The Asset Protection Law Letter
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               THE ASSET PROTECTION LAW LETTER            

Finally… Some Finality in Estate Planning

Dear Friend and Colleague,

After years of uncertainty, Congress has finally removed the uncertainty surrounding the taxation of decedents’ estates. Estate planning attorneys (and our clients) can now plan to reduce estate taxes with some degree of confidence that the landscape will not radically change as soon as the ink on the estate plan is dry.

The American Taxpayer Relief Act of 2012

On January 1, 2013, Congress enacted the American Taxpayer Relief Act of 2012, the law that averted us all going over the “fiscal cliff.” The Act ended a tortuous road that the estate tax and gift tax have followed for more than a decade. Beginning in 2001, the exclusions from estate taxes rose steadily from $1 million for persons dying in 2001 to $3.5 million in 2009. The lifetime exclusion from gift tax remained constant, at $1 million. In 2010, the one thing that no one expected to happen actually happened: The estate tax was completely eliminated for decedents dying in 2010! In late 2010, Congress approved a temporary patch of the estate tax. The exclusion was increased to $5 million for persons dying in 2011 and 2012. The gift tax exclusion was also increased to $5 million. But both were scheduled to revert to their 2001 levels ($1 million) unless Congress acted. It made estate planning throughout this decade akin to throwing darts.

Here is what Congress made permanent last week:

  • The exclusion from estate tax is $5 million, indexed for inflation. [The exclusion in 2012 was $5,120,000.]
  • The lifetime exclusion from gift taxes — also $5 million — is fully integrated with the estate tax. To the extent that a person uses part of his/her $5 million gift tax exclusion during life, it reduces — dollar for dollar — the estate tax exclusion available to reduce estate taxes at death. For example, if a person makes $2 million in gifts during life, the person has $3 million left to offset estate taxes at death.
  • For estates exceeding the $5 million exclusion, the estate tax rate was increased slightly, from 35% to 40%.
  • “Portability” — the ability of a surviving spouse to use the “unused” estate tax exclusion of a deceased spouse — was made permanent. (It was set to expire after 2012.) For some estates, portability is a significant estate planning tool; for others, it’s useless (more on that below).

The Act provided us with certainty. It did not, however, make estate planning easy.

Estate Planning Before “Portability”

For most married couples, there is no estate tax when the first of the two spouses dies. Since 1981, the Internal Revenue Code (the “Code”) has provided married couples with an unlimited marital deduction, which is the Code saying to every married couple “If you give what you have to your surviving spouse, there are no estate taxes on the first death.” In enacting the unlimited marital deduction, Congress was content to treat a married couple as a unit, and wait until the second spouse dies to impose the estate tax.

But the unlimited marital deduction comes at a price: The interplay of the lifetime exclusion and the unlimited marital deduction results in a married couple losing one lifetime exclusion. Here’s an example. Let’s assume that Mr. and Mrs. Brown have an $11 million estate. Mr. Brown dies in 2013, leaving everything to Mrs. Brown. The unlimited marital deduction kicks in, resulting in Mrs. Brown inheriting the entire $11 million free of estate taxes. But Mr. Brown’s estate never got to use his $5 million exclusion, because it didn’t need to. Let’s further assume that Mrs. Brown dies in 2014, leaving an $11 million estate to her children. Her estate uses her $5 million exclusion, leaving the balance — $6 million — subject to estate taxes, and a $2.4 million tax bill. The loss of one lifetime $5 million exclusion resulted in millions in estate taxes.

Estate planners have always had an easy fix to the loss of one spouse’s lifetime exclusion: An “A-B” trust. With an A-B trust, the assets in the trust divide into two sub-trusts when the first spouse dies, as follows:

The “Exemption Trust” (the “B” trust) is sometimes called a “credit shelter” or “bypass” trust, but the substance is always the same. The Exemption Trust is an irrevocable trust into which the community property of the first spouse to die is deposited, up to the estate tax exclusion available in the year of the decedent’s death. For someone dying in 2013 (ignoring the inflation adjustment) it’s $5 million. The balance of the estate is deposited into the “Survivor’s Trust” (the “A” trust) which usually is (but is not required to be) a trust revocable by the surviving spouse.

The assets in the Survivor’s Trust qualify for the unlimited marital deduction, because these assets pass directly from the decedent to the surviving spouse. The assets in the Exemption Trust do not qualify for the unlimited marital deduction, because they do not pass directly to the surviving spouse; they go into an irrevocable trust. But Mr. Brown’s estate uses his $5 million exclusion to avoid estate tax on Mr. Brown’s death.

Thus far, the estate planner really hasn’t accomplished anything: Mr. Brown could have written a holographic will on the back of an envelope leaving everything to Mrs. Brown, and the unlimited marital deduction would have eliminated estate taxes on his death. The A-B trust works its magic on the second death.

The key feature in the Exemption Trust is a provision that appears in every Exemption Trust, limiting Mrs. Brown’s ability to withdraw the assets of the Exemption Trust to her “health, maintenance, education and support” needs. These magic words come courtesy of §2041(b)(1)(A) of the Code, which provides that if a beneficiary’s ability to withdraw assets from a trust is limited to the “ascertainable standard” of “health, education, support and maintenance,” then the beneficiary does not possess a “general power of appointment” over those assets. And without a GPA, the beneficiary is not deemed to own the assets. Bottom line: When Mrs. Brown dies, all of the assets in the Exemption Trust escape estate taxes.

Let’s assume that when Mrs. Brown dies, there are still $6 million in the Survivor’s Trust. The assets in the Survivor’s Trust are subject to estate taxes upon her death, but her estate has its own $5 million exclusion, resulting in only $1 million being subject to estate taxes. That’s a $400,000 bill, not $2.4 million. And if the $5 million in the Exemption Trust appreciated to $9 million between Mr. Brown’s death and Mrs. Brown’s death, all of the assets of the Exemption Trust escape estate taxes.

Our clients sometimes ask why the IRS is so willing to forego millions in estate taxes by allowing the simple expedient of an “A-B” trust. The IRS’ seeming munificence is borne of the fact that an A-B trust allows married couples to place themselves in the same position they would be in if they had not married. If Mr. Brown had a $5 million estate, and Mrs. Brown had a $5 million estate, and if they had never met and never married, each could have shielded his/her own $5 million estate from estate taxes.

As wonderful as the A-B trust is, it comes at a price. Inherent in an A-B trust is an income tax detriment. One of the best benefits of the Code is the forgiveness of the tax on appreciated assets when a person dies. Let’s assume Mr. Brown bought Ford Motor Co. stock for $10 per share, and his son inherits the stock at a time when the stock is worth $100 per share. The $90 gain inherent in each share is forgiven. The son gets the stock at a “stepped-up basis” of $100. If the son later sells the stock when it’s worth $101, his capital gain is $1 per share, not $91.

In order to qualify for the stepped-up basis, an asset must have been included in the decedent’s estate, and the assets in the Exemption Trust are not included in the decedent’s estate. In our example, if the Ford Motor Co. stock had gone into the Exemption Trust at a time when it was worth $10 per share, the son’s “basis” in the stock would be $10, and had he sold the stock for $101, his gain would be $91 per share. Until recently, estate planners did not let the loss of the step-up in basis affect the planning. The marginal rate of estate tax (now 40%) is always higher than the capital gains rate (now 20% for incomes above $450,000). It was deemed best to suffer the capital gain in order to avoid the estate tax. But with a married couple being able to shield $10 million from estate tax, that is no longer a safe bet.

Along Comes “Portability”

Last week, the Act made “portability,” which was scheduled to expire, a permanent feature of the Code. Portability is the Congress’ way of telling married couples that they no longer need to create an A-B trust — or do any sort of estate planning — in order to double-up on the estate tax exclusions.

With portability, the executor of the first of a married couple to die is given the right to pass the “unused” estate tax exclusion to the surviving spouse, as follows:

The key is that there will almost always be an “unused” exclusion, because the first spouse to die will use the unlimited marital deduction to eliminate estate taxes on the first death. If the deceased spouse was married more than once, the executor may elect to pass the unused amount to the last spouse to whom the deceased spouse was married. In addition, if the deceased spouse had an unused lifetime gift tax exclusion, the estate can elect to pass the unused gift tax exclusion to the surviving spouse.

Advantages and Disadvantages of Portability

The advent of portability didn’t make estate planning easier; it made it substantially more difficult because it presents every married couple (and their estate planner) with a choice between two systems, each with its own benefits and detriments.

The principal detriment to portability is that the most a married couple will ever get to shield from estate tax is the decedent’s exclusion and the survivor’s exclusion, which is likely to be $5 million plus inflation adjustments. As we have seen, if a married couple instead uses an A-B trust, and the assets in the Exemption Trust appreciate from $5 million to $12 million between the first and second deaths, the entire $12 escapes estate taxes. Since everything in excess of $5 million in the Survivor’s Trust is subject to estate tax on the second death, the surviving spouse is well-advised to spend down the Survivor’s Trust to zero (or at least down to $5 million) before touching any of the assets in the Exemption Trust.

The principal advantage of portability over an A-B trust is that the ultimate beneficiaries — usually the children — do receive a stepped-up basis in the inherited assets, because all of the assets are included in the estate of the surviving spouse.

The advent of portability presents us with some non-tax issues that we didn’t have to face when we were limited to A-B trusts. In order to double up on the estate tax exclusions, the Exemption Trust had to be irrevocable, a fact that displeased many surviving spouses once they learned that they could not freely change the terms of their estate plans. If portability is elected, there is no longer a need for an A-B trust, and the trust that is created for probate avoidance can be freely revocable by the surviving spouse. But that presents its own asset protection difficulties. One of the ancillary benefits of an Exemption Trust is that if the surviving spouse develops difficulties with his/her own creditors following the death of the first spouse, the assets of the Exemption Trust are shielded from the surviving spouse’s creditors. But if portability is elected, and the trust is freely revocable by the surviving spouse, there is no protection from creditors.

The Bottom Line

As a general rule, married couples with estates greater than $10 million should eschew portability and stick with their A-B trust. The ability to shield all of the appreciation in the Exemption Trust from estate tax more than offsets the loss of the step-up in basis. But married couples whose estates will likely never reach $10 million will benefit from portability. There is no point in losing the income tax benefits of the step-up in basis in order to avoid an estate tax that will likely never be incurred.

All married couples doing their estate planning for the first time or who are reviewing their estate plans should avoid a requiring the trustee to divide the trust into sub-trusts upon the first of a married couple to die. The better practice is to give the trustee the option to either create an A-B trust or elect portability.

Very Truly Yours,


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Robert F. KluegerJD, LLM 
Mr. Klueger is one of the very few private attorneys in America who has argued a tax case before the United States Supreme Court, [United States v. Brockamp, 519 US 347 (1997)], which resulted in a change in the tax law regarding tax refund claims filed by disabled taxpayers....

Jacob Stein, JD, LLM
Mr. Stein is one of California’s best known attorneys and AV rated by Martindale-Hubbell (highest possible rating). He lectures dozens of legal seminars each year on the subjects of asset protection and advanced tax planning....
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