Effective estate planning can be tough even when we understand the rules. These days, thanks to a surprising twist in tax law, wealth managers are faced with a new level of uncertainty when it comes to the wealth transfer needs of their clients. As you’ve likely heard, 2010 represents the first time in almost 100 years in which there is no federal estate tax. The fact that the estate tax was allowed to expire blindsided many in the financial and estate planning communities, who expected it to survive 2009 in some form and continue into the foreseeable future.
To high-net-worth clients, the death of the estate tax may sound too good to be true. In its absence, will they be able to pass along as much as they like to their heirs without the federal government taking a significant share? A closer look at the current estate tax situation reveals that it may not be the estate planning panacea that clients imagine.
No taxes? Not quite
Along with the elimination of the estate tax comes a new tax problem. In the past, capital assets owned by a decedent were eligible for an increase in tax basis to the fair market value at the date of death (or alternate valuation date). Although those assets were included in the decedent’s taxable estate, the step-up in basis actually benefited heirs who stood to inherit capital assets by eliminating any built-in capital gain. Under the new rules, inherited property is subject to a carryover basis–the same basis as if the assets remained in the hands of the decedent–which could have significant income tax consequences.
Clients may find some relief from the carryover tax basis in the form of an available basis allocation, up to a total of $4.3 million in assets. A basis step-up can be allocated to $3 million in property passing to a surviving spouse, with another $1.3 million basis step-up allocated to property passing to a non-spouse heir. The allocation of any basis step-up appears generous when coupled with the lack of an estate tax. Still, for high-net-worth clients and their heirs, the advent of the carryover basis may cause some headaches. Because basis records are often missing or incomplete, many planners feel that establishing the carryover basis will be a significant challenge.
How should you adjust your estate planning approach in this new landscape? Considering that another change to the estate tax likely will be coming down the pike very soon, this is a tricky question to answer. The chatter from Capitol Hill suggests that the estate tax, along with an estate tax exemption, will be reinstated. According to many commentators, the exemption amount will be the same as it was at the end of 2009–$3.5 million per individual. Will that be enough to shelter your clients from estate taxes? For higher-net-worth clients, the answer is no, so prepare to chart a new course for them as soon as clear guidance emerges.
Also keep in mind that the estate tax may be instituted retroactively, effective January 1, 2010. If you have clients who have either passed away this year or implemented estate planning strategies based on the expiration of the estate tax, be prepared to address this alarming possibility with clients and their families. Some clients have already voiced their desire to defend their position under current law and challenge the constitutionality of a retroactive tax.
What can you do now?
At this point, it’s difficult to predict the outcome of the political wrangling over the federal estate tax. Until a new law takes effect, wealth managers should work with clients’ attorneys to refine their current estate planning documents. Provisions in wills and trusts that were drafted several years ago, when the estate tax lapse of 2010 could not have been foreseen, may trigger unintended results today.
Revisit the documents. Many estate planning documents use a formula to determine how much of the decedent’s assets should be allocated to funding the credit shelter trust (also commonly known as the bypass trust). One of the factors used in the funding formula is the amount that can pass free of estate taxes (the federal exemption) at the time of death. Left unchecked and unrevised, provisions in your clients’ current documents could lead to the unintentional over- or underfunding of a credit shelter trust. That’s why it’s key to review those documents, determine their funding provisions, and discuss possible revisions and amendments with your clients’ attorneys. This step alone can go a long way toward reducing the uncertainty surrounding the current estate tax law (or lack thereof).
Consider the use of disclaimers. While reviewing your clients’ estate plans, consider whether it makes sense to bring disclaimers into play. Could qualified disclaimers be used to resolve some of the issues that may arise under the current law upon death of a client?
A disclaimer is one of the most effective–if not the most effective–postmortem planning tools you have at your disposal. It allows the intended recipient of a decedent’s property to refuse receipt of the property and transfer it free of transfer taxes to a subsequent heir or trust. Essentially, the disclaimer functions as if the intended recipient has predeceased the actual decedent, therefore allowing the next person or trust to receive the property. For example, a disclaimer can help clients avoid unintended funding results upon the death of a spouse. The disclaimer allows the surviving spouse to review his or her needs and determine how much, if any, of the decedent’s assets should be disclaimed to fund the credit shelter trust.
To be effective, a qualified disclaimer must be executed within nine months of the property owner’s death. Who will receive disclaimed property depends on the provisions of the estate planning documents, such as the will or trust; the primary and contingent beneficiaries named in a beneficiary designation; or the state laws of intestacy. Again, be sure to work closely with your clients’ attorneys, keeping in mind that different states may require you to consider a host of other tax issues as well.
And remember: in this time of uncertainty, no one has all of the estate planning answers, but you can certainly help your clients make decisions they feel comfortable with based on the best available information.
Gavin Morrissey is the director of advanced planning at Commonwealth Financial Network, in San Diego, California. He can be reached at firstname.lastname@example.org.