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Back to the basics of estate planning: reexamining estate planning needs, regardless of wealth.

In Brief

The enactment of the American Taxpayer Relief Act of 2012 [ATRA; P.L. 112-240, 126 Stat. 2313 (2013)] on January 2, 2013, was widely publicized by the popular press and mass media, which concluded that more than 99% of Americans no longer had to worry about estate taxes. Some financial services professionals complained about the loss of planning opportunities. Lost in the translation was the fact that estate planning is not the same as estate tax planning. Everyone needs estate planning--regardless of magnitude of wealth. This article shows that estate planning is indeed alive and well.

The American Taxpayer Relief Act of 2012 (ATRA) made sweeping changes in many areas of tax law, including the much-publicized creation of a new top income tax bracket of 39.6% for high income earners, and a new 20% top rate for capital gains and qualified dividends. Somewhat less noteworthy were the changes made to the estate and gift taxes. Less attention was paid to this issue because for two years prior to ATRA, the impact of the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 [TRA 2010, P.L. 111-312, 124 Stat. 3296 (2010)] had been felt. TRA 2010 had set the federal estate tax exemption amount at $5 million per person, indexed for inflation, and also reunified the federal gift and generation skipping transfer (GST) tax exemption at $5 million, indexed for inflation, for 2011 and 2012. TRA 2010 also introduced the concept of "portability." In years past, failure on the part of the first spouse to die to properly utilize his or her federal estate and gift tax exemption amounts resulted in the loss of those exemptions. With portability, in many circumstances, the surviving spouse could now use his or her own exemption plus the unused exemption of the deceased spouse, known as the deceased spousal unused exclusion amount or DSUEA.

TRA 2010 was in effect for only two years. However, ATRA made permanent its $5 million federal exemption for estate, gift, and GST taxes. ATRA also made the portability of the estate and gift tax exemptions permanent, but it did not extend portability to the GST tax. In addition, ATRA increased the top estate and gift tax bracket from 35% to 40%.

Estate Tax Stability Only Skin Deep

Under current law, estate tea planning is only for the few who are generally considered ultra-high-net-worth taxpayers. According to most estimates, more than 99% of families will have no exposure to federal estate taxes (see Paul Sullivan, "The End of a Decade of Uncertainty Over Gift and Estate Taxes," The New York Times, Jan. 4, 2013). According to 2011 estimates from the Tax Policy Center, there would have been only an estimated 3,300 estates in the United States that would owe federal estate taxes in 2011 under a $5 million exemption (Urban-Brookings Tax Policy Center, Table T11-0156, http://www.taxpolicycenter.org/taxtopics/estatetax.cfrn).

As a result, financial services professionals complain that the estate planning market has dried up, and relatively few prospects and clients want to engage financial advisors on estate planning matters. A major misunderstanding is the fact that estate planning is not the same as estate tax planning.

Many tax, legal, and financial services advisors applauded ATRA for finally giving U.S. taxpayers certainty and stability in the estate tax area. Popular media and news publications constantly reported that estate planning was unnecessary due to the permanency of the federal exemption amounts. Yet, a mere three months after the enactment of ATRA, President Obama released his annual budget proposal for fiscal year 2014 (General Explanations of the Administration's Fiscal Year 2014 Revenue Proposals, U.S. Dept, of the Treasury, April 2013). The president's proposal would, in 2018, reduce the federal estate tax exemption amount to $3.5 million, raise the top tax rate to 45% from today's 40%, and de-unify gift taxes from estate taxes, reducing the gift tax exemption back to $1 million. President Obama's budget proposal for fiscal year 2015 contains similar provisions. And on the other side of the aisle, Representative Robert Latta (ROhio) introduced a bill on February 15, 2013, that would have permanently repealed the federal estate tax (Permanently Repeal the Estate Tax Act of 2013, H.R. 782, 113th Cong.).

Little attention was paid by the popular press to the fact that (as of the writing of this article) 20 states and the District of Columbia still impose a state estate or inheritance tax, or both, with rates as high as 20% (Survey of State Estate, Inheritance and Gift Taxes, Research Department, Minnesota House of Representatives, December 2012). For example, Connecticut and Minnesota are the only two states that have a gift tax. However, several states have some form of "gift in contemplation of death" exception that would bring gifts back into the taxable estate if made within a certain period of time prior to death.

Prior to the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) (P.L. 107-16, 115 Stat. 38, 2001), states shared in the collection of estate taxes on the federal estate tax return. Estates could claim a credit for state estate taxes of up to 16% of the taxable estate. Therefore, many states taxed estates or inheritances at a level that would allow the state to take full advantage of the credit without actually applying an additional tax; this was commonly referred to as a sponge tax. EGTRRA, however, phased out this credit and replaced it with a deduction for state estate taxes. Those states whose estate taxes were tied to the federal credit lost tax revenue when the credit was phased out. They were confronted with the choice to either lose this tax revenue or take legislative action. This legislative action was commonly known as decoupling by separating the state estate tax system from the federal one and imposing a separate state estate tax.

For states that did not rely upon the sponge tax, some chose to levy no estate taxes or repealed their estate tax laws so there would be no increased estate tax burden on resident decedents. Other states already had separate estate tax systems in place. For most of the states that impose a separate estate or inheritance tax, or both, the state exemption amounts are significantly less than the federal exemption amounts. For example, New Jersey's estate tax exemption amount is still only $675,000 (Survey of State Estate, Inheritance, and Gift Taxes, 2012). Several states have a $1 million exemption amount. Also, other than Hawaii, no state has yet enacted a state version of portability. Accordingly, even families with a modest net worth may be subject to state estate taxes. Planning is essential to minimize the impact of state taxes.

Planning Beyond Taxes

With all the talk about federal estate tax exemptions and top tax rates, lost is the reality that estate planning is something that everyone needs, regardless of net worth. Most people want to safeguard their wealth and use it to better their lives and the lives of their family members. If they have young children, then estate planning is especially important to protect their children and ensure that someone will be there to care for them. Parents' wealth can be used to help children get a head start. The difference between those that have modest wealth versus substantial wealth is that only the latter will need estate tax and wealth transfer planning. Even then, great care must be exercised, because history has shown that there is no permanency in the estate tax laws. Laws change based upon politics and economic times. No one knows what the laws will be at the time of death.

For the vast majority of U.S. taxpayers, there should also be increased focus on income tax planning due to:

* the higher income tax brackets created by the ATRA,

* the need to focus on income in respect of a decedent (1RD), which is generated by assets such as qualified retirement accounts, and

* decisions impacting basis, such as gifting assets to beneficiaries during life, or leaving them through bequests at death.

Other important considerations include cash flow and asset protection planning during retirement, long-term care, and Medicaid planning.

As trusted advisors, CPAs should remind individuals that estate tax laws remain uncertain because attitudes shift based upon time, economic considerations, and political whims. You also need to ensure that they all have estate plans. At a bare minimum, everyone needs the following:

* a last will and testament

* a living will

* a healthcare proxy

* a durable financial power of attorney

* life, disability income, and long-term care insurance.

At higher wealth levels, particularly if an individual lives in a state that has a state inheritance or estate tax, other estate planning strategies to consider include the following:

* a revocable living trust

* a credit shelter trust or disclaimer trust

* an irrevocable life insurance trust or spousal limited access trust.

For the truly wealthy who have estates subject to the federal estate tax, complicated wealth transfer techniques and strategies, such as grantor retained annuity trusts, sales to intentionally defective grantor trusts, or charitable remainder trusts may be required. This article will not discuss such complex gifting strategies; instead, it will focus on estate planning for the "99 percenters."

Last Will and Testament

For most people, this is the primary document detailing the distribution of their estate at death. It is a legal document that describes how the legal representative of the estate (the executor) should distribute the decedent's assets. The person making the will is known as the testator. If a person dies without a will, that person is considered to have died intestate and their estate is distributed according to state law, which is often not what the individual would have intended. Many individuals do not have a will or have one that was drafted many years ago and should be updated for changes in the law and for life events.

If the testator has minor children, the will also should have provisions designating a guardian, that is, a trusted individual who would we responsible for raising the decedent's children if both parents are gone. An individual should designate a guardian even if the testator has a spouse because of the possibility of a simultaneous death, children of a prior marriage, or the possibility of incapacity or unwillingness of the surviving spouse to care for the children. Agonizing over the choice of who should be the named guardian often is a stumbling block in an estate plan. A guardian needs to have the ability, willingness, financial and emotional capacities, and appropriate morals and values. Courts typically honor the decedent's choice in the will, but if a guardian is not named, the court will appoint one, and that person may not have been the decedent's choice.

The administration of the estate can involve the management of assets, payment of expenses, tax decisions, negotiations on behalf of the estate, running a business on an interim basis, appointment and removal of fiduciaries, and more. As a result, an individual's choice of executor is not simply a matter of picking a close family member. An executor should have organizational skills and business sense and be familiar with local resources that may be available for various purposes. The executor should be astute enough to know when to call in professional advisors to assist, particularly with regard to taxation, because certain choices and elections may need to be timely made.

If an individual already has a will, she should review the choice of executor or guardian. Perhaps they are no longer suitable choices, because of age, financial situation, a falling out, change in lifestyle, or other circumstances.

If an individual already has a will, key questions an advisor should ask include the following:

* Do you know what your will provides? Wills often are technical documents and should be carefully reviewed. Most people do not recollect everything the will says or does.

* Does it still accomplish what you intended? In many cases, particularly if a will was drafted when the federal estate tax exemption was lower and the federal estate tax rate was higher, a will could cause an inadvertent disinheritance of the spouse or children (see the credit shelter trust discussion below). The will also may have focused on the federal estate tax while ignoring the state estate tax because it was a bigger concern at that time. Today, however, the reverse may be true for many families. Older wills could cause state estate tax to be incurred when it could otherwise be easily avoided.

* How long ago was the will executed? Most people believe that executing a will is a once-and-done affair and may have executed their wills many years ago. But since that time, many significant life events may have occurred, including new children, a divorce or remarriage, a significant change in income or net worth, an inheritance or windfall, and significant changes in tax laws.

Living Will

A living will, also known as an advanced directive, is an important legal document. The living will allows an individual to tell medical providers and others what he wants with respect to life-prolonging measures and medicines in the event of a terminal illness. In many states, a living will also designates a person to make the appropriate decisions at the appropriate time. Although a living will is colloquially known as the "pull-the-plug" document, its impact can be just the opposite, depending upon an individual's religious and moral beliefs.

Healthcare Directives

The healthcare directive, also known as a healthcare proxy or healthcare power of attorney, is a legal document that designates a trusted individual to make medical decisions on behalf of a patient in the event the patient is unable to do so as a result of a physical or mental injury or incapacity. Depending upon state law, the living will and healthcare directive may be embodied in the same document or separate documents. Healthcare directives typically incorporate do-not-resuscitate (DNR) orders, which prohibit medical personnel from providing advanced cardiac life support measures when an individual's heart or breathing stops.

Many older living wills and healthcare directives do not comply with the requirements set out in the Health Insurance Portability and Accountability Act of 1996 (HIPAA) with respect to medical privacy. Today, well-drafted documents specifically provide the client's representatives with the authority to access and review medical records in order to make well-informed decisions. Clients should make sure that their documents comply with the HIPAA privacy rules.

Durable Financial Power of Attorney

The durable financial power of attorney (POA) is a legal document that allows an individual (the principal) to designate another (the agent or attorney-in-fact) to manage the principal's financial affairs in the event she is incapacitated, disabled, or otherwise unable to manage her financial affairs. The powers that are delegated to the agent can be either very specific or very broad, depending upon the circumstances.

POAs are governed by individual state laws, which have been updated in recent years. For example, in some states the attorney-in-fact has the statutory power to make gifts on behalf of the principal, but in other states, specific authority to make gifts must be given to the attorney-in-fact in the POA. In light of the high federal estate and gift tax exemption, POAs that authorize gifts may need to be reconsidered. On the other hand, for wealthy clients, POAs may allow for gifting so that wealth transfer strategies may be implemented to reduce the size of the gross estate. A careful review is required and specific powers need to be addressed depending upon the circumstances.

Life Insurance

Life insurance is important as a wealth and legacy creator as well as to financially protect surviving family members. The death benefit of an individually owned life insurance policy is includable in the gross estate for purposes of calculating federal and state estate taxes. Therefore, life insurance ownership may cause estate tax consequences, particularly on the state level. Used appropriately, however--such as in an irrevocable trust--life insurance can be a great equalizer. It can help to create the liquidity to pay estate taxes or it can be used to replace wealth lost to taxes.

Disability Income Insurance

Similar to life insurance, disability income insurance protects against the loss of continuing income due to the wage-earner's sickness or injury. Long-term, consistent earned income is the primary driver of wealth accumulation for most families. Without earned income, most individuals cannot make additional contributions to retirement plans or investment accounts; cannot built credit to qualify for a mortgage to purchase a home; cannot obtain credit to finance a business; and do not have the cash flow necessary to meet basic living needs. Because the continued availability of income is a determinant in the savings and investment component of wealth accumulation, it is an important estate planning tool. Adequate disability income insurance can protect the source of income in the event of sickness or injury and protect the estate.

Long-Term Care Insurance

Few people think about long-term care insurance (LTCI) as an estate planning tool, yet it is one of the most important. Advances made in medicine and the movement toward healthier lifestyles has greatly increased longevity, which, in turn, has increased the possibility of needing assisted living facilities, nursing home care, and home health care. LTCI helps cover these expenses. Without this insurance, personal assets must be used, depleting the estate for legacy purposes.

Beneficiary Designations

Life insurance beneficiary designations also greatly impact estate planning. Unfortunately, it is common for policy ownership and beneficiary designations to be uncoordinated, causing unforeseen tax issues. For example, a policy owned by an individual insuring a spouse's life but naming a child as beneficiary can cause inadvertent and adverse tax consequences. According to the rules, when the policy owner, insured, and beneficiary are three separate individuals, the policy owner is deemed to have made a taxable gift to the beneficiary. This is commonly known as the "Goodman Triangle" (Goodman v. Comm V, 156 F.2d 218, 2d Cir. 1946).

Sadly, there are other common problems with beneficiary designations, such as failing to remove a divorced spouse as a beneficiary. Depending upon state law and the terms of the divorce decree, an ex-spouse may be entitled to the death benefit. In addition to the emotional issues, this may have estate tax consequences. Another common mistake is to name a minor as a beneficiary. Insurance carriers will not pay death benefits to a minor and additional legal action may be required. Life insurance beneficiary designations are often not coordinated with the estate plan, or worse, improperly completed.

In this author's experience, it is not uncommon for individuals to forget to change beneficiary designations when important life events occur, particularly divorce. Beneficiary designations should also be reviewed for qualified retirement plans, annuities, and other financial products and accounts. Many court cases have demonstrated the harmful impact of failure to monitor and change beneficiary designations (see Hillman v. Maretta, 133 S. Ct. 1943, June 3, 2013; Kennedy v. Plan Administrator for DuPont Savings and Invoice Plan, 555 U.S. 285, 2009).

Revocable Living Trusts

Revocable living trusts (RLT) are created to act as a will substitute, help minimize probate expenses, secure privacy, and aid in situations otherwise requiring a proxy. For individuals that own real estate in multiple states, an RLT may be useful in avoiding ancillary probate. Clients with closely held businesses may also benefit from a revocable living trust. RLTs may be called for in those states that have higher probate, administration, and ancillary fees. Depending upon the state and the size of the estate, legal fees can be quite high, even in an uncontested probate proceeding. Therefore, avoiding probate may be desirable.

When created, RLTs are the main documents in an estate plan. The will tends to be a document that funnels, or pours over, upon death, those assets that were not transferred into the RLT during life. RLTs work optimally, however, only when assets are re-titled in the name of the trust. Often, the RLT is drafted by the attorney and signed by the grantor, but no assets are re-titled into the trust. As a result, the purpose of the RLT to avoid probate and secure privacy may not be fulfilled, because the probate process is required to funnel the assets into the trust. In addition, if the RLT does not have title to assets, the trustee of the trust cannot stand in the place of the grantor in the event of sickness, injury, disability, or other unavailability.

Credit Shelter Trusts

Prior to portability, credit shelter trusts (CST)--also known as bypass trusts, family trusts, or B trusts--were commonly used to preserve the estate tax exemption amount of the first spouse to die. They were designed to hold the first decedent's assets up to the estate exemption amount. The estate exemption amount was a "use it or lose it" proposition. Portability has diminished the reasons for needing a CST, at least from the federal estate tax perspective. In order to preserve portability, the federal estate tax return, Form 706, must be filed upon the first death, even though no federal estate tax is due. As previously noted, however, many states still have a state estate or inheritance tax, or both (and only Hawaii has a state version of portability). Accordingly, even families with a modest net worth may be subject to state estate taxes, so a CST can be useful to preserve the state estate tax exemption.

Depending upon the language and provisions used in a CST, older documents may result in the inadvertent disinheritance of the spouse or children. This situation arises due to the increased federal exemption. The funding of a CST for federal estate tax purposes also must be weighed against the creation of potential state estate tax consequences because of lower state exemption amounts. Individuals must consult with their attorneys to carefully review older estate documents. Notwithstanding the tax reasons, credit shelter trusts may still be desirable because they serve many other purposes as well:

* To ensure that assets continue to be appropriately managed and invested, perhaps because surviving family members may not have the requisite investment or business acumen, or because of the complexity of the asset (for example, a closely held business);

* To preserve the inheritance of children from a first marriage;

* To freeze the value of assets going into the trust so that asset growth is not subjected to additional estate taxes (particularly useful for wealthy individuals);

* To provide a level of spendthrift protection to ensure that assets are not depleted by trust beneficiaries;

* To protect assets from the claims of potential creditors, including ex-spouses, of the trust beneficiaries; and

* To create a family legacy that may financially assist lineal descendants for hundreds of years (if not in perpetuity), if executed correctly and in the appropriate jurisdictions.

A disclaimer trust is similar to a credit shelter trust although, procedurally, it is funded differently. Whereas a credit shelter trust is affirmatively funded by the provisions in the decedent's will or revocable living trust, a disclaimer trust is funded by the surviving spouse's election to disclaim assets being left to him or her. Such disclaimed assets are then redirected to fund the trust. The disclaimer trust operates similarly to the CST but gives the flexibility to make the decision to hind the trust dependent upon the economic needs of the surviving spouse and the financial and legal considerations that exist at the time of the first death. In most cases, disclaimer provisions should be considered to provide maximum flexibility.

Life Insurance Trusts or Spousal Limited Access Trusts

The need for life insurance for estate tax liquidity has diminished in light of the higher federal estate exemption. Yet, this strategy is still a viable estate planning tool for the mass affluent or moderately wealthy. Life insurance is purchased inside an irrevocable life insurance trust (ILIT) for several reasons. Some of those reasons are similar to those of the credit shelter trust and include the following:

* To keep life insurance proceeds out of the taxable estate. The death proceeds of individually owned life insurance policies are included in the calculation of the gross estate. Thus, someone with modest net worth could conceivably have a federal or state estate tax issue, or both, solely because of the amount of life insurance owned. ILITs help prevent that situation.

* To provide a source of liquidity. The insurance can be used to loan money to the estate or to buy illiquid assets from the estate, giving the estate liquidity to pay taxes. Estates or heirs, or both, may also be subject to hefty income tax burdens. The tax liability may be a result of assets included in the taxable estate, including IRD assets such as qualified retirement plans, traditional IRAs (individual retirement accounts), annuities, pensions, and nonqualified deferred compensation plans. Insurance in an ILIT can be used to provide liquidity to pay the income taxes on these assets or to replace the wealth lost to taxes.

* To replace wealth that may have been gifted to charity. Charitable gifts reduce the potential inheritance heirs would have received. This strategy may be more attractive to moderately wealthy individuals instead of the very wealthy, to ensure that heirs receive as much as possible.

* To ensure that children receive an inheritance. Using insurance avoids the need for a parent to adjust spending habits and lifestyle to ensure that assets are left over at death.

* To create a lasting financial legacy for future generations. Consider this a dynasty trust for the less wealthy.

* To protect the life insurance death proceeds. For example, from creditors and from the spendthrift tendencies of beneficiaries.

The spousal limited access trust (SLAT) is nothing more than an ILIT (or credit shelter-type trust) that has been carefully drafted and funded. In a SLAT, the grantor's spouse also is a beneficiary of the trust. As a result, during the grantor's lifetime, the spouse, as a trust beneficiary, may obtain access to income and principal, including the cash values of a permanent life insurance policy. This provides the grantor with indirect access to cash values through the spouse. The SLAT overcomes the objection of having permanent cash value life insurance policies owned inside an irrevocable trust because of the loss of access to policy cash values.

Estate Planning Is Not Dead

Many estate planning strategies and techniques apply to the more than 99% of U.S. taxpayers that will never be subject to federal estate taxation; clearly, estate planning is not dead. Estate tax planning and wealth transfer strategies may be less common under the higher federal estate tax exemption, but in many states, estate tax planning is still required. There are many estate planning strategies that CPAs can use in the unlikely event that the tax laws remain permanent.

One of the greatest services that CPAs can provide is to ensure that a client's estate plan is completed. Having documents drafted by attorneys and executed by clients is not enough; they are merely an interim step to completing and monetizing the estate plan. Financial professionals can work with tax and legal advisors to retitle assets; determine an appropriate fiduciary; ensure appropriate beneficiary designations on qualified plans, life insurance, annuities, investment accounts, and employee benefits; provide adequate communication and education to designated fiduciaries as well as to heirs; organize important documents; simplify administration; and help individuals obtain the appropriate types and amounts of life and disability income insurance.

The pronouncement of the death of estate planning by the popular press and mass media is premature. There is still plenty of estate planning work for financial services professionals to do for their clients.

Victor Ngai, JD, CLU, ChFC, is the assistant vice president of the Business Resource Center, an advanced planning consultative service at the Guardian Life Insurance Company of America, New York, N. Y.
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Title Annotation:Finance: estates & trusts
Author:Ngai, Victor
Publication:The CPA Journal
Geographic Code:1USA
Date:Jan 1, 2015
Words:4647
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