WHY ESTATE PLANNING STILL MATTERS
For many years, estate tax planning was a fairly insignificant area of tax law, primarily because there were not that many people who had estates to tax. But with the advent in 1981 of what is known as the “Unlimited Marital Deduction”, and with the increase in the estate tax exemption from less than $100,000 in 1981 to $600,000 by 1987, coupled with a general increase in wealth, primarily resulting from booming stock markets and real estate markets in the 1980’s, 1990’s and well into the 2000’s, estate tax planning came to the forefront. At the same time, income tax planning was relegated to the back benches, largely due to the closing of virtually all the income tax “loopholes” which tax advisors peddled to high income earners looking for income tax relief.
Although the S & P 500 and the Dow Industrials, two fairly broad measures of the stock markets, have come back to near all-time highs, real estate values in most areas remain moribund. Furthermore, this writer has anecdotal evidence that people just do not have the wealth and/or income they once had before things came crumbling down in 2007. As a result, not only are once wealthy, but now less wealthy, people reluctant to do estate tax planning through arcane gift and estate tax techniques, even those who have significant wealth remain adverse to engaging in estate planning techniques which may benefit their heirs but which could, in the event of continue economic decline, leave them at risk.
For years, due to the broad reach of the estate tax, the estate tax “tail” often wagged the estate planning “dog,” that is, good estate planning was often driven too much by tax planning than it was by good estate planning. But now that the estate tax exemption has been made permanent at $5+ million, (to be increased annually based on a cost of living adjustment), and due to the so-called “portability” provisions which allow a surviving spouse to “inherit” their deceased spouse’s $5+ million, most people can now structure their estates the way they want to structure them, instead of structuring their estates to fit inside a “Procrustean bed” previously forced upon them by the estate tax.
The following pages will provide guidance to persons planning their estates under the new laws. With the high estate exemptions now being permanent, most people should consider this brave new world of planning without fear of the estate tax man.
For ease of explanation, for purposes of this article, parents, e.g. Mom and Dad, will be assumed to be the high income, high tax bracket, high wealth individuals, and children will be considered the low income, low income tax bracket, low wealth individuals. Furthermore, although explanations will usually refer to parents and children, with parents passing wealth to children, these planning techniques are almost universally applicable between any individuals, whether between parent and child, husband and wife, friend to friend, etc. The only prerequisite to planning is that there should have one person who has wealth and wishes to share that wealth with another person, whether now or in the future, or at death. Or, perhaps it should be said, the only prerequisite to this type of planning is that one person wishes to contribute as little as possible in the payment of taxes, whether such taxes are income, capital gain, gift or estate taxes.
ESTATE TAX PLANNING COMBINED WITH INCOME TAX PLANNING
Back in the good old days, you know, the 1970’s, it was very easy to shift income from a high income tax rate person a to lower income tax rate person. Believe it or not, it was allowable to place any amount of money into a trust, the income of which trust would be payable to the trust beneficiary, and then, after a period of up to ten years, the money placed in trust would come back to the donor, i.e. the person who put the money into the trust in the first place. There was no gift tax on such a structure, and the income was taxed to the donee/child, not the higher tax parent. So let’s say you wanted to pay for your child’s education; you could set up one of these trusts (called a “Clifford Trust” for those who might want to study the history further) fund it with cash, and then invest in income-producing securities or real estate. Of course, back in the ‘70’s you could get more than .1% even on an insured passbook savings account. In the mid to late ‘70’s, interest rates were well above 10%, so the income transferred to lower bracket children was significant with the use of the Clifford Trust, with the result that the income could be used to pay for the child’s education and be taxed at the child’s significantly lower income tax rates.
Well guess what: the Clifford Trust is back. Oh, it hasn’t been formally reinstated, but with the $5 million estate and gift tax exemption, a trust just like a Clifford trust can be established without fear of incurring any gift tax and without the likelihood of the structure adversely affecting your future estate tax. And if you have more than $5 million (or $10 million between husband and wife) you can still take advantage of the gifting exemption to set up a similar structure without the burden of gift taxes.
So how might this be accomplished? Let’s say you live in California and aren’t too enamored of the 63% marginal income tax bracket you find yourself in. (Are you listening Phil Mickelson?) So you and your spouse set up a trust in Nevada for your child who is attending college in Nevada. Let’s say you put $500,000 in the trust and are able to buy annuities or find some investment which returns 5%. (I know 5% is hard to get these days, but if you get some professional help and don’t just default to your friendly bank CD’s, you can find some decent returns.) The trust will be sitused, i.e. domiciled, in Nevada and it will provide that income will be paid only to your child. As the income is distributed to the child, she uses the income to pay for her tuition, books, living expenses, etc. When tax time comes, since you retained no right to exercise certain prohibited controls over the trust, the income is taxed to your daughter at her lower tax rate, and if she can establish that she is living in Nevada (or some other lower income tax state) and not living at home with you in California, California cannot tax the income and the federal tax will be based on her tax rate, not yours. If you are concerned about someday having access to the principal of the trust, just in case, the trust can be created as a Nevada Spendthrift Trust, sometimes otherwise called a Nevada Asset Protection Trust, and the principal could be available to you, in the discretion of the trustee. The result can be, then, that all income may be taxable to your daughter at her lower rates, and, in keeping with good estate planning, at your death the value of the trust need not be included in your estate for estate tax purposes.
Of course, this technique works for anyone, even those who do not live in high state income tax states. It’s just more dramatic using a person in California as the example because of the power to avoid California state income tax along with the application of lower federal income tax rates. So don’t avoid this strategy just because you live in a no or low income tax state.
REVISE THAT OLD A-B “CREDIT SHELTER” TRUST TO BE A STREAMLINED “DISCLAIMER TRUST”
If you were married and set up a revocable (“living”) trust in the past thirty years, it is very possible your trust was created as what has been called the “A-B” Trust or the “Credit Shelter” Trust. All these terms mean is that upon the death of the first spouse to die, the deceased spouse’s share of the estate (generally one half of the estate in a community property state, there being 8 such states) or the deceased spouse’s trust (generally the entire separate property trust for a spouse who established the trust in a separate property state, there being 42 such states), is set aside in trust for the continued benefit of the surviving spouse. The advantage of this approach is that the surviving spouse gets to utilize the deceased spouse’s assets until death, receiving all income and having the power to access principal if needed for support, but with the result that the assets held in the continuing trust for the surviving spouse’s benefit are not included in the taxable estate of the surviving spouse.
This planning technique was very important when the estate tax exemption was set at $600,000, because for many people, the estate would exceed $600,000, so by preserving the $600,000 exemption on the death of the first spouse, the entire estate could be $1.2 million ($600,000 for the first spouse, plus $600,000 for the second spouse; get it?) before any estate tax would be imposed. But since the late 1990’s this exemption has grown from $600,000 to $5 million, with the result that most couples will not reach the $5 million mark, so there is no need to preserve the other $5 million exemption of the first spouse to die.
Although the preservation of the deceased spouse’s $600,000 exemption was well worth the effort, nevertheless, it was an effort to split the estate into two separate trusts on the first spouse’s death. This entailed actually retitling assets so it would be clear that half the assets were in the surviving spouse’s trust (sometimes the “A” trust) and the other half of the assets were in the deceased spouse’s trust (sometimes the “B” trust). Then, once the split was accomplished, it would be necessary to file two separate tax returns and be sure that the B trust was administered within the parameters established under the original trust document.
With today’s exemption of $5 million for each spouse, and with the fact that the surviving spouse can “inherit” the deceased spouse’s unused $5 million exemption (e.g., if on the death of the first spouse to die, say she had $1 million, then $4 million of her $5 million would remain unused, so the surviving spouse would have his $5 million plus his deceased wife’s remaining $4 million, so he would have a full $9 million exemption available at his death!), there is less need or likelihood that the A-B split of the trust will be necessary.
Therefore, if you still have these A-B type provisions in your trust, and if your estate is under $10 million, it would be worthwhile to review your trust and perhaps replace the A-B split with a “Disclaimer” trust. What the Disclaimer does differently is this: It still allows the surviving spouse to split the estate if they wish, but the surviving spouse is not obligated to do so. Thus, the surviving spouse can decide at the time of the first spouse’s death whether or not to split the trust. In most cases, the split may not be necessary, so all the effort associated with the split can be avoided; nevertheless, the surviving spouse may choose to disclaim all or any lesser amount of the deceased spouse’s share of the estate (or of the deceased spouse’s separate trust in a non-community property state). The effect of the disclaimer is the same as the effect of the A-B split, i.e. the amount disclaimed passes into a second trust for the continuing benefit of the surviving spouse, and at the death of the surviving spouse, the amount of the estate in the disclaimer trust is not included as part of the surviving spouse’s estate, thereby foregoing estate tax. It is likely in most cases that as long as the estate tax exemption of $5 million has not been reduced, and/or as long as the estate of the surviving spouse is not likely to increase significantly in value, there will be no need to disclaim any amount to this disclaimer trust, with the result that the entire trust estate remains intact in one trust, thereby avoiding the effort and expense otherwise associated with the A-B split. (And if you understood all of that on a first reading, give yourself a gold star.)
Until 1986, it was possible to establish a trust for successive generations such that, as the estate would pass between generations, i.e. from parent, to child, to grandchild, etc., there would be no estate tax imposed as the assets passed to each succeeding generation. For most people this was not an issue, but think about how this might benefit you if your last name is Rockefeller. So the very, very wealthy would establish trusts for the benefit of their issue, to pass down to successive generations, with each generation having access, and even some control, of the trust assets; then, once the current generation died off, the assets would continue in trust to the next generation, then the next and the next, until the trust had to terminate, as might be required by state law. But as long as the trust could pass between generations, the assets would pass free of estate tax, thereby preserving and sheltering very large estates from, what was then, the 55% estate tax.
In 1986 Congress put an end to this little game by imposing the Generation Skipping Transfer Tax. What this tax did was limit the ability to create these types of trusts. Although it was still possible to create such a trust, it could be funded with only $1 million ($2 million for husband and wife), thus effectively putting an end to this type of planning for the very, very wealthy.
Aside from the estate tax, another benefit of these generational trusts is that the trusts are very hard to break, that is, if a beneficiary of one of these trusts misbehaves (as beneficiaries of such trusts have a tendency to do), and if the beneficiary is sued and has a large judgment declared against him, the person seeking to collect on the judgment would have virtually no way to reach the assets of the trust to collect on the judgment against the misbehaving beneficiary, so the beneficiary could continue in his profligate ways and the victim would be left holding a worthless piece of paper called a judgment.
Although we do not want to encourage misbehavior, many people are concerned about protecting what they leave to their children from the child’s misfortune. As a result, a common estate planning practice in recent years has been to leave a child’s inheritance in trust, rather than leave it to the child outright, so that if the child has a bad turn of events in a business, or if the child goes through a divorce, a trust which retains the child’s inheritance can preserve the inherited estate from losses associated with a business or from the divorce court, thereby ensuring the child will have some resources available to him regardless of such misfortune.
With the increase in the estate tax exemption to $5 million came an increase in the generation skipping transfer tax exemption to $5 million as well. This means that you can now set up a multi-generational trust with a lot of money (e.g. up to $10 million for husband and wife acting together) and not have to worry about the impact of the generation skipping tax as the trust estate passes from your child to his children and so on. Nevada law allows a trust like this to go on for 365 years! So now that we are not so restricted in setting up trusts like this, due to the very high exemptions now available, multi-generational trust planning should be considered. The use of these types of trusts will preserve your estate for your children’s benefit instead of paying off on a bad marriage.
There remain many tax planning opportunities. Where family members live in different states, it is possible to direct income to persons in those states where the income taxes are lowest, or to merely direct income to family members who are in a lower federal income tax bracket. It just takes a little bit of time and creative thinking to determine which structures might be most advantageous, and then deciding to move forward. Give one of the attorneys at Grant Morris Dodds, PLLC a call at 702-938-2244 to see what we can do for you. Some see taxes as a game; be sure you play the game well.