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.

Federal estate tax planning has become a less important planning objective for an increasing number estate planning clients due to a combination of the substantial increase in the federal estate exemption in recent years and the decline in the net worth of many clients due to the slide real estate and stock values.

The Estate Tax

As of the date this article is written, we continue to lack certainty regarding the structure of the federal estate tax, including the amount of the estate tax exemption and the rates for the current year — 2010. However, it appears likely that the federal estate tax will neither be eliminated (as many have hoped) nor return to the $1.0 million level in 2011 (as now provided by law). General consensus is that the federal estate tax exemption will find its new home in the ballpark of $3.5 million per person (the estate tax exemption for 2009). Estates over this amount were taxed at the rate of 45% in 2009.

Background of the Family Exemption Trust

Basic federal estate planning for a couple simply entails designing the estate plan to utilize the estate tax exemptions of both husband and wife. If the estate tax exemption is $3.5 Million per person then couples with the proper federal estate tax planning through Family Exemption Trusts (a/k/a A/B trust, family trust, bypass trust, credit shelter trust) potentially should be able to eliminate federal estate taxes on estates of $7 million or less.

Gifts to a spouse or charity are not subject to federal estate tax. Therefore, such gifts do not utilize a client’s federal estate tax exemption, which is lost if not used at death. Gifts to a spouse are added to the surviving spouse’s estate and taxed at his/her death if the surviving spouse’s total gross estate exceeds the exemption amount. Therefore, if each spouse is going to take advantage of the federal estate tax exemption, he/she needs to give the assets to someone other than a spouse or charity. One option is to simply pass the assets on to the next generation. Of course, surviving spouses in most situations are hesitant to do so because they would lose complete control over and access to the assets. And that is where the Family Exemption Trust comes in. Assets passing to the Family Exemption Trust are deemed to have passed on to the next generation for estate tax purposes, thus utilizing the first spouse’s exemption, while the surviving spouse continues to retain access to the assets as a beneficiary of the trust.

The Family Exemption Trust is often designed with the surviving spouse receiving all of the income from the trust for life along with the right to be paid principal pursuant to certain standards. A common standard for distributing trust assets to a spouse is for the spouse’s “health, education, maintenance and support.” These are magic words in estate planning because this “ascertainable standard” even enables the surviving spouse to serve as the trustee of the trust, capable of making distributions to him/herself without the trust being considered part of surviving spouse’s estate. There is no minimum access that the surviving spouse must be given, but there is a maximum access and control that if exceeded would result in the trust assets being deemed part of the surviving spouse estate for federal tax purposes, thus completely defeating the estate tax planning benefit of the Family Exemption Trust.

The Problem with Many Older Estate Plans

Many older estate plans, some of which were drafted when the estate tax exemption was below $1.0 Million, require the mandatory funding of the Family Exemption Trust, often through funding formulas that put all of the first spouse’s assets in the Family Exemption Trust. Now, when clients realize that they may no longer need a Family Exemption Trust for federal estate tax planning purposes, most instinctively want to eliminate it so that assets pass outright to the surviving spouse. Also, some clients are surprised to learn that their estate plans provide that at the death of the first spouse, all of the assets of the first spouse pass to Family Exemption Trust, with none of it going outright to the surviving spouse.

Asset Protection and the Elimination of the Family Exemption Trust?

Should the Family Exemption Trust be eliminated where it serves no federal estate tax planning purpose? It depends.

There are benefits to funding the Family Exemption Trusts other than federal estate tax planning. Family Exemption Trusts provide substantial asset protection benefits. They also increase the likelihood that the first spouse’s children (or other intended beneficiaries) ultimately receive the assets.

In most cases, assets in the Family Exemption Trust are protected against the surviving spouse’s creditors. Because the surviving spouse does not have the ability to withdraw the assets from the trust, the surviving spouse’s creditors generally cannot do so either.

Because the Family Exemption Trust becomes irrevocable at the death of the first spouse, the surviving spouse does not have the ability to change its terms. Therefore, the surviving spouse cannot disinherit a child following an argument. In addition, the surviving spouse does not have the right to give the trust assets to someone else. This may be an important consideration if the surviving spouse remarries, and the new husband or wife exercises influence over the surviving spouse. Once the assets leave the trust then they cease being protected.

In evaluating whether or not to keep or eliminate the Family Exemption Trust, you should ask yourself the following questions:

• Do you wish to achieve greater asset protection by keeping the assets out of the surviving spouse’s name? [This is especially important if the surviving spouse is or may someday be engaged in a potentially risky profession or business.]
• Do you wish to provide greater assurance that part of the marital assets will ultimately pass to the children (and not to the surviving spouse’s new husband or wife) by placing limits on the surviving spouse’s access to those assets? [This protects against influence from both the new spouse and certain children who seek to exclude other children.]
• Do you wish to protect the surviving spouse from potential loss if he/she remarries and then divorces? And, if you are the surviving spouse, do you want the ability to tell a future spouse that the assets are not yours to share?

In light of these important considerations, some clients will choose to partially fund the Family Exemption Trust even though it is unnecessary for federal estate tax purposes. In other instances, clients will choose to keep it simple and just leave everything outright to the surviving spouse.

Optional Funding of Family Exemption Trust via Disclaimer

In most estate plans, the surviving spouse should retain the option to fund the Family Exemption Trust through a disclaimer. A disclaimer is a formal statement that essentially causes the assets to bypass you and pass to the next beneficiary in line to inherit. In this case, that would be the Family Exemption Trust. Therefore, with disclaimer exemption planning the surviving spouse can decide whether or not to fund the Family Exemption Trust after consulting with advisors and weighing the facts that then exist, such as estate and income tax laws, the likelihood of remarriage, or the need for asset protection planning.

Second Marriages and Blended Families

The planning goals for first marriages are often different than those for subsequent marriages. In the case of first marriages, where the children belong to both the husband and wife, spouses are far more likely to leave the assets to the surviving spouse, knowing that their children are also the natural heirs of their spouse.

On the other hand, in blended families, couples are more likely to want to protect against the surviving spouse disinheriting children from a prior marriage. In such cases, clients may desire some level of mandatory funding of the Family Exemption Trust, and occasionally even leave some or all the assets directly to the children, thus bypassing the surviving spouse entirely.

Leaving Assets Directly to Children’s Trusts

Younger couples, recognizing the likelihood that the surviving spouse will remarry, sometimes desire to leave a portion of their assets to their children in trust instead of the surviving spouse. These couples seek the assurance that their children will not be deprived, especially in respect to the education of the child, as the result of influences exerted upon their surviving spouse by a new husband or wife.

Summary

Deciding whether and to what extent couples should use a Family Exemption Trust arrangement, even if they do not have federal estate tax planning concerns, requires an informed and thoughtful analysis. In addition to providing federal estate tax savings, Family Exemption Trusts provide important asset protection benefits and greater assurances that your assets ultimately pass to your intended beneficiaries.

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.