This situation presents some
unique challenges for CPAs providing estate planning
advice in the coming years. This article suggests
strategies accountants should consider when helping
clients understand the implications of the new law
and how to minimize the transfer tax bite over the
next decade (For more information on the act’s
estate tax provisions, see “The
Uncertainty of Death and Taxes,” JofA ,
Oct.01, page 95. )
WHAT IT DOES AND DOESN’T DO
To briefly summarize
what the 2001 act does or does not do with regard
to estate and gift taxes, consider the following
provisions:
The estate tax is scheduled to be
repealed for only one year, 2010, unless Congress
extends the repeal or makes other changes before
that time.
The exemption amount (the amount of
transfers at death free of federal tax) increases
gradually from the 2002 and 2003 amount of $1
million as follows: 2004 to 2005
| $1.5 million |
2006 to 2008 | $2 million
| 2009 | $3.5
million | 2010 |
No tax | 2011 |
$1 million
|
Even with the estate tax repeal, the
tax basis of inherited assets will no longer be
stepped up to fair market value on the date of
death, except for a limited step-up of $1.3
million on selected assets and an additional $3
million on property passing to a surviving spouse.
The act did not repeal the gift tax
but rather froze it at a $1 million lifetime
exclusion.
Before repeal in 2010, the top estate
tax rate on assets above the exemption amount will
steadily inch down to 45% in 2009 from 55% today.
Some observers have characterized the new
provisions as a “strange new world.” The
complexity of the situation is magnified when you
consider that at the time of this writing, federal
budget surpluses are vanishing as the United
States moves into a wartime economy, rendering the
2001 act vulnerable to the winds of political
change and economic necessity. Moreover, there
will be two presidential elections and four
congressional elections by 2011. No one can
predict accurately the future political climate.
One popular prediction is that future legislation
will freeze the estate tax rates and exemptions at
some point during the phaseout period. This
possibility increases the need for CPAs to
encourage their clients to plan for all
eventualities.
Exemption
Equivalents: 2001 to 2015
| | Source:
Phoenix Life Insurance Co., Hartford,
Connecticut, www.phl.com
. |
MAKE GOOD USE OF INCREASING EXEMPTIONS
With the increasing
exemption amounts through 2009, it’s more
important than ever for CPAs to advise married
couples to make sure each spouse has sufficient
assets titled in their own names. (Assets in joint
name can’t be used to fund an exemption bypass
trust.) Equally important is for the client’s
attorney to conduct a timely review of the
couple’s estate planning documents. Many married
couples have testamentary plans with trusts to be
funded by the maximum exemption amount. As that
amount increases through 2009, so should the
amount of assets the spouses maintain in separate
names. This will maximize the assets that can pass
to beneficiaries estate-tax-free during the
phaseout period. The cost of wasting a spouse’s
exemption by not having enough assets titled
separately is magnified as the exemption grows
over the next eight years. However, the new law
may make certain estate planning provisions
inconsistent with the testator’s intent, as the
following example demonstrates:
Example 1. John and Mary
have a $4 million estate with asset ownership
split equally. The will of the first spouse to
die, with a $2 million estate, passes the full
exemption amount to the couple’s children, with
the balance passing to the surviving spouse. This
allocation will work well in 2002 with a $1
million exemption, leaving the surviving spouse $1
million. However, this allocation could
effectively disinherit a surviving spouse in 2006,
when the exemption amount reaches $2 million.
With the uncertainty the new law creates, legal
counsel may need to review revocable documents
such as wills and living trusts more frequently
than in the past—as often as once a year during
the phaseout period. Clients are free to modify
these documents as often as they wish until death,
for example, by a codicil or by an amended trust
agreement. Clients will need to have their wills
address multiple scenarios depending on the estate
tax rules in effect at the time of the their
death. For example, John and Mary might add a
provision to their wills capping the amount
passing to their children at $1.5 million
regardless of how high the exemption amount
climbs. CPAs may also want to suggest
clients make increased use of disclaimer
provisions. In well-drafted wills and related
documents (such as beneficiary designations for
IRAs and other retirement plans) such provisions
offer the flexibility of postmortem planning to
the surviving spouse or other beneficiaries in
light of existing tax laws and circumstances at
the time. Disclaimers permit the survivor to
disclaim certain assets if it is beneficial to do
so based on the laws in effect when the spouse
dies or on family needs. Returning to John and
Mary, their estate plan could continue to pass the
maximum exemption amount to their children, who
could disclaim any assets the surviving parent
needs.
GIFT TAX—STILL NOT GONE
Congress froze the
gift tax exemption at $1 million for 2002 and
beyond, thus uncoupling the current unified gift
and estate tax system in 2004 (when the estate tax
exemption goes to $1.5 million). The top marginal
gift tax rate will match the declining estate tax
rate through 2009, and then switch to the highest
marginal income tax rate (scheduled to be 35% in
2010). Retaining the gift tax will deter
donors from making large transfers of appreciated
property to taxpayers in a lower marginal capital
gains bracket. While repeal of the federal estate
tax means no estate tax on testamentary transfers,
a gift tax on lifetime transfers in excess of the
gift tax exemption will remain. Therefore, as a
general rule, CPAs should advise clients to strive
to avoid making gifts that would trigger gift
taxes. However, they should continue recommending
that clients use the $11,000 annual gift exclusion
(up from $10,000 in 2001 based on inflation
adjustments), which is unchanged under the act.
Developing gift tax strategies that maximize use
of the $1 million gift tax exemption will also be
important for some clients. In 2002, a client who
has already used his or her 2001 exemption amount
of $675,000 can give approximately $325,000 more
without incurring gift tax. This is the difference
between the 2002 exemption and the 2001 exemption
($1,000,000 minus $675,000 equals $325,000.) Such
gifts remove both assets and future appreciation
from the client’s estate in the event the estate
tax is not ultimately repealed. Because of
the gift tax changes, CPAs will find techniques
that leverage the lifetime gift
exemption—including grantor retained trusts and
the family limited partnership—to be popular. A
grantor retained annuity trust (GRAT) is
irrevocable; the grantor transfers assets to it
and retains the right to receive an annuity for a
fixed term of years. At the end of that term, the
remaining principal is paid to the individual
beneficiaries, removing it from the grantor’s
estate. The grantor is considered to be making a
current gift to the remaindermen of the right to
receive trust assets at a specified future date.
The amount of the gift is based on the value of
the transferred property less the value of the
annuity. A grantor who survives the trust
term can realize significant tax savings. The
biggest risk of using a GRAT is the possibility
the grantor will not survive. If this happens, all
or part of the GRAT property might be included in
the grantor’s estate for estate tax purposes.
A December 2000 case, A. J. Walton,
115 TC 589 (2000), provides support for
creating a GRAT without any gift tax liability.
Previously, the IRS maintained it was impossible
to “zero out” a GRAT (which happens when the
actuarial present value of the right to receive
the annuity is equal to the beginning trust
principal) because there was always the
possibility the grantor might die before the trust
expired (Treasury regulations section
25.2702-3(e), example (5)). In Walton
, the Tax Court unanimously held that the
retained annuity should be valued for a term of
years, not for the shorter of the term or the
grantor’s prior death. To zero out a GRAT, the
annuity payout rate must be set high enough to
result in no gift. Using a zeroed out GRAT
eliminates the risk of paying gift taxes on
property that will be included in the grantor’s
estate if he or she does not survive the GRAT
term. A zeroed out GRAT that outperforms the
applicable federal rate for gifts over its term
(5.6% for February 2002) can result in even more
transfer tax savings for the grantor.
Example 2. Milton
establishes a GRAT to benefit his nephew. The
initial value of the trust principal is $1
million. The IRC section 7520 annuity rate is 6%.
To zero out a 10-year GRAT, the required annuity
payment would be $135,868. According to IRS
publication 1457, table B, the annuity factor for
a 6% rate and a 10-year period is 7.3601. Under
these assumptions CPAs can compute the required
annuity payment as follows: $1,000,000 7.3601 =
$135,868. There are other ways CPAs can
recommend clients leverage the lifetime gift
exemption. Gifts of family limited partnership
interests allow taxpayers to make prudent use of
discounts from fair market value that often apply
to gifts of such interests. CPAs should urge
clients to be cautious in making these gifts,
however, because the IRS has raised questions
about the magnitude of the discounts. Treasury
regulations section 25.2512-3 requires appraisals
from independent experts on hard-to-value assets.
It is best for clients to assume the IRS will
challenge the valuation.
SUBSTITUTING INCOME TAX FOR ESTATE TAX
In 2010 the act
replaces the current “step-up” in basis for
appreciated property transferred at death with a
modified “carryover” basis—the lesser of the
decedent’s original basis or the property’s fair
market value on the date of death. Under the new
law if the estate tax repeal takes effect in 2010,
an executor can generally step up the basis of
assets of the executor’s choice totaling $1.3
million. The surviving spouse is entitled to an
additional $3 million in basis step-up. Although
no tax would be due at the time of the transfer,
the beneficiary would incur capital gains taxes at
the time he or she sold the asset. Careful
tracking of the cost basis of assets by taxpayers
is essential now to prepare for postrepeal
carryover basis.
Example 3. At the time of
her death in 2010, Donna has an estate composed
entirely of marketable securities valued at $4.8
million. Her cost basis is $500,000. If she leaves
these securities to her nephew, her executor will
be able to increase the cost basis of certain
securities (selected by the executor) by a total
of only $1.3 million. If Donna leaves the
securities to her husband, her executor will be
able to increase the cost basis by $4.3 million,
eliminating any immediate income tax problems.
CPAs should advise clients to anticipate the
impact of the carryover basis in their estate
planning documents by leaving their spouse enough
appreciated property to make full use of the $4.3
million step-up. For spousal assets to qualify for
this provision, the transfer must be either
outright or through a qualified terminable
interest property (QTIP) trust. (QTIP trusts are
used where the decedent wants the surviving spouse
to enjoy certain estate assets during the
survivor’s lifetime, but also wants to control the
ultimate disposition of the property to children
or others.) In example 3, Donna could have put her
estate in a QTIP trust for her husband with her
nephew as the ultimate beneficiary, thereby taking
full advantage of the spousal basis step-up.
Personal residence. In 2010 a decedent’s
personal residence can qualify for the $250,000
gain exclusion (IRC section 121(d)(9)) if the
estate, an heir or a qualified trust sells the
home. If the sale takes place within three years
after the owner’s death, the qualified seller may
be able to use the two-out-of-five-years rule for
capital gains exclusion. (The taxpayer’s estate
can exclude the gain if, during the five-year
period that ends on the date of sale, the decedent
owned and used the property as a principal
residence for periods totaling two years or more.)
Therefore, CPAs may want to advise clients to
avoid giving away a home during their lifetime so
the house is available to make use of this tax
relief.
GENERATION SKIPPING TRANSFER TAX
The generation
skipping transfer (GST) tax applies to property
transfers made to an individual more than one
generation younger than the transferor. The tax
rate equals the highest federal estate tax rate.
Each individual currently has a GST exemption of
$1.1 million (up from $1.06 million in 2001 based
on inflation adjustments). In 2004 that exemption
goes to $1.5 million and then begins to track the
estate tax exemption amount. It’s
important for CPAs to be certain that a client’s
testamentary intentions are known and carried out
in his or her estate documents. Because of the
increasing GST exemption (as with the estate tax
exemption) a trust for grandchildren contemplated
as a $1.1 million bequest might increase if the
client’s current testamentary plan uses a funding
formula based on the maximum exemption. If the
client continues to use such a formula, the result
could be more assets put in trust for the children
(and grandchildren, ultimately) than he or she
intended.
Example 4. Addison’s will,
drafted in 2000, sets aside an amount equal to the
maximum GST exemption (currently $1.1 million) for
his grandchildren (his so-called “skip” persons).
Since the funding formula for this bequest equals
the maximum GST exemption, the allowable, or
tax-free, amount passing to Addison’s
grandchildren will increase to $3.5 million by
2009. This may be more than he intended them to
have and, based on the size of his estate, could
effectively disinherit his children. If Addison
dies in 2010, his grandchildren will get nothing
since there is no exemption amount in that year.
To avoid these problems, his CPA should advise
Addison to reformulate his bequest to leave his
grandchildren a percentage of his estate or a
specific dollar amount, capping it at the unused
GST exemption amount. CPAs should also
remember that generation-skipping or “dynasty”
trusts provide useful ways to protect assets for
beneficiaries in case of a divorce or a lawsuit by
the beneficiary’s creditors. Dynasty trusts can
provide incentives to encourage (or discourage)
descendants to behave in certain ways. The trust
can be written to distribute funds when the
beneficiary attains specific goals such as
graduating from college with a certain grade point
average, earning an advanced degree or pursuing a
certain career. The trust also can be written with
the flexibility to adapt to changes in the law and
to unanticipated changes in family situations.
LIFE INSURANCE STILL VIABLE?
With so much talk
about the death tax repeal, to some clients and
CPAs life insurance as an estate planning tool may
appear obsolete. On the contrary, the uncertainty
concerning complete repeal suggests many estate
plans still need insurance support to cover estate
settlement costs. It may still be a good idea for
clients to make prudent use of life insurance to
hedge their bets of either not surviving until
2010 or of living beyond the point when the tax is
reinstated. Some practitioners suggest that
permanent life insurance is still advisable given
the loss of basis step-up on appreciated assets
and a potential future income tax to
beneficiaries. Letting a client’s insurance
coverage lapse may not meet his or her needs if
the law’s sunset provisions prevail.
Irrevocable life insurance trusts also may
still make sense for some clients, although the
type of life insurance product used in the trust
may change. Ten-year guaranteed term insurance
might be suitable to match the current tax repeal
schedule. If the trust uses permanent insurance,
it may be prudent for the client to add trust
provisions allowing distribution of the policy
during the grantor’s lifetime. Such a provision
might be carefully drafted to allow the trustee to
distribute the policy as he or she determines (but
not to the grantor). In addition to being
effective in removing life insurance death
benefits from an estate, irrevocable insurance
trusts also protect the policy proceeds from the
beneficiary’s creditors.
EXECUTOR AND TRUSTEE CHOICES
It has always been
important for CPAs to help clients select the
right fiduciary. While most clients typically
choose family members, a corporate executor or
trustee (such as a bank or trust company) may be
better suited to the task of selecting assets to
receive the limited step-up in basis after 2010.
But where family members often serve without
compensation, a corporate fiduciary will charge a
fee generally based on estate size. Unless
the decedent’s will provides specific directions,
executors will have to allocate assets among
different beneficiaries and decide which of those
assets will receive a step-up in basis using the
general and spousal allocations. Such decisions
will have important income tax ramifications. The
trustee’s basis decisions will also have an impact
on how much a beneficiary receives. An heir who
gets $10,000 of stock with a basis of $10,000 will
receive his or her full bequest. An heir who gets
the same amount of stock with a $1,000 basis could
lose nearly $2,000 to income taxes. If a
client decides to name a family member as executor
or trustee, the family member may wish to seek
professional advice from a CPA or attorney before
making these difficult basis choices. CPAs will be
able to identify any special income tax situations
and advise the executor accordingly. In some cases
the fairest decision the trustee can make is to
allocate the $1.3 million basis step-up equally
among the estate’s beneficiaries.
BE FLEXIBLE
Under the new law, a client could die in one of
three distinct periods: during the phaseout
through 2009, upon repeal in 2010 or after
reinstatement in 2011. Each period has different
rates and exemptions and, accordingly, different
planning needs unique to each client. Even if
Congress does permanently repeal the estate tax,
the need for good estate planning won’t end. The
issues will simply change. The effective
disposition of assets is the crux of estate
planning and will remain the central focus for
individuals, their CPAs and attorneys.
With the uncertainty in the 2001 act, CPAs
should advise taxpayers struggling with estate
planning issues to consider a variety of
strategies including: using a revocable document,
avoiding gift taxes, maximizing the use of
exemption amounts and using disclaimers. The best
advice CPAs can give clients during these complex
times is to remain flexible. In so doing, clients
will be ready for whatever news Congress may
bring—good or bad. |