Estate Planning In the New Tax Environment

A well-executed estate plan is important but plans can become outdated, which is why clients are instructed to frequently review these plans in light of changing circumstances. There are a number of reasons to revisit estate plans, including marriage, divorce, or simply a change in planning desires. But life changes aside, individuals may need to revisit their existing plans due an evolving tax environment.

The relatively recent passage of the American Taxpayer Relief Act of 2012 (ATRA) created more tax certainly in the estate planning world, but it also changed how we view and implement estate plans. For individuals who executed documents prior to ATRA, this is as good time to ask how their current documents operate under today’s tax laws.

ATRA made permanent the combined gift and estate tax exemption at $5 million per person. This amount is adjusted annually for inflation and the effective exemption amount for 2014 is $5.34 million. “Portability” is also now permanent. Portability allows a surviving spouse to elect to use a deceased spouse’s unused exemption in addition to their own exemption. With portability, a married couple potentially has an exemption amount of $10.68 million in 2014, regardless of which spouse owns property or who dies first. This is a major change from prior law.

It is anticipated that these high exemptions will result in less than 0.2% of estates being taxable. But in no way does that mean estate planning is unnecessary. Along with the permanently high exemption rate, ATRA brought us increased income tax rates. The focus now turns to income tax issues in planning, especially for couples with significant wealth but who still fall below a combined exemption amount: roughly the $5-8 million range. For these couples, it is critical to review existing documents from this new tax perspective.

There are two basic approaches for clients within the “range”: (1) traditional two-share planning and (2) full use of portability.

Prior to ATRA many couples created two-share Wills in order to maximize the use of their individual exemptions. Under prior law the available exemptions were lower and if exemption was not used there was no to a surviving spouse. Now that the exemption amount is “permanent” at a high level, those same individuals need to understand how their two-share Wills operate in today’s tax world. With the higher exemption amount, all or most of a spouse’s estate may be left to a bypass trust, effectively leaving the second marital share or marital trust unfunded or relatively low. The assets transferred to the bypass trust at the first death will get an income tax basis step-up for the first death. Only assets that go to the marital share will get an income tax basis step-up at both the first death, and then again as they may remain in the estate at the second spouse. The loss of basis step-up is something to consider.

While existing two-share Wills may no longer be necessary for estate tax reasons, it does not mean they are completely unnecessary. There are non-tax reasons to execute a two-share plan, including second marriage situations and asset protection. A martial trust is still an excellent option for a surviving spouse who may not be financially savvy or who may serve as an easy target for financial abuse or creditors. Placing assets in a marital trust also protects the property from a new spouse’s reach in the event of remarriage. In blended family situations, the two-share set-up allows for control the ultimate disposition of wealth and ensure that an individual’s biological children (who may not be the biological children of the surviving spouse) receive their intended shares.  The actual distribution provisions of each share needs attention.

With the high exemption amount plus the permanency of portability, many couples with estates in the “range” may still decide that a two-share approach is not for them.  Instead an “all to spouse” plan may seem like an attractive option. With this approach, a couple plans to give assets outright to the surviving spouse or to a trust solely for the surviving spouse and then relies on the surviving spouse to elect for portability in a timely manner in order take advantage of both spouses’ exemption amounts. The method gives the surviving spouse some flexibility to decide what to do with the assets at the first spouse’s death and can take advantage of the second basis step-up at the surviving spouse’s death.  This approach can be effective but along with the perceived simplicity comes the potential for hidden complications, not to mention a large amount of responsibility placed on the surviving spouse.

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