Estate Planning For The 99%

Jan 19 2014, 4:34pm CST | by

Estate Planning For The 99%

Lawyers and wealth managers who specialize in passing assets to the next generation love to brag about their ultra high net worth clients. But privately they admit that many (or most) of those who seek their help with wills and trusts don’t fall in this category. And lately they would have us believe that tax planning for these folks, most notably those with assets in the $5 million to $10 million range, is very, very, challenging.

That was one of the continuing themes last week at the Heckerling Institute on Estate Planning in Orlando, the annual Super Bowl on the subject. The catalyst for the discussion among the 2,900 lawyers, accountants and insurance pros gathered there, was a planning device that Congress introduced on an interim basis starting in 2011 and made permanent with the American Taxpayer Relief Tax Act of 2012. Tax geeks dubbed it “portability.”

Despite its wonky name (which mind you does not actually appear in the tax code so don’t blame Congress for this particular jargon), portability solved a pressing problem and had all the hallmarks of a consumer-friendly new rule for the 99%. In a nutshell, the law made it possible for widows and widowers to carry over the estate tax exemption of the spouse who died most recently and add it to their own. The tax law refers to the sum carried over as the “deceased spousal unused exclusion amount.” In common parlance it has become known by the short-hand, “the DSUE amount.”

At current rates this enables married couples to transfer $5.34 million apiece ($10.68 million together) tax-free. This tax-free amount (also called the “exclusion” or “exemption”), which is adjusted for inflation, will reach $6.58 million 10 years from now, and $8.95 million in 20 years, according to projections by Bernstein Global Wealth Management.

Public service announcement: To take advantage of this option or “elect portability” (in legal lingo), the executor handling the estate of the spouse who died must file an estate tax return (Internal Revenue Service Form 706), even if no tax is due. This return is due nine months after death with a six-month extension allowed. (For questions and answers about other aspects of portability, see “A Married Couple’s Guide To Estate Planning.”)

Portability doesn’t change the fact that you can give an unlimited amount to your spouse, during life or through your estate plan (provided she or he is a U.S. citizen) with no tax applied–this is the unlimited marital deduction. But until portability became part of the law, without proper planning, when the second spouse died anything above the exempt amount not going to charity would be taxed. In other words, the first spouse’s exemption would be lost.

To avoid that problem you either had to leave assets to someone other than your spouse, or set up a special kind of trust, called a bypass or credit shelter trust (more about which below). Now it’s possible to rely on portability instead. As of last summer, both the marital deduction and portability also apply to same-sex married couples.

And yet if last week’s meeting is any indication, some of the most influential voices in the trusts and estates bar don’t want to stop using the trusts they relied on before portability was even a glimmer in the legislators’ or the tax geeks’ eye. Their rallying cry is flexibility: Give clients the option of whether or not to use trusts down the line.

Thomas W. Abendroth, a lawyer with Schiff Hardin in Chicago, who at the 2012 meeting started his lecture about portability with a hilarious parody of a Viagra ad, this year very thoroughly, but somewhat tentatively laid out the lawyers’ dilemma.

“Portability was a sea change since it is no longer necessary to rely on a bypass trust and retitle assets between spouses in order to use the exclusion of effectively,” he said in a presentation titled “Portability: Now Available In Generic Form.” He also noted that another big advantage of portability is that assets get a basis adjustment to the fair market value on the date of the surviving spouse’s death. The advantage of this fresh start is that it limits the capital gains tax inheritors must pay if they sell appreciated property. In contrast, this step-up in basis is not available for assets that went into a trust at the first spouse’s death.

Portability also works well for assets that can’t easily or tax-effectively be managed from within a bypass trust, such as a house or retirement accounts, he noted.

Still, like other colleagues at the conference, Abendroth was reluctant to give up the old planning tools. He honed in on what he called “oddball situations” when these still might be preferable, for example to:

  • Protect against disgruntled spouses, creditors and others who may sue your heirs
  • Prevent the evil stepmother or stepfather from cutting your children out
  • Preserve the exclusion, in a remarriage in case the new spouse dies first
  • Make your grandchildren rich. Portability does not apply to the generation-skipping transfer tax that is levied, on top of any estate tax, to transfers to grandchildren or more remote descendants of more than $5.34 million. You can apply all or part of your exclusion from that tax to the bypass trust and include grandchildren as beneficiaries.
  • Reduce state estate tax if you live in a state that has one. Nineteen states and the District of Columbia have a separate estate tax, and none have portability provisions. (See “Where Not To Die in 2014”).

The old standby for doing all these things is the bypass trust which, so far as taxes are concerned, portability ought to have rendered extinct for the 99%.

Unromantic as it may sound, it starts with each of you holding at least $5.34 million worth of assets (or as much of that as you can afford) in your own name. In your will or living trust (each spouse needs to have one of her own), divide your estate into two parts. When the first of you dies, an amount up to the federal exclusion goes into the bypass trust. It can distribute income and principal to family members (typically the surviving spouse or partner, although it can also benefit children and grandchildren) for as long as that individual is alive, and after that pass on whatever is left to the people you designate (for example, the children).

Because funds in the bypass trust (often labeled the family trust) are covered by the exclusion amount, they will not be taxed when you die no matter how large the trust grows. Putting them in trust, rather than leaving them to your spouse or partner outright, ensures that they will not be considered part of her estate, either. Therefore, they are not subject to tax when she dies. Neither is any increase in the value of the funds after they go into the trust.

Whether or not taxes are a concern, keep that bypass trust on the back burner, Abendroth and other lawyers are now advising, especially for clients with estates in the $5 million to $10 million range, or higher. When the first spouse dies, you can do what’s best based on all the sands that may have shifted since the estate planning documents were written, including:

  • The age and health of the survivor
  • The children’s financial needs
  • Current income- and estate-tax rates
  • Tax rates in the states where the surviving spouse and beneficiaries live
  • Growth potential of the assets

One way to do that is to give the spouse the option to disclaim (or turn down) some assets and funnel them into the bypass trust to make use of the deceased spouse’s estate tax exemption. If need be, the survivor can still receive income or principal from the trust, but whatever remains in it bypasses the survivor’s estate.

Another possible approach, which got much more airtime last week, is to use an additional trust, called a contingent qualified terminable interest property (QTIP) trust or Clayton QTIP, and leave open the possibility to shift assets between two pots after the first spouse dies.

It’s enough to make even the most financially savvy client’s eyes glaze over.

First a little background about QTIP trusts. Traditionally they have been used to preserve assets for the children in case the spouse remarries. Here’s how QTIPs work: Instead of leaving your spouse’s share of the estate to him or her outright, you put it in this special type of marital trust. The trust must require the trustee to pay all income to the surviving spouse for life (the trustee can sometimes make distributions of principal as well) and not permit distributions to anyone other than the spouse while he or she is alive. When that spouse dies, however, the trust reserves whatever is left for children or whomever you specify in the trust. Only then is the property in the QTIP trust subject to estate tax.

To apply the marital deduction to the QTIP, there’s a formality that must be observed: Your executor, who signs the federal estate tax return, Form 706, must elect to treat the trust property as if it has passed to the surviving spouse. This is called a QTIP election. There have been plenty of malpractice lawsuits against executors, as well as the lawyers and accountants they hired to prepare the estate tax return, who neglected this detail.

A Clayton QTIP–named for the 1992 Fifth Circuit U.S. Court of Appeals case Clayton v. Commissioner and also the subject of Treasury Regulations (see Treas. Reg. § 20.2056(b)-7(d) and 7(h))—is a variation on this theme. It has been used in the past to deal with uncertainty about estate tax rates by postponing the decision about how to allocate the estate between the bypass trust and the marital share until the first spouse died. Now lawyers are recommending the same strategy can be employed with respect to portability. In other words: Postpone the decision about how to divide assets between the QTIP trust, to which portability would be applied; and the bypass trust, which would use at least some of the exemption amount of the spouse who just died.

In terms of the legal documents required, there are at least a couple of ways to set things up. You can start out with two trusts, or just a single trust that can be split into two after the QTIP election has been made.

Who decides how the pie gets divided? There is one potential pitfall if the executor making a QTIP election is the surviving spouse. Shifting what otherwise would have been his or her right to receive distributions from the trust may be considered a taxable gift. (The law on this point isn’t entirely clear.) So the conservative approach is to give the power to make a QTIP election to a co-executor or, if the spouse is the sole executor, to an independent party.

In effect then, portability, which was designed to make things simpler, has inspired greater complexity or creativity (depending on your perspective). The hybrid approach that some lawyers are now proposing is even harder for them to explain to clients–both when they set up the plan and after the first spouse dies. It also has the potential to take financial power away from the surviving spouse.

Understandably, lawyers see their role to anticipate and provide for every contingency. But many clients crave simplicity. In fact, when I speak and write on this subject, audience members ask whether they can do without lawyers altogether, and rely on the growing number of self-help legal products for estate planning–something that I discourage.

From a business development standpoint, therefore, lawyers’ ambivalence about portability–or in some cases strenuous objection to it–could backfire. The alternatives they are now offering, however clever or well intentioned, may introduce far more legal gyrations than even the most sophisticated clients are willing to stomach.

Archive of Articles By Deborah L. Jacobs

Deborah L. Jacobs, a lawyer and journalist, is the author of Estate Planning Smarts: A Practical, User-Friendly, Action-Oriented Guide, now available in the third edition.

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