The January 1 passage of the American Taxpayer Relief Act of 2012 (ATRA) has estate planners reexamining their basic tax strategies for married couples.
Here’s the major challenge planners have faced: For more than three decades, the estate tax laws have featured an unlimited marital deduction, meaning one spouse could gift or bequeath the other an unlimited amount of assets without tax. Sounds good, but relying on the marital deduction could mean that the first spouse to die would fail to use another feature of the system—a limited amount of assets that could go to anyone other than a spouse and not be taxed. Technically, this exclusion took the form of a credit on the estate tax return, but it’s commonly been called a personal exemption, so that’s the term I’ll use here.
The personal exemption rose from $175,000 in the early 1980s to $5 million in 2012, but was slated to revert to $1 million if no “fiscal cliff” deal got done. For a California couple with a $10 million estate, a spouse who died in 2012 leaving everything to her mate meant that upon his death, only $5 million would escape estate tax. In other words, the first spouse to die would have wasted her personal exemption.
To avoid this result, planners have used a “bypass trust,” also known as a “credit shelter trust.” The bypass trust, incorporated into either a will or a living trust, is an irrevocable trust funded at the death of the first spouse. By a bit of sleight of hand, the bypass trust was counted as a non-spouse for tax purposes and so would be funded with whatever the exemption amount was when the first spouse died. With a sleight of the other hand, the bypass trust would then provide all the income and maybe even all of the principal for the surviving spouse if properly drafted and administered. That way, the couple enjoyed the fruits of both spouses’ exemptions.
Nothing in ATRA directly affects the use of a bypass trust. What did change started with a temporary fix to the estate tax laws in 2010 that came as a surprise to many planners, something known as “portability.” Portability let a surviving spouse claim, and thus preserve, the personal exemption of the first spouse to die without having to use a trust. ATRA has made portability a permanent feature of the estate tax system.
And something else has changed. Capital gains tax rates have gone up at both the federal and state levels. High earners now pay a federal capital gains rate of 20 percent, plus an additional 3.8 percent tax imposed by the Obamacare legislation. And our friends in Sacramento, to fund their own excessive pensions, have boosted the maximum state income tax rate to 13 percent (California has no preferential rate for capital gains). Add them all together and the capital gains tax rate approaches that of the new estate tax rate of 40 percent.
There’s an important difference between the bypass trust and portability. Assets assigned to the bypass trust retain as their cost basis their value at the date of the first spouse’s death. Assets covered by portability can take advantage of another important aspect of death taxes: They’re given a new cost basis equal to the value on the date of death of the surviving spouse, called a “step-up” in basis.
Let’s look again at our $10 million couple and assume the entire estate consists of an apartment complex for which the cost basis had been reduced by depreciation essentially to zero. On the death of the first spouse, her half receives a step-up in basis to $5 million.
Now assume the husband lives another 14 years, at which time the value of the apartment complex is $12.5 million and cost of living adjustments have boosted the personal exemption to $7.5 million. Whether the couple uses a bypass trust or portability, the result will be no estate taxes. But from the heirs’ standpoint, the results will be quite different. Using the bypass trust, the basis of the wife’s half will be reduced by 14 years of allowable depreciation. The total basis will then be $8.75 million—$6.25 million for the husband’s stepped-up basis and $2.5 million for the wife’s half via the bypass trust.
Using portability, the new basis for the heirs will be the full $12.5 million. If they keep the complex, their allowable depreciation will be almost 50 percent greater, sheltering more of the income. If the heirs sell the complex, they’ll avoid capital gains taxes because the step-up in basis would cover the entire value of the complex, which was held entirely by the surviving spouse. Had the couple used a bypass trust, the heirs would face capital gains taxes at a rate as high as 38 percent for the $3.75 million difference between the value and the cost basis of $8.75 million. Portability can protect heirs from some pretty big taxes, which is why it’s getting renewed attention from planners.
Über-estate planner Ted Hellman of the Hanson Bridgett law firm in Larkspur says he’ll likely continue to recommend bypass trusts in a majority of cases because of other benefits they provide, including protection of assets from the creditors of the surviving spouse and assuring that the dispositive plans of the first spouse to die are carried out. The challenge, he says, will be to draft the bypass trust to allow some or all of the trust assets to be covered by portability, achieving the best of both worlds.
As readers can see, these are complex and challenging issues. Even though ATRA dramatically reduced the number of estates potentially facing estate taxes, it remains important to be sure that estate plans are designed for the new era of portability and higher capital gains taxes.
Get thee to a plannery, and make sure your planner is fully conversant with this new paradigm.
