David Dickey: A Major Paradigm Shift in Estate Planning
Wednesday, February 11th, 2015
There has been a major paradigm change in estate planning, with the emphasis shifting from planning for the minimization of the federal estate tax to planning for the minimization of the federal and state capital gains tax (income tax), for all but the wealthiest of taxpayers. This shift has been accompanied by a new emphasis on asset protection planning.
The federal estate tax is an excise tax imposed by the government upon the fair market value of assets transferred from one person to another, whether by gift (during life) or upon death (e.g., a bequest by Will from deceased parent to a child). Historically, the tax has been as high as 90% (during World War II) and is currently at 40%. That’s not 40% of the income from the asset: it’s 40% of the fair market value of theentireasset! There has always been an exemption from the estate tax for each individual, and that exemption is now a whopping $5,430,000 per person (in 2015), a huge increase from traditional levels. With proper planning, that exemption can be doubled to $10, 860,000 for a husband and wife. Such generous exemptions remove or can remove most families from the application of the federal estate tax. Even with such large available exemptions from the estate tax, estate planning should not be ignored for reasons described below.
Looking to the past, when: (1) the estate tax rates were much higher (e.g., 55%); (2) the estate tax exemption was much lower (e.g., $1,000,000 per person); and (3) the capital gains rate was much lower (e.g., 15% federal plus 6% state), most estate planning involved one of two methods, both of which focused on the estate tax. First, the first spouse to die would leave all of his or her assets outright and free of trust by Will to the surviving spouse. When the surviving spouse subsequently died, assuming his or her estate did not exceed in value the exemption applicable at that time (in our example $1,000,000), there would have been no estate tax. Of course, the survivor could have lost the assets to creditors, over-reaching children, or a new spouse, so the use of a marital trust such as a QTIP Trust (which can avoid such losses) would still have been recommended (particularly in second marriages where the first spouse to die wanted to take care of the surviving spouse for life but wanted the assets to pass upon the survivor’s subsequent death to the children of the first decedent). On the other hand, if the assets that passed to the surviving spouse, when combined with his or her separate assets, caused that survivor’s estate to exceed $1,000,000 in value, an estate tax would have been imposed on the assets in the survivor’s estate in excess of that exemption. To prevent that result, a second primary method of asset transfer was generally used; it was known as the A/B Trust technique. The first decedent would create two trusts (A & B) under his or her Will. One of those trusts, known as the Credit Shelter Trust, or the ByPass Trust, would be funded at the first spouse’s death with a formula amount equal to the exemption available to the first decedent. By using the formula, the testator did not need to change his or her Will every year. This ByPass Trust would not qualify for the estate tax marital deduction but would be sheltered from estate tax by the use of the first decedent’s exemption ($1,000,000 in our example). The surviving spouse could receive all of the income from this trust as well as such amounts from the principal of the trust as would be necessary to provide for his or her reasonable support, maintenance and healthcare. Despite the use of the assets for life, when the surviving spouse died, the assets would “bypass” (or not be included in) his or her estate for estate tax purposes and would then pass free of estate tax to, or in trust for the benefit of, the members of the next generation. Any assets of the first decedent in excess of his or her exemption would generally pass either outright to the surviving spouse or into a Marital QTIP Trust for the survivor’s lifetime benefit, with the result that there would be no estate tax imposed at the first death. In either event, the assets passing outright or in the QTIP would be included in the surviving spouse’s estate where they would be taxed if, when combined with the survivor’s separate assets, they exceeded in value the survivor’s separate exemption amount. Under the A/B Trust technique, BOTH spouses would be allowed the use of their respective exemptions and thus, in our example, the family as a whole, would be entitled to two exemptions rather than one. If the surviving spouse was in the 55% bracket, the use of the ByPass Trust would have saved estate taxes not only on the $1,000,000 placed into the ByPass Trust by the first decedent but also on all of the growth on the $1,000,000 in that ByPass Trust between the date of the death of the first decedent and the date of death of the survivor. That would have been a savings of $550,000 plus 55% of the growth. One major drawback of the use of a ByPass Trust was that the assets contained in it did not get a stepped-up basis for income tax purposes at the date of the survivor’s death (as the assets in the QTIP Trust did). However, the higher estate tax rate generally caused taxpayers to focus on estate tax planning rather than income tax planning.
What is meant by a “stepped-up basis?” Let’s take an example: suppose Mr. Oglethorpe purchased land in Pooler in 1950 and paid $100,000 for it. In 2015, the value was $1,000,000. If he sold the land in 2015, he would have a capital gain of $900,000 (which, at 2015 rates, could be as high as 29.8%--20% federal long-term capital gain rate; 6% state LTCG rate; and 3.8% ObamaCare tax penalty). [The President is proposing a further increase in the federal capital gain rate from 20% to 28%]. However, assume that Mr. Oglethorpe died in 2015 still holding the property and did not sell it. The Internal Revenue Code allows an adjustment to the income tax basis of an asset that is included in the gross estate of a taxpayer at death. Thus, if the executor of Mr. Oglethorpe’s estate were to sell the land AFTER his death, there would be no gain because the fair market value of the land ($1,000,000) would become the new basis. In other words, the income tax basis of assets will get to step-up (or down) to fair market value if included in the taxable estate of a decedent for estate tax purposes. If the basis is equal to the value, there is no gain on sale.
Under current law (not looking back), from an income tax viewpoint, the problem with a ByPass Trust is that the assets used to fund it will get a stepped–up basis on the first spouse’s death but, since they are not included in the surviving spouse‘s taxable estate, will NOT get a second basis adjustment at the death of the surviving spouse. Thus, if there should be growth on the assets after the first spouse’s death, that growth will not escape income tax when the assets are later sold by the Trustee of the ByPass Trust (or by the trust beneficiaries after distribution from the trust to them). Most estate plans using the A/B trust technique fund the ByPass Trust with a formula that places the exemption amount of the first decedent in the ByPass Trust. Since the ByPass Trust’s assets escape inclusion in the surviving spouse’s estate, they will not get a stepped-up basis at the second death. Yet, with such a huge increase in the exemption, if the combined estates of the spouses do not exceed the survivor’s separate exemption of $5,430,000 (in 2015), there will have been no need for the Bypass Trust because no estate tax will have been due, and the stepped-up basis will have been lost for nothing. A Marital QTIP includible in the surviving spouse’s estate can protect the assets from future spouses, creditors and over-reaching children, while allowing the first decedent to direct the ultimate disposition of the QTIP assets after the survivor’s death, and still allow for a stepped-up basis at the second death (since the assets will be included in the survivor’s taxable estate).
If the combined estates of both spouses are between $5,430,000 and $10, 860,000, the analysis becomes more complex: a ByPass Trust can be used to take advantage of both credits as in the traditional A/B Trust plan, but an independent trustee could be given the right to distribute to the surviving spouse from the trust such amount of asset value as will cause the survivor’s estate to reach but not exceed his or her separate exemption amount. The distributed assets will then be included in the survivor’s estate and obtain a stepped-up basis. Alternatively, the surviving spouse can be given a right known as a general power of appointment to appoint an amount of property from the ByPass Trust to his or her estate which will not create any estate tax but which will allow a stepped-up basis on the assets so appointed. Neither of these strategies will create any estate tax but will allow a step-up in basis of the distributed or appointed assets. These may not be good strategies, however, for a second marriage where the survivor might be expected to leave the appointed or distributed assets to his or her separate children from a prior marriage.
Fortunately, Congress has now provided help to the taxpayer in this situation. The first spouse does not need to create a ByPass Trust any longer in order to permit the family to use both exemptions. Previously, the exemption of one spouse could not be transported to the other: a ByPass Trust had to be used to take advantage of both exemptions. Congress now allows what is known as “portability.” Under this favorable rule, a surviving spouse can use the unused exemption of the first spouse to die. This amount, known as the Deceased Spouse’s Unused Exemption (“DSUE”) can be “ported” over and used by the surviving spouse (by gift during life or against the estate tax at the survivor’s death). Suppose for example that, in a second marriage scenario, the husband died first and bequeathed $1,000,000 directly to his children from a prior marriage. He established a Marital QTIP Trust for his spouse (which gave her all of the income during her over-life but left the remainder of the trust to his separate children upon her subsequent death). The testamentary gift to the children would consume $1M of his exemption. The remaining $4,430,000 of his exemption would be unused since it passed into a QTIP Trust qualifying for the Marital deduction and no exemption was needed to shelter it from estate tax. If the husband’s executor timely filed a Form 706 to elect Portability, then the DSUE of $4,430,000 would be added to the surviving spouse’s $5,430,000, thus sheltering $9,860,000 from estate tax at the surviving spouse’s death (plus the $1M sheltered which was given to the children). [Complex rules apply if the wife remarries and then the new husband also predeceases her.] The beauty is that both exemptions would be fully available and all but $1,000,000 would also get a stepped-up basis on the wife’s subsequent death. The QTIP Trust could, with proper additional planning, be split into two parts and the first decedent’s remaining Generation-Skipping Tax Exemption (“GSTE”) could be allocated to one of the two parts that would be funded with an amount (or share) equal to the first decedent’s remaining GSTE (currently also $5,430,000--less any part previously used). The part to which the first decedent’s GSTE would be allocated would be “sheltered” from the application of the harsh Generation-Skipping Tax. As a result, that “sheltered” part could escape estate and generation-skipping taxation at multiple generational levels (while remaining in trust for a long time to provide protection against creditors, predators, and divorcing spouses at each generation, etc.). The surviving spouse would also have her remaining GSTE available for use against the balance of the QTIP (if so structured) and/or her separate assets. Note that to elect portability, an estate tax return has to be filed at the first death EVEN IF it would not otherwise be required.
For couples with more than $10, 860,000, the complexity level increases and more sophisticated estate planning techniques may be in order. The take away is that if you are not using trusts to protect against potential creditors of your family members, and/or if you have a ByPass Trust funded by a formula under the document, you should revisit your plan soon.
The material in this publication was created as of the date set forth above and is based on laws, court decisions, administrative rulings and congressional materials that existed at that time, and should not be construed as legal advice or legal opinions on specific facts. The information in this publication is not intended to create, and the publication or transmission of it does not establish or constitute, an attorney-client relationship. Internal Revenue Service rules require that we advise you that the tax advice, if any, contained in this article was not intended or written to be used by you, and cannot be used by you, for the purposes of (i) avoiding penalties under the Internal Revenue Code, or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein.