Review Your Will, Living Trust and Plan in 2013. Congress has just concluded tax legislation as part of its effort to avert the fiscal cliff. While the Senate called it the “American Taxpayer Relief Act of 2012,’’ likely it will have a 2013 moniker. While the 157 pages have not been analyzed yet, a number of key points may be made about the impact on estate planning, bearing in mind that final legislation, interpretations, and more are to follow. For those who think estate planning no longer is relevant because they are safely under the $5 million inflation adjusted exemption amount, think again. Estate planning never was only about federal estate taxes. Asset protection, succession planning, insurance and retirement planning, and much more, remain relevant. For those taxpayers, the good news is that the focus of planning can now more securely be on those issues. For wealthier taxpayers thinking they’ve finished planning in 2012, think again. There are three more “fiscal cliffs” coming up and Congress will have to deal with other aspects of deficit reduction, which may further impact estate planning for the ultra-wealthy. True, you’ve been given a bit of breathing room on planning, but don’t squander it. The bottom line for everyone is that now is the time to act, but how you should do so has be decisively and perhaps permanently affected but the recent tax legislation.
All Taxpayers. Many taxpayers’ initial reaction to the 2013 tax law is that nothing needs to be done. Moderately wealthy taxpayers may believe, since the federal estate tax will not apply to them, that no planning is necessary. Wealthy taxpayers may think they completed all of their planning in 2012. But, just like those late night TV infomercials, “There’s more!”
- FLPs and LLCs. Family LLCs or partnerships (“FLPs”) will continue to be vital to control assets, protect assets from creditors and irresponsible heirs. Even if the federal estate tax benefits wane, these entities should remain the cornerstone of many plans. But given the restrictions on itemized deductions, and that it is pegged at a lower income level then the maximum income tax rates, many high income taxpayers will find deductions disappearing. For these taxpayers, creative and careful use of LLCs and FLPs to shift income (subject to the family partnership rules) and shift qualifying deductions to their LLC or FLP, may provide valuable income tax benefits. Thus, LLCs and FLPs that had been intended for estate tax discounts may morph into income tax planning tools. The asset protection and control benefits will continue to be useful regardless of the tax changes. This will continue to make FLPs and LLCs, when properly planned for in the new tax environment, great tools for a broad cross-section of taxpayers.
- Itemized Deductions, Residency and Domicile. The restrictions on itemized deductions will push wealthy taxpayers who can shift their domicile and residency to a no or low tax state to do so with greater vigor. This will not only save state estate taxes and property taxes for which deductions may be fare more limited, but it will have a significant impact on where you should revise and sign new estate planning documents.
- Roth Conversions. Under prior law there are only a limited number times that you can roll a 401(k) or certain defined contribution plans into a Roth IRA. Specifically, unless you changed jobs, retired or reached age 59 ½, rolling into a Roth was not allowed. Now, however, conversion will be permitted for anyone. This will require you to pay current income taxes on the value of the plan rolled over, but perhaps that was the point. It may generate income tax to help the deficit. Why would any taxpayer undertake this type of planning? Simply because in the right circumstances it can be quite valuable. If you fear greater tax rates in the future (not so likely at this point) it would be advisable. If you do convert likely you will want income tax projections to try to minimize rate bracket creep from the additional income. A meaningful advantage for some taxpayers will be that a Roth has no required minimum distributions so that the money might stay protected from creditors and claimants. If your state law (check first) protects Roth funds this may prove an advantageous asset protection benefit from some. For ultra-high net worth clients rolling into a Roth and paying income tax may reduce your taxable estate.
Moderate Wealth Taxpayers. For those who are wealthy, but not super-wealthy, what might appear to be a permanent $5 million exemption makes the confiscatory estate tax possibly a worry of the past. The combination of the $5 million estate tax exemption, inflation indexing, and the ability of spouses to use their deceased spouse’s exemption under the portability rules, makes federal estate tax worries academic for the vast majority of Americans. Even more so, it appears that there is some permanence and confidence to the new $5 million exemption level so the worries that should have had moderate wealth taxpayers planning until now (but really had most stuck in the mud and not planning) are changed. But plenty of other worries remain. Estate planning is just as important for you, only it will be different.
- Review and Revise. The prudent step to take is to re-evaluate your estate plan and documents. Since the estate tax exemption remains at $5 million, to be indexed for inflation, most wealthy Americans will remain below the federal tax threshold. For most taxpayers who have deferred planning waiting for more estate tax certainty, wait no more. Review, revise and update your plan. However, don’t forget the lessons of the estate tax roller coaster ride of the past few years: draft and plan flexibly.
- Will Update. With the estate tax exemption fixed at $5 million, it may significantly affect how your assets are distributed under old wills and revocable trusts. Too many people have deferred updating their documents for years because of the uncertainty in the law. If you were one of those that ignored estate planning since the 2010 Tax Act first raised the exemption to $5 million thinking that estate planning didn’t apply to you, now that there seems to be some permanency, move forward on updating your planning. With the uncertainty apparently resolved, stop delaying. Protect your goals and loved ones. If a new estate tax law is passed, which is what most tax professionals anticipate, your will, living trust and overall plan will certainly need to be reviewed and possibly updated. Most wills and revocable trusts had plans that are formula based. Make sure the formulas work in the new tax environment. Many states still have estate taxes so you need to be sure that the formulas not only work in the current $5 million federal environment, but in the context of any state estate tax you might face.
- 2012 Remorse. If you’re having buyer’s remorse because the exemption will remain high, be mindful that the return of inflation, increasing longevity and other factors could all work to make your planning prove invaluable. So don’t unwind your plan. Further, no one knows which way the fickle political tax winds will blow in the future. It may not have been coincidence that on New Year’s Eve CNN coverage bounced from interviews of Honey Boo Boo to updates on Congressional fiscal cliff matters. It is also important to recognize that most sophisticated trust plans provide a range of valuable benefits, which are in addition to federal estate tax benefits. The odds are that your plan, even if the exemption stayed the same, is well worthwhile. See “Reconsidering Irrevocable 2012 Gifts,” below.
- Life Insurance. If you have owned life insurance for the purpose of paying an estate tax you will never face, don’t cancel the policy before having it evaluated. A good policy might make sense to retain as a ballast against other investments you hold, or to secure other purposes. If that policy is held in an irrevocable life insurance trust, after you have your insurance consultant review the policy, have your estate planner review the trust. Often there is tremendous flexibility in an insurance plan (both the policy and trust) that might facilitate your remaking a plan that was intended to pay estate tax into a new and more useful tool. If you held life insurance inside a pension plan, your advisers may have cautioned you to remove it because of adverse estate tax consequences. If your estate is safely below the new estate exemption, it may no longer matter. If you have an old insurance trust it undoubtedly has annual demand (so called “Crummey” powers) that make the gifts you make to the trust qualify for the annual gift tax exclusion. If your estate, inclusive of insurance and likely future appreciation, will remain below the threshold, you might not want to bother issuing these annual notices. Don’t simply ignore them. Your insurance trust provides valuable asset protection benefits as well and ignoring its terms may undermine that protection. See “Irrevocable Trusts,” below.
- Irrevocable Trusts. You should evaluate any existing irrevocable trusts. If you had a trust, for example for children or grandchildren to hold annual gifts, with the possible permanency of the $5 million exemption these may no longer be needed for estate tax purposes. However, before you simply cancel and distribute the funds, consider the impact of an outright distribution on divorce of your heirs/beneficiaries. The bottom line is that all irrevocable trusts, just like the insurance trusts discussed in the preceding section, should be reviewed in light of the new estate tax paradigm, and determine how they can be modified, or even eliminated, to provide you the best result in the current environment. Some irrevocable trusts may permit an independent trustee to distribute “so much or all of the principal….” This type of clause may suffice to distribute the trust to current beneficiaries and terminate the trust. Caution, however, is in order. What of contingent or other beneficiaries? Will terminating a trust that is no longer needed to address estate tax issues simply put those assets in harm’s way in the event of a recipient beneficiaries divorce? There may be other options to clean up an old trust and revitalize it. See “Reconsidering Irrevocable 2012 Gifts,” below.
Ultra-High Net Worth Taxpayers. The $5 million exemption is positive news, but relative to the size of your estate the $3.5 million exemption initially proposed by President Obama compared to the $5 million compromise is not significant to you. The 40% maximum tax rate is higher than 2012, but much lower than it could have been. That is great news, but a 40% rate can still decimate a closely held business, or undermine wealth accumulation goals.
- It Ain’t Over. With Congress having more bites at the tax apple in coming rounds of deficit reduction negotiations, those with ultra-high net worth that think they can breathe a sigh of relief, think again. Restrictions on grantor retained annuity trusts (“GRATs”), valuation discounts, and perhaps even on excluding grantor trusts from your estates, may all be up for grabs in future legislation. The fact that these matters appear not to have been addressed in the current legislation may only be due to time constraints. These could all show revenue additions to the federal budget part of future deficit reduction activities. Given that the estate tax exemption is now an inflation indexed $5 million, doubled for married couples because of portability, there may be little resistance to these changes as they will only affect a tiny fraction of the wealthiest Americans.
- Finish a Good Thing. Consider “topping” off gifts to GST exempt grantor trusts that you started in 2012. Many of these trust plans fell short of the $5 million gift goal because time was too limited to complete all desired transfers. Use the recent legislation as a reprieve to complete the transfers of as much as you can to your trusts.
- Plan Before the Next Adverse Tax Change. Take advantage of this current window of opportunity to consummate note sale transactions and other steps to shift greater future values into protective trusts, and freeze the value of your remaining estate while you can. The bad news is that a 40% tax rate is very high, and if your estate is, or will be, well in excess of the $5 million inflation adjusted exemption, you should take maximum advantage of sophisticated estate freeze techniques before Washington deficit cutters attack them. If you completed sophisticated 2012 trust planning you may have the estate planning infrastructure in place to complete more planning with modest cost and effort. If your irrevocable trusts were created as grantor trusts in states with favorable trust laws, they may be just what is needed to complete a sale transaction (or perhaps an additional sales transaction) now. If you had costly appraisals done in 2012 if you make additional transfers of the same assets (e.g., selling interests in a business that you made a $5 million gift of in 2012) you may be able to use the same appraisal report.
Asset Protection Planning. Whatever happens in Washington, it will have no impact on the litigious nature of our society. Use the $5 million exemption to implement (or if you started in 2012, to continue to implement) asset protection planning. Don’t dismantle existing family partnerships or LLCs, use them as asset protection tools, even if the discounts no longer affect your planning. Use the newly liberalized rules on Roth conversions to convert retirement assets into Roth IRAs. Roth IRAs, in contrast to regular IRAs, have no required minimum distributions, so assets can remain in the protective Roth envelope for as long as you wish. So long as your state law provides creditor protection for Roth IRAs, this can be a simple asset protection homerun.
Divorce Protection Planning. Whatever changes affect the tax law, the reality of a high divorce rate will not change. Too many moderate wealth taxpayers will fall into the “gee I can get a simple will,” attitude because “I won’t face an estate tax.” But the 50% purported oft quoted divorce rate can decimate an estate to a more significant degree than a 40% estate tax rate. And, unlike the estate tax, the divorce courts won’t give your heir the first $5 million free of claims. All assets might be at risk. So, regardless of whether estate taxes will ever be a concern, you should almost assuredly use similar trust planning for heirs to protect their assets from the ravages of divorce.
Income Tax Planning for Most Income Taxpayers. For most Americans the new tax law effectively eliminates the worries most Americans will ever have about becoming ensnared by the Alternative Minimum Tax (“AMT”). It also makes permanent the tax cuts enacted as part of the Economic Growth and Tax Relief Reconciliation Act of 2001 (“EGTRRA”) and the Jobs and Growth Tax Relief Reconciliation Act of 2003 (“JGTRRA”). This means, for most Americans, the prior tax rate brackets of 10%, 15%, 25%, 28%, 33% and 35% remain.
Income Tax Planning for High Income Taxpayers. Income tax planning will become the new estate planning for many moderate wealth taxpayers. For those who had previously been more worried about estate tax, income tax worries may become paramount. While most Americans are breathing a sigh of relief that the Bush era tax cuts did not end for them (although they are struggling with a not insignificant payroll tax increase), for high income taxpayers a combination of higher rates and phase out of itemized exemptions will create significantly more tax cost. When this is combined with the 3.8% tax on passive investment income, the overall income tax costs are pretty substantial.
- Higher Income Tax Rate. A new 39.6% tax bracket has been added. This higher rate will apply to those earning over $400,000 for single taxpayers, $425,000 for head of household taxpayers, and $450,000 for married taxpayers.
- Capital Gains. A new higher 20% capital gains rate will apply to capital gains and dividends at the same threshold the higher 39.6% rate above will apply. For middle income taxpayers the 15% rate is retained and for taxpayers in the lowest 10% and 15% brackets a 0% rate will apply. See the discussion about using FLPs and LLCs to shift income.
- Medicare Tax. Starting January 1, 2013 a 3.8% Medicare tax will apply to net investment income. Wages are subject to a 2.9% Medicare payroll tax. Workers and employers each pay half, or 1.45%. The Medicare tax is assessed on all earnings or wages without a cap. Starting in 2013, a 0.9% Medicare tax will be imposed on wages and self-employment income over $200,000 for singles and $250,000 for married couples. IRC Sec. 3101(b)(2). That will make the marginal tax rate 2.35%. Under 2012 law only wages/earnings were subject to the Medicare tax. Starting January 1, 2013 a 3.8% Medicare tax will apply to net investment income if adjusted gross income (“AGI”) is over $200,000 for single taxpayers or $250,000 on a joint tax return. IRC Sec. 1411. The lesser of net investment income or the excess of modified adjusted gross income (“MAGI”) over the threshold, will be subject to this new tax. Investment income derived as part of a trade or business is not subject to the new Medicare tax on investment income unless it results from investment of working capital.
- Itemized Deductions. Personal exemptions and itemized deductions will be phased out at new thresholds: $250,000 for single taxpayers, $275,000 for heads of household and $300,000 for married taxpayers filing jointly. Note that every tax rule has different income thresholds. This was certainly intentional in that the Republicans can claim partial victory by having kept “tax increases” to taxpayers making over $400,000 single and $450,000 married, when the reality is that, as the itemized deduction phase out proves, the tax increases occur at lower levels. From a planning perspective, having different thresholds for almost every tax benefit/reduction makes planning very complicated. Having rules of thumb as to what level of income triggers tax implications won’t be practical.
- Medical Expenses. Deductions for certain medical expenses will be reduced, and for many eliminated. Under prior law you could only deduct medical expenses to the extent exceed 7.5% of adjusted gross income (AGI). This restriction is in addition to the others that limit the tax benefits of itemized deductions, above. Starting with 2013 you’ll only be able to deduct medical expenses as an itemized deduction if they exceed 10% of your AGI. IRC Sec. 213.
- FLPs and LLCs. The use of family partnerships and LLCs to shift income will take on new importance for some families.
- Minimizing Higher Capital Gains Taxes. Charitable remainder trusts (“CRTs”) had fallen into disuse because of the low capital gains rates. The new tax rate structure should increase the use of CRTs to minimize or defer capital gains taxes for those selling businesses or valuable assets, such as a large concentrated stock position. Better coordinating the harvesting of gains and losses to minimize the now higher income tax rates will have increased importance. Since many wealthy taxpayers created one or more complex grantor trusts (trusts on which they remain liable for the income even though the earnings remain in the trust) the “pots” over which the harvesting will have to be coordinated will be broader.
Trust Income Tax Planning. Planning for trusts and estates to address the higher rates and compressed brackets, and timing distributions to beneficiaries to minimize overall trust/beneficiary tax burdens, will take on new importance and complexity. It may even change historical distribution patterns for some trusts.
Understanding Your 2012 Planning. Given the incredible sophistication and highly technical nature of much of the better 2012 planning, it is advisable to review the planning and documentation you implemented in 2012 and be certain you and the various individuals named in your plan (trust protector, individual trustee, loan director, investment trustee, etc.) all understand their respective roles. Ideally, a meeting with all these people present to review the trust document terms that relate to operations should take place.
2012 Follow Up. 2012 planning will require follow up and review of critical steps if it is to succeed. Consider the following:
- Loose Ends. No plan completed under the pressure of 2012 deadlines and the veritable tidal wave of work every adviser is facing will be free of loose ends, typographical errors or the need for other “housekeeping.” The way to address these potential loose ends is to review all the documents, calculations and organize them for future follow up.
- Additional Legal Documents. Most plans will require additional legal work that was deferred until after the 2012 crush as not being essential to complete by year end. For example, it was common when interests in an entity, such as a corporation or limited liability company were given or sold to a trust that the legal work completed in 2012 was limited to the assignment of the interest involved. The shareholders’ agreement or operating agreement and other ancillary documents may remain to be completed. Stock certificates may not have been issued. Since the focus for many transactions was completing the essentials of a gift or sale before year end, in many cases most other documents and steps were left for follow up after year end. You should, with your advisers, endeavor to identify any such missing documents or incomplete steps and set up meetings or milestone dates to assure that they will be addressed and not overlooked.
- Gift Tax Returns. Importantly, for any significant 2012 planning a gift tax return will have to be filed in 2013 reporting the 2012 gifts. There are disclosures and steps which must be taken on gift tax returns that are critical to the success of your plan. Generation skipping transfer (“GST”) tax exemption, perhaps, should be affirmatively allocated to protect your 2012 gifts. In order to run the period of time during which the IRS can audit a gift tax return (“toll the statute of limitations”) your gift tax return will have to fully disclose all relevant information concerning a gift. This is referred to as “adequate disclosure.” This will require that your CPA will have to be provided with copies of legal documents your attorney created (or as discussed above, will still have to create), financial documentation corroborating values and transfers from your wealth manager, and complete appraisal reports (see below). Given the massive number of gift tax returns and the complexity involved your CPA might well advise that you extend the date of filing your 2012 gift tax return so decisions can be made once the law is known (e.g., late allocation of GST exemption). If you sold assets to a trust, even thought it was not intended to be a gift, such “non-gift” transactions are commonly reported on gift tax returns to run the period of time during which the IRS can audit the transaction. There are also a number of technical issues that your CPA may have to address when filing your gift tax return. If you are married can your spouse elect to “split-gifts” with you by treating your gifts as if ½ were made by him or her? Will this be advantageous if it is permitted? Etc.
- Income Tax Returns. Income tax returns will have to be filed in a manner that reflects the planning that was done. For example, if on November 1 you transferred 50% of your interests in what had been a single member (you were the only owner/member) limited liability company (“LLC”) to an irrevocable trust, the LLC would no longer be a single member disregarded entity but rather, in most instances, a partnership for income tax purposes. If you gave 25% of your 45% interest in a family S corporation to your trust on November 1, the income from the S corporation for the 2012 year will have to be allocated between you and the trust for the portion of the year you each owned that 25% transferred interest. There are a host of other steps your CPA may have to consider in light of 2012 planning.
- Grantor Trust Status. Many, perhaps most, trusts set up in 2012 were “grantor trusts.” The income of such trusts is reported on your return even though the earnings may be held in the trust. You should endeavor to have your CPA and wealth manager project the tax consequences in advance so that you can appropriately plan for the tax payments and future impact.
- 2013 Sale Transactions. Many people who started planning later in 2012 would have benefited from selling assets to their grantor trust, however, due to time constraints, many of these transactions were not completed. When evaluating possibly completing such transactions in 2013, watch the dates on appraisals. If too much time elapses the appraisals will be stale and new or updated ones will be required. Also, carefully monitor with your tax advisers how new law changes may affect the planning for such a sale.
- Reconsidering Irrevocable 2012 Gifts. If you have second thoughts or new concerns about the planning you finished in 2012, perhaps as a result of the contents of any new tax law, the flexibility of many trusts, the use of disclaimers (refusing to accept interests in a gift), some of the options on gift tax return decisions, decanting (pouring one trust into a new and typically better crafted trust), may all afford opportunities to adjust planning that you are not as comfortable with as you initially thought. This should be addressed with your advisers as early as possible in 2013. Make appointments now to meet with your CPA, estate planner, wealth manager, trust officer, insurance consultant and other critical advisers so you can address these points quickly. For example, if you accept the benefit of an asset, you may no longer be able to disclaim your interests in it.
- Appraisals. If you had an appraisal started in 2012 for your 2012 gifts or sales to trusts, be certain to follow up and obtain a final complete appraisal. Many appraisals were issued only as numbers with the full reports to be completed after year end. Your CPA will require a complete appraisal to file a gift tax return and you certainly want the detailed report for your records as well.
- Approvals. Third party contractual approvals were essential for many transactions. If you have not received them, you need to make a judgment call. Should you follow up now and get the approvals you should have had risking opening up a proverbial Pandora’s Box? You should also bear in mind that if approvals were required and not received, the IRS might argue that the lack of required approvals made the transfer incomplete.
- Defined Value Clauses. Many gifts and sales completed in 2012 were planned using a mechanism to reduce the risk of a tax being triggered if the IRS increases the value of the assets given (e.g., stock in a hard to value closely held business). Review with all of your advisers how these mechanisms should be handled post-transfer. For example, what should be reported on a Form K-1 for an S corporation if the actual percentage (number of shares) of stock cannot be known until an audit is finalized? Who votes the equity interests during the period before an audit occurs? Reasonably addressing these practical implications may be important to the ultimate success of the mechanism used.
- Distributions. Distributions from entities have to reflect the new ownership interests. Distributions from trusts must reflect the intent of the trusts. If a goal of a trust is to assure that the assets are removed from your estate, regular distributions might be used by the IRS to argue that you had an understanding with the trustee to receive distributions and serve as a basis of including the trust assets in your estate.
- Developing Case Law. It is not only major tax bills that are important to consider. Other laws can change that affect your planning. For example, some of the recent developments that affect self-settled asset protection trusts (trust you give assets to but remain a beneficiary of) might have you reconsider how certain aspects of such a trust might be handled. It might be feasible to disclaim certain interests in such a trust to enhance the likelihood of the trust being respected.
More Information. We have emailed to our data base a regular stream of planning materials. We have mailed numerous articles in hard copy to all clients that we can identify that engaged in 2012 planning. Our newsletter has for several issues addressed specific planning steps. In 2013, articles will address post-2012 planning and new developments in the estate tax laws. If you have not, or do not, receive these materials, or would like materials on a particular issue please email me [email protected] and I’ll send whatever materials we have that might help you.
Contact Us if We Can Help. We are here to help during throughout the uncertainty and changing estate planning environment. Let us know how we can assist you and your other advisers with reviewing or revising your will and planning, and in follow up on completing and implementing your 2012 planning. Please call or email at your convenience.
Also, you may be interested in our special 60-minute teleconference entitled, “Fiscal Cliff Legislation and What It Means for Your Clients“ on January 4th or January 9th with Robert S. Keebler, CPA, MST, AEP (Distinguished).
ABOUT THE AUTHOR
Martin M. Shenkman, J.D., CPA, MBA
Martin “Marty” Shenkman, Esq., CPA, MBA is an estate planning attorney and Certified Public Accountant from Paramus, New Jersey. He received his Bachelor of Science degree from Wharton School, University of Pennsylvania 1977 with a concentration in accounting and economics. He received a Masters degree in Business Administration from the University of Michigan 1981, with a concentration in tax and finance.
Mr. Shenkman is a widely quoted expert on tax matters and is a regular source for numerous financial and business publications, including The Wall Street Journal, Fortune, Money, The New York Times, and others. He has appeared as a tax expert on numerous television and cable television shows including The Today Show, CNN, NBC Evening News, CNBC, MSNBC, CNN-FN and others. He is a frequent guest on radio talk shows throughout the country and has a regular weekly radio show on Money Matters Financial Network.
Mr. Shenkman is a prolific author, having published thirty-four books and more than seven hundred articles. Mr. Shenkman has served as contributing editor to a host of publications, including: New Jersey Lawyer, The Journal of Real Estate Finance, Real Estate Insight, Commercial Leasing Law & Strategy, The Journal of Accountancy, Real Estate Accounting and Taxation, Shopping Centers Today, and others.
Mr Shenkman is active in numerous charitable organizations, sitting on many boards and planned giving committees and lectures regularly for these and other organizations.