Estate Planning in 2015 and Beyond: No Longer a One-Size-Fits-All Approach
Historically, many lawyers have taken somewhat of a “one-size-fits-all” approach to estate planning, focusing primarily on reducing future estate tax and only tangentially considering federal income taxes, state estate and income taxes, international issues, asset protection (including protection from divorce), charitable planning, and other nontax objectives (i.e. , keeping assets in the bloodline). Over the past 15 years, the combination of significant federal and state legislative changes, an increasingly litigious society, and a globalizing economy have forced practitioners to rethink the manner in which estate plans have been structured and introduce a myriad of additional factors that must be considered. What was once a one-size-fits-all approach has morphed into a Pandora’s box, requiring practitioners to take a much more thoughtful and calculated approach to planning and to consider the interplay among federal and state estate and income taxes, and many nontax considerations. This article discusses some of the recent legislative changes affecting estate planning and the manner in which estate planning has changed to adapt to such changes.
Historical Approach to Estate Planning
The complexity of today’s planning cannot be fully appreciated without first understanding the relative simplicity of planning in years past. In 2000, prior to the enactment of the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA),1 the estate and gift tax applicable exclusion amount (commonly referred to as the estate and gift tax exemption) was only $675,000; the top federal estate and gift tax rate was 55 percent (with an additional 5 percent surtax for higher estates intended to phase out the estate and gift tax exemption); the federal capital gains tax rate was 20 percent; and “portability” and the net investment income tax (NIIT) did not exist. In this tax environment, little variation existed in the estate plans that practitioners implemented for clients, at least from a tax perspective. The primary objectives were to take full advantage of the client’s estate and gift tax exemption and, for clients owning assets in excess of the estate and gift tax exemption (or the combined exemptions for a married couple), to remove assets with high appreciation potential from the taxable estate so that growth on the value of the assets could occur outside of the taxable estate.
For married couples, the first objective generally was achieved by utilizing a bypass trust/marital trust or A/B plan (traditional plan), whereby upon the death of the first-to-die spouse (DS), assets having a fair market value (FMV) equal to the DS’s remaining federal estate and gift tax exemption would fund a bypass trust, which would be exempt from federal estate tax upon the surviving spouse’s (SS) death. The balance of the DS’s assets would pass to the SS (outright or in trust), which would utilize the federal estate tax marital deduction so that no federal estate taxes would be imposed upon the DS’s death. To ensure that the DS held assets sufficient in value to fully fund the bypass trust (thereby fully utilizing the estate and gift tax exemption of the DS), couples were often forced to divide and retitle their assets so that each spouse owned assets having a FMV at least equal to the estate and gift tax exemption. Any portion of a DS’s estate and gift tax exemption not used upon his or her death was forever lost.
The second objective was typically achieved through the implementation of lifetime gifting techniques. When a client makes a lifetime gift, the donee takes a carryover basis in the gifted asset equal to the donor’s basis in the gifted asset immediately prior to the transfer.2 As a result, although the donor has effectively removed any post-gift appreciation from his or her estate, if the donee subsequently sells the gifted asset, the donee would have to pay capital gains tax on all of the appreciation, even that appreciation occurring prior to the gift.3 At a time when the estate tax rate was sufficiently higher than the capital gains tax rate (and no NIIT existed), the estate tax saved by making a lifetime gift almost invariably exceeded the future capital gains tax associated with the gift.4
Legislative Changes and Their Impact on Planning
• Recent Legislative Changes — Even through the 2000s, as the estate and gift tax exemption increased, estate plans generally remained the same. However, the American Taxpayer Relief Act of 2012 (ATRA)5 drastically altered the way in which practitioners approach estate planning. Significantly, ATRA permanently 1) increased the estate, gift, and generation-skipping transfer (GST) tax exemptions to $5 million indexed annually for inflation ($5.43 million in 2015); 2) increased the estate, gift, and GST tax rates to 40 percent (from 35 percent); 3) increased the capital gains tax rate to 20 percent; and 4) extended portability of the estate and gift tax exemption between spouses. In addition to these changes, the 3.8 percent NIIT, which generally applies to passive income, such as gross income from interest, dividends, rents, royalties, annuities, and gains from the disposition of property, became effective in 2013.
In addition to changes in the law, society is changing. The increasing rate at which lawsuits are filed and the prevalence of divorce has led many clients and practitioners to place a greater emphasis on integrating asset protection strategies into estate plans. This has led a number of states to enact legislation permitting the use of domestic asset protection trusts or DAPTs as a way to protect asset from future creditors while allowing the settlor of the DAPT to retain a beneficial interest in the assets transferred to the trust.6
Moreover, as society and the economy become increasingly global, a greater number of individuals are deciding to live and/or invest abroad, thus, requiring practitioners to consider additional complex issues, such as compliance with the various reporting requirements of the Foreign Account Tax Compliance Act (FATCA), which generally requires U.S. taxpayers to report their ownership interest in certain foreign accounts, and wealth transfer tax and cross-border income tax planning issues related to planning for non-U.S. citizens with U.S. citizen children and grandchildren.7
In light of these changes, estate planning has become more dynamic than ever before. Traditional plans and lifetime gifts are no longer the sure-fire tax savers they once were. In fact, the plans developed in the past may end up costing the client significantly more from an overall tax perspective than if no planning had been undertaken in the first place. Practitioners are now required to take into consideration a myriad of factors, which historically only tangentially factored into estate planning considerations. The remainder of this article provides a brief discussion of some of the estate planning strategies that practitioners should consider when developing estate plans in 2015 and beyond.
Planning in 2015 and Beyond: The Impact of Portability on Planning Decisions
Portability refers to the concept of transferring a DS’s unused estate and gift tax exemption (DSUE amount) to his or her SS.8 In its simplest form, portability involves the DS leaving all of his or her assets outright to his or her SS (or to a marital deduction trust for the benefit of the SS), eliminating the need for a bypass trust ( i.e. , a trust established for the benefit of a SS that will not be included in the SS’s estate for estate tax purposes) (basic portability plan).9 Although the main rationale for enacting portability was to simplify estate planning, portability places a greater significance on the facts and circumstances of each particular client, requiring practitioners to take a much more calculated approach to planning. In determining whether a traditional plan or a portability-driven plan is most beneficial, the following factors must be carefully considered:
• Post-Death Appreciation — If a traditional plan is utilized, the assets transferred to the bypass trust and all appreciation occurring after the DS’s death should be shielded from federal estate tax. If the basic portability plan is utilized and the SS receives all assets outright, all appreciation will be included in the SS’s gross estate for federal estate tax purposes (gross estate) and subject to estate tax upon the SS’s death. While this may not be fatal, it could cause an estate tax upon the SS’s death if there is significant appreciation because the DSUE amount is not indexed for inflation. Of course, this must be weighed against the step-up in basis that will occur upon the SS’s death.
• Basis Considerations — If a traditional plan is utilized because the assets of the bypass trust will not be included in the SS’s estate, the assets will not receive a second basis step-up to FMV at the SS’s death, which may ultimately result in the imposition of the capital gains tax and NIIT when the assets are sold. If the basic portability plan is utilized, the assets that would otherwise fund the bypass trust will be included in the SS’s gross estate and, therefore, will receive a second basis step-up at the SS’s death, which would avoid such taxes on any appreciation occurring prior to the SS’s death.
• GST Tax Exemption Considerations — If a traditional plan is utilized, the DS’s GST tax exemption would typically be allocated to the bypass trust, thereby shielding the assets from GST tax, as well as estate tax, for multiple generations. Unlike the estate and gift tax exemption, the GST tax exemption is not portable. As a result, if the basic portability plan is utilized, the DS’s GST tax exemption may be wasted.
• Asset Protection Considerations — If a traditional plan is utilized, the assets transferred to the bypass trust would be protected from the SS’s creditors. Because the assets would be held in trust, the SS’s creditors should not have access to the assets (except to the extent that distributions are made to the SS) and, if the SS remarries, the new spouse should not be entitled to any portion of the assets owned by the trust upon a subsequent divorce. However, if the basic portability plan is utilized and the assets are distributed outright to the SS, there would be no creditor protection because the assets would be owned directly by the SS.
• Control Over Ultimate Disposition of Assets — If a traditional plan is utilized, the DS can direct the ultimate disposition of all of his or her assets upon the death of the SS through provisions in the bypass trust and/or marital trusts (assuming the marital share is held in trust). If the basic portability plan is utilized, the DS loses all control over the ultimate disposition of assets upon the SS’s death if the assets are distributed outright to the SS. This is a serious issue in blended family situations when the DS has children from a prior marriage.
• State Law Considerations — Currently, no states allow portability of the DS’s state estate and gift tax exemption, further complicating planning decisions.10 If portability is elected and a bypass trust is not funded, the DS’s estate will not be able to utilize the state estate and gift tax exemption, therefore, increasing the amount of state estate tax that will be due upon the SS’s death.11 One approach that could be utilized to take full advantage of the state estate and gift tax exemption would be for the DS to fund a bypass trust with the state estate and gift tax exemption, leave the balance of his or her assets to a QTIP trust and make a portability election with respect to the DS’s remaining estate and gift tax exemption. This would eliminate state estate tax upon the DS’s death and permit the SS to utilize the DS’s DSUE amount.
• Non-U.S. Surviving Spouse — If the SS is a non-U.S. citizen, assets passing to the SS qualify for the federal estate tax marital deduction only if such assets pass to a special type of marital trust known as a qualified domestic trust (QDOT).12 If the basic portability plan is utilized and all of the DS’s assets pass outright to the non-U.S. SS, not only would the marital deduction be denied, but the DS will not be able to port his or her DSUE amount to the non-U.S. SS.
• Advanced Portability Planning Approaches — Many of the negative aspects associated with the basic portability plan can be mitigated or even eliminated through the use of careful planning. One alternative approach would be for the DS to leave all of his or her assets to a qualified terminable interest property (QTIP) trust (QTIP trust plan). leaving the assets to a QTIP trust, the assets will be protected from the SS’s creditors, the DS would control the ultimate disposition of the assets and a reverse QTIP election could be made to allocate the DS’s GST tax exemption to the trust.13 Additionally, because the assets in the QTIP trust would be included in the SS’s gross estate upon his or her death,14 the assets would receive a second basis step-up.15 The QTIP trust plan is able to achieve many of the same benefits of a traditional plan, with one significant exception — post-death appreciation will be subject to estate tax upon the SS’s death.16
Another approach that provides all of the benefits of the QTIP trust plan but also addresses the post-death appreciation issue is the grantor trust plan. Pursuant to the grantor trust plan, the DS would transfer assets having a FMV equal to the DS’s remaining estate and gift tax exemption to the SS outright with the balance of the DS’s assets passing to a QTIP trust.17 Immediately after the SS receives the assets from the DS’s estate, the SS would transfer assets having a FMV equal to the DSUE amount to an irrevocable grantor trust for the benefit of the DS’s and the SS’s descendants. This transfer would be treated as a gift by the SS, but would be shielded from gift tax by the DSUE amount. Because the gift is to an irrevocable trust, all appreciation occurring after the transfer would be shielded from estate tax (just as if a bypass trust were funded by the DS). Additionally, because the trust would be structured as a grantor trust, the SS would be liable for the trust’s income tax, thus, allowing tax-free growth of the trust assets. Moreover, if the trust is created in a DAPT jurisdiction, it may be possible for the SS to be a beneficiary of the trust.18
Maximizing the Tax Efficiency of Lifetime Gifts
For clients with assets valued in excess of the estate and gift tax exemption or who anticipate their assets will appreciate by the time of their death to a value in excess of the estate and gift tax exemption, various lifetime gifting techniques may be implemented to reduce the value of the taxable estate. As discussed above, historically, when the estate tax rate was significantly higher than the capital gains tax rate (and there was no NIIT), the estate tax savings achieved by transferring future appreciation out of one’s estate during life almost invariably exceeded the increased income tax liability associated with the gift. Accordingly, practitioners could obtain a great tax result for their clients without the need to consider the income tax consequences of lifetime gifts.
Example:
Assume that in 2000, A, an individual, owned stock with a fair market value of $10,000,000 and a basis of $2,000,000. Assume further that at the time of A ’s death, the stock has appreciated in value to $25,000,000. If A holds onto the stock until death, A ’s gross estate will include the entire $25,000,000 value of the stock, resulting in estate tax of $13,722,250.19 The beneficiary of the stock would receive a stepped-up basis and, therefore, would incur no capital gains tax on pre-death appreciation of a post-death sale. If, on the other hand, A makes a gift of the stock to a grantor trust in 2000, A will pay gift tax of $4,920,250 on the transfer.20 The trust will take a $5,936,200 basis in the stock21 and pay capital gains tax of $3,812,750 on all pre-death appreciation.22 This results in a total tax liability of $8,733,000. Accordingly, a lifetime gift in 2000 would result in a tax savings of $4,989,250.
Today, however, the landscape is far more complex. With a 23.8 percent maximum tax rate on capital gains (including the NIIT) and a 40 percent estate tax rate, practitioners must carefully analyze the income tax exposure to the donee of the gifted asset to determine whether a lifetime gift will be tax efficient.
Example: Assume the same facts as the above example, except that the year is 2014 and that A dies in 2033. If A holds onto the stock until death, A ’s gross estate will include the entire $25,000,000 value of the stock, resulting in estate tax of $6,420,000.23 The beneficiary of the stock would receive a stepped-up basis and, therefore, would incur no capital gains tax on pre-death appreciation. This estate tax liability assumes an estate tax exemption in 2033 of $8,950,000.24 If, however, A makes a gift of the stock to a grantor trust in 2014, A will pay gift tax of $1,864,000 on the transfer.25 The trust will take a $3,491,200 basis in the stock26 and pay capital gains tax of $4,301,760 and NIIT tax of $817,334.40 on all pre-death appreciation. This results in a total tax liability of $6,983,094.40. Accordingly, it would cost $563,094.40 more in total taxes to make a gift of the stock in 2014.
In today’s tax environment, in order to make lifetime gifts worthwhile, further planning is required beyond the initial gift. A post-gift asset exchange with a grantor trust is an effective technique to mitigate or even eliminate the capital gains tax and NIIT attributable to appreciation occurring prior to the donor’s death.27 Through the use of a post-gift asset exchange, the trust will receive assets with a basis equal to fair market value (or as close thereto as possible), and the donor will receive the low-basis asset previously gifted to the trust. These low-basis assets will be included in the donor’s gross estate, thereby receiving a step-up in basis upon the donor’s death.28 Although a detailed discussion on the available post-gift asset exchanges techniques is beyond the scope of this article, each technique deserves a brief mention.29
• Cash Purchase — The simplest way for a donor to make a post-gift asset exchange is for the donor to use cash to purchase the previously gifted assets from the trust. As long as the trust was structured as a grantor trust with respect to the donor, no gain or loss should be recognized on the sale.30
• Third-Party Financing — The donor could borrow the necessary funds from a third-party lender and use the borrowed funds to purchase the gifted assets. It is not necessary that the loan be repaid prior to the donor’s death; rather, the loan could be repaid after the donor’s death and would be deductible on the donor’s estate tax return.31
• Promissory Note — If the donor is unable to secure a loan from a third-party lender, or, if the donor would rather not borrow money from a third-party lender, the donor could purchase the gifted assets from the trust in exchange for a promissory note. However, there are several risks involved with using a promissory note in this manner tied to the uncertainty regarding the income tax treatment of a grantor trust upon the death of the grantor.32
• Exercise Substitution Power — Alternatively, the donor may be able to execute a post-gift asset exchange if the trust contains a “substitution power.” A substitution power is a provision commonly employed by estate planners to invoke grantor trust status that permits the grantor of the trust to reacquire the trust corpus by substituting other property of an equivalent value.33 In this case, assets with little or no gain would be exchanged with low-basis assets owned by the grantor trust.
• Decant Gifted Asset to New Trust — If the trust to which the donor made the lifetime gift (distributing trust) does not contain a substitution power, the trustees of the distributing trust may, depending on the particular state law governing the distributing trust, be able to “decant” the assets of distributing trust to another trust (receiving trust) having different terms and conditions than the distributing trust, including a substitution power.34 After the gifted assets have been decanted into the receiving trust, the donor can exercise the substitution power, exchanging the donor’s high-basis assets for the receiving trust’s low-basis assets.
Charitable Planning / Asset Protection Considerations
With federal income tax rates tax rates as high as 39.6 percent and an additional 3.8 percent NIIT (as well as high state income taxes), clients are increasingly shifting their focus toward estate planning techniques that provide not only future estate tax benefits, but immediate income tax benefits. For those individuals who are charitably inclined, charitable remainder trusts and charitable lead trusts are excellent planning tools and should be considered.35
Society continues to grow more and more litigious and with the increased recognition of the risks associated with failed marriages, clients and their advisors are increasingly concerned with protecting assets from the claims of future creditors, making it increasingly important to properly incorporate asset protection planning strategies into estate plans. A full discussion of asset protection planning is also beyond the scope of this article and there is an abundance of literature available that discusses asset protection, in general.36
From investing in “exempt assets,” such as life insurance, annuities, retirement accounts, and tenancy by the entireties property, to using limited partnerships and limited liability companies (LLCs) so that a creditor’s sole remedy against the owner of a partnership interest in a partnership or a membership interest in an LLC will be limited to a charging order,37 to using self-settled asset protection trusts in a state that has legislation permitting the creation of domestic asset protection trusts, the sky is the limit for implementing asset protection for a client.
Conclusion
Recent changes in the law have drastically altered the way in which practitioners approach estate planning. The interplay of federal and state estate and income taxes and asset protection considerations has significantly increased the complexity of planning decisions. Gone are the days of the one-size-fits-all estate plan. Today, practitioners are required to take into consideration an array of factors that historically were often not more than an afterthought, turning estate planning into a Pandora’s box.
1 Pub. L. No. 107-16.
2 See I.R.C. §1015. For purposes of this article, any reference to the I.R.C. refers to the Internal Revenue Code of 1986, as amended.
3 See I.R.C. §1014. If no gift is made, all future appreciation would be included in the donor’s gross estate and subject to estate tax. However, the asset would receive a basis step-up to FMV, thereby eliminating any capital gains tax.
4 See Jay D. Waxenberg and Nathan R. Brown, The Narrowing Tax Efficiency Gap, Trust & Estates 22 (July 2014), and Jay D. Waxenberg and Nathan R. Brown, The Narrowing Tax Efficiency Gap: Part II, Trust & Estates 24 (Sept. 2014) [hereinafter Waxenberg & Brown, The Narrowing Tax Efficiency Gap ].
5 2012 H.R. 8.
6 Alaska, Delaware, Hawaii, Mississippi, Missouri, Nevada, New Hampshire, Ohio, Oklahoma, Rhode Island, South Dakota, Tennessee, Utah, Virginia, and Wyoming all have enacted DAPT legislation.
7 See Scott A. Bowman, Ellen K. Harrison, and Gideon Rothchild, The Alphabet Soup of International Planning, reprinted from the proceedings of the
48th Annual Heckerling Institute on Estate Planning (Jan. 2014) (for a detailed discussion on FATCA). A discussion of the international issues that must be taken into consideration is beyond the scope of this article.
8 See Richard S. Franklin, Lester B. Law, and George D. Karibjanian, Portability – The Game Changer, American Bar Association, Real Property, Trusts and Estates Section, Estate and Gift Committee Project (Jan. 2013) (for a detailed discussion on the topic). A detailed discussion on portability is beyond the scope of this article.
9 Portability eliminates the need to fund a bypass trust upon the DS’s death because it is no longer use it or lose it with respect to the DS’s estate and gift tax exemption.
10 See Lisa M. Rico, Estate Planning with Portability in Decoupled States, Probate & Property (May/June 2013) (for a detailed discussion on state law consideration in portability planning).
11 In New York, for example, if the DS’s estate files a federal estate tax return and elects portability, the estate is bound by the federal QTIP election for state estate tax purposes and, as a result, cannot utilize the state AEA.
12 See I.R.C. §§2056(d) and 2056A.
13 I. R.C. §2652(a)(3).
14 See I.R.C. §2044.
15 The QTIP trust plan is a very flexible planning alternative. The DS’s personal representative could make a full or partial QTIP election or the SS could disclaim all or a portion of the assets into a bypass trust.
16 See I.R.C. §§2056A(a)(3), 2056(b)(7)(B)(v), 2010(c)(5)(A). If the SS is a non-U.S. citizen, a QDOT election must be made on the estate tax return along with the QTIP and portability elections; see Treas. Reg. §20.2010-2T(b)(4);Treas. Reg. §20.2010-2T(b)(5), Ex. 3. When property passes to a QDOT, the DSUE amount of the DS must be redetermined upon the occurrence of the final distribution or other event (generally the death of the SS) on which estate tax is imposed under §2056A.
17 A reverse QTIP election would be made with respect to the QTIP trust to allocate the DS’s GST tax exemption to the QTIP trust.
18 DAPTs are discussed in detail below.
19 See former I.R.C. §2011. This assumes that, at the time of A ’s death, the laws in effect for 2000 apply, and that A dies in a “pick-up state,” which imposes state estate tax in an amount equal to the state death tax credit. Accordingly, the $13,722,250 is comprised of federal estate tax of $10,255,450 and state estate tax of $3,466,800.
20 Based on the rate tables in effect in 2000.
21 $2,000,000 carryover basis plus $3,936,200 gift tax paid on net appreciation.
22 ($25,000,000 – $5,936,250) x. 20.
23 ($25,000,000 x. 40) – ($8,950,000 x. 40).
24 See Paul S. Lee , Paradigm Shift: The ATRA-Math (Planning After the American Tax Relief Act of 2012) (May 2013). The 2033 projected exemption amount of $8,950,000 used for purposes of the calculations in this article is based on an average rate of inflation as projected by Bernstein Global Wealth Management.
25 ($10,000,000 x. 40) – ($5,340,000 x. 40).
26 $2,000,000 carryover basis + $1,491,200 gift tax paid on net appreciation.
27 See Rev. Rul. 85-13, 1981-1 C.B. 184.These techniques only work if the initial gift was to a grantor trust. Otherwise, the exchange would be a taxable transaction.
28 See I.R.C. §1014, which provides, generally, that the basis of property in the hands of a person acquiring the property from a decedent is the fair market value of the property on the date of the decedent’s death.
29 See Waxenberg & Brown , The Narrowing Tax Efficiency Gap.
30 See Rev. Rul. 85-13, 1981-1 C.B. 184.
31 See I.R.C. §2053(a).
32 See Jonathan G. Blattmachr, Mitchell M. Gans, and Hugh H. Jacobson, Income Tax Effects of Termination of Grantor Trust Status Reason of The Grantor’s Death, 97 J. T ax’n 149 (2002). This article provides a detailed analysis of the income tax consequences upon the death of a grantor of a grantor trust when, prior to death, the grantor sold assets to the trust in exchange for a promissory note, the principal balance of which remains outstanding on the date of the grantor’s death.
33 See I.R.C. §675(4)(C).
34 Currently, 19 states have decanting statutes.
35 See Nathan R. Brown, A Primer on Charitable Remainder Trusts, 39 Estates, Gifts and Trusts J. 255 (Nov. 13, 2014). A detailed discussion on charitable trusts is beyond the scope of this article. However, for a detailed discussion on charitable remainder trusts. S ee Daniel L. Daniels and David T. Leibell, Charitable Lead Trusts: A Primer, Planned Giving Design Center (Nov. 21, 2000) (for a detailed discussion on charitable lead trusts), available at http://www.pgdc.com/pgdc/charitable-lead-trusts-primer.
36 See Howard D. Rosen and Gideon Rothschild, Asset Protection Planning, No. 810 (3d ed.); Barry A. Nelson, Asset Protection & Estate Planning: Why Not Have Both? (2011) , available at http://www.estatetaxlawyers.com/articles/2011AssetProtectionAndEstatePlanning.pdf.
37 See Fla. Stat. §§608.433, 620.8504, and 620.1703; see also Del Code §§17-703 and 18-703.
David Pratt is the co-chair of the personal planning department of Proskauer Rose, LLP, and the managing partner of the Boca Raton office. He is a fellow of the American College of Trust and Estate Counsel and American College of Tax Counsel, and is Florida board certified in taxation and wills, trusts, and estates. He is also a past chair of The Florida Bar Tax Section and an adjunct professor at the University of Florida’s Levin College of Law and the University of Miami’s School of Law, where he teaches estate tax planning in its LL.M. programs.
Nathan R. Brown is an associate in the personal planning department of Proskauer Rose, LLP, based out of the Boca Raton office. He practices in the areas of domestic and international estate planning.
This column is submitted on behalf of the Tax Law Section, Cristin Conley Keane, chair, and Michael D. Miller and Benjamin Jablow, editors.
