It’s official!  President Obama signed into law the Tax Relief Act of 2010 making major gift, estate and generation skipping tax changes.  Under the new law, the estate tax exemption is increased to $5 million per taxpayer and the maximum tax rate is lowered to 35%.  In addition, the unused exemption of a deceased spouse may be transferred to the surviving spouse, who together would have a combined estate tax exemption of $10 million per couple.  This article highlights the implications of these tax law changes on estate planning.

What does this Mean for You?

With proper planning, the increased exemption means that far fewer families will owe federal estate tax when their loved ones pass away.  It also means that many of the estate tax planning structures currently found in estate plans have become obsolete, and in some cases, unnecessary.

For instance, in the case of married couples, will and trust provisions that provide for the assets of the first spouse to pass to a “credit shelter trust” (this trust sometimes goes by other names) may be unnecessary for estate tax purposes.  Instead, the assets could simply be passed to the surviving spouse.  However, there are still important non-tax reasons why passing the assets to a credit shelter trust remains a wise choice.  Primarily, the credit shelter trust will continue to perform the valuable function of protecting assets from potential loss if the surviving spouse remarries or engages in professional, business or investment activities exposing him or her to risk of loss; thereby fulfilling the legacy wishes of the spouse establishing the trust.

Of course, the transfer of the unused exemption amount of the first spouse to the surviving spouse reduces the importance of dividing assets between spouses.  This is particularly helpful in situations where dividing assets between spouses is difficult because a large portion of the assets consist of retirement plans or closely held business interests subject to transfer restrictions.  There remain many cases, however, where dividing assets during life is a very good idea.

Changes Remain Temporary

The new estate tax laws accompanied the extension of the Bush-era tax cuts originally passed in 2001.  As a result, this new estate tax structure is not permanent and will expire in 2013.  In view of the history of the estate tax, the significant but failed attempts to eliminate the estate tax over the last decade, and the federal government’s need for additional revenue, it is likely that this new structure will become permanent in 2013.  Since the modern estate tax was enacted in 1916, the exemption amount has decreased only once – during the Great Depression.  In addition, the proponents of the estate tax recognize that a higher exemption makes the estate tax less of a political issue.  It is possible, however, that in view of the need for additional revenue sources, the tax rate could be increased above the current 35% level.

Conclusion

The new estate tax law creates opportunities for many clients to better plan their estates to address non-estate tax goals.  These goals often include determining when and how to pass on their assets in order to provide the beneficiaries with the greatest benefit.  This may involve implementing trust arrangements to protect the assets from loss due to divorce, risky spending or investment choices, or claims arising from business activities.  Also, the temporary nature of the law should be considered.  Estate planning should never be undertaken from a “one size fits all” approach.  While clients often have similar goals, their circumstances and beneficiaries are unique, requiring each client’s estate plan to be individually designed.

It is common that trusts are drafted so that the trustee has the discretionary power to distribute income and/or principal for the beneficiary’s health, education, maintenance and support.  And when the beneficiary attains a certain age, the principal is distributed.  Frequently, principal is distributed in installments, such as when the beneficiary attains the ages of 25, 30 and 35, so as to give the beneficiary a second and even a third chance to use the assets wisely. 

While the distribution pattern above is a fine place to start the discussion, the proper distribution pattern should be based on the desires of the client, the nature of the assets in trust, and the strengths, weaknesses and needs of the beneficiary.  On occasion, a 25 year old may be prepared to receive his/her inheritance; however, this is certainly the exception and not the rule. 

Determining the proper distribution pattern requires the consideration of many issues, including the following:

·        Is the beneficiary in a happy marriage?  (Do you know?) 

·        What is the education level attained by the beneficiary and his/her ability to earn a comfortable living? 

·        Will the beneficiary be relying on the trust funds to pay living expenses? 

·        Will the beneficiary need the trust funds for retirement?

·        Does the beneficiary have a tendency to spend more than he/she makes? 

·        Does the beneficiary make sound financial decisions?

·        Is the beneficiary likely to engage in a risky occupation, business venture or behavior? 

·        Should the beneficiary be rewarded for good behavior, such as graduating from college, and discouraged from bad behavior, such as not going to college? 

·        Are the trust funds likely to be expended educating the beneficiary, thus making the timing of principal distributions less relevant? 

We find that clients increasingly wish to postpone the ages at which principal distributions will be made, especially where there is a significant sum of trust assets.  Sometimes, we preserve part of the assets for distribution to the beneficiary when he/she nears retirement age, such as at the age of 60.  In other instances, the assets are held in trust for the beneficiary’s lifetime, then distributed to the beneficiary’s children when they attain an appropriate age. 

In addition to postponing distributions for the purpose of avoiding the loss of assets, we also consider how access to money at too young of an age may affect the beneficiary’s internal drive for achievement.  I think most of us would agree that having assets handed to us generally reduces the motivation to work hard to achieve success.  Further, access to money at too young of an age may result in the beneficiary not acquiring the tools, provided by a good education and work experience, needed to prepare him/her for earning a living.  In addition, social scientists have found that our happiness is enhanced by the pursuit and attainment of our financial goals.  While money does not make people happy, the lack of it can make people unhappy.  And more specifically, the lack of security has been shown to reduce one’s happiness. 

At first blush, clients sometimes feel that they do not wish to postpone distributions to their children or other beneficiaries because they do not want to convey to them a lack of confidence in their judgment.  However, with the passing of time wise beneficiaries are usually grateful that the effort was made to protect them from exposing their inheritances to their own poor decisions or to the loss of the assets in a divorce or failed business venture. 

In summary, if your goal is to share the product of your hard work with your loved ones in a manner that will promote their happiness, you should carefully consider when and how distributions are to be made.