In 2012, Congress made “permanent” a $5 million exemption from federal gift and estate tax, indexed for inflation. Today, that number (known as the exclusion amount) has climbed to $5.45 million—which means that a married couple, with proper planning, can transfer up to $10.9 million without gift or estate tax. Tens of thousands of relatively wealthy individuals whose estates fall under the new threshold1 now can shift their planning from reducing the size of the taxable estate—the primary goal of traditional estate planning—to other goals, including:
The 2012 changes in the estate tax also introduced “portability”—the ability of the surviving spouse to use the deceased spouse’s unused exclusion (or DSUE) in certain circumstances. Portability also has lessened some of the planning pressure that married couples faced before 2012. But portability presents some issues of its own, including for estates that fall below the federal threshold for estate tax.
This column will examine these and other planning goals. And while it focuses on estates that are not taxable for federal purposes, some of the topics may warrant consideration in planning for taxable estates.
1 According to IRS statistics, nearly 23,000 taxable estate tax returns were filed in 2006. In 2014, the number of returns filed for taxable estates decreased to 5,158.
Taking account of the step-up in basis at death. Increasingly, estate planning involves an asset-by-asset review to determine which assets can be sold now, with little or no capital gains, or gifted with a comparatively high carryover basis. For those seeking to minimize capital gains imposed on heirs when assets are sold, it may be advisable to hold onto low-basis assets until death, when the basis will be stepped up to market value. For example, it may mean waiting until death to transfer an interest in the family company to a child, or passing the family home by will instead of giving it to the children today. This approach tends to work better for elderly clients or clients with short life expectancies, simply because they may not need or want the same flexibility as a client who expects to live for many more years.
Changing the assets in GRATs and other grantor trusts. A grantor retained annuity trust (a GRAT) is an estate freeze technique intended to keep future appreciation on assets out of the taxpayer’s estate. Traditionally, GRATs are funded with assets that are expected to appreciate substantially, and the grantor receives an annuity in return; at the end of the trust term, the assets (presumably much appreciated) are transferred to a younger generation (typically, children) or a trust for their benefit free of further gift or estate tax. GRATs are grantor trusts for income tax purposes, so transactions between the grantor and the GRAT have no income tax consequences. For a taxpayer who is the beneficiary of an existing GRAT or other irrevocable grantor trust holding low-basis but highly appreciated assets, it may be desirable to swap out the trust assets for high-basis assets so that the low-basis assets are owned by the grantor. This allows highly appreciated assets swapped out of the trust to benefit from a stepped-up basis at death. This technique highlights the additional flexibility in capital gain planning that is provided when grantor trusts are used for gifts to family members.
Under current law, the beneficiary of an estate generally does not pay taxes on his or her inheritance and also receives the inherited property with a step-up in basis to the property’s date-of-death valuation. But an individual or family trust fund that inherits so-called “income in respect of a decedent” (IRD)—items of income that would have been taxable to the decedent as ordinary income had he lived—must pay income tax on the gift, whether or not the value of the asset was taxable in the estate. A charity that inherits IRD, however, generally pays no income tax due to its tax-exempt status under Code Section 501(a).
Retirement plan assets are one example of IRD, and are particularly important because they may constitute a significant portion of a client’s estate. Non-statutory stock options, deferred compensation, and installment sale payments also may give rise to IRD. Currently, the maximum federal income tax rate is 39.6 percent. New Yorkers face New York State’s maximum income tax rate of 8.82 percent and also may be subject to local income tax in New York City or Yonkers. As a result, a significant part of IRD assets can be “lost” to taxes when the IRD becomes payable to individual beneficiaries or a trust for their benefit.
Substantial taxes can be saved by simply changing the allocation of assets among charitable beneficiaries and other heirs. Even with federal estate tax out of the equation, more is available for non-charitable beneficiaries if the testator’s charitable goals can be met using IRD and if non-charitable bequests can be funded out of property that is not IRD.
The will, revocable trust, or beneficiary designation should specifically provide that items of IRD (or some portion of those items) pass to charity. Where desired, a fixed dollar cap or formula may be used to limit the amount going to charity out of IRD assets. It is important, though, that the estate’s right to IRD not be distributed in satisfaction of a dollar amount legacy under the decedent’s will or revocable trust; if that approach is used, or if the estate or revocable trust elects to draw down the IRD to pay a dollar-amount charitable legacy, there can be a realization of taxable income within the estate or trust. It generally is recommended that pension assets be allocated to charity through the account’s beneficiary designation, rather than through the will or revocable trust. However, it is important to keep track of such designations because the designation in a retirement plan takes precedence over the terms of a will. Individuals should regularly review their beneficiary designations to make sure they are up-to-date.
If the state estate tax exemption is lower than the federal exemption, which currently is the case in New York, hard decisions may have to be made both during the planning phase and after death. For example, even though a valuation discount might not be needed to bring an estate within the federal exclusion amount, a discount may be the only way to avoid state estate tax, but the discount comes with a cost in the form of a lower basis in the discounted assets.
In addition, states generally have not adopted portability. In the past, married couples commonly were urged to create trusts (sometimes called “bypass” or “credit shelter” trusts) to take advantage of both spouses’ federal estate tax exemptions. The couple’s estate plan would provide that, at the death of the first spouse, property in the amount of that spouse’s estate tax exemption would be set aside in a trust from which distributions could be made to the surviving spouse.
However, to the extent property remained in that trust at the second spouse’s death, that trust would not be included for estate-tax purposes in the estate of the second spouse (thereby “bypassing” the second spouse’s estate for tax purposes). For many couples, bypass trusts may now be unnecessary for federal estate tax purposes due to portability of the federal exclusion amount (assuming portability is preserved and assuming other tax benefits—such as valuation discounts—are not a factor). In fact, those trusts could be undesirable for federal purposes, because of a lost opportunity to step up the basis of assets in the trust upon the second spouse’s death. And yet they may still be a good idea for state estate tax purposes, if there is a lower state exclusion amount or no portability for state estate tax purposes. In such a case, an individual may want to consider use of a bypass trust at the death of the first spouse that is funded by reference to the applicable state exclusion amount and the terms of which permit liberal distributions to the surviving spouse, addressing the possibility that the income-tax benefit of a step-up in basis might outweigh the benefit of bypassing the surviving spouse’s estate. Alternatively, consideration could be given to providing for an outright transfer to the spouse with a disclaimer provision leading to a bypass trust for the spouse, increasing the flexibility of the surviving spouse for purposes of state estate taxes.
Consideration also might be given to using a formula to create a testamentary CRT or other charitable bequests, with the goal of keeping the value of the taxable estate under the state estate tax threshold.
New York is particularly unusual in that it currently has an estate tax exemption of $4,187,500 (rising to the federal level in 2019), but if the estate exceeds 105 percent of that amount, the benefit of the state exemption is lost, and the full estate becomes subject to New York estate tax (at rates of up to 16 percent). Practitioners refer to this situation as “the cliff.” Keeping a New York estate below the cliff amount may be critically important, and some of the old techniques to reduce assets in the estate may continue to be used. A formula contribution to charity to keep the estate free of New York tax should be considered; even better, one might use IRA-type assets for this purpose. In the simplified example below, involving an estate slightly above the New York threshold, a $212,500 bequest to charity would save $324,400 in estate taxes and result in a larger net amount passing to taxable beneficiaries.
In most cases, portability will simplify the ability of a married couple to use their collective $10.9 million federal estate tax exemption. Where one partner has insufficient assets to take advantage of his or her estate tax exemption, the existence of portability may even be a compelling reason for an unmarried couple to wed, so that the wealthier spouse may take advantage of both exemptions without having to re-title assets between the individuals. The estate must file an estate tax return on the death of the first spouse in order to elect portability for the surviving spouse, even though the first estate is not taxable. If a decision is made not to elect portability, the lawyer for the estate will want to document it, and may even want to get a waiver signed by the executor.
Portability allows an individual to use his or her last deceased spouse’s unused exclusion. A person who is widowed and remarries may use the first spouse’s DSUE for lifetime gifting or for bequests at death—provided spouse #2 is still alive. But if spouse #2 dies, the unused part of the first spouse’s DSUE is lost, despite the fact that she or he may have been married to spouse #1 for 40 years and to the spouse #2 for only three years. The generation-skipping transfer (GST) tax exclusion is not portable. If a couple is interested in passing assets to a skip generation, typically grandchildren, GST planning may be needed as part of the estate plan, even in the age of portability. If the spouses do not wish to make dispositions for the benefit of grandchildren at the first spouse’s death, a trust can be created for the benefit of the surviving spouse to which the deceased spouse’s GST exemption is allocated.
Charity. If a taxpayer intends to provide for charity, there is a strong tax incentive to make the gift during his or her lifetime, instead of at death, to take advantage of the income tax charitable deduction and the ability of the charitable beneficiary (or a qualifying charitable remainder trust or CRT) to sell appreciated assets without incurring tax on the capital gain.
Still, there may be cases where a non-qualifying CRT presents an appealing alternative, especially for an individual who is not looking to decrease the value of his or her estate in order to reduce or avoid federal estate tax. For example, a non-qualifying CRT is an option to consider where the intended income beneficiary is sufficiently young that a trust for his or her lifetime benefit would not be a qualifying CRT (because of the requirement that the value of the charitable remainder be at least 10 percent of the value of the assets when the CRT is created) or where the gifted asset is one that would be enjoyed or occupied by the life beneficiary (e.g., an art collection or a residence). However, because a non-qualifying CRT will not be exempt from income tax, it will be important to consider the rate of tax on undistributed income in the trust. Trusts are taxed at the highest marginal rate of 39.6 percent on taxable income in excess of $12,400 in 2016; an individual, by contrast, is not subject to that tax rate until taxable income reaches $415,050 ($466,950 for married taxpayers filing jointly).
Asset protection. Taxpayers continue to be concerned about protecting assets against creditors, regardless of the estate size, and against the spending choices of profligate heirs. Accordingly, a spendthrift trust for the benefit of children may make sense even if there is no tax-driven reason to incorporate trusts in an estate plan.
Alternative scenarios. Asset values might increase, and the “permanent” exemption from gift and estate tax might decrease, so any plan that is premised on an expectation of a non-taxable estate should also contain flexibility that will enable the estate plan to make sense even in a taxable-estate context.
Whether or not an estate will be subject to federal estate tax, there continue to be possible advantages in using a revocable trust as a planning tool, such as a reduced likelihood of delays in estate administration and less court disclosure of confidential information. A revocable trust may circumvent the need for judicial probate altogether (if all the assets are in the revocable trust or in a form that passes by operation of law to a surviving co-owner or a designated beneficiary) or at least minimize the amount of assets passing through the probate estate. A revocable trust ordinarily will not obviate the need for a will; a simple pour-over will is almost always advisable in order to dispose of assets not successfully transferred into the revocable trust or put in joint name prior to the decedent’s death.
Conclusion With a $5.45 million floor in 2016 for taxable estates, and a combined federal estate tax exclusion for married couples of $10.9 million, the purpose of estate planning for most taxpayers has moved away from strategies to reduce the taxable estate and toward capital gains and income tax planning.
For clients interested in supporting charity, the incentive to make gifts during their lifetimes is even greater, in order to take advantage of the income tax charitable deduction.
Of course, a “permanent” exclusion amount is not necessarily permanent at all. Although many observers doubt Congress has much interest in tackling the estate tax again, proposals still circulate to do exactly that. Various proposals would reduce the exclusion amount. Other proposals would limit the ability to engage in capital gain planning with grantor trusts. Inevitably, good estate planning will require ongoing vigilance.
IRC Section 2010(c): Portability election.
IRS Estate Tax Statistics: www.irs.gov/uac/SOITax-Stats-Estate-Tax-Statistics.
PLR 201438014: (Ruling that where decedent’s trust used IRA assets to satisfy pecuniary charitable legacies, the trust must include the income in respect of a decedent in gross income and that, because the terms of the trust did not require the legacies be paid from gross income, the trust is not entitled to a charitable income tax deduction.)
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Written by Jane L. Wilton, general counsel, The New York Community Trust.
© The New York Community Trust 2016