The American Taxpayer Relief Act of 2012 (the “2012 Act”) was signed into law by President Obama on January 2nd. A summary of the important income tax features of the 2012 Act can be read here. This article summarizes the federal estate, gift and generation-skipping transfer (or “GST”) tax provisions of the 2012 Act, and some of its implications for estate planning in the years ahead.
Summary of Changes
The 2012 Act makes only a few references to the estate, gift and GST taxes, but those references have important and far-reaching implications. First, the $5 million per-person exemption that was available in 2011 and 2012 did not expire as scheduled and will remain in effect in 2013 (and beyond). Even more significantly, the $5 million exemption amount will continue to be indexed for inflation. For 2013, the indexed exemption is expected to be roughly $5,250,000 (up from $5,120,000 in 2012), but if, as some believe, we are entering a period of higher inflation, the estate, gift and GST exemptions could increase even more significantly in the future.
Second, the tax rate for estate, gift and GST transfers in excess of the exemption amount was increased from 35% to 40%, not the top 55% rate that previously was scheduled to come back into effect in 2013.
Third, the 2012 Act preserves and clarifies the rules that make the $5 million gift and estate tax exemptions (but not the GST exemption) “portable” between spouses. As discussed below, these rules make it possible for a surviving spouse to use a deceased spouse’s unused exemption on future transfers. If the surviving spouse remarries, the surviving spouse also has the option of passing the first spouse’s unused exemption to the new spouse, along with the surviving spouse’s own unused $5 million exemption. For example, if a husband (“H1”) dies before his wife, W, and H1 leaves $3 million of unused exemption, W could later marry H2 and, if W dies before H2, W could make more than $8 million of unused exemption available to H2. H2 also would have his own remaining $5 million exemption available.
Fourth, the most commonly considered tools for wealth transfer planning – irrevocable “grantor” trusts, grantor retained annuity trusts (“GRATs”), valuation discounts for closely-held business entities such as limited partnerships, qualified personal residence trusts (“QPRTs”), etc. – remain viable strategies for future wealth transfer efforts. Some of these techniques had been targeted for adverse action by the Obama Administration, but the 2012 Act did nothing to alter them.
Fifth, and perhaps most importantly, the estate, gift and GST tax laws are now permanent and are not scheduled to “sunset” in the future. To be sure, Congress can change these laws in the future, but clients may plan their affairs with less concern about sudden and dramatically adverse changes in the estate, gift and GST tax laws.
Implications of 2012 Act for Estate Planning Clients
Aside from the higher 40% tax rate, the changes in the estate, gift and GST tax laws under the 2012 Act generally are favorable for clients. Still, each client’s situation must be evaluated to determine whether further planning is appropriate as a result of the new law. Some of the more common situations that clients may encounter are discussed below.
Clients Whose Assets Are Less Than $5 Million.
For individuals with less than $5 million, and for married couples whose combined wealth is less than $5 million, the 2012 Act frees them to plan their estates with little concern about estate, gift and GST taxes.
However, it should be remembered that the proceeds of life insurance will be includible in the insured’s gross estate for estate tax purposes if the insured owns the policy at death. Therefore, even clients whose net worth is less than $5 million may have an estate that exceeds the $5 million threshold. If so, some additional estate tax planning may be appropriate.
Married Couples With Estate Planning Documents Signed Under Prior Law.
Married clients who in the past signed wills or revocable trusts containing tax-sensitive provisions will want to consider whether to amend their documents to take into account the greater flexibility available under the new law.
From 1997 through 2009, for example, when the estate tax exemption was between $600,000 and $3.5 million and “portability” was not available, married couples often divided ownership of their assets between them and signed wills or trusts that divided assets after death between a “family trust” and a “marital trust” in order to take advantage of both of their estate tax exemptions. Under the 2012 Act, married couples will be able to achieve the same tax result without those complications. Instead, the first spouse to die could simply leave all his assets to his surviving spouse, and the surviving spouse could utilize the $10,000,000 exemption for gift and estate tax purposes. Alternatively, for asset protection reasons married couples may want to own more of their assets as tenants by the entireties, which they now may do with less concern that the first spouse’s estate and gift tax exemption will be wasted.
While the idea of streamlining generally is appealing, there are tax issues to consider before a married couple decides to simplify their estate planning documents in the fashion just described. First, the $5 million GST exemption is not portable between spouses. Therefore, married clients who wish to utilize both of their GST exemptions for grandchildren or more remote descendants will require more complicated tax provisions in their wills or revocable trusts. Second, while the estate and gift tax exemption is portable between spouses, portability is not automatic; the estate of the first spouse to die must file an estate tax return in order to assure that the decedent’s surviving spouse is able to use the deceased spouse’s unused estate and gift tax exemption. We expect that more estate tax returns will be filed in the future simply to confirm the availability of unused estate and gift tax exemption for the surviving spouse.
Married Clients Whose Combined Wealth Is Between $5 Million and $10 Million.
Married couples whose combined wealth is between $5 million and $10 million now have the more flexible planning options described above. They can use straightforward estate planning documents that leave all of their combined estates to the surviving spouse, or they can elect to own more of their assets as tenants by the entireties for asset protection reasons. In either case, if the estate of the first spouse to die files an estate tax return and makes the first spouse’s exemption “portable,” the surviving spouse will have the ability to shield more than $10 million from estate taxes at his or her later death. As noted above, however, portability is not available for the GST exemption. Therefore, married couples who wish to use both of their GST exemptions for grandchildren or more remote descendants will continue to require more complicated planning.
Married Couples With Combined Families.
The 2012 Act does not resolve the thorny inheritance issues that can arise when a decedent’s surviving spouse is not the parent of the decedent’s children. Those issues require thoughtful planning, carefully drafted documents and good communication. While the 2012 Tax Act may reduce the tax complications that can arise in these situations, there may need to be greater attention in the planning process given to how a decedent’s unused estate and gift tax exemption will be preserved and utilized for the benefit of the surviving spouse and decedent’s children, and how those heirs will work together to achieve common objectives.
Clients Whose Assets Are Greater Than $5 Million/Married Couples Whose Assets are Greater Than $10 Million.
Clients in this category of wealth continue to face a high tax rate (40%) on the wealth that is in excess of their available exemption(s). The good news is that the full panoply of planning techniques that were available prior to the 2012 Act can continue to be used in the future. In addition, the gift tax annual exclusion is now $14,000 per donee; therefore, married couples now can give any individual donee $28,000 per year under the annual gift tax annual exclusions without estate or gift tax consequences. Additional gift tax exclusions are available for payments of certain medical and education expenses. Still, wealthy clients need to give regular attention to their estate planning to assure that their intentions are realized with a minimum of estate tax consequences.