Estate Planning: A Tax Simplification Nightmare

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ESTATE PLANNING: A TAX SIMPLIFICATION NIGHTMARE

As the years have rolled by, it seems that Congress' tax simplification efforts have been counterproductive. Instead of becoming more simple, the tax code has become more complex, especially in the estate planning area where estate taxes, generation skipping transfer taxes, excise taxes on excess qualified plan benefits, and federal income tax concerns come into play.

For IRS purposes, the taxable estate includes virtually anything and everything which is owned. It will include any IRA, KEOGH, pension plan, and profit sharing plan, as well as the death benefit value of any life insurance policies on the decedent's life for which the decedent was the owner. Because the taxable estate includes all of these assets, your own estate may be much larger than it seems to you now. You need not feel like a millionaire to have a taxable estate that should be carefully planned and managed from a federal tax standpoint.

Two major taxes which will impact on virtually all sizeable estates are the federal death tax and the federal generation skipping transfer tax. From a general concept standpoint, these two taxes should be considered as operating independently of each other, but from a tax planning and drafting standpoint, how we deal with one may adversely impact the other. This article will describe each of the two taxes both independently and as they operate together.

From a federal death tax standpoint, each person is currently entitled to two big deductions (or deduction equivalent). Each person is entitled to give, tax free, $1,500,000 worth of property to any recipients. In addition each person is entitled to give an unlimited amount to a surviving spouse on a tax free basis. Consider, for example, the case of simple Wills which leave everything to the surviving spouse and then, only when the two spouses had passed away, does anything go to the children. The estate of the first spouse to die would be completely tax free since virtually everything that passes to a surviving spouse qualifies for a deduction. However, when the second spouse passes away, his or her estate would be entitled to give $1,500,000 tax free to the children, and the balance would be subject to death taxes. Since only the surviving spouse is utilizing the $1,500,000 gifting exemption, these simple wills only pass $1,500,000 to the children on a tax free basis.

However, by restructuring the disposition of the assets owned by the spouse who is first to die, the amount going tax free to the children can be increased to $1,500,000 by taking advantage of the $1,500,000 exemption for the first spouse as well as the second spouse. This is accomplished in the first estate by having the first $1,500,000 worth of property go into a "tax savings trust" which is designed to provide financial security for the surviving spouse but which is also designed so as not to be taxed in the second estate. This way, the trust utilizes the $1,500,000 exemption for the first estate so that the funding of the trust is done on a non-taxable basis. The trust is therefore not a part of the second estate. Thereafter, when the second spouse dies, that spouse is also entitled to give another $1,500,000 away tax free to the children. By properly structuring the first estate, $1,500,000 can be distributed to the children on a death tax free basis. Since it isn't known which of the spouses will pass away first, it is necessary to provide similar documents for each spouse so that this tax saving trust can be established in the first estate regardless of who might pass away first. It is equally important to structure the marital balance sheet so that each spouse has $1,500,000 of potential "funding source" assets in his or her individual name. Since it isn't known who will pass away first, it is important that each spouse be capable of establishing the tax savings trust on the first estate.

For death tax purposes, the first $1,500,000 worth of property in the first estate will be distributed to the tax savings trust, but what should be done with the balance of the property owned by the first spouse to die? In most cases whatever is done will probably qualify for the marital deduction so no death taxes are owed by the first estate. There are basically four choices to accomplish this: one, an outright bequest to the surviving spouse; two, a bequest in trust where the spouse has unlimited withdrawal rights; three, a distribution to a trust where the spouse has income rights only and no ability to withdraw or appoint principal, although principal can be distributed in the trustee's discretion; and four, a bequest in trust where the spouse has the unlimited right to say who receives it when he or she subsequently dies. Basically, there is no practical difference between alternatives one and two, except that if the marital deduction bequest is made in the trust format, then there may be a Pennsylvania inheritance tax advantage on the second estate. An outright gift would be subject to Pennsylvania inheritance tax when the second spouse died, but a trust format is not directly taxed in the second estate. (The Pennsylvania estate tax may make up the difference, but it will certainly not make the tax situation worse.) Therefore, a trust vehicle is usually recommended for the marital deduction bequest.

The third marital deduction alternative also gives us the potential Pennsylvania inheritance tax advantage, and, unlike the fourth alternative, also allows us to achieve some generation skipping transfer tax advantages, with the corresponding disadvantage of being more restrictive for the surviving spouse. However, there is a way of obtaining the benefits of both an unlimited withdrawal right marital deduction trust and obtaining the same generation skipping transfer tax advantages. This can be done by providing that the unlimited principal withdrawal right is subject to the trustee's right to veto any such withdrawal if the trustee deems the spouse to be of diminished mental capacity. In addition, it also can be provided that the principal distribution powers of the trustee are restructured if the surviving spouse becomes a resident of a nursing home. This way, not only are the desired tax advantages achieved, but marital trust assets can be safeguarded from medical expenses.

The second major tax to be reckoned with in planning an estate is the generation skipping transfer tax. The generation skipping transfer tax has its genesis in the IRS belief that each person should give his or her property to the next generation in line and so on from generation to generation so that inherited property is taxed at each and every generation from a death tax standpoint. To the extent that a distribution is made, for example, to a grandchild, then the intervening generation (the children) have been skipped. The IRS believes that it has been deprived of the death taxes which it would have received on that intervening generation. To counteract this, Congress promulgated the generation skipping transfer tax which in theory is designed to recapture the death taxes which would have been paid by the skipped/intervening generation. Since it is not always possible to know at what tax bracket that intervening generation would have paid its death taxes, the law imposes a flat tax of fifty-five percent (55%), that being the maximum rate of federal death taxes. In their infinite wisdom, IRS and Congress have recognized that a 55% flat tax can produce confiscatory results, and accordingly a $1,500,000 exemption amount is allowed to each spouse. In other words, $1,500,000 can be given to the grandchildren (for example) without incurring any generation skipping transfer taxes. This $1,500,000 exemption is available to each spouse such that a total of $3,000,000 is available on an exemption basis for each married couple. It should be kept in mind, however, that this $1,500,000 exemption has nothing to do with the $1,500,000 exemption amount discussed above in connection with the death taxes, except that if the uses of the two different exemptions are not coordinated, adverse tax consequences can result.

The $1,500,000 generation skipping transfer tax exemption can be allocated to an outright gift to the beneficiary or it can be allocated to a trust for the benefit of the beneficiary. If it is allocated to a trust vehicle, one of the important aspects of the generation skipping transfer tax is that "once exempt, always exempt" (provided certain safeguards are observed). Thus, if the $1,500,000 exemption amount is put in a segregated trust, and that trust grows to $5,000,000 over the ensuing years before being distributed to the grandchildren, then the entire $5,000,000 would be exempt when paid to the grandchildren. Correspondingly, if the trust were completely subject to the generation skipping transfer tax, the full $5,000,000 would be subject to tax when paid to the grandchildren.

Although the purpose of this article is not to explain the generation skipping transfer tax in every detail, one additional nuance needs to be disclosed. Even though it may be intended to have distributions go to the children and not the grandchildren, if a child dies, and there is eventually a distribution to the grandchildren, this will be deemed a distribution subject to the generation skipping transfer tax. The two exceptions to this are when the distribution to the grandchildren is done either on a direct bequest basis on the second spouse's death as a result of a power of appointment given to the second spouse under a general power of appointment marital deduction trust, or from a marital deduction trust which is fully exempt from the generation skipping transfer tax due to the $1,500,000 exemption allocation done at the time of either spouse's death depending on the type of marital deduction trust. Similarly, the exercise of a discretionary income distribution power to make a distribution to a grandchild (to have the income taxed at the grandchild's lower income tax bracket) is subject to the generation skipping transfer tax.

What is done to minimize the death tax or income tax and what is done to minimize the generation skipping transfer tax can have interactive consequences.

In connection with the generation skipping transfer tax, one of the planning possibilities for the "once exempt, always exempt" rule, is to place the exemption amounts in a segregated trust and invest that trust for growth. The balance of the inheritance which is not exempt from the generation skipping transfer tax can be placed in a separate trust to be invested for income. In addition, it is possible to provide for the payment of certain expenses and non-generation skipping distributions to be made from the non-exempt trust, and save the exempt trust for generation skipping distributions. In this manner, it is possible to have a balanced portfolio (when the aggregate investments of the two trusts are considered), and at the same time maximize the total tax-free inheritance of the grandchildren.

This segregated trust approach, however, means that after the first spouse has passed away and before the second spouse has died, there may actually be three trusts in existence as opposed to the normal two (i.e. the tax savings trust and marital deduction trust) which are needed for death tax planning. And in some cases, there may be as many as four trusts. (In addition, after both spouses have died, there may be two trusts instead of one.)

If the $1,500,000 generation skipping transfer tax exemption amount has not been diminished by lifetime gifts, then the first $1,500,000 of the exemption is usually allocated to the tax savings trust so that it is completely exempt. The balance of the $1,500,000 exemption should be allocated to the restrictive marital deduction trust (alternative number three discussed above), but if the assets of the marital deduction trust exceed the exemption allocated to it, then this marital deduction trust should be bifurcated into two separate marital deduction trusts, one of which is exempt from generation skipping transfer tax, and the second of which is not exempt. On the second spouse's death there may be an opportunity to allocate his or her exemption amount to the non-exempt marital deduction trust depending on the type of marital deduction trust set up in the first estate. Only exempt trusts should be merged with exempt trusts, otherwise the previously exempt trust will become partially taxable. Obviously, this produces an escalation in the complexity and cost of the trusts' administration.

As retirement savings continue to appreciate over the years, IRA's and other qualified plans will represent an increasingly large portion of each person's taxable estate. If the tax savings trust for death tax purposes is made the beneficiary or partial beneficiary of an IRA or other qualified plan account in order to obtain the death tax savings, an analysis must be made of the anticipated savings and the anticipated costs of that course of action to make sure that the net tax effect is in fact a tax savings. The best time to make this analysis is at the time that the plan participant dies (i.e. at the estate of the first spouse to die). The analysis is accomplished through an extremely complicated formula wherein the anticipated savings are compared to the anticipated costs.

If the tax savings trust is designated as the IRA beneficiary, then the savings will be the present discounted value of the death taxes which would have been payable by the surviving spouse's estate if the amount paid to the tax savings trust were included in the surviving spouse's federal taxable estate rather than in the tax savings trust.

Correspondingly, it may be desirable to have an IRA or qualified plan account paid to a restrictive type marital deduction trust. This could make those funds available to the surviving spouse for his or her financial security but still guaranty that the funds will be distributed to the beneficiaries chosen by the spouse first to die and not those beneficiaries designated under the surviving spouse's will. This is very often used in a second marriage situation and this can be accomplished through specialized trust provisions which deal with a number of different income and principal allocation issues. It will also allow the surviving spouse to rollover the IRA or qualified plan account into the surviving spouse's own IRA account and still have the spouse's IRA revert back to the trust upon his or her death. This tax-free rollover capability allows the trust and surviving spouse to defer the income taxes on the payout of the plan benefits and still guarantee who the ultimate beneficiaries will be.

Proper estate planning and balance sheet structuring can save approximately $230,000 of federal death taxes upon the second spouse's death, and potentially a considerable amount of generation skipping transfer taxes depending upon the size of the balance sheet and the ultimate distribution of the estate or trust. Achieving these tax savings, however, has a cost factor: the estate planning documents and the administration of the trusts created can become exceedingly complex and cumbersome. For that reason, it is equally important to include within the tax planning provisions, an ability for the executor or trustee to undo or ignore the unwanted tax planning procedures if the anticipated tax savings do not justify the excess administrative burdens and complexities.

Part 2 of 2

As was discussed in Part 1, the second major tax to be reckoned with in planning estates is the generation skipping transfer tax. The provisions of that tax give each person a $1,500,000 exemption, so that for married couples, the cumulative exemption available is $3,000,000.

The generation skipping transfer tax exemption can be allocated to an outright gift to a beneficiary or it can be allocated to a trust for the benefit of the beneficiary. If it is allocated to a trust vehicle, one of the important aspects of the generation skipping transfer tax is that "once exempt, always exempt" (provided certain safeguards are observed). Thus, if the $1,500,000 exemption amount is put in a segregated trust, and that trust grows to $5,000,000 over the ensuing years before being distributed to the grandchildren, then the entire $5,000,000 would be exempt when paid to the grandchildren. Correspondingly, if the trust were completely subject to the generation skipping transfer tax, the full $5,000,000 would be subject to tax when paid to the grandchildren.

Although the purpose of this article is not to explain the generation skipping transfer tax in every detail, one additional nuance needs to be disclosed. Even though it may be intended to have distributions go to the children and not the grandchildren, if a child dies, and there is eventually a distribution to the grandchildren, this will be deemed a distribution subject to the generation skipping transfer tax. The two exceptions to this are when the distribution to the grandchildren is done either on a direct bequest basis on the second spouse's death as a result of a power of appointment given to the second spouse under a general power of appointment marital deduction trust, or from a marital deduction trust which is fully exempt from the generation skipping transfer tax due to the $1,000,000 exemption allocation done at the time of either spouse's death depending on the type of marital deduction trust. Similarly, the exercise of a discretionary income distribution power to make a distribution to a grandchild (to have the income taxed at the grandchild's lower income tax bracket) is subject to the generation skipping transfer tax.

What is done to minimize the death tax or income tax and what is done to minimize the generation skipping transfer tax can have interactive consequences.

This segregated trust approach, however, means that after the first spouse has passed away and before the second spouse has died, there may actually be three trusts in existence as opposed to the normal two (i.e., the tax savings trust and marital deduction trust) which are needed for death tax planning. And in some cases, there may be as many as four trusts. (In addition, after both spouses have died, there may be two trusts instead of one.)

It may be desirable to have an IRA or qualified plan account paid to a restrictive type marital deduction trust. This could make those funds available to the surviving spouse for his or her financial security but still guaranty that the funds will be distributed to the beneficiaries chosen by the spouse first to die and not those beneficiaries designated under the surviving spouse's will. This is very often used in a second marriage situation and can be accomplished through specialized trust provisions which deal with a number of different income and principal allocation issues.

Andrew H. Dohan is the estate planning attorney at Lentz, Cantor & Massey, a regional law firm with offices at 460 East King Road, Malvern, Pennsylvania, 19355. Copyright is reserved by the author.