The recently concluded 49th Annual Heckerling Institute on Estate Planning built on the groundbreaking themes that dominated the previous year’s conference, which had challenged estate planners to take a fresh look at the role of income tax (and income tax basis) planning in advising our clients. We’re now another year down the road since the massive transformation in the overall estate planning landscape that was ushered in by the American Taxpayer Relief Act of 2012 (ATRA). The consensus at this year’s conference was that for all but the top 0.2 percent of U.S. taxpayers, the most vital functions of the estate planner are to implement the client’s dispositive objectives, consider ways to minimize state estate taxes and maximize opportunities to save income taxes (including via portability of the applicable exclusion amount of the first spouse to die to maximize the extent of the step-up in basis on the second spouse’s death).
Flexibility is Key
Given the ever-changing myriad of federal and state transfer tax and income tax laws that may potentially apply to a particular client and the extremely difficult-to-predict variable of the state where the client’s children and grandchildren will ultimately reside, the favored approach continues to be to maintain flexibility in our clients’ estate plans through the use of qualified terminable interest property (QTIP) elections (including Clayton QTIP planning) and qualified disclaimer planning. Moreover, long-time stalwarts in the estate planner’s toolkit, such as generating discounts through family limited partnerships and estate freezes, may do some clients more harm than good because such strategies come at potentially severe income tax costs by limiting the extent of the step-up in basis for property acquired from a decedent. Accordingly, in many instances, estate plans that made great sense prior to 2013 may need to be revised or unwound.
In addition, stability may be fleeting in certain of the techniques that we use. In particular, there’s concern that sales to irrevocable grantor trusts in exchange for a trustee’s promissory note may be on the radar both by the Internal Revenue Service in the audit context and in subsequent legislation. Although the extent of this attack is unclear, and the consensus view is that estate tax reform is highly unlikely to occur during 2015, the estate planner needs to be mindful of the potential for further upheaval in the estate-planning landscape in advising her clients.
Unwinding Pre-ATRA Transaction
With the drastically expanded estate tax exemptions and the permanence of portability under ATRA, to quote the late Steve Jobs, we now need to “think differently” than we used to prior to ATRA. In many cases, this will lead us to counsel our clients to modify, or to unwind, estate plans that made great sense just a few years ago. Instead, dispositive objectives, state tax law planning and income tax planning now predominate. Such was the message trumpeted at Heckerling, including in the excellent presentation of John F. Bergner.
The federal estate tax is simply irrelevant to most U.S. taxpayers. Accordingly, we need to identify those techniques (such as bypass trusts and family limited partnerships (FLPs) that are no longer needed to save federal estate taxes, and which, if unchanged, can actually hurt our clients by increasing the amount of income taxes to be incurred by the client’s beneficiaries after the client dies. This could occur because the pre-ATRA estate plan used a credit shelter trust—which, absent further planning, such as through distributions to the surviving spouse or conferring a formula-based general power of appointment (POA) on the surviving spouse, eliminates the ability to obtain a step-up in basis of the assets in the credit shelter trust upon the second spouse’s death. This could also occur because the estate plan involved the use of entities (such as FLPs or family limited liability companies (FLLCs)) that were intended to produce valuation discounts on death due to the lack of marketability and lack of control of the decedent’s entity interest. A valuation discount for estate tax purposes will correspondingly reduce the extent of the step-up in basis and, thereby, increase income taxes when the beneficiary subsequently sells the entity interest.1
Further complicating this analysis, however, is that the estate planning is being done in a multi-dimensional prism in which applicable state estate taxes need to be factored in as well. So it’s not simply a matter of considering federal estate taxes, income taxes and the step-up in basis— because you don’t want the income tax benefit of maximizing the step-up in basis to come at the peril of producing state estate taxes on the death of the first spouse to die.
The following unwind strategies can potentially be employed in our post-ATRA environment to reduce income taxes:
- Avoiding valuation discounts for client-owned assets, including by liquidating FLPs or FLLCs, or giving the senior family member the unilateral right to liquidate the entity;
- Causing inclusion of assets in the settlor’s estate, including through the “offensive use” of Internal Revenue Code Sections 2036 and 2038 or by having the settlor purchase the remainder interest in a successful grantor retained annuity trust;
- Causing inclusion of trust assets in a beneficiary’s estate, including by giving the beneficiary a general POA to produce estate tax inclusion in the beneficiary’s estate under IRC Section 2041;
- Changing ownership of spousal assets to achieve a new income tax basis for appreciated assets and to preserve the income tax basis of loss assets, for example, a swap of assets between spouses (which will generally be tax-free under IRC Section 1041) can allow the spouse with the shorter life expectancy to get the appreciated assets;
- Planning to avoid imposition of the 3.8 percent net investment income tax;
- Addressing life insurance policies and life insurance trusts that are no longer needed; and
- Turning off grantor trust status to facilitate tax savings on income distributed to beneficiaries who are subject to tax at a lower marginal income tax rate.
- A reduction in the extent of the step-up in basis will also reduce depreciation deductions on depreciable property.