Emergency Will Repairs for 2010 (Part II)
Reprinted from The Estate Analyst, March, 2010
By Robert L. Moshman, Esq.
I have been a stranger in a strange land.
— Moses, Exodus
f I should die before I wake, how much will the tax man take? Lord only knows the answer. It is eminently reasonable for American taxpayers to ask how their estates will be taxed after they are deceased. People can make meaningful choices while they are alive, but after they are dead, not so much.
Let us return now to the task of repairing wills in an environment of a repealed estate tax that may be revisited upon testators retroactively...and posthumously.
Lost in the Wilderness
In the context of repeal and retroactive un-repeal, every will that is exposed to probate is now in the perilous circumstance of inviting judicial second-guessing and litigation from disgruntled beneficiaries who can now challenge testamentary intent under the cloud of confusion that exists.
Who can really say what any testator understands or intends when Congress itself has left the well-trodden paths of tax reform and scampered off into the wild?
For many small or moderate estates, the dangers of a retroactive tax have very little to do with the actual estate tax burden involved. The likely retroactive rules may provide the $3.5-million exemption, and marital estates have the unlimited marital deduction to fall back on. Even in the remote event of a reinstated Federal estate tax in 2011, with an exemption of $1 million, the vast majority of estates would still not be taxed.
Three Non-Tax Dangers: The real and present dangers to the vast majority of estates at this unusual juncture now lie not in estate tax burdens but in
1) the thwarting of testamentary intent,
2) wasteful conflict and proceedings to interpret testamentary intent, and
3) being blindsided by capital gains.
A testator may have intended to maximize tax-saving techniques based on changing tax laws but may never have intended a will clause providing "the maximum that can be transferred to my credit shelter trust without triggering estate tax" to mean "transfer 100% of my estate to my credit shelter trust, and leave my spouse nothing." And conversely, a clause to "transfer to my credit shelter trust the full exemption amount as it exists on the date of my death" may not have been intended to cause 100% of assets to go to a surviving spouse if the exemption no longer exists.
No testator would have intended a costly and time-consuming judicial exercise that pits one family member against another. That is a nightmare scenario in which there are no winners.
The A-B Estate Plan
Many estate plans for married couples have some version of the A-B architecture either in a will or a trust. The A portion of the estate goes to a surviving spouse and therefore qualifies for the unlimited marital exemption, and the B portion of the estate goes to the children or other beneficiaries of the estate and qualifies for the testator's own exemption.
The A portion of the estate can be placed into a marital trust for the surviving spouse (or given outright) and will qualify for the marital deduction. All or part of a spouse's portion of the estate can be set up as a Qualified Terminable Interest Property and placed in a QTIP trust.
This approach allows assets to qualify for the marital deduction yet be protected in the trust. Minimum distribution rules must be satisfied. And there are variations on coordinating various assets and life insurance with a QTIP trust. This is about where normal people get confused about estate planning, but the overall idea is really simple: Part of the estate goes to the spouse and qualifies for a marital deduction.
The non-spousal, or B portion, of the estate can also go into a trust and can be known as a credit shelter trust or a bypass trust. It is called a credit shelter trust because it causes a portion of the testator's estate to go to non-spousal beneficiaries under the shelter of the estate tax exemption.
It should therefore be called an "exemption shelter," but the estate tax exemption was once expressed as a tax credit, and the terms for sheltering that credit have lingered. The same approach is also called a bypass trust because it causes assets to bypass or circumvent the surviving spouse's estate and go directly to the beneficiaries of the couple, generally their children. This prevents the estate from accumulating to a level that would cause taxation in the surviving spouse's estate.
Example: A couple with $10 million planned their estate in 2008. At that time, there was an estate tax exemption of $2 million. If Husband died and left all assets to Wife, there would be no tax at his death due to the marital exemption; however, at Wife's death, all $10 million would be in her estate, and she would only have an exemption of $2 million. By utilizing an A-B arrangement, Husband's exemption would not be wasted, and $4 million of the marital estate would be protected.
The trick for planning in 2008 was to anticipate that the Federal estate tax exemption was going to rise to $3.5 million in 2009 (protecting $7 million for a marital couple) and then could possible rise higher after that (or so people thought). As a result, the language inserted in wills and trusts in years leading up to 2010 would attempt to maximize whatever exemption was available at the time of a testator's death.
But then there were unanticipated events. The repeal of the estate tax went into effect. Language that would have previously maximized the non-spousal B trust now leaves the B trust nothing. And if Congress re-imposes the estate tax retroactively, what then? Should the credit shelter trust be funded retroactively? And if not, the entire estate will end up accumulating in the surviving spouse's estate, despite the careful A-B structure of the couple's estate plan.
Spell Out Intentions
If you say what you mean and mean what you say-and really spell it all out-it may be possible to at least deter will challenges and all other judicial or legislative interpretations of what was intended.
To truly spell out testamentary intentions for a large estate that may continue to fluctuate in size, one would need to provide a more specific scheme of distributions for asset levels of various sizes and for estate tax exemptions of various levels. The means of determining asset levels would need to be defined in the will or trust.
The will can be revised to itemize the testator's intentions in each of the possible scenarios. After all, the scenarios are not unlimited. There are several rather likely scenarios and a few remote ones. A will can recite the testator's awareness of these changing circumstances and then provide for a specific testamentary scheme of distributions under each of the possible scenarios.
Carve-Outs
Generic solutions will not work. Every estate is in a different situation. Marital estates of any size may have had transfers of assets to create sufficient separate assets for each spouse that would be suitable for credit shelter trusts.
A spouse may be a priority for portions of the estate, such as a home and a percentage of assets. Or the spouse may already be the joint owner of the home and will be left with the home and other assets through joint ownership.
Many testators want to leave a portion of their estate directly to their children or set up trusts for their children. This remains prudent for tax purposes for larger estates because Congress may re-impose the estate tax at any time, and assets that were provided to children bypass a surviving spouse's estate.
Note: Estate sizes are also fluctuating greatly as a result of the stock market's volatility, the real estate bubble, and the high inflation that many experts anticipate in a few years. With all these caveats in mind, here are a few approaches that may be useful for certain estates.
Lifetime Gifts: Once given, the transfer is complete, and there are no further arguments after death about what the testator intended...unless the gift is not documented. A gift can be memorialized and reported for tax purposes with an allocation of the lifetime gift tax exemption. Concurrent documentation of the donor's mental capacity may be another useful precaution.
Specific Bequests: A bequest of specific real estate or belongings will be distributed first and leave the balance of assets to be divided. This is a way of carving out portions of an estate that will not be subject to interpretation based on tax impact. While many estates restrict specific bequests to personal property, such as jewelry or photographs, there is nothing to prevent an expansion of this approach so that less of the estate is subject to interpretation.
The First $100,000: After specific bequests of property, it is possible to also make bequests from the balance of the estate. "I leave the first $100,000 to my son, Mel." "I leave the next $500,000 to my wife, Nell." Problems arise when the testator overestimates the size of the estate. Giving out $1 million from a $20-million estate leaves a wide margin for error. To correct for this, large bequests can be based on meeting a threshold. "If my estate, as defined elsewhere in this will, surpasses $5 million, then I leave the following bequests." Another approach is to leave percentages of the remainder of the estate, after providing for key family members.
The Outside Estate
The prospect of a complex will being scrutinized under the gauntlet of courts and squabbling beneficiaries is most unbecoming.
Faced with the prospect of will challenges and interpretations due to retroactive tax laws, a long-forgotten attribute of living trusts takes on sudden importance. The living trust approach is a well-tested, tried-and-true method that eliminates analysis of wills by avoiding probate.
At one time, avoiding probate was a key objective in estate planning. If the phrase "How To Avoid Probate" rings a bell, and you come up with the name "Dacey," give yourself a pat on the back. Norman Dacey's book on the subject was the heavyweight champion of the estate planning world in its day. It sold 2 million copies and was banned by the Connecticut Supreme Court, which concluded that Dacey was practicing law without a license.
In Dacey's heyday, probate-unfriendly states were more common. Over the past 30 years, many states have reformed the probate process and have made it so convenient and user-friendly that laypersons needn't feel intimidated and may not even require an attorney to shepherd them through the process.
There are a few holdout jurisdictions, however. For example, New York administers the Estate Powers and Trust Law and Surrogate's Court Procedure Act in the context of local procedural rules that seem designed to make attorneys and executors go insane.
Modern Probate: Today, estate administration has been simplified in many jurisdictions. Moreover, the majority of assets may end up being transferred outside of the probate estate via retirement accounts, joint bank accounts, transfer on death accounts, insurance policies, real estate held in joint ownership with right of survivorship, and brokerage accounts with beneficiary designations. Any number of assets can be moved into these vehicles and can avoid probate and second-guessing.
Note, however, that the flow of such assets by private contract remains outside of the probate court's jurisdiction but does not remain outside of the testator's taxable estate. And the testator who sets up numerous accounts and contractual arrangements to avoid probate may also end up not having a coherent plan that saves taxes and protects beneficiaries.
Trusts Prevail: The right way to avoid probate is to take the testamentary plan for distributing assets and relocate it to a living trust.
A living trust is established during the testator's lifetime and becomes permanent at the testator's death. It is not administered by a probate court and is harder to challenge because the assets were already in the trust with the grantor's approval during the grantor's lifetime. Trusts are private, are funded without expense or delay, and provide protection against creditors. In short, trusts rock.
Capital Gains Dance Party
Perhaps the greatest threat of all, at the moment, that affects the largest number of estates, is the tax on capital gains. Can anyone determine if the basis for appreciated assets will step up, carry over, circle back, jump down, spin around, or skip to my Lou my darling?
Let's review. There was a stepped-up basis for appreciated assets owned at death. This has now become a carryover basis. It may return to 2001 laws that were built into the estate tax repeal as a default under the Byrd Rule. Or it may continue or switch under some other approach taken by Congress, but no one can predict what, how, or when.
With that kind of uncertainty, and with the opportunity to exploit capital gains tax rates at low levels and property valuations at low levels, a testator may want to realize capital gains now and take advantage of known advantages, rather than risk unknown consequences.
From an estate planning perspective, the longstanding philosophy of holding highly appreciated assets until death has to be reconsidered because the benefit of a stepped-up basis is in doubt. However, taking an appreciated asset out of the estate can have a significant impact on the remaining balance of assets. A checklist of questions applies if an appreciated asset is being considered for a current transfer that will remove it from the future estate:
 Which asset has the most appreciation in value now?
Which asset has the greatest potential for additional appreciation?
Is the asset a significant part of the estate of one spouse rather than the other, and should the remaining assets be redistributed to maximize estate planning in the event an estate tax with exemptions is reinstated?
Was the asset transferred to one of the beneficiaries of the estate for full consideration, and should the transfer be treated as an advancement from the estate? Should the remaining distributions be adjusted?
Was all or part of the $1-million gift tax exemption allocated to the transfer?
|
