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How to Prepare for the Approaching Estate Planning Crossroad

Published on: Jun 23 2020

We’re approaching a crossroad in estate planning, and many of my readers are among those who most need to take action before we reach it.

Few people today have to worry about federal estate and gift taxes, be-cause of the high level of exemptions. The 2017 tax law doubled the individual exemption to $10 million. After indexing for inflation, the exemption is $11.58 million per person in 2020 and $23.16 million per couple.

The current estimates are that when the 2018 estate tax return data are final, about 4,000 returns will be filed and only about 1,900 will show some estate tax was imposed. As a comparison, about 109,000 estate tax returns were filed in 2001.

I think there is a high probability of significant changes in the estate tax law in the coming years, and that’s the crossroad we are approaching. If Congress doesn’t take action, the lifetime exemption will be slashed in half automatically by operation of law after 2025.

If there’s a major change in power after this November’s elections, the exemption could be reduced sooner or could be reduced by more than half. The result is that in a few years estates with values as low as $3 million to $5 million could be subject again to estate and gift taxes. Your estate plan needs to be structured to achieve the results you want under today’s law.

Also, it should be flexible enough to adapt to changes in the law that take effect before you’re able to revise the plan.Here are key issues to consider.Eliminate outdated formula clauses. This is the most important action and has been needed for several years. Estate planners routinely used formula clauses in wills for many decades, and those old formulas or their remnants still are in many wills. The clauses can be very detrimental to a surviving spouse.

A formula clause splits the deceased’s property between the estate and a trust using a simple formula. The strategy was developed to take full advantage of the lifetime estate and gift tax credit when it was much lower than it is now. Suppose an estate was worth $1.5 million when the lifetime exemption was $600,000.

Under a standard formula clause, a portion of the estate would be transferred to a trust, usually known as a credit shelter trust or by-pass trust, up to the maximum amount of the lifetime federal estate and gift tax exemption in effect at the time. The rest of the estate would go to the surviving spouse. The trust usually would support the surviving spouse for life. After that spouse passed away, the assets remaining in the trust would go to the couple’s children. In this case, $600,000 would go into the trust, and the surviving spouse would inherit $900,000. The estate would avoid federal taxes, and the surviving spouse would live on the funds provided for that purpose.

With today’s exemption amount and a will with such a formula clause, the entire estate would go to the trust, and the surviving spouse would inherit nothing outright. Most states would prevent a complete disinheritance of a spouse without a pre- or post-nuptial agreement, but many of them would give the surviving spouse only one-third of the estate. Unless your intent is to disinherit your spouse, have any formula clauses revised or eliminated.

Rely on portability or add a trust? Under current law, the surviving spouse can take over the unused lifetime exemption of the first spouse to pass away, if the estate of the first spouse to pass away elects to allow the transfer. This is known as the portability election and is taken simply by filing an estate tax return, even when no taxes are due.

The portability election allows a married couple to take full advantage of each spouse’s lifetime exemption, shielding $23.16 million in 2020 from estate and gift taxes, regardless of which spouse has legal title to the property. Many estate plans now provide that the entire estate of the first spouse to pass away is bequeathed to the surviving spouse. This allows the surviving spouse to inherit the entire estate and eventually transfer the remaining assets to the next generation free of estate and gift taxes, up to $23.16 million in 2020.

It is a simple, clean way to pass an estate to a surviving spouse and the next generation tax free.Despite the benefits of portability, using it for the entire estate isn’t a good idea for everyone. Some people still should consider combining portability for part of the estate with a credit shelter trust, a QTIP trust, or another type of trust for the rest of the estate, though without the use of an old-style formula clause.

A trust can protect the assets from any creditors of the surviving spouse. A trust also could provide professional management of the assets and protection from mismanagement and con artists. A trust that gives the trustee discretion over distributions can prevent overspending and reduce income taxes. Some people want to use a trust to ensure their children or other loved ones are the final beneficiaries of the remaining assets. The trust prevents the assets from eventually being inherited instead by a subsequent spouse (or previous spouse), children from another marriage, other relatives, or charity.

When a trust is used, a different type of formula is needed to deter-mine how much of the estate would be transferred to the trust and how much would be bequeathed to the surviving spouse. A flexible formula that automatically adapts to changes in the tax law would say, for example, the trust would receive the federal exemption amount, or 40% of the estate, whichever is less. Or it could set a maximum dollar amount that would go to the trust. The surviving spouse would receive the rest of the estate.

Don’t forget state taxes. About 20 states still have some form of estate or inheritance tax, or both. Some have exemption amounts that are much lower than the federal exemption.When your state has these taxes, discuss possible strategies with your estate planner, such as QTIP trusts and lifetime gifts. You’ll need an estimate of the potential taxes, so you can decide if the cost and restrictions of a strategy are worth the tax reduction.

Lifetime gifts. When an estate might be taxable, lifetime gifts are a good way to transfer wealth to the next generation without incurring estate and gift taxes. Talk with your estate planner about which assets would be good for you to transfer now. Also review our March and April 2020 issues. Add flexibility to the plan. As I said earlier, we don’t know what the federal estate tax will be in a few years. You can prepare the plan for uncertainty by inserting a few provisions, especially in trusts, that increase flexibility.

For example, a trust can include powers of appointment. Generally, these powers allow the trust creator or one or more beneficiaries to name who will receive part of the trust, even someone who wasn’t originally a beneficiary. There are many different types of powers of appointment, and they are very flexible.

A power of appointment can save estate or gift taxes if the federal exemption amount is reduced in the future. For example, an adult child who is scheduled to receive distributions from the trust might appoint his or her children to receive distributions instead so the entire inheritance isn’t in his estate. Another form of flexibility is to give the trustee or a group of trustees discretion to determine distributions.

Among other factors, they would consider how to structure distributions to reduce taxes.Another good idea, if state law allows it, is to provide for decanting of a trust. Decanting is a process in which the trust assets are shifted to a new trust. This can be valuable when the old trust is irrevocable and either the tax law or family circumstances change, making the old trust less than an optimum solution.

Trust decanting is relatively new, but a number of states now have adopted laws in recent years that allow it under certain circumstances.

You also can name one or more trust protectors and empower them to change key provisions of the trust. A trust protector also can monitor the activities of the trustee and replace the trustee if that seems warranted.The right tools for you will depend on your situation and goals.Now is a good time to take a fresh look at your estate plan with the potential changes in the next few years in mind.

Already, many people are reviewing their plans because of inadequacies highlighted by the coronavirus pandemic. While doing that, consider how the federal estate tax might change in the next few years and add some flexibility to cope with potential changes.



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