THE NEW TAX ACT
As you undoubtedly know, the so-called “fiscal cliff” was avoided by the passage of the American Taxpayer Relief Act of 2012 (“ATRA”). The same basic issues, of course, will reappear within the debt-limit/government-shutdown debate coming up in February and March. With the passage of ATRA, the focus of that debate will presumably be on spending. That does not mean, however, that increased taxes are off the table. Already the tax-fairness argument has reappeared in the form of closing abusive loopholes or curbing excessive deductions. Whether something is “abusive” or “excessive” or good public policy depends on one’s point of view. Senator Russell Long set out the yardstick for tax fairness many years ago: “Don’t tax you, don’t tax me. Tax the man behind the tree.” We think that 2013 will be the year where we find out just how many people are hiding behind that tree.
Most of the public debate over ATRA involved issues related to the income tax, not the estate/gift tax. Thus, the newspapers were filled with the reports of the increase to the individual tax bracket and the capital gain rates for those with $400,000 or more of annual income ($450,000 married filing jointly), the elimination of the payroll tax holiday and the increase to the employee’s (and self-employed’s) social security portion of FICA, and other income tax changes. Independent from ATRA are other tax changes beginning in 2013.
THE ESTATE/GIFT/GST TAX CHANGES
ATRA contained estate, gift, and GST tax changes that were simple in design but far reaching in effect. This is a good news/bad news story. The headline bad news is, of course, an estate, gift, and GST tax rate increase from 35% to 40%. However, this bad news could have been much worse. Before ATRA, the law was governed by the 2010 Lame Duck Congress’ extension of the 2001 “Bush tax cuts.” The 2001 Tax Act eliminated the federal death tax for those dying in 2010 but then the whole tax act was scheduled to sunset on December 31, 2010 so that the law reverted back to the pre-2001 law thereafter. This would have exposed estates exceeding $1 million to a federal tax with rates up to 55%. The 2010 tax act moved sunset until December 31, 2012 and raised the threshold to $5 million, indexed for inflation, and froze the rate at 35%. ATRA made the 2010 extension permanent but increased this 35% rate to 40%. ATRA retained the $5 million (indexed) threshold.
Other than the rate hike, ATRA is a pro-taxpayer measure. Although fairly straightforward in design, the new tax act has sweeping planning implications:
No sunset. Unlike the planning environment since 2001, we now can plan without a sunset provision. This will produce more certainty as to how estate plans will actually operate. Permanency of tax acts, of course, is somewhat illusory: Congress can change the tax law, and, in fact, does so with some regularity. Nevertheless, any future change must come, more or less, from an agreement by Congress (and the President unless it is by a veto-proof vote) instead of changing automatically. Given the present toxic political environment, one would be more comfortable with change not being the default result as it is with sunset, but instead requiring an agreement to change the law.
The enhanced credit shelter amount. By extending the 2010 treatment, the current threshold will be $5 million indexed. For 2012, the indexing brought this threshold to $5.12 million and for 2013 it is projected at $5.25 million. Maryland, of course, has a $1 million threshold for the Maryland estate tax. Obviously, the increased federal amount permits more planning options as long as those plans are implemented with an appreciation of the lower state threshold (either by deciding that paying the state estate tax at the death of the first spouse is a reasonable trade off or by deferring the state estate tax). For maximum deferral with a married couple, planning may involve segregating assets coming from the first spouse to die in three potential trusts: one free of both state and federal tax, one free from federal tax but deferring the state tax, and one deferring both federal and state taxes. For single individuals or unmarried couples, total deferral is problematic.
Lifetime gifting. A dramatic change under the 2010 extension was matching lifetime gifting to the unified credit amount. Before the 2010 extension, lifetime gifts were capped at $1 million per taxpayer. By increasing the ability to make lifetime gifts up to the $5 million (indexed) threshold, clients had an enhanced opportunity to make sizeable gifts to pass wealth, including interests in closely held businesses, to the next generation. By carrying forward the tying of the lifetime gifting to the estate tax amount, this opportunity continues and, not incidentally, the potential “claw back” of large gifts made by clients under the 2010 act becomes moot.
Portability. The 2010 extension permitted a surviving spouse to use the deceased spouse’s unified credit to the extent not used at the first death. This was a “simplification” provision which, in practice, was not so simple because it required a federal tax return to be filed to preserve the later use of that credit equivalency. What portability does is eliminate the requirement that a credit shelter trust be used to double up this tax threshold at the second death. Portability is a very useful mechanism especially where much of the wealth consists of deferred benefit retirement plans where the use of a credit shelter trust involves a lessening of income tax advantages. In many instances, however, a better plan is to fund a credit shelter trust regardless of portability so that asset growth is outside of the death tax system and to permit greater tax planning flexibility in the event of a subsequent marriage by the surviving spouse. Funding the credit shelter trust, however, means foregoing the basis step-up at the second death. The new tax act extends portability and clarifies an ambiguity in how portability works.
Effective estate planning involves tailoring a plan to meet a client’s goals. Often such planning must deal with the challenges presented by the state and federal estate tax. ATRA makes dealing with the federal tax much easier. Obviously, ATRA is a major development. Arguably, it is at least as significant as the 2001 Tax Act. Unfortunately, there is no set template that can be used as a universal “fix” or “cure” for all clients. Every client must determine what tradeoffs, if any, they are willing to make in exchange for meeting their planning goals. The new law presents a good reason to review existing estate plans. Usually, of course, it is family considerations, not a new tax law that drives (and should drive) estate planning.