This article discusses some strategies that married taxpayers can use to manage their estate tax liability by creating certain types of trusts. During the past 10 years, the federal estate tax has not been a major concern for most family financial planners because of the high lifetime exemption ($12.06 million for individuals and $24.12 million for married couples in 2022), which exempts a vast majority of clients from its reach. But as of this writing, with possible tax reform ahead, tax planners are uneasy because they cannot estimate with reasonable certainty how much estate tax a client family could be facing (if any at all).
Tax professionals are fully aware that certain changes in the estate tax are already scheduled to happen because the sunset provision of the 2017 law known as the Tax Cuts and Jobs Act (TCJA), P.L. 115-97, calls for the lifetime exemption per individual to be dramatically reduced to $5 million (adjusted for inflation) in 2026. But the sunset provision might be only the beginning of a slide toward more dramatic increases in the estate tax — in one form or another.
At the time this is being written, proposals to further increase death taxes in the near term have been widely publicized. There have also been calls to raise capital gains and other taxes and (worst of all for taxpayers) eliminate basis step-up for appreciated assets now permitted under Sec. 1014. These proposals give rise to much uncertainty for estate planners, who would prefer to have clearer answers about what changes might lie ahead before they modify anything with their clients' estate plans.
Planning an estate with all the unknowns about increasing estate taxes
Over a decade ago (before the era of super-high exemptions) taxpayers were eager to take advantage of a wide variety of strategies to minimize the value of their estate assets and their tax liability. These included tactics such as aggressive lifetime gifting to family members, discounting of minority interests, and, most significantly, a wide variety of creative trusts. The good news is that these strategies are generally still available today.
However, like everyone else, married taxpayers have been putting off revising their overall estate plan because of the unknowns about the size of the lifetime exemption and whether they will be subject to estate taxes at all. And many married couples have chosen to keep estate planning and their wills as simple as possible. They often feel that it is sufficient to simply name their spouse as the beneficiary and, wherever possible, title their assets jointly, as joint tenants with rights of survivorship in accordance with the laws of their state. They often think that this is adequate for a good estate plan because of the unlimited marital deduction, which permits a taxpayer to pass assets to a surviving spouse and remain free from estate taxes (as long as the spouse is a U.S. citizen) (Sec. 2056).
However, some married clients need to be reminded that the unlimited marital deduction for assets that go to a surviving spouse merely defers estate taxes, it doesn't avoid them. During a transitional period like the present one, passing all your assets directly to your spouse could be a big mistake. For one thing, the surviving spouse's estate will include all the property that was transferred from the first spouse. Second, the surviving spouse's estate may be subject to higher taxes in view of proposed new tax legislation. Third, and most important, unless an estate tax return is prepared making the portability election, any unused lifetime exemption from the first spouse could be lost forever.
Searching for a better option rather than passing all assets 'directly' to your spouse
Despite all the unknowns about higher estate taxes, married taxpayers still have options that could minimize their overall tax burden. Because they have two full lifetime exemptions, it is often a good idea to have a trust drafted under an attorney's guidance that would serve to preserve the full value of both lifetime exemptions. To accomplish this, many advisers have found that a regular bypass trust can be a married couple's best choice. However, others have found that planning for portability may be a better, and easier, alternative for preserving both lifetime exemptions.
First, a closer look at a regular bypass trust
The popular bypass trust (also known as the credit shelter trust) is funded after the first spouse's death. Funding is generally required by a preset formula, or dollar amount. Rather than passing estate assets directly to the surviving spouse, the objective of the bypass trust is to provide for the spouse's needs for life. The trust will continue to hold the assets (separate and apart from the estate of the surviving spouse), and the assets will later be distributed to the named beneficiaries after the death of the second spouse.
What are the advantages of a traditional bypass trust?
A traditional bypass trust has often been considered the best tax-saving strategy for married couples, and this was especially true in the era when lifetime exemptions were low. Its main advantage is that it provides a simple way to ensure the maximum use of the full exemption of both spouses. However, bypass trusts offer at least three additional benefits that should not be overlooked:
- Assets in the bypass trust can appreciate further in value and not be included in the surviving spouse's estate. In times of rising prices and inflation, this feature can be invaluable when estate assets have significant growth potential (like real estate, business interests, and high-growth stock).
- Assets held in the trust will generally have asset protection from creditors of the surviving spouse and children — as long as the assets remain in the trust.
- The trust provides control and assurances that the assets will go to the children and other beneficiaries as intended and, at the same time, protects against the possibility that a surviving spouse may seek to redirect assets to nonintended beneficiaries.
What about portability rather than a bypass trust to preserve 'both' lifetime exemptions?
This is a question that is being raised more frequently as estate planners are learning that portability can, in many cases, be a simpler and more efficient way to maximize the benefits of the two lifetime exemptions. Section 303 of the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010, P.L. 111-312, indicates how easy it can be to elect portability to preserve the exemption of the first estate. This is confirmed in the instructions for Form 706, United States Estate (and Generation-Skipping Transfer) Tax Return, which state that the election can be made to preserve any unused exemption by simply "timely filing a complete Form 706" for the first estate — whether or not a tax return is actually required.
Of course, many will bristle at the thought of having to file a tax return when it is not required by law. However, the cost and effort needed to prepare a federal estate tax return should be weighed against the potential estate planning benefits with the help of a tax professional. Some will be surprised to learn that the cost of preparing a tax return could be minuscule when compared to the enormous estate tax savings that can be achieved by a surviving spouse when a second lifetime exemption (upwards of $12 million) is preserved.
Advantages of portability over a regular bypass trust
Aside from being another effective way to preserve the full lifetime exemptions, there are other reasons some surviving spouses may prefer portability over establishing a bypass trust. These include:
- Electing portability avoids the costs associated with creating, funding, and administering a bypass trust, as well as the requirements for trust accounting and filing annual tax returns, etc.
- If portability is elected, the assets in the surviving spouse's estate will generally be allowed a second step-up in basis for federal income tax purposes. Conversely, if the assets had been put in a regular bypass trust, basis step-up would be allowed only one time, upon the first spouse's death.
At the time of this writing, there is too much uncertainty regarding potential tax changes for married taxpayers to be able to confidently choose their best overall planning strategy. The bypass trust and portability appear to be the two leading options available to minimize their estate tax. However, to be able to choose between them, much guesswork is needed because of the two huge unknowns mentioned earlier:
- What will the amount of the federal estate tax and lifetime exemption be?
- Will the basis step-up be eliminated, which would increase liability for capital gains taxes?
Enter the marital disclaimer trust
For some couples, a wait-and-see strategy might be best. When having their wills prepared, married taxpayers may wish to ask their attorney how to cover all their bases in view of the current uncertainties involving the tax code and estate taxes. They might ask if there is a way to wait until later, when more information is available, before having to choose between:
- A bypass trust plan;
- Portability; or
- Simply having all assets pass directly to the surviving spouse.
Put another way, some married taxpayers might prefer to delay choosing among these options, reasoning that a high estate tax exemption would make the need for trusts unnecessary.
For clients such as these, a marital disclaimer trust could be a top choice because of the flexibility that it provides. Most important, a disclaimer trust strategy will give the surviving spouse the ability to wait for a better time to decide if it would be advantageous to disclaim asset ownership and permit the implementation of a trust. Assets in a disclaimer trust are typically held separate and apart from the surviving spouse's estate. And, as with a regular bypass trust, any remaining assets and any increase in their value after the first spouse's death will pass tax-free to the remaining beneficiaries.
As with a regular bypass trust, a marital disclaimer trust also makes it possible to achieve major tax savings by ensuring the maximum benefits of both lifetime exemptions. But, unlike the regular bypass trust, funding does not require a preset formula or dollar amount.
Choosing between a traditional bypass trust and a marital disclaimer trust
Despite the popularity of the marital disclaimer trust, many will argue in favor of the regular bypass trust because of the added control that the first spouse has over the assets and their ultimate distribution to the designated beneficiaries.
Many married taxpayers will wind up choosing the marital disclaimer trust because of its flexibility and the ability of a surviving spouse to decide, later, if a trust will be needed to serve the family's best interests. If they decide on this type of trust, however, they should be aware that when disclaiming assets in an estate, there are certain rules to follow to minimize federal estate or gift taxes. These rules are set forth in Regs. Sec. 25.2518-2 and should be discussed with a tax professional. First and foremost, a disclaimer by the surviving spouse must be irrevocable and unqualified. And, in general terms, the other key requirements are:
- The disclaimer must be in writing;
- The writing must be delivered to the appropriate representative within nine months of the date on which the transfer creating the interest in the disclaimant is made;
- The disclaiming party (surviving spouse) must not have accepted the property interest that is being disclaimed or any of its benefits; and
- The deceased spouse's will must contain provisions for the marital disclaimer trust.
Failure to meet all the requirements for a disclaimer could have unfavorable tax consequences. A nonqualified disclaimer could cause the surviving spouse to be deemed to be the party making the transfer, by way of gifts, to the successor donees. This would not only upset the trust strategy plan, but it would also lead to gift tax reporting and requirements to file Form 709, United States Gift (and Generation-Skipping Transfer) Tax Return.
This article has focused on certain important estate planning concepts. Besides the trusts discussed above, a variety of other strategies can be used by married couples, too, of course. Because of the uncertainties that lie ahead involving potential changes to the tax code, married taxpayers should seek professional guidance before choosing an estate planning alternative. More than ever, they need to be made aware of the potential risks and rewards — whether these involve federal estate tax or capital gains tax — that come with various planning strategies.
About the author
Thomas J. Stemmy, CPA, CVA, E.A., is president/managing partner of Stemmy, Tidler & Morris PA in Annapolis, Md. To comment on this article or to suggest an idea for another article, contact Dave Strausfeld at David.Strausfeld@aicpa-cima.com.
"The Grantor Trust Rules: An Exploited Mismatch," The Tax Adviser, Nov. 2021
"Recent Developments in Estate Planning: Part 2," The Tax Adviser, Nov. 2021
"Recent Developments in Estate Planning: Part 1," The Tax Adviser, Oct. 2021
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