There I was, enjoying the tranquility of Saturday morning, well before anyone else in the household had even begun to stir. A nice, hot cup of coffee was warming my hands by the warm glow of the fireplace. I know what happened next will, well, strike most of you as rather strange behavior. (I suppose it is.) Nevertheless, it is what we estate planning attorneys do from time to time in our idle moments.
Yes, even as large, fluffy snowflakes continued to fall on the white landscape outside our hearth room window - my mind drifted to thoughts about the current state of the federal estate tax (or lack thereof). I took another sip and mused to myself: "What kinds of estate plans are still okay (and perhaps not okay) in this federal estate taxless environment?" The answers shocked me, taking me nearly three days to recover to the point I could compose this posting. What follows is my stream of conscience. Read it if you dare.
First, a bit of background is in order. When there was a federal estate tax (as recently as 2009), there was a federal estate tax exemption. For example, last year the exemption was $3.5 million and the tax rate on the amount over that exemption was 45%. Married couples could maximize their estate tax protection by utilizing the exemptions of both spouses through certain trusts, oftentimes referred to as "A-B Trusts". Under such Trusts, assets in value up to the estate tax exemption commonly would be directed upon the death of the first spouse to a "B" (or "Bypass") Trust for the benefit of the survivor and descendants, and such exempted assets would later avoid inclusion in the estate of the surviving spouse. Thus, at the death of the surviving spouse, the assets attributed to the surviving spouse would utilize his or her estate tax exemption and the IRS would be disinherited up to the maximum extent permitted. Here is where it gets a little tricky.
There were several methods for directing assets to the "B Trust" upon the death of the first spouse. For simplicity, I will refer to one as the "Automatic" Estate Tax Plan approach and the other as the "Wait-and-See" Estate Tax Plan approach. Under the Automatic approach, a formula such as the "maximum amount of assets not subject to federal estate taxes" (i.e., up to the full exemption amount) would be channeled directly to the "B Trust" for the benefit of the surviving spouse and descendants. Under the Wait-and-See approach, the surviving spouse could "disclaim" any or all of the assets of the deceased spouse which, in a well-drafted Trust Agreement, would then be channeled directly to the "B Trust" for the benefit of the surviving spouse and descendants. Okay, if you are still with me, here is where it gets even a little trickier.
Even given the estate tax planning alternatives noted above, however, most married couples had no plans to utilize both of their available estate tax exemptions. Their estate planning typically consisted of joint ownership of assets, beneficiary designations to one another (e.g., life insurance and retirement funds), and possibly simple, Sweetheart Wills (i.e., each spouse made their surviving spouse the direct beneficiary). And this No Estate Tax Plan Plan could be very expensive. For example, say Dick and Jane had a $7 million estate when Dick dies. All assets passed to Jane with no federal estate tax at that time (i.e., thanks to the Unlimited Marital Deduction). However, since Dick and Jane did not have A-B Trust planning, the IRS inherited more than $1.5 million upon Jane's death (assuming a $3.5 million exemption in effect upon each respective death). Here is where it gets really tricky.
Since New Year's Eve 2010, there has been no federal estate tax. Zip, zero, nada. While that is all well to the good, that does not mean that there is no potential federal tax as a result of one's death. You see, under the laws in play when there was a federal estate tax, all property owned by a decedent enjoyed a "stepped-up basis" to the date of death fair market value. In other words, assume Dick and Jane owned a commercial building they purchased for $100,000 in 1970. Upon the surviving spouse's death in 2009, the building had an appraised value of $1,000,000. If their children inherited the building and sold it for it's appraised value that year, then they would keep the full $1,000,000. Problem: Under the law now in play, this stepped-up basis has been replaced by a "carryover basis". So, depending on the circumstances of their overall estate value and the estate plan Dick and Jane made (or failed to revise) these children may be liable for capital gains taxes upon the sale of the building... for its $900,000 in capital appreciation since 1970. Yikes! But wait, there's more.
Under the new federal estate taxless law, each taxpayer, whether single or married, may exempt up to $1.3 million from carryover basis. In other words, each taxpayer still gets a stepped-up basis upon death up to $1.3 million. In addition, if the deceased spouse leaves assets outright or in a QTIP Marital Trust (i.e., a Trust under which the survivor is the only beneficiary during his/her lifetime and such survivor must receive all of the income at least annually and no person has the power to appoint any part of the trust property to any person other than the survivor), an additional $3 million in assets may be "stepped-up" for capital gains purposes. Such assets are called "qualified spousal property". (See Code Secs. 1022(c)(3), 1022(c)(3)(A), and 1022(c)(3)(B). Are you ready for your head to start hurting? Oh, it already is. Okay, I'll wait continue while you go find some aspirin and water. When you return, read on.
Ironically, it turns out that under the new federal estate taxless law, the No Estate Tax Plan of Dick and Jane clearly maximizes their stepped-up basis protection. You see, the first $1.3 million is stepped-up at Dick's death, with an additional $3 million available for step-up because it passes outright to Jane. Then, upon Jane's death, up to an additional $1.3 million is stepped-up. Curiously, by having a No Estate Tax Plan, Dick and Jane accidentally maximize their overall federal tax protection (i.e., from capital gains taxation). This same result would be reached if Dick and Jane had made a "Wait-and-See" Estate Plan for federal estate tax planning plans. Why? Because all assets would have passed to Jane in a QTIP Marital Trust, subject only to her "disclaimer" to a "B Trust" for federal estate tax exemption purposes. Bottom line: Both the No Estate Tax Plan approach and the Wait-and-See Estate Tax Plan approach are okay in the present federal estate taxless environment. But what about the "Automatic" Estate Tax Plan approach described earlier? Danger, Will Robinson!
Recall that under the Automatic Estate Tax Plan approach a formula such as the "maximum amount of assets not subject to federal estate taxes" (i.e., up to the full exemption amount) channels assets to fund the "B Trust". Unfortunately, in the present federal estate taxless environment, the "B Trust" is neither an outright transfer to a surviving spouse, nor is it a transfer to a QTIP Marital Trust for a surviving spouse.* Bottom line: All of Dick's assets would be directed to his "B Trust" and only his guaranteed $1.3 million in step-up would be applied. This can be a very costly gotcha. What should you do, now that your eyes have been opened to this present federal tax law anomaly?
Have your estate plan thoroughly reviewed. Yesterday.
This subject matter is extremely complex and this posting is by no means an exhaustive legal treatise, as there are just too many moving parts.
Stay tuned. In future postings I will continue the Dick and Jane saga in the context of the return of the federal estate tax. How will their No Estate Tax Plan fare then, hmmm?
* Don't hold me to it, but it would seem the "B Trust" MAY QUALIFY for the $3,000,000 spousal basis increase as "qualified terminable interest property" and, then, ONLY IF (1) the surviving spouse is entitled to all of the income from the property, payable annually or at more frequent intervals, or has a usufruct interest for life in the property, AND (2) no person has a power to appoint any part of the property to any person other than the surviving spouse. (See Code Sec. 1022(c)(5)(B)(ii))At least such an approach may give you a fighting chance with the IRS.