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Teetering on the brink of the “fiscal cliff,” Congress finally voted to come to a partial compromise. About two hours into the New Year in Washington, the Senate voted 89-8 to pass H.R. 8, the “American Taxpayer Relief Act.” Late into the evening of the same day (January 1, 2013) the House of Representatives followed suit and voted 257-167 to pass the measure. President Obama has indicated that he will sign the legislation.
From an estate tax perspective, the measure makes permanent all of the provisions of TRA 2010, except the rate. In other words, there is an exclusion of $5 million, adjusted for inflation. Thus, for 2013, the exclusion is $5.25 million. This is “unified” with the gift tax and may be used at death or during lifetime, with lifetime use subtracted from the amount remaining for use at death. The tax rate is capped at 40% rather than the 35% provided in prior law.
The “portability” provision is similarly retained by the new law. Thus, the exclusion amount of the first spouse to die may be used by the surviving spouse, assuming an estate tax return is filed for the pre-deceasing spouse.
GST exemption is also set at an inflation-adjusted $5 million. However, as with prior law, GST exemption is not portable. Thus, in order to preserve the GST exemption of the first spouse to die, the use of a credit shelter trust is needed. Of course, the use of a credit shelter trust is also advisable to provide remarriage protection and other benefits.
State estate taxes are deductible (no credit), as with prior law. The legislation did not address several items which the Administration has on its wish list. (For example, the Administration has wanted to limit GRATs by imposing a minimum term and has wanted to have GST exemption expire after 70 years.)
On the income tax side, the tax rates on income below $400,000 (for single filers, $450,000 for married filing jointly) have been made permanent at their current level. The tax rate for income above that level will rise from 35% to 39.6%, the rate pre-2001. Further, qualified dividend and capital gain income tax rates will be going up from 15% to 20% for that same group but will remain at their current levels for those with income below that amount.
The “charitable rollover” IRA provisions have been extended for years 2012 and 2013 only. Thus, an individual over age 70 ½ can give up to $100,000 from an IRA without taking the amount into income. This can be important for some taxpayers because the charitable deduction otherwise may be capped or not fully offset the income.
As to the spending side, the “sequestration” cuts which were to begin on January 1st have been delayed by two months. In order to avoid spending cuts embodied in the sequestration, the tax legislation embodied in the “American Taxpayer Relief Act” may have to be revisited. Thus, what is “permanent” under the American Taxpayer Relief Act may not end up being quite as permanent as we have been lead to believe.
Stephen C. Hartnett, J.D., LL.M.
Associate Director of Education
American Academy of Estate Planning Attorneys, Inc.
9444 Balboa Avenue, Suite 300
San Diego, California 92123
Phone: (858) 453-2128
www.aaepa.com
As we enter the summer of 2012, few people are concerned with year-end matters. However, when the ball drops on New Year’s Eve, there is a scheduled increase in income tax rates nonetheless. As a result, now may be a great time to “Roth” IRAs.
Roth IRA Conversion
A Roth IRA is similar to a traditional IRA in that the assets in the IRA build without income taxation. However, there are a few features that are different from a traditional IRA. There is no income tax deduction upon contribution to a Roth IRA. So, why would one want to invest in a Roth IRA? Neither the assets, nor the growth of the assets, are subject to income taxation upon withdrawal.
While there are income limitations upon contributions to a Roth IRA, there is no income limitation for conversions from a traditional IRA to a Roth IRA. Thus, for those with significant traditional IRAs or with the ability to rollover a qualified plan to a traditional IRA, they could create a large Roth IRA by converting their existing plan.
Income Tax Timing
With income tax rates scheduled to increase next year, now may be the best time in the foreseeable future to convert. The converted amount would be subject to income taxation at this year’s lower income tax rates.
In future years, when distributions are taken, not only will they avoid the income tax hike occurring next year, they will not be taxed at all.
No Estate Tax on Income Tax
This is also a good estate planning tool. Because they are income tax-free, Roth IRAs are particularly potent assets to leave to beneficiaries. Essentially, it is like being able to set aside money today to pay the beneficiary’s income tax later. However, it’s even better. The income tax which was paid in the conversion process is removed from the estate.
Thus, the Roth IRA conversion process has reduced estate tax concerns by pre-paying income tax and thus shrinking the size of the taxable estate.
Summary
As we’ve seen, converting a traditional IRA to a Roth IRA in 2012 may make a great deal of sense for Income Tax and Estate Tax reasons. Throughout the rest of 2012, I’ll keep you current on ways to take advantage of the ever-narrowing opportunity available before “Taxmageddon” at the end of this year.
Stephen C. Hartnett, J.D., LL.M.
Associate Director of Education
American Academy of Estate Planning Attorneys, Inc.
9444 Balboa Avenue, Suite 300
San Diego, California 92123
Phone: (858) 453-2128
www.aaepa.com
In my last two posts, we’ve been looking at James and Susan, married business owners in their late 50’s. James and Susan have a net worth of just under $20 million, and they’ve come to you with some pretty simple estate planning goals: they want to provide first for each other, and then for their two children, Mark, 35, who is married with three children, and Emily, 33, who is a newlywed with no children. Of course, they also want to minimize their overall tax bill as much as possible.
One of the strategies we explored at the Academy Spring Summit that would be particularly useful for a couple such as James and Susan is to establish Qualified Personal Residence Trusts (“QPRTs”) for their primary residence and one secondary residence. If they expect the homes to appreciate significantly, QPRTs may be a great way to move that wealth out of their estates and transfer it to their children in trust.
With a QPRT, an owner gives a residence to the trust while retaining the right to use the property during a term of years. After the term of years, they can retain an option to rent the property from the trust for fair market value rent or the spouse can be given a right to live rent-free. While clients often are not crazy about having to pay rent to live in their own home after the term, this strategy is a great way of removing even more value from their estates.
IRC §2036 provides that if the grantor of the trust dies during the term, the property is included in the grantor’s taxable estate. However, if the grantor survives the term, the property is removed from the taxable estate without further use of applicable exclusion. This can be a powerful way to remove wealth from the grantor’s estate. This is especially powerful when the value of the underlying real estate is depressed in value, as in today’s market.
So, James and Susan can transfer up to two residences into QPRTs and, assuming they outlive the terms designated for the trusts, ownership of the properties will ultimately be transferred to trusts for James and Susan’s children with the following benefits:
- James and Susan can retain the use of the residences
- Because the trusts for the children don’t receive ownership of the properties until the expiration of the specified term of years, the value of the gift to the children is discounted
- Assuming James and Susan survive the term of years specified when the QPRTs are established, the value of the residences are removed from their taxable estates without further use of the applicable estate tax exclusion
Another trick to minimize both the use of applicable exclusion and the mortality risk is doing multiple QPRTs on each residence. For example, James could take his 50% interest in the residence and set up three QPRTs of different terms, let’s say 5-, 10-, and 15-years. Susan could do likewise. If James dies after 8 years and Susan lives 17 years, we would have been successful in removing all of the QPRTs Susan set up and one out of three that James set up. The 10- and 15-year QPRTs which James set up will be included in his estate because he failed to outlive the terms. An additional bonus to fractionalizing the residence with multiple terms is a fractional interest discount. Typically, a fractional interest in real estate would qualify for a valuation deduction of at least 10%. So, 1/4 of a $1 million property would not be worth $250,000, but, rather, would be worth $225,000.
Between the discount inherent in giving only the remainder interest in the QPRT, and the fractional interest discount, this is a very cost-effective way to transfer the asset. Typically, clients may refrain from doing QPRTs because the strategy can use a large amount of applicable exclusion. However, with the new, temporary $5 million applicable exclusion, QPRTs may make more sense than ever.
We also explored other strategies at our conference, including Grantor Retained Annuity Trusts and a sale of the business to the intentionally defective grantor trust.
Stephen C. Hartnett, J.D., LL.M.
Associate Director of Education
American Academy of Estate Planning Attorneys, Inc.
6050 Santo Rd Ste 240
San Diego, CA 92124
858-453-2128
www.aaepa.com
In my last post, we looked at a Case Study from the Academy’s New Orleans conference. I introduced you to your new clients, James and Susan. They’re a married couple in their late 50’s who met in college and have built a successful business, Widget Corp., amassing a current net worth of just under $20 million. Susan and James have two children. Mark, 35, is married with three children, and Emily, 33, is a newlywed with no children.
Susan and James’ estate planning goals are pretty straightforward: they want to leave their assets first to each other, then to their children and, of course, they want to reduce their ultimate tax burden as much as possible. So, what strategies do you suggest?
One advanced planning strategy we discussed at the Academy Spring Summit, and that Susan and James might want to consider, is gifting to irrevocable trusts. An irrevocable trust can be used to make a current gift to remove the assets from a grantor’s taxable estate. This is a particularly timely strategy, due to the temporary $5 million applicable exclusion available to each James and Susan under TRA 2010. Irrevocable trusts can be a great strategy for other reasons, as well:
- Protection of assets from beneficiaries’ creditors
- Protection of assets from future beneficiary divorce
- Protection of assets from the creditors of the grantor
- Protection of assets from mismanagement by beneficiaries
In a jurisdiction that has repealed the Rule against Perpetuities, the assets in an irrevocable trust can be held for future generations and can avoid being subject to estate taxation or to creditors of any future generation.
As an example, let’s take a look at a trust established by James. James’s trust would be set up for the benefit of Susan, their two children, Mark and Emily, and their three grandchildren. James would gift into this trust any remaining portion of his $5 million applicable exclusion not used up through other planning strategies. The year following the transfer of these assets into the trust, he would file Form 709 to report the gift. In addition, he would allocate his GST exemption (currently $5 million) to the trust.
Each year James would contribute annual exclusion gifts for Mark, Emily, and the three grandchildren. Of course, the trust would be drafted so that additional grandchildren would also be included as beneficiaries and Crummey power holders.
Let’s assume James gifts $3,000,000 worth of assets into the trust plus the maximum annual exclusion gift each year during his life expectancy.
Assuming a 4% rate of return, the $3,000,000 initial gift to will grow to $7,998,000 during James’s 25-year life expectancy. With James in a 50% estate tax bracket, this results in tax savings of $3,999,000.
On to the annual exclusion gifts: with five beneficiaries at $13,000 each, that’s $65,000 in annual gifting. These annual exclusion gifts will grow to $2,812,000 during James’s 25-year life expectancy, again assuming a 4% rate of return. This results in a tax savings of $1,546,600 (without the use of the applicable exclusion).
Between the $3,000,000 initially transferred into the trust and the annual exclusion gifts added each year, the assets in the irrevocable trust at James’s death will have grown to $10,810,000. This results in an ultimate tax savings of $5,545,600 – and this is only the view from James’s side of the fence. Remember, we can set up a separate irrevocable trust for Susan!
In my next post, we’ll look at an additional strategy James and Susan can use to transfer wealth out of their taxable estate and ensure that it makes its way to their children.
Stephen C. Hartnett
Associate Director of Education
American Academy of Estate Planning Attorneys, Inc.
6050 Santo Rd Ste 240
San Diego, CA 92124
858-453-2128
www.aaepa.com
I just got back from New Orleans, the Crescent City, where the American Academy of Estate Planning Attorneys held its Spring Summit conference. Everyone had a wonderful time, though the 8am sessions came a little early for those who had been out on Bourbon Street the night before!
I gave several presentations, including one on estate planning under the new, temporary TRA 2010. In this blog, I’ll give a brief overview of what TRA 2010 does and then look at the fact pattern we examined. In the next two blogs I’ll go over some of the strategies that might work in this case.
2011 and 2012
In 2011 and 2012 the system for gift and estate taxes is (mostly) unified.
Gift Tax
For gift tax purposes, the “basic” exclusion stands at an unprecedented $5 million. In addition, the surviving spouse can use the predeceasing spouse’s “Deceased Spousal Unused Exclusion Amount” or “DSUEA.” In order for the surviving spouse to be able to use the DSUEA, an estate tax return must have been timely-filed for the pre-deceasing spouse.
Estate Tax
For estate tax purposes, the “basic” exclusion is also $5 million. The DSUEA is also available, but only for the last deceased spouse. There is a step-up in basis.
Generation Skipping Tax
For generation skipping tax (GST) purposes there is also $5 million exemption available to shield generation-skipping transfers. Note that, unlike the gift and estate tax, there is no portability of the deceased spouse’s unused GST exemption.
For gift tax, estate tax, and GST purposes, the rate for transfers in excess of the exclusions / exemptions is 35%.
2013 and beyond:
In 2013, TRA 2010 sunsets (with EGTRRA) and we revert to pre-2001 law. This means that the applicable exclusion reverts to $1 million. It may be used in life or at death. For GST purposes, there is a $1 million exemption, inflation-adjusted from the base year. For practical purposes, this means that the 2013 GST exemption is likely to be about $1.4 million.
Case Study:
It’s a beautiful spring morning, and new clients have just walked into your office. James and Susan are a married couple who met in college and spent the early years of their marriage growing a business alongside their family. Now in their late 50’s, their business is thriving, and James and Susan have a combined net worth of just under $20 million.
The timing couldn’t be better for James and Susan to do some serious estate planning, because of the new law. This may very well turn out to be a unique window of opportunity for high net worth clients, like them. In my next blog posts we’ll look at their assets in greater depth and look at some strategies that might work well for them to take advantage of this unique window of opportunity.
Stephen C. Hartnett, J.D., LL.M.
Associate Director of Education
American Academy of Estate Planning Attorneys, Inc.
6050 Santo Rd Ste 240
San Diego, CA 92124
858-453-2123
www.aaepa.com
It has often been said that the path to knowledge begins with knowing what you don’t know. As usual, this year’s Heckerling Institute helps put the estate planning attorney on the path to knowledge by highlighting how much we do not know.
Section 2001(b)(1) calculates the estate tax in the year of death as the sum of the tax on the taxable estate and the tax on the amount of adjusted taxable gifts over the aggregate amount that would have been paid on the gifts if they had been taxed as part of the decedent’s estate in the year of death. Section 2001(b)(2).
This works fine in a situation of a rising applicable exclusion. However, in the situation of a declining applicable exclusion, as we may have in 2013, it may cause an estate tax on prior non-taxable gifts.
- Example: John has $6 million and gifts $5 million in 2011. He dies in 2013 with $1 million.
Section 2001 is intended to add back the prior gifts so that the $1 million is taxed at the rate of 50% rather than an effective rate of 34.58%.
Instead, Section 2001 could be read to tax the situation as a $6 million estate, or $2,940,800 less the unified credit of $345,800, which would result in $2,595,000 in tax.
The speakers at Heckerling were uncertain how the clawback issue would be resolved. However, they and I think it would be grossly unfair to give an applicable exclusion of $5 million in 2011 and 2012, only to have the decedent’s estate discover that those gifts resulted in an estate tax at the decedent’s death in 2013.
Of course, even if the clawback does exist, one would still be better off to use their $5 million applicable exclusion in 2011 or 2012. At least the appreciation on the asset would escape transfer taxes.
In our example, let’s say John’s $5 million of gifts in 2011 appreciates to $10 million by the time of his death. Thus, without the gifts in 2011, John’s estate would be $11 million and the tax would be $5,395,000, after use of his exclusion. Even with application of the clawback, the John’s estate would have saved quite a bit by doing the gifting. The tax would be $2,595,000 rather than $5,395,000.
As the days and hours ticked down in 2010, we faced a great deal of uncertainty on the extension of EGTRRA. With the potential “clawback,” we likely will be facing at least as much uncertainty in the waning days of 2012.
Stephen C. Hartnett, J.D., LL.M.
Associate Director of Education
American Academy of Estate Planning Attorneys, Inc.
6050 Santo Rd., Ste. 240
San Diego, CA 92124
858-453-2128
www.aaepa.com
After much wrangling and politics, on December 17th, President Obama signed the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010, otherwise known as “TRA 2010.” The law did many things:
- Temporarily extended the Bush-era income tax cuts,
- Temporarily extended the program extending unemployment insurance benefits,
- Temporarily cut employee’s FICA tax by 2%, and
- Temporarily provided estate tax relief.
From an estate planning perspective, the new law set the amount that could pass without an estate tax at $5 million per person for 2010-2012. However, the new law is temporary and will expire after 2012. In 2013, the amount that can be passed free from tax will go back down to $1 million per person. Thus, unless the law is changed again between now and then, someone dying in 2013 would only be able to pass $1 million without an estate tax.
As before, you can use a portion of that exclusion to make lifetime gifts, but then it would not be available at death. In 2010, you can use up to $1 million of your exclusion during your lifetime. In 2011 and 2012, you can use your whole $5 million exclusion during life. Of course, then you would not have any available at death.
Congress also introduced a new “portability” provision. This is where one spouse can add their deceased spouse’s remaining estate tax exclusion to their own exclusion to shelter more from taxes. This portability provision, also known as the “Deceased Spousal Unused Exclusion Amount,” can be used to shelter the assets of the surviving spouse. While intriguing on the surface, under current law this portability tax benefit only happens if both spouses die in 2011 or 2012. If either spouse hangs on until 2013 or beyond, there is no portability option available.
In addition, the new law reduces the top estate and gift tax rate to 35% in 2010-2012. However, a top rate of 55% returns in 2013 and thereafter.
So, what’s the gist of the new law? Prior to TRA 2010 we were facing a return to the $1 million estate tax exclusion on January 1, 2011. Now, we are still facing a return to the $1 million estate tax exclusion; it’s just put off for two years now—to January 1, 2013. The bottom line is that TRA 2010 is temporary. In two years, it will disappear as though it had never existed.
Stephen C. Hartnett, J.D., LL.M.
Associate Director of Education
American Academy of Estate Planning Attorneys, Inc.
6050 Santo Rd., Ste. 240
San Diego, CA 92124
858-453-2128
www.aaepa.com
Clients often ask advice regarding how best to leave assets in order to maximize tax advantage. They look to the estate planning attorney for advice on income taxes, estate taxes, and even property taxes. But, perhaps the best advice we can give is how not to leave assets: directly.
Clients typically see the advantages to leaving assets directly to their beneficiaries: simplicity. But, often they do not see the potential downside to doing so and the advantages to leaving the assets in trust for the beneficiaries’ use.
Each year, many beneficiaries who have been given their bequests directly end up penniless. Often this is through their mismanagement of the assets, as in the recently publicized case of Nick Martin. After the sale of the business his father started, Martin received $10 million after taxes. A decade later, mismanagement and missteps left him with little. Here is a link to a recent New York Times article on the topic: New York Times Article
Whether it is through mismanagement, divorce, or creditors, the work of a lifetime can be dissipated surprisingly quickly if it is not carefully protected. Estate planning attorneys know that a continuing trust is usually the best way to protect against these risks while also providing the potential for tax minimization.
If your client expresses a desire to leave the assets outright to their beneficiaries, do you attempt to educate your client regarding the benefits of a continuing trust? Do you discuss divorce protection for the beneficiary? Do you discuss asset protection for the beneficiary? Do you discuss GST planning to save estate taxes at the beneficiary’s death? Do you discuss third party management of the assets?
While the client has the ultimate decision on the matter, they can only make an informed decision after they know the pros and cons. Do you try to educate your client on the options available to them?
Stephen C. Hartnett, J.D., LL.M.
Associate Director of Education
American Academy of Estate Planning Attorneys, Inc.
6050 Santo Rd., Ste. 240
San Diego, CA 92124
858-453-2128
www.aaepa.com
In 2010, estate planning attorneys have been wondering “what will happen to the estate tax?” We have been wondering whether the pre-EGTRRA estate tax applicable exclusion of $1 million will return or if Congress will finally fix the mess it created years ago. Will the exclusion go back to the $3.5 million we had in 2009 under EGTRRA? Will there be restrictions on GRATs? Will there be restrictions on FLPs?
The intricacies of the estate tax may be in the front of our minds. The estate tax and its strategies may even be of importance to many of our clients. But, seldom is estate tax planning the most important thing we do for our clients. Even with the applicable exclusion at $1 million, most people will not have a taxable estate. But, everyone is concerned about taking care of those closest to them.
We advise clients how to leave assets to their beneficiaries, while minimizing the risk that the assets will be squandered or attached by creditors. We advise clients how to leave assets for their child with special needs, without jeopardizing the child’s governmental benefits. Many of us help our clients with elder law matters, helping them keep their home even in the face of health concerns.
As we approach the holiday season, it’s important to recognize how important we are in the lives of our clients. Our planning enables our clients to make it through very difficult times more easily. We help our clients protect those most important to them from the hardships in life, even when they cannot be there themselves.
Do you have a memorable story to share? Has a client shared how you have made a difference? Please share your story!
Stephen C. Hartnett, J.D., LL.M.
Associate Director of Education
American Academy of Estate Planning Attorneys, Inc.
6050 Santo Rd., Ste. 240
San Diego, CA 92124
858-453-2128
www.aaepa.com
As we all know, there is no estate or GST tax in 2010. However, the estate and GST taxes return next year. Without Congressional action, the applicable exclusion will be $1 million. Thus, a wealthy individual who dies on December 31, 2010, will face an entirely different tax outcome than one who dies the following day.
Let’s look at someone with $100 million. If they die on this New Year’s Eve, their estate would owe no any estate tax, regardless of to whom the assets were given. If the person died the following day, they would have $99 million estate taxed at 55%. Their estate would owe $54,654,200 to federal and state taxing authorities, leaving $45,345,800. If they had chosen to leave the assets to skip persons, the result would be even more burdensome. Depending on the GST exemption available next year, only about $30 million would end up in the beneficiaries’ hands and $70 million would end up in the hands of the tax collectors.
Is a day of life worth millions of dollars?
With less than two months left before the estate tax returns, this is no longer merely an abstract question anymore. U.S. Rep. Cynthia Lummis (R-Wy.) has stated that she has constituents who have told her that they are contemplating taking their life at the end of the year rather than see their estates be subject to estate tax.
http://news.yahoo.com/s/ap/20101029/ap_on_go_co/us_congresswoman_tax_cuts
Contrary to popular belief, suicides normally decline during the winter months and rise again in the spring, according to the Annenberg Public Policy Center at the University of Pennsylvania.
http://www.psychologytoday.com/articles/200401/holiday-suicide-myth
Will we buck the norm and see a significant rise in suicides among the wealthy at the end of the year because of the imminent return of the estate tax? Should estate planning attorneys prepare for a wave of trust and estate administration cases? Or, do you think that clients are not serious about it? Are clients really willing to die to save estate tax, even lots of it?
As I examined in my blog from February 18th of this year, the estate planning attorney may have varying ethical duties with regard to a client’s expression of suicidal intent depending on the ethical rules and the legality of suicide in the jurisdiction. If your client has expressed a serious plan to take their own life, re-read that blog to see what the ethical duties are.
What do you think? Are clients really willing to die to save estate taxes?
Stephen C. Hartnett, J.D., LL.M.
Associate Director of Education
American Academy of Estate Planning Attorneys, Inc.
6050 Santo Rd., Ste. 240
San Diego, CA 92124
858-453-2128
www.aaepa.com
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