In December, 2017 Congress did the near unthinkable. It passed the Tax Cuts and Jobs Act of 2017 (the “Act”) which, among other changes, raised the exemption from the federal estate, gift and generation skipping transfer taxes to $11,180,000 ($11.4 Million effective for decedents dying or making gifts in January 1, 2019). Many estate planning practitioners have been left pondering “Now what do I advise my clients?” Do we still want to make lifetime gifs to children? Are the old marital/credit trust plans with A/B trusts still the appropriate trust design?
While not exactly repealing the federal estate tax, with such a high exemption ($11.4 Million per person and $22.8 Million per married couple with portability), almost no one need fear the estate tax any longer. Unfortunately, these increases are currently scheduled to sunset at the end of 2025 which means the exemption may return to its pre-2018 level of $5.5 Million per person and $11 Million per married couple.
This article will review a number of estate planning issues that should be addressed and provide possible solutions to the new estate tax world in which we live. The article is divided into three parts: (i) designing estate documents that are effective both with the new tax law and also if there is a reversion to the old law in 2025, (ii) examining and fixing existing estate documents and (iii) gift planning.
- Income Tax Issues and New Uses for the QTIP Marital Trust.
Perhaps the biggest conundrum faced by estate planners when the exemption was increased to $5 Million in 2010 was how to preserve the step up in basis under I.R.C. §1014 while minimizing estate taxes. With combined federal and state income taxes exceeding 40% in certain states, income taxes may be more of a problem from high net worth families than the estate tax (40% plus any state inheritance tax). With almost no one having to worry about the federal estate tax, planners should be focusing on minimizing income taxes which generally means protecting the step-up in basis at the death of both spouses. The surviving spouse would like to get a step-up in basis on all assets inherited from the first spouse to die, and then the children getting a second step-up when their mother or father later dies.
This is pretty simple to achieve if one leaves all of the family assets to the surviving spouse at the first spouse’s death, the classic “I love you will” (the “ILU Plan”). The spouse will get a step-up in all the assets left to him/her (exceptions are annuities and retirement plans and other income in respect of a decedent property and installment notes). Then the survivor will own all the assets when he/she later dies which get a second step-up at that time. There is unlikely to be any estate tax at the second spouse’s death, because the spouse will have his/her own $11.4 Million exemption and also the unused exemption of the first spouse to die (referred to as the “portable exemption”). But, there are problems with such a plan. First, the current exemption may revert back to a substantially lower level. With the state of politics and the ballooning federal deficit, future taxation is at best uncertain. Second, there is total loss of control over the assets. If the surviving spouse remarries, he/she will have unlimited control over the disposition of the “family” assets. Third, if there is a plan to leave assets in trust for the children after the second spouse dies and then have the assets pass on to grandchildren, the generation skipping transfer tax (the “GSTT”) may become a problem at the second death. This is because the portable exemption does not apply to the GSTT.
For example, assume an estate of $22.8 Million. If all the assets are left outright to the surviving spouse, the spouse will have his/her own exemption of $11.4 Million and the deceased spouse’s unused exemption of $11.4 Million (the “portable exemption”) for a total of $22.8 Million. However, when the second spouse dies and tries to leave the remaining assets in a generation skipping trust, there only will be $11.4 Million of GSTT exemption to allocate to the trust. This means that $11.4 Million of the $22.8 Million will be subject to the GSTT. At 40% GSTT, this means a potential GSTT of over $4.5 Million.
What is a QTIP – A QTIP addresses these issues very well. A QTIP is a special form of marital trust under which the surviving spouse must be paid all of the net income of the QTIP each year. There can be no other beneficiary besides the surviving spouse during the spouse’s lifetime. The spouse also can be paid additional amounts for health, maintenance and support. If the trust has these requirements, then it will qualify for the unlimited marital deduction, resulting in no federal estate tax at the first death. The assets payable to the QTIP will get a step up in basis. When the surviving spouse later dies, the entire QTIP will be included in his/her taxable estate which means that the assets in the QTIP will get the second step-up at that time. So far, so good. Any appreciation in the QTIP assets during the surviving spouse’s life will get a new cost basis and can be sold without any capital gain tax. The result – no income tax on the assets in the estate and no federal estate tax if the value of the QTIP and the surviving spouse’s assets are less than the $11.4 portable exemption from the first spouse and the exemption of the surviving spouse. Not bad!
However, if the estate plan includes generation skipping gifts (either outright gifts to grandchild or gifts in trust for children that will eventually pass to grandchildren when the children later die), there still may be a GSTT problem. The survivor’s estate only will have one GSTT exemption to use just like in the ILU scenario, because the GSTT exemption is not portable. One either uses it at the first death or loses it (just like the estate tax exemption in the days before portability). Fortunately, there is a special rule for QTIP’s called a Reverse QTIP election (I.R.C. §2652) which permits a QTIP to be divided into two separate trust shares, with the executor allocating the unused GSTT exemption of first spouse to die to one of trust shares. In this way, the family still gets to use two GSTT exemptions of $11.4 Million which will avoid the problem of the ILU Plan discussed above. This cannot be done with the ILU plan.
Besides these GSTT saving benefits, leaving assets to a QTIP provide all the traditional benefits of leaving assets in trust, creditor protection and assuring that the family estate plan is respected during the surviving spouse’s lifetime and at his/her death. Plus using a QTIP adds considerable flexibility to the estate plan. Because of the unpredictability of future estate tax law, minimizing estate taxes may become paramount again. This is when flexibility may save the day. For example, Congress could repeal the step-up in basis. One may remember the carryover basis rules we suffered through in 2010. It could happen again if Congress needs tax revenue. In that case, one may wish for the old marital trust/credit trust formula that carved out the federal exemption amount at the first death and put it into a by-pass trust. The by-pass trust was not subject to federal estate taxes at either the first spouse’s death or at the second spouse’s death. All growth of assets at the second death avoided estate taxes at that time. But all is not lost. The same procedure that permits division of a marital trust into two separate shares now can be used to divide the QTIP into two shares, a B share exactly equal to the federal exemption and an A share receiving the balance of the estate. The executor does not have to make a marital deduction election for the B share. Thus the old format easily can be resurrected at the first spouse’s death.
This is not much different than leaving an ILU plan with a disclaimer trust, a plan design favored by many estate planners. If the will has a contingent disclaimer trust built into it, then the surviving spouse will have the option of accepting all of the assets or making a disclaimer of a portion of the estate equal to the federal exemption. The net result will be the same – IF THE SURVIVING SPOUSE UNDERSTANDS WHAT NEEDS TO BE DONE AND IS WILLING TO MAKE THE DISCLAIMER. The author’s experience is that convincing a spouse to make a disclaimer is problematic at best. Often the spouse will prefer to have complete control of the assets and will not make the disclaimer even if it will benefit the children in the long run. Or just as likely, the spouse will not understand the significance of making the disclaimer, or the technical disclaimer requirements, and won’t make the decision.
For spouses who like this tax planning but do not like giving up control of the assets which will be held in trust, there is an answer. The spouse can be sole trustee of the QTIP. For advisors who do not like to trust the surviving spouse to be trustee, think of the alternative. If the family chooses the ILU Plan, then the spouse will have outright ownership and control of all the family assets. The spouse as trustee is a very reasonable approach for most families.
In conclusion, it would seem that the traditional reasons for the marital/credit trust design have been replaced by the QTIP design for many estates. Typical reasons for the credit trust were to let one trust (the B trust) grow by not making distributions to the spouse during the spouse’s remaining lifetime. But with the new $11.4 exemption per spouse, this is unlikely to be meaningful except in very large estates.
A good reason to retain the B trust could be when the surviving spouse is likely to remarry. Then it is possible to lose the first spouse’s “unused exemption” if the new spouse dies before the surviving spouse. The surviving spouse’s estate then will get the “unused exemption” of the new spouse which can be significantly lower or even zero. However with the new higher exemption and the fact that it is indexed, this is not likely to present a serious problem for most people. However, if it is viewed as a problem, then the executor can do the QTIP division and preserve the first spouse’s exemption by using it at the first spouse’s death. And since the money will be in trust no matter what the executor decides, the likelihood of a smart decision to use the B trust is greater than if the family was using an ILU plan.
When choosing the new QTIP design, it is important for the executor and trustee to have the power to divide the trust without court approval. Alternatively, a trust may have a trust protector provision giving one or more people the power to make certain elections for the trust (e.g., to divide the trust into an A trust and a B trust). Then the surviving spouse may not be the person who has to make the decision. The idea should be to make any of the trust divisions described above simple and inexpensive.
- Fixing Older Estate Plans
What if a client already has an estate plan that includes a marital/credit trust format. The documents may work just fine without any change. If the B trust has the same provisions as are required for a QTIP trust, then all the executor has to do is make an election to qualify to B trust for the marital deduction. However, sometimes the B trust has provisions which will not permit it to qualify as a QTIP.
Some B trusts do not require the income to be distributed to the surviving spouse each year. Instead, the terms may permit the trustee to accumulate income and make discretionary distributions instead (e.g., distributions for health, maintenance and support). This trust will not qualify for the marital deduction and cannot be a QTIP. Or the trust may have other potential beneficiaries. Sometimes trusts are drafted to give the trustee discretion to pay income and/or principal to the decedent’s children. Such a trust also will not qualify for the marital deduction.
In such cases, the estate plan will have to be redrafted with the appropriate QTIP provisions (unless the family prefers such a plan for their own good reasons). But what if the spouse whose document needs to be changed is incapacitated or just died. It still may not be too late to fix such a trust.
Pennsylvania, like many other jurisdictions, has adopted a version of the Uniform Trust Code which permits the modification of trusts either (i) by the trustee and beneficiaries through a non-judicial settlement agreement if the modification is not inconsistent with a material purpose of the trust (20 Pa. C.S. §7710.1) or (ii) by the settlor and all beneficiaries even if the modification is inconsistent with a material purpose of the trust (20 Pa. C.S. §7740.1) Pennsylvania law also authorizes the modification of irrevocable trusts with court approval and specifically authorizes modification of irrevocable trusts in order to achieve a settlor’s tax objectives (20 Pa. C.S. §7740.6). So if the family and its advisors act quickly and with unity, it may be possible to change an existing trust to satisfy the requirements of the QTIP rules.
If the deceased spouse died a number of years ago and the trust already has come into existence as a B trust that did not qualify for the marital deduction, the family may want to consider terminating the trust and distribute all of the trust assets to the surviving spouse (assuming he/she is eligible to receive the assets upon termination). The trust may have a provision that provides an easy method of terminating the trust without court approval. If it does not have such a provision, then it still may be possible to terminate the trust with court approval. (20 PA C.S. §7740.4).
When considering whether to modify or terminate a trust for which an election has not already been made to prepay inheritance tax under section 2113 of the Pennsylvania Inheritance and Estate Tax Act (72 P.S. §9113(a)), planners should keep in mind that the Pennsylvania Department of Revenue has adopted a statement of policy (61 Pa. Code § 94.3) indicating that if a trust is terminated non-judicially under Pa. C.S. §7710.1 without requesting a Future Interest Compromise (Form REV-1647 Schedule M), Pennsylvania will reserve the right to assess Pennsylvania Inheritance Tax against the assets of the trust valued as of the date of termination. Planners should consider whether to proceed with a judicial modification or termination pursuant to Pa. C.S. §7740.4 or §7740.6 (rather than non-judicially under Pa. C.S. §7710.1 or § 7740.1), or make sure to timely submit a request for Future Interest Compromise.
- To Gift or Not to Gift
Traditional Gifts – For many years, conventional wisdom held that clients should gift assets during their lifetimes in order to remove the value of those assets, and (hopefully) the future appreciation in the value of those assets, from the clients’ taxable estates in order to avoid federal estate tax. In some cases, assets gifted during lifetime might also be discounted giving extra leverage. The reasoning behind the conventional wisdom is that even though the gifted assets have a carry-over basis in the hands of the donee, future capital gains would be taxed at a rate far lower than the federal estate tax rate. However, with the increase in the federal estate exemption, federal estate tax will not be an issue for most clients. Also, with the IRS making it much more difficult to obtain discounts on gifts, planning tools like family partnerships have lost much of their luster. Therefore, it may be more prudent for clients to retain their low-basis assets rather than transfer them during lifetime in order to maximize the step-up in basis.
Gift with Strings – If a client is determined to make lifetime gifts in trust of low-basis assets, it is possible to transfer the property in such a way that the gift still will be included in his/her estate for federal estate tax purposes even though the income is paid out each year to other beneficiaries. This can be done by the client retaining certain powers that bring the trust back into his/her estate when the client dies (e.g., a retained limited power of appointment). And if the trust is set up as a grantor trust, the client may be able to do a tax free exchange of assets with the trust to get back low basis assets before dying.
Gifts to Older Generation. If neither federal estate tax nor generation-skipping transfer tax is an issue for a client who owns low-basis assets, the client can transfer such assets to an individual in an older generation (e.g., a parent) who has a shorter life expectancy than the client. When the parent dies, there will be a step-up basis and the client will inherit the assets back from the parent. Such a transfer could be made to a trust in such a way that the asset would be included in the older individual’s estate for federal estate tax purposes and, provided that donee survives one year from the date of the gift, upon death the gifted assets would receive the step-up in basis.
In conclusion, it is a new world for estate planning. One believes that using a QTIP Marital Trust can solve many of the problems faced by our wealthier clients. New tax law brings new opportunities and leaving an old estate plan alone may be a significant mistake.