Changes in the estate tax laws have caused attorneys to scurry, trying to figure out how to perform estate planning over the next ten years. Over the next ten years, the estate tax laws will change substantially. Primarily, the rates will be going down, exemptions will be going up, and there will be a difference between the gift tax rates and the estate tax rates. All of this, coupled with problems in the economy and changing world events, may cause some uncertainty in the legal community about estate planning issues.
Before discussing how attorneys should advise their clients under these new estate tax laws, a brief summary of the changes is in order.
The estate tax exclusion will be escalating from $1,000,000 to $3,500,000 over the next ten years. (See chart, which follows.)
2002 and 2003 $ 1,000,000
2004 and 2005 $ 1,500,000
2006 to 2008 $ 2,000,000
2009 $ 3,500,000
In the year 2010, the estate tax will completely disappear for one year. In the following year, 2011, these tax changes will be completely eliminated, and the law will revert to the estate tax laws as set-forth prior to the new changes, unless the current estate tax laws are re-enacted. Attorneys will be faced with the dilemma of not knowing whether the estate tax may completely disappear in that year or revert back to the old law.
In addition to the estate tax exemption changes, the rates will be gradually changing over the next several years. The current ceiling rate is 55%, but the ceiling rate will be gradually fazed out as follows, 50% in 2002, 45% in 2007, and eliminated in 2010.
The lifetime gift tax exemption, which is currently $1,000,000, will be frozen at $1,000,000, per spouse, regardless of the amount of the estate tax exemption. By 2010, the rate will be gradually reduced to 35%.
Also, the generation skipping exemption will be escalating along with the estate tax exemptions.
Quite frankly, one of the best planning approaches under the new estate tax laws is to just to stay the course. Since factors such as the economy, political power changes, and the unrest in the Middle East render uncertain where the estate tax exemptions will be in the next ten years, it makes sense to continue creating two trusts, one for the husband and one for the wife, in order to shelter as much of the estate exemption as possible in each of their estates. In doing so, you will still obtain the advantage of the double exemption, irrespective of the amount of the exemption. The downside to doing this type of planning is that there may be some additional administrative matters for the client because you are allocating assets between the two trusts, to ensure that the maximum estate tax exemption is sheltered in both estates.
Further, it still makes sense to take advantage of the Unlimited Marital Deduction in the husband’s, as well as the wife’s, trusts. In the case of a premature death, a spouse’s trust could exceed the estate exemption. Therefore, it is important to take full advantage of the unlimited marital deduction as a tax deferral technique.
In these uncertain times, attorneys should focus more on the non-estate tax aspects of estate planning. A trust provides a client with additional planning advantages beyond mere tax planning. For instance, upon the death of a client, a trust can provide income tax planning for the family. By creating a Spray Trust in the Exemption Trust, income can be allocated among multiple beneficiaries at lower tax brackets. The Exemption Trust can provide that the income is payable to the spouse and the descendants, thereby spreading income to multiple beneficiaries. To further protect the spouse, the document can provide for the spouse to be the primary beneficiary.
ASSET PROTECTION PLANNING
A trust can also provide asset protection for the surviving spouse and the children. That is done by providing within the trust of the first spouse to die that the trust be kept intact for the lifetime of the spouse, and the income and principal be made available not only for the spouse, but also for the descendants. By adding a Spendthrift Clause to the trust, the assets are protected from attachment. It protects the spouse from future marital claims if he or she should get remarried, from creditors and from judgments. In short, not only does this set up a trust for tax planning purposes, but it also creates a trust that survives past the client’s death to protect assets for the spouse and children.
Particularly in a large estate, once the spouse has died, the continuation of this trust would protect the assets set aside for the children for their lifetime via the Spendthrift Clause. The other advantage of continuing the trust would be that assets could be protected for the minor beneficiaries until they reach certain ages of maturity.
Even with these changes in the estate tax laws, when you create an estate plan, there still is a need to provide the complementary documents connected with a trust. These would include the Pour Over Will (the will that adds non-funded trust assets to the trust at the client’s death), the Powers of Attorney for Healthcare (to protect medical decisions), and the Powers of Attorney for Property (to handle any non-trust assets).
If your client’s children are minors at the time the trust is being prepared, consider a clause that would allow them to become co-trustees when they reach an age of, for example, 25, so that there will be no need to redo the trust when the children are older and capable of performing the duties of a trustee. Further, consider including clauses to equalize distribution in the event loans are made in the future to some of the beneficiaries, but not to all the beneficiaries.
Even with the estate tax changes, tax-free gifting (the $10,000 annual exclusion) still makes sense when gifting to family members. The tax changes do not alter the utility of using a Family Limited Partnership (FLP) as a gifting tool over the next ten years.
Under a FLP, a client can essentially gift assets to children or grandchildren (or other beneficiaries), and still maintain full control over those assets, both as the general partner and by utilizing controlled tax planning gift trusts. Not only is the client able to control the assets, but the client can also take advantage of accelerated gifting through a discounting allowance. The I.R.S. has allowed what is called a "discount" for transfers of FLP interests because of their lack of transferability and marketability. In addition, the beneficiaries generally only receive a minority interest in the partnership. Therefore, a minority discount is allowed.
For instance, if a client were to transfer $1,000,000 of assets to a FLP, and gift a one percent interest of the FLP to a gifting trust for the child, on its face, it would appear as though the client made a $10,000 gift. However, because the child has no control over the assets and only has a small portion of the partnership interest, the asset is not worth $10,000. Assuming that the I.R.S. allows a 35 percent discount on such a transfer, the client could essentially transfer over $15,000. In other words, the client has accelerated gifting under such a process.
Not only could a client be able to gift away and make use of his or her annual $10,000 exclusion, but in larger estates the client could also make use of his or her lifetime exemption. This exemption will be fixed at $1,000,000 by 2002. A wealthier client could transfer over $1,500,000 of assets ($3,000,000 for spouses), applying a 35 percent discount to the $1,000,000 gift tax exemption, plus $15,000 ($30,000 for spouses) to each beneficiary. If the client were married, these numbers would double.
In addition to the estate tax, gift tax, and control advantages of FLPs, the partnership can also be a means of income tax planning. For instance, if interest in the partnership is transferred to minor children in lower income tax brackets, the income generated by that partnership interest would be taxed at that child’s lower income tax bracket, provided the child is over 14 years of age. For example, $10,000 of income in a parent’s 39 percent bracket would result in $3,900 of income tax. However, when that same $10,000 is transferred to children or grandchildren at a 15 percent bracket, the income tax on that would be $1,500. In other words, a savings of $2,400 ($3,900 - $1,500) is realized. The FLP, because of this income tax advantage, is an ideal tool for providing education funding for children.
The other advantage of the FLP is that it provides some asset protection. The underlying assets of a FLP are not attachable by a creditor. Creditors can only obtain a charging order against a partnership. However, the general partner can withhold distributions indefinitely, if he or she can establish a business purpose. This prevents the creditors from getting to the partnership assets.
The FLP can be a valuable advanced tax planning tool for wealthier clients with larger estates because it provides the client with control, gift and estate tax planning advantages, income tax planning advantages, means of education funding, and, lastly, a vehicle for asset protection. The best assets to place into a FLP are assets that, by their nature, are unmarketable, such as real estate and closely held business interests, (non-Subchapter S interests), and equipment.
Although the I.R.S. has been attacking these vehicles vigorously over the last several years, the cases still support the validity of the partnerships, so long as the planner followed the formalities of structuring these partnerships and the client was not on his or her death bed at the time of formation, and the client was reasonable in taking any discounting on the gifting aspect. There is one proviso. In those partnerships, which take securities as partnership assets, one should be much more cautious about establishing valuations for the partnership, particularly the discounting valuations.
Estate planning is still alive. At least for the next ten years, and actually more than ever, it is important that you create estate plans that are flexible enough to deal with the uncertainties of the new tax laws. It is highly recommended that if you get involved in estate planning, you become cognizant of these rules and guidelines. Otherwise, you could open yourself up to potential malpractice issues.
Richard A. Kuenster, J.D., LL.M. (Masters in Tax Law) has been concentrating in the areas of estate, tax, business planning and investment consulting for over 20 years. He graduated from the University of Notre Dame and received his law degree and Masters of Tax Law at John Marshall Law School. Along with having written numerous articles in his areas of expertise, he has been quoted in a number of periodicals, including the Wall Street Journal. Along with his law practice, he has an estate planning consulting practice for attorneys to assist them in probate matters and designing estate plans for their clients. He can be contacted at 630-238-0400, regarding his consulting practice.