A New Paradigm
by Robert L. Moshman
ne door closes, another door opens. Could it be that some of the estate plans that are now being drafted will contain estate tax strategies that are being utilized for the very last time? But there is a lot more changing that just the strategies.
Without an estate tax, we must shift our way of thinking; there is an entirely new set of priorities involving areas beyond estate taxation. And every adjustment in an estate plan sets up multiple chain reactions of consequences throughout the estate. That leaves hidden traps to be aware of.
In light of the dramatic changes in the transfer tax system, what questions and issues should be reviewed between estate-planning professionals and their clients? What drafting strategies apply to these transitional times? What is the current role of life insurance in the estate plan? Are generation-skipping strategies still valid?
Here we take a brief excursion through the noteworthy strategies that are emerging. And along the way, we compile a checklist of topics that should be addressed during the client consultation.
Strategic Planning Areas
Let's first identify the elements of the new planning paradigm. What we find immediately is an extended period of transitional rules. Having rules in transition is always challenging enough, but instead of subtle changes over two or three years, as we have often experienced in this area of tax code, a total sea change arrived with the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA).1
The Last March: To begin with, estate plans must continue to deal with the existing transfer tax system as it continues to be phased out. On the one hand, a short-term approach anticipating estate taxation is needed, while on the other hand, a long-term approach anticipating the elimination of transfer taxes must now be included as well. Planning for the immediate tax system would be necessary even if the transitional period were taking place over a shorter period of time. No one can assume that any individual, regardless of age or health, will outlive a tax system.
But this transitional period is certainly not brief. We now have an applicable exclusion amount of $1 million and a top Federal estate tax rate of 50 percent. Six years from now, in 2008, we will still have a Federal estate tax, albeit with an applicable exclusion amount of $2 million and a top rate of 46 percent. A great many estates that are currently exposed to estate tax liability will continue to face such tax until the applicable exclusion amount goes to $3.5 million or the repeal takes effect.
Gift Adjustments: With the increase of the applicable exclusion amount for gift tax purposes reaching $1 million, estates that had previously maximized lifetime gifts when the exclusion amount was $675,000 now can transfer an additional $325,000. The annual gift tax exclusion, now at $11,000, remains a useful strategy along with gift-splitting techniques.
Long Term Trusts: Individuals may want to reevaluate how long trusts will be needed. If long-term trusts were solely devised to minimize estate taxation upon successive transfers, and estate tax is repealed, perhaps earlier distribution of more of the trust would then be preferred. However, there are other reasons for long-term trusts. It is therefore important to elicit the grantor's objectives rather than make assumptions.
Flexibility: In the context of so much uncertainty, the flexibility of granting trustees or family members various rights to modify arrangements for the purpose of reducing various tax liabilities may be useful.
Life Insurance: With the potential elimination of the estate tax, life insurance for the purpose of supplying liquidity at death might seem to have a limited time left to be relevant. Yet it is not possible to rely on the estate tax being phased out. Having life insurance that terminates in 2010 would not be prudent since the estate tax could be reinstated automatically in 2011.
The Carryover Basis: The $1.3-million step-up in basis that will remain after 2009 will preclude any capital gains taxation for many estates. Typically, $1.3 million of unrecognized gains would involve properties of considerable value, eliminating most estates from that consideration. But for those large estates now focused on transfer taxation, future income tax considerations will move to the forefront of planning. The allocation of that stepped-up basis to particular assets and/or beneficiaries becomes a critical concern. Moreover, for those estates, the existing assumptions about retaining records on capital assets go out the window and permanent retention becomes the rule. Those estates may also consider the lifetime sale of assets for which basis is uncertain.
The QTIP Trust: With the arrival of the carryover basis, the qualified terminable interest property (QTIP) trust may be directly affected in many estates. Up to $3 million of capital gains can receive a stepped-up basis if transferred to a spouse. But if the spouse's income interest is contingent on the executor's QTIP election, it may not qualify for that step-up in basis. Keeping appreciated assets in a separate spousal trust may be indicated for certain estates.
Tax Allocation: With assets being redistributed based on changing tax consequences, the allocation of tax payments must be carefully reconsidered.
The Professional Trustee: Making a fair decision about the distribution of assets is always part fact and part perception. The acceptance of any decision that affects the balance of interests received by the respective beneficiaries will determine future family relationships, not to mention the outcome of intrafamily litigation. Where family members are thrust into fiduciary roles, the new paradigm may expose them to challenges and litigation over the allocation of stepped-up basis or of tax liability, and an exoneration clause may be warranted.
Formulas For Disaster
Flash forward to the year 2010. The estate tax has, in theory, been eliminated and, in theory, Congress has acted to prevent it from being reinstated. But in the years that have passed, a percentage of wealthy individuals will have estate plans that call for assets to be distributed in accordance with formula clauses. Clauses that simply "reduce tax to zero," or make transfers "free of tax" or make other generalized statements may now have unintended consequences. More detailed clauses may be needed to address changes in the estate, in the tax rates, and identify the distribution of assets as percentages of the estate.
1. The Credit Shelter Formula
What distribution of assets is contemplated in terms of percentage of the total estate? Remember, the size of the unified credit keeps going up but the size of estates is not guaranteed to do the same. Some estates will rise or just hold their own. Other estates will fall precipitously. With the potential for the applicable exclusion amount and asset valuations to swing in opposite directions, a formula clause could result in wildly disparate results.
Example: Mrs. L. has an estate now valued at $10 million. It is possible that a drop in the value of her stock portfolio or business assets would reduce her estate to $5 million. A formula clause contemplates the applicable exclusion amount going to her nephew, Alan. How much will Alan receive? With these facts, the amount Alan inherits could be as low as $1 million if Mrs. L. were to die during 2002 or 2003. This would represent 10% of $10 million. Yet Mrs. L. could also die during 2009 when the applicable exclusion amount is $3.5 million. If Mrs. L's estate had dropped to $5 million during 2009, the applicable exclusion amount would represent 70% of the estate.
What would Mrs. L. prefer? How much does she want Alan to receive? Although this example exaggerates the likely possibilities, it illustrates the disparity in results that flow from reliance on a rigid formula as opposed to the testator's actual intentions in distributing assets.
These same facts take on additional meaning (and potential for family disputes), depending on the context. For example, suppose Alan is Mrs. L's child from a previous marriage. As the applicable exclusion amount increases, Alan's share of the estate may be cutting into assets remaining for other heirs. And while Mrs. L's intentions may now be to maximize Alan's share, that may not have been contemplated when Mr. and Mrs. L's estates were originally planned.
Looking beyond 2010, the outcome of a formula clause is even more unpredictable. There may be no tax, in which case Alan could receive nothing without some other provision in Mrs. L's will. On the other hand, the sunset provision could reinstate the estate tax and resurrect an applicable exclusion amount of $1 million, causing Alan's share of the estate to drop from $3.5 million to $1 million.
Clearly, maximizing such credits is not within the best interests of every estate. Reactions to unknown asset levels and uncertain tax rules require the utmost of flexibility. This places greater significance on trust arrangements where discretion can be exercised.
2. The Disclaimer Formula
With a heightened possibility that tax circumstances will allow more assets to accumulate in a given estate during life, there is a greater likelihood that such assets will be disclaimed by primary beneficiaries. The passing of disclaimed assets should not be permitted to happen by default, nor by a rigid formula. Anticipation of the use of disclaimers calls for a disclaimer trust that incorporates flexibility in directing assets to appropriate beneficiaries and provides for appropriate management and distribution of assets.
3. GST Formulas
If a formula clause has generation-skipping transfer exemptions from each spouse passing to a trust, the combined amounts could well exceed the amounts originally contemplated. Capping such amounts may now become desirable depending on the size of the estate and the testator's intentions.
Asset Protection
It is clear that in the absence of a federal estate tax, the focus for many estates shifts to income tax issues and state transfer taxes. But there may be a more fundamental shift in the non-tax category of estate-planning priorities. The biggest threats to accumulated wealth may no longer be taxes of any kind. Asset protection may become the most critical guiding principle of estate planning. Specifically, the threats may arrive as follows:
Assets diverted by divorce following distribution to a beneficiary.
Assets exposed to the financial liabilities of heirs.
Lack of conservation when assets are being divided among free-spending beneficiaries rather than centrally managed and supervised.
Assets improperly diversified or supervised from an investment perspective.
Distributional strategies and patterns must also be reexamined. Some individuals who would have commenced lifetime distribution of assets in an effort to minimize estate tax liability may now be less inclined to relinquish any of the assets. The unintended consequence may be the need to provide lifetime income to heirs.
A Long Transition
Estate planners understand the need for flexibility in a world where change and uncertainty are the only constants. Yet the current transitional period we have entered is far more challenging than anything experienced previously. We face an estate tax that is sharply reduced, eliminated, and then potentially reinstated. We face the future imposition of a carryover basis for assets transferred at death. And while those are the most visible issues, there are a host of subsidiary changes that affect strategic planning.2
We hope we've touched on several of those changes here. And as the long transitional period of transfer tax history unfolds, there will undoubtedly be many shifting priorities and adjustments to preferred strategies. While this discussion has touched on many of the areas of change, upcoming issues of this newsletter will focus on QTIPs, GSTs, and the other specific techniques are evolving in important ways in this new paradigm.
Client Interview Checklist
The re-education of clients is a far greater problem than many estate planners anticipated. Clients have ingrained understandings about laws that have now changed and their priorities need to be redirected. At the same time, other clients have an over-simplified view of the estate tax simply not existing any longer. The client interview is an opportunity to educate the client about new opportunities while simultaneously gathering necessary information. Here are several relevant discussion areas.
There is still an estate tax to be planned for; no one can assume that he or she will outlive the current estate tax. Wills and revocable living trusts should be reviewed for estates greater than $1 million.
In light of uncertainties and rapid changes, more frequent estate-planning reviews are needed from this point forward.
Changing rules and conditions also make it important to incorporate flexibility into plans by means of discretionary trust powers, special trustees, powers of appointment, and disclaimer trusts.
Information will need to be preserved concerning capital basis. The potential for capital gains tax at death affects the choice of assets to be transferred or liquidated during life, the retention of records, and the assessment of beneficiary tax brackets.
Life insurance coverage may require adjustment since liquidity concerns shift from estate taxation to income taxation and other liabilities.
Are long-term trusts intended only for estate tax reduction and would earlier distribution of certain assets be preferred if the repeal of estate tax does, in fact, take place?
Formula clauses must be carefully designed and customized for each estate since there is a potential for previously benign formula clauses to backfire in the current context. What are the testator's goals and objectives?
Asset protection-where are the biggest potential liabilities or tax threats to the value of the assets?
With more assets accumulated in the grantor's estate, portfolio management is critical and long-term oversight by a professional trustee has advantages.
TECHNICAL REFERENCES
1 The Tax Relief Act of 2001, The Estate Analyst (June, 2001); What's new for 2002, The Estate Analyst (January, 2002); The New Carryover Basis, The Estate Analyst (March, 2002).
2 Several articles raised points reflected in this article as well as other valuable ideas. Berall, Harrison, Blattmachr, and Detzel, Planning for carryover basis that can be/should be/must be done now, 29 Estate Planning (WG&L) 3, p. 99 (March, 2002); Aucutt, An A-to-Z `to do' list following EGTRRA, 28 Estate Planning (WG&L) 12, p. 606 (Dec., 2001); Eisen, Estate planning under 2001 tax act present new challenges, 28 Estate Planning (WG&L) 11, p. 515 (Nov., 2001); Zaritsky, How estate tax "repeal" will affect your estate planning practice, 7 ALI-ABA Estate Planning Course Materials Journal 5, p. 5 (Oct., 2001); and Leimberg and Gibbons, Dealing with EGTRRA's impact on an insurance professional's practice, 28 Estate Planning (WG&L) 9, p. 403 (Sept., 2001).
© K.S. 2002
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