By:  Heinz Brisske

Estate planning has truly evolved over the past 20 years. Gone, for now, is the uncertainty about the federal estate tax exemptions. It may no longer be required for all married couples to use trusts to minimize these taxes. For most families, income taxes are a more important and more immediate concern than estate taxes, and planning for basis step-up and lower capital gains taxes have become a relevant concern.

Also gone is “simple” planning for the “traditional” family; it can certainly be argued that “traditional” is an evolving term when it comes to estate planning. Major planning goals beyond estate taxes for many families, even traditional families, include protecting and preserving assets from creditors, from divorcing spouses, and from non-financially disciplined children and other heirs, as well as providing a family legacy rather than a quick-fix distribution without regard to its consequences.

In this article you will learn why estate planning has become more complicated, and what you need to do now to insure that your estate plan is flexible enough to roll with the changes.

Warning: Estate Planning Today is Harder Than Ever Before
In 1995 the federal estate tax exemption was only $600,000 and the estate tax rate was 55%. Back then it was easy to accumulate a taxable estate by simply owning a home, a few investments and some life insurance. And while married couples could pass on two times the exemption ($1.2 million) free from estate taxes if they incorporated Marital/Family Trusts into their estate plan, these trusts came with strings attached. Yet these inflexible trusts were worth it to avoid the hefty 55% tax on assets valued over $600,000.

Fast forward 20 years and in 2015 the federal estate tax exemption is a whopping $5.43 million and will continue to increase annually based on inflation. In addition, between 2002 and 2013 the federal estate tax rate dropped from 55% to 40%. On top of the generous exemption and lower tax rate, married couples can now combine their estate tax exemptions and pass on two times the threshold ($10.68 million) without Marital/Family Trust planning by making the portability election.

Thus, today the focus of estate planning has shifted away from estate tax planning to more relevant concerns:

  • While the federal estate tax rate has declined from 55% to 40%, since 2012 the top federal income tax rate has increased from 35% to 43.4% and the top long-term capital gains rate has increased from 15% to 23.8%. This has made minimizing income taxes an integral part of estate planning.
  • Today many families are blended, dysfunctional or completely estranged. We live in a world of constant change, both personally, financially and politically. These factors have made flexible estate planning and finding ways to modify what was thought to be an irrevocable plan the “new normal.”

Preserving and protecting assets for your descendants or other loved ones, and creating a family legacy, one that will survive you and will potentially impact multiple generations, is gaining traction and replacing the emphasis on tax planning.

Estate Planning for the “New Normal” – Minimizing Income Taxes, Maintaining Flexibility and “Changing” Irrevocable Plans
Under a traditional Marital/Family Trust plan the goal was to exclude the Family Trust assets, including all appreciation, from the surviving spouse’s taxable estate. While the Family Trust assets would not receive a step up in basis, this type of planning made sense since the top estate tax rate of 55% dwarfed the top capital gains rate of 15%.

Today with the generous and ever-increasing estate tax exemption and “portability” of the exemption available to married couples, it is estimated that 99.8% of Americans will have no federal estate tax exposure. As a result, traditional Marital/Family Trust planning is no longer a necessity for the majority of families. In fact, an older Marital/Family Trust plan will lead to income tax liability for heirs since the assets of the Family Trust will not receive a step up in basis.

Therefore, instead of planning for excluding assets from the taxable estate, the new trend for couples with less than $10 million is to plan for estate inclusion so that their heirs will receive a basis step up. This can be accomplished in a number of ways:

  • Leaving assets outright to your spouse and making the portability election; but beware if your spouse is a spendthrift, has creditor issues, or if you want to insure your assets stay within your bloodline.
  • Taking a wait-and-see approach, such as all to the Family Trust with the ability to disclaim to the Marital Trust or vice versa.
  • Including flexibility in the Marital Trust provisions.
  • Using a Family Trust but allowing for basis increase through a customized power of appointment.

Portability: Is It All It’s Cracked Up to Be?
What exactly is portability, and how does it work?

It is important to understand that portability applies only to married couples. It is also relevant that the applicable exclusion amount (the amount excluded from federal estate taxation) is $5 million per person. Since it is indexed for inflation, its actual value in 2015 is $5.43 million. Finally, portability applies only to the federal estate tax; it does not apply to the Illinois state estate tax.

If the first spouse to die has not used his or her entire applicable exclusion amount, then whatever portion of the applicable exclusion amount that remains unused at the first spouse’s death is available to the surviving spouse to add to his or her own remaining applicable exclusion amount at his or her subsequent death. Portability is not automatic, however. An estate tax return must be filed for the first spouse’s estate (even if his or her estate is nontaxable) under which the surviving spouse elects to “port” the predeceased spouse’s unused AEA.

Portability is available without regard to the size of the estate. For example, if one spouse dies without having used any of his applicable exclusion amount, his surviving spouse can opt to add that amount to her applicable exclusion amount for lifetime gifting purposes and for estate tax planning purposes. In this example, she would add $5.43 million to her $5.43 million applicable exclusion amount, for a total of $10.86 million.

Portability offers benefits for the “right” couple:

Simplicity for the married couple:

  • Whose assets are valued at less than their combined applicable exclusion amount and are not likely to appreciate beyond;
  • Who have little or no risk aversion when it comes to creditors; and
  • Who are not concerned about the prospect of remarriage of the survivor, in which all of the original assets could be expended on the new spouse or family.
  • This couple can do relatively simple planning by executing wills or a revocable trust in which everything passes to the survivor outright.·

Step-up in basis: Portability ensures a step-up in cost basis to fair market value of assets upon the second death, thus potentially avoiding capital gains tax upon the subsequent sale of such assets. For this reason, certain types of assets may be better suited for a portability election, e.g., a primary residence.

There are drawbacks, however, to electing portability in lieu of proactive planning, the more important of which are:

  • No Inflation adjustment: Once portability is elected, and the deceased spouse’s applicable exclusion amount is transferred, that amount is no longer adjusted for inflation; it’s frozen; if the spouses proactively plan prior to the death of either, and create a bypass trust at the death of the first spouse to die, the value of the estate at the first death, adjusted for inflation, will escape estate taxation at the second death.
  • No Asset Protection: Assets transferred outright to a surviving spouse have no asset protection benefits, whereas the terms of a bypass trust can include protections against creditors, predators and dishonest individuals (it should be noted that some asset protection benefits can be built into a Marital Trust, for which a portability election can be made).
  • Loss of GST Election: There is no ability to port the decedent’s generation-skipping transfer tax exemption to the surviving spouse, which may cause additional tax on the death of the decedent’s child or children.
  • Limited to Last Deceased Spouse: A surviving spouse may only use the remaining applicable exclusion amount of her last deceased spouse, a potential problem specifically for a younger couple. For example, if Dick predeceases Jane, and Jane later remarries Harry, Dick’s unused applicable exclusion amount is lost upon Harry’s death if Harry also predeceases Jane (note, however, that Jane could have used Dick’s applicable exclusion amount to accomplish lifetime gifting before Harry’s death, thus “preserving” it, a tactic specifically sanctioned by the IRS).
  • Loss of Control: The predeceased spouse loses complete control over the assets left directly to a spouse (though, again, this can be addressed to a degree through the use of a Marital Trust for the benefit of the surviving spouse).
  • Lack of Certainty: A permanent estate tax is only permanent until Congress decides to change it. Historically, the federal estate tax has been a political football that has bounced around in various directions, a situation that is likely to continue as time goes on.
  • Not Available for Illinois Estate Tax: For those of you who live in Illinois, you are still saddled with a state estate tax with a threshold of $4 million, i.e., estates over $4 million are taxed on the entire amount of the estate at progressive rates; the $4 million is not indexed for inflation, and portability does not apply. Furthermore, considering the fiscal issues facing the state, how long will a $4 million threshold survive? What other changes are in the offing?
  • Lack of Flexibility: Relying on portability provides no flexibility and little opportunity for ongoing planning, and substantially reduces the potential for “legacy” planning for your descendants and other loved ones.

As illustrated, while portability is, indeed, beneficial in certain situations, it is not appropriate for every couple. There remain situations where traditional planning (using trusts to hold the decedent’s assets for the benefit of the surviving spouse and perhaps the children) will be more advantageous and/or provide more comfort and control than the portability election. In many cases, however, drafting flexibility into an estate plan to defer the decision about portability until after the first death may be prudent where future economic circumstances and human behaviors are difficult to predict.

Building Flexibility Into Your Estate Plan
While building flexibility into your plan is ideal, what if your plan becomes irrevocable before you were able to make it flexible? What if the plan needs to be modified to obtain a step up in basis or for other income tax reasons? What if you create an irrevocable trust for the benefit of a beneficiary who later becomes incapacitated or disabled? What if it would be advantageous to change the situs of your irrevocable trust or its governing law, add or remove beneficiaries, add a trust protector or advisor, or change the trustee structure? Is it possible to modify or even revoke your inflexible, irrevocable trust? The answer under many circumstances is yes, by:

  • Reforming the trust: Using judicial interpretation to determine and properly restate your intent.
  • Modifying the trust: Changing the terms of the trust by agreement or a court order to meet your tax‐saving objectives provided that the resulting terms are not inconsistent with your intent.
  • Equitably deviating the trust: Modifying the trust provisions by agreement or a court order upon the showing of an unforeseen change in circumstance the impact of which would frustrate your intent.
  • Invoking the Trust Protector: Allowing a third‐party to exercise specific powers as defined in the trust agreement.
  • Decanting the trust: Allowing the trustee to distribute property in further trust for a beneficiary.

Planning Tip: How old are your current estate planning documents? Do they still contain mandatory Marital/Family Trust provisions? Do they include a trust protector or advisor? Do they allow for decanting and changing the trust situs? Do they address the possibility that a beneficiary could become incapacitated or disabled? If your documents are more than a few years old, then it’s time for an estate planning checkup.

Where Does Estate Planning Go From Here?
Estate-tax driven estate plans are a thing of the past for most Americans. Higher income tax rates, changing state laws, unfavorable jurisdictions and wayward heirs all add up to the need for an estate plan that adapts over time. Modern estate planning also demands that estate plans be reviewed regularly and adjusted for changes in personal and family circumstances, financial circumstances, legislative and case law updates, federal and state estate tax changes, and income tax modifications. Regardless of how flexible your estate planning documents are, they remain static while everything around them is in a state of constant flux.

We are reminded of the overused, but still very true, saying: the one constant in life is change. Modern families need modern estate planning solutions, and our firm is ready to help you and your loved ones plan for now as well as what may happen in the future.