Private Client

Action Item: This year, Blank Rome’s annual estate planning newsletter will be issued in six installments. Each installment will discuss certain concepts and techniques that we hope may be of interest to our clients and friends. This installment of our annual estate planning newsletter will focus on general gift, estate, generation-skipping transfer, and income tax matters. We urge you to review this installment to ensure that your 2016 estate and tax planning is in order.

1. Transfer Taxes. The major changes made in 2010 in the law regarding gift, estate, and generation-skipping transfer (“GST”) taxes (collectively, “transfer taxes”) are now permanent.
   1. Gift Tax. The tax-free “annual exclusion” amount remains $14,000 in 2015. The cumulative lifetime exemption increased from $5,430,000 in 2015 to $5,450,000 in 2016 (inflation adjustment). The tax rate on gifts in excess of $5,450,000 remains at 40%.
   2. Estate Tax. The estate tax exemption (reduced by certain lifetime gifts) also increased from $5,430,000 in 2015 to $5,450,000 in 2016, and the tax rate on the excess value of an estate also remains at 40%. All of a decedent’s assets (other than “income in respect of a decedent,” such as IRAs and retirement plan benefits), as well as a surviving spouse’s half of any community property assets, will have an income tax basis equal to the fair market value of those assets at the date of death [“stepped-up (or down) basis”]. In this regard, securities brokers still are required to retain basis records and report the income tax basis of securities to the IRS. Accordingly, be sure to advise your broker of your basis in securities received by gift or inheritance. In addition, executors now must report the basis of inherited assets as shown on the federal estate tax return to the IRS and to the beneficiary of the asset.
   3. GST Tax. For 2016, the GST tax rate also remains at 40% and the lifetime exemption also has increased (inflation adjustment) from $5,430,000 in 2015 to $5,450,000 in 2016. Paragraph 5 on page 6 includes more information about the GST tax.
   4. Portability of Estate Tax Exemption. The “portability” rules provide for the transfer of a deceased spouse’s unused estate tax exemption (“deceased spousal unused exclusion amount” or “DSUEA”) to a surviving spouse (without inflation adjustments). Thus, if a 2016 decedent’s taxable estate is not more than $5,450,000, the DSUEA can be used by the surviving spouse with respect to both gift taxes and estate taxes (but not GST taxes). Portability is not available if either spouse is a nonresident alien. Portability may allow some couples to forgo a more complex estate plan while still taking advantage of both spouses’ transfer tax exemptions. Portability must be irrevocably elected on a timely filed (including extensions) estate tax return, even if a return is not otherwise required to be filed.
      
      A typical estate plan for a married couple generally has provided for the establishment of two (or three) trusts at the death of the first spouse: A “Survivor’s Trust”; a “Residual (or “Exemption” or “Bypass” or “Credit Shelter”) Trust”; and possibly a “Marital Trust.” One of the reasons for the Residual Trust is to use the deceased spouse’s estate tax exemption to the fullest extent possible. Under the new portability law, however, if one spouse dies and leaves assets to persons (other than the surviving spouse and charity) in an aggregate amount less than the basic exclusion amount ($5,450,000 in 2016), the surviving spouse may be able to use the DSUEA as well as the surviving spouse’s own exemption.
      
      This portability provision may eliminate the need to create a “Residual Trust” at the first spouse’s death. For example, if this year the first spouse to die leaves all of his or her assets to the surviving spouse, no part of the deceased spouse’s exemption is used because of the marital deduction available for assets passing to a surviving spouse at the first spouse’s death. Unless the surviving spouse remarries and survives his or her new spouse, he or she will have an aggregate exemption of (i) $5,450,000 (“DSUEA”) and (ii) his or her own inflation-adjusted $5,450,000 exemption ($10,900,000 total in 2016). Similarly, if in 2016 the first spouse to die leaves $1,000,000 to his or her children, the surviving spouse will have an aggregate exemption of $9,900,000 (use of the remaining $4,450,000 “DSUEA” in addition to his or her own inflation-adjusted $5,450,000 exemption).
      
      In many cases, however, we will advise our clients to continue to use a Residual Trust as part of their estate plans for both tax and non-tax reasons.
      
      Tax reasons include the following: (i) The DSUEA is not indexed for inflation; (ii) eliminating estate tax on any appreciation of Residual Trust assets at the surviving spouse’s death, regardless of the value of the surviving spouse’s assets; (iii) allowing for an allocation of the deceased spouse’s GST exemption to the Residual Trust, because the GST exemption is not portable. An allocation of a decedent’s GST tax exemption to the Residual Trust at death can reduce GST taxes if assets are left to grandchildren, either directly or in a trust benefitting both children and grandchildren; (iv) the surviving spouse could remarry and be limited to using the unused exemption of his or her second predeceased spouse if any (a DSUEA thus may inhibit remarriage); and (v) an estate tax return must be filed timely to qualify for portability.
      
      Non-tax reasons include the following: (i) Limiting (or eliminating) the ability of the surviving spouse to direct the disposition of the deceased spouse’s assets on the surviving spouse’s death; (ii) restricting the surviving spouse’s right to use principal (perhaps only for health, support, and maintenance); (iii) providing creditor protection (creditors generally cannot reach the assets in an irrevocable trust established by another person); and (iv) providing professional management if desired.
      
      Residual Trust disadvantages include the following: (i) Annual costs for the preparation of Residual Trust income tax returns and maintaining separate records for the Residual Trust; (ii) the possible loss of a further stepped-up basis on the surviving spouse’s death; (iii) lack of surviving spouse ability to change the estate plan to adapt to changed circumstances, unless as is often the case the surviving spouse has a limited power to change the Residual Trust distribution provisions; (iv) lack of ability to offset capital gains and losses realized by the surviving spouse and the Residual Trust; (v) Residual Trust assets generally cannot be used to implement further estate planning techniques; (vi) the surviving spouse cannot use the $250,000 exclusion from capital gain upon the sale of a residence held in the Residual Trust; and (vii) possible need to accelerate taxable distributions from retirement accounts.
      
      Two Planning Tips. If the reasons for establishing a Residual Trust are not significant, but you nevertheless want to provide for the possible establishment of a Residual Trust in case your spouse decides that it is advisable to do so, your estate plan can provide for distribution of your estate to your spouse, but include a provision that would allow your surviving spouse to “disclaim” all or a portion of his or her inheritance and arrange for the disclaimed assets to be allocated to a Residual Trust (“Disclaimer Trust”). The surviving spouse could make his or her decision to disclaim during the nine-month period following the first spouse’s death. The only difference between a Disclaimer Trust and a Residual Trust established by the first spouse is that the surviving spouse could not have a power to provide for distribution of the assets of a Disclaimer Trust in a manner different from the first spouse’s distribution plan.
      
      A qualified Marital Trust enables a deceased spouse to maintain control over the distribution of the trust assets upon the death of the surviving spouse, can preserve the deceased spouse’s unused GST exemption through a “reverse QTIP election,” and provides a greater degree of creditor protection than would be afforded by an outright bequest to a surviving spouse. Using a Marital Trust to accomplish these objectives (rather than a Residual Trust) may allow the trust assets to receive a step-up in basis upon the death of the surviving spouse and, in some cases, may postpone payment of state level estate taxes until the death of the surviving spouse. In addition, the surviving spouse may wish to elect portability and subsequently use the deceased spouse’s remaining estate and gift tax exemption (DSUEA) to make lifetime gifts tax-free. Uncertainty currently exists regarding the validity of a qualified Marital Trust (“QTIP”) election made solely to allow for the use of portability, which may prevent the surviving spouse from implementing this further planning strategy, but the IRS has promised guidance on this issue.
2. Income Tax Changes. The following is a brief summary of the income tax changes made in 2013, taking into account 2016 inflation adjustments:
   • The highest tax rate is increased from 35% to 39.6% for incomes in excess of $466,950 (was $464,850) (joint return), $441,000 (was $439,000) (head of household), and $415,050 (was $413,200) (single). These brackets will continue to be adjusted for inflation annually;
   • The social security tax remains increased from 4.2% to 6.2%;
   • The alternative minimum tax (“AMT”) exemption amounts are increased to $83,800 (was $83,400) (joint return) and $53,900 (was $53,600) (single);
   • The maximum tax rates for most long-term capital gains and dividends remain increased from 15% to 20%; and
   • The itemized deduction and personal exemption “phase-outs” were reinstated with adjusted gross income thresholds of $311,300 (was $309,900) (joint return), $285,350 (was $284,050) (head of household), and $259,400 (was $258,250) (single), which thresholds will continue to be adjusted for inflation annually. These “stealth tax” provisions effectively increase marginal tax rates for those affected.
     
     In addition, a 3.8% “Medicare” tax is still imposed on investment income (including capital gains) of “high-earning” taxpayers, and a 0.9% Medicare tax is still imposed on employment income earned by those taxpayers.
3. Regulatory Notice. We are providing this letter and the enclosure as a commentary on current legal issues as a service to our clients and friends; neither should be considered legal advice, which depends on the unique facts of each situation.