“Does the Fiscal Cliff Legislation Eliminate the Need for Estate Tax Planning for Clients Worth Less Than $ 10 Million?”

Congress’ eleventh hour inability to agree as to whether (and to what extent) the Bush-era tax cuts enacted in 2001 would expire on December 31, 2012 resulted in anxious taxpayers scrambling to make estate planning decisions and wealth transfers by year end.  The purpose of these transfers was to utilize some or all of  the $5 million federal estate and gift tax exemption ($10 million per couple with “portability” as described below). Their fear was inaction by Congress, which would have resulted in a reduction in the exemption to only $1 million per individual, without portability for couples.

Alas, Congress did act in early January, 2013 when the President signed the “fiscal cliff” legislation! Somewhat surprisingly, the $5 million federal exemption amount per individual ($10 million per couple) as well as portability of the exemption between spouse’s estates (meaning that the unused portion of the deceased spouse’s $5 million dollar exemption is added to the surviving spouse’s $5 million exemption), was deemed to be “permanent” under the new law.

What does this mean for estate planning clients who have significant wealth, albeit less than $10 million?  Should couples with assets less than $10 million ignore all tax planning and have simple Wills that provide merely for outright distribution on the first death to the surviving spouse?  For many taxpayers, such a  plan might be enough to insure that no federal estate tax is paid at either spouse’s death.  However, several reasons exist to use a Disclaimed Property Trust, regardless of net worth, as a means to provide necessary flexibility to the estate plan, as well as to protect a surviving spouse with an unanticipated federal estate tax situation years after the Wills were drafted.

A Disclaimed Property Trust (DPT) should now be considered in most estate plans to allow flexibility in administering estates and as a hedge against potential federal estate tax issues.  A DPT can be included in a Will and invoked, if necessary, by the surviving spouse upon the first death to take full advantage of the deceased spouse’s federal estate tax exemption, especially if portability should be repealed or the exemption lowered in the future.  Assets owned individually by the deceased spouse, if disclaimed by the survivor, are held in a DPT for the survivor’s benefit.  The survivor will receive the income from the trust and the trustee will have the discretion to use the principal for his benefit.  However, at the survivor’s subsequent death, the assets in the DPT, including any appreciation thereon during the survivor’s lifetime, are excluded from his taxable estate.  This “wait and see” approach to tax planning provides flexibility so that if the first spouse to die owns substantial assets at the time of his death, the survivor can shelter assets up to the exemption amount (and the appreciation thereon) from imposition of the federal estate tax.

If the DPT is not utilized, the surviving spouse’s taxable estate will include all the joint assets and the individual assets of the first spouse to die as well as the appreciation thereon.  One might argue that the DPT is irrelevant for estates up to $10 million because to the extent the exemption of the first spouse to die is not utilized, the portability feature built into current law would allow the surviving spouse’s estate to take advantage of the unused exemption of the deceased spouse, thereby adding this amount to his own $5 million exemption amount.  Again, this may lead one to conclude that only a simple estate plan is warranted: i.e. total estate less than $10 million + portability = no need for a DPT.

However, can a middle aged couple who has accumulated wealth (and who will continue to do so for many years) know with any certainty that the “permanency” of the current law with portability and a combined $10 million exemption is in fact here to stay?  The unpredictability of Congress over the last decade makes it more difficult than ever to answer this question with any sense of confidence.  Assume a husband and wife worth a total of $6 million each sign Wills in 2013 which provide that upon the first death all assets owned by the deceased spouse will pass outright to the survivor.  Assume further that when the first spouse dies ten years later, the estate is worth $10 million but the federal exemption amount has been reduced to only $2.5 million per individual and $5 million per couple.  Further, assume that when Congress decreased the exemption, it eliminated the portability feature.  There will be no federal estate tax at the first death (assuming the unlimited marital deduction).  However, upon the surviving spouse’s subsequent death, his taxable estate will include all of the assets inherited from the first to die and his estate will be subject to tax on all assets over his own $2.5 million exemption.  If instead the Wills provided the opportunity for the surviving spouse to disclaim an amount of assets equal to the exemption of  the first spouse to die, $2.5 million would have been held, estate tax free, in a DPT.  The survivor’s taxable estate would not include those assets or the appreciation thereon, and would still have the ability to utilize his own $2.5 million exemption.  Thus, by use of a DPT at the first death, the couple would have been able to shelter $5 million from federal estate tax as opposed to only $ 2.5 million.

Similarly, when spouses become sick and die within a short time of one another, the ability of the spouse with a smaller estate to disclaim assets received by the spouse with the greater estate may result in estate tax savings. With portability, this issue is not relevant. However, if portability is ever removed, the flexibility of a disclaimer provision in a Will may be quite useful.

Uncertainty in the future of the estate tax exemption is not the only tax reason to consider use of a DPT.  There may be income tax reasons for a surviving spouse to disclaim assets that would otherwise pass outright to him.  Historically, the income tax rates imposed on trust income is higher than that imposed on an individual taxpayer.  However, with Congress’ creative measures to raise revenue, no one can say for sure that a time won’t come when the income tax rates imposed on individuals is higher than that imposed on trusts.  In that case, a surviving spouse might choose to utilize a DPT to minimize the payment of taxes on the income produced by the inherited assets.

There may be non-tax reasons for a surviving spouse to disclaim assets upon the death of his spouse.  A survivor who stands to receive a large sum of money outright may feel uncomfortable managing the assets.  Perhaps he identifies himself as a spendthrift, or fears repeated requests by relatives or friends for “loans” or gifts following receipt of an inheritance.  In this case, disclaiming the assets will authorize a third party trustee to make the decisions as to whether a requested expense is reasonable and necessary.  Similarly, if the survivor is less competent than he was when the couple first executed their Wills, he may feel more confident in having another party manage the assets.

If a surviving spouse feels vulnerable knowing that whatever assets he preserves during his lifetime will pass to the couple’s heirs according to his own Will, he might utilize a DPT for some or all of the assets passing to him from the deceased spouse.  The assets in the DPT, to the extent not used for the surviving spouse during his lifetime, will pass at his death according to the Will of the first deceased spouse.  The survivor will have no ability to change the appointed disposition of the first deceased’s assets and therefore cannot be the prey of undue influence by designing or disgruntled heirs who might pressure the surviving spouse to change his Will to leave a larger share to them.

Protection from future creditors may be another reason for a surviving spouse to disclaim some or all of his inheritance.  If the survivor is in a profession which exposes him to liability, having his inheritance held in a DPT which is also a spendthrift trust may allow the assets to be preserved for a couple’s heirs.

The majority of clients do not want to have their Wills re-drafted every time there is a change in the tax law or in their family dynamics.  A Will which includes a disclaimer provision, whereby disclaimed assets can be held in a DPT, can provide enough flexibility so that a couple might not need to change their Wills after the first ones are executed.