Almost a year after the passage of a massive package of tax changes, the implications are still rippling through the estate planning world. A highlight of the law was the increase in the exemption to $10.5 million for a couple, but more broadly, the act has produced a complete paradigm change. Astute financial advisors will capitalize on these and assume a more central role in the estate planning process.
There is no better forum for getting a sense of what's important now than the Heckerling Institute on Estate Planning, which is set for Jan. 13-17 in Orlando, Fla. To get a sense of the big ideas rumbling through the industry, I polled several of the presenters about their topics.
One key issue is the new portability of estate-tax exclusions between spouses. The traditional estate plan was built on a bypass trust (which gives a surviving spouse access to wealth but does not include it in the survivor's estate) and a marital trust (which qualified for an unlimited estate-tax marital deduction). With portability now permanent, surviving spouses can benefit from the first-to-die spouse's exemption without a bypass trust. In addition, assets passed to the surviving spouse will receive another step-up in basis at his or her own death.
But relying on portability has its drawbacks. There is no portability for state estate taxes (except in Hawaii) and the generation-skipping transfer tax, for instance. Further, if the bequest is outright, there is no protection from lawsuits or future spouses.
How important is the loss of a basis step-up on bypass trust assets? "The problem with examples of the potential benefits of this second step-up is that they often assume that the asset or assets that pass to the credit shelter trust or surviving spouse are retained for the life of the surviving spouse," explains Thomas Abendroth, leader of the private clients, trusts and estates group at Schiff Hardin in Chicago. "This is likely to be true only if the assets are closely held stocks in a family business or real estate. By contrast, a portfolio of marketable securities in a bypass trust is likely to turn over during the surviving spouse's life." The result may be only modest appreciation at the second death.
IMPACT OF BASIS STEP-UP
Having assets included in the taxable estate, for most clients, secures an increase in the tax basis of those assets - and maximizing the basis step-up for clients can still be incredibly important for reducing capital gains. "Mathematics that used to support planning to aggressively push assets out of the estate don't apply anymore," says Paul S. Lee, national managing director at Bernstein Global Wealth Management in New York.
Most states don't have a state estate tax and most clients do not exceed the higher federal exemption amounts. So the new paradigm is to create estate-tax inclusion for many clients, not to avoid it. Many advisors might assume they'll need a different planning decision for clients worth more than $10.5 million who will be subject to a federal estate tax. But this is not necessarily so.
The maximum estate-tax cost for a client in a state without an estate tax is the 40% federal estate-tax rate. But compare this with the maximum income tax rate: 20% capital gains, plus the 3.8% Medicare surcharge, plus the state income tax. In California, for example, the latter could be 13.3%. So the client's marginal income tax rates can be close to the 40% estate-tax rate, and estate inclusion may be less costly than the capital gains the heirs would face.
"The key to planning is obtaining better understanding of the tax nature of the client's assets," Lee suggests. Estate planners think of stocks and bonds, but there are other holdings that really benefit from a step-up in basis.
For example, intellectual property in the hands of the creator has a zero tax basis. This could be subject to ordinary income tax rates plus the 3.8% Medicare tax. If a client dies with this asset, its basis will be increased to the fair value on death and it becomes a long-term asset for capital gains purposes. If, instead, you counsel a client to gift away that asset during his or her lifetime - common planning advice, until now - you're exacerbating the overall long-term tax problem.
Similarly, if a client dies with negative basis commercial real estate interests, the step-up may solve the income tax issue. Gold, artwork and collectibles are taxed at a 28% capital gains rate, plus a 3.8% Medicare tax, so these assets might also be better retained in the client's estate.
The idea is to measure the transfer-tax costs against the income tax savings of the step-up in basis. To properly address the income tax savings of the basis step-up, you have to look at the beneficiaries' income tax rate, not the client's, Lee says. "So if children live in California, that is a very high tax in contrast to a child living in Florida." To cope with this reality, the client might establish separate trusts for each child and then determine the optimal tax treatment for each.
FORCING ESTATE-TAX INCLUSION
An advisor can manage tax basis by forcing estate-tax inclusion when income tax benefits are greater than the transfer-tax costs. How do you do so? One approach is the creative granting of general powers of appointment to beneficiaries who have excess exclusion.
A general power of appointment is a right given to a person to designate or appoint where assets can be distributed. A general power includes the right to appoint assets to your estate or creditors. So giving Aunt Jane, who has modest wealth, a general power to appoint assets in a trust her niece created can cause those trust assets to be taxable in Aunt Jane's estate, where they will trigger no tax. Assets in the niece's trust will all get a step-up in tax basis.
Another simple approach is to ensure that clients die with the lowest-basis assets. There are many ways to accomplish this goal. If a client has made transfers to a grantor trust, he or she may be able to exchange or swap cash for appreciated assets held in the trust, thereby bringing those assets into their estate for a step-up.
"Swapping is fine, but that is passive," Lee says. "There are more creative ways to change the basis of an asset in a client's hands without requiring a taxable event or death to get the basis changed."
Partnership income tax rules allow you to change the basis of an asset without requiring a taxable event or death. If you have high- and low-basis assets inside a partnership and an older partner with low outside basis, the partnership can take the high-basis asset into the partnership and liquidate the older partner, giving zero-basis assets to him or her. If that partner dies with those assets in his or her own name, the assets will obtain a step-up in tax basis outside the partnership. This also avoids the valuation discounts an older partner may not want on holding a partnership interest.
If the partnership has a Code Section 754 election in place, the stripped basis that came off that asset becomes an upward basis adjustment for the remaining partners. Complex, but just a hint of the creative basis-generating planning experts like Lee are considering.
Most families, however, don't have the $10.5 million in assets that would trigger federal estate tax. What should planners focus on with such clients? The answer is asset protection planning, to protect wealth through the generations.
Many estate plans continue to leave assets outright, without the protection of trusts, or in trusts that terminate (for example, pay all to the child at age 30) or provide rights of withdrawal that expose trust assets to creditors' reach. For trusts that have not yet been activated (like a child's trust in a will while the parent is alive), the fix is easy: Simply create a new will.
But planners should explore these issues for all existing trusts; there can be ways to fix even irrevocable trusts that do not provide optimal asset protection.
"Use decanting options" - pouring the old trust into a new and better trust - suggests Gideon Rothschild, chairman of the trusts, estates and asset protection practice at Moses & Singer in New York. "Don't just let them go."
When new trusts are planned, they should have long-term durations and in many states can even be perpetual. This extends the period of the asset protection as long as is feasible. "The data shows substantial inflow of trust assets to states that permit perpetual trusts," says Robert Sitkoff, a professor at Harvard Law School.
Many clients argue that they don't want the complexity and costs of trusts. "I don't want to rule from the grave," some might say.
Yet educating clients on the benefits is an important role for planners. Advisors can overcome objections by incorporating trust protectors to allow for removal and appointment of trustees, or by providing broad powers of appointment to beneficiaries, so they can leave assets to whomever they want, Rothschild suggests. Trusts can acquire art and homes, and make loans to beneficiaries. With this flexibility, you can still preserve assets from the reach of creditors and divorce judgments.
The number of clients with trusts is likely to increase. Understanding the income tax implications is vital for planners.
There are three different Medicare taxes to consider:
* The surtax for wages is 0.9%. When you add up the Social Security tax and hospital insurance tax, it's 1.45% for the employee, 1.45% for the employer and the new additional 0.9% for the employee over a certain level. That adds up to 3.8%.
* Those who are self-employed pay 3.8%.
* There's also the 3.8% Medicare tax on investment income.
The implication: "If you plan and get out of one tax, but end up paying another, there will be no net benefit," cautions John Goldsbury of U.S. Trust in Charlotte, N.C.
Some income can miss all three taxes. For example, a surviving spouse who's named as executor and takes a fee escapes all three surtaxes. Surviving spouses often forgo fees, but perhaps should not.
There are other ways to minimize this tax. While unearned income of a minor child is taxed at the parent's marginal rate, there is nothing that imputes the 3.8% surcharge from parent to child. If a parent simply includes a child's unearned income on the parent's return, the unearned income could be subject to the surcharge. "But if the child files his or her own return apart from the parent, the unearned income will be taxed at the parent's marginal rate, but the surcharge will not apply unless we're talking about $200,000-plus of unearned income - a fairly rare event," suggests Sam Donaldson, a professor at Georgia State University College of Law in Atlanta.
Another strategy concerns the transfer of closely held business interests taxed as S corporations or partnerships. Transfers of such interests to family members who actively participate in the business are fine, but in the hands of nonparticipating family members, the pass-through income allocable to such interests is net investment income.
Donaldson's recommendation: "Instead, if the interests given to nonparticipating family members are held in a grantor trust, the income will be taxed to the grantor and not subject to the 3.8% surcharge, provided the grantor materially participates in the business."
Martin M. Shenkman, CPA, PFS, JD, is a Financial Planning contributing writer and an estate planner in Paramus, N.J. He runs laweasy.com, a free legal website.