In the early hours of Jan. 1, the U.S. Senate passed legislation to avoid the fiscal cliff. Nearly 20 hours later, the House followed suit. Several surprising outcomes regarding estate planning emerged as part of the deal.
The new tax rates and exemption amounts are set. The federal estate tax rate moves up from 35 percent to 40 percent, with the exemption amount now at $5.25 million, which will be adjusted annually for inflation. For tax-efficiency purposes, married couples can take advantage of the opportunity to pass $10.5 million to loved ones free of estate tax. And spousal portability allows a surviving spouse to utilize any remaining portion of their deceased spouse’s federal estate tax exemption amount.
Additionally, the lifetime gift exemption amount has been unified with the estate tax exemption amount at $5.25 million and also will adjust annually for inflation. Many Americans will experience significant income tax increases as a result of the fiscal cliff deal, but the newly established permanent estate tax rates and exemption amount give wealth planners certainty that has been lacking for more than a decade.
The generation-skipping tax (GST) exemption amount has also been set at $5.25 million — assets in trust not used by loved ones can skip to the next generation, tax free. Such a generation skip would normally constitute a taxable event, imposing a 40 percent tax. The GST exemption employed in trust can avoid taxes on trust assets for transferees for 100 years or more, including all the growth in the portfolio. The most widespread use of the GST exemption is for wealthy individuals whose children already enjoy enough assets, will be earning enough assets or will inherit enough assets to assure the greatest likelihood that the trust assets will not be spent during the children’s lifetimes.
The high federal estate and gift tax exemption amounts will ultimately reduce the states’ future revenue. Previously, states received a pickup estate tax that allowed them to collect estate tax from the federal government without additionally charging the estate of the decedent. This was accomplished by giving taxpayers a dollar-for-dollar credit for any state estate taxes paid. The credit expired, which caused most pickup taxes to automatically expire as well.
It is possible that states will construct new methods to make up for budget shortfalls, particularly if the debt ceiling debates carry on. For example, Connecticut’s law requires anyone who gives a gift of $2 million or more to pay gift tax, even though the federal exemption is $5.25 million. Other states could follow suit and impose a gift tax at a lower exemption amount than the federal level — and they could do it retroactively.
For gifts made in 2012, it is critical to check off the final step to ensure the completion of any gift to a trust: the timely filing of a gift tax return. The filing of a complete return starts the three-year clock with the federal government, and once the statute of limitations has run out, the IRS can no longer audit the return. If a return is prepared but does not meet the specific adequate disclosure requirement, the statute of limitations does not start ticking.
Tactics to try
With some certainty that the estate tax exemption amount will remain unchanged, individuals should now consider employing taxable gifts again. Taxpayers whose net worth continues to grow in excess of $5.25 million looking to transfer assets will pay the gift tax. However, gifts made during one’s lifetime will enjoy a more favorable tax treatment, will suffer less shrinkage due to taxes, will avoid state estate taxes and will enjoy future growth, free of any state and gift tax.
Here are a few of the trust and non-trust estate planning strategies that married and single persons should explore in 2013:
- Foundations: With increased taxes, gifts to charity have a greater tax-deductible value. Gifts to foundations allow full deduction in the year of the gift, whereas transfers out of foundation can be as small as 5 percent on an annual basis, allowing assets in the foundation to continue to grow.
- Charitable trust: These enable one to make gifts to charity and receive immediate deductions. One can continue to receive income from the charitable gift for a period of time. Gifts can also be made where the charity gets a distribution each year and the loved ones receive the remainder.
- Family mission planning: The family mission and preparing heirs for inheritances are critical to ensuring a successful transfer of wealth and family values, to helping minimize conflict and maximize harmony and to supporting charitable endeavors.
- Life insurance trusts: Funding a trust with a life insurance policy is a smart way to get a windfall of cash when someone passes away to pay off estate taxes. It’s also an avenue for getting a big asset off of one’s balance sheet, keeping a large amount of cash safe and protected. Make sure the trust is named as the beneficiary and policy owner (e.g., John Doe Irrevocable Trust). If a house is put into a trust and the house is insured, make sure to get the insurance policy changed to reflect the ownership by the trust. The trust should be the primary insured on the policy, and the individual can be the secondary.
Several valuable opportunities emerged as part of the fiscal cliff negotiations that pleasantly surprised the estate planning community. We are not completely out of the woods, however, with the debt ceiling debates just around the corner. When it comes to safeguarding wealth and family values, it’s important now to look ahead without losing sight of what’s in the rearview mirror.
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