Estate Planning Beyond the “Fiscal Cliff”

Peter A. Rivellini

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Well, here we are, at the beginning of April, and the dust is settling on the other side of the dreaded “Fiscal Cliff.”  Although our President did not change this year, the tax landscape sure did.  Many people took steps last year to get ready for 2013.  Now that we are here, we should take some time to look back at the 2012 planning as well as to look forward to what the new tax laws have in store for everyone.

Looking Back: 2012 Planning

During the 2012 calendar year, Americans enjoyed a record-high estate, gift and GST tax exemption amount of $5,120,000.  Unfortunately, the dysfunctional tax laws on our books had the exemption amount dropping to a mere $1,000,000 at the end of 2012.  Like many prudent taxpayers, several of you took measures to lock in the higher 2012 exemption amount for fear of losing it.  Several set up irrevocable gifting trusts, while some couples set up separate trusts for each spouse. Many took advantage of the trust laws in jurisdictions outside of Florida.

Before we get ahead of ourselves, it is important to identify the steps that should be taken in order to finish the 2012 planning.  The basic steps include:

  1. Ensure that the funding of the trust was memorialized in writing.
  2. Make sure your accountant is familiar with your trusts and provide him or her a copy of the trust agreement.
  3. Discuss with your accountant the filing of the IRS Form 709 Gift Tax Return, which is due at the same time you file your 2012 personal income tax return.
  4. If you gifted real property, an interest in a closely held business or other assets that are difficult to value, you will need to have your property appraised and attach the appraisal to your gift tax return.
  5. Consider whether any GST Exemption should be allocated to the trust, or to other gifts made during 2012.
  6. If you are married, consider whether you should gift split with your spouse, which requires filing separate gift tax returns for each spouse.
  7. Make sure a bank account is established for each trust.
  8. Educate your trustee about his or her responsibilities regarding the administration of the trust.

These steps are not exclusive.  An irrevocable trust is not a document that can just be signed and stuck in your desk without further thought.  On the contrary, an irrevocable trust requires regular monitoring, administration and consideration of further refinements and changes.

American Taxpayer Relief Act of 2012

Congress and the President reached an agreement in early January and enacted the American Taxpayer Relief Act of 2012 (“ATRA”), which permanently extends the Tax Act provisions of 2001 and 2003.  In 2010, Congress extended the provisions for an additional two years. ATRA extends most of the provisions indefinitely with a few modifications.  The major changes enacted as part of ATRA are as follows:

Estate/Gift Tax

  1. The estate and gift tax applicable exclusion amount was increased to $5,250,000, adjusted for inflation.
  2. Portability of a deceased spouse’s unused exclusion amount for estate and gift tax remains permanent.
  3. The generation skipping transfer exemption amount remains at $5,250,000.
  4. The maximum rate for estate, gift, and generation skipping transfers increases from 35% to 40%.
  5. Unrelated to ATRA, in 2013 the annual gift tax exclusion increased from $13,000/donee to $14,000/done, and the amount of the annual gift tax exclusion for gifts to non-citizen spouses increased from $139,000 to $143,000.

Income Tax

  1. If your income is above $400,000 filing individually or $450,000 filing jointly, your ordinary income tax rate will increase to the 39.6% maximum tax bracket. Ordinary income tax for other individuals remains the same.
  2. Dividends remain taxed at long-term capital gains rates as opposed to ordinary income rates.
  3. The long-term capital gains rate is 0% if your ordinary income is taxed at 15% or lower, 15% if your taxable income is below $400,000 filing individually or $450,000 filing jointly, or 20% if your income is above $400,000 filing individually or $450,000 filing jointly.
  4. Certain itemized deductions, including deductions for mortgage interest, property taxes, state and local taxes and charitable contributions, will be reduced if your income is above the threshold of $250,000 filing individually or $300,000 filing jointly. The itemized deduction is reduced by 3% of the excess of your adjusted gross income (AGI) over the threshold amount, but not by more than 80% of the total itemized deductions. The personal and dependency exemptions are reduced by 2% for every $2,500 or part thereof of the excess of your AGI over the threshold amount.
  5. Unrelated to ATRA, a 3.8% Medicare surtax is imposed on your investment-like income and a 0.9% tax is imposed on your total income if your modified adjusted income is above $200,000 filing individually or $250,000 filing jointly.
  6. The 2% payroll tax cut for employees was not extended.
  7. The alternative minimum tax exemption amount is now $40,400 if filing individually and $80,800 if filing jointly and will now be indexed for inflation in future years.
  8. Various other itemized deductions were extended through 2013.

Retirement Assets

  1. Retroactive to 2012, if you are over 70½, you may now make qualified charitable distributions from your IRA of up to $100,000.
  2. Direct rollovers from your 401(k), 403(b) and 457(b) plans can now be rolled into a ROTH IRA, and such rollovers are now even easier as most of the timing limitations are eliminated.
  3. While ATRA addresses quite a few items, many of the President’s budget proposals involving transfer tax-related items were not resolved.  Certain transfer tax-related items and other revenue-raising provisions may very well be addressed in future legislation on tax reforms. A few of the substantial transfer-tax related items that might be addressed are:
  4. Changing the treatment of Intentionally Defective Grantor Trusts (IDGTs). IDGTs currently allow a grantor to place assets in a trust excluded from his gross estate while allowing the grantor to pay the tax on the trust’s income. The President’s proposal would include the assets in the grantor’s estate, and would subject them to estate tax. Additionally, distributions from an IDGT would be subject to gift tax, and if the trust ceases to be a grantor trust, the remaining assets would be subject to gift tax as well.
  5. Changing the Grantor Retained Annuity Trust (GRAT) rules. Additional requirements of a ten year minimum term, a remainder interest greater than zero, and an annuity amount that cannot decrease in any year during the term, may be imposed on GRATs.
  6. Eliminating some of the valuation discounts for closely-held entities.
  7. Limiting the duration of the GST exemption to 90 years for new trusts and additions to preexisting trusts.

Looking Forward: 2013 Planning
There are many issues to consider given the changes of ATRA coupled with the potential changes that may come in future legislation.  Among the most important issues are the following:

  • Changes to 2012 Plans: In light of the permanency of the exemption amounts, we may have breathing room to button up the plans that were set in place in 2012.  In many cases, it may be possible to modify the 2012 plans despite the fact that irrevocable trusts were used.  For example, in Florida, our decanting statute allows a trustee to use his or her discretionary power to distribute the trust property to a second trust containing different terms, so long as the second trust does not contain any new beneficiaries that were not included in the first trust.  Another type of modification would be where a beneficiary disclaims (i.e., refuses) some or all of the assets given to an individual or to a trust, which would cause the assets to be redirected. Florida also allows a trust’s beneficiaries and trustee to judicially modify the trust terms if such modification is in the best interest of the beneficiaries or would effectuate the settlor’s intent in creating the trust.
  • Changes to Existing EP Documents:  Regardless of the steps you took in 2012, you will want to review any wills, revocable trusts, or ancillary documents to ensure that your overall estate plan is cohesive. Many estate planning documents were prepared when the exemption amount was much less than the current $5,250,000.  In a typical marital/residuary trust document, this would mean that the first $5,250,000 would be distributed to the nonmarital residuary trust (or to the non-spouse beneficiaries), leaving only the balance for the spouse.  Accordingly, the permanent exemption amount could lead to unintended negative results.
  • GRATs:  The current low asset values and interest rates make 2013 a good time to think about creating a short-term GRAT before any of the previously-mentioned proposals are enacted. A GRAT distributes to you a fixed amount from the trust for a period of years. If the annuity you receive is equal to the amount you transferred to the GRAT, plus interest, anything left in the GRAT at the end of the term of years will be a gift to your beneficiary without gift or estate tax. For instance, if you transfer $1,000 to a five-year GRAT with a fixed interest of 5%, you would receive five yearly payments of $210, totaling $1,050. If the Trust assets had appreciated to $1,200, you would have made a tax-free gift of the appreciation, or $150.  However, if you die during the term of years, the trust assets and their appreciation are subject to estate tax. Currently, GRATs may be as short as two years, which mitigates the risk of dying during the term. A series of consecutive short-term GRATs, such as five consecutive two-year terms comprising an overall ten-year period, is known as a Rolling GRAT. Death during the overall Rolling GRAT period will not undermine the benefits of any of the prior two-year GRATs that have already terminated. This technique helps avoid the risk of market fluctuations and any exceptionally performing two-year period would not be weakened by a lesser performance during any other two-year term, because each GRAT operates independently. But these short-term GRATs may be the target of new restrictive reforms. This shrinks the window to take advantage of such techniques.
  • Gifts to IDGTs:  IDGTs are tax-efficient because the trust allows the grantor to pay the income tax, which essentially makes a tax-free gift of that amount from the grantor to the trust. But creating an IDGT after any of the previously mentioned reforms would subject your IDGT to additional gift and estate tax, nullifying the benefit of placing the assets in a trust. While the benefit of paying the income on the current IDGTs may not seem impactful, the dollars add up over time and allow a substantial tax-free gift. It is for this reason that the budget proposals would attempt to modify the current IDGT law. Consider a gift to an IDGT in 2013 before any of the President’s proposals are implemented and the benefit of paying the income tax on your trust is negated.
  • Sales or Loans to IDGTs:  A sale to an IDGT is similar to a GRAT; if the assets in an IDGT appreciate faster than the interest rates, the difference will be a gift to your beneficiary without estate or gift tax. The assets can be sold to the IDGT for a percentage of the assets’ value and a promissory note for the balance, or, the assets may be loaned to the trust and paid back over time with interest. In either case, any return earned by the trust from investing the assets that is greater than the amount needed to pay the interest on the loan or promissory note is a tax-free gift to the trust’s beneficiaries. Consider either option while the interest rates are low and investments on the trust will likely surpass the interest owed.
  • Swapping Assets with IDGTs:  If you previously sold or transferred an asset with a low-basis to a grantor trust, consider repurchasing or swapping the asset in exchange for a different asset of equivalent value with a higher basis. By swapping your high-basis assets for the trust’s low-basis assets, the-low basis assets can be included in your estate and become eligible for a step up in basis at your death. If a loss asset is owned outright, consider reacquiring one or more low-basis assets from the trust by substituting the loss asset.  This way, the loss is preserved in the trust. A separate, but important, benefit of the power to substitute property with a grantor trust is to control cash flow, by substituting assets into or out of the trust depending on your cash needs. Remove the cash-flowing assets if you need the income or transfer the cash-flowing assets to the trust to further reduce your taxable estate.
  • Use Excess Exemption Amount:  Consider making gifts in the coming year to take advantage of the high exemption amount. Even if all of your exemption was used last year, there is an additional $130,000 exempt from gift tax in 2013 because the exemption is indexed for inflation.  This makes it possible to implement some of the above techniques without additional gift tax.
  • Make Taxable Gifts:  Consider making lifetime taxable gifts. Lifetime taxable gifts cost less than post-mortem gifts because the tax paid on the post-mortem gift is itself subject to tax. Lifetime gifts further allow any appreciation on the asset to be gifted without tax. While some states have a state estate tax, most do not have a state gift tax. Lifetime gifts are therefore preferable to post-mortem gifts. Florida currently does not have either a state gift or state estate tax.
  • Charitable Giving: Consider a Charitable Lead Annuity Trust. Similar to a GRAT, the annuity is paid to a charity instead of to you. Again, at the end of the term of years, whatever is remaining will be transferred to your non-charitable beneficiaries. Consider making a charitable distribution from your IRA or gifting appreciated assets directly to a charity to avoid any capital gains and Medicare surtax you would otherwise have to recognize on a sale of the asset.