Estate Taxes are Probably Not Your Problem: Simplify Your Will, Review Your Estate Planning Devices

As we have noted in this newsletter on a number of occasions in the past year and a half, the federal estate tax has become a non-issue for most married couples, and opportunities to simplify estate plans now abound.  In 2014, one individual will be able to pass up to $5,340,000 without having a federally taxable estate and a married couple will be able to pass double that or $10,680,000. That unified credit is also now “portable” meaning that the estate of the first spouse to die could use the marital deduction to avoid tax and then pass the whole of his or her credit on to the surviving spouse.

Unfortunately, any wills that were done prior to 2012 do not take these high limits into account.  If your wills were done fifteen years ago in 1998, the assumption would have been that $625,000 was what a person could pass tax free, and $1,250,000 would have been the ceiling a married couple would need to hit before paying estate tax (but only if the couple had “split” their assets 50/50 and taken other necessary planning steps).  Given these assumptions, your 1998 Will quite likely would have contained a device called a “unified credit trust” or a “bypass trust”, which would have been designed to pass the exemption amount ($625,000 in the 1998 example) free of tax.  That device would also have held that money outside of the surviving spouse’s estate when that spouse died. 

For most couples the unified credit trust is now not only unhelpful,  it can be downright hurtful.  Trusts are more difficult and expensive to administer than outright gifts.  They require attention, accounting and tax returns.  Generally trusts are simply inconvenient.  Unless there is a compelling tax or personal need for a trust, it is probably best avoided.

The unified credit trust has the added potential disadvantage of creating higher capital gains taxes on the death of the second spouse.  Under the Internal Revenue Code, property held by an individual gets a stepped-up basis upon that person’s death.  Assuming generally rising asset prices, this is beneficial and has the effect of reducing capital gains taxes.   The rub with the unified credit trust is that assets passing into that trust necessarily do not pass to the surviving spouse and when the surviving spouse dies they do not get this step-up in basis.  This situation can create additional significant tax liability when assets passing into a trust are rapidly appreciating in value or when a significant amount of time elapses between the deaths of the two spouses (e.g., when one spouse is significantly younger than the other).

It should be noted that this problem is also present, and perhaps more pronounced, in the case of lifetime irrevocable trusts and in family limited partnerships.  These devices, intended to escape estate taxes, now may no longer serve that previously needed purpose, meanwhile assets in those longer duration vehicles have appreciated in value with no corresponding basis increase.  At a time when capital gain rates increase to 20% for trusts, estates and individuals in the highest tax bracket (plus the potential for a 3.8% “Obamacare” tax)  these devices may invite further review, simplification and perhaps “un-doing.”

— Rod Fluck


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