Before we consider how wealthy clients should proceed with estate planning following the 11th-hour passage of the American Taxpayer Relief Act of 2012 (ATRA) on January 1, let’s review how we got to this point.
The transfer tax regime, it’s important to note, has been unpredictable for the last decade. The Economic Growth and Tax Relief Reconciliation Act of 2001 increased the estate tax and generation-skipping transfer (GST) tax exemptions from $675,000 in 2001 to $3.5 million in 2009. This was followed by a one-year repeal of the estate tax in 2010 and a reinstatement of the tax in 2011 with an exemption of $1 million. (The gift tax exemption was capped at $1 million.)
Most estate planners expected Congress to pass legislation to prevent the repeal of the estate tax, but it failed to act.
That resulted in a one-year reprieve that allowed a number of large estates to escape taxation, including that of New York Yankees owner George Steinbrenner, who left his heirs an estate worth about $1.15 billion, and natural gas tycoon Dan Duncan, who left an estate of about $9 billion.
Congress could have enacted a permanent fix in 2010 to avoid the reversion of transfer tax exemptions and rates to the same levels they were at before 2001, but Congress was only able to pass a temporary, two-year patch—the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010. The gift, estate and GST tax exemptions were increased under this legislation to $5 million for 2011 and $5.12 million for 2012, but sunset provisions would have switched the exemptions and rates to 2001 levels as of January 1.
Estate planners spent significant time with clients in 2011 and 2012 to make sure they used their increased gift and GST tax exemptions before January 1 if they had the ability to do so. This advice was given under the threat of sunset provisions that would have decreased estate and gift tax exemptions to $1 million and the GST exemption to $1.39 million. Estate planners advised clients to take action since Congress could have failed to extend the benefactor-friendly exemptions beyond 2012. For most wealthy clients, the risk of missing out on a $5 million gift free of tax far outweighed the risk of buyer’s remorse if the exemptions were extended.
Ultimately, Congress surprised the estate planning community by permanently extending the $5 million gift, estate and GST tax exemptions, with increases for inflation, albeit at an increased top tax rate of 40%, up from 35%.
The 2012 act also made permanent the portability provisions that allow a surviving spouse to take advantage of a deceased spouse’s unused gift and estate tax exemptions. Portability can alleviate the need to transfer assets between spouses to ensure the full use of each spouse’s gift and estate tax exemptions. However, the GST tax exemption is not portable, so high-net-worth clients who wish to take full advantage of their GST exemption should not rely on portability.
Although the recent transfer tax legislation has been described as “permanent,” it may be more accurate to say it is not subject to any sunset provisions. There are no guarantees that Congress will not again change the exemptions or the tax rates. Hence, estate planners should advise wealthy clients to use their gift and GST exemptions during their lives and take advantage of appropriate estate planning techniques, just as they advised them before January 1.
This cautious approach is merited when one considers that transfer tax laws have been in a state of flux for over a decade. Every significant piece of federal tax legislation during that period has impacted the transfer tax laws. Moreover, Congress and President Obama continue to grapple with the debt ceiling and broader tax reform, meaning the transfer tax could conceivably be put back on the negotiating table. Clients who did not use their exemptions in 2011 and 2012 because they did not believe Congress would allow the exemptions to decrease to $1 million proved to be correct. But that doesn’t mean there’s no longer a risk of exemptions decreasing.
Another reason advisors should urge clients to act is that transfer tax exemptions have been among the keys to successful long-term wealth transfer planning. For example, assume a 50-year-old client transfers $5 million to a GST exempt trust, and then lives another 35 years. Not only will the initial $5 million pass tax-free at the client’s death and be sheltered from GST tax as the wealth passes in trust from generation to generation, but so will all of the appreciation on that $5 million. Contrast that with what happens if the client does not make any lifetime transfers, but rather relies on existing exemptions to transfer wealth to an exempt trust upon his or her death. Even taking into account the inflation adjustment provided under the American Taxpayer Relief Act of 2012, most wealthy clients would probably expect their investments to appreciate at a greater rate. The client who waits until death is allowing Congress to dictate how much wealth will pass free of tax at death, while the client who uses lifetime planning techniques will have greater control over the level of wealth passing to family members free of transfer tax. Moreover, if lifetime transfers are made to an irrevocable grantor trust, where the client is liable for the trust’s income taxes, the tax-free wealth transfer can be amplified.
Advisors also need to consider that important tax and estate planning vehicles continue to be part of the Obama administration’s revenue proposals. None of the proposals were addressed by the January act, and who knows if Congress will ever act on them, but well-informed clients will continue to use them while they remain available:
• Grantor Retained Annuity Trusts. The administration has proposed a minimum 10-year term for GRATs. While this would not eliminate the use of GRATs for younger, healthy clients, it obviously would prohibit the use of the short-term, “rolling” GRATs that have become widely used by high-net-worth clients. Because the annuity payments are self-adjusting if the IRS successfully challenges gift values, GRATs are particularly useful when transferring assets that are hard to value.
• Valuation Discounts. The administration has proposed the elimination of valuation discounts for family-controlled entities, including operating businesses and investment entities. Moreover, the IRS continues to challenge estate planning that incorporates valuation discounts on family-controlled entities. However, wealthy clients should, with the help of expert counsel, continue to seek appropriate valuation discounts that consider lack of control and lack of marketability.
• GST Exempt Trusts. With more states allowing perpetual trusts, the administration has proposed limiting the duration of GST-exempt trusts to 90 years. The importance of long-term GST planning for wealthy clients cannot be overstated because it can allow wealth held in trust to pass from generation to generation without a transfer tax. Non-exempt trusts can be subject to tax every generation, which can have a devastating effect on a family’s ability to increase or even maintain their wealth over long periods of time.
• Grantor Trusts. Although the administration’s proposals for the future treatment of grantor trusts are not well constructed, there is a risk that grantor trusts may not be available forever. Grantor trusts are a long-standing and effective technique in planning for wealthy clients. Those who have not implemented grantor trust planning should consider doing so before the opportunity is eliminated.
Advisors should note that if assets transferred to a trust in 2012 have decreased in value, a late GST allocation can be used to take advantage of the lower values. Also, for clients who created grantor trusts in 2012, advisors should determine whether the trusts should be leveraged to take advantage of historically low interest rates. Leverage can freeze the client’s estate at a low rate of return, while allowing the trust assets to appreciate at a greater rate.
L. Timothy Halleron is a partner in the private client group at McDermott Will & Emery LLP.