On Dec. 17, President Obama enacted tax legislation that extended the Bush-era tax cuts, which were due to expire Jan. 1. The legislation contains provisions for estate, gift and generation skipping transfer (GST) taxes (collectively, the Transfer Taxes), including an option for 2010 decedents. This article is not meant to provide a detailed analysis of the new law. Rather, it points out some of the key Transfer Tax provisions and how they can affect your clients’ planning.
It is important to note that the new law is temporary. Unless Congress acts before Jan. 1, 2013, the Transfer Tax exemptions and tax rates will revert to what they were in 2001. For example, the federal estate tax exemption will return to $1 million per person, with a maximum rate of 55 percent in 2013.
While the focus of this article is on wealth transfer opportunities and traps for the unwary, for 2011 and 2012 the new law provides much-needed clarity for estates of people who died in 2010 and for those who made gifts in 2010. Executors of estates of 2010 decedents may elect to be taxed under the 2010 rules of no estate tax, but with the modified carry-over basis for the sale of inherited assets. Alternatively, executors may elect the $5 million federal estate tax exemption (known also as the unified credit) and the 35 percent estate tax rate of the recently enacted law.
Under the new law, there is a per-person estate tax exemption of $5 million and a top marginal estate tax rate of 35 percent from January 2011 through 2012 (subject, as mentioned earlier, to any interim legislation). This exemption amount and tax rate also applies to gift and GST taxes for the same time period. In addition, the legislation adopted a so-called “portability” feature for the estate tax exemption, which allows any unused estate tax exemption from the death of the first spouse to be transferred to the surviving spouse for use at his or her subsequent death. The exemption for GST purposes, however, is not portable. The new law also reinstated the stepped-up basis upon death.
A few observations come to mind. Many congressional Democrats were, and remain, incensed over what they feel to be overly generous concessions the president gave to the Republicans. This group, inasmuch as the unified credit was slated to be $1 million per person in 2011, with a maximum rate of 55 percent, was seemingly amenable to an exemption of $3.5 million per person and a 45 percent top rate.
Many Republicans still want full repeal. In fact, during the second week of January 2011, two proposals were made by congressional Republicans for full repeal. Rather than providing the public with a permanent Transfer Tax law, all Congress did was “pass the buck” for two more years. Consequently, the issue is far from over, but there is likely a two-year window where rich and divestment-oriented clients can take advantage of unavailable wealth transfer opportunities. The new legislation also affords grantors of so-called, “ILITS” (irrevocable life insurance trusts) the opportunity to pre-fund such trusts without incurring gift or GST taxes.
As a result of the new law, an individual can make gift and GST tax-free transfers to heirs, either outright or in trust, of $5 million. This is above any annual exclusion gifts. Last year, by comparison, the lifetime gift amount was $1 million. Any gift higher than that was subject to a gift tax. Now, for example, a husband and wife who already gifted $2 million to a trust for the benefit of their heirs can make additional gifts of $8 million. As a result, we envision a significant increase in the creation and funding of GST-exempt and so-called “Dynasty” trusts, over the next two years.
Some of the omissions from the new legislation are as important as what Congress addressed. Specifically, certain planning techniques that Congress was presumably targeting for reform, such as zeroed out GRATS and discounts associated with family limited partnerships (and limited liability companies), are not affected by the legislation and remain viable and tax efficient wealth transfer strategies.
One potential pitfall is the increased disparity between the federal estate tax exemption and the amount exempt from state (where applicable) estate/inheritance tax (in Pennsylvania, for example, there is an inheritance tax between 4.5 percent and 15 percent, depending on the relationship of the beneficiary to the decedent). If a testamentary credit shelter trust is funded with the full $5 million, this will result in the payment of applicable state estate/inheritance taxes, which perhaps the family would rather avoid. There are several ways to address this potential problem including funding a credit shelter trust by using a disclaimer.
Another ramification is that some decedents who die in 2011 and 2012 may inadvertently disinherit their spouse. For example, some wills provide that the amount of money exempt from federal estate tax is to be paid to heirs other than the surviving spouse (i.e. children or a credit shelter trust that benefits heirs other than the spouse) and that the excess is paid to the surviving spouse. Attorneys who incorporated such a provision incorrectly anticipated that there would always be a federal estate tax or that the exemption would be less than the decedent’s estate. Under such a scenario, the children would get the $5 million exempt amount (possibly the entire probate estate) and the spouse nothing. Such a provision, in addition to not reflecting the testamentary intent of the decedent, might result in the payment of state estate tax (otherwise avoidable) as set forth above, and post-mortem litigation.
Some of the planning tips offered by Citrin Cooperman Wealth Management for attorneys to consider, primarily as a result of the new legislation, include:
• Planning Tip No. 1: Ask your clients what they want to accomplish with their wealth while alive and upon death. Keep in mind that people created wills and trusts prior to the imposition of Transfer Taxes. Even clients without exposure to Transfer Tax require estate planning and trusts for a variety of reasons, including but not limited to creditor protection, asset preservation and administration, trusts for minors, special needs trusts, QTIP trusts, QDOTs and probate avoidance.
Review your clients’ estate plans. This includes reviewing their beneficiary designations and how property is owned.
Make sure that their wills and overall plan properly shelter the new exemptions and do not disinherit the spouse. Wealthy clients should not rely on portability of the estate tax exemption. It is advisable to fund, or at least have the option to fund, a GST exempt credit shelter trust upon the first spouse to die. This is because the GST exemption is not portable. Moreover, the appreciation of the credit shelter trust is outside of the surviving spouse’s taxable estate.
• Planning Tip No. 2: Now is an ideal time to transfer wealth in a tax-efficient manner. Interest rates are at historic lows and many assets are at depressed values. Clients should consider taking advantage of their new gifting capacity. Gifts, other than annual exclusion gifts, will reduce the amount of available exemption upon death, but any growth on the gifted sum inures to the benefit to the donor’s heirs, estate tax-free (and perhaps GST tax-free). Wealthy clients, especially those with estates greater than 10 million dollars, should still aggressively take advantage of family loans, GRATS, QPRTs, and discounted gifting.
• Planning Tip No. 3: If your clients intend to make annual exclusion gifts this year, there is no reason to wait until the last minute, assuming they have the financial ability to make them earlier. By making the gifts, for example, in early 2011 as compared to December 2011, the recipient of the gift, be it a trust or individual, will benefit from the use of the money or the appreciation thereon for 11 or so extra months.
• Planning Tip No. 4: Review all life insurance policies. A so-called “policy audit” will indicate if a policy will likely require greater than expected premiums to avoid a lapse prior to maturity. If a trust-owned policy is underfunded or underperforming, or the insured is perhaps likely to live longer than anticipated, it might be prudent to take advantage of the two-year window to gift additional sums to the trust to satisfy premium obligations. In a policy not owned by an ILIT, perhaps the grantor should consider the sale or gift of the policy to an ILIT to avoid estate tax on the death benefit.
A well contemplated estate plan remains an important part of an overall financial plan. It is important for clients to be certain that their estate planning documents fit with the new law, and that their overall plan reflects their intentions in a tax-efficient manner. •
David B. Bruckman is managing director of Citrin Cooperman Wealth Management, a registered investment adviser that provides personal financial planning, investments and insurance. He can be reached at 212-697-1000 or firstname.lastname@example.org.
Alan Mandeloff is president of Citrin Cooperman Wealth Management, a registered investment adviser that provides personal financial planning, investments and insurance. He can be reached at 215-545-4800 or email@example.com.