How does the New Tax Act Affect my Estate Plan?

If you think the new tax law, which slates the elimination of the estate tax and generation skipping transfer tax for the year 2010, was designed to simplify the estate planning process, think again. While the gradual increase in the estate tax exemption equivalent will allow folks to transfer more and more at death without estate tax or generation skipping tax consequence, planning for the most efficient transfer of this wealth has never been more challenging or complex.

Before the new tax Act, most attorneys recommended tax planning through a will or trust for married clients whose combined taxable estates totaled more than approximately $750,000. Most often, this tax planning involved the use of a trust which would hold the deceased spouse's estate to the extent the value of the estate did not exceed the exemption equivalent available to the deceased spouse's estate ($675,000) in 2000 and 2001. This trust is frequently called a bypass trust or credit shelter trust. The assets held by the bypass trust are excluded from the surviving spouse's taxable estate at the surviving spouse's death.

Because most bypass trusts name the surviving spouse as the primary beneficiary during the surviving spouse's lifetime, most estate plans will not need to be changed. However, if someone other than the surviving spouse is the beneficiary of the bypass trust, the new Act may cause unintended harm to a surviving spouse. For example: Husband and Wife's taxable estate totals $3,000,000. They had tax planned wills drawn up in 1996, when the exemption equivalent was $600,000. They named their children as the primary beneficiaries of the bypass trust. Husband dies in 2004 when the exemption equivalent is $1,500,000. Because Husband's one-half of the community property totals $1,500,000, wife is left only with her community one-half of the estate because the bypass trust is funded with $1,500,000 and the children are the beneficiaries of the bypass trust.

The staged estate tax relief, coupled with the limits the new Act places on the step up in basis allowed on assets of a decedent's estate, necessitates a more flexible approach to estate planning with more of an eye toward minimizing income tax. The typical tax planned will or trust leaves an amount equal to the exemption equivalent to the surviving spouse. If the first spouse dies before the estate tax is completely phased out, the bypass trust must be funded pursuant to the terms of the deceased spouse's will or trust. If the second spouse dies after 2009, or in a year in which the exemption equivalent exceeds the value of the second spouse's estate plus the bypass trust, the tax planned wills signed by the couple years before could actually cause an income tax disadvantage.

For example, Husband and Wife have a combined taxable estate totaling $3,000,000. Husband dies in 2003 and the bypass trust is funded with $1,000,000, the exemption equivalent for 2003. Wife later dies in 2009 when the value of her estate plus the value of the assets in the bypass trust equal $3,500,000. Because only the assets owned by the wife are eligible to receive the limited step up in basis, the assets in the bypass trust are not able to be stepped up. If this couple had simple wills leaving everything to each other outright, no estate tax would be due upon the Wife's death and the entire $3,500,000 would have received a step up in basis. The result in this case is due to these facts. As bad as it sounds, if the wife had died shortly after the husband, the tax result would have been better in regard to the step up in basis of the assets. The new Act increases the importance of a flexible estate plan and deepens the attorney's duty to consider individual circumstances to minimize both estate and income tax consequences.

In order to maximize flexibility and manage the competing goals of minimizing both estate and income tax consequences, the disclaimer, an under utilized estate planning tool, should be considered. A disclaimer is a document that allows a devisee to refuse to take property given to him or her in a will or trust. The property then passes as if the disclaiming devisee predeceased the testator. In some cases, especially in traditional family situations, documents should now provide that all assets pass outright to the surviving spouse, and in the event the surviving spouse disclaims assets, the disclaimed assets pass to the bypass trust. This would allow the surviving spouse more flexibility in her approach to tax planning.

While the disclaimer gives the surviving spouse more flexibility, potential drawbacks should be considered. First, if the surviving spouse chooses to disclaim property into the bypass trust, she cannot be the trustee of the bypass trust. Second, since a disclaimer must be filed within nine months from the date of death, the spouse must make a calculated decision at a very emotional time.

Third, the surviving spouse may not prioritize tax planning as highly as the decedent and might choose not to disclaim property even when disclaiming property into the bypass trust makes good sense. Fourth, when the surviving spouse inherits assets outright, the distribution of those assets are governed by the surviving spouse's will or trust at her death. Consequently, the spouse who dies first may not be able to predetermine with certainty who receives his or her assets upon the death of the surviving spouse, as the surviving spouse inherits outright and may or may not choose to disclaim those assets into the bypass trust. This can be an important drawback to the disclaimer approach in blended families.

In sum, if you are married and your combined estates total more than $1,000,000 or if you have tax planned wills or trusts, regardless of the value of your combined estates, it is important for you to have your documents reviewed in light of the new Act. Further, the emerging importance of income tax avoidance, as the estate tax is phased out, warrants heightened vigilance with regard to your estate plan.