Greater estate tax law certainty eases planning — a little

While estate planning is about more than just taxes, taxes are still an important consideration. Fortunately, the American Taxpayer Relief Act of 2012 (ATRA) provided a little more certainty on that front.

Before the act, estate tax rates and exemptions had been only temporary, with the exemption scheduled to drop and the top rate rise — both significantly. ATRA made permanent the 2012 exemption amounts — annually indexing them for inflation — and increased the top rate by only five percentage points. (See the Chart “Gift and estate tax exemptions and rates.”)

But it's important to keep in mind that “permanence” is a relative term here. Congress can make more estate tax law changes in the future. Nevertheless, the ATRA estate tax exemption and rate provisions have no expiration dates, which provides a greater level of estate tax law certainty than we had previously.

How much is your estate worth?

Begin by listing all of your assets and their value, including cash, stocks and bonds, notes and mortgages, annuities, retirement benefits, your personal residence, other real estate, partnership interests, life insurance, automobiles, artwork, jewelry, and collectibles. If you’re married, prepare a similar list for your spouse’s assets. And be careful to review how you title the assets, to include them correctly in each spouse’s list.

If you own a life insurance policy at the time of your death, the proceeds on that policy usually will be includable in your estate. Remember: That’s proceeds. Your $1 million term insurance policy that isn’t worth much while you’re alive is suddenly worth $1 million on your death. If your estate is large enough, a significant share of those proceeds may go to the government as taxes, not to your chosen beneficiaries.

How the estate tax system works

Here’s a simplified way to project your estate tax exposure. Take the value of your estate, net of any debts. Also subtract any assets that will pass to charity on your death — such transfers are deductions for your estate.

Then if you’re married and your spouse is a U.S. citizen, subtract any assets you’ll pass to him or her. Those assets qualify for the marital deduction and avoid estate taxes until the surviving spouse dies.

The net number represents your taxable estate.

You can transfer up to your available exemption amount at death free of estate taxes. So if your taxable estate is equal to or less than the estate tax exemption in the year of your death (reduced by any gift tax exemption you used during your life), no federal estate tax will be due when you die. But if your taxable estate exceeds this amount, it will be subject to estate tax.

The impact of 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. Because of differences between federal and state law, it’s vital to consider the rules in your state. The nuances are many; be sure to consult an estate planning professional with expertise on your particular state.

The marital deduction

The marital deduction is one of the most powerful estate planning tools. For federal tax purposes, any assets passing to a surviving spouse pass tax-free at the time the first spouse dies, as long as the surviving spouse is a U.S. citizen. (If either you or your spouse isn’t a U.S. citizen, see “Noncitizen spouses.”) Therefore, if you and your spouse are willing to pass all of your assets to the survivor, no federal estate tax will be due on the first spouse’s death.

But this doesn’t solve your estate tax problem. First, if the surviving spouse doesn’t remarry, that spouse won’t be able to take advantage of the marital deduction when he or she dies. Thus, the assets transferred from the first spouse could be subject to tax in the survivor’s estate, depending on the size of the estate and the estate tax laws in effect at the survivor’s death. Second, if your spouse does remarry, you probably don’t want him or her to pass all assets to the new spouse even if it would save estate taxes.

Exemption “portability”

Because assets in an estate equal to the available exemption amount aren’t subject to estate taxes, a married couple can use their exemptions to avoid tax on up to double the exemption amount. (See the Chart “Gift and estate tax exemptions and rates.”)

When one spouse dies and part (or all) of his or her estate tax exemption is unused at his or her death, the estate can elect to permit the surviving spouse to use the deceased spouse’s remaining estate tax exemption. Thus, the exemption is “portable” between spouses.

Similar results can be achieved by making asset transfers between spouses during life and/or setting up certain trusts at death (both discussed later in this section). But the portability election is simpler and, if proper planning hasn’t been done before the first spouse’s death, can provide valuable flexibility. Plus, the surviving spouse can use the remaining exemption to make lifetime gifts.

Still, making lifetime asset transfers and setting up certain trusts can provide benefits that the portability election doesn’t offer.

Credit shelter trusts

One effective way to preserve both spouses’ exemptions and enjoy additional benefits is to use a credit shelter trust. Before exemption portability, credit shelter trusts were necessary to protect the exemptions of both spouses if 1) their combined estates exceeded the estate tax exemption, and 2) the couple didn’t want, at the first spouse’s death, to use that spouse’s exemption to transfer assets to the next generation (or to other beneficiaries besides the surviving spouse) — in other words, in situations where the couple wanted the surviving spouse to continue to benefit from those assets.

Now portability eliminates the need for a credit shelter trust for that purpose. However, such trusts continue to offer significant benefits, including:

Professional asset management,
Protection of assets against creditors’ claims,
Generation-skipping transfer (GST) tax planning (portability doesn’t apply to the GST tax),
Preservation of state exclusion amounts in states that don’t recognize portability, and
Preservation of the exemption even if a surviving spouse remarries. (Portability is available only for the most recent spouse’s exemption.)

But perhaps the biggest benefit of a credit shelter trust is the ability to avoid transfer taxes on future appreciation of assets in the trust.

Let’s look at an example: The Joneses each hold $5.45 million of assets in their own names, and they haven’t used up any of their lifetime gift tax exemptions. At Mr. Jones’ death, all of his assets pass to Mrs. Jones — tax-free because of the marital deduction. Mr. Jones’ taxable estate is zero. His estate makes the portability election, so Mrs. Jones can use his exemption.

Mrs. Jones dies several years later without having used any of her or Mr. Jones’ exemptions on lifetime gifts, and without remarrying. So her estate has $10.90 million of exemption available. (For simplicity we’re ignoring inflation adjustments we're rounding the amounts.) But her estate has grown by 30% to $14.17 million. As a result, $3.27 million is subject to estate tax, which means $1.31 million goes to estate taxes (assuming the current 40% rate applies), leaving her heirs with $12.86 million.

Let’s look at an alternative: Mr. Jones’ will calls for assets equal to the estate tax exemption to go into a credit shelter trust on his death. This trust provides income to Mrs. Jones during her lifetime. She also can receive principal payments if she needs them to maintain her lifestyle. Because of the trust language, Mr. Jones may allocate $5.45 million (his exemption amount) to the trust to protect it from estate taxes; the trust assets won’t be included in Mrs. Jones’ taxable estate at her death.

Let’s assume that the $5.45 million in the trust and the $5.45 million outside the trust both grew at the same rate as in our first scenario. So at Mrs. Jones’ death, the trust is worth $7.085 million and her estate is also worth $7.085 million. But because the credit shelter trust assets aren’t included in her taxable estate, only $1.64 million is subject to estate tax. So only $656,000 goes to estate taxes, leaving her heirs $13.51 million.

The estate tax savings could be even greater if the Joneses structure their estates so that the credit shelter trust will hold the assets that are most likely to produce the greatest amount of growth. Let’s say that their combined estates still grow to $14.17 million, but all of the growth occurs within the credit shelter trust.

At Mrs. Jones’ death, the credit shelter trust is worth $8.72 million and Mrs. Jones’ estate remains at $5.45 million. Because her taxable estate doesn’t exceed her estate tax exemption, there is no estate tax liability at her death and the full $14.17 million passes to her heirs.

The Joneses do give up something for the credit shelter trust’s tax advantages: Mrs. Jones doesn’t have unlimited access to the funds in the credit shelter trust because, if she did, the trust would be includable in her estate.

Still, Mr. Jones can give her all of the trust income and any principal she needs to maintain her lifestyle. And the family can save significant estate taxes. But the outcome could be quite different if both spouses didn’t hold enough assets in their own names. (See the Case Study “Splitting assets.”)

Warning: If you already have a credit shelter trust in place, it’s important to review it to ensure you're taking full advantage of the inflation-indexed estate tax exemption. See the Planning Tip “Make sure your credit shelter trust will achieve your goals.”

QTIP trusts

When assets in an estate will exceed the amount that can fund a credit shelter trust, a common estate planning concern is that, if those excess assets are distributed outright to the surviving spouse, they’ll eventually be distributed in a manner against the original owner’s wishes. For instance, you may want stock in your business to pass only to the child active in the business, but your spouse may feel it should be distributed to all the children. Or you may want to ensure that after your spouse’s death the assets will go to your children from a prior marriage.

You can address such concerns by structuring your estate plan so some or all of your assets pass into a qualified terminable interest property (QTIP) trust. The QTIP trust allows you to provide your surviving spouse with income from the trust for the remainder of his or her lifetime. You also can provide your spouse with as little or as much access to the trust’s principal as you choose. On your spouse’s death, the remaining QTIP trust assets pass as the trust indicates.

Thus, you can provide support for your spouse during his or her lifetime but dictate who will receive the trust assets after your spouse’s death. Because of the marital deduction, no estate taxes are due at your death. But the entire value of the QTIP trust will be included in your spouse’s estate. •

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