The current federal estate tax threshold is $11.18 million. What, if anything does this mean for the 99% of Americans who are below this level? Can these folks happily tune out of the estate planning discussion? Not if they engaged in any type of estate tax planning during the past 20 years. Here’s why:
Most estate tax planning has historically focused on reducing the amount of assets includible in a decedent’s ‘gross taxable estate’. If, for example, we did estate tax planning in 2002, our goal was to reduce the gross taxable estate to $1.0 million. Anything above this would have been taxed at a rate of 40% upon death. Some people made a gift of the excess directly to children. Others- (wisely) concerned about the children’s possible liabilities such as divorce, gifted the excess assets to various types of estate tax trusts. These moves were advisable at the time, but triggered a lurking capital gains tax problem for the gifted assets.
The reason for this is that a completed gift (whether to a trust or outright to a person) results in what’s called a ‘carryover’ basis. The original purchase price becomes the recipient’s “floor” to measure future possible (capital) gain upon sale. Let’s say I bought stock for $20 and gifted it to my son during my life. If it is worth $50 upon my death, he will have to pay capital gains taxes on the $30 difference when he sells. By contrast, if I keep the stock and Junior inherits it through my will, living trust, or beneficiary designation, he gets a so-called ‘step-up’ in cost basis to the fair market value ($50) as of my date of death. He would then pay no capital gains taxes upon sale of the asset. Specifically, the Internal Revenue Code (Sec. 1015) provides that assets includible in a decedent’s gross taxable estate go to the new owner with a date of death cost basis.
To reduce capital gains taxes as much as possible, our goal was always to maximize what passed through the gross taxable estate without overshooting the mark. Remember that every dollar in excess of the applicable threshold incurred 40% estate taxes. We therefore, opted to move these ‘excess’ assets, even though doing so triggered a (historically 15-18%) capital gains problem. Using numbers to illustrate, if my estate was $1,100,000 in the year 2002, I wanted my children to avoid having to pay 40% tax on the $100,000 estate taxable amount. It would have been correct to gift the excess $100,000 to an ‘estate tax’ type trust even though doing this saddled them with built in (15-18%) capital gains tax consequences.
Fast forward to the present: The current estate tax threshold of ($11.18 million) means that we can unwind some of the old planning to allow more assets to pass through one’s gross taxable estate, thereby deriving the capital gains benefits otherwise lost if we leave the documents as is. This is especially important now that the Capital Gains Tax rate has crept up in recent years.
The impediment to revisiting this planning is the widespread but mistaken notion that irrevocable trusts can’t be changed. This is not true. Statutory reformation allows irrevocable trusts to be revoked or modified with the written consent of the grantors and beneficiaries. When the consent of a key player isn’t possible, such as a Credit Shelter Trust of a now- deceased settlor, or a beneficiary that we may now seek to exclude, we can look to “Decant” trust assets into a new trust with more favorable provisions.
In addition to the tax savings motivation to amend old trusts, there are numerous other reasons to do so. We may wish to build in more comprehensive protections against long term care expenses. Amending an existing trust will also enable us to better protect a beneficiary with problems such as mental illness, substance abuse, compulsive spending, developmental disabilities or other family dynamic challenges.
The bottom line is that a fresh review of stale documents can yield tremendous benefits.