction, by imposing limitations which conform to IRS requirements. It is often used in conjunction with a “QTIP” trust. In most cases where a non-citizen spouse is involved, a QDOT should be included in the estate plan of the citizen spouse or the estate plan of the couple.
Another circumstance in which a specialized trust may be needed is where a descendent has medical, mental or behavioral issues, so that is desirable that a fund be established for their care and maintenance, but which is not controlled by them. An Asset Protection Trust or Special Needs Trust might be appropriate in these cases.
Also, since portability is not applicable to generation skipping tax (“GST”), if any significant amount is to pass to beneficiaries more than one generation removed from the makers of the trust (“settlers”), trust planning will be necessary to reduce this tax.
Other Tax Avoidance Strategies: Inter Vivos Gifts, Insurance, Charitable and Grantor Trusts
Of course, if the estate is large and will clearly, or very likely, be subject to estate tax, there are numerous methods of reducing the size of the estate which will be subject to tax. One simple, yet effective, strategy is to use the annual gift tax exemption. This is currently $14,000 (it did not go up in 2015). Each spouse can give that amount to as many individuals as they want annually, without either incurring gift tax or being required to file a gift tax return. (A gift tax return must be filed in any year that lifetime gifts above the $14,000 amount are given, so that the IRS can keep track of your lifetime giving, in order to debit it against the combined estate tax/gift tax exemption). In this manner, a significant amount can be removed from your estate, tax free, every year.
It is beyond the scope of this article to detail all of the advanced strategies for reducing the tax bite on large estates. But, some of these include: insurance trusts (ILIT), which hold life estate policies on the settlers in order to pay for the estate tax; charitable lead or remainder trusts, which give some of the assets or income to charity while retaining an interest for the settlors or beneficiaries; grantor retained trusts (GRUT, GRAT) which remove assets from the estate, but allow the settlors to benefit during their lifetime.
The bottom line is that while the changes to the federal estate tax law clarify and simplify many aspects of estate planning law, especially for smaller estates, no estate plan should be adopted without a through and specific review of the assets, needs and plans of the individuals involved.
1 This article deals with Federal estate tax planning. Some states collect their own estate tax, which may require estate tax planning specifically aimed at dealing with those taxes. Insofar as my estate planning practice is limited to California, where there is no State estate tax, I do not deal with these issues. Please consult a local attorney if you live elsewhere than California. Also, in general, this article deals with general topics of law, which may or may not be applicable to your situation, and which is not intended to, and is not, legal advice to be relied upon by any reader. You should consult an attorney for any advice, and fully apprise them of your individual situation.