The huge tax law passed in December-officially, the Tax Relief, Unemployment Insurance Authorization and Job Creation Act of 2010, which somehow neglected to include "World Peace" in the title-had few changes on the income tax side. The same tax rates from last year continue this year, as do various income tax benefits. Some tax breaks that lapsed in 2010 were reinstated retroactively and extended for this year.
However, the new law made dramatic changes to estate taxes. The federal exemption, known as the applicable exclusion amount, was set at $5 million, far above the $3.5 million in effect when the estate tax was last seen, in 2009.
Amounts more than $5 million will be taxed at 35%, down from 45% in 2009. In addition, the estate-tax exclusion was made portable between married couples; any amount unused by the first spouse to die carries over for the surviving spouse's estate.
"Portability does open up planning opportunities for clients," says Mike Foltz of Balasa Dinverno Foltz, a wealth management firm in Itasca, Ill. Although portability may seem to diminish the need for traditional strategies, such as trusts, smart planners can show their clients how trusts are still necessary to create even better estate plans.
To see how the new portability arrangement might work, assume a man we'll call Jerry dies this year, leaving a $7 million estate. He leaves $6 million to his wife, Lynn, and $1 million to their children. Bequests to a spouse who is a U.S. citizen are tax-free, no matter how large, and the $1 million going to the children is sheltered by Jerry's estate- tax exclusion. Therefore, Jerry's estate owes no federal estate tax.
Suppose that Lynn dies next year, when the estate-tax exclusion is set to remain at $5 million. Lynn's estate can use her $5 million exclusion plus the $4 million Jerry didn't use, for a total of $9 million. The combination of the $5 million exclusion and spousal portability effectively gives married couples a $10 million exemption from federal estate tax. (In estate planning lingo, portability is known as DSUEA, for the deceased spouse's unused exclusion amount.)
For many clients, the reaction might be, "With a $10 million estate-tax exemption, we're home free." Why incur the time and expense developing a complicated estate plan with multiple trusts when a simple plan that emphasizes spousal bequests can avoid estate tax?
"The biggest advantage of portability is that it can permit married couples to reduce the expense and complexity of their estate plans," agrees Julie Ann Garber, an attorney with the law firm Becker & Poliakoff in Fort Myers, Fla. "However, there are still reasons for married couples to consider planning with trusts," she adds. "The same may be true for unwed couples."
Phil Kavesh of Kavesh Minor & Otis, a law firm in Torrance, Calif., notes that many couples can benefit from trusts in their estate plan. In fact, Kavesh compiled a list of 12 Reasons to Fund a Bypass Trust Rather than Elect Portability. (A bypass trust, also known as a credit shelter trust, typically is structured to receive assets following the death of the first spouse sheltered by the estate-tax exclusion, yet shield those assets from estate tax upon the death of the surviving spouse.)
THE DURABLE DOZEN
What are some reasons to keep using bypass trusts-and perhaps other trusts as well-in this era of portability? For starters, Kavesh cautions that current laws only apply to this year and next. For 2013, there might be a smaller estate-tax exclusion or even a repeal of exclusion portability between spouses.
"I don't think married couples should adopt simplified estate plans, with the surviving spouse receiving most of the decedent's assets, until it is clear that portability will become permanent," Garber says. "Until then, I cannot recommend that clients rely on it."
The runner-up reason Kavesh cites is that assets might grow between the first and second spouses' deaths. In the above example, the $6 million Jerry leaves to Lynn, along with Lynn's own assets, might appreciate so much that Lynn dies with an estate that's subject to estate tax.
"The DSUEA [$4 million in this example] is not indexed for inflation," Kavesh points out. If the first spouse to die leaves assets to a properly drafted bypass trust, subsequent appreciation will be out of the surviving spouse's estate, regardless of when the second death occurs or what the tax law is at that time.
Another advantage of a bypass trust, according to Kavesh, is the right of the first spouse to die to distribute his or her assets the way he or she wishes, which might not be identical to the surviving spouse's distribution plan. Using a bypass trust also reduces the risk that, if the surviving spouse remarries, the deceased spouse's assets may eventually wind up in the hands of people the decedent never knew.
What's more, Kavesh points out that an estate plan based on portability is not necessarily simple after the first death. "The executor must make a DSUEA election on Form 706, the estate-tax return," he says.
At the second death, which may take place decades later, that estate's executor must know this election was made and use it to get the tax benefit. Kavesh asserts that some small- and moderate-size estates will have to take the time to prepare and file Form 706 in order to preserve the first spouse to die's unused exclusion amount for the surviving spouse.
Gideon Rothschild, a partner at Moses & Singer, a New York law firm, cites state estate tax as yet one more issue to consider. "If one spouse leaves everything to the other, the estate of the second spouse to die might exceed the state exemption amount," he says. "Some states have an estate tax with a lower exemption, such as $1 million in New York."
Even a relatively modest estate could owe $100,000 in state estate tax. Saving that much tax by using a bypass trust might be worth the time, expense and restrictions on heirs.
WHEN TO USE PORTABILITY
Even though many lawyers believe portability has its flaws, there are some clients for whom it could be useful, Rothschild says. He describes a situation in which one spouse has most of his or her assets in IRAs or qualified retirement plans. "You can't equalize assets by transferring those retirement assets to the other spouse," he says. "If you leave an IRA to a trust, you may not be able to get maximum tax deferral after the owner's death. However, if the IRA owner names the spouse as outright beneficiary, you have the opportunity for a spousal rollover, which can lead to a longer stretchout."
Here's another situation where it might pay to leave assets outright to a surviving spouse and rely on portability for estate-tax shelter: "That might be a good strategy for a couple where one spouse holds highly appreciated assets," says Rothschild, citing the basis step-up rules.
Foltz also mentions enhanced income tax basis step-ups as a benefit of portability. "Couples can achieve a double income tax basis step-up on some or all of their assets," he says. In the past, couples would divide ownership of assets so assets owned by the first-to-die spouse would be placed into a credit shelter trust and utilize the decedent's estate-tax exemption amount. Upon the first-to-die spouse's death, such assets receive a basis step-up to fair market value. With such a step-up, capital gains tax on a subsequent sale can be reduced.
However, Foltz adds that assets do not receive a second basis step-up upon the second-to-die spouse's death if those assets had been placed in a credit shelter trust. With portability, assets may be owned jointly and basis step-up occurs upon the first-to-die spouse's death to the extent available for jointly held assets. "Then a second basis step-up occurs when the survivor passes away," he says.
Indeed, portability may let more clients hold assets jointly with right of survivorship, thus reducing exposure to probate. "If it has been advantageous to separate ownership in order to use both spouses' estate-tax exemptions, that might not be necessary now," Garber says.
For most clients, though, Rothschild would not suggest simply leaving assets to the surviving spouse and relying upon portability. Instead, the client might leave assets to the surviving spouse but specify in a will that the spouse can disclaim assets to a credit shelter trust. If one heir files a formal disclaimer within nine months of death, assets left to that heir will pass to the next party designated to receive them, which could be a trust.
Proponents of disclaimers say they open the door to look-back tax planning; heirs can evaluate current tax law and current personal circumstances, and then decide whether to keep or relinquish assets. Garber has increasingly used disclaimers in clients' estate plans as the estate-tax exemption increased in recent years. "In some situations, deaths and disclaimers have been used effectively. The key has been to meet regularly with clients to make sure they understand the disclaimer strategy and what the possible benefits would be."
Nevertheless, Rothschild still prefers A-B trusts, which might be considered the standard estate plan for married couples who have significant assets. Assets are left to both a trust for the surviving spouse (A trust) and to a bypass trust (B trust), to provide tax shelter, asset protection and control over distributions.
"A-B trust planning is still necessary for clients in a second or later marriage, especially if each spouse has a different group of final beneficiaries, such as their own children," Garber says. This also may be the case for clients in their first marriage who want to ensure that, after one spouse dies, their assets will pass to their kids and not to a new spouse or the new spouse's children. Garber notes that unmarried couples (of same or opposite gender) would need to use a bypass trust in order to get up to $10 million worth of estate-tax exclusion.
Kavesh also describes the A-B trust set-up as a natural fit for couples in remarriages with children from previous relationships. With this arrangement, each spouse can specify a division of assets between the other spouse and their own children. "Otherwise, I like to create flexibility in a couple's estate plan. Disclaimer planning can give the surviving spouse flexibility in funding the bypass trust," Kavesh says.
For added flexibility, Kavesh designs estate plans that allow the bypass trust to be terminated during the surviving spouse's lifetime. "That might be in the best interest of the surviving spouse and beneficiaries, depending on future changes in tax law, the desire to get a second step-up in basis or a change in the beneficiaries' circumstances," he says.
Not all estate-planning lawyers favor disclaimers. Rothschild doesn't like them because "I'm not sure it will happen." For example, an heir so empowered may make a poor decision or be reluctant to part with wealth.
A PLANNER'S POINT OF VIEW
It might come as no surprise that estate planning lawyers would find fault with portability and thus emphasize the continued need for sophisticated trusts. Foltz, who is a principal at a wealth management firm as well as an experienced attorney, sees both sides of this issue. "Clients definitely are looking to make their estate plans simpler," he says. "Portability lends itself to that."
Foltz points out advantages to a portability-based plan such as basis step-ups, as explained above, and asset protection. "Where one spouse has exposure to creditors' claims, his or her estate-tax exemption amount may still be used even if marital assets are titled in the other spouse's name for asset-protection purposes."
However, Foltz adds that many couples still need to have a multiple trust structure in their estate plan. The reasons he mentions are state estate-tax obligations, remarriage concerns, appreciation between the first and second death and situations where it's desirable to restrict access to inherited assets.
It all adds up to a topic that planners should be discussing with clients, who might be advised to follow up with their attorney. "Portability has not made estate planning easier," Garber says. "Estate planning is certainly no longer one size fits all or even one size fits most. You must evaluate each client on a case-by-case basis."