What makes this deal such a game changer? A lot of it comes down to the estate tax. Not only is that $5.12 million exemption now permanent, it is also inflation-adjusted and portable between spouses.
The fear that drove waves of clients to engage in estate planning in the closing months of 2012 may never appear again. Outside the ultrahigh-net-worth sector, most clients will not fear the estate tax. Most will no longer care (although there may be some concern for state estate taxes). Estate planning has changed forever.
These changes also have implications for the income tax planning that planners are regularly involved in.
HIGHER TAX RATES
The backdrop for these changes is a change in the effective tax rates for the highest earners. The new law makes permanent the tax cuts enacted as part of the 2001 tax overhaul so that, for most Americans, the prior tax rates remain in effect. But higher-income clients, the mainstay of many planners' practices, face a tougher income tax regime.
A new 39.6% top marginal tax bracket has been restored for high earners. These same clients will also face a new higher 20% tax rate on dividends and capital gains. These rates are in addition to the 3.8% Medicare tax on investment income. And itemized deductions and personal exemptions are phased out on income of $250,000 for singles and $300,000 for married couples filing jointly. When all these factors are combined with state income taxes, affluent clients could face a combined tax rate of more than 50%.
The immediate challenges will be ascertaining the real and often unexpected impact of the new laws on planning - and educating clients to deal with these new realities. What might you do to alleviate this painful new income tax burden? And how might your actions interact with a client's estate planning? There are a host of options, each with its own unique twists.
HARVESTING GAINS & LOSSES
For many high-income clients, an estate planning move has complicated harvesting of gains and losses. Obviously, planners prefer to have all assets in-house so that asset allocation and gain/loss harvesting can be controlled and best executed. Yet some clients have always insisted on maintaining some investment assets under a different roof. That obviously necessitates some coordination with whomever is managing these other assets.
In 2012, like no other year in the history of the estate tax, wealthy clients formed and made gifts to sophisticated irrevocable trusts. And many, perhaps most, of these 2012 gift trusts were structured as grantor trusts - in which the client who set them up retains a tax liability on the trust's earnings, even if the earnings remain in the trust and are not (or even cannot) be distributed. So before planners can harvest gains and losses, they'll have to determine who might owe taxes on the trust income (whether it is a grantor trust or not), and who is managing the investments of each of these trusts to coordinate overall asset allocations and gain/loss harvesting.
But the process may be even more complicated. Many of the 2012 gift trusts were also formed as directed trusts, meaning a designated person - an investment trustee or investment advisor - has the authority to make investment decisions, rather than the general trustee. So harvesting gains and losses, or modifying asset allocation or location decisions, may require the coordination of several different trustees, trust investment advisors and managers. Planners should start asking clients who else they'll need to coordinate with come December.
Charitable contributions might be used to offset some gain, but the phase-outs for itemized deductions might negate some charitable planning. Charitable remainder trusts, through which the client can gift appreciated assets to be sold and defer capital gains tax, are another option. These trusts are not subject to the new Medicare tax on passive income, another advantage.
Life insurance products have long offered a tax-favored envelope to protect investment dollars. But the new tax increases substantially enhance the benefit of investment buildup inside the protective skin of an insurance policy. There are several new twists to life insurance planning in light of the new estate-tax laws.
Clients with wealth under the estate- tax threshold - potentially $10.24 million for a couple for 2012, and inflation indexed in future years - might skip the complexity and cost of a life insurance trust and merely own their policies directly. It's far from optimal from the perspective of protecting the assets. But the estate-tax rationale for insurance trusts now doesn't apply to most clients.
A planning technique that has been used over the years, but which most estate planners frowned upon, was purchasing life insurance inside a retirement plan - so pretax dollars could be used to fund premiums. Estate planners were generally worried about the inclusion of the insurance proceeds in the insured's estate. That has changed for clients under the large exemption amounts.
It had been common for planners to work with clients' estate planners to divide assets into separate accounts and names so that both spouses would have sufficient assets to fund a bypass trust. This almost ubiquitous planning step has changed in many ways.
Many wealthy clients gave most or all of their $5.12 million exemption to trusts in 2012. If only one spouse made such gifts, the spouse who did not use up his or her exemption might consider holding all assets in his or her name to fund the bypass trust. For the vast majority of clients, unless state estate-tax planning requires asset division, title to assets may be irrelevant from a tax planning perspective.
These trusts are designed to protect a surviving spouse by providing access to trust assets, but keeping them outside the surviving spouse's estate. They were the mainstay of many client plans, but the "new normal" of estate planning changes this.
Most clients will simply be far enough from the inflation-adjusted exemption amount that they will want to avoid the complexity of bypass trusts - titling assets, dealing with a trustee, filing trust income tax returns and so forth. Moreover, for clients who gifted most or all of their exemption amounts in 2012, setting up a trust for modest assets may not be cost effective.
Estate planners will, quite appropriately, endeavor to persuade clients that trusts are needed to address state estate tax, divorce/remarriage risk and more. And most wills and revocable living trusts mandate the funding of these trusts. But many clients will simply no longer tolerate the complexity.
For many of your high-net-worth clients, it's going to be essential to revise estate planning documents. Planners will face new challenges in coordinating with their clients' estate planners to ensure that planning is done properly and in a manner that best meets client goals.
Martin M. Shenkman, CPA, PFS, J.D., is a Financial Planning contributing writer and an estate planner in Paramus, N.J. He runs laweasy.com, a free legal website.