Recent Tax Changes Require an Estate Plan Review

Recent Tax Changes Require an Estate Plan Review

On December 17, 2010, the Tax Relief, Unemployment Insurance Reauthorization and Job Creation Act of 2010 (the 2010 Tax Act) was signed into law. The Act extends, for two years, certain income and investment tax provisions of the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) and the Jobs and Growth Tax Relief Reconciliation Act of 2003 (JGTRRA) that were otherwise scheduled to sunset at the end of 2010. The Act also introduces a number of new provisions, most notably those having to do with the estate tax. Clients should take this opportunity to review their existing estate plans, estate planning documents, and wealth transfer intentions, particularly wills and trusts that may have been established more than four or five years ago.

The 2010 Tax Act

The new tax legislation resolved uncertainties created by EGTRRA, which had gradually increased the individual estate tax exemption from $675,000 in 2001 to $3.5 million for deaths occurring in 2009. However, EGTRRA also temporarily repealed the estate tax for calendar year 2010, which left many to wonder how estates could be taxed in 2011 and beyond. While many expected that the $3.5 million estate tax exemption would be made permanent, the 2010 Tax Act provided different and more generous provisions.

The 2010 Tax Act raises the estate tax exemption amount to $5 million and imposes a top estate tax rate of 35%. Without this legislation, the estate tax exemption would have reverted to $1 million for 2011 with a top estate tax rate of 55%. Beginning in 2012, the exemption will be indexed to inflation in $10,000 increments.

The 2010 Tax Act also sets a top tax rate of 35% on gift and generation-skipping taxes. The gift tax exemption is also raised to $5 million and thereby “unified” with the estate tax credit and the generation-skipping tax credit. As a result, wealthy clients may want to contemplate using gift tax exemption in 2011 and 2012 while it’s this high as a way to get more assets out of one’s estate and hedge against the risk that the estate tax exemption could revert back to $3.5 million or even $1 million.

The 2010 Tax Act also introduced the unique concept of “portability” of the estate tax exemption of a deceased spouse, which essentially means a surviving spouse in 2011 or 2012 are entitled to the unused estate tax exemption of their “last deceased spouse.” For example, if the first deceased spouse’s estate was valued at $2 million, the $3 million exemption not used would roll over to the surviving spouse thereby giving that spouse a total estate tax exemption of $8 million. It is expected that portability will become permanent in 2013, however, it currently only applies where the death of both spouses occurs before December 31, 2012.

The 2010 Tax Act’s increased estate tax exemption and introduction of portability puts most Americans in a position of having little or no realistic exposure to federal estate taxes. However, proper estate planning will still be needed to protect against state level wealth transfer taxes, provide creditor protection, avoid probate, grant powers of attorney to make financial and health decisions in case of incapacitation, appoint guardianship for minor children, and instruct on the proper distribution of assets to family members. Furthermore, the 2010 Tax Act is temporary. Absent any further changes to the estate tax laws, the Act will sunset in 2013, reverting to a $1 million estate tax exemption and a 55% federal estate tax.

As a result of the recent estate tax legislation, its temporary nature, and the fact that there have been four different estate tax exemptions over the last three years, clients should consult their estate planning and financial advisors to make sure that their wealth transfer intentions have not been compromised. If estate plans had not been drafted to take into account past and potential changes in estate tax laws, there could be unintended and dire consequences. For instance, many estate plans are drafted such that, upon the death of the first spouse, an amount equal to the available estate tax exemption will pass to a Credit Shelter Trust, sometimes referred to as a Bypass or B Trust, fully utilizing the first spouse’s estate tax exemption. These trusts were very important prior to the introduction of exemption portability. The balance of the estate will then typically pass to the surviving spouse or to a marital trust benefitting the spouse. This is often referred to as A/B estate plan.

Below is an example how an A/B estate plan could be distributed differently depending on when the first spouse dies. The example will assume that the first spouse’s estate is valued at $5 million and that the assets passed to the Credit Shelter trust will not benefit the surviving spouse, which is often the case where children from a prior marriage are involved:

First Spouse Dies with a $5 million estate

Year of Death

Applicable Estate Tax Exemption

B Trust


Surviving Spouse Receives



$2 mm

$3.0 mm



$3.5 mm

$1.5 mm




$5 mm

2011, 2012


$5 mm






The Role of the Attorney, CPA, Trustee and Financial Advisor

The Attorney and CPA An estate plan, which often includes a will, durable powers of attorney, and trust, are generally drafted by an attorney, who will be responsible for interviewing the client and determining what trust design and features will best address the client’s needs. An attorney may also be retained to address future issues that may arise with the trust or its administration. Trusts can have complex tax considerations and filing requirements, especially irrevocable or non-grantor trusts. To assist in tax planning and filing, the trustee may retain the services of a tax professional, such as a CPA. The tax professional should be consulted about the ramifications of any investment that the trustee or the investment professional are proposing to make, to determine if it presents any unique tax concerns for the trust.

The Trustee The trustee has legal control over the trust, including the management of trust assets. There is no legal requirement that a trust have a corporate or professional trustee. Often times a trusted family member, tax or financial advisor can serve as trustee. However, to avoid any potential conflicts of interests and adverse tax consequences, it is often recommended that the trustee not have any financial interests in the trust. The trustee has the fiduciary responsibility to make sure that the trust is administered according to the wishes of the grantor and pursuant to the terms of the trust.

The Financial Advisor Trustees often choose one or more investment professionals to assist them in evaluating appropriate investments for the trust’s assets. Professionals available to provide these services include trust departments at financial institutions, registered investment advisors, financial advisors, and insurance agents. These investment professionals will not provide legal or tax advice, but will instead work with the trustee, attorney and tax advisor to find suitable investments to meet the trusts objectives. The role of the financial advisor in legacy planning is crucial. In many instances, the financial advisor has a better understanding of the client’s overall financial status, investment objectives, retirement goals, and intentions with respect to wealth transfer. They tend to meet with clients more frequently than attorneys and are intimately aware of the disposition of their client’s wealth, which may include real estate, business interests, qualified retirement accounts, nonqualified retirement assets, stocks, bonds and other brokerage accounts. Often times the financial advisor is the quarterback of the client’s wealth management team, working with the other players such as the client’s attorneys, CPA, and trustees.

Trust Taxation

Taxation of trust income is an important factor in the managing and investing trust assets. As a separate taxable entity, irrevocable trusts will generally have their own tax identification number and must annually file their own fiduciary income tax return (IRS Form 1041). Revocable trusts on the other hand report the trust’s taxable income as the grantor’s own each year on the grantor’s individual tax return (IRS Form 1040).

Depending on the purpose of an irrevocable trust, inappropriate investments could have significant adverse tax consequences. Irrevocable trusts are subject to a very compressed income tax bracket, whereby its income will be subject to the highest marginal tax rate as soon as the income exceeds $11,350 (2011). By way of comparison, individuals do not reach the highest tax bracket until their income exceeds $379,150. The highest tax rate is currently 35%, and could rise to 39.6% in 2013 if Congress is unable to pass new income tax legislation before then. In addition, the pending 3.8% health care tax on passive or investment income is also scheduled to apply to trusts in 2013, potentially leading to a top irrevocable trust income tax rate of 43.4%.

An irrevocable trust can avoid trust income tax when it distributes income to beneficiaries. This concept, known as “distributable net income,” simply refers to the fact that the trust is allowed to deduct these distributions against trust income earned. The trust issues a tax form called a K-1 to the appropriate beneficiary, who then reports the income on his or her individual tax return and pays income tax on the distribution received at their effective tax rate.

Any income or gains that remain in the trust at the end of the tax year are taxable to the trust. However, the trust will get the same tax treatment as an individual, depending on the nature of the income or gain. For example, certain income from municipal bonds is tax exempt, and this is true for trusts. Likewise, trusts also enjoy favorable tax treatment on long term capital gains and qualified dividend income. This enables advisors to build tax efficient investment portfolios for trusts in the same manner as for individual clients.

Tax efficiency can be of particular concern where an irrevocable trust does not require or authorize full distribution of trust annual income. For those trust scenarios, advisors could consider using tax-deferred and tax-efficient investments, such as government and municipal bonds, real property, and even annuities, as well as investment strategiess, such as minimizing portfolio turnover, investing in stocks that do not pay dividends, and selectively selling stocks at a loss to offset taxable gains elsewhere in the trust portfolio.

Managing and Investing Trust Assets

In providing investment counsel and advice to a trust, financial advisors must work closely with the trustee to understand the trust, its specific provisions, and its basic objectives. The trustee should be able to explain in general terms why the trust was established and its financial objectives. For example, is the trust designed to provide current income to a particular beneficiary, such as a surviving spouse? This is very common and can obviously help determine how trust assets should be invested. In a different trust, the goal may be to maximize growth or trust assets and control future distributions to beneficiaries in the future. In these situations, tax efficiency becomes more important.

Advisors providing investment advice to trustees must still thoroughly review the trust provisions. While many trusts place no restrictions on the nature or type of investments a trustee can make, trust language may authorize or limit the specific types of investments. A grantor may restrict the trust to specific types of investments, such as certain stock, equity sectors or tax-free municipal bonds. A trustee generally may be prevented from investing in hard-to-value assets, such as collectibles and closely held stock. Finally, the trust may prohibit the trustee from making certain investments considered inconsistent with the grantor’s values, morals or ethics.

Advisors must also consider the nature of the trustee’s important duties: first, optimizing the risk and return of the trust portfolio and, second, paying a reasonable income to the income beneficiaries while preserving trust assets for eventual distribution to the trust’s remainder beneficiaries. More practically, advisors must balance the needs of the income and principal beneficiaries, and invest trust assets in well diversified portfolios, while avoiding unnecessary costs, including investment expenses and inflation risk, and considering the trust income tax consequences of any investment transaction.


The 2010 Tax Act’s significant, but temporary, increase in the gift and estate tax exemption provides an opportunity to help their clients update existing estate plans, wills and trusts as well as review the investment objectives of those estate planning documents.

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