Responding to a reporter investigating rumors of the sickness of one of his relatives, Mark Twain famously wrote "[t]he report of my death was an exaggeration." As financial advisors consider the implications of the Tax Relief, Unemployment Insurance Reauthorization and Job Creation Act of 2010 (the "2010 Tax Act"), it would be wise to similarly view as unfounded any rumors that estate planning is no longer necessary for most Americans.
Mid-December 2010, to the surprise of many, the President signed broad new tax legislation that significantly changed estate, gift and generation-skipping transfer ("GST") taxes. Not only may the new law have a dramatic impact on our clients' existing estate planning intentions and documents, which Advisors should review at the earliest opportunity, it may also provide occasion to propose gifting additional planning strategies for Higher Net Worth clients that could benefit multiple generations.
Among its many important provisions, Advisors must understand that the new law is temporary - most of the favorable tax provisions sunset December 31, 2012. The Iowa Caucuses will be held in the first full week of February 2012 and the country will thereafter be involved in a spirited Presidential election campaign focusing on a host of important issues, including the federal debt and deficit reduction.
Inevitably, the considerable income and estate tax uncertainties we faced in 2010 will resurface and, by the summer of 2012, if not sooner, we will again be speculating whether Congress can get past political gridlock and pass new, permanent tax legislation for 2013 and beyond or will simply allow the 2001 tax law scenarios to resume in effect (which could mean a $1 million unified exemption, with a top estate and gift tax rate of 55%). Thus, it is critical for Advisors to review these matters with clients over the next 15 - 20 months, including opportunities and risks, to ensure they properly implement any potential tax saving or other wealth transfer strategies.
The 2010 Tax Act
Most pundits and professional associations have by now conceded that the changes to estate, gift and GST taxes were unanticipated. Expectations had developed in 2010 that legislative agreement might be reached on a permanent estate tax scenario involving a $3.5 million estate tax exemption and a top federal estate tax of 45%. Of course, the 2010 Tax Act provided much more and different provisions.
Under the new law, effective through December 31, 2012, exemptions and tax rates of the federal estate, gift and GST tax systems have been unified. The lifetime gift exemption, the at-death estate tax exemption, and the GST exemption are each now at $5 million per client, essentially $10 million for a married couple. In addition, the top tax rate on wealth transfer exceeding the exemption amounts is 35%. These changes were unexpectedly significant, as prior to the 2010 "repeal" of estate and GST taxes, the lifetime gift exemption was capped at $1 million per client, the estate and GST exemptions were capped at $3.5 million per client, and the top tax rate was 45%. Future wealth transfer without exposure to taxation could be even higher for our clients, as the new legislation contemplates that each of the three exemptions will be adjusted for inflation after 2011.
The temporary repeal of estate and GST taxes for calendar 2010 had created a great deal of estate tax uncertainty, and the 2010 Tax Act includes provisions necessary to give clarity to estates and heirs that unfortunately had a death occur last year. The new law provides executors and trustees two different approaches to utilize in administering 2010 estates: the default rule is that the estate will utilize the new exemption and tax rate - a $5 million estate tax exemption and a top estate tax rate of 35%.
In the alternative, executors and trustees can elect (using IRS Form 8939) to have a 0% estate tax and transfer family wealth using modified carryover basis (wherein non-spousal heirs have a limited right to increase the decedent's carryover basis in inherited assets by $1.3 million, plus an additional $3 million ($4.3 million in total) for surviving spouses). Calculations should be done with a client's accountants and attorneys, however, estates less than $5 million would almost always use the default $5 million estate tax exemption. Depending ultimately on the nature of and decedent's cost basis in specific inherited assets, the more an estate gets beyond $5 million, the more likely descendants may elect to utilize modified carryover basis.
The new legislation introduces the unique concept of "portability" of the estate tax exemption of a deceased spouse, which essentially means that a surviving spouse in 2011 or 2012 can use the unused estate tax exemption of the "last deceased spouse." (Technically referred to as the deceased spousal unused exclusion amount "DSUEA.") Thus, if the first deceased spouse's exemption is left fully intact, the surviving spouse will be able to transfer $10 million, during their lifetime or at death, gift and estate tax free. As an example, assume Husband and Wife have all of their assets jointly titled, their net worth is $7.5 million, and Wife dies first in 2011.
When Wife dies, her estate will not necessarily need to use any of her $5 million estate tax exemption, since all of the assets are jointly titled and the unlimited marital deduction allows Wife to transfer her share of the joint assets to Husband without any federal estate tax. Assume further that Husband passes in 2012 witth the estate still worth $7.5 million. With full portability of the estate tax exemption between spouses, under these facts, Husband has "inherited" Wife's unused estate tax exemption, and he can transfer $10 million free from federal estate taxes at the time of his death. Husband's $7.5 million estate will therefore not owe any federal estate taxes.
Portability is a more complex subject than may be immediately evident. Among other things, once allocated, the unused exemption is not subject to being increased through inflation indexing. Also, the deceased spouse's GST exemption is not portable. Finally, use of the last deceased spouse's exemption is not automatic, and an election will need to be made on the last deceased spouse's federal estate tax return. Advisors should understand that, no matter how small or large an estate may be at first death, it is necessary to timely file a 706 estate tax return to ensure that portability remains available to the surviving spouse. While present expectations are that portability will become permanent in 2013, at this time, the concept is only applicable to instances where the death of both spouses occurs before December 31, 2012.
"Death" of Estate Planning is an Exaggeration
The 2010 Tax Act has temporarily put most Americans in a position where they have little or no realistic exposure to estate tax on wealth transfer upon second death. With recent estate tax exemptions at $3.5 million and less, it has been estimated for years that only a small percentage, perhaps less than 2%, of estate tax returns were filed with taxes due [ cite? ].
For those of us in the financial services industry, one could argue that these statistics are skewed, as wealthier Americans are more likely to have a relationship with a financial advisor [ cite #C ], and industry wide we may find that as many as 10% of our clients have real, effective estate tax concerns, even with a $5 million exemption. Still, revised estimates are that under the new law, for deaths occurring in 2011, only a little more than 3,500 estates will file an IRS Form 706 with taxes due [ cite? ].
Beyond the estate tax issue, the above portability example illustrates how use of the estate tax exemption between spouses ostensibly works the same way that a Revocable Living Trust and Bypass Trust strategy works, but without the need for setting up the Bypass Trust. Accordingly, some early analysts of the 2010 Tax Act suggested a greatly reduced need for most Americans to engage in timely or expensive estate planning.
On the contrary, the need for estate planning is not reduced or eliminated by the new law, and estate planning remains critical for all our clients. In fact, Advisors may find that, while they can never be the final definitive source for the estate tax advice clients must obtain from their attorneys and accountants, they have the capability and a great opportunity to undertake the non-tax wealth transfer analysis their clients will want and need.
Estate planning has now become more about the true objectives of wealth transfer: What will the surviving spouse's financial condition and needs be in the event of early, untimely first death? How about children ; are there spendthrifts or special needs or other circumstances?
With 50% percent of first marriages, 67% of second, and 74% of third marriages ending in divorce, is there a need to provide for the last surviving spouse as well children from prior marriages? With many clients having traditional IRAs comprise a significant part of their total net worth, what are the income, not estate, tax benefits for heirs of a Roth IRA or a Stretch IRA?
A widely used strategy in many states (though not popular in certain states), Revocable Living Trusts ("RLTs") continue to be an effective means of addressing simple, commonly encountered wealth transfer objectives. Avoiding the unnecessary costs and delays associated with having an estate pass through probate is one of the most important goals in implementing a RLT strategy. In addition, RLT grantors retain a degree of control over the ultimate beneficiaries of the estate, even when incapacitated subsequent to establishing the RLT. This control can be a very important objective where the client is in a second or third marriage situation, or there are issues relating to child or grandchild beneficiaries and their ability to utilize their inheritance as intended by the decedent(s).
Also, a RLT can be relatively easily amended or changed to address dynamic family changes over time. Finally, a RLT strategy can provide grantors and beneficiaries creditor protection. Notwithstanding portability under the 2010 Tax Act as discussed above, many clients will continue to be well served by the RLT strategy.
In considering the dispositive provisions of a RLT or other trust, Advisors must consider what are referred to as formula disposition clauses - provisions that direct the amount of an estate passing to a bypass trust to be the federal estate tax exemption amount. In the 29 months since December 2008, there have arguably been four different federal estate tax exemptions ($2 million 2008; $3.5 million 2009; unlimited 2010; $5 million 2011), which would make it nearly impossible for grantors of a RLT with a formula disposition clause to have any clear expectation as to how much of the estate would be transferred to the surviving spouse or a bypass trust on first death.
While there are no easy answers to remedy these issues, it is clear that a RLT or similar estate planning document should be drafted with maximum flexibility and discretion for the executor or trustee and, to every feasible extent, setting minimum and maximum amounts passed to a surviving spouse or bypass trust.
Advisors should also be well aware that, while the 2010 Tax Act effects significant changes to the federal transfer tax system, state estate taxes remain unchanged. In some cases, a much larger and potentially unnecessary state estate tax could be triggered if an existing estate plan attempts only to maximize the federal estate tax exemption with a formula disposition clause. California and Florida continue to have no state estate tax; however, there is now greater disparity between the $5 million federal exemption amount and certain state exemption amounts (e.g., New Jersey, Minnesota-$675,000; New York-$1 million).
Advisors whose clients include those with a two-state presence might also review the possibility of changing one's domicile to avoid or minimize potential imposition of state estate taxes. Finally, while the federal exemption is now portable, state death tax exemptions are not, so it will be even more important for estate plans to provide executors or trustees flexibility to make appropriate decisions to maximize tax savings.
With fewer Americans exposed to the prospect of estate taxation in connection with non-spousal wealth transfer, two familiar income tax strategies remain a cornerstone of an advisors estate planning conversations - Stretch IRAs and Roth IRAs. The primary benefit of the Stretch IRA is that it allows IRA beneficiaries to take minimum, life expectancy based, distributions from an inherited IRA, thus paying minimum income tax on distributions, and to continue enjoying tax-deferred growth for as long as possible.
Without stretch provisions, beneficiaries may be required to distribute the full account balance in a period much shorter than the beneficiary's life expectancy, possibly causing them to be in a higher tax bracket or otherwise resulting in significant income taxes on distributions. The 2010 Tax Act, coupled with the prospect of significantly higher future income tax rates, makes the Stretch IRA a compelling strategy for clients that intend to effect non-spousal wealth transfer with at least some portion of their IRA.
Roth IRAs and Roth Conversions were a very hot topic during 2010, based mostly on the elimination of the $100,000 adjusted gross income limitation and the expected rise in ordinary income tax rates in 2011. Given that the 2010 Tax Act extends existing ordinary income tax rates for 2011 and 2012, the strategy, especially in an estate planning context, will continue to be a very constructive conversation with clients. While using a Roth IRA to enhance a clients' retirement income strategy requires much analysis (including iterations of assumptions about a Roth account owners' investment time horizon, future investment returns, and future income tax bracket), as an estate planning proposition, it can be simpler and more conceptual.
For a highest income tax bracket, High Net Worth client that does not anticipate needing all or any of the Roth account distributions to maintain retirement cash and lifestyle needs, the opportunity to convert at least some of a traditional IRA or 401k account at relatively low income tax rates can be a great benefit, as the Roth account allows them to avoid required minimum distributions and therefore maximize wealth transfer of their retirement savings for their heirs.
Finally, for some, the efficacy of life insurance and Irrevocable Life Insurance Trusts (ILITs) were initially deliberated in light of the increased estate tax exemption. Given the temporary nature of the new legislation, it would be unwise for an advisor to consider allowing existing policies to lapse or otherwise recommend abandoning any ILIT established or strategy already in place. Regardless of the potential estate tax benefits, early, untimely death inherently involves unexpected expenses and financial difficulties, and the tax free nature of the insurance death benefit can certainly help to ease the challenges faced by the insured's surviving heirs.
Ready, Set, Go
With recent estate tax exemptions of $3.5 million and less, one of the more effective techniques for reducing the size of a client's taxable estate has been a well planned lifetime gifting program. Based on the 2010 Tax Act's act sizeable increases in the gift, estate, and GST exemptions, the next 20 months will involve much discussion of the many planning opportunities for High Net Worth clients to transfer significant wealth to grandchildren during their lifetimes without paying gift or GST tax.
Depending on the assets to be gifted, certain methods are more effective than others, and it may be prudent for clients to take advantage of the additional $4 million of tax-free gifting that is available for the next two years. Not only will additional gifting take full advantage of the $5 million lifetime exemption, it will remove future appreciation of the gifted asset from the client's estate and potentially shift income to beneficiaries in lower income tax brackets.
However, advisors should be careful in recommending that clients make completed gifts before there is a clearer picture of the 2013 gift, estate, and GST scenario. The advisor's approach should be, "Ready, Set, Go" - get ready by having the conversation, get set by identifying suitable assets and potential gifting strategies, and implement when there is clarity as to what may be in store for 2013 and beyond.
Most of our clients will want to know that the new legislation left the annual gift exclusion unchanged at $13,000 per donee for 2011 ($26,000 per donee from a married couple). These excluded gifts are not subject to gift tax and do not reduce either of the lifetime gift or at death estate tax exemptions. This annual amount could potentially increase soon, as the exclusion will be indexed for inflation in 2012.
While there are many gift planning opportunities for advisors to contemplate, many issues need to be incorporated in the analysis. As an example of only a few, assume a wealthy, married client with a liquid, $15 million estate wants to gift $10 million cash to a newly created irrevocable dynasty trust for their grandchildren. Irrevocable trusts are taxpaying entities the same as individuals, and pay income tax at the same high rates as individuals-the high federal income tax bracket being 35%.
However trusts have just five, compressed tax brackets, and pay income tax on undistributed income in excess of only $11,350 in 2011. With income rates expected to rise in 2013, trusts are also set to be subject to the 3.8% surcharge on undistributed income imposed by the health care reform legislation. A massive, multi-million dollar dynasty trust corpus, making little, if any, regular distribution to beneficiaries, could be an income tax headache the wealthy donors had not fully considered.
Perhaps more important, there is also the potential for a "claw back," i.e., the $5 million gifts made before 2013 by the hypothetical wealthy couple could be subject to an estate tax in or after 2013 if the federal estate tax exemption is significantly reduced at the time of death. That said, most industry professionals are taking the position that Congress did not intend that gifts made through 2012 would be subject to an additional estate tax in 2013 or thereafter, that some form of legislative or administrative relief will likely be passed before the end of 2012, and that advisors should be confident in maximizing their clients' use of their lifetime gift exemptions despite the claw back potential.
Charitable strategies and charitable trusts will continue to be of interest to our clients. The new legislation extends the opportunity for clients older than 70 1/2/ to transfer up to $100,000 of their annual, required minimum distribution direct to charity. This avoids recognition of the RMD as income (and, of course, there is no corresponding charitable deduction). Also, with capital gains tax rates continuing low at 15% through the end of 2012, and the prospect of higher ordinary income tax rates in 2013, the Charitable Lead Trust strategy is garnering more attention at this time as compared to the Charitable Remainder Trust.
For difficult to value assets, including family businesses, the new legislation has no impact on the use of valuation discounts when transferring ownership interests in family entities as a part of a gifting program. Further, although there have been several recently proposed legislative efforts to eliminate the short term grantor retained annuity trust ("GRAT") strategy by requiring a minimum 10-year term, the new tax law does not contain that restriction. Thus, for an advisor of High Net Worth clients, family entity planning, short term GRATs and sale transactions to trusts should be seriously considered, especially in light of the increased exemption amounts, and the current low valuation and interest rate environment.
Conclusion
The 2010 Tax Act may leave some with the misperception that a unified $5 million gift, esate, and GST exemption obviates the need for any estate planning. That is not the case, and there are important wealth transfer discussions that advisors should undertake as 2013 approaches. These conversations will relate to both lifetime gifts and at death wealth transfer, and will be equally useful for our upper income and wealthy clients. An important factor tempering any action advisors take on their clients' behalf is that the new law is for the most part only effective through the end of 2012.
Dru Donatelli is an AVP and Advanced Planning Attorney, Field Director for John Hancock Financial Services. He may be reached at [email protected].