Your wealthiest clients and prospects may have heard by now some good news about estate planning. But that’s a problem. What they’ve heard might prompt them to think everything is OK and do nothing. And that’s not the case. A big concern right now is that clients will become complacent about their estates now that the laws have changed, at least according to Jeremy Spackman at Oshins & Associates LLC in Las Vegas.
“When clients hear that the $5.25 million per person exclusion from federal estate and gift tax has been made permanent, they think they either don’t need to do anything right now or they don’t need to do anything at all,” he says.
The January 2 enactment of the American Taxpayer Relief Act, coupled with the new 3.8% Medicare surtax that hits trusts, estates and certain individuals, will give advisors a new opportunity to get in front of the affluent with estate planning help. New advantages—and challenges—await the wealthy, even those who updated their estate plans last year, anticipating a possible return in 2013 to the estate tax rates of the Clinton era.
Other folks have neglected their estate plans in the last few years, and advisors must let them know they shouldn’t sit on their hands forever, even though the new law is supposedly permanent. “That just means until the next change,” says Spackman. A future Washington, he says, could still lower the high estate tax exclusion, quash bounteous planning techniques or make other unfriendly changes. So clients should act now.
New Rules For Estate And Gift Taxes
Relatively few Americans will owe federal death taxes going forward because of a relatively high exclusion that can cover both estate and gift taxes together (meaning the client can transfer $5.25 million of assets tax-free either before or after death). It’s only those who owe that may pay more.
Under the taxpayer relief act, the estate tax rate now tops out at 40%, 5% higher than before. The clients who are affected must have sufficient life insurance for liquidity. The 40% rate also applies to taxable gifts.
Another permanent feature of the law is spousal portability—which means a widowed spouse can use up the rest of his or her deceased partner’s estate tax exclusion. But it is neither automatic nor hassle-free.
If a widow wants to take the unused exclusion, the personal representative of the deceased spouse must make an election on a federal estate tax return. The return must be filed on time, with an extension allowed, after the first death, says Boston attorney Mary Schmidt, founder of Schmidt & Federico. These actions entail a return-preparation fee that may not otherwise have been necessary.
Moreover, the first estate must remain open for tax purposes until the second spouse passes on. “The statute of limitations doesn’t begin to run, so the personal representative of the first spouse’s estate doesn’t get released from liability,” says Schmidt. That’s something to consider when one spouse is much younger. The personal representative could be on the hook for longer than he wants to be.
“It may seem like a win-win for the parties to agree in a prenup that the survivor can utilize the unused estate tax exclusion. But with second marriages, portability can be a hot issue,” says Schmidt, who specializes in estate planning for blended families.
Also, advisors must remember that although the federal government recognizes portability, states don’t.
Same Time Next Year
Another now-permanent feature of the tax law is that the exclusion is indexed for inflation every year. Clients who exhausted their exclusion in 2012 when it was $5.12 million per individual can now gift an additional $130,000 free of taxes, and that doubles to $260,000 for a husband and wife.
Given the already high exclusion, even 2% inflation yields a six-figure bump. That takes annual gift planning to a whole new level.
“It’s a big difference from $14,000”—the current annual exclusion from gift tax—“in terms of the planning clients can do,” says Suzanne Shier, director of wealth planning and tax strategies at Northern Trust in Chicago.
“We’re encouraging clients who have fully utilized their lifetime exclusion to regularly consider taking advantage of annual indexing with leveraged gifting techniques, such as grantor-retained annuity trusts with a near-zero remainder,” Shier says. “And we’re still able to use strategies that involve valuation discounts.” These advanced techniques are still available under the new law, despite practitioners’ fears they wouldn’t be.
Higher Taxes For Trusts
The taxpayer relief act raised the top rates trusts pay on income. For 2013, the new rates apply when the trust’s taxable income tops $11,950. And the 3.8% Medicare contribution tax further applies to trust income above that figure, says Shier. (See the chart for details.)
These tax increases likewise affect individuals, albeit at much higher income levels, which could create issues for clients with grantor trusts. The income of these popular trusts is taxed to the trust creator, rather than the trust itself. This allows the trust assets to grow without a tax burden and ultimately funnels greater wealth to the trust beneficiaries.
But with today’s higher tax rates for upper-income individuals, “grantors may not feel as kindly toward the beneficiaries as when they set the trust up,” Schmidt predicts. Such clients might consider discontinuing grantor-trust status. How they do that will depend on the specifics of each trust.
Shier adds that the grantor must be comfortable bearing the tax burden before he or she recognizes a big gain in the trust.
A non-grantor trust, depending on its terms, may be able to distribute its income in a way that reduces the family’s total tax bill, although flowing capital out of the trust restrains its ability to grow. Distributions carry out taxable income to the beneficiaries, who then pay tax at their individual rates. Income is taxed at the trust level only if the trust retains it.
“Ordinary income held in a non-grantor trust could be taxed as high as 39.6% plus 3.8% for a total of 43.4%, versus maybe 15% if you kick it out to a young beneficiary,” says Steven Klammer, a senior vice president at Bryn Mawr Trust in Bryn Mawr, Pa. “There is so much greater focus now on distributions, the type of income that’s earned and the tax rates of the beneficiaries.”
But income tax savings are only one factor to consider in making distributions from a trust. “You can’t ignore your fiduciary responsibility just for good income tax planning,” Klammer says. For discretionary trusts, that responsibility includes balancing the interests of the trust’s income and remainder beneficiaries, he says. The more that’s distributed, the lower the remainder will be at the end of the trust term, all else being equal.
The conclusion? Although retaining income to grow a trust may mean paying more in taxes with the passage of the new law, “there’s a point at which that is going to be a cost of effective estate planning and transfer tax planning,” says L. Timothy Halleron, a partner in the private client group at McDermott Will & Emery LLP in Chicago.
More Trusts, More Trust Planning
Apart from the latest tax law changes, the large number of trusts that the wealthy created last year means they need more help, observes Spackman.
For instance, some individuals may not fully appreciate the responsibilities that come with their freshly minted trusts. Spackman says, “If the trust purchased life insurance, premiums need to be paid. If there was an installment sale along with the gift, the trust needs to make payments back to the client. People may need some hand-holding to understand the implications of what they did.”
Others may be ripe for more planning, especially if they rushed to plan at year’s end, Halleron points out. Last-minute-Johnnies probably funded their trusts with cash or marketable securities. Depending on how a trust was drafted, Halleron says it’s possible those assets “can now be swapped back into the client’s hands in exchange for an interest in a business, hedge fund or private equity fund—assets that would have been difficult to transfer into a trust in a hurried time frame.”
Or you could suggest one of the leveraged techniques that remains permitted, at least for now. For example, the client may be able to sell assets to the trust—thereby moving them out of his estate—in exchange for a promissory note bearing interest at the Applicable Federal Rate, which is pretty low these days. “If the trust was initially funded with $5 million, the client may be able to sell it up to $45 million in assets,” says Halleron, explaining that ninefold is a rule of thumb for this type of transaction. “That’s a huge planning opportunity.”