Trusts, Estates and Succession

Although the American Taxpayer Relief Act of 2012 (“ATRA”) might have made estate planning simpler for most taxpayers by “permanently” increasing the federal estate tax exemption to $5,000,000 (indexed for inflation), it has simultaneously increased the income tax cost of creating and maintaining trusts to protect those assets from the beneficiaries’ creditors (including spouses), and to keep those assets out of the beneficiaries’ estates for estate tax purposes.

Under ATRA, effective January 1, 2013, the top income tax rate for estates and trusts increased from 35% to 39.6% for taxable income over $11,950.00, and the tax rate on qualified dividends and capital gains increased from 15% to 20% for taxable income over $11,950.00.  In addition, under the Affordable Care and Patient Protection Act, there is a 3.8% Medicare tax on the lesser of net investment income or taxable income above $11,950.00 for estates and trusts.

As a result, many estates and trusts will be hit with a tax of 43.4% on ordinary income and 23.8% on qualified dividends and capital gains, and these rates are higher than would be the case if the assets generating that income were owned by individuals and not held in trust.

This is significant because trusts are an integral part of many estate plans.  For example, the Will of a married person typically creates a Credit Shelter Trust for the estate tax exempt amount, to keep that amount, together with the income and growth thereon, out of the surviving spouse’s estate, but available for the spouse in case he or she ever needs it.  The Credit Shelter Trust also protects against the spouse’s potential creditors (including future spouses).  Additionally, many married persons also leave the amount in excess of the estate tax exempt amount in a marital Q-tip trust for the benefit of the spouse – similarly protecting the principle against the spouse’s potential creditors (including future spouses).  And significantly, many people establish trusts for the benefit of their children and/or grandchildren (whether because of their age, spendthrift tendencies, incapacity, or any number of other reasons).  Such trusts may or may not be tax motivated, but could nevertheless feel the pinch of these new income tax laws.

Bottom line, although trusts continue to protect assets against estate taxes and potential creditors, and in some cases protect children or even grandchildren against their own indiscretions (and against creditor and spousal claims), ATRA has increased the income tax cost of maintaining such trusts.  Clients may therefore wish to consider whether the benefits of creating such trusts now outweigh the costs, and Trustees should consider whether the benefits of maintaining trusts outweigh the income tax costs.  If trusts are to be implemented or maintained both clients and Trustees should consider some or all of the following ways to mitigate the effect of the increased tax rates for estates and trusts:

a.  Distribute income to beneficiaries .  To the extent the trust distributes income, the income will be taxable to the beneficiary at the beneficiary’s rate.

b.  Invest for qualified dividends, long-term capital gains and tax-exempt income.

c.  Limit turnover, so as to minimize capital gains taxes.

d.  Distribute capital gains to beneficiaries.  It is sometimes possible to include capital gains in distributable net income (DNI), in which case the capital gains will pass through to the beneficiaries.

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This blog was prepared by Robert S. Lewis, Esq. For over 45 years, Mr. Lewis has concentrated his practice in estate planning, estate and trust administration, real estate, and corporate and business matters. Contact him at: rlewis@capehart.com

Whew!  I don’t know about you but I am glad that Fiscal Cliff stuff is over — well, at least the automatic tax increase part of it. Among other issues covered in the American Taxpayer Relief Act of 2012, Congress finally resolved the uncertainty in the federal estate and gift tax law that has been plaguing us since 2009.  Starting in 2010, there was no estate tax, then there was a tax but only on assets above $5 million, then there was the possibility that a 55% tax would apply in 2013 to assets above $1 million…how could we possibly plan in that climate?

Well the uncertainty is gone and we are all in a much better place.  I won’t go into all the details of the Tax Act, because you will be bombarded with numerous summaries of the new Act.  But we now know that the federal estate and gift tax will only apply to assets over $5 million (actually $5.25 million as adjusted for inflation in 2013) at a maximum rate of 40%. For families with less than $5 million, the planning becomes much easier and certain.  I would still recommend that, if you are in this category, you create trusts in your Will for your beneficiaries – not for tax reasons, but to protect your beneficiaries from claims of creditors, matrimonial claims, or to protect a beneficiary who can’t make wise financial decisions.  As I have mentioned before, there are many different types of trusts and a full discussion of those is not the point of this post.

The Tax Act also made permanent the concept of “Portability” – the ability of a surviving spouse to “use” the unused share of the $5 million exemption of his or her deceased spouse.  Remember, you can leave any amount to a spouse (transfers to a spouse are exempt from estate or gift tax) and can devise assets (including lifetime gifts) worth up to $5 million to all others without paying any estate tax.  But what if the first spouse to die does not use all of his exemption? With Portability, the surviving spouse can use the unused portion of the deceased spouse’s exemption amount to protect her own assets.  Say the first spouse to die has an estate of $2 million and the surviving spouse has $6 million. Using Portability, even with total family wealth of $8 million, no federal estate tax would be due after the death of both spouses. If the first to die leaves his assets to his spouse, he uses none of his exemption (since transfers to a spouse are gift and estate tax free). His entire unused exemption of $5 million can be carried over (it’s portable – get it?) to the surviving spouse. She can now protect the family wealth of $8 million, and could even protect an additional $2 million, using her own exemption of $5 million plus the $5 million from her deceased husband.

There are many regulations and limitations, but that is the concept of Portability. It was first introduced on a temporary basis for 2011 and 2012, but no one knew what was supposed to happen to it after 2012.  So it was not very valuable – to be effective, both spouses would have to die no later than 2012.  But now it is permanent. It will be especially helpful for families where one spouse has more assets than the other if ownership cannot be equalized easily.  For instance, suppose one spouse has the bulk of her assets tied up in an IRA. It is impossible to transfer ownership of assets tied up in retirement accounts between spouses, so Portability can help eliminate estate tax in this situation.

There will be many uses for the concept of Portability.  While it will not replace a well thought out estate plan, Portability will be another tool for an estate planner to consider in helping you in the future.

Questions regarding this article may be sent to Publications@Capehart.com.

Well, the results are in.  President Obama has been re-elected.  The Democrats have won the Senate.  The Republicans have won the house.  No party can claim a mandate.

What does this mean for us?  From the standpoint of estate and gift taxes, it means a lot.  Currently, each individual has a $5,120,000 exemption from the federal estate tax.  The exemption also applies to lifetime giving.

These exemptions are scheduled to expire at the end of this year.  Absent new legislation, the current law will sunset and the exemptions will revert to $1,000,000.  In that event, estates in excess of this amount will be taxed at rates ranging from 41% to 55%.   The exemption for gifting will be $1,000,000 as well.

Three scenarios could occur as to this law: (1) the current law could be extended, (2) the current law can expire and we can revert to the old law, or (3) new legislation can be passed.  Most likely, the second scenario will play out.

Why? President Obama has stated that he would not extend the current law before and that was when he had incentive to work with the Republicans on this issue.  He proposed a compromise of a $3,500,000 exemption which was rejected.  Moreover, he does not have to do anything to reinstate the $1,000,000 exemption.  The law will change, for lack of a better term, due to inaction.  Finally, the chance of new legislation being passed is slim.  The gridlock inWashington will not be broken over this issue.

So, what should you do?  Without question, you should review your existing estate plan.  Gifts can be made between now and the end of the year up to the $5,120,000 exemption amount.  These can be outright gifts or those made through a variety of trusts.

Contact an attorney in our group.  We will be happy to assist you in any way we can.