A typical estate plan includes a will, a financial power of attorney, and an advance directive for health care. Other tools are often used, such as trusts and gifts, to shelter assets from waste and taxes.
Uncertainty has been the catchword in 2010 to describe the state of tax laws governing gifts and estates. In 2001, Congress enacted a law designed to slowly repeal the estate tax. Under this law, the highest estate tax rate gradually declined to 45% in 2009, and the tax-free exempt amount gradually increased to $3.5 million in 2009. To everyone’s surprise, Congress allowed the estate tax to “lapse” in 2010. On January 1, 2011, the tax laws will revert to pre-2002 form with the highest tax rate at 55% and a tax-free exempt amount of only $1 million. There has been some talk of retroactively imposing estate taxes on 2010 estates, although it seems unlikely at this point. Many observers believe that Congress will establish the highest rates between 35% and 45% and exempt between $3.5 million and $5 million from taxes, but politics may get in the way of this result.
Congress did not repeal the gift tax or its exclusions. Therefore, individuals are still allowed an exclusion from the gift tax for gifts of up to $13,000 per donee each year to an unlimited number of donees. Spouses can combine their annual exclusion amounts through “gift splitting,” allowing a married couple in 2011 to give gifts of up to $26,000 per donee tax-free. Gifts in excess of the annual exclusion amount may also be offset by an individual’s lifetime gift tax exemption of $1 million in 2011. In addition, payments of qualified tuition and health care expenses are not subject to gift tax. If a gift tax does apply, the rate in 2011 will be the highest individual income tax rate, which is expected to be 35%.
There is always uncertainty in the law, and the year 2011 will be no exception. Yet, whatever Congress does in 2011, it will likely result in a tax regime that is familiar to estate planning professionals. Therefore, traditional strategies for an effective estate plan will not change. What will change are the number of clients impacted by the estate tax. If Congress does not act, a single client with net assets of $1 million, or married clients with net assets of $2 million, will certainly be subject to estate taxes. Consequently, more clients will be able to save their family hundreds of thousands of dollars with a tax sensitive estate plan. Many clients do not realize that a taxable estate often includes life insurance, retirement accounts, joint accounts, and the residence, as well as other probate assets. Including these other assets means that accumulating a “taxable estate” of a couple million dollars is not as out of reach as it might seem. The following are a few tools that we have historically recommended to our clients and will continue to recommend in 2011:
Last Will and Testament
Every client should have a will to provide for the orderly distribution of property, to reduce probate expenses, and to arrange for the care of minor children. A married couple with a taxable estate has even more of a reason for having well drafted wills. By incorporating a bypass trust into their wills, a married couple can both defer any estate taxes until the survivor’s death and reduce the estate taxes due at the survivor’s death.
A bypass trust is an arrangement whereby a married client has some or all of his or her property put into trust upon his or her death. The objective of a bypass trust is to decrease the aggregate total estate taxes paid by a couple upon their deaths by maximizing the use of the tax-free exempt amount available to every individual. For example, a married couple with $2 million in assets could save $400,000 in taxes by using this tool instead of leaving the entire estate outright to the surviving spouse.
Individuals are allowed an annual exclusion from the gift tax for gifts of up to $13,000, per donee (to an unlimited number of donees). Spouses can combine their exclusion amounts, allowing a married couple in 2011 to give gifts of up to $26,000 per donee tax-free. Gifting techniques, with varying complexity, allow individuals to transfer wealth prior to their death. Starting a program early is the key to transferring large amounts of wealth. For example, a married couple with 2 children and 4 grandchildren could give away $156,000 each year ($26,000 x 6) without ever paying gift or estate taxes on the transferred assets. If they start this program at 65 years of age, and both die 20 years later, they could protect over $3 million from estate taxes at their death.
Trusts and Partnerships
There are several legal arrangements, besides a will, that can reduce estate tax liability. A properly drafted life insurance trust that owns a life insurance policy will keep the proceeds from being included in the client’s or the client’s spouse’s taxable estate at death. After the client’s death, the trustee invests the insurance proceeds and administers the trust for one or more beneficiaries (typically, the surviving spouse, children, and grandchildren).
A family limited partnership is another useful way to transfer wealth during a client’s life. Typically, the client is the general partner and his or her children are the limited partners. The general partner retains control of the assets owned by the partnership while he or she gifts value to the children, reducing future estate taxes. At the client’s death, the children can obtain access to the underlying assets or continue to operate the partnership as a form of “mutual fund.”
Capital Gains and Loss
If Congress fails to act, long-term capital gains will revert to pre-2003 rates starting on January 1, 2011. The pre-2003 rates were 20% for taxpayers in tax brackets higher than 15%, and 10% for taxpayers in lower tax brackets, a large increase over the 15% and 0% rates of 2010. Therefore, the timing of capital gain and loss recognition may have a major impact on a client’s taxes.
Financial Power of Attorney
Many clients were advised to have their wills and trust agreements reviewed in 2010 to be certain the repeal of the estate tax did not produce unwanted results. Those clients should again visit their estate planning professional in 2011 to ensure their plan is still intact with the return of the estate tax. Clients should also be prepared to adjust their plans, if necessary, when Congress acts. Executing a financial power of attorney is recommended to ensure that changes to an estate plan can be made when the time is right, even if the client has lost capacity in the interim.
Advance Directive for Health Care
Not all estate planning in 2011 will be tax related. Having an advance directive for health care, which combines what was historically known as the health care power of attorney and the living will, may be more important for a client than any tax planning. Choosing a health care agent prior to incapacity can save a client’s family from the delay, expense, and emotional toll of petitioning for a court-appointed guardian. Any year is a good year to plan for health care issues, and 2011 is no exception.
Estate planning is as important as ever in 2011. More clients and their families will be affected by the changes, both anticipated and unexpected, in the law. If Congress does not act, there will be an opportunity to help more clients transfer more wealth to their loved ones. Applying proven estate planning techniques with personalized modification is an approach that we believe will serve our clients best. We recommend meeting with an estate planning professional in early 2011 to discuss the right plan for you.