Estate Planning After the American Taxpayer Relief Act of 2012

-Contributed by Heather K. Craig

At cliff’s edge, on New Year’s Day, 2013, Congress passed the “American Taxpayer Relief Act of 2012’’ (“ATRA”), which the President signed the next day.  What’s exciting is that many changes are labeled “permanent,” allowing greater certainty in planning, although, of course, permanence means only whatever future Congresses decide it means.

Here are some of the key provisions for estate planning:

$5 Million+ Exemption Retained.  The $5,000,000 indexed estate, gift, and generation-skipping transfer tax (“GST”) exemption is retained.  The 2013 exemption is $5,250,000, or $10,500,000 for a married couple.  Many estates will fall below this threshold, so many clients will now consider discarding complex tax planning from their estate planning.  Of course, there are many non-tax reasons for trusts and other components of estate plans, so each client must analyze the decision in light of tax and non-tax considerations.

Rate Increase.  The estate, gift, and GST top tax rate is increased from 35% to 40%.  For individuals whose estates (including life insurance death benefits) exceed $5,250,000, this increases the incentive to implement tax planning.

Portability and Other Changes Retained.  All of the other transfer tax provisions from 2011 and 2012 are extended permanently.  These include the lifetime gift exemption being the same as the death exemption, indexing of the exemption, and “portability”[1] of the exemption between spouses.

Other ATRA Provisions.  Additional provisions affecting estate planning include the following, all of which are stated to be permanent:

  • The top income tax bracket is increased to 39.6% for the portion of taxable income exceeding $450,000 for married couples and $400,000 for individuals;[2]
  •  The phase-out of personal exemptions and itemized deductions is reinstated for individuals with gross income in excess of new indexed threshold amounts;
  • The rates on qualified dividends and long-term capital gains are adjusted by adding new 15% and 20% brackets;[3]
  • Permanent alternative minimum tax relief is enacted by providing revised exemption amounts that are indexed for inflation; and
  • Miscellaneous extenders, including the ability to make certain tax-free distributions to charity from individual retirement plans (including IRAs) in 2012-2013, with special transition rules in light of the fact that this was not extended until after 2012 had ended.

Non-ATRA Matters.  ATRA provides a seemingly permanent and historically high, inflation-adjusted, and portable exemption amount.  Thus, concern over the volatility of federal estate tax for the majority of individuals is reduced.  However, it is important to keep in mind other valuable estate planning issues and opportunities, including the following.

Tennessee Inheritance Tax.  Although Tennessee repealed its gift tax in 2012, the state inheritance tax does not disappear completely until 2016.  Until then, the exemption increases annually from $1.25 million in 2013, to $2 million in 2014, to $5 million in 2015, and the exemption is not portable between spouses.[4]  Clients whose estates exceed these amounts should consider whether Tennessee tax planning may remain appropriate for the next three years.

Asset Protection and Divorce Planning.  The favorable $5,000,000+ exemption remains a good opportunity to implement (or to continue to implement) asset protection and divorce planning.  Clients can utilize irrevocable trusts, family partnerships, or LLCs as asset protection tools. Tennessee law specifically authorizes creation of “asset protection trusts,” where a transferor can retain access to both income and principal while insulating the trust assets from creditors.  Also, Tennessee allows trusts to be created for much longer duration than ever before, up to 360 years, allowing greater opportunities for creditor protection benefits for future generations.

Family Business Entities.  Family limited partnerships (“FLPs”) and limited liability companies (“LLCs”) will continue to be vital to manage and control assets, protect assets from creditors and irresponsible heirs, and more.  Even if the federal estate tax benefits decrease, these entities should remain the cornerstone of many estate plans because the asset protection and control benefits of LLCs and FLPs will continue to be useful regardless of the tax changes.

WHAT SHOULD CLIENTS DO?

We recommend that all clients:

  1. Review all tax planning to ensure it is up-to-date in light of this more stable planning environment.  Estate plans in wills and trusts that allocate assets based on formulas might become distorted or inappropriate in light of these new realities.  Even seemingly unrelated documents, such as powers of attorney that contain limitations on gifting powers, may be affected.
  2. Continue gifting.  Clients who failed to use the entirety of their gift and/or GST exemptions in 2012 still have the opportunity to do so in 2013 and beyond.  Moreover, clients can expect to acquire additional gift and GST exemptions in each new year.  Long-term, the permanent indexing feature of the exemption may have the most dramatic financial impact of the transfer tax provisions in ATRA.
  3. If any family members owe you money, consider gifts of cancellation of debt or restructuring of terms based on currently low interest rates.
  4. Review all non-tax aspects of planning, including asset protection, fiduciary appointments, and provisions of trusts you have established or of which you are a trustee or beneficiary.  As estate and inheritance tax concerns fade, give further thought to how your wealth should be managed for and ultimately released to your intended beneficiaries.
  5. Consider charitable gifts, the most tax-wise way to make the gift, and how this fits into your planning.

[1] Portability allows a surviving spouse to transfer the predeceasing spouse’s unused estate tax exemption amount to the surviving spouse. Note that an estate electing portability must file a federal estate tax return whether or not any estate tax is due.  Also note that the GST exemption is not portable between spouses, meaning that a married couple whose estate exceeds one exemption (currently $5,250,000) and who plans to provide significant gifts to grandchildren needs to plan for use of both spouses’ GST exemptions.

[2] Under existing law, an additional 3.8% net investment tax applies to investment income for taxpayers in the highest marginal bracket.  Thus, the top rate on ordinary income (interest, rents, and dividends) will be 39.6% + 3.8% = 43.4%.

[3] The top bracket is 23.8% if the net investment tax applies.  See footnote 2.

[4] A chart of the combined federal estate tax and Tennessee inheritance tax is available here.

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