Estate planning may be a little less challenging in 2013

Estate planning is never easy. You must address your own mortality while determining the best strategies to ensure that your assets will be distributed according to your wishes and that your loved ones will be provided for after you’re gone. You also must consider how loved ones will react to your estate planning decisions, which may be difficult if, for example, a family business is involved or you wish to provide more to certain family members. But estate planning may be a little less challenging now that we have more certainty about the future of gift, estate and generation-skipping transfer (GST) taxes.

The American Taxpayer Relief Act of 2012 makes exemptions and rates for these taxes, as well as certain related breaks, permanent. Estate taxes will increase somewhat, but not as much as they would have without the legislation. And the permanence will make it easier to determine how to make the most of your exemptions and keep taxes to a minimum while achieving your other estate planning goals.

Estate tax

Under the Taxpayer Relief act, for 2013 and future years, the top estate tax rate will be 40%. This is a five percentage point increase over the 2012 rate, but significantly less than the 55% rate that was scheduled to return for 2013. The estate tax exemption will continue to be an annually inflation-adjusted $5 million, so for 2013 it’s $5.25 million. This will provide significant tax savings over the $1 million exemption that had been scheduled to return for 2013. (See the Chart “Transfer tax exemptions and highest rates.”)

The Taxpayer Relief act also makes permanent exemption “portability” between spouses: If part (or all) of one spouse’s estate tax exemption is unused at death, the estate can elect to permit the surviving spouse to use the deceased spouse’s remaining estate tax exemption. Making this election is simple and provides flexibility if proper planning hasn’t been done before the first spouse’s death.

But exemption portability doesn’t provide all of the benefits that applying the exemption to a credit shelter trust does. So married couples should still consider making asset transfers and setting up credit shelter trusts to ensure they take full advantage of both spouses’ exemptions. Transfers to your spouse — during life or at death — are tax-free under the marital deduction (assuming he or she is a U.S. citizen).

Gift tax

Under the Taxpayer Relief act, the gift tax continues to follow the estate tax exemption and rates. (See the Chart “Transfer tax exemptions and highest rates.”) Any gift tax exemption used during life reduces the estate tax exemption available at death.

But keep in mind that you can exclude certain gifts of up to $14,000 (up from $13,000 for 2012) per recipient each year ($28,000 per recipient if your spouse elects to split the gift with you or you’re giving community property) without using up any of your gift tax exemption.

GST tax

The generation-skipping transfer tax generally applies to transfers (both during life and at death) made to people two generations or more below you, such as your grandchildren.

Under the Taxpayer Relief act, the GST tax also continues to follow the estate tax exemption, and the GST tax rate continues to be the same as the top estate tax rate. (See the Chart “Transfer tax exemptions and highest rates.”) Warning: Exemption portability between spouses doesn’t apply to the GST tax exemption.

State taxes

Many states, prompted by changes to the federal estate tax (such as increases in the federal exemption amount and elimination of the credit for state death tax), now impose estate tax at a lower threshold than the federal government does. To avoid unexpected tax liability or other unintended consequences, it’s critical to consider state law.

The nuances are many; be sure to consult a tax advisor with expertise on your particular state.

Tax-smart giving

Giving away assets now will help you reduce the size of your taxable estate. (See the Case Study “Making lifetime gifts can substantially reduce estate taxes.”)

Here are some additional strategies for tax-smart giving:

Choose gifts wisely. Consider both estate and income tax consequences and the economic aspects of any gifts you’d like to make:

To minimize estate tax, gift property with the greatest future appreciation potential.

To minimize your beneficiary’s income tax, gift property that hasn’t already appreciated significantly since you’ve owned it.

To minimize your own income tax, don’t gift property that’s declined in value. Instead, sell the property so you can take the tax loss and then gift the sale proceeds.

Plan gifts to grandchildren carefully. Annual exclusion gifts are generally exempt from the GST tax, so they also help you preserve your GST tax exemption for other transfers. For gifts that don’t qualify for the exclusion to be completely tax-free, you generally must apply both your GST tax exemption and your gift tax exemption.

So, for example, if you make an annual exclusion gift to your grandson and you want to give him an additional $30,000 in the same year to help him make a down payment on his first home, you’ll have to use $30,000 of your GST tax exemption plus $30,000 of your gift tax exemption to avoid any tax on the transfer.

Gift interests in your business. If you own a business, you can leverage your gift tax exclusions and exemption by gifting ownership interests, which may be eligible for valuation discounts. So, for example, if the discounts total 30%, in 2013 you can gift an ownership interest equal to as much as $20,000 tax-free because the discounted value doesn’t exceed the $14,000 annual exclusion. Warning: The IRS may challenge the value; a professional appraisal is strongly recommended. (For more on transferring interests in your business, see “Succession within the family.”)

Gift FLP interests. Another way to benefit from valuation discounts is to set up a family limited partnership. You fund the FLP and then gift limited partnership interests. Warning: The IRS is scrutinizing FLPs, so be sure to set up and operate yours properly.

Pay tuition and medical expenses. You may pay these expenses for a loved one without the payment being treated as a taxable gift, as long as the payment is made directly to the provider.

Make gifts to charity. Donations to qualified charities aren’t subject to gift taxes and may provide an income tax deduction. (See the “Charitable Giving” section for more information.)

Trusts

Trusts can provide significant tax savings while preserving some control over what happens to the transferred assets. Here are some trusts you may want to consider and the estate tax benefits they provide:

Credit shelter trust. Also referred to as a “bypass trust,” this is funded at the first spouse’s death to take advantage of his or her full estate tax exemption. The trust primarily benefits the children, but the surviving spouse can receive income, and perhaps a portion of principal, during his or her lifetime, and the trust provides some advantages over the exemption portability election. It can protect assets from creditors and shield future appreciation on them from estate taxes.

QDOT. A qualified domestic trust can allow you and your non-U.S.-citizen spouse to take advantage of the unlimited marital deduction.

QTIP trust. A qualified terminable interest property trust passes trust income to your spouse for life, with the remainder of the trust assets passing as you’ve designated. The trust gives you (not your surviving spouse) control over the final disposition of your property and is often used to protect the interests of children from a previous marriage.

ILIT. An irrevocable life insurance trust owns one or more policies on your life, and it manages and distributes policy proceeds according to your wishes. An ILIT keeps insurance proceeds, which could otherwise be subject to estate tax, out of your estate (and possibly your spouse’s). You aren’t allowed to retain any powers over the policy, such as the right to change the beneficiary. The trust can be designed so that it can make a loan to your estate for liquidity needs, such as paying estate tax.

Crummey trust. This trust allows you to enjoy both the control of a trust that will transfer assets at a later date and the tax savings of an outright gift. ILITs are often structured as Crummey trusts so that annual exclusion gifts can fund the ILIT’s payment of insurance premiums.

GRAT and GRUT. Grantor-retained annuity trusts and grantor-retained unitrusts allow you to give assets to your children today — removing them from your taxable estate at a reduced value for gift tax purposes (provided you survive the trust’s term) — while you receive payments from the trust for a specified term. At the end of the term, the principal may pass to the beneficiaries or remain in the trust. In a GRAT, the income you receive is an annuity based on the assets’ value on the date the trust is formed. In a GRUT, the payments are a set percentage of the assets’ value as redetermined each year. These trusts may be especially beneficial in a low-interest rate environment like we have today.

QPRT. A qualified personal residence trust is similar to a GRAT except that, instead of holding assets, the trust holds your home — and, instead of receiving annuity payments, you enjoy the right to live in your home for a set number of years. At the end of the term, your beneficiaries own the home. You may continue to live there if the trustees or owners agree and you pay fair market rent.

Dynasty trust. The dynasty trust allows assets to skip several generations of taxation. You can fund the trust either during your lifetime by making gifts or at death in the form of bequests. The trust remains in existence from generation to generation. Because the beneficiaries have restrictions on their access to the trust funds, the trust is excluded from their estates. If any of the beneficiaries have a real need for funds, the trust can make distributions to them. If you live in a state that hasn’t abolished the rule against perpetuities, special planning is required.

Life insurance

Life insurance can replace income, offer a way to equalize assets among children active and inactive in a family business, provide cash to pay estate tax or be a vehicle for passing leveraged funds free of estate tax.

Life insurance proceeds generally aren’t subject to income tax. But, if you own the policy, the proceeds will be included in your estate:

Ownership is determined by several factors, including who has the right to name the beneficiaries of the proceeds. Generally, to reap maximum tax benefits you must sacrifice some control and flexibility as well as some ease and cost of administration.

Determining who should own insurance on your life is a complex task because there are many possible owners, including you or your spouse, your children, your business, and an ILIT.

To choose the best owner, consider why you want the insurance, such as to replace income, to provide liquidity or to transfer wealth to your heirs. You must also determine the importance to you of tax implications, control, flexibility, and ease and cost of administration. •

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