The American Taxpayer Relief Act of 2012 (ATRA) was signed into law on Jan. 2, 2013, averting the fiscal cliff and avoiding draconian changes to our transfer tax system.  Far from the grand bargain needed to deal with our nation’s unsustainable deficits, ATRA was, in essence, a patch to prevent the expiration of the Bush-era tax cuts from falling on middle-income taxpayers.  Even so, ATRA contained a number of promising transfer-tax provisions that were adopted “permanently,” resulting in planning clarity for 2013 and beyond.

The prominent transfer tax provisions include:

·      The estate, gift and generation-skipping transfer (GST) tax exemptions are set at $5 million and are indexed annually for inflation from 2011 on.  For 2013, the transfer tax exemptions are $5.25 million per individual.

·      The top transfer tax rates are set at 40 percent (an increase from the 35 percent maximum tax rate in 2012, but less than President Obama’s desired 45 percent maximum rate of 2009);

·      Spousal portability was permanently extended, allowing a surviving spouse to use the unused estate tax exemption of a deceased spouse to shelter lifetime gifts from gift tax or to pass additional assets free of estate tax at the surviving spouse’s subsequent death.  Note, portability doesn’t apply for GST purposes.

Based on these provisions, here are my 10 planning pointers and predictions.

1. Meaning of Permanency

The gift, estate, and GST tax provisions are now “permanent,” meaning that the sunset provisions of the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) have been repealed.  Still, a fiscally challenged Congress must, at some point, deal with real spending cuts and additional revenue raising, so count on further changes to our tax system overall and more than a few tweaks to transfer taxation in the years to come.  

2. Expect Future Revenue Raising

Possible methods for increasing transfer tax revenue currently include: (1) limiting or eliminating minority discounts for family companies or partnerships; (2) limiting the number of generational transfers of assets held in trust which can be sheltered by the GST tax exemption; (3) limiting the benefits of grantor trust status of a trust;  (4) mandating a minimum 10-year term for grantor retained annuity trusts; and (5) requiring basis consistency and reporting for gifted and inherited property.

3. Benefits of Unification and Indexing

ATRA makes the unification of the gift, estate and GST tax exemptions permanent, ensuring expansive wealth transfer opportunities during life and at death.  Moreover, indexing the exemptions should help minimize transfer taxes, as long as the indexing somewhat shadows the growth of the taxpayer’s estate.  Caution: While the big three transfer taxes (gift, estate and GST) are all indexed annually, there’s no indexing of a deceased spouse’s unused exclusion in the case of portability.    

4. State Death Taxes Still a Factor

Currently, 22 states and the District of Columbia have a separate state death tax.  ATRA doesn’t alter state laws pertaining to transfer taxation, and it permanently extends the federal deduction for state estate taxes.  However, ATRA permanently eliminates a state death tax credit, and its elimination sharply curtails state death tax revenue. 

In the nearly one-half of states that do have a state death tax, it may make sense to use a credit shelter trust to hold the state exemption amount and then use portability for any excess over the amount held in trust.  More specifically, portability can be used in combination with a credit shelter trust to eliminate state estate tax in states with no state-only QTIP election. In any event, be wary of funding a credit shelter trust for more than the excess of the state exemption amount, as this will likely result in unwarranted state estate taxes.  

5. Basis Planning Becoming More Important

The combination of exemption portability and sizable transfer tax exemptions, along with ATRA’s increased income tax rates, warrants a more detailed comparison of the basis in assets transferred by gift against the likely step-up in basis for assets transferred at death. Specifically, lifetime gifts may not result in tax savings because the income taxes paid as a result of the carryover basis may be greater than the estate tax saved by transferring the property during life.  In making the decision to gift or not to gift, greater attention will need to be paid to running the numbers under each scenario and using realistic appreciation assumptions.

6. Credit Shelter Trusts vs. Portability

Estate planning for all but the truly affluent will most often entail weighing the benefits of using trust-based plans for asset protection and dispositive control against the simplicity of portability and passing assets outright.  Toward that end and with exemption portability, the use of mandatory bypass trusts in the vast majority of estate plans is sure to decline. 

Portability has a number of noticeable benefits in passing assets outright, as it preserves the step-up in basis upon the surviving spouse’s death, it negates the need to re-title assets among various trusts and there’s no requirement to file annual income tax returns.  Portability also possesses a cost-effective simplicity that makes it appealing to clients, and it can better accommodate large qualified plans than can credit shelter trusts.  

Conversely, credit shelter trusts are more advantageous if the goal is to afford beneficiaries asset protection, to provide for dispositive control and they can be useful in second marriages to ensure that assets will ultimately go to desired beneficiaries.  While credit shelter trusts aren’t tax-efficient income accumulation vehicles (undistributed net investment income in excess of $11,950 in 2013 is taxed at 43.4 percent), they, nevertheless, allow for the allocation of one’s GST tax exemption and can shelter future appreciation from further estate tax.

7. Flexible Planning Considerations

Because of economic uncertainty and political unpredictability, maintaining flexibility in estate planning strategies and planning documents continues to be essential.  Consider granting broad special powers of appointment to certain beneficiaries, providing the power to decant to cure potential trust issues and inadequacies, naming trust protectors for trust oversight and trust modification and crafting flexibility into trustee provisions.  

Spousal lifetime access trusts (SLATS), a favored and flexible technique in 2012 for the tax-efficient transfer of wealth while giving the donee spouse beneficial access, should remain a popular planning strategy in 2013 and beyond.  Also, plan for postmortem flexibility by exploiting disclaimer trusts, one-lung marital trusts (OLMT) and/or Clayton contingent martial trusts (CCMT), to decide whether and in what amount to utilize portability.

More specifically, portability can be used for assets that aren’t disclaimed in disclaimer trust situations and for qualified terminable interest property elections in the case of OLMTs and CCMTs.  As such, the most powerful post-mortem planning technique may not be either portability or credit shelter trusts alone, but both together in a “to be determined” portion that makes planning sense.   If you’re intent on using credit shelter trusts alone, consider granting a trust protector or an independent party broad discretion to distribute assets back to the surviving spouse as a beneficiary for step-up in basis purposes or providing an independent party the power to grant a general power of appointment to the surviving spouse at some future point in time to accomplish the same end.

8.  Trust & Estate Income Tax Considerations

The taxable income of a trust or estate is taxed at the highest individual income tax rate (39.6 percent) for amounts in excess of $11,950 in 2013.  Additionally, a 3.8 percent medicare tax is imposed on the undistributed net investment income of trusts in excess of the income level at which the highest rate applies ($11,950 for 2013).  Therefore, many irrevocable trusts will now be taxed at 43.4 percent on undistributed net investment income, increasing the need for tax-favored investing (that is, municipal bonds and life insurance) and heating up the pressure on trustees to make distributions to beneficiaries who may be taxed at a lower marginal rate.  Likewise, because of the higher income tax rates that apply to estates, income tax planning considerations will likely be an important post-mortem planning issue.

Some trusts, however, received a boost from the increase in tax rates under ATRA. Consider the top federal tax rate for sales of long-term capital assets has increased from 15 percent in 2012 to a high of 23.8 percent (if the 3.8 percent Medicare tax applies) in 2013, an increase of nearly 60 percent.  Moreover, in those states that have a state income tax, the combined capital gain rate will be 28 percent to 32 percent.  As such, charitable remainder unitrusts and charitable remainder annuity trusts should see greater activity, even in this low interest rate environment, due to the larger tax savings available.

9. Get Gift Tax Returns Right

For 2011, there were an estimated 220,000 gift tax returns filed.  Commentators opine that, due to the large number of gifts made in 2012, there are likely to be more than twice that number of gift tax returns filed for 2012.  Therefore, expect the Internal Revenue Service to devote considerably more time and resources toward auditing gift tax returns as opposed to estate tax returns.  Consider that in 2012, less than 4,000 returns were filed for taxable estates.  Accordingly, tax professionals should pay particular attention to the details in filing 709 gift tax returns.  

On the 709 preparation checklist, consider disclosing defined value formulas and swaps that may be made in 2013 to start the statute of limitations.  Make sure that appraisals are qualified and in a form acceptable to the IRS.  Handle gift-splitting issues with great care, especially if gift splitting is used in SLAT situations, in which the donee spouse’s interest must be severable, ascertainable and de minimis.  Allocate GST tax exemption (in or out) when appropriate, and deal with any unreported gift sins from the past on the current 709 return.  Finally, count on an audit pipeline lasting for a couple of years.

10. Life Insurance Shifts from Estate Tax to Income Tax

With a permanent increase in the elevated estate tax exemption coupled with exemption portability, expect to see an overall decrease in the use of life insurance for estate liquidity purposes and an increase in the use of lower death benefit/higher cash value life insurance that can be borrowed from on a tax-free basis and can serve as a bond alternative in a rising interest rate environment.  Such insurance can be owned in one’s estate as an additional retirement savings vehicle or through a SLAT, in which the donor spouse and insured can have indirect access to the cash value through the donee spouse as beneficiary.  

Increasingly, the focus will be less on the tax considerations of estate and life insurance planning and more on using life insurance for earnings replacement, business succession liquidity, legacy equalization, etc. Operationally, there will be a greater need for post-transaction monitoring by the agent and changes to cash value products themselves to help clients better manage their cash and fixed income positions.  Note, clients who utilized all of the GST tax exemption in 2012 now have an additional $130,000 as a result of indexing in 2013, which can be allocated toward irrevocable life insurance trusts. Finally, anticipate seeing less in the way of Crummey trusts, as more clients use their upped transfer tax exemptions for single pay policies as part of their overall diversification and asset allocation.

In this post-ATRA environment, practitioners will need to expand their suite of services to rely less on wealth transfer tax planning (less than 0.5 percent of taxpayers will have a taxable estate) and more on other offerings like asset protection, elder care, retirement and succession planning.  They’ll also need to retool themselves regarding portability now that it’s permanent, focus more on the non-tax reasons for establishing trusts and helping to educate clients on preparing their heirs to receive and manage the assets they inherit.  And maybe that’s good news, because estate planning, at its core, is the continuing effort to help clients leave an intended legacy, in which property is passed on in a manner that protects and empowers the family unit and the next generation.