Over nearly 40 years, the pendulum of federal estate tax has swung wildly. Recent years have proven no different — from taxing estates over $3.5 million in 2009 to imposing absolutely no estate tax in 2010 (for just one glorious year). But in 2012, the American Taxpayer Relief Act (ATRA) changed the landscape, making permanent a 40% tax on gifts and estates valued above the $5 million exemption amount.
The shift to a higher and permanent exemption amount, coupled with rising federal income tax rates, has resulted in the need for different tax planning strategies for those above and below the $5 million threshold. Below are a few questions and answers to put our current planning landscape into perspective.
What was the roller coaster of federal estate tax planning like leading up to 2012?
It has been in flux for years. Initially, the goal was to tax the highest-net-worth individuals upon their death, but in recent years that hasn’t been the case. For example, in 1997, the estate exemption amount was only $600,000. Many middle-class taxpayers were surpassing that threshold with just their home, 401(k) or IRA, and a life insurance policy. A wave of legislation began increasing the exemption, gradually at first, then jumping to $1 million in 2002 and up to $3.5 million by 2009. The estate tax rate itself continued to vary as well, from as high as 55% to 35% over the years, and in 2010 there was zero estate tax, regardless of the value of the estate.
While individuals with large estates continued to focus on moving money out of their estates, in reality for many the uncertainty caused estate planning to stall. It wasn’t until ATRA in 2012, when the $5 million exemption (indexed for inflation) and a 40% estate tax rate was made permanent, that things started to change at both the federal and state levels. ATRA made 32 states rethink and ultimately eliminate their estate tax in an effort to keep residents, along with their tax dollars, from moving out.
What does estate planning look like today, post-ATRA?
It’s more than just ATRA affecting today’s planning world. With the top federal income tax rate at 39.6%, a 20% capital gains rate, a 3.8% tax on net investment income and the return of itemized deduction phase-outs, income tax planning has taken a front seat ahead of estate tax planning — particularly for estates that will not hit the estate tax threshold.
For estates above the $5 million mark (or $10 million if married), transferring assets during an individual’s lifetime is becoming more common. This strategy removes potential future appreciation on the asset from the estate, removes the actual estate tax from the estate and locks in the current exemption amounts (because we know permanent is never permanent when it comes to taxes). However, taxpayers need to be strategic about which assets they are giving away and when. For example, when a person makes a gift during his or her lifetime, the recipient doesn’t get to adjust the basis of that gift to market value. Then it becomes an income tax issue, which could be significant in the current rate structure. Making that same gift upon death may make more sense, when the basis will be adjusted to the value under current tax law. So there are many factors to consider, such as the potential future appreciation inherent in the asset (especially when dealing with real estate) and what the income and estate tax rates may be when the asset is sold or the person dies. Absent a crystal ball, there’s a lot of analysis and planning to do.
ATRA also made permanent the ability for a surviving spouse to use any of the deceased spouse’s remaining estate tax exemption. How has this “portability” impacted estate planning?
Portability of the exemption has completely changed the planning landscape, in a positive way. Before this became an option, both spouses had to have enough assets in each of their names to fully use the estate tax exemption. In 2011 when portability was introduced, the first spouse to die was able to “port” over to his or her spouse the unused exemption. The ability to make this election means married couples can potentially simplify their estate planning, such as eliminating credit shelter trusts that were often set up to protect the exemption.
For estates over $10 million, there are a couple issues to consider. Even though portability is an option, it may make sense to use up the exemption during life and get future appreciation out of certain estates, such as a profitable portfolio of stocks. It’s also important to note that while ATRA made the Generation-Skipping Transfer (GST) tax exemption permanent at $5 million, ATRA did not make it portable. So those using the portability technique may unintentionally subject an estate to the GST tax.
Regardless of how much an estate is worth when the first spouse dies, it almost always makes sense to file an estate tax return and elect portability. You never know how much of that exemption may be needed down the road.
How do individuals know if they have the right estate and income tax planning strategies in place?
Anyone with an estate plan that has not been reviewed in the last couple of years should meet with both their attorney and accountant to review documents that may have been created when the laws were very different. Make sure mechanisms and tools still make sense, such as trust structures. If no longer needed, getting rid of them could simplify post-death administration. Ultra-high-net-worth individuals may want to look at their intentionally defective trusts, which are available today but are not guaranteed to be there in the future. Lifetime gifting, coupled with currently available valuation discounts, is also a strategy worth reevaluating. Currently proposed regulations, if made permanent, could significantly reduce or even eliminate some of those valuation discounts. The bottom line is look at plans closely and often, and determine what is the most effective approach in today’s regulatory environment.
What should be the end goal of any solid estate plan?
Individuals need to make sure their wishes are clearly stated so assets go where they want them to. When planning, individuals should start with where they want assets to end up — kids, charities, family members with special needs — then determine how to do it efficiently. They must consider all of the factors, such as the tax implications of retirement plans, charitable giving during life instead of death, income and estate tax rates, etc. While attorneys handle the legalities, a CPA is in the best position to help with the financial analysis. Careful estate tax planning and coordination of professionals can help individuals accomplish much of what they set out to do in a very tax-efficient way.
Cohen & Company is not rendering legal, accounting or other professional advice. Any action taken based on information in this blog should be taken only after a detailed review of the specific facts and circumstances.