The $5 million exemption
Congress knew that they had to act for two years but for purely political reasons waited until the last minute to extend the “Bush era tax cuts” for most taxpayers. There was great surprise, however, when congress finally passed the new estate tax law on January 1, 2013. Few people had predicted that congress would keep the estate tax exemption level at $5 million per person! And….. the $5 million exemption will be indexed for inflation. For 2012 the indexed amount was $5,120,00 and for 2013 it will be $5,250,000 per person..The “death tax” exemption was scheduled to revert back to the pre Tax Relief Act of 2001 level of $1 million per person on January 1, 2013 if congress did not act. The $3.5 million exemption level that existed in 2009 was the highest that most analysts felt could be hoped for.
However the top tax rate, on estates that exceed the exemption level, will go up to 40% from the current 35%, rather than the scheduled 55% that would have been imposed if congress did not act. These changes are “permanent” which doesn’t really mean permanent…only that congress must act to change them. However, congressmen typically don’t like to take things away from voters since it can hurt their reelection prospects. For this reason, there is some hope that the death tax exemption level and tax rates will continue for an extended time.
The Portability Provision
One of the most beneficial aspects of the new tax bill is continuation of the exemption “portability” provision. This provision allows the executor or trustee to transfer the unused portion of the deceased spouse’s estate tax exemption to the surviving spouse. This means that a married couple can be assured of being able to take advantage of the $5 million indexed exemption for each spouse, without the need for a bypass trust. Previously it was necessary to use a bypass trust to capture the deceased spouse’s exemption and, even then, one would lose the difference between the exemption level and the amount of the value of the deceased spouse’s estate. So, there is no more need for a bypass trust…….right? Well, not so fast!
Shall I Deep Six My Bypass Trust?
In many cases, it is true, that there will be no need for the bypass trust. But before you call your estate planning attorney and tell him to amend your trust and remove the bypass trust, consider the following:
First, you still need to have a trust to avoid probate. This is one of the major reasons for having a trust and it still exists. So even though you may want to amend your trust, the trust itself is still a valuable estate planning tool that you definitely want to keep in force.
Second, if you are in a second marriage or if you want to make sure that your spouse doesn’t change the named beneficiaries after you die, you need an irrevocable bypass trust to lock in beneficiaries for your portion of the estate. If you have a bypass trust it will be irrevocable and your surviving spouse will not be permitted to change the beneficiaries you have designated for your portion of the estate no matter if there is subsequent marriage or any other reason he may have for wanting to disinherit your named beneficiaries.
Third, a bypass trust may come in handy to protect rapidly appreciating assets in the deceased spouse’s estate. If the deceased spouse’s assets are expected to appreciate in value at a more rapid rate the inflation index, you can utilize the bypass trust to protect those assets from future estate taxes on the amount that exceeds the indexed exemption rate. For example if your spouse dies in 2013 and has a $5 million estate you could shield all of those assets from future taxes regardless of how much their value appreciates in future years by use of the bypass trust. If you didn’t use the bypass trust and just transferred the assets and the unused exemption to the surviving spouse, then the surviving spouse would have to pay 40% estate taxes on the amount that the deceased spouse’s estate appreciated in excess of the index. For example, consider the case in which the deceased spouse’s estate had a value $5 million when he died and it appreciated to $8 million six years later. At a likely index inflation rate of 3%, the indexed estate tax exemption would be about $6 million. Therefore, when the surviving spouse passed away, the estate would incur a tax of 40% of the added $2 million, i.e. $800,000. In this case, using the bypass trust would be very valuable.
When should You Bypass the Bypass Trust?
If you don’t have assets that will potentially appreciate in value and there is no concern about locking in beneficiaries, then you (i.e. your executor or trustee) may opt to not use the bypass trust. There is a caution however. If you simply bequeath all you assets to your spouse, your executor will still have to prepare an estate tax return to determine the amount of the unused estate tax exemption and to proactively make the election to transfer this unused exemption to the surviving spouse. Previously, with smaller estates, it was usually not necessary to prepare and file an estate tax return (IRS form 706). With the new portability law, however, it will now be necessary to file such a return if you want to take advantage of the ability to transfer the unused exemption. This is good news for CPAs but not so good news for executors of small estates. The executor must decide whether to spend the money on preparing and filing an estate tax return or gambling that the estate will remain small and will not need the unused portion of the deceased spouse’s exemption.
Consult Your Attorney
No attorney, and certainly not this one, would end an article with out cautioning the reader to consult their attorney regarding the impact of the new estate tax law on your particular situation. New trusts should take the portability provision into account and most existing trusts will probably need to be amended to fully take advantage of the new portability clause.