Income Tax Planning Becomes A New Focus For Estate Planners

October 23rd, 2014

After the American Taxpayer Relief Act of 2012, the Patient Protection and Affordable Care Act of 2010, and the Health Care and Education Reconciliation Act of 2010 were enacted, there were some immediate changes to the tax structure, especially for estate planners. If one couples those changes with the fact that Ohio abolished the estate tax (aka death tax) in 2013, then many of the current methods of tax avoidance (e.g., A/B or marital trusts) and estate planning may have changed.

Although the schedules are all over the Internet, the basics are that tax brackets for the highest income earners are 39.6%. There is also a Medicare surcharge of 3.8%. Tax rate structures for trusts also skyrocketed. Any income over $11,950 for irrevocable trusts in 2013 cost $3,090 plus 39% of the amount over the $11,950. This is staggering considering the number of revocable (“living”) trusts that become irrevocable upon the settlor’s death, and many of those will have income triggering the highest marginal tax rate. There are numerous other changes, but the purpose of this article is to suggest that estate planners have a new focus—dealing with income tax planning rather than past worries, such as the death tax.

The tax changes are not all doom and gloom. There are now new estate tax exemptions for the federal estate tax, meaning in 2014 the estate tax exemption is $5,340,000 and most estates will not have to pay any estate tax at the federal level. This exemption is reduced by the amount of lifetime gifts that you made up to the full exemption amount during life. Thus if you made no lifetime gifts, the $5,340,000 exemption means that you owe no estate taxes to the federal government if your estate is under that amount.

The tax changes also provided what is known as “portability” of the marital deduction. As it stands, you may pass an unlimited amount of property to your spouse free of tax under the unlimited marital deduction. However, any property that remains in the surviving spouse’s estate at the second death will be subject to the tax.

Portability may eliminate the need for a credit shelter (marital deduction or bypass trust) or QTIP trust in some circumstances. If the first spouse died and timely filed a federal estate tax return electing to preserve or “port” the first spouse’s excess exemption amount to the surviving spouse for his or her use, a couple may pass an amount up to $10,680,000 (two times the current estate exemption because of 2 spouses) to children free of the tax while sheltering later appreciation from the tax. You do not need a QTIP election or credit shelter trust to take advantage of the full marital deduction.

The thought is that perhaps all of these marital trusts may not be necessary for achieving the marital deduction goal. Problems arise such as mandatory income streams if a traditional bypass trust is established. And now that there is portability, the mandatory income requirement of the traditional bypass or credit shelter to preserve the marital deduction no longer exists. Not to say that a QTIP trust is never needed. If there are split families (second marriages), with the goal to leave assets to the children of the first marriage while preserving income streams for the second spouse, then this type of trust is necessary.

Some methods for minimizing taxes include, but are not limited to:

  • Charitable remainder trusts;
  • Distributing capital gain income rather than accumulating;
  • Splitting trusts or multiple trusts; or
  • Creating intentionally defective grantor trusts.

The bottom line is that clients and estate planners must rethink the reasons why certain trusts are used, and focus on the need to avoid income taxes to the client and future beneficiaries.