Hedging Against Post-ATRA Step-up Planning Perils

Hedging Against Post-ATRA Step-up Planning Perils

The American Taxpayer Relief Act, now widely referred to as ATRA, has dramatically impacted the estate planning industry.

The army of planners – attorneys, CPAs, insurance agents – has been rocked by the fact that the permanent estate and gift tax environment has effectively marginalized planning aimed at saving or eliminating estate taxes for families.

The Tax Policy Center projects that just 0.14% of adult deaths this year will result in federal estate tax. This figure is drastically reduced post-ATRA, down from 2.3% in 1999 and 7.65% in 1976.

The indexed applicable exclusion of $5.34 million is anticipated to grow to $7 million within 10 years if left unchanged, according to Alliance Bernstein. This means that in the relatively near future, families with taxable estates under $14 million will not be subject to Federal estate tax.

That’s a heck of a lot of wind taken out of our collective sails.

Change is always difficult, and this transition is no exception.

Effectively, the vast majority of estate planners, whether an attorney, CPA or insurance professional, must evolve as tax planners.

We are now operating in an environment that (in some states) the combined Federal, state and local top marginal income-tax rates are higher than the 40% Federal estate tax rate. And the gap has closed significantly between combined rates on capital gains and estate taxes.

In California for example, the combined capital gains tax rates are nearly equal to the Federal estate tax, at 33% (or more depending on additional factors).

There was a major push by planners to convince clients to maximize their applicable exclusions and move $10 million out of their estate prior to the end of 2012. Today, however, despite the fact that the applicable exclusion is larger due to indexing, a different strategy may make a lot more sense.

a new strategy

With portability and the step-up in basis received on assets at the first spouse’s passing and when the surviving spouse passes, it should be the aim for many planners to advise clients to seek the step-up in basis by simply keeping assets in their taxable estate.

A step-up in basis means that when an heir inherits certain assets, the tax-basis can be “stepped-up” to the fair market value at the time of the benefactor’s death. This is of enormous significance, given that what the heir receives can, if desired, be immediately sold without any capital gains taxes due, for example.

If the benefactor transferred the property as a gift, the step-up is not available and therefore the transferred assets would still have gains subject to tax.

The convergence of estate, gift, income and capital gains tax rates makes basis planning one of the most critical planning components today.

leveraging assets

With the revived focus on this planning, it is essential to carefully navigate which assets are retained and transferred and how to get the most tax-leverage possible.

Low-basis assets are particularly attractive to retain for the step-up, including stock, intellectual property, art, gold, and fully depreciated investment real estate. High-basis assets don’t reap the same level of tax benefits from estate inclusion and may be considered for repositioning.

However, something that few are talking about is the possibility, if not probability, for the “permanent” estate and gift tax levels to be altered in the future. This is almost a certainty given all of the talk in Washington D.C. about potential revenue sources and the fact that changes are bandied about within the current administration.

In fact, the President’s 2015 White House Budget Proposal includes proposed changes to the “permanent” rules. The following is an excerpt from the U.S. Department of the Treasury’s “General Explanations of the Administration’s Fiscal Year 2015 Revenue Proposals”:

Beginning in 2018, the proposal would make permanent the estate, GST, and gift tax parameters as they applied during 2009. The top tax rate would be 45 percent and the exclusion amount would be $3.5 million for estate and GST taxes, and $1 million for gift taxes. There would be no indexing for inflation. The proposal would confirm that, in computing gift and estate tax liabilities, no estate or gift tax would be incurred by reason of decreases in the applicable exclusion amount with respect to a prior gift that was excluded from tax at the time of the transfer. Finally, the unused estate and gift tax exclusion of a decedent electing portability and dying on or after the effective date of the proposal would be available to the decedent’s surviving spouse in full on the surviving spouse’s death, but would be limited during the surviving spouse’s life to the amount of remaining exemption the decedent could have applied to his or her gifts made in the year of his or her death.

The proposal would be effective for the estates of decedents dying, and for transfers made, after December 31, 2017.

the risk in waiting

There is a potentially significant risk in retaining assets inside the taxable estate should a material change to the applicable exclusion, estate and gift tax rates be adopted by Congress.

While the step-up will be achieved, the risk of unanticipated tax-exposure is a real possibility. Unfortunately, a wait-and-see approach does not provide much, if any upside.

This risk is insurable and manageable, however, and it requires planners to quantify risks and create structures that can address this as a contingency plan.

Consider the consequences of a full adoption of the White House 2015 Budget proposal. It would represent a 12.5% increase in estate and gift tax rates and a roughly 35% reduction in applicable exclusion and permanently removing the indexing.

These would create rather onerous unintended consequences to a “die with your assets” strategy.

Today, a couple with a taxable estate of $10.5 million would likely receive the good advice to retain assets inside the estate and allow them to receive a step-up in basis upon the first spouses’ passing, and then again at the time of the surviving spouse’s death. Because the theoretical estate is valued at less than the lifetime applicable exclusion, there would be no Federal estate tax owed.

If, however, the Administration’s proposed changes take effect and the surviving spouse passes after 2017, estate taxes exceeding $1.5 million could become due. That equates to nearly 15% of the estates’ value being swallowed up by potential changes in Federal law.

While many will choose to wait and see, smart planners will collaborate and urge clients to protect their estates against this possible challenge.

life insurance: the perfect hedge

The use of annual exclusions to fund death-benefit oriented life insurance in an irrevocable trust may be the perfect hedge.

For this hypothetical family with a $10.5 million taxable estate that believes, based on “permanent” rules, that they have no exposure to Federal estate taxes, it may be a smart move to purchase an amount of life insurance in an irrevocable trust that is equal to any probable change in either tax or applicable exclusions, given the information that is available today.

The best-case scenario is a step-up in basis on assets in the estate, no Federal estate tax due and a surplus of tax-free cash designed to have attractive internal rate of return available for heirs.

The worst case scenario is a step-up in basis on assets in the estate and an estate tax due because of Federal policy changes.

With the life insurance in place, however, assets can still be available to transfer to subsequent generations, given the cash from tax-free death benefits available to fund taxes.

It cannot be assumed that the Federal estate and gift tax rules will remain “permanent.” Contingency planning with life insurance is a smart hedge.

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