The 2001 tax reform act built uncertainty into the estate-planning process. Under the act, estate tax rates decrease until 2009. The estate tax disappears — for one year — in 2010. In 2011, the rates and exemptions revert to 2001 levels.
Adding to the uncertainty, Congress has proposed additional changes to the estate tax law, up to and including permanent repeal, every year since 2001. With the re-election of George W. Bush and the increase in the Republican majority in Congress, the possibility of permanent repeal of the estate tax cannot be ruled out. This leaves clients in an exceedingly difficult estate-planning environment. That uncertainty, however, need not cause planning paralysis. This article aims to provide a road map to intelligent estate planning in this in-flux tax environment.
2001, A Tax Oddity
Under the 2001 act, the rates of estate and generation-skipping transfer tax drop from a high of 55 percent in 2001 to a low of 45 percent in 2009. At the same time, the size of the estate and generation-skipping transfer tax exemptions increases from a low of $1 million in 2001 to a high of $3.5 million in 2009. The estate and generation-skipping transfer tax is repealed for one year in 2010. In 2011, the estate and generation-skipping transfer tax is reinstated and rates and exemptions go back to 2001 levels — a 55 percent top rate and a $1 million exemption. The 2001 tax act does not repeal the gift tax.
Although the rates of the gift tax go down in tandem with the estate tax rates from 2001 to 2009, the gift tax exemption remains level at $1 million. In 2010, when the estate tax is repealed for one year, the gift tax remains equal to the top income tax rate.
In addition to these changes, the 2001 tax act eliminates the state death tax credit, that was a dollar-for-dollar credit against the federal estate tax, up to certain limits, for any estate tax paid. Many states charged a state estate tax, known as a “sop up” or “sponge” tax, exactly equal to the federal death tax credit. With the elimination of the state death tax credit came the elimination of those sponge taxes. In response, many states have enacted separate estate taxes with exemptions that are lower than the exemption allowed against federal estate tax.
Here are five planning steps that planners and clients should consider in light of estate tax uncertainty.
Step #1
Continue Planning with Unified Credit.
For married couples, wills should continue traditional unified credit planning, whereby the exemption amount of the first spouse to die is placed in a “credit shelter” trust for the benefit of the surviving spouse, thus allowing the couple to shelter two exemption amounts from tax rather than only one after both spouses have died. This advice is subject to the following caveats: In a second marriage, it is common for the unified credit disposition to favor the client's children, with the balance of the estate passing to the spouse. To avoid a disproportionate allocation of assets to the children, the will could provide for a ceiling on the amount passing to them.
Alternatively, the will could leave in the executor's hands the decision about how much the children will receive. The will could provide for a disposition of the entire residue to a QTIP marital trust, giving the executor discretion to decide that some of the property passing to the QTIP trust should instead pass to the children. Though this approach has the advantage of being flexible, it may be difficult to find an executor willing to exercise this authority.
If the client's will leaves his full estate tax exemption to a credit shelter trust, the estate may be subject to state estate taxes if the exemption from the state estate tax is lower than the exemption from federal tax. The client should consider leaving an amount equal to the lower of the state estate tax exemption and the federal estate tax exemption to the credit shelter trust.
The balance of the estate could be left to a QTIP marital trust. This will produce a zero state estate tax. Moreover, if the will is drawn correctly, the executor can be given discretion to move money from the QTIP trust back to the credit shelter trust at the time of the decedent's death in order to bring the size of the credit shelter trust up to an amount equal to the federal estate tax exemption, provided that the state estate tax is paid.
Step #2
Consider Use of a Revocable Trust.
A will cannot be changed after the client becomes incapacitated, even if the client has given someone the power of attorney. A revocable trust agreement, on the other hand, can be written to provide the trustee the power to amend the trust agreement. Clients may wish to consider using a revocable trust agreement and granting the trustee, perhaps with the consent of a third-party trust “protector,” the power to change the agreement to accomplish the client's tax or other objectives in the event of significant change in the tax law.
Step #3
Avoid Taxable Gifts.
With the gift tax exemption stalled at $1 million and the estate tax exemption on the rise, clients should be stingy about taxable gifts. However, while taxable gifts probably don't make much sense now, nontaxable gifts, such as annual exclusion gifts and gifts to 529 accounts can make a great deal of sense.
Step #4
Pros and Cons of Using the $1 Million Gift Tax Exemption.
Clients should consider carefully the advantages and disadvantages of making a $1 million unified credit gift. Gifts using the client's $1 million gift tax exemption can make sense, but the client should take some caveats into consideration:
First, the client should consider the interplay of estate tax savings versus loss of step-up in basis. Remember, gifted assets do not receive the benefit of a step-up in cost basis at death. If a client is not likely to have a taxable estate in the year of death (because of the scheduled increases in the unified credit), then a gift of the unified credit during lifetime may simply be costing the client a step-up in basis on the gifted property.
Second, there is no increase in the gift tax exemption scheduled — it remains flat at $1 million. Therefore, clients should be more aware than ever of making the most efficient use of a unified credit gift. Rather than making a simple gift of cash or marketable securities worth $1 million, clients should consider whether or not the gift can be leveraged through the use of valuation discounts, such as those presented by fractionalized gifts of real estate or gifts of limited partnership or limited liability company interests. Clients should also consider whether or not the gift can be leveraged through the use of time-value-of-money discounts, such as those presented by deferred gift trusts, including qualified personal residence trusts, grantor retained annuity trusts and charitable-lead trusts.
Grantor retained annuity trusts and charitable-lead annuity trusts are particularly valuable techniques at this time because they can allow a client to shift appreciation of gifted property to the next generation without any use of the gift tax exemption.
Step #5
Nontax Estate Planning Still Necessary.
Traditional nontax estate planning objectives must still be planned for, including planning for the proper distribution of a client's assets, probate avoidance planning through a revocable living trust, planning for the management of assets for young children and disabled beneficiaries, asset protection planning through trusts, partnerships and other vehicles and incapacity planning, including powers of attorney and living wills.
The phrase “nothing is certain but death and taxes” needs to be amended to read “nothing is certain but death, or more uncertain than estate taxes.” As a result of estate tax uncertainty, many clients may be tempted not to do any planning at all. This could end up hurting both the client and his heirs. By considering the planning ideas discussed in this article, the client can create an estate plan that maximizes flexibility no matter what happens to the estate tax in the future.
