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Certainty At Last? Estate and Tax Planning After The American Tax Payer Relief Act of 2012

As first appeared in the May 2013 Louisville Bar Association Bar Briefs.

After over a decade of constantly changing rules and uncertainty surrounding the future of the federal estate and gift tax laws, Congress and President Obama finally provided clarity with the American Taxpayer Relief Act of 2012, which was actually enacted on Jan. 2, 2013. The changes the Act put in place are effective for tax years beginning after December 31, 2012.

Historically high tax exemption amounts

In 2012, the estate tax and gift tax exemption amounts were $5.12 million with a flat tax rate of 35 percent for any amount transferred over this $5.12 million exemption amount.  Under prior law, these estate and gift tax exemption amounts were scheduled to “sunset” after December 31, 2012 and were each set to return to $1 million, with a top marginal tax rate of 55 percent. This scheduled reduction in estate and gift tax exemption amounts caused many individuals and married couples to make substantial gifts in 2012 in order to take advantage of a perceived once-in-a-lifetime opportunity.

However, taking advantage of the increased exemption amounts with large gifts was not a worry free matter either as there was some concern that if the estate tax exemption was reduced to $1 million, those who made large gifts and used more than $1 million of their tax exemption in connection with large gifts in 2011 and 2012 would be subject to some sort of the “clawback” as a result of the large gifts.  The fear with any clawback was that the value of those gifts would be dragged back into the individual’s gross estate resulting in increased taxes at his or her death.

Much to the relief of practitioners and their clients, the Act was passed and provides that the federal estate, gift and generation-skipping transfer (GST) tax exemption amounts will each remain at $5 million permanently, indexed for inflation in the future. For 2013, these indexed exemption amounts are actually $5.25 million.  Unfortunately the meaning of “permanent” in Washington, D.C. politics means that these high exemption amounts will remain in place until Congress changes their collective mind and changes the tax exemption amounts with future legislative action. While the Act maintained these tax exemption amounts at historically high levels, the tax rate on estates, gifts and generation-skipping transfers over the exemption amounts was increased from a flat 35 percent in 2012 to a flat 40 percent in 2013 and beyond.

Portability

One of the most important aspects of the Act is that it makes “portability” of the estate and gift tax exemption amounts to a surviving spouse permanent.  The GST tax exemption is not portable to the surviving spouse. Portability was a part of estate and gift tax legislation passed in 2010 and was also scheduled to sunset at the end of 2012. Portability allows a surviving spouse to receive and utilize any estate or gift tax exemption amount unused by the deceased spouse at his or her death. Portability helps ensure that estate and gift tax exemptions will not be wasted if the first spouse to die is unable to fully use his or her estate or gift tax exemption amount. For example, if a wife dies in 2013 only utilizing $2 million of her estate tax exemption amount (e.g. she has $2 million of assets pass into a credit shelter trust for the benefit of her husband and children), her executor can file a federal estate tax return to elect to “port” her unused estate tax exemption amount of $3.25 million to her husband. This means that he then has $8.5 million (his own $5.25 million plus the $3.25 million from his wife) of transfer tax exemption to apply against his lifetime gifts and/or at his death.

The “catch” with portability is that in order to transfer this unused tax exemption amount to the surviving spouse, a federal estate tax return (Form 706) must be timely filed for the deceased spouse.  In order to be timely, the estate tax return must be filed within nine months of the individual’s date of death, but may be extended automatically by an additional six months if Form 4768 is filed with the IRS within the original nine month period.

This estate tax return requirement has posed a new challenge to attorneys who are advising executors through the estate administration process.  In order to ensure that the attorney has fulfilled his or her duties to the executor, the attorney needs to advise the executor of the requirement to file an estate tax return to transfer the deceased spouse’s unused estate tax exemption amount to the surviving spouse and also advise the executor with respect to the benefits and costs of filing this return.  (Luckily, the IRS has relaxed some of the valuation reporting requirements on an estate tax return, if the estate tax return is filed solely for portability purposes.  Treas. Reg. Section 20.2010-2T(a)(7)(ii).)

This discussion with the executor may be an even greater challenge if the executor is not the surviving spouse, such as when it is a second marriage and a child is named as the executor.  If the executor decides against filing an estate tax return, it is generally recommended that the attorney send the executor a detailed letter explaining the situation and requirement to file an estate tax return, and have the letter confirm that after being advised of all the benefits and costs of filing the estate tax return, the executor has elected not to file the estate tax return.  This should help to protect the attorney from any second guessing by the executor or beneficiaries of the surviving spouse’s estate.

Balancing estates

While making portability permanent would seem to eliminate the need to “balance” the estates of both spouses during their lifetimes, ensuring both spouses have significant assets still has advantages and is often recommended. One reason to continue balancing estates is to shelter assets, as well as the growth and appreciation of those assets, from estate tax at the surviving spouse’s death by using a credit shelter trust. Let’s look at the example of a husband and wife again. Each has $5.25 million of assets in their names (a total of $10.5 million). The husband dies in 2013 and all of his assets pass to a credit shelter trust for his wife’s lifetime benefit. The wife dies later in 2020, and both her assets and the assets in her husband’s credit shelter trust have each grown to $8 million (a total of $16 million). Assuming no inflation adjustments in this example, the wife’s estate will only have approximately $2.75 million in assets subject to estate tax. At a 40 percent tax rate, that would result in $1.1 million in estate tax. Alternatively, if all of the husband’s assets passed to the wife at his death and portability was elected, at the wife’s death she would be able to “shelter” $10.5 million, with $7.5 million then being subject to tax. At a 40 percent tax rate, that would result in $3 million in estate tax.

Balancing estates and maximizing the estate tax exemption amount used at the first spouse’s death protects against future appreciation of assets being subject to future estate tax and against future decreases in the federal estate tax exemption amount. In addition, if a couple’s estate plan keeps assets in trust for the lifetime of their children (generation-skipping trusts), using a credit shelter trust at the first spouse’s death and applying the first spouse’s GST exemption will ensure that the GST tax exemption is maximized; this GST exemption is not portable to a surviving spouse. Allocating GST exemption will ensure that the assets passing to the trusts for the children will not be subject to estate tax at their deaths.

There are also several non-tax reasons to balance estates and continue to utilize credit shelter trusts.  One such advantage of using a credit shelter trust is that the assets held in the trust for the surviving spouse’s lifetime should provide asset protection for the surviving spouse.  The assets in the credit shelter trust should be protected from any creditors of the surviving spouse as well as protection for the surviving spouse and children in the event the surviving spouse remarries.

Some commentators have suggested that it may be better to use a marital or QTIP (qualifying terminable interest property) trust rather than a credit shelter trust at the first spouse’s death.  This is generally suggested when a married couple does not have any estate tax concerns, and it is unlikely that they will in the future.

A QTIP trust is solely for the benefit of the surviving spouse (e.g. children cannot be beneficiaries of the trust during the surviving spouse’s lifetime), and is included in the surviving spouse’s estate for estate taxes.  The QTIP trust would still provide some asset protection and could be structured to protect against a subsequent marriage by the surviving spouse.  While this may seem like wasting the opportunity to shelter assets from estate tax, having all of the first spouse’s assets pass to a QTIP trust would allow full portability of the first spouse’s estate tax exemption amount to the surviving spouse.  Under current law, this would give the surviving spouse at least $10.5 million to shelter assets at his or her death.

Since all of the surviving spouse’s assets together with the entire QTIP trust will be included in the surviving spouse’s estate at his or her death, then all of these assets will all receive a full step up in basis at the surviving spouse’s death, reducing any capital gains on those assets sold after the death of the surviving spouse.  The assets in a credit shelter trust will not receive a step up in basis at the surviving spouse’s death.  While this is a great planning idea under the Act, it may not be effective unless the IRS changes a position it has previously taken.  Under Rev. Proc. 2001-38, 2001-1, C.B. 1335, the IRS has stated that any QTIP election will be disregarded automatically to the extent it is not necessary to reduce estate taxes at the first spouse’s death.  The IRS has been asked to reconsider this position in light of portability of tax exemption to a surviving spouse, but it has yet to officially change this position.

Revisit Estate Plans

While balancing estates and using credit shelter trusts is still recommended in many instances, the increased estate tax exemption amount together with portability will allow many individuals and married couples the opportunity to simplify their estate plan if that is desired.  Many estate plans prepared prior to 2009 were prepared with the previous (and significantly lower) estate tax exemption amounts in mind.  These estate plans should likely be revisited in light of the Act to determine if the estate plan still makes sense and whether it can be simplified.

Certain areas unaffected by the Act

The new law did not address several areas that have drawn increased attention from lawmakers as well as President Obama over the past couple years.

First, the Act did not make any change to the estate tax treatment of irrevocable “grantor” trusts.  Income generated on a grantor trust’s assets is taxed to the grantor (or the person establishing the trust), rather than the trust itself. Grantor trusts are generally not includible in a person’s estate for estate tax and can increase the tax benefits of making substantial lifetime gifts to the trust, since the income tax is paid by the grantor rather than from the trust income, thus allowing the trust assets to grow free of income and estate tax. In addition, grantor trusts provide the opportunity for the grantor to sell appreciated assets to that trust without having to recognize capital gains on the sale.

Over the past couple years there have been several proposals to change the estate tax treatment of grantor trusts.  Under these proposals, grantor trusts would be generally be included in the grantor’s estate for estate taxes, thus eliminating all tax benefits of grantor trusts.  Since the Act did not address grantor trusts, for the time being grantor trusts are still able to be used by estate planners to achieve the tax benefits described above.  However, grantor trusts continue to be a topic of much debate and their favorable status could change in the future.

Second, the Act did not address another relatively recent proposal of limiting the time which assets can remain exempt from GST tax.  Currently, assuming a trust is established in a jurisdiction that has repealed the rule against perpetuities (such as Kentucky), trusts that are fully exempt from GST tax could escape any estate or GST tax forever.  However, there have been recent proposals which would limit this time period and provide that GST tax exemption can only last for a maximum of 90 years.  At the end of the 90 year period, any distribution would likely then be subject to GST tax.

Since this 90 year GST tax exemption limitation is only a proposal, the use of GST tax exemption to avoid transfer taxes is still a valuable method to pass assets to multiple generations without the assets being subject to tax at each generation.

The future looks more certain

The Act has opened the door on many planning opportunities which otherwise would have been unavailable in 2013 and beyond. One significant estate planning aspect of the new law is that it extends the opportunity to individuals who were unable to or did not make large gifts in 2011 or 2012 to make those large lifetime gifts now. Making large lifetime gifts can ensure that future asset growth and appreciation is sheltered from tax at that person’s death and at the death of his or her spouse or children.

For married couples, the Act continues the opportunity for spouses to make substantial lifetime gifts to non-reciprocal trusts for the benefit of the other spouse. In order to be “non-reciprocal,” the trusts must be created at different times, funded with different assets, and have terms which are substantially different from each other to avoid any negative tax and/or asset protection consequences. Such trusts should only be prepared after consultation with an attorney and other trusted advisors.

The American Taxpayer Relief Act of 2012 has provided a great deal of certainty for estate and gift planning with the “permanence” of the estate and gift tax exemptions and has solidified certain planning techniques and opened the door to many new planning opportunities.  However, with these increased techniques and opportunities comes increased responsibility on the part of the attorney to advise his or her client on all relevant aspects and choices when drafting an estate plan as well as carrying out the estate plan through the estate administration process.

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