BROOKE T.CLEARY, JD, LLM SANTA BARBARA,CA93108 PARALEGALS:
(ADMITTED ALSO IN FL) TELEPHONE: (805)965-1329 DIBBY ALLAN GREEN, ACP
J.LEE JOHNSON, JD, LLM FACSIMILE: (805)965-7637 CHERYL E.WRIGHT
(ADMITTED ALSO IN IL, KY, MO, TN) BEVERLY M.ROBISON
ALEC C.YARBROUGH, JD, LLM KIM A.ARCE
June 2013
Estate Planning for 2013: New Laws Create New Planning Opportunities
Dear Friends,
As you all know, on January 2, 2013, President Obama signed the “American Taxpayer Relief Act of 2012,” commonly referred to as the “2012 Tax Act.” Now that the dust is settling a bit, we want to alert you about a few important changes you may want to consider. As you know, every time Congress wants to simplify, it only makes it more complex. The 2012 Tax Act is no exception, particularly with regard to the new planning options dealing with “portability” of a spouse’s estate and gift tax exemption, discussed below. Your decisions may impact multiple family generations in various ways, so it is important to understand these changes.
That being said, this letter is meant to provide you with a general background and is not meant to address your specific situation. We encourage you to make an appoint-ment with us in order to review your estate plan and discuss any questions you may have.
The new income tax rules and permanence in the estate tax provisions make the 2012 Tax Act significant. The new rules provide some certainty in the planning process by taking out prior sunset provisions, thereby making “portability” permanent, instituting a top 40% estate tax rate, and making the 2012 applicable exclusions for estate and gift taxes permanent. This letter will address the following issues:
I. Portability;
II. What Planning Options Are Still Viable; III. Medicare Tax;
IV. International Planning Considerations; and V. Property Tax Updates.
I. PORTABILITY
A. What is Portability?
Portability is a concept for married persons that allows a surviving spouse to use his or her deceased spouse’s unused exemption amount. What does this mean? The “exemption amount” is the value of assets a person may gift and/or transfer at death without incurring any transfer taxes. For 2013, the exemption amount is $5.25 million per person. Prior to portability, if a spouse’s exemption amount was not used, it was lost. Thus, most estate plans would set up a separate trust, known by many names, such as the residual trust, bypass trust, exemption trust, or credit shelter trust, to ensure that the first spouse’s exemption would not be lost by “transferring” that exemption to this new irrevocable trust. Of course, if the total family assets were less than the exemption amount (i.e., $5.25 million in 2013), then the estate plan would not need to use the residual trust for tax purposes since no estate taxes would be due; however, as will be discussed below, there are reasons other than estate taxes that warrant consideration of a residual trust.
Under the new portability rules, the deceased spouse’s $5.25 million unused exemption amount could now be transferred to the surviving spouse for his or her use thus allowing the surviving spouse to use the full $10.5 million in estate tax exemptions to save the estate taxes on the deceased spouse’s estate without the need of a residual trust (for estate tax purposes – again there may be other reasons to consider a residual trust). However, an estate tax return must be filed in the first spouse to die’s estate to make an affirmative election to use portability. There is no such thing as an easy version of the estate tax return. Therefore, this can still be an expensive prospect.
B. Should You Consider Portability in Your Estate Plan?
Whether or not you should consider employing a portability planning option depends on many factors, including not only the size of your estate, but also several important non-estate tax considerations. The information below is not meant to be an exhaustive discussion of the advantages and disadvantages of portability.
Advantages of Portability
1. A Simpler Estate Plan. As mentioned above, without portability, at least two separate
irrevocable subtrusts have to be created at the first spouse’s death to use each spouse’s exemption amount in full. With portability, married couples will not need a residual trust to utilize the deceased spouse’s exemption amount. This simplifies the estate plan and saves administrative costs associated with multiple trusts such as separate income tax returns for the residual trust, new Medicare sur-tax planning complexities (see discussion below), and the additional accounting necessary for a separate trust.
2. Step-Up in Income Tax Basis. When a person dies, the income tax basis (for capital gains)
of all of the assets of the estate is “stepped-up” to the fair market value of such assets as of the date of death. Assets in the residual trust do not get another step-up in basis upon the surviving spouse’s death. With portability, the assets received by the surviving spouse from the deceased spouse receive an additional step-up in basis at the surviving spouse’s death. This could save capital gains tax for the next generation on the subsequent sale of those assets.
3. Added Control for the Surviving Spouse. Portability will satisfy a client’s desires to provide added control over the assets and give more flexibility to the surviving spouse inasmuch as the surviving spouse will continue to own all the family assets outright for estate tax purposes. Of course, depending upon the family situation, this may also be a disadvantage. (Note, it is usually recommended that all of the surviving spouse’s assets be held in a revocable trust to avoid California probate.)
Disadvantages of Portability
1. Alteration of Estate Plan. As previously stated, with portability the surviving spouse may
have control over the deceased spouse’s share of assets. This means, that the surviving spouse can dispose of such assets in a manner contrary to the deceased spouse’s wishes. (This, of course, is a significant disadvantage to those families that involve second marriages.)
2. Lack of Creditor Protection. When a residual trust (or a QTIP Trust, discussed below) is
used to hold the assets of the deceased spouse, creditors of the surviving spouse may not seize assets in the residual trust. However, if the surviving spouse has ownership over assets, they may become subject to attack by the surviving spouse’s creditors. (Note, check your liability insurance policies and your umbrella policy to ensure that you are fully and completely protected from liabilities.)
3. Subsequent Appreciation Included. Assets in a residual trust are not includible in the
surviving spouse’s estate. So, appreciation of these assets after the deceased spouse’s death is not subject to estate tax at the surviving spouse’s death. If the residual trust is discarded in favor of portability, any subsequent appreciation of assets owned by the surviving spouse will be included in the surviving spouse’s estate. (But, there are some interesting planning opportunities here, contact us for more details.)
4. Loss of $1 Million Property Tax Exclusion. For California real property transferred
between a parent and child, there is an exclusion from property tax reassessment for $1 million of assessed
value of property other than the principal residence. With a residual trust, the deceased spouse’s $1 million exemption exclusion is preserved and will apply upon the surviving spouse’s death. Thus, the family can utilize a full $2 million exclusion. With portability, if the surviving spouse becomes the sole owner of all the family real estate assets, then upon such surviving spouse’s death only the surviving spouse’s $1 million property tax exclusion will be available. Thus, the deceased spouse’ $1 million of exclusion for assessed value is lost (unless property is transferred to children at the death of the first spouse to die).
5. Loss of Generation-Skipping Transfer (“GST”) Tax Exemption. A GST tax (currently
another 40% tax in addition to the estate tax of 40%) generally applies when property is transferred from a grandparent to grandchild (there are exceptions). Each person has a lifetime GST tax exemption equal to the estate and gift tax exemption. Thus, no GST tax is due for 2013 transfers of less than $5.25 million (assuming no prior GST exemption used). Under portability, the deceased spouse’s unused GST tax exemption cannot be transferred to the surviving spouse and it will be lost if not utilized. However, if the deceased spouse’s assets were in a residual trust (or a QTIP Trust, discussed below), his or her GST exemption would still be available on the surviving spouse’s death. This option may be important if the family wants to protect their grandchildren from future unknown creditors especially in divorce situations.
6. Loss of Income Tax-Savings Option. Structured properly, a residual trust may allocate the trust income to various members in lower income tax brackets thus providing the family unit overall income tax savings. In addition, careful planning may also save California income taxes and the new Medicare surtax if the income can be properly and appropriately allocated to other beneficiaries, especially non-California residents, if the income is not needed by a surviving spouse. (Note, care must be taken as to who is eligible to receive trust income if the trust owns California real estate and one wants to avoid reassessment.)
C. New Use of an “Old” Planning Structure: The Irrevocable QTIP Trust
An “old” planning structure, referred to by many names such as a “QTIP Trust” (Qualified Terminable Interest Property Trust) or a “Marital Trust,” can be adapted to take advantage of portability. This will allow use of portability while minimizing many, but not all, of its disadvantages.
Under this planning option, rather then giving the deceased spouse’s assets directly to the surviving spouse, such assets pass to the QTIP Trust, an irrevocable trust that qualifies for the marital deduction. This means that no estate tax is due for gifts to this trust since the surviving spouse is the sole beneficiary. Importantly, even though the assets are in the QTIP Trust, the deceased spouse’s estate and gift tax exemption amount can still be “given” and thus utilized by the surviving spouse. The QTIP Trust assets will be included in the estate of the surviving spouse thereby gaining a step-up in income tax basis. In addition, the deceased spouse’s GST tax exemption can be preserved (by way of what is known as a “reverse QTIP election”), and no property tax reassessment will be triggered.
Moreover, for larger estates the surviving spouse may take advantage of portability by having the surviving spouse make a gift of non-QTIP property to a new irrevocable gift trust using the deceased spouse’s unused gift tax exemption. This added planning option can be more beneficial in some larger estates than using a residual trust (due to complex grantor trust rules).
II. WHAT PLANNING OPTIONS ARE STILL VIABLE?
Many of our traditional planning tools remain perfectly viable. These include:
‚ Asset Protection using trusts in states outside of California.
‚ Family Business Succession Management. Please note that only about 33% of family
businesses succeed from the first generation to the second generation and only around 15% make it to the third generation. This is largely due to family conflict which often leads to the break-up of the business and even very expensive litigation among family members, which then will impact all subsequent generations. Moreover, just this May, one California Appellate Court officially recognized a new cause of action called “intentional interference with expected inheritance.” This provides parties with a civil tort cause of action if they have “no adequate remedy” in probate law, thereby expanding the potential for litigation. There are solutions to help maximize the chances for transitional success for your family and minimize the potential for litigation; however, this takes time and planning before the succession event occurs.
‚ Other Tax Planning Vehicles such as GRATS, QPRTS, various kinds of grantor trusts (IDGTs), family limited partnerships or LLC’s, and Delaware series limited partnerships and LLC’s.
III. MEDICARE TAX
In 2010, Congress enacted Internal Revenue Code §1411, which imposes a 3.8% tax on certain investment income, effective after December 31, 2012. Because this tax is intended to help fund Medicare, it is often referred to as the Medicare Contribution Tax (“MCT”). The MCT applies not only to individuals but to trusts and estates as well. For trusts and estates, the MCT applies to the lesser of two alternative tax bases: (1) the undistributed net investment income (“NII”), or (2) the taxable income in excess of $11,950. The threshold for trusts is significantly lower than for individuals. By example, a married couple has a joint threshold of $250,000. While some trust beneficiaries may have incomes above the individual thresholds, this will often not be the case. Thus, absent planning (and there are significant planning opportunities), this 3.8% tax may apply to trust income above $11,950, rather than to amounts above the higher individual thresholds. If interested, please make an appointment to discuss what MCT planning may be appropriate for your situation.
IV. INTERNATIONAL PLANNING CONSIDERATIONS
If you (or your spouse, if married) are not a U.S. citizen and/or a U.S. resident, certain considerations need be taken into account when implementing any estate and tax planning. For U.S. citizens and residents, special attention is also required if you or your spouse have any offshore bank accounts or other foreign assets. Ownership of such foreign assets may require a taxpayer to file the Report of Foreign Bank and Financial Account (“FBAR”), Statement of Specified Foreign Financial Assets (Form 8938) and numerous other reporting forms. Form 8938 may even be required for certain non-citizen, non-residents.
A U.S. person is required to file an FBAR statement, separate from their income tax returns, if they have a financial interest in, or signature authority over, foreign financial accounts with an aggregate value which exceeds $10,000 at any time during the calendar year. Individuals are required to file Form 8938 with their income tax return if their foreign financial assets are valued at a set threshold amount, which varies depending upon the tax status.
For those who have not complied with these reporting requirements, the Offshore Voluntary Disclosure Program may be worth considering as a means to become compliant while minimizing the risk of criminal prosecution.
V. PROPERTY TAX UPDATE
Last month (May), a panel discussion by the Assessors of Ventura, Los Angeles, San Diego and Orange Counties given at a tax conference in Los Angeles, indicated that the new 2013 values (as of January 1st) are overall showing an increase this year for each of these counties. This reflects actual general
considering during this time of recession whether to deliberately trigger a reassessment in order to make their temporary decline in value permanent for the future, might want to consider doing so fairly soon.
We have also noticed a greater aggressiveness on the part of some California Assessors and the State Board of Equalization to contact legal entities (corporations, partnerships, LLC’s) seeking information on any transfers of interests in the legal entity to determine whether reassessment might be triggered. As a reminder, a transfer of any interest in a legal entity, no matter how small (even 0.1%) can possibly trigger a reassessment – it all depends on the history of the entity and its real property. A transfer of an interest in a legal entity can happen on a sale, a gift, a death, or if an interest is owned in a trust it happens whenever a trust beneficiary changes. Any transfer that does trigger a change of control or ownership of the legal entity must be reported within 90 days of the date of transfer (e.g., date of gift, date of death) or there is an automatic mandatory penalty of 10% of the tax. If you receive a request for information from the Board of Equalization and do not reply within the 90-day time frame, you can be subject to the same automatic penalty.
Finally, keep in mind that every partnership agreement, LLC operating agreement, and shareholders’ agreement should have provisions requiring owners to promptly notify the legal entity of transfers of interests in the entity (including deaths or change of trust beneficiaries), specifying who will report the transfers and who will pay any penalty incurred for non-reporting, and specifying who bears the increased tax cost if there is a reassessment. You may also want to consider updating your limited partnership agreement or LLC operating agreement because California adopted an entirely new limited partnership act applicable to all limited partnerships as of January 1, 2010, and an entirely new LLC Act applicable to all LLCs as of January 1, 2014.
As previously stated, the above information is general in nature and there are different ramifications and applications for each person and each situation. Consequently, it is important to have your estate plan reviewed to determine if any of the points discussed in this letter may impact your plan. We are happy to conduct such a review for you upon request. If you have any questions or would like to learn more about portability, international issues, and/or property tax planning, please feel free to contact our office.
Sincerely yours,
AMBRECHT & ASSOCIATES
By:
