The American Taxpayer Relief Act of 2012

As 2012 came to an end, the drama of what action, if any, would be taken by Congress and the president concerning the so-called “fiscal cliff” was in full view for all Americans to witness. The drama ended with the Senate and House of Representatives passing legislation known as the American Taxpayer Relief Act of 2012 (ATRA), which the president signed on January 2, 2013. ATRA made significant changes to various income tax provisions, but it also addressed several provisions in the transfer tax laws, the most important of which include the following:

  • The estate, gift and generation-skipping transfer (GST) tax exemptions that were scheduled to be significantly reduced for 2013 have been extended and indexed for inflation. The result is estate, gift and GST tax exemptions of $5 million, adjusted annually for inflation. The inflation-adjusted exemptions for 2013 are $5.25 million, up from $5.12 million in 2012.
  • The top rate for estate, gift and GST tax purposes has been increased from 35 percent to 40 percent.
  • The provisions concerning portability, which were enacted in 2010 but which originally applied only to individuals dying in 2011 and 2012, have been extended and made permanent. Portability is the concept which allows a deceased spouse’s unused estate tax exemption amount (the Deceased Spousal Unused Exclusion Amount, or DSUEA) to be transferred or “ported” to his or her surviving spouse, thereby increasing the exemption available to the surviving spouse at his or her subsequent death. Thus, generally, if an individual dies in 2013 without effectively using his or her $5.25 million exemption, this amount is added to the surviving spouse’s exemption, which then becomes $10.5 million. It is important to note, however, that the GST tax exemption is not portable.
  • The exemption amounts and availability of portability are effective now in 2013 and have been made permanent unless and until Congress takes future action to modify these provisions. This addresses the uncertainty that has existed since the enactment of the 2001 and 2010 Tax Acts.

Other significant provisions of the legislation worth noting include the following:

  • The top income tax bracket for individuals has increased to 39.6 percent on taxable income in excess of $450,000 for married individuals filing joint returns, $425,000 for heads of households and $400,000 for unmarried individuals. These are the threshold amounts for 2013, and these amounts will be indexed for the future.
  • Prior law reduced the maximum rate on long-term capital gains to 15 percent and also applied the same 15 percent rate to qualified dividends. The new legislation adds a 20 percent bracket for the taxation of qualified dividends and long-term capital gains for individuals to whom the new 39.6 percent tax bracket applies.
  • The ability of individuals who have reached age 70 1/2 to make tax-free distributions from individual retirement plans to charity has been extended through 2013. The maximum distribution amount is $100,000.

Reviewing Current Documents in Light of ATRA

The new, permanent estate tax exemption of $5 million, adjusted annually for inflation, may result in unintended (and possibly painful) tax consequences if your estate planning documents have not been reviewed recently. Since the enactment of the unlimited estate tax marital deduction in 1981, the majority of estate plans for married couples with substantial wealth have included a trust that would be funded with an amount equal to the federal estate tax exemption, generally known as a Credit ShelterTrust or an Exemption Equivalent Trust. This trust was often a “sprinkling trust,” which allowed trust income and principal to be paid to a surviving spouse and also to a class consisting of the decedent’s children, grandchildren or more remote descendants. Any assets in excess of the amount of the federal estate tax exemption would pass outright to the surviving spouse or would be used to fund a Marital Trust, which would be structured in a way that would qualify the trust for the unlimited estate tax marital deduction. This two-trust planning allowed both spouses to fully utilize their respective federal estate tax exemptions. No estate tax would be due at the first spouse’s death, and only the Marital Trust would be subject to estate tax at the death of the surviving spouse. The Credit Shelter Trust assets—including appreciation thereon—would pass tax-free to the children or other beneficiaries. The increase in the amount of the federal estate tax exemption, however, can lead to surprising results if your will and/or revocable trust contains such a plan.

Ten years ago, the federal estate tax exemption was only $1 million. For many individuals using the two- trust plan discussed above, the increase in the amount of the federal estate tax exemption means that a far larger proportion of their assets, perhaps even all of their assets, will be held in the Credit Shelter Trust at the death of the first spouse. A client who thought that he was establishing a Credit Shelter Trust of $1 million may find that his entire estate is now held in the Credit Shelter Trust. This may be particularly troubling to the surviving spouse, who may have more limited or even no access to the funds held in the Credit Shelter Trust. Some estate plans would give the entire estate tax exemption amount to a decedent’s children or other descendants, leaving no part of it for the surviving spouse. The result may be that the surviving spouse decides that he or she must exercise statutory rights, such as the right of election to take a specific share of the decedent’s estate, so as not to be totally disinherited. This complication may add procedural difficulty and expense to an estate administration, as well as making less property available to the surviving spouse.

The increase in the federal estate tax exemption may lead to additional problems for clients who live in states that still have an estate tax. Many such states have “decoupled” from the federal tax system, and, as a result, their state estate tax exemptions are no longer equal to the federal estate tax exemption. For example, in New Jersey, the state estate tax exemption is $675,000; in New York, $1 million; in Connecticut, $2 million; and in Illinois, $4 million. As a result, a client’s will or revocable trust that has not been revised may contain a Credit Shelter Trust that greatly exceeds the state estate tax exemption. The result could be an unnecessary state estate tax at the death of the first spouse, which could equal almost $400,000.

Estate plans that were revised to deal with decoupling may create two separate Credit Shelter Trusts, one funded with the state estate tax exemption and another funded with the difference between the state and federal estate tax exemptions. This technique may no longer be necessary given portability.

Many clients have been reluctant in recent years to review their estate plans, because it appeared that the law in this area was in constant flux, and any changes made to a client’s estate plan would only have to be revisited when there was relative certainty in the tax law. Now that the larger estate tax exemption has been made permanent, however, it is our recommendation that clients review their plans and make sure those plans continue to carry out their wishes and protect their families in the manner that they desire.

Simpler Planning Options May Be Available

Now that the federal gift, estate and GST tax exemptions are at an all-time high and are portable between spouses, some married couples with less than $10.5 million in combined assets will prefer to leave everything outright to a surviving spouse. Doing so can avoid the costs and complexities of creating and managing trusts and will be particularly appropriate for congenial first-marriage families including children who are responsible with stable marriages, and who have strong bonds of mutual trust and loyalty.

Outright distributions also may offer income tax advantages over the traditional two-trust estate plan if assets appreciate before the death of the surviving spouse. That is because all assets owned outright by the surviving spouse will receive a “stepped-up” income tax basis equal to their date of death value, so that if those assets are later sold, there will be no income tax on pre-death appreciation. By comparison, under traditional estate plans, only the assets of the Marital Trust would receive a “stepped-up” basis at the death of the surviving spouse; the income tax basis of assets held in the Credit Shelter Trust would be “carried over” from the date of death of the first spouse to die, and any interim appreciation would trigger additional income tax when the assets are later sold.

Outright distributions also may offer other income tax advantages. Under ATRA and the Patient Protection and Affordable Care Act (PPACA), the top income tax rates apply to trusts when their income reaches only $11,950. By comparison, the top income tax rates apply to individuals when their income reaches $200,000 (Medicare tax) or $400,000 (earnings, qualified dividends, capital gains); those filing jointly would have even higher income thresholds before the top rates apply. Thus, when trusts are part of an estate plan, trustees must pay careful attention to investment selection, as well as to distribution or allocation of assets and deductions among trusts and beneficiaries.

As an alternative to leaving everything outright to each other, clients may include standby “disclaimer trusts” in their estate plans in order to give the surviving spouse the ability to decide later whether to accept the assets outright or effectively direct them to a trust, depending on subsequent facts and circumstances. Disclaimer trusts provide a balance between simplicity and flexibility, but clients should understand that there are practical and technical reasons why a surviving spouse may be unable to make an effective disclaimer.

Trusts Still Provide Significant Advantages

With the increase in the federal estate tax exemption, trusts may be unnecessary for clients whose sole purpose is to avoid, or postpone, federal estate tax. A simple estate plan utilizing outright distributions and relying on portability may meet the needs of some clients. Others, however, such as clients in a second marriage with children from a prior marriage, will continue to desire the benefits of traditional trusts and other estate planning vehicles, which can serve important non-tax objectives. The good news is that, thanks to ATRA, it no longer is necessary to structure many of these entities according to the requirements of federal transfer tax rules.

Revocable trusts—the traditional staple of certain estate plans—will continue to be used (as will substitutes) in order to avoid probate and “ancillary probate,” which is an additional probate process in a state that is not one’s residence but where one owns real estate, mineral interests or tangible personal property. This will reduce probate-related costs, delays and public disclosure of dispositive provisions. Revocable trusts may direct all property outright to the surviving spouse at the death of the creator of the trust, but they also may create further trusts for the spouse and others.

Because state estate tax exemptions are now generally lower than the federal estate tax exemption, state estate tax exemption trusts will be used by many clients to avoid potential state estate taxes, which otherwise could cost some families hundreds of thousands of dollars. For example, the New York estate tax is assessed on amounts exceeding $1 million, and the Illinois estate tax is assessed on amounts exceeding $4 million. Thus, it is often advisable to create at least one Credit Shelter-type Trust funded with the maximum state estate tax exemption amount, even if the balance of the assets will pass outright to the surviving spouse.

“Dynasty trusts” will continue to be cost-effective vehicles for taking advantage of the $5.25 million GST tax exemption for each spouse, which is not portable. Such trusts allow assets to remain in the family for generations without estate tax. Therefore, trusts that utilize a client’s GST tax exemption will continue to be an important part of estate plans. GST tax-exempt trusts are especially useful when assets are likely to appreciate in value, since initial contributions and future growth will remain transfer-tax free for future generations.

ATRA also will enable many couples to create non-traditional “marital trusts” during life or at death, to set aside funds for the spouse while safeguarding the remainder for children or other family members. If the couple’s combined assets will not exceed $10.5 million, there may be no need to structure the Marital Trust in a way that qualifies it for the estate tax marital deduction. This will add flexibility, permitting, for example, accumulation of income or distributions to other beneficiaries during the spouse’s life.

Other significant non-tax advantages of trusts include:

  • Providing for the management of assets for beneficiaries who cannot, cannot yet or do not want to manage assets, such as in the case of minors or individuals who are incapacitated.
  • Taking care of a person’s spouse, but also making sure that whatever remains when the spouse dies makes it to one’s descendants rather than, for instance, to one’s spouse’s next spouse, or to his or her (rather than your) descendants.
  • Protecting against future creditors of the trust’s beneficiaries, including a child’s or grandchild’s potential ex-spouse(s).
  • Protecting against a person’s own potential future creditors, such as protecting a professional’s assets
  • against future malpractice claims that exceed his or her insurance coverage.
  • Protecting assets against Medicaid and similar claims, and providing for persons with disabilities or special needs.
  • Protecting beneficiaries from being manipulated out of their assets, from giving them away inappropriately or from spending them recklessly (“spendthrift” trusts).
  • Providing incentives for beneficiaries to work, or to perform public service, rather than giving them access to considerable sums at too young an age.
  • Segregating assets acquired prior to marriage from assets acquired during the marriage, and, in some
  • states, limiting spousal rights.
  • Protecting family assets in instances in which children will not enter into, or may not comply with, prenuptial agreements.
  • Dealing with community and non-community property in community property jurisdictions, such as California.
  • Controlling the management and disposition of interests in businesses, real estate, works of art, family compounds and other important assets.
  • Providing for charity, at present or in the future.
  • Permitting the present sale of capital assets without having to pay a present capital gains tax by the use of certain types of charitable trusts.
  • Protecting the assets of persons who are neither citizens nor residents of the United States from American taxes, now and for future generations.
  • Dealing with questions such as that posed in a January 19, 2013, Wall Street Journal headline, which read: “Can You Trust Your Kid With $5.25 Million?”
  • Owning and managing life insurance and the proceeds thereof.
  • Providing for the funding of buy-sell agreements.
  • Receiving retirement plan proceeds and administering them appropriately.
  • Caring for parents or others who need financial assistance.
  • Accumulating assets for persons under the age of 21, or, if appropriate, beyond.
  • Permitting funds earned by a trust to be distributed to its beneficiaries, but with the creator of the trust paying all applicable income and capital gains taxes (a “grantor trust”), thereby permitting what are, in effect, additional but gift-tax-free gifts to or for the benefit of the trust’s beneficiaries.
  • Permitting funds to be applied to the benefit of one or more beneficiaries, rather than to be owned by or paid to these beneficiaries.
  • Accumulating estate-tax-free funds, to be made available to an executor to cover future estate and, if applicable, estate-tax liabilities, perhaps to protect business assets or real estate from having to be sold in a hurry at “fire sale” prices.
  • Providing “blind trusts” for certain high-level government officials, who are not permitted to know how their assets are being invested, to avoid conflicts of interest.

Similar to trusts, limited liability companies, family partnerships and C corporations will remain useful tools. Advantages of these tools can include removing appreciating assets from an individual’s gross taxable estate, business succession planning, protection against future creditors and perhaps strategic shifting of taxable income or deductions. Moreover, under ATRA, it is still possible to transfer minority interests in various entities at a discounted value, thereby leveraging the ability to make gifts that do not exceed exemption amounts. In addition, short-term grantor retained annuity trusts (GRATs) remain viable and attractive options for shifting appreciation tax-free to children.

Accordingly, whether in separate documents or included as parts of wills or revocable trusts, in appropriate circumstances, trusts will continue to be as necessary after the enactment of the recent changes in the federal estate tax as they were in the past.

Use of DSUEA and Application to Marital Agreements

Before relying on portability as the cornerstone of an estate plan, several limitations on portability should be noted.

  • First, DSUEA cannot be used by a surviving spouse unless the executor of the deceased spouse is willing to file a federal estate tax return and make a portability election. Executors may not agree, however, to cooperate with the surviving spouse by filing an otherwise unnecessary federal estate tax return. Thus, some estate plans will now include marital agreements with provisions that mandate the future cooperation of a spouse’s executor.
  • Second, although federal transfer tax exemptions are indexed for inflation, the DSUEA is not. Therefore, younger clients with appreciating assets may be less willing to rely on portability because doing so would limit their ability to shelter future growth from gift or estate tax.
  • Third, for those taxpayers living in states with a state estate tax (e.g., New York, New Jersey, Illinois, Connecticut), fully relying on portability will result in losing a potentially valuable state estate tax exemption, and in a higher aggregate estate tax at the death of the surviving spouse.
  • Lastly, a taxpayer’s GST tax exemption is not portable, so the failure to create and fund trusts and

to allocate GST tax exemption may incur a GST tax for those taxpayers wishing to ultimately benefit grandchildren or more remote descendants.

For an individual who has DSUEA from a predeceased spouse, there are several important points to keep in mind when using that DSUEA for lifetime gifting or at death.

The Last Deceased Spouse Rule

DSUEA can be used only while the predeceased spouse from whom it came (“Spouse 1”) is your “last deceased spouse,” meaning that if you subsequently remarry and your new spouse (“Spouse 2”) also predeceases you, the DSUEA from Spouse 1 is no longer available to you for your use.

Some important points in connection with the last deceased spouse rule are:

  • Remarriage alone does not affect who will be considered the last deceased spouse.
  • You can use DSUEA from Spouse 1 while you are married to Spouse 2, as long as Spouse 2 is living.
  • The identity of your last deceased spouse is not affected by whether his or her estate elects portability or whether he or she has any DSUEA available.

Ordering Rule

The portability election is retroactive to the predeceased spouse’s date of death, so that the surviving spouse can use DSUEA at any time after the predeceased spouse’s death (even prior to the filing of a federal estate tax return).

If you have DSUEA from a predeceased spouse, that DSUEA will be applied first, before your own basic exclusion amount, if you make a lifetime taxable gift. This is significant because so long as you do not have a new “last deceased spouse,” you can continue to utilize the DSUEA from your predeceased spouse in connection with lifetime gifting—even if you have remarried.

  • You may wish to consider lifetime gifting if the DSUEA from your current spouse (Spouse 2) would be less than that from your predeceased spouse (Spouse 1). Otherwise, you risk losing the DSUEA from Spouse 1 if Spouse 2 predeceases you.
  • You can use DSUEA from multiple deceased spouses. For example, you can make taxable gifts utilizing the DSUEA received from Spouse 1 and, if Spouse 2 also predeceases you and leaves DSUEA, you would then have DSUEA from Spouse 2 available for your use.

Marital Agreements

In light of the last deceased spouse rule discussed above, the potential loss of DSUEA can become a factor in negotiating a premarital agreement. The potential acquisition of DSUEA from a spouse with an estate smaller than the estate tax exemption amount may provide an additional bargaining chip for the less wealthy party to the agreement.

As noted above, if there is an executor appointed for the decedent’s estate, then the portability election may only be made by the executor. If the executor does not file an estate tax return (e.g., because the decedent’s estate is not otherwise required to file a return), a surviving spouse cannot make the portability election unless he or she is appointed in some fiduciary capacity by the applicable court. This raises particular concerns about second marriages where (i) the spouse may not be a beneficiary of the decedent’s estate, (ii) the expense of preparing and filing a return might not be a proper estate expense and (iii) the executor may owe no fiduciary duty to the surviving spouse. A premarital agreement can provide that the first spouse to die must direct his or her executor to file a return for the purpose of electing portability at the request of the surviving spouse. The cost of preparing the return can also be allocated to one of the parties or divided between them.

Conclusion

ATRA opens the door to a greater range of estate planning options for a majority of American families. With permanently high federal transfer tax exemptions that are portable between spouses, some married couples will now prefer the simplicity of leaving all assets outright to the surviving spouse. Other clients will continue to create trusts and other estate planning vehicles because the advantages of these options may outweigh any initial startup costs or added complexity. Choosing the best option for individual clients will require a thoughtful evaluation of family and financial objectives along with a careful balance of competing tax and non-tax considerations.