Myths and Realities of the New Estate Tax Changes

Ted Kurlowicz, JD, LLM, CLU®, ChFC®, CAP®

Ted Kurlowicz, JD, LLM, CLU®, ChFC®, CAP® Ted is the Charles E. Drimal Professor of Estate Planning and a Professor of Taxation at The American College.

Now that the initial shock and surprise resulting from the long-overdue estate tax reform has subsided, there’s been some time to pause and reflect. At first glance, the immediate reaction of many estate planners that I spoke with was that Armageddon had arrived. This certainly is not the case, but paralysis or procrastination will result in lost opportunity. In the discussion that follows, I’ll try to debunk some of the myths that have been offered in the immediate aftermath of the new estate tax rules. The implications of the law will be viewed prospectively and I will, by design, ignore 2010’s rather interesting situation where the compromise bill provided a choice to be made by executors on whether to elect the federal estate tax with the basis stepup or no federal estate tax with a modified carryover basis for assets left to heirs

Myth: The increase in the exemption amount to $5 million and the reduction in the estate tax rate to 35 percent were the biggest surprises in the estate tax compromise.
Reality: The attempts by some in Congress to reach a more timely compromise in the 2008 to 2010 interval revealed that there would not be enough votes in the Senate to fix the federal estate tax at the 2009 levels of a $3.5 million exemption and a 45 percent tax rate. In fact, the Senate had previously agreed in principle to these critical components of the law as finally enacted.

The biggest surprise in the new legislation was the reunification of the estate and gift tax systems with the increase in the gift tax exemption to $5 million. This presents many tax-saving opportunities. 


Myth: At least the uncertainty has been solved and clients can plan their estates without the questions that have been haunting us for a decade.
Reality: This compromise bill was enacted for a two-year period, so we face the same scenario of a return to the June 2001 tax law in 2013. If Congress handles this new sunset in the same manner as the estate tax repeal of 2010, the next resolution will not be provided until the eve of 2014 and won’t be permanent then either.

Myth: The $5 million exemption ($10 million for a married couple) is large enough that estate planning can be ignored for 99 percent of the U.S. population.
Reality: Estate planning should never have been driven by taxes, and ignoring the estate plan to concentrate on other agendas would be a real disservice to most clients. We still need to discuss the client’s legacy plans and assist the client in answering the who, how and when with respect to both accumulated wealth and wealth added by death benefits from life insurance or employee benefits.

Many risks other than federal estate tax could diminish the efficiency of the client’s estate plan. For example, the client may wish to plan for long-term care or capacity issues. Most people will want to distribute their estate with the minimum of delay or probate costs. Perhaps the intended heirs have creditor problems or lack the capability for managing the inherited assets. Finally, many people will have testamentary charitable intentions irrespective of the federal estate tax.

Another important tax issue to address with many clients well below the $5 million threshold is the state-level inheritance or estate taxes. In states with a separate inheritance tax (such as Pennsylvania) a tax is imposed on estates for assets left to anyone but the surviving spouse without a significant exemption. A number of states that decoupled from the federal exemption and impose what was formerly known as the credit estate tax or sponge tax have state estate tax rates up to 16 percent with exemption amounts either at $675,000 or $1 million depending upon how their law is structured.

Myth: The $5 million exemption will eliminate the need for filing gift or estate tax returns for most Americans.
Reality: This is no time to get sloppy with estate and gift tax compliance. The rules with respect to filing Form 709 for lifetime gifts have not changed. Any taxable gift requires a federal gift tax return. Hence, any gifts that are not excluded (those under the $13,000 annual exclusion) or deducted from the gift tax base must be reported even though the exemption for taxable gifts is $5 million. In addition, the three year statute of limitations that prevents the IRS from disputing a gift after the statutory period only applies if a return was filed. We will continue to recommend filing gift tax returns to secure this protection. In some instances, filing a gift tax return is prudent even if the return is unnecessary to receive protection from the statute if the asset transferred lends itself to valuation disputes. For example, a gift tax return should be filed for gifts of units in a family limited partnership (FLP) even if the donor believes the gifts fall below the $13,000 annual exclusion.

The Form 706 federal estate tax return has been made more important by the new law in many otherwise nontaxable estates. The portability of the exemption between spouses requires the filing of the federal estate tax return for the first spouse to die to report the Deceased Spousal Unused Exclusion Amount (DSUEA) that is being transferred to the surviving spouse.

Myth: The portability provision will dramatically simplify planning.
Reality: “How do I love thee? Let me count your DSUEA.” The portability provision contains a serial remarriage prevention clause. The surviving spouse does potentially (if the return is filed) take the deceased spouse’s unused exemption. However, a subsequent marriage and death of the new spouse eliminates the first deceased spouse’s exemption and leaves the two-time survivor with the second spouse’s unused exemption. Confused yet? The DSUEA is not indexed for inflation and this remarriage issue would seem to indicate that the survivor ought to make a gift first from the DSUEA available if there is the inclination and capability of making gifts. This will have to be somehow cleared up by IRS guidance and a timely filed gift tax return.

Myth: The portability provision will make the unified credit (exemption) trust extinct.
Reality: The portability provision allowing the surviving spouse to inherit the deceased spouse’s unused exemption does present a tempting opportunity to simplify the estate plans of couples whose wealth is sufficient to consider federal estate tax planning. Remember, the $5 million exemption is only enacted for two years and many couples may find themselves more concerned about the estate tax again in 2014.

The use of the traditional marital deduction and unified credit (exemption) trusts would still be indicated in many circumstances. In the estate plan of a couple with $10 million or more in assets, the use of the exemption trust funded with $5 million at the death of the first spouse to die creates an estate freeze. The $5 million exemption amount could be applied at the first death to the value of the assets at the time of that death, and any subsequent appreciation would avoid tax later. The use of the $5 million exemption at the time of the first death would be particularly beneficial if Congress decides later to allow these provisions to lapse and the exclusion goes back to some lesser amount.

Myth: The use of trusts will decrease dramatically.
Reality: Most trusts are designed for reasons other than the federal estate tax. The most substantial trusts in terms of value were created by families who view the difference between the $3.5 million and $5 million exemptions as a rounding error. And the reduction in the number of Americans subject to the federal estate tax will not change the fundamental reasons for creating trusts. That is, the need still exists to provide creditor protection, defer the distribution of assets to beneficiaries until appropriate ages, delegate distribution decision-making authority to independent third parties, reduce probate costs and manage assets for heirs with special needs.

Myth: The use of life insurance for estate planning purposes has diminished in importance.
Reality: There are two estate planning purposes for life insurance. First, there is the estate enhancement need to increase the insured’s estate to some desired level. This purpose could be as simple as providing income replacement for someone who dies prematurely prior to accumulating enough wealth to provide for his or her family. In some instances, the estate enhancement need extends beyond the insured’s working years because of the need to support one or more heirs after the insured’s death. For example, the client could have one or more children or grandchildren who will be unable to support themselves due to a disability or other cause. The estate enhancement use of life insurance is unaffected by the federal estate tax.

The second estate planning purpose for life insurance is wealth replacement/ estate liquidity. One major need for wealth replacement is the estate or inheritance taxes imposed on the client’s estate. To some degree, this need has been diminished for estates between $3.5 million and $5 million as a result of the increased exemption. The wealth replacement target amount is reduced for all taxable estates as a result of the reduction in the rate from 45 percent to 35 percent. However, the federal estate tax change does not sound the death knell for wealth replacement coverage. My experience has shown me that wealth replacement coverage in estates that are somewhat marginal with respect to the exemption amount often face persistency problems. For estates well over the $5 million exemption amount, the federal estate tax remains a significant risk.

The estate liquidity needs for life insurance often apply even in nontaxable estates. The lessons learned from the recent past with respect to the large reduction in asset values indicates the problems an estate might face holding assets during a market crash. For example, there must’ve been a lot of disappointed heirs of estates holding real estate during the last three or four years. The federal estate tax or other inheritance taxes only exacerbate the liquidity problems because assets must be sold to pay these taxes. The need for life insurance for estate liquidity purposes continues to be a viable planning solution.

Certainly, the change in the federal estate tax laws presents an opportunity to revisit clients with existing life insurance. Examining the existing coverage with respect to the estate planning purpose and the current status of the policy is fitting. Now is the best time to discuss the value of the policy as an asset class with the client and make adjustments to the policy or the estate planning structure as appropriate.

Myth: The $5 million federal estate tax exemption has diminished the importance of lifetime gifts in the estate planning process.
Reality: The single largest opportunity created by the new estate tax law is the ability to make $5 million of taxable or generation-skipping gifts without paying gift or GST taxes. Remember that this change potentially has a two year shelf life. Although the estate tax exemption had risen as high as $3.5 million in 2009, the gift tax exemption was permanently set at $1 million. While the rollback of the gift tax exemption is certainly possible, it seems very unlikely that Congress would attempt to later tax gifts made in 2011 and 2012 under the temporary $5 million exemption. Following is a list of suggested opportunities for using the $5 million gift tax exemption:
• Transfer substantial interests in the closely held family business to successor generations sooner than otherwise possible.

• Use valuation discounts to transfer wealth as efficiently as possible for high net worth families.

• Make use of both spouses’ $5 million gift and GST tax exemptions in high net worth families. The ability for a high net worth couple to fund a $10 million generation-skipping trust during their lifetimes is an incredible opportunity. This trust could be funded with life insurance or assets that have been discounted to further leverage the exemption amounts into greater wealth transfers.

• Use the $5 million exemption amount to make larger life insurance purchases in irrevocable life insurance trusts (ILITs) than could otherwise be supported by the available $13,000 annual exclusion Crummey powers.

• Use the $5 million exemption amount to repair previous estate planning efforts that have gone awry. Many estate planning techniques previously implemented have not performed as planned. For example, the policy performance in an ILIT may be below the initial illustrations, and additional contributions may be required to support the policy. Perhaps a split dollar life insurance plan needs to be terminated. Maybe a policy was funded through premium financing and the outstanding loans are substantial. Or, the grantor retained annuity trust (GRAT) created by the client is underperforming as a result of the drop in value of the underlying trust assets. The $5 million exemption can be used as a repair tool to make sizable additional gifts to address these and a multitude of other scenarios.

In the wake of the federal estate tax reform, being mindful of what is true and what is misconception about the impact of the changes on estate planning is crucial to capitalize on the opportunities available to clients.