Although the recently passed tax bill clarifying the estate tax situation was good news for affluent Americans, some provisions in the bill have also created a sense of urgency for the advisors of affluent clients to review existing estate plans to ensure these do not contain provisions that could, ironically, increase their tax liability.
In a video presentation, Robert Klueger, a California certified tax law specialist with the firm Klueger & Stein LLP in Los Angeles, reviews three changes from the tax bill. The first two have been well documented: an increase in the exclusion from estate taxes to $5 million for an individual and $10 million for a married couple; and for those portions of an estate subject to the federal “death tax,” a reduction in the tax rate to 35% for the increment over $5 million.
Klueger devotes the bulk of his comments on the video to the third change, which he argues should prompt a review of existing estate planning for wealthy clients. This is the portability of the estate tax exclusion, which allows a spouse who does not use the $5 million exclusion before his or her death to pass it on to the surviving spouse who can then shield $10 million from estate taxes under the unlimited marital deduction.
Klueger explains that before passage of the 2010 tax bill, it was necessary to use an estate planning strategy called an AB trust to double up on the exclusion from estate taxes. Now, thanks to the portability feature, an AB trust is no longer necessary. However, that leaves those with such a trust with a feature that could do more harm than good.
With an AB trust, the assets in an estate of, say, $4 million would be divided half and half between A and B spouses, thus doubling up on the exclusion. However, the creators of the AB Trust had to pay a price in the form of an income tax.
That, says Klueger, is where the step up in basis to fair market value part of the tax code comes into play. For example, say a client buys shares in a company for $10 and sees the stock price appreciate to $100, resulting in a capital gain of $90. But if that person inherits the stock, the capital gain is forgiven and the beneficiary gets a new basis of $100, so that if the heir sells for $101, his capital gain is $1, not $91.
However, because of the way the IRC is written, if the property was in the B Trust, the beneficiary would not get the step up in basis to fair market value.
Klueger says that before the recent changes in the estate tax provisions, this was not of great concern because the estate tax rates were always higher than the income tax rates: capital gains rates were 15%, while estate taxes rates went as high as 55%. So many clients were willing to pay the income tax in order to save on the estate tax.
Under the new tax law, someone with an estate valued at less than $5 million will never have to pay estate taxes. But if the assets are in a B Trust, he or she will not get the step up in basis to fair market value, and instead will incur an income tax liability at a higher rate than if the assets were in an estate that, due to the new, higher exclusion amount, would not be subject to any estate tax at all.
What should folks do who have an AB trust do, and what should their advisors recommend? Klueger says clients should at least review their estate tax plans to see whether they are looking at an estate plan that offer a “detriment with no benefit.”