Changing Your Estate Planning Strategy Under the New Tax Law

One of the major surprises in the December 2010 estate tax law is known as portability. Under the old law (and the law that is scheduled to return in 2013 if Congress doesn’t act before then) each person had a lifetime estate tax exemption with a use-it-or-lose-it feature. If your Estate Planning Strategy didn’t use all your lifetime exemption, the unused amount was lost.

Under portability, a surviving spouse can take over the unused exemption amount of the first spouse to die. Each spouse has a $5 million lifetime exemption, and the couple has a true joint $10 million exemption. Under the previous law a couple could use each spouse’s entire exemption amount only if each spouse separately owned assets at least equal to the exemption amount.

While portability is a great benefit, the question now is: Who should rely on it and how should your estate planning strategy be adjusted for portability?

Under the old law, married couples were encouraged to split ownership of assets so that each spouse owned at least the lifetime exemption amount. In addition, part of the standard estate planning was to leave a portion of the estate equal to the exemption amount either directly to the children or in a bypass trust that would benefit the surviving spouse during his or her lifetime but eventually benefit the children.

Here’s how the bypass trust works absent portability. Let’s say Max Profits has a $6 million estate and the estate tax exemption is $5 million. Max could leave everything to his wife, Rosie, and the estate wouldn’t owe any taxes because the marital deduction would shelter the entire estate. But that would leave Rosie with the $6 million estate plus her own estate. She’d have the burden of doing all the tax estate planning and would have an estate exceeding her exempt amount.

Instead, Max’s will transfers $5 million to the bypass trust and $1 million directly to Rosie. The bypass trust provides that income and principal is distributed to Rosie to the extent she needs it, and then any remaining amount goes to the children after Rosie’s demise. The amount in the bypass trust is shielded by Max’s lifetime exemption, and the $1 million to Rosie qualifies for the marital deduction, so there is no tax to Max’s estate. Rosie still has her own lifetime exemption and the $5 million in the bypass trust won’t be in her estate. The result is all of both estates avoid estate taxes.

Portability is a great benefit when someone whose estate was worth more than the lifetime exemption amount did not properly plan. With portability, the bypass trust might not be necessary to eliminate estate taxes. In the above example, Max can leave the entire estate to Rosie. She can add Max’s unused exemption to her own exemption and have a $10 million exemption available to her estate.

When the joint estate is valued at less than $10 million (and likely to remain so), the bypass trust is unnecessary to eliminate taxes. The lifetime exemptions of the two spouses will shelter both estates.

That doesn’t mean bypass trusts should be abandoned in your estate planning. Consider the following ways in which bypass trusts solve problems or achieve goals:

? The trust will protect the assets from creditors, both your creditors and those of your family members. If you work in a lawsuit-prone occupation or worry your heirs could be subject to lawsuits or other creditor claims (say, from financial irresponsibility or gambling), a bypass trust could be a good idea.

? A bypass trust is insurance against some consequences of a remarriage by the surviving spouse. The most-feared scenarios are that after a remarriage the spouse decides to favor the new spouse and his or her family instead of the children from the previous marriage or the second spouse makes off with the money. A bypass trust avoids these results while fully providing for the surviving spouse.

? A detail in the portability requirements also is a reason to consider a bypass trust. A person who has had more than one spouse takes the exemption of only one deceased spouse, and he or she doesn’t get to choose which exemption to use. Only the exemption of the latest spouse to die is available.

Continue the scenario above. Max leaves all his money and his unused estate tax exemption to Rosie. After a while Rosie remarries to Sy. A few years later Sy dies and leaves an unused exemption of only $1 million. Max’s $5 million exemption is lost. Rosie can add only Sy’s $1 million exemption to hers. Max could have used his $5 million exemption and still provided for Rosie by leaving part of his estate to a bypass trust.

? Right now it might look like two $5 million exemptions will leave Rosie with an estate that is clear of estate taxes by a wide margin. But suppose Rosie lives a couple more decades. In addition, the investment portfolio is invested well and we have another bull market like 1982-2000. Rosie will be rich with an estate exceeding the $10 million of exemptions she has. Her estate will be partly depleted by estate taxes. If Max had put his $5 million in a bypass trust, it and all its future appreciation would be out of Rosie’s estate and would pass tax free to their children after Rosie is provided for.

? You shouldn’t forget the generation-skipping transfer tax. This is the additional tax at a rate of 35% imposed on gifts made directly to grandchildren or later generations. Each person has a $5 million exemption from the GSTT that is separate from the estate tax exemption and that is not portable. When you have a large estate or want to provide directly for grandchildren, you take advantage of the GSTT exemption either by making direct gifts to the grandchildren or including them as primary or contingent beneficiaries of a trust such as a bypass trust.

? A number of states have estate taxes, and most of them have exemptions lower than the federal amount and no portability provisions. When you live in one of these states, you probably want to use a bypass trust for at least the state exemption amount.

? Portability depends on your executor making an election on the estate tax return. If for some reason the executor doesn’t make the election properly, your spouse can’t take your unused exemption.

? Current estate tax law is good only for those who pass away in 2011 and 2012. Congress could extend the law or make it permanent. Or it could let it revert back to the 2001 law. Or it could extend the law, absent portability. Or the law could be changed completely. There are a wide range of possible changes in the estate tax. You might want to play it safe and include a bypass trust in your estate plan.

There is a major disadvantage of a bypass trust to consider. When you leave assets to your spouse and he or she in turn leaves them to your children, your children increase the tax basis to the current fair market value. All appreciation during the lives of you and your spouse avoids capital gains taxes. When you leave assets to a bypass trust the basis is increased to fair market value as of the date of your death. But that also is the basis your children take when assets eventually are distributed from the trust to them. All appreciation that occurred in the interim is subject to capital gains taxes when they sell the assets. For joint estates up to $10 million, you can avoid both the capital gains taxes and estate taxes by leaving the assets directly to your spouse. Possible taxes on capital gains that accrue during your surviving spouse’s lifetime after your passing is the price paid for any benefits of the bypass trust.

As we’ve stated a number of times since Congress began increasing the estate tax exemption in the 2001 tax law, most of you want to avoid a clause in your will that automatically places into a bypass trust the maximum exemption amount. That could leave your spouse with little or nothing in his or her own name. Instead, decide how much of your estate should go to a bypass trust and how much directly to your spouse. Your will could state, for example, that the bypass trust receives the lesser of the federal exemption amount and 50% or your estate.

Portability is a great benefit to those who didn’t do a good job of estate planning. It also provides flexibility and options for the surviving spouse. But you need to carefully consider whether you want to rely on portability to avoid estate taxes or whether a bypass trust still can be a key part of your estate planning.