'Give While You Live' 2012 Estate Tax Planning Guide

Unpredictability is still the name of the game in the world of estate tax planning. The future of the estate tax is just as unpredictable as our national politics. Fortunately, the new Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010, which President Obama signed into law in December, presents some simple ways to save tax dollars through gifting until January 1, 2013. Now is also the time to update and simplify estate tax planning in a variety of estate planning documents.

Transfer Tax Exemption Amounts and Tax Rates*

* Taxpayers may elect out of estate tax for 2010. Portability of estate tax exemption applies beginning in 2011. Inflation adjustments may apply beginning in 2012.

Brief Summary of Transfer Tax Provisions of 2010 Tax Act

• The amount exempt from estate taxes increases to $5 million per person between the tax years 2010 and 2012, indexed for inflation in 2012. This increase in exemption means that estates of married couples with a combined value of $10 million can now escape the estate tax. After 2012, the amount is scheduled to return to $1 million per person.

• The estate tax exemption through 2012 is “portable” between spouses—a major new benefit. Under prior law, couples had to utilize elaborate estate tax planning to claim the combined estate tax exemption available to a married couple ($10 million under the 2010 Act). Typical planning involved the funding of a “bypass” or “credit shelter” trust on the death of the predeceased spouse. A married couple often had to retitle assets to facilitate the funding of that trust, regardless of which spouse died first. Decision-making remains complex with portability.

• The executor of a deceased spouse’s estate is now allowed to transfer the unused exemption amount of a deceased spouse to the surviving spouse. If you’re the surviving spouse, you may then apply the unused exemption amount to shelter assets subject to tax after your own death without complex trust planning. (Note, however, that the portability benefits will only be available for the estates of deceased spouses dying after 2010.)

• Portability creates the odd circumstance that a surviving spouse may be required to file an estate tax return to preserve the deceased spouse’s exemption amount, even though the estate is not taxable. An expensive estate tax return may have to be filed to make an election to preserve portability even though a return was not otherwise required. Ironically, a provision intended to reduce the cost of transferring wealth may increase the cost! In addition, many grieving surviving spouses will miss the nine month deadline and lose their right to use their beloved’s unused exemption amount!

• Portability Example:

Husband has $11 million and Wife has $3 million. Wife dies in 2011 and Husband dies in 2012. Wife’s estate files a timely filed federal estate tax return on Form 706 which allocates portability to Husband even though a return was not otherwise required to be filed. Husband’s estate qualifies a total exemption amount of $7 million (his own exemption amount of $5 million plus wife’s unused “portable” exemption amount of $2 million).

• Portability does not get future appreciation out of the survivor’s estate. Assets bequeathed to a surviving spouse and protected by the new “portable” estate tax exclusion will increase in value. However, the portable portion of that exclusion is frozen at the date-of-death value, without even the benefit of inflation indexing. Assets held in a bypass trust after a spouse dies can appreciate without limit and not be subject to tax in the surviving spouse’s estate. But not if the couple chooses the cheaper portability plan of leaving the deceased spouse’s property to the surviving spouse outright. This means that a bypass trust should be considered for the first death to avoid paying taxes on appreciating assets.

• The surviving spouse must decide whether to fund a bypass trust without the benefit of hindsight. To make the optimal decision, consider which assets may be used to fund the bypass trust, the appreciation potential of those assets, the life expectancy of the surviving spouse, the likelihood that the surviving spouse will remarry and leave a second surviving spouse, and the inflation increase in the estate tax exemption allowable under applicable federal law. Portability may be most attractive for those marrying only once and planning to die with assets of $5 to $10 million. Consider that the deceased spouse has more control with a bypass trust and that a bypass trust can be used for creditor protection purposes. Married and unmarried couples can use a bypass trust to arrange for the assets go to those they both know and love rather than risking that their beloved will leave the assets to a new spouse after the first death.

• Transferring all assets to the surviving spouse outright and relying upon portability of the exemption amount to eliminate the estate tax after the survivor’s death brings step-up in basis for the assets of both spouses on second death. Assets included in the surviving spouse’s estate would receive an adjustment (a “step-up”) in income tax basis on the surviving spouse’s death. That basis adjustment would eliminate capital gains tax on appreciation through the surviving spouse’s death. Note that assets allocated to a bypass trust would not qualify for this adjustment.

• Portability makes sense for certain qualified retirement plans. It can be a lot of work and expense to divide qualified retirement plans among properly drafted sub-trusts. This additional work and expense can be avoided for certain individuals through the use of portability.

• Portability only applies to the last deceased spouse. Taxpayers take a chance of losing their deceased spouse’s exclusion amount when they remarry; it will be lost if the new spouse predeceases the taxpayer. This alone can be reason to use a bypass trust. The portable estate tax exclusion of a “last deceased spouse”, or a bypass trust, can save a wealthy family estate taxes of up to $1,750,000 ($5,000,000 x 35%). In any event, consider if a prenuptial agreement is needed to protect your interest in the portable exclusion amount or bypass trust. The privity requirement means that the new spouse can’t use the exemption amount of spouse’s deceased spouse. Marrying a poor dying person for his or her portable $5,000,000 exemption amount is now great estate tax planning! Portability could even encourage wealthy married couples to divorce so that each may marry a poor dying person for the extra $5,000,000 exemption to bring the original couple's total exemption amount to $20,000,000!

• Portability Privity Example:

Mary Jane has $11 million and spouse Frank has $3 million. Frank dies in 2011 and Frank’s estate files a timely filed federal estate tax return on Form 706 which allocates portability to Mary Jane even though a return was not otherwise required to be filed. Mary Jane is entitled to use Frank’s “portable” $2 million exemption amount until Mary Jane marries Jack, who has $50 million and Jack dies. Jack’s estate uses his $5 million estate tax exemption in its entirety. Mary Jane then dies. Mary Jane’s estate qualifies for her own exemption amount of $5 million. Mary Jane’s estate is now barred from using Frank’s unused “portable” exemption amount of $2 million because Frank is not Mary Jane’s “last deceased spouse”. Mary Jane may want to consider divorcing Jack if Jack gets a terminal diagnosis in order to preserve her use of Frank’s portable exclusion amount!

• Portability is not applicable to the GST (generation-skipping transfer) tax. The amount exempt from GST taxes between 2010 and 2012 is $5 million and is scheduled to return to $1 million after 2012. Couples may make up to $10 million of tax-free generation skipping transfers until 2013. If you’re wishing to take advantage of the GST exemption for an estate, you must establish a trust in any event. The GST tax rate is 35% in 2011 and 2012. It is now zero for 2010.

• The estate tax is reactivated as of January 1, 2010. The estate of a person who died in 2010 may opt out of the estate tax rules, in exchange for a partial step-up in income tax basis. An analysis should be done regarding the best alternative for the estates of those who died in 2010. Fortunately, recognizing that the estate tax rollercoaster has made transfer tax planning difficult or worse, the 2010 Act provides additional time for executors of 2010 estates to make certain elections and actions. Executors and trustees whose estates might benefit from these extensions should consider withholding distributions pending analysis of how the new law applies.

• Every taxable estate is likely to be audited. The IRS will be receiving far fewer estate tax returns now that the exemption amount is up to $5,000,000. Expect all filed returns to be audited.

Estate Tax Savings for 2011 and 2012

Predictions are that the largest transfer of wealth in our history will occur over the next two years. We have never before seen an exemption amount as high as $5,000,000 and we have never seen estate and gift tax rates as low as 35%. This temporary opportunity allows significant gifts with little or no gift tax. These gifts can be made through a variety of trust structures to enable the donor to retain various benefits. Plan carefully to leverage the value of such gifts. Consider two main courses of action for 2011 and 2012:

• 1. Utilize the new, higher $5 million estate, gift and GST tax exemptions to avoid the risk of adverse political change after 2012 by making gifts to your children, grandchildren and other loved ones. These gifts can include:
  
  
  • annual exclusion gifts and other outright gifts of cash or marketable securities
  
  
  • transfers of minority interest in family-owned businesses and real estate. (The 2010 Act includes none of the proposed restrictions on discount planning.)
  
  
  • using Grantor Retained Annuity Trusts. GRATs had been slated for substantial restrictions, tantamount to repealing the tax benefits from creating and funding those trusts. The 2010 Act includes no restrictions on GRATs, and we are still using them to deflect appreciation to future generations.
  
  
  • forgiving loans to children and grandchildren or trusts created on their behalf.
  
  
  • Make $13,000 annual gift tax exclusion gifts for 2011 and 2012 (you can give $13,000 to each person, meaning that spouses can give a combined total of $26,000 to each child and grandchild). Consider that gifts of tuition payments and medical expenses, if paid directly to the academic or medical institutions, are still tax-free and can be made at any time.
  
  
  • making taxable gifts at the favorable 35 percent rate.
  
  
• 2. Review your estate plan documents, such as wills and revocable trusts, to ensure that those documents are consistent with the new law.

The changes in the 2010 Act make it essential for you to review all formula clauses keyed to estate tax exemption amounts. This review might include not only the obvious ones such as the funding clause for a bypass trust, but also estate-related clauses in prenuptial and buyout agreements. Formula clauses may need to be modified to include explanatory provisions, caps and floors, and other safeguards to deal with the unknowns of 2013 and beyond. Consider that portability of the estate tax exemption may go away after 2012. Consider that future economic turmoil could change assumptions about the value of assets. Consider liquidity needs. Each individual situation should be analyzed separately to maximize tax savings. Sometimes you just have to run the numbers.

Always use a disclaimer option for flexibility so that survivor can disclaim to a bypass trust. Keep most traditional planning in place. Some estate lawyers are using trust protectors and special trustees for added flexibility. Others don’t want the added complexity of a trust protector or special trustee.

In many instances, individual documents can be simplified. Regardless of the value of your assets, now is a great time to make sure you don’t have old tax planning in your documents because old tax planning is often worse than no tax planning.

Of course, making large gifts can have major unintended emotional and financial impacts on a family that aren’t always positive. Suppose, for instance, the recipient isn’t old enough or mature enough to manage the gift wisely. Perhaps other relatives will be offended because they didn’t receive an equal gift. Blended families have even more to think about because they have children and assets from previous marriages.

Now, while the higher exemption amount and lower estate and gift tax rates are still in effect, is the ideal time to take advantage of this temporary opportunity to make large gifts to loved ones. It’s also important to make sure your documents are up-to-date to protect yourself and your loved ones.

© 2011 John E. O’Grady

The information contained in this article is general in nature and should not be relied upon for any specific situation. Consult a qualified attorney for any specific legal advice.