Something Old, Something New, Something Borrowed, Something Blue:

Estate Planning Tools Married to New Realities

Recent favorable changes to the federal estate tax and the three-year phase out of the Tennessee inheritance tax mean that most Tennesseans now have no realistic expectation of their estates being hit by death taxes. December’s “Where There’s A Will” column[1] highlighted numerous ways estate planning is unaffected if clients no longer are concerned about death taxes. This article explores how estate planning will change in 2013 and beyond.

Something Old: Congress brings back a semblance of tax continuity

In the early hours of 2013, Congress passed the American Taxpayer Relief Act of 2012 (ATRA), which President Obama signed into law the following day. Key provisions of ATRA for estate planning include:[2]

  • Retaining the indexed and unified estate, gift, and generation-skipping transfer (GST) tax “exclusion amount” (exemption), $5,250,000 per person in 2013;
  • Extending “portability” of the estate tax exemption between spouses,[3] meaning a combined exemption for a married couple of $10,500,000 this year;
  • Increasing the estate, gift and GST tax rate from 35 percent to 40 percent;
  • Unfavorable income tax changes, including increasing the top rate to 39.6 percent,[4] phasing out personal exemptions and itemized deductions, and adding new 15 percent and 20 percent brackets for qualified dividends and long-term capital gains;[5] and
  • Favorable income tax changes, including permanent alternative minimum tax relief and extending (for 2013 only) the ability to make certain tax-free distributions from IRAs to charity.

After many years of estate tax uncertainty, ATRA’s big contribution is making the rules permanent. Now the vast majority of Tennesseans can be confident that their estates will result in no death taxes.[6] That confidence significantly changes how individuals and their planners approach certain aspects of estate planning.

Something New: Income taxes will cause clients to think in ways quite different from how they were trained to think for death taxes

Increased tax rates and reduced deductions make income tax planning more important at the same time that death tax planning is declining in importance. This shift turns some longstanding estate planning maxims on their heads.

For example, death tax planning revolves around reducing the values of clients’ taxable estates through (1) lifetime gifts to remove assets from the donor’s estate, (2) testamentary planning that keeps assets out of the donees’ estates, and (3) discount planning to reduce the values of assets as they are transferred during life and at death. Funding irrevocable gift trusts and irrevocable life insurance trusts (ILITs) during life and creating bypass /credit shelter trusts (CSTs) at death are staples of death tax planning to exclude assets from taxable estates. Similarly, creating family limited partnerships (FLPs) or limited liability companies (LLCs) and fractionalizing asset ownership are common mechanisms to reduce the values of assets in an estate in order to reduce the resulting death taxes.

However, when a client is more concerned about obtaining an income tax basis step-up[7] for assets at death than about death taxes, she wants to retain ownership of the assets during life and doesn’t want the asset values diminished through fractional interest or entity discounts. Planners previously counseled clients about balancing the competing death tax and income tax incentives, but recent tax law changes have tilted the scales. Married couples who previously split ownership of assets for death tax planning now will consider re-titling the assets as tenants by the entirety in order to obtain a full basis step-up at the second of their deaths. Clients might consider distributing assets from existing gift trusts and CSTs to include the assets in beneficiaries’ estates, or unwinding family LLCs/FLPs in order to increase the values of assets in the owners’ estates.

Thoughtful planning will look for ways to maximize creditor protection benefits while causing estate inclusion and reducing valuation discounts. Adding to an existing irrevocable trust[8] or drafting into a new trust a testamentary general power of appointment for the settlor can bring the trust assets back into the settlor’s taxable estate and achieve an income tax basis step-up at the settlor’s death, with only modest additional creditor risk. Drafting to give beneficiaries testamentary general powers of appointment can accomplish the same results at their deaths. Modifying LLC operating agreements, FLP agreements, and corporate buy-sell agreements to loosen transfer restrictions and give more power to minority owners, while maintaining sufficient creditor protection and family control over the entity, can increase the basis step-ups available at owners’ deaths.

The large gift tax exemption creates income-tax shifting opportunities for clients who might not otherwise have any incentive to gift. A client aware of an impending income tax event should consider whether to gift the affected asset to children or other beneficiaries in lower tax brackets. (Of course, the recipients can consider gifting the asset back to the original donor at a later date.) Similarly, creating family LLCs/FLPs can reduce the overall income tax burden by allocating portions of the income to owners in lower income tax brackets, and trustees now have greater incentive to consider distributions to carry income from more highly taxed trusts to beneficiaries in lower brackets.

Something Borrowed: Familiar tax tools will be repurposed for asset protection, control and thoughtful disposition

Clients whose estates (including life insurance death benefits) fall below the federal exemption amounts now will consider cutting or excluding familiar strategies from their plans.[9 ]However, planners and clients need to analyze the non-death-tax benefits of trusts and family entities (corporations, LLCs and FLPs) before removing these structures from existing plans or deciding not to include them in new estate plans.

Trusts. Almost all trusts offer protection of the assets from the beneficiaries’ creditors and loss of assets in divorce. In addition, most lifetime irrevocable trusts are exempt from claims by creditors of the trust settlor. ILITs, irrevocable gift trusts, “spousal lifetime access trusts” (or “SLATs,” a form of lifetime CST created by one spouse for the benefit of the other), and testamentary CSTs, all typically created with death tax planning in mind, are highly effective tools to protect assets from creditors of the beneficiaries and the settlor. The following types of trusts offer varying levels of creditor protection, with the distinctions being whether the settlor is a beneficiary and in whose taxable estate the assets are includible.

CSTs and GST Trusts. Creating a trust at the first spouse’s death for death tax planning always had the added benefit of protecting trust assets from the surviving spouse’s creditors. Similarly, creating trusts for children’s lifetimes is effective to keep the trust assets out of their taxable estates and to maximize the use of GST tax exemptions, but such trusts also protect assets from the children’s divorces and creditors.

SLATs. SLATs, including non-reciprocal SLATs created by spouses for each other, are intended to keep assets out of the beneficiary spouse’s taxable estate (sacrificing a basis step-up at the beneficiary spouse’s death). SLATs generally will be protected from the claims of the donor’s and beneficiary’s creditors. The exception is any distribution the trust mandates to or for the beneficiary spouse, so making distributions purely discretionary is preferable.

QTIPs. A “qualified terminable interest property” (QTIP) trust, created by one spouse for the other, causes no gift or estate tax upon creation, but is included in the beneficiary spouse’s taxable estate. And why might that be a good thing? Because the asset will be eligible for an income tax basis step-up at the beneficiary spouse’s death. The principal of a QTIP trust should be exempt from the beneficiary spouse’s creditors and, if the trust is created during the donor spouse’s life, from the donor spouse’s creditors.[10]

TISTS. Tennessee is in the minority of states allowing self-settled “domestic asset protection trusts” (DAPTs). Tennessee’s version is called a “Tennessee Investment Services Trust” (TIST) and our state statutes[11] are among the most advantageous in the nation for protecting assets from future creditors. A TIST permits a client to use the client’s own assets to fund an irrevocable trust of which the client is a beneficiary and, contrary to centuries of common law, the assets are protected from claims of the settlor-beneficiary’s creditors. TISTs can be structured to be includible in the settlor’s taxable estate or excluded from the settlor’s taxable estate.

Family entities. Family corporations, LLCs  and FLPs can offer significant death tax planning benefits, but they also are powerful tools to manage family wealth, to protect that wealth from creditors of the owners, and to control the ultimate disposition of that wealth. Entity buy-sell agreements with voting structures and transferability restrictions create an incubator for family assets, safe from many threats to those assets. Clients who created such entities in part to reduce death taxes need to be educated as to how valuable those entities can be for preserving and growing family wealth.

Something Blue: Some existing plans will create sad outcomes

Significant changes in death tax exemptions make formula dispositions keyed to those exemptions suspect. Many married couples’ wills or revocable trusts include first-death formulas allocating the maximum amount that can pass free of federal estate tax and Tennessee inheritance tax to children or a CST, excluded from the surviving spouse’s taxable estate, and the balance to the surviving spouse or a marital trust. Now such formula allocations might result in outcomes vastly different from what the clients originally envisioned. For example, assume the first spouse to die has an estate of $5 million. In 2012, the children or the CST would have received $1 million and the surviving spouse or the marital trust would have received $4 million. In 2015 (when the Tennessee exemption increases to $5 million), the children or the CST would receive $5 million and the surviving spouse or the marital trust would receive nothing. Such distortion could be catastrophic and needs to be corrected.

Conclusion

With the narrowed reach of federal and state death taxes, most Tennesseans will be freed from concern about these taxes. As the focus of these clients’ estate planning shifts, a host of structures and strategies, some familiar and some new, are available to meet their needs and avoid planning disasters.

Notes

  1. Eddy R. Smith, The Report of my Practice’s Death was an Exaggeration: The Healthy Prognosis for Estate Planning in Tennessee, Tenn. Bar J., December 2012, at 32 (http://www.tba.org/journal/the-healthy-prognosis-for-estate-planning-in-...)
  2. Several proposed restrictions on estate planning techniques (for example, restricting the availability of valuation discounts, reducing the advantages of “grantor trusts,” and increasing the minimum term for “grantor retained annuity trusts”) were not included in ATRA, but might be included in future legislation.
  3. Portability means a surviving spouse may apply any unused portion of a deceased spouse’s estate tax exemption to lifetime gifts and testamentary transfers. The GST tax exemption is not portable.
  4. Under existing law, an additional 3.8 percent net investment tax applies to investment income for taxpayers in the highest marginal bracket. Thus, the top rate on ordinary income (interest, rents and dividends) will be 39.6 percent + 3.8 percent = 43.4 percent.
  5. The top bracket is 23.8 percent if the net investment tax applies. See footnote 2.
  6. A chart showing the combined federal estate tax and Tennessee inheritance tax exposure for estates through 2016 is included online at http://tinyurl.com/b3m7coo. Clients whose estates (including life insurance death benefits) approach or exceed the federal exemption amount have increased incentives to plan due to the higher tax rate and the specter of existing strategies being curtailed by further Congressional action.
  7. Under Internal Revenue Code §1014, the income tax basis (the deemed cost for purposes of determining capital gain or loss) of property acquired from a decedent generally is adjusted to its fair market value at the decedent’s death. If the fair market value exceeds the basis in the hands of the decedent, this constitutes a step-up of the basis and built-in appreciation is eliminated. If, however, the property depreciated in the decedent’s hands, the property will receive a step-down in basis.
  8. This could be accomplished through a modification under Tenn. Code Ann. § 35-15-411(a) or by decanting pursuant to Tenn. Code Ann. § 35-15-816(b)(27).
  9. Remember the lingering Tennessee inheritance tax before eliminating helpful tax planning before 2016.
  10. The income from the trust is likely available to the beneficiary spouse’s creditors because the income must be distributed to or for the beneficiary spouse.
  11. Tenn. Code Ann. §35-16-101 et seq.

Eddy R. Smith EDDY R. SMITH practices trust and estate law with Holbrook Peterson Smith PLLC in Knoxville. He is a fellow of the American College of Trust and Estate Counsel and past chair of the Tennessee Bar Association Estate Planning and Probate Section. He can be reached at edsmith@hpestatelaw.com.

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Death Tax Chart (updated Jan 2013)60.96 KB