March 2013

QUARTERLY INSIGHTS FOR CLIENTS: How the New Tax Law Affects Estate Planning


How the New Tax Law Affects Estate Planning

In our January Email Alert, we summarized the changes to estate, gift and income taxes made by the American Taxpayer Relief Act of 2012 (the “Act”). Highlights include:

  • A new 40% tax rate and $5.25 million exemption (adjusted for inflation after 2013) apply for estate, gift and generation-skipping transfer taxes.
  • Subject to certain exceptions, a surviving spouse can use a deceased spouse’s estate and gift tax exemption without the need for a specially designed trust.
  • Beginning this year, irrevocable trusts are subject to a new top tax rate of 39.6% on all ordinary income over $11,950, and to a new 3.8% Medicare tax on undistributed net investment income above that amount (under a 2010 law first effective this year).

As promised, this edition of our Quarterly Insights for Clients notes how the Act affects estate planning.

Some Married Couples Might Eliminate Trusts from Their Plans

Up to now, married couples wishing to save estate tax for their families created an irrevocable trust for the surviving spouse, instead of simply leaving assets directly to the survivor. Use of one of these “exemption” or “bypass” trusts was required to preserve both spouses’ tax exemptions, since leaving the estate of the first to die directly to the survivor meant that only the survivor’s exemption was available to reduce estate tax. A new planning option called “portability” became temporarily available only during 2011 and 2012, but was made permanent by the Act. Portability means that a deceased spouse’s estate can elect to pass any unused gift and estate tax exemption to a surviving spouse without utilizing an exemption trust for the survivor. Under some circumstances, this can produce estate tax savings similar to an exemption trust.

Whether to simplify estate plans by using portability, now that it has become a permanent option, is a complex decision. It depends on many variables:

Factors suggesting portability

  • There can be greater income tax savings with portability when assets passing from a surviving spouse are later sold by beneficiaries.
  • As a result of the new law, there may be higher income taxes on an exemption trust than in the past.
  • IRAs and retirement plans do not fit well in an exemption trust.
  • An exemption trust must file income tax returns and can have administrative costs, typically over the surviving spouse’s entire lifetime.

Factors suggesting an exemption trust

  • Greater asset growth can be protected from estate tax with an exemption trust.
  • An exemption trust can protect assets from creditors and from a surviving spouse’s new husband, wife, or children, preserve assets for children of a spouse’s prior marriage, and provide for investment management for a survivor.
  • Married couples can save more estate tax for grandchildren and more remote descendants through an exemption trust than with portability (“generation-skipping” planning).
  • Married couples leaving real estate to children can potentially shelter more value from Prop. 13 property tax reassessment with an exemption trust than with portability.

A married couple interested in portability’s simplicity could include an exemption trust in their estate plans, but give the survivor the option of deciding whether to actually implement the trust when the first spouse ultimately dies (“disclaimer” planning). This could be a practical compromise in some cases. However, portability may not be appropriate in many second marriages, or where each spouse wants certainty about where his or her estate will ultimately go after the death of the surviving spouse.

Planning Ideas for Reducing High Income Tax on Irrevocable Trusts

The combination of the new higher federal taxes on trust income and California’s “highest in the nation” state income tax can make it very expensive to retain income inside an irrevocable trust. Simply totaling the top federal tax rate of 39.6%, the 3.8% Medicare tax, and California’s top tax rate of 13.3% produces a tax burden of nearly 57%. Of course, this is a worst case scenario that will not apply to many irrevocable trusts, since it may be possible to deduct some of a trust’s California tax against the federal, thus reducing the overall burden. Also, not many irrevocable trusts will have income high enough to reach California’s top tax bracket of 13.3%. However, a trust needs only about $49,000 of taxable income to reach the 9.3% California tax rate, and the top 39.6% federal tax rate applies to ordinary income over only $11,950.

It may be helpful to include language in irrevocable trusts suggesting that trustees try to minimize tax on trust income. For example, the trust might allow the trustee to distribute income to trust beneficiaries if their tax brackets are lower than the trust’s, as long as the beneficiaries are able to maturely handle the distributions. Also, since the new Medicare tax applies only to undistributed net investment income, the trust might allow distributions of such income, like capital gains, and encourage the trustee to minimize the tax through design and management of the trust’s investment portfolio. For those now serving as trustees of irrevocable trusts, these federal and California taxes should be considered when investing trust assets and planning discretionary distributions to beneficiaries.

Individuals looking to minimize tax on irrevocable trust income may consider creating trusts outside of California in states that do not tax trust income. By using out of state trustees and carefully designing how distributions are made to California beneficiaries, the California trust income tax can be avoided on income that is accumulated and not distributed to California beneficiaries. Existing trusts may be moved out of California to a zero income tax state, if not prohibited by the trust document. While keeping trusts out of California will not save federal tax on trust income, it can reduce the overall income tax burden on accumulated income not distributed to California beneficiaries.

Impact of 40% Tax Rate and $5.25 Million Exemption

The Act created certainty with estate, gift and generation-skipping transfer taxes, after over 10 years of uncertainty about tax rates, exemptions, and the very existence of the taxes in the future. The law states that the changes made by the Act are “permanent.” This allows individuals to do estate planning with fewer unknowns about how their gifts and estates will be taxed, barring an unforeseen future change in the law.

The Act imposes a flat 40% rate on all taxable gifts and estates above the $5.25 million exemption in 2013, with a higher exemption in future years when inflation adjustments occur. If an estate is unlikely to ever exceed $5.25 million for an individual, or $10.5 million for a married couple (using two tax exemptions), planning may become less focused on saving estate tax, and more focused on protecting and utilizing assets for family members. For those whose estates may exceed the tax exemption in the future, the 40% of the estate lost to estate tax without planning strongly suggests the need for an ongoing estate tax planning focus.

As pointed out in our Quarterly Insights for Clients at the end of 2012, there are a host of non-tax reasons why individuals will continue to do estate planning, even when estate tax savings is not a goal. There will always be the need to plan what will happen with assets and liabilities when one dies or becomes incapacitated, for the benefit of family and other beneficiaries, as finances and family change over time. Reducing estate tax is simply one of many estate planning goals which may need attention. Also, while the Act may reduce estate tax concerns for some, it brings a new focus on income tax planning for assets passing at death or given away during lifetime. There are many variables to weigh when taking income tax into account, and we will discuss them in an upcoming Quarterly Insights for Clients.

This publication is for informational purposes only and is not intended to provide legal or tax advice, or to create an attorney-client relationship.

Pursuant to IRS Circular 230, unless expressly stated to the contrary, any tax advice is not intended and cannot be used to (i) avoid penalties under the Internal Revenue Code or (ii) promote, market or recommend any transaction or matter to another party.