Estate & Asset Protection Planning Strategies to Reduce or Eliminate Estate Taxes
Todd E, Lutsky, Esq. LLM
Cushing & Dolan, P.C.
Attorneys At Law
Totten Pond Road Office Park
375 Totten Pond Road, Suite 200
Waltham, MA 02451
Federal Estate Tax Changes
The fiscal cliff has come and gone. What is left in its wake and how does it impact your estate planning decisions? The tables that follow will show the rate and the exemption changes for the estate and gift taxes that have and will occur from 2005 thru 2015. You will see that in 2005 the estate tax rate was at 47% but over the years has fallen to as low as 35% but has seemed to settled in at 40% of your total taxable estate. The only impending legislative discussions as of now was President Obama’s 2015 budget proposal in which he wants to go back to the 2009 estate tax rules which would put the federal estate tax exemption at $3,500,000 and return the estate tax rate to 45%. Keeping this in mind, while we have been told that the estate tax laws shown here are now “permanent” one must ask, “What does that really mean?” Advanced planning is and always will be the best possible way to protect you from paying unnecessary taxes.
The estate tax exemption amounts listed in the table that follows represent the amount of assets any one person can leave to someone other than a spouse without paying any estate taxes. The old problem with this was that if you did not use the exemptions at your death then you would lose them. However, following the fiscal cliff the government has now created something called Portability of Exemptions.
What is Portability?
In order to understand the concept of portability, it must be understood how the federal estate tax exemptions operated prior to portability. There were two basic rules seeming in conflict.
The first rule was that one spouse could leave all assets to the surviving spouse with a simple will. This is the Unlimited Marital Deduction, which allows you to leave as many assets as you like to your spouse without paying estate taxes. As a result, there would be no federal estate tax upon the first death because of the Unlimited Marital Deduction.
The second rule dealt with the couples estate tax exemptions. While each spouse was entitled to his or her own exemption ($5.34 Million for 2014) the surviving spouse was not permitted to use the exemption that was available to the first spouse upon the death of the first spouse, even though all assets could be left to the surviving spouse free of estate taxes.
In simple terms, the estate tax exemption was not portable. The exemption either was used when the first spouse died or it was lost forever, and the federal estate tax cost of wasting the exemption with an “I Love You” plan would be as much as $2.136 million ($5.34 million x 40%).
Because the estate tax exemption was not portable, in a typical case involving a married couple, each spouse would adopt a revocable living trust to be funded either during life or at death with whatever the exemption amount might be.
Upon the death of the first spouse to die, the trust would break down into two shares a marital share and a remainder or by pass share. This way the assets of the deceased spouse’s trust would be held in the trust but for the benefit of the surviving spouse. Those trust assets, while includable in the deceased spouse’s estate, would be taxable now, but by design would be equal to or less than the federal exemption amount so no estate tax would currently be due. This way the surviving spouse could enjoy the assets without being the outright owner thereby enabling these assets to not be included in her estate upon her death. This also means that all future growth on these assets are also outside of her estate all of which will help to reduce or even eliminate estate taxes on the surviving spouses death, provided the assets are below the estate tax exemption amount.
With the introduction of portability, the surviving spouse is able to use the first deceased spouse’s unused exemption which has become known as DSUE.
In our example, if all the assets were left to the surviving spouse instead of into bypass trust, the surviving spouse’s DSUE would be $5.34 million. On the other hand, if the first spouse to die left $2 million to children, the DSUE available to the surviving spouse would be $3.34 million ($5.34 million less $2 million left to the children).
Problems with Portability
First, portability is not automatic and requires an election which is not mandatory. In order to elect portability, the surviving spouse must timely file a federal estate tax return (generally 9 months after the date of death or 15 months if extended) and, where an estate tax return otherwise would not required to be filed. One problem here would be the estate of the surviving spouse who understood that portability eliminated the need for planning on the first death, may not be aware or remember that an estate tax return is required to be filed in order to elect portability and may simply do nothing thereby leaving the surviving spouse with only his or her exemption and a federal estate tax liability. These problems are compounded by the fact that this would be an emotionally trying time for the surviving spouse with potentially less attention being paid to these matters.
Second, DESUE is not indexed for inflation whereas the surviving spouse’s own exemption will be indexed for inflation. This means that, should the first spouse to die leave assets to the surviving spouse, then those assets double in value (money doubles every 10 years at 7.2%) the appreciation will not be protected by portability. For example, if you have a $7,000,000 estate, even if portability were effectively elected, the surviving spouses estate would be worth $7,000,000 all of which would be subject growth and which could easily exceed the combined exemptions amounts of the surviving spouse, since the DESUE amount will not be increasing over the years to keep up with this potential for growth, thereby resulting in an estate tax liability. Another problem is that laws do and will change in the future so these exemption amounts could be lower by the time the surviving spouse dies resulting in even a larger estate tax liability. Therefore, in order to provide clients with some level of certainty the goal should be to leave the surviving spouses taxable estate as small as possible by continuing to do trust planning and sheltering the exemption amount on the first spouse’s death, as well as allowing all future growth on those assets to be estate tax free.
Third, the so-called generation skipping tax exemption is not portable and, while most people would understand the generation skipping taxes are for the wealthy, these taxes can come into play simply when a couple wishes to protect their assets for their children and keep the assets away from their children’s creditors and spouses and ultimately be sure the funds pass to their grandchildren. It is this very idea of getting assets to the grandchildren that forces us to consider the generation skipping tax exemption and related issues. A generation skipping tax can be an issue even in the most simple of cases.
Fourth, portability is not applicable in Massachusetts, which has retained the old rule of using the exemption on the first death or losing it altogether. This is especially important in Massachusetts for when you exceed the exemption amount you pay estate tax on the entire amount of the estate and not just the amount over the exemption. Therefore, if the first spouse to die does not use his or her exemption amount and leaves all assets to the surviving spouse and the surviving spouses estate exceeds the state exemption amount, which is currently set at $1,000,000, then that exemption amount would also be wasted and the full value of the estate would be subject to Massachusetts estate tax. Therefore, estate planning remains important.
Fifth, if portability is elected then the first spouse to dies estate will remain open for audit by the Internal Revenue Service until the surviving spouse’s estate is closed.
There are non-tax reasons to not rely on portability. The first reason is to control the assets after the death of the first spouse to die. By leaving assets in trust on the first death, the assets can be protected from claims of surviving spouse’s creditors and surviving spouse’s marriage and divorce.
Finally, a remarriage by the surviving spouse could result in the loss of the DESUE from the first spouse since DESUE is only attributable to the most recent deceased spouse. For example, if a husband dies and leaves all assets to the surviving spouse, the surviving spouse would have a $5.34 million DSUE amount.
If the surviving spouse remarries and the second spouse dies prior to her and leaves say three million to someone other than the spouse, ( such as his children from a prior marriage), she would loose the DSUE from her first spouse and would be left with only the DSUE from her second husband.
In that case, the DSUE would be $2.34 million instead of $5.34 million, which would clearly adversely affect her estate tax liability upon her demise. Therefore, while estate tax portability may exist it is certainly something taxpayers should not relay on and instead continue to focus on using trusts to most tax efficiently pass their assets to their loved ones.
The Benefits of Estate Tax Planning with Trusts
In the event portability is not elected as discussed above, the old rules of estate tax unlimited marital deduction and all the tax problems that go with it will continue to apply. This occurs most frequently when the first spouse dies and leaves everything to the surviving spouse. This generally happens because spouses tend to own things jointly or have designated beneficiaries on things like life insurance and 401k or IRA accounts being the spouse. The better approach is to implement some trusts that leave assets in trust for the benefit of the spouse and that allows the spouse to be the trustee as well as benefit from the assets while utilizing the first spouses’ exemption amounts. Finally, the Massachusetts estate tax tables are shown below and they demonstrate that the Massachusetts exemption amount has been stuck at $1,000,000 since 2006 and remains there to this day. Like the federal exemption, these are the amount of assets that you can leave to someone other than the spouse and not pay state estate taxes. However, be careful for if you exceed this amount you will loose it and have to pay tax on the full value of the estate not just the amount over the exemption amount. Finally, remember that portability of exemptions do no apply to the Massachusetts estate tax exemptions.
Let’s use an example to help us understand how to best utilize these estate tax exemptions and reduce and possibly eliminate your federal and state estate tax liability. John and Jane are married and own a home worth approximately $1 million, a vacation home worth approximately $500,000, IRA accounts worth approximately $500,000 and miscellaneous investment accounts worth in total approximately $3 million. Assume that they own all of their assets jointly except for the IRA accounts, which are owned in their respective names but have each other listed as the designated beneficiaries. They have three children, three grandchildren, and are both 55 years of age. Many families in this situation have similar objectives, such as avoiding the costs associated with the probate process, reducing and possibly eliminating estate taxes, not giving up control over their assets during their lives, and ensuring the proper blood line disposition of their assets following their deaths. Asset protection planning for a couple like this may not be a top priority but may be pursued through the use of long term care insurance, but this is not to say that irrevocable trusts are not an option.
It is important for John and Jane to have two trusts in order for them to more fully take advantage of both their current $5.34 million federal and $1 million Massachusetts exemption amounts. As mentioned above, an exemption amount is the amount of assets an individual can leave to someone other than a spouse without paying any estate taxes. However, keep in mind that one must plan for the future as the federal exemption has changed in the past and is likely to change again in the future. By planning one can always make sure to take advantage of whatever the federal and state exemptions are in effect whenever someone dies. In this regard, just because your estate is currently worth less than $5 million does not mean you should not do your planning. In this regard, remember the Massachusetts exemption is stuck at $1 million and has been since 2006, so you need to plan to avoid the state estate taxes at a bear minimum, and in turn you can prepare for any future federal estate tax at the same time.
It is important to plan prior to the death of the first spouse, because any plan that shifts all the assets to the surviving spouse will, assuming the failure to elect portability, result in the loss of one federal exemption and one Massachusetts exemption, regardless of weather or not federal portability is elected, which is the common result when people have simple wills or own everything jointly.
In our example, prior to planning, John and Jane were set up to leave all assets to each other, which is easily missed by the unwary. The government allows for something called the unlimited marital deduction, which means you can leave as much as you want to your spouse without paying any estate taxes on the first death. This format allows the government to collect more in taxes upon the death of the surviving spouse than would otherwise be the case if some advanced planning had been done. In other words, don’t let the government do your estate planning. Essentially, you must use your exemption while living through the use of gifts, or upon your death, as the government does not allow the surviving spouse, with the exception mentioned above, to use any unused exemption equivalent amount remaining after the death of the first spouse. In this regard it is important to use as much of the current $5.34 million exemption as possible so as to reduce and/or possibly eliminate the future federal and state estate taxes, as the future remains so uncertain.
In order to take advantage of these exemption amounts, the trusts are designed with separate shares built in. These revocable trusts for Massachusetts residents are designed in such a way that upon the death of the first spouse, the trust will break down into three sub trusts; a general marital share, a special marital share, and a remainder or by pass share. Depending on where you reside, there may or may not be this extra share called the special marital share, which would be designed to help reduce any state estate taxes that may be imposed upon the first spouse’s death. The surviving spouse, as trustee, would be directed to allocate to the general marital share the exact amount of assets necessary to eliminate federal estate taxes. This is generally any amount currently over $5,340,000 or whatever the federal exemption amount is in effect on the date of death. The trustee would also be directed to allocate the special marital share; in the case of a Massachusetts resident, the exact amount of assets needed to eliminate Massachusetts’ or your state’s estate taxes. This is generally the amount currently over $1,000,000 or whatever the exemption amount is that is in effect on the date of death. These amounts will depend upon the size of the decedent’s estate and the exemption equivalent amount in effect for the year of death. This formula will allow you to take advantage of whatever the exemption amount is in effect on the date of your death. This leaves the remainder or by pass share to be funded with the state exemption amount of $1,000,000 or your state’s equivalent amount. This is important with all the changes that have been and will continue to take place regarding the federal and state estate tax situation.
These three shares would be administered separately upon the death of the first spouse. The general marital share will provide that all income must be paid to the surviving spouse during life. Additionally, the surviving spouse, as trustee, would be permitted to withdraw principal upon request. The surviving spouse also will be permitted to direct the final disposition of the marital assets upon his or her death. Essentially these assets are left to the surviving spouse free and clear (although technically in trust). Any assets in the marital share will ultimately be taxed in the surviving spouse’s estate, but would escape taxation on the first spouse’s death. If John died first and his trust had one half of the family assets (i.e. $2.5 million) then his marital share would not have any assets in it, as all the trust assets would be split between the special marital and the remainder or by pass share with the special marital share getting $1.5 million and the by pass share getting $1,000,000.
The assets of the remainder share would be subject to federal and state estate tax on John’s death, but no tax would be due as John would simply utilize a portion of his current $5.34 million exemption amount upon his death and would completely utilize his Massachusetts exemption amount as the remainder share is designed to be funded with the state exemption amount of $1,000,000 or your state’s equivalent exemption amount. While the assets of the special marital share, which exceed the Massachusetts exemption amount or your state’s exemption amount, will only be taxed at the federal level as a Massachusetts, or your state’s, estate tax QTIP election will be made to allow these assets to pass under the unlimited marital deduction and be taxed in Massachusetts, or in your state on the death of the surviving spouse. This special marital share coupled with the remainder share, will be equal to or less than the federal exemption amount, so while it will be subject to federal estate taxes on the death of the first spouse there will be no federal estate tax due. Remember, the assets of the remainder share alone will never exceed the Massachusetts exemption amount, resulting in no tax due at the state level on the first spouse’s death either.
The remainder and special marital share will also provide that all income must be paid to the surviving spouse for life. Remember, the surviving spouse is the trustee, so a great deal of control is being maintained by the surviving spouse. Additionally, the surviving spouse will be permitted to withdraw principal to the extent necessary to maintain his or her health and support in the standard of living to which they were accustomed as of the date of the death of the first spouse. This small restriction is what enables John and Jane to more fully utilize both their current federal $5,340,000 and Massachusetts $1 million, or your state’s equivalent, exemption amounts, thereby allowing them to transfer currently $10,680,000 of assets to their family federal estate tax free and $2 million Massachusetts or state estate tax free. In addition, all the assets of the special marital share and remainder share will grow federal estate tax-free, as such assets will not be included in the surviving spouse’s estate regardless of how much they grow between the date of the death of the first spouse and the date of the second spouse’s death.
Federal Estate and Gift Tax Exemptions and Rates
|year||Estate Transfer Exempt Amount (Applicable Exclusion Amount)||Lifetime Gift |
|Highest Estate and Gift Tax Rates|
|2005||$1.5 Million||$1 Million||47%|
|2006||$2 Million||$1 Million||46%|
|2007||$2 Million||$1 Million||45%|
|2008||$2 Million||$1 Million||45%|
|2009||$3.5 Million||$1 Million||45%|
|2010||Tax Repealed*||$1 Million||35% (gift tax)|
|2011||$5 Million||$5 Million||35%|
|2012||$5.12 Million||$5.12 Million||35%|
|2013||$5.25 Million||$5.25 Million||40%|
|2014||$5.34 Million||$5.34 Million||40%|
|2015||$5.43 Million||$5.43 Million||40%|
Table A Unified Rate Schedule
|Column A Taxable amount over||Column B|
Taxable amount not over
Tax on amount in
Rate of tax on
excess over amount
in Column A
Reflecting repeal of the 5% surtax. This is effective for estates of decedents dying and lifetime gifts made after 2001.
Why You Need a Trust for Federal Estate Tax
This example will show you that by leaving assets to a trust for the benefit of a spouse, as described above, will enable a couple to utilize these estate tax exemptions, and reduce and possibly eliminate estate taxes depending on the size of the estate. Below is what would happen to John and Jane in our example above assuming they only have a simple “I Love You” will that leaves all assets to the surviving spouse and has done no other planning.
Scenario 1: $5,000,000 Estate – $5,000,000 Exemption
Without Planning: At first glance it appears that even without doing any planning in this case there would be no federal estate tax either way. However, that is the trap that the unwary can easily fall into, for without planning the full $5 million is going to be subject to both federal and state estate taxes on the second death. While there may be no tax due on the second death remember this also does not take into account any future growth on these assets. Remember if portability is not elected and the assets grow until the death of the surviving spouse, they could further expand her exemption amount, resulting in unnecessary tax liability. There is no reason to have these assets growing estate taxable when the trusts can shelter the assets and have them grow estate tax free as laws can always change, and the government can lower these exemptions. It is always best to shelter or utilize whatever exemption is available to you on the date of your death as it will always result in fewer taxes due upon the death of the surviving spouse as will be shown below.
With Revocable Trust Planning: The trust allows assets to be left for the benefit of a spouse while enabling the assets in the deceased spouse’s trust to utilized the deceased spouse’s exemption, as described above. In addition, the deceased spouse’s trust special marital and by pass shares will not be federally taxed again when the surviving spouse dies. Therefore, the planning side of the above example would result in the sheltering of $2.5 million from estate taxes on the death of the surviving spouse most certainly resulting in less estate taxes due upon the death of the surviving spouse. In addition, the full 2.5 million will be able to grow estate tax free.
With Irrevocable Trust Planning: Now let’s see what it would look like if this same couple decided they wanted to protect assets from the nursing home as well as do basic estate planning to reduce probate costs and estate taxes. By setting up two irrevocable Medicaid Trusts you can obtain the same probate avoidance and estate tax benefits as with the revocable trusts shown above while at the same time protecting the assets in these trusts from the costs of long term care. This is especially effective for estates of $2,000,000 and below.
With Irrevocable Trust Planning – Continued: This can be accomplished while maintaining a significant degree of control over your assets. In fact, you can be both the grantor and retain the right to remove and replace the trustee of these trusts so as to retain control and simply put, these irrevocable trusts are not as frightening as you may think. For example, if your home, vacation home or rental properties were inside of these trusts, you could continue to live there, rent them or sell and even replace them anytime you wish all with no adverse income tax consequences. In the event you sell your home, you would still get to utilize your capital gains exclusion of $500,000 if married and $250,000 if single. Also, any such real estate transaction will not reset the 5 year Medicaid ineligibility period discussed below. All the income generated from the trust flows through to your personal income tax return, Form 1040 so you do not pay any more in income taxes after you have these trusts in place. You can also put investment or bank accounts into these trusts and you will maintain the ability to manage and invest the assets as well as collect all the income generated from these trust assets. A complete discussion of these trusts is beyond the scope of this article, but you can contact Todd E. Lutsky, Esq. with the firm of Cushing & Dolan at 617-523-1555 for more information.
Reducing Estate Taxes – Larger Estates
If your estate is on the larger side, then you are subject to estate taxes even with proper planning. In fact, if you have an estate over $10,000,000, then you will be assessed a 5% surcharge.
Life Insurance is it Tax Free?
- Income tax free to the beneficiary
- Estate taxable as valued on date of death
Life insurance may cause your estate to be taxable when maybe it would not have been otherwise.
Solution: Irrevocable Life Insurance Trust
- Assets in this type of trust are creditor protected
- Assets in this type of trust are estate tax free
- This trust is a grantor trust for income tax purposes which means that you are considered the owner for income tax purposes. In other words, any income would be taxed at your individual rates and not at the higher trust tax rates at least while you are living.
Solution: First to Die Irrevocable Life Insurance Trust
- Donor will be the insured
- Proceeds from the insurance will be estate and income tax free
- Trustee will be the spouse or children
- Spouse may be beneficiary upon death of the donor
- Assets unused not taxed in spouse’s estate at death either
Solution: Second to Die Irrevocable Life Insurance Trust
- Donor would be both spouses as they both will be the insured
- Trustee could be a child or children but not the Donors
- Donors retain the power to remove the trustees but the replacement trustee must not be anyone related or subordinate to the Donors.
- The proceeds from the insurance will be estate and income tax free
Larger estates face an estate tax problem even with proper planning. The federal estate tax rates begin at 30% and go as high as 45%. There is also a special Generation Skipping Tax of 45%. The maximum estate tax rate may be back to 55% in 2013. Your estate may lose as much as 80% to various taxes on the death of the second spouse if income taxes are considered especially with regard to qualified plan assets such as IRAs.
If you consider gifting property away during your life, you may consider a Qualified Personal Residence Trust (QPRT), a Grantor Retained Annuity Trust (GRAT), a Charitable Remainder Trust (CRT), a self-canceling installment note (SCIN), or even a private life annuity.
Regular and Series Limited Liability Companies:
- Provide creditor protection against personal assets in the case of an accident on the rental property
- Maintain control over your assets during life provided ownership is split between you and your spouse
- Provide a lack of control discount for estate tax valuation purposes thereby reducing estate tax
- Provide a lack of marketability discount for estate tax valuation purposes thereby reducing estate tax
- No adverse income tax consequences year to year as these entities are taxed at your individual rates
- Regular LLC is ideal for owning investment accounts
- Series LLC is ideal for owning rental properties
- Consider a Delaware Series LLC when you have more than two rental properties
Securities offered through Securities America Inc., Member FINRA/SIPC and advisory services offered through Securities America Advisors, Inc. Armstrong Advisory Group, Cushing & Dolan and The Securities America Companies are unaffiliated. Representatives of Securities America Inc. do not provide legal or tax advice. The scenarios provided are for illustrative purposes only and not intended to represent client experiences of Armstrong Advisory Group or the Securities America companies. Please consult with a local attorney or tax advisor who is familiar with the particular laws of your state. December 2014 – AT 1071699.1