January 2011

Interpreting the New Federal Estate Tax Law Changes for 2010, 2011, and 2012: Opportunities and Considerations

Despite the amount of your wealth, proper estate planning remains essential; even in light the new Federal Estate tax law changes. This article will discuss the new Federal Estate tax laws, compare and contrast the Federal rules with the existing Massachusetts estate tax laws and will discuss the many non-tax reasons why estate planning remains vital.

The New Federal Estate Tax Laws

New Exemptions and Top Tax Rate

On December 17, 2010, Congress enacted a new tax law, which raises the Federal estate tax exemptions to $5,000,000 per person ($10,000,000 per married couple) for estates of decedents who die in 2011 and 2012. The new law reunites the Federal and gift tax exemptions (the amount of funds that one can gift or leave to non-spousal beneficiaries) to $5,000,000 per person during one’s lifetime. Previously Federal law only allowed a $1,000,000 lifetime gift exemption, but at times a larger estate tax exemption.

Congress also lowered the tax rate on gifts and inheritances to non-spousal beneficiaries in excess of $5,000,000 to 35%, down from 55%. The new law also increases the Federal generation skipping transfer tax exemption (the amount that you can leave to your grandchildren and great grandchildren) to $5,000,000 per person.

The new exemption amount and tax rate under the new law are in effect, however, for only two years. Then Congress will need to act again to determine the exemption amounts in future years, otherwise the exemption will automatically revert back to $1,000,000 per person in 2013 with a top estate tax bracket of 55% plus 5% for very large estates.

New Federal Law for Estates of Decedents Who Died in 2010

Prior to the enactment of this new law, the Federal estate tax law had been repealed for estates of individuals who died in 2010. In place of the Federal estate tax in 2010, the Federal law allowed a limited partial basis step up on inherited assets of $1,300,000 for capital gains purposes with an extra $3,000,000 basis step up for assets which pass to a surviving spouse, or in a special trust for the benefit of a surviving spouse.

Under the new law, for estates of decedents who died in 2010, the Executor of the estate can now elect out of the new law, to apply the old law (with no estate tax on the assets, but they receive limited basis step up in the hands of the heirs as set forth above), otherwise the new law will apply. If the Executor chooses to apply the new law retroactively to the 2010 estate, then $5,000,000 of assets can pass estate tax free to non-spousal beneficiaries with a top estate tax bracket of 35% on assets that pass in excess of that amount. Also, the inherited assets received by the heirs will have a “ fully stepped up” basis for capital gains purposes. This means that the inherited assets, in most cases, will have a new basis equal to their date of death value for capital gains purposes going forward.

Unscrambling the New Federal Estate Tax Rules

Certainly all of these tax law changes are confusing. They can make your head spin! But what do they really mean for you?

It is important to note that these are changes only apply to the determination of the Federal estate tax law. These changes have no application to the law currently in effect for taxing estates of individuals domiciled in Massachusetts . The Massachusetts estate tax laws, discussed below, remain unchanged by the new Federal law.

So, in light of the new Federal Estate tax law changes, is it time to throw out that big stack of estate planning documents sitting in your dresser drawer? With these new super large exemptions at the Federal level, do we still need our estate planning documents any more? The answer is, as you would expect: you still need to to have a properly drafted estate plan. Don’t dispose of the documents just yet!

The good “old-fashioned” reasons why one should have an estate plan are still viable, and some of these considerations will be discussed in this article.

While it is true that Congress just passed a big break for wealthy families this does not mean that you, if you have modest assets, do not require an estate plan. For those individuals who are fortunate to have a significant amount of assets, the new law opens up a variety of estate planning opportunities.

It is important to remember that the new Federal estate tax exemptions are only in effect for two years. So when the next Presidential election rolls around, just two short years from now, given the skyrocketing Federal budget deficit and the increasing pressure to raise revenue, the appropriate amount of the Federal estate tax exemption may continue to be a hotly contested issue for 2013 and beyond. One cannot guarantee that the Federal gift and estate tax exemptions will remain at $5,000,000 per person two years from now. Most likely, however, they will. But even so, good quality estate planning is important for other reasons.

The Differences Between the Massachusetts Estate Tax Law and the New Federal Estate Tax Rules

If you live in Massachusetts, the maximum exemption for assets that can be left to non-spousal beneficiaries (your kids, friends and grandchildren) is limited to $1 million dollars per person (not $5,000,000 - the new Federal exemption amount). Assets left to children upon the death of the surviving spouse, are still taxed at the rate of approximately 11% in excess of the $1,000,000. So, Massachusetts couples will still benefit from a traditional two trust estate plan to double the Massachusetts estate tax exemption to the $2,000,000 figure (each trust will qualify for up to $1,000,000 of exemption). The new law may cause more Massachusetts residents to establish their new domicile outside of Massachusetts, in other states that have “more friendly” estate tax rules, to escape the Massachusetts estate tax bite.

The value of your real estate, other savings and investments and your life insurance death benefits if not properly owned, will be counted as part of your gross estate to determine if you exceed the $1,000,000 exemption amount in Massachusetts. So proper estate tax planning still remains crucial for Massachusetts residents because the $1,000,000 exemption is not as large as first appears.

Portability of the Unused Federal Estate Tax Exemption: A New Concept

The new Federal estate tax law also introduces a new concept of “portability”, previously unavailable in the prior Federal estate tax law, applicable to an estate of a married individual who dies in 2011 or 2012. Now, if the first deceased spouse fails to use the full amount of their $5 million exemption at their death, the new Federal Estate tax law provides that the Executor of the estate of the surviving spouse can now apply the unused portion of the deceased spouse’s $5,000,000 exemption, to the Federal estate of the surviving spouse. So if the first spouse to die only used $3,000,000 of their $5,000,000 exemption, the surviving spouse’s estate can leave $7,000,000 of assets to kids without causing a Federal estate tax ($2,000,000 of their spouse’s unused exemption plus their own $5,000,000 of exempt assets (for a total of $7,000,000)). But the new law also states that you can’t stack multiple unused exemptions from many prior deceased spouses. Only the unused exemption from your most recent deceased spouse you were married to when he/she died can be used to shelter assets in your estate. So the portability of a prior deceased spouse's unused exemption can be lost if you remarry.

But, the Federal generation skipping tax exemption of $5,000,000 per person is not “portable” between spouses. This may or may not be a technical error in the new law.

Planning Tips:

Even though the exemption is portable on the Federal level, for wealthy couples, it is still wise to establish a two-trust plan which funds the first $5,000,000 of assets into a special trust that qualifies for the full $5,000,000 exemption, at the first spouse’s death (and not rely on portability). This is because the $5,000,000 in the trust of the first spouse to die will continue to appreciate between the first and second spouse’s death with proper investment, and the appreciated amount of the first spouse’s trust is also exempt from being counted as part of the surviving spouse’s estate, not just the original $5,000,000.

It is important to remember, however, that no such concept of “portability” of unused exemptions from one spouse to the surviving spouse, exists in Massachusetts estate tax law. For Massachusetts residents, if the first spouse does not fully utilize their full $1 million dollar exemption at their death, the unused portion of the exemption will be permanently lost in the surviving spouse’s estate and will not be carried over from the first to the second spouse’s estate as under the new Federal law.

However, like the Federal law, the first $1,000,000 set aside in a special trust upon the first spouse’s death for a Massachusetts resident , can continue to appreciate in value between the first and the second spouse’s death, and the original $1,000,000 plus the appreciation on the $1,000,000 will not be taxed in the surviving spouse’s estate on his/her death for Massachusetts estate tax purposes.

So once again, it is vital that our Massachusetts clients with assets in excess of $1,000,000 keep in place, at least for the foreseeable future their double trust arrangement, as part of their existing estate plan. In this manner, each spouse’s estate can fully utilize the benefit of their $1,000,000 estate tax exemptions.

The New Law and Irrevocable Life Insurance Trusts

Many will question whether they still need their irrevocable life insurance trusts any longer. The answer, in most cases is yes---keep the irrevocable trust(s) in place. Under the new Federal estate tax law and also under state estate tax law, the irrevocable life insurance trust, if properly drafted and maintained remains a viable vehicle to exclude life insurance death proceeds out of the estates of a decedent and their surviving spouse. Without this vehicle, it is easy for the size of one’s estate to exceed the $1,000,000 Massachusetts estate tax exemption upon the death of the surviving spouse, because the life insurance death benefit(s), if you own your own life insurance policy(s) will be counted as part of your total gross estate both for Federal and Massachusetts estate tax purposes and will be subject to estate tax.

Non-Estate Tax Reasons for Completing Estate Planning

There are many reasons for completing your estate plan other than to save estate taxes. It is popular myth that you don’t need estate planning if you are not wealthy.

Trusts continue to provide asset protection for beneficiaries under a variety of circumstances. Assets funded into trust also avoid probate in multiple jurisdictions. Trusts also provide structure and a predetermined plan for your assets to be properly invested, managed and eventually distributed in an orderly fashion to your children, grandchildren, friends and/or other beneficiaries after your death.

Trusts can also be established to hold assets to protect a child with disabilities and special needs to protect the child as he or she becomes an adult.

A durable power of attorney is a must for any individual who has any level of assets. In the event of your disability, a durable power of attorney allows another to control your financial matters without the necessity of having to go to probate court to have a guardian and/or conservator to manage assets on your behalf. These are often costly and invasive proceedings and often involve the courts in your private life.

A living will/health care proxy enables another to make medical decisions for you, if you are unable to communicate them yourself, and also sets forth your feelings regarding extended life support.

Young couples with children need an estate plan and trust to protect their minor children (sometimes funded with life insurance) to create an estate if there is a premature death of both spouses. Young couples often do not have significant assets. This technique assures that there will be plenty of funds around to raise the children and to send them to college. Their Wills may also nominate the guardians to take care of their children if they are no longer around to do so.

Retirement savings in IRAs, pensions and 401(k)s need proper estate planning, so that these hard earned assets reach the right people, at the right time during your lifetime and after your demise.

The above situations illustrate that you do not have to be rich to require a comprehensive estate plan.

Re-examination of Existing Estate Plans in Light of the New Federal Estate Tax Laws

The new Federal law does suggest that individuals should reexamine their existing estate plans and, in some situations modify the plan to take advantage of the opportunities presented by the new law and also to make certain that these new rules do not cause unintended consequences. If you have moved to Massachusetts from another estate or have not updated your estate plan for some time, now is a good time to have the plan reviewed.

The new Federal rules make gifting of significant assets to loved ones much more attractive (at least for the next two years). A properly structured gift, that also takes into account the capital gains and Medicaid planning rules, may save your loved ones significant Massachusetts and Federal estate taxes and preserve assets. For wealthier clients with appreciating assets, the law preserves some techniques to pass wealth to your children with minimal or no gift tax cost, in limited situations, that may be applicable to your particular circumstances.

Every family’s situation is different, and we anticipate that our clients will have many questions about the new law. With change comes opportunity. We are available to meet with you to discuss how the new laws affect you and your loved ones.

The Federal estate tax laws may have changed, but your need for quality estate planning remains as important as ever. Only sound planning can bring peace of mind.