Death of Estate Tax Planning?

Only a handful of estates are worth more than $5.0 million (approximately 1 in 1,000), so the new law will eliminate estate taxes on all but the very largest estates.

With the new exemption portability rules, there is little need to worry about estate or gift taxes. Consequently, for 99.9% of estates, complex exemption planning with multiple trusts should become extinct

But what about estates worth more than $10.0 million?

Estate vs. Income Tax

The new estate tax rate of 35% has reduced the spread between estate taxes and income taxes to such a degree that estate tax planning for even the largest estates may become obsolete.

NOTE: Estate tax planning involves the comparison between the estate tax rate and the federal and state income tax rate. When the estate tax rate was 50% or higher, the financial advantage of eliminating estate taxes was clear; with the tax rates now roughly the same, the rationale for estate tax planning has greatly diminished.

For example, assume a federal capital gain tax rate of 15% and a state tax rate of 5% (a combined 20%). When the estate tax rate was 55%, there was a 35% spread between the estate tax and income tax; under the new rules, the spread is only 15%. If the capital gain rate returns to its traditional 20% rate and the taxpayer lives in a state that has an income tax rate of 9% (California or New York), the spread drops to only 6%.

NOTE: For collectibles (artwork, jewelry, antiques), the federal income tax rate is 28%, so for these items, the combined federal and state income tax rate may actually be higher than the federal estate tax rate.

Drawbacks

There are other drawbacks to using the traditional estate-tax minimization techniques:

1. California Proposition 13 – Each spouse has a $1.0 million exemption for real property transferred directly to children or grandchildren under Proposition 13 (property tax reappraisal rules).

If, however, the parents place their real estate in a family limited partnership or other entity, the exemption is lost. Because the exemption is based on the property’s “assessed” value and not the fair market value, an estate worth $10.0 million may have an assessed value of only $2.0 million and the exemption could cover all the properties against a property tax reassessment. Assuming a 2% property tax rate, the difference could be $160,000 in annual property tax increases.

2. Basis Step-Up. In general, property distributed through an estate obtains a basis adjustment to fair market value as of the date of death. Thus, if an estate comprised of real property worth $100 million ($80 million of which is allocated to the buildings and $20 million is allocated to the raw land) is taxed at 35%, the properties will have a new basis for depreciation purposes of $80 million. The benefit of this deduction to the beneficiaries may offset 2-4% of the estate tax

3. Uncertain Federal and State Tax Rates and Future Economic Conditions. As states cope with severe budget shortfalls, many could raise taxes in the future. Also, the federal capital gains rate of 15% could be raised to 20%. As state and federal income taxes rise, the gap between income taxes and estate taxes narrows.

Coupled with depreciation benefits and potential property tax savings, it is not clear that estates taxed at 35% will benefit from estate tax planning.

Remember, complex estate tax planning can be expensive, time-consuming, an administrative burden and subject to IRS challenge. Also, these complex strategies can backfire if certain assumptions about future tax laws or economic conditions prove to be faulty.

Conclusion:

The current estate and gift tax regime is a huge bounty to the extremely wealthy. Predictions are that the new law will survive its expiration date of December 31, 2012.

Because of the elimination of estate taxes for married couples with estates under $10.0 million and a 35% estate tax rate on any amounts over the exemption, there may be little incentive to engage in customary estate tax minimization.

2010 Law

The estate tax was eliminated in 2010; however, many estates were adversely impacted by the 2010 law.

The 2010 law substituted a “carry-over” basis tax regime, which meant that beneficiaries received the same asset basis held by the decedent. Thus, untaxed asset appreciation was preserved and upon sale, beneficiaries would pay federal and state income taxes on any gains.

Now, estates affected by the 2010 law may elect to use the new law, thereby avoiding the carry-over basis rules. Estates with appreciated assets are prime candidates for the election, because any untaxed appreciation is eliminated under the traditional concept of revaluing assets at fair market prices upon death.

Elections

Executors who want the new law to apply to 2010 estates or take advantage of the portability of unused exemptions will need to make timely elections to trigger these provisions.

Maximize Gifts

To leverage the new gift-tax exemptions, very large estates should consider the traditional estate planning concepts of fractional interest discounts through family limited partnerships or similar entities.

NOTE: For many estates below $10.0 million, using these conventional planning strategies may have negative income tax consequences – if so, then consider unwinding these entities.

Traditional Estate Planning

Traditional three-trust planning may still be considered in case the new law expires. Although most estate planners believe the new law will survive, there is always the possibility that it will not.

To play it safe, amend the existing three-trust estate plan to take into account the new law, but leave it in place as a backup.

Remember, current estate plans contain distribution provisions for the assets, regardless of the changes in tax law.

Introduction

In late December, 2010, President Obama struck a tax compromise with Republicans regarding income, estate and gift taxes.

Through 2012, income taxes remain frozen, however, gift and estate taxes are eliminated for all but the very richest Americans.

Changes

The estate and gift tax exemption is worth $5.0 million ($10.0 for husbands and wives) and will be increased for inflation after 2011.

The law became effective for those dying after January 1, 2010 and is set to expire on December 31, 2012, although most tax professionals believe the law will remain. Estates exceeding these exemptions will be taxed at 35% (down from the 45%).

Gifts

The most striking feature of the new law involves the gift-tax rules.

The annual gift-tax exemption of $13,000 per beneficiary (and indexed for inflation) still applies, however, the lifetime gift-tax exemption, which is in addition to the annual exemption, has been increased from $1.0 million to $5.0 million ($10.0 million for married couples).

Thus, the new gift tax rules provide a major wealth transfer opportunity for those with large family land and stock holdings, as well as family businesses.

Unused Exemptions

For married couples, the exemption is now treated as a collective $10.0 exemption (rather than two individual $5.0 million exemptions), which means that any unused portion of the exemption after the death of the first spouse transfers to the surviving spouse.

Under prior law, each spouse held the exemption personally, which meant that complicated multiple trust arrangements were required to maximize the exemptions.

These new “portable” exemptions, eliminate the need for the traditional three-trust setup (a credit shelter trust, a marital Q-TIP trust and a survivor’s trust) to minimize taxes

NOTE: Couples with estate plans designed to minimize estate taxes should review them in light of the increase in exemptions.NOTE: The portability of the unused exemption may be reduced or lost if the surviving spouse remarries and outlives the new spouse. The surviving spouse receives the unused exemption from the last surviving spouse – thus, the size of a potential spouse’s estate-tax exemption may become an important marriage consideration!

GST

The generation-skipping tax (GST) exemption is now equal to the estate-tax exemption of $5.0 million ($10.0 for married couples). However, there is no portability of the GST exemption.

Use of the traditional by-pass trust will probably continue for those seeking to leave assets to grandchildren or others who are subject to the GST