Estate Planning and the Aftermath of the American Taxpayer Relief Act

By: Jennifer L. Zegel

The American Taxpayer Relief Act of 2012 (P.L. 112-240) (“the Act”) was enacted on January 2, 2013. The Act provides some permanence to the federal tax rates and exemption amounts with respect to the estate, gift, and generation-skipping transfer tax laws. The Act is a welcomed respite from the ever-changing transfer tax rates and laws that have plagued estate planning attorneys, financial planners, and wealth advisors for the last several years. However, the Act and other laws that recently became effective have heightened the need for a stronger focus on income tax planning as part of an overall estate plan.

The Act set the estate and gift tax exemption amount at $5,000,000 (indexed for inflation) per individual. The exemption amount is the total amount that a person can transfer to others during life or at death without incurring gift, estate, or generation-skipping transfer tax. In 2013, the exemption amount is $5,250,000 for an individual and $10,500,000 for a married couple. The Act also increased the tax rate to 40% on estate and gift tax transfers that exceed the exemption amount. Some experts opine that the Act eliminates the need for sophisticated estate planning for individuals and married couples who do not have a net worth exceeding $5,000,000. While it is true that individuals and married couples with less than $5,000,000 do not need to worry about federal gift and estate tax planning, there is still always a need to establish an estate plan. At a minimum, an estate plan ensures the transfer of assets to intended recipients, provides guardianship designations for minor children, and can establish a trust for practical purposes, such as protecting assets from creditors, a spouse of a beneficiary, or a beneficiary who is a spendthrift. The majority of estate plans now also likely require some sophistication with respect to income tax planning because the Act heightened the necessity of incorporating income tax planning into a basic estate plan.

Among other tax provisions, the Act continues the 2012 income and capital gains tax rates except for taxpayers with adjusted gross incomes above $400,000 (single filers) and $450,000 (joint filers) and estates and trusts with unearned income exceeding $11,950. For those individuals, estates and trusts, long-term capital gains and qualified dividends will be taxed at 20%, rather than 15%, and ordinary income will be taxed at 39.6%. In addition to the new tax provisions set forth in the Act, effective January 1, 2013, The Health Care and Education Reconciliation Act of 2010 (P.L. 111-152) introduced section 1411 to the Internal Revenue Code (the “Medicare tax”), which significantly changes the income tax landscape for many individuals, estates and trusts.

The Medicare tax applies a surtax of 3.8% on Net Investment Income (“NII”). NII includes gross income from interest, dividends, annuities, royalties, and rents, and net gain attributable to the disposition of property, and other gross income from a passive activity, trade, or business, and short and long-term capital gains. NII does not include wage income, income from an active trade or business, amounts subject to self-employment tax, tax-exempt bonds, and distributions from IRAs, pensions, 401(k) plans and other qualified annuity and deferred compensation plans. Nevertheless, caution must be taken with respect to distributions from IRAs, pensions and other retirement plans because these types of taxable distributions are included in adjusted gross income, and the Medicare tax applies to the lesser of a taxpayer’s NII or the amount of adjusted gross income above the applicable threshold amount.

For individuals, the Medicare tax applies for adjusted gross incomes above $200,000 (single filers) and $250,000 (joint filers). Many individuals who are not top income earners and not affected by the Act will feel the affect of the Medicare tax. For estates and trusts, the Medicare tax applies to the lesser of undistributed NII or unearned income that exceeds $11,950. Therefore, under the Act and the Medicare tax, a modest size trust or estate with income above $11,950 will be taxed on the surplus at the highest income tax rate of 39.6% plus the 3.8% Medicare tax, for a total income tax of 43.4%. In addition, although capital gains are not typically considered income to a trust or estate, they are encompassed in the definition of NII and will subject an estate or trust to the additional 3.8% Medicare tax for any undistributed capital gains.

Proper planning can help to avoid, minimize or offset income taxes for individuals, estates and trusts. Incorporating income tax planning in estate and trust administration is necessary and now part of the fiduciary duties of a trustee and an executor. For instance, a trustee may choose to offset a high income tax by distributing a trust asset with significant appreciation to a beneficiary in a lower tax bracket to reduce or potentially eliminate all income tax owed on the asset, so long as the distribution would not violate any provisions or purpose of the trust. Additionally, an executor may decide to invest estate assets in tax-exempt bonds, before final distribution to beneficiaries, which avoids the estate incurring taxable income or paying the Medicare tax. An individual in a high-income tax bracket may plan to gift highly appreciated stock to a person in a lower tax bracket to avoid paying the higher capital gains rate and Medicare tax when the stock is sold. Estate planners should incorporate extra flexibility into estate plans and trust agreements to allow for the acceleration or delay of distributions and the ability to make unequal or in-kind distributions to beneficiaries to avoid or reduce taxes owed. However, establishing plans that avoid or minimize income taxes by altering the timing or amount of a distribution must be weighed against the intent of the transferor to treat all beneficiaries equally and the overall investment philosophy and plan of the transferor regarding whether assets should be distributed or left to continue to appreciate in value.

Due to the changes in income tax rates on individuals, estates, and trusts, it is important to consider and incorporate the impact of income taxes when preparing an estate plan, establishing a trust, and administering an estate or trust. In some situations, income tax considerations can be more important than transfer tax consequences if proper planning is not established. As a result, individuals and fiduciaries should examine and evaluate their estate plans, trust documents, and estate administration investment and distribution schemes on an annual basis, and should consult with legal, tax, and investment advisors to ensure their goals, needs, and tax strategies are being efficiently and effectively accomplished.

For questions, comments or additional information, please contact Jen Zegel, Partner in our Estates & Trusts Group, at jzegel@regerlaw.com or via phone at 215.495.6523.