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InvestmentNews: Sandy, give us an overview of what has gone on — what the new law is and what advisers should be looking for.
Mr. Schlesinger: The Tax Relief Unemployment Insurance Reauthorization and Job Creation Act is a compendium of three laws to accomplish various things that were trade-offs. Congress did what I think I can safely say none of us expected it to do. The law was signed by President [Barack] Obama on Dec. 17 — 14 days before we were supposed to go back to [the laws of] 2001.
The law covers many areas, including income tax areas which will only be touched on briefly today. We are going to touch on the transfer tax areas, namely the estate tax, gift tax and generation-skipping transfer tax. Almost everything we are talking about is only for 2010, 2011 and 2012. Without congressional action in 2013, in most instances, you go back to 2001. And we will get into that, probably in some detail, a little bit later. Let's go first to the death tax.
Many of you must have believed up until Dec. 17 that the estate tax for 2010 was repealed and replaced by a regime called modified carry-over basis. In point of fact, the act unrepealed the estate tax for 2010 and put in a federal estate tax of $5 million unified credit, a unified-credit exemption equivalent of $5 million and a flat tax rate of 35%. So you may say to me, “But wait, that is a retroactive tax. How could they do it?” Well, they solved the problem. You are in the estate tax regime but you can opt out of it into what is called modified carry-over basis, which is what the law was in 2010 had Congress not acted. Now, I'm not going to spend this whole time on modified carry-over basis but the answer to that is, you have an election. You as the executor must make this choice. This can be a very difficult choice. On its face, it looks pretty simple in a way; if your estate is under $5 million, you may want to stay within the estate tax regime. But remember, you have to take into consideration what modified carry-over basis means.
You may remember that for 2010, there was a voluntary $1.3 million step-up in basis that had to be allocated by the executor or personal representative — plus a spouse got an additional $3 million of given basis against what was a modified carry-over basis. One important thing to remember about modified carry-over basis: The basis was a lesser of the basis of the decedent before he died, meaning basically what the person paid for the property or the fair market value at date of death. So in order to go into a modified-carry-over-basis regime, you may still have needed appraisals and valuations because it was a lesser of the decedent's basis or the fair market value at date of death.
One should keep in mind the fact that income tax rates from the Bush tax cuts were reinstated and that that reinstatement means that the capital gains rates for 2011 and 2012 are a maximum of 15%. So that is going to have some impact on whether you elect carry-over basis.
The other impact about carry-over basis is, it is not a capital gains tax at death. If in fact the property is not sold, you don't incur that tax. So if the family intends to retain the assets for an unlimited period of time or for at least the foreseeable future, you may not worry about electing into modified carry-over basis and not having the estate tax.
I should add that the [Internal Revenue Service] has not come out with a form yet, but they have a proposed form which is floating around. It is called Form 8939, Allocation of Increase in Basis for a Property Acquired from a Decedent. It appears that that return will be due no earlier than Sept. 19, but rumor has it that it may be due by Oct. 15.
Now, going past 2010 on the estate tax: For 2011 and 2012, we have an estate tax with a 35% rate and a $5 million unified-credit exemption equivalent. That means that if you have an estate of under $5 million, there will be no federal estate tax, and that amount is indexed for inflation from 2010 but doesn't start until 2012. So your benchmark is 2010, but the indexing starts in 2012.
The state death tax deduction is back, not the state death tax credit. We all know a credit is far more valuable than a deduction. Many states had based their estate tax on the state death tax credit, which was repealed for tax years after 2005. So you now have a state death tax deduction which effectively gives you a benefit of a 35% deduction because that is the maximum tax rate. So it is valuable but not as valuable as it was, because when tax rates go down, the value of the deduction goes down.
The federal estate tax return for 2010 — remember, there was no federal estate tax for most of 2010, theoretically — is due no earlier than Sept. 19.
I do want to take a look at how this $5 million exemption affects formula clauses. I'm just going to pass over it now, but during our discussion later, we really should talk about it in some depth. For all documents that have been drafted with any type of formula clause, whether it is a marital-deduction formula clause or a child deduction formula clause, you have got to be very, very careful because you have a $5 million unified credit in effect now. So if you drafted a will, let's say in 2001, and you had an exemption — I guess it was $1 million then — and you had $5 million, you met your unified credit trust, which may go to your spouse and/or children to-gether or to your children or children from prior marriages. If you had $5 million, the unified credit trust got $1 million, and your spouse got $4 million with that right in trust.
If you have that same clause today, it is quite possibly subject to a construction that the unified credit trust — which may or may not include your spouse — has $5 million. Guess what? Your spouse has nothing unless she has a state right of election. Or you have the issue of a litigation of a construction per se. Did you really mean to do that? That can be costly and quite a problem.
I also want to point out that under the 2010 law before the statute, 20 jurisdictions —19 states and the District of Columbia — passed legislation trying to conform their laws as to construction of wills, revocable trusts and estate-planning documents as to what formula clauses meant. And in general, those statutes that were enacted were enacted to say that if you had a formula clause and you died in 2010, the clause — unless there was information to the contrary — was treated as if you had died in 2009, in general.
Now whether that still holds up when you now have the new statute, I just don't know. And again, that is going to be a very serious issue and a very serious litigated issue, I think, in many instances.
InvestmentNews: Sandy, we will come back to some of these issues and some of the highlights, too, because these are weighty issues. But let's turn to Carol and talk a little bit about what some of her clients are doing and some of the issues that she faces now that the new law is in effect. Carol, tell us what is going on in Delaware.
Ms. Kroch: We are seeing a tremendous opportunity amidst what is obviously a fair amount of confusion. I guess I want to comment that I think there are two really important take-aways that I see with this act. One is not to rely on something called portability, which I think is a topic we will talk about quite a bit: This is the notion that the surviving spouse can use an exemption amount that was not used by the first spouse.
And I think that the take-away for most estate planners is that that is a very risky approach and that traditional estate planning — where people think about using their exemptions during their lifetime even though it may be available to their spouse — is one of the most important take-aways in terms of planning. And we will probably get back to that a little bit. But then the question is, if you are not going to rely on portability, what do you do?
You have an enhanced exemption, and I think it is a terrific opportunity, for families that can afford it, to think about lifetime gifts that take advantage of what is now a $5 million exemption for two years. That is a huge opportunity and unless the Congress acts, it will go away. And as Sandy says, we don't know what Congress will do and it is a temptation not to want to decrease exemptions and increase rates later. But we have a window of certainty with a tremendous opportunity, for example, to create a so-called Delaware dynasty trust or, in other states, a perpetual-trust concept.
This means that a $5 million lifetime gift can be made free of gift tax, free of estate tax and grow permanently for the benefit of your family members.
Mr. Schlesinger: But Carol, let's be clear that if you use that $5 million exemption during life, you lose it at death.
Ms. Kroch: Yes. You can't have it twice. But the interesting thing going back to portability that I was a little negative on, if it should happen that during these two years where the rules are clear, a first spouse dies without having used the exemption, the second spouse can actually use it and make large lifetime gifts while that exemption is still around.
InvestmentNews: We will come back to those things, too, but let's talk to Ray a little bit. Ray, tell us what your clients are doing and what you are telling them.
Mr. Radigan: The first thing I want to do is address what Sandy talked about, and that is the estate tax and the choice that you have in [tax year] 2010. Generally speaking, we are helping our clients in that respect, and if the taxable estate is clearly under $5 million, no harm, no foul. Assuming they are fully protected by the $5 million exemption and there are no lifetime gifts, you might as well be in the estate tax regime, because at the end of the day, you are not paying a federal estate tax, but of course there are state estate tax consequences to worry about.
Once you get a taxable estate beyond $5 million — and for somebody who died in 2010, my opinion is you have to do the math — do I pay a 35% estate tax on the excess or do I pay future capital gains taxes given the fact that I have this modified carry-over basis? As you are close to that $5 million and slightly above that $5 million taxable-estate number, I think you have to do the math. The further you get away from that $5 million taxable estate, the more obvious it is in most instances that you are going to opt for opting out of the estate tax and having the modified carry-over basis.
So that is the first thing. The second thing Sandy mentioned was formula clauses. Don't forget, the estate tax exemption years ago used to be $600,000, then $1 million and now it is $5 million, and that can have a huge difference on what property goes to which beneficiaries. So going forward, I think we have to be careful with formula clauses. I think we might use ceilings as a way to make sure you cap out as to what property goes where. You might continue to use disclaimers. So I think we have to re-look at the formula clauses. And then I think getting back to our clients just in general, don't forget, we have a $1 million gift tax exemption in 2010, and now for the next two years, it is $5 million. We have a lot of affluent married couples who capped out and used their $1 million exemption each.
Now they each have an additional $4 million to use, and that is just on the gift tax exemption side. So I think we are seeing a lot more gifting opportunities, and we are going to see that over the next two years. And I hate to say this, but we are not exactly sure what is going to happen after 2013. So there are a lot of planning opportunities, and given the way the law is structured today, I think a lot of our clients are going to take advantage of those opportunities.
InvestmentNews: How important is real estate in the gifting and in this whole estate-planning thing, and how much should advisers be on the lookout for what their clients have in addition to their financial assets? Should they try to find out more about their real estate assets?
Mr. Radigan: When you are talking about gifting assets, it could be any one of a number of different types of asset classes — the most traditional being cash. Then you are talking about a brokerage type of account or securities, stocks, bonds. It might include hedge funds. It might include real estate. It might include business entities. And the business entities might hold on to these business assets. And when you start talking about business entities and everything else, you get into valuation issues like, “What is the appropriate discount? I think all of this is on the table again. And I think what we are seeing with our clients is that a lot of them use, for example, the zeroed- out grantor-retained-annuity trust, because they didn't have much if any of the gift tax exemption to use.
Now they have another $4 million to use. And not only that, the [generation-skipping-tax] exemption has been bumped up to $5 million. So I see all sorts of planning opportunities — the same leveraging opportunities we saw before. I think we might see more skipping of generations now that the exemption is that much higher. So these are all issues that are on the table. We have two years, quite frankly, to figure this out.
I think we want to leverage the exemption like we always have. We want to use $1 of the exemption today and hopefully pass on property that is worth more than that down the future. And I just think now that we have bumped up the gift tax exemption for two years, it is fair game as to what type of gift-giving strategies you are going to see out there.
Mr. Schlesinger: I would like to go back a bit so we put in perspective that we are all playing with the same rules for 2011 and 2012, both as to the gift tax and to the GST tax. Remember, prior to the 2010 act, the unified credit was $1 million, not indexed for inflation. And in 2010, it was at a 35% rate. And that stayed for 2010; the act did not change that.
For 2011 and 2012, the gift tax exemption increased to $5 million at a maximum tax rate of 35% and they reunified the gift and estate tax so they are now parallel. And that is very important. And I am going to make a comment on that in one second.
Keep one very important thing in mind about gifts. Only Connecticut and Tennessee and Puerto Rico have a gift tax. So making gifts becomes even more viable on a state tax basis.
So therefore, when you are talking 35%, you don't have to go look at the state gift tax. Many states do have an estate tax, however, and the use of the $5 million unified credit by sheltering it in an estate in 2011 or 2012 may have very serious state estate tax consequences.
For argument's sake, if you use your whole $5 million unified credit in a state like New York or New Jersey, that would give rise to a $391,600 state estate tax. In Connecticut — I'm only going to do a couple of states — there would be a $121,800 tax. In Florida and states which have no estate tax, it would be zero. But you have to look at that, because that could be very dramatic.
Now going back to the real estate issue, you have got to look at other issues with real estate. One, it is a very good time to gift real estate. Why? Because the real estate market is still under par. And so therefore, you probably can get much lower valuations of real estate than you could have three years ago, even now.
Number two, you have to be very careful, because if you are gifting real estate, you have to be very careful as to whether there is an income tax consequence to the gift on the real estate. Because if the real estate has negative basis due to either refinancing or financing or accelerated depreciation, the transfer by gift of real estate may be an income taxable event.
Ms. Kroch: And if I can follow up on that, Sandy, for very high-net-worth clients who are going to clearly be over any foreseeable exemption amount, the gift opportunities are tremendous and you do want to look at different assets to determine which are more likely to grow quickly, because they may have some income tax issues. But if you are a family of lesser means, by adopting something like making a gift of real estate, you may end up with an income tax consequence that is much greater than the estate tax that you would save.
And so it becomes very important to look at the income tax basis, which is typically the purchase price but with something like real estate is reduced by depreciation benefits that have been taken for commercial real estate.
Mr. Schlesinger: And just to be clear — and this is very important, Carol — you have modified carry-over basis for 2010 only if you elect into it. For 2011 and 2012, you have “stepped-up basis,” which is not really an accurate term. You get a basis based on the value at date of death or valuation date.
Ms. Kroch: Yes, if it is in the decedent's estate.
Mr. Schlesinger: That's correct.
Ms. Kroch: But if it is given away, then it has a gift basis, which is the basis in the hands of the transferor, which is the purchase price as reduced by any depreciation. And that is where you can have the income tax issue.
So it is more important than ever for families to look at specific assets and determine which are the best assets to gift and which are the best to retain in the estate.
InvestmentNews: Are there particular strategies that you think are going to be more popular than others in this environment that advisers listening to this should make sure they are aware of and are able to use when clients walk in the door?
Mr. Radigan: Sales to an effective grantor trust are somewhat elaborate strategies, but I think they are just going to be as useful as before. A zeroed-out grantor-retained-annuity trust was great because you use very little of the gift tax exemption. Well now that I have $4 million to play with, maybe I don't have to play that game so much, and I might have leveraging opportunities in other strategies. A sale to an effective grantor trust is a complicated strategy, but basically, I make a gift, let's say of seed money into a trust, I use my gift tax exemption, and then what typically happens thereafter is, I sell an asset to the trust in return for a note. And it is an interest-only note. And the interest rate environment we are in is very low right now and the trust doesn't have to pay back the note, let's say, until the note expires.
The point is, it provides a leveraging opportunity. The difference between the strategy I just described and a zeroed-out GRAT is that I can, for example, name grandchildren as beneficiaries of my trust, allocate my GST exemption to that and basically skip generations. I really can't allocate my GST exemption to a GRAT until it is over. And that is where most of the appreciation has happened.
So I think we are going to see the same strategies. The fact that we have a higher GST exemption means that we might see more skip types of transactions.
Ms. Kroch: First and foremost, this is a real opportunity to talk to families about how much they feel they can afford to give away, because for families that are concerned about making outright gifts of amounts between $1 million and $4 million, the GRAT strategy allows a family or a grantor to gift future appreciation but still get the value of the asset that was put into the trust back.
And if somebody is not ready to make a gift, that may be an opportunity. But somebody who is able to give money away should put money into a long-term trust vehicle now — money, property, securities, any asset with value that is likely to grow. The long-term growth over generations, free from estate, gift and generation-skipping tax, is really quite astonishing. And I think what is really different right now, and what Sandy had said before about the so-called unification of the gift and generation-skipping tax exemptions, is that before, you could only do $1 million if you wanted to avoid gift tax. Now you can set up a generation-skipping trust with a $5 million exemption if you can afford it. And I think that is a huge opportunity.
Once that is funded, then there is an opportunity for families of great wealth to consider additional transactions. For example, having that trust do an installment sale, and purchase assets from the family in a so-called estate freeze. And [they should] think about things like GRATs where they have run out of exemption. But I think the first question for families is, can they afford to make gifts now?
Mr. Radigan: I agree with Carol. You can't let the tax law wag the dog, because what happens is, we get all excited by this, forgetting whether the client is in the position to make these gifts. I think you have to obviously get over that hurdle first before you even start talking about some of these gifting strategies.
Mr. Schlesinger: You couldn't be more correct. We are sitting here and we are saying we can bankrupt all of our clients very easily under this new law by just giving away everything. Well, first of all, before we talk about all the fancy stuff, maybe we ought to go back a step. You still have the annual exclusion, and that annual exclusion is still $13,000 per person per year, indexed for inflation. And [for] 2011, it stays at $13,000. So clients can still do that and they can give it to everybody in the world, and a husband and wife if they want to do it together can give $26,000, which can be substantial.
Second, you still have the law that you can make gifts directly to an educational provider above the annual exclusion gifts for anybody you want. And you can also make payments directly to a medical provider or to an insurance company above all of this other stuff. And I can't tell you how many times I have sat down with clients and said, “You know you have a $1 million exemption, and you have the $13,000 and you have the other,” and the client turns around and says, “I wouldn't even think of giving the $13,000.” So the reality of it is, you go through all of the fancy things and we often skip the plain simple groundwork of what some of this is.
In fact, one of the great ironies here with this great giveaway of Congress in this legislation, they didn't touch the annual exclusion of $13,000, which is sort of ironic as far as I'm concerned.
InvestmentNews: You think they should have made it bigger?
Mr. Schlesinger: Yes, bigger. I mean, the unified credit has only been increased, I think, $10,000; it went into effect in, like, the "80s and was indexed for inflation only in 2001. In the 2001 bill, there was a proposal to increase it to $35,000, but it just didn't happen. But now, obviously, the argument could be, “If you have $5 million, why are you worried about $13,000?”
Ms. Kroch: Well you know, Sandy, I think it is important for our audience to understand that the $5 million, although it is a very large number, is a one-time number. It is aggregate for all of the gifts you make. If you are a family with a lot of grandchildren, and you are a married couple, you can give every single grandchild from the two of you $26,000 a year, every year. So I always call the annual exclusion gift the gift that keeps on giving. It can be a lot of money.
Mr. Schlesinger: Honestly, I have a client who has 11 children and 45 grandchildren. Figure that out. It's a lot.
Ms. Kroch: I also wanted to turn for a minute to this question of not being ready to give away money. Obviously, people have to figure out what they can afford to give away and what they are comfortable with. When it is a question of comfort, there are reasons to use a trust. You can get a lot of comfort that there will be a separate vehicle that will manage the assets with a trustee. There can be all sorts of limitations on distributions. You can give a trustee the discretion to make distributions of both principal and income. And sometimes people can become comfortable with gifting that they can afford when they understand trust vehicles better.
InvestmentNews: One of the attendees asked a very basic question: How many families in the United States will the new $5 million limit affect, and what percentage of the states will be affected?
Mr. Radigan: What I have read is, they have projected 2.6 million Americans will die in 2011. Of those, they expect about 3,600 people to actually pay an estate tax under this new regime. I think that works out to 0.14% of American households that are going to have to pay this tax. That is the type of number that we are talking about.
And I will tell you right now, from a revenue standpoint, compared with the general federal budget, this is relatively insignificant. I mean, whether you had a $1 million exemption or a $5 million exemption, at the end of the day, the estate tax revenue was no more than 1% of the total revenues.
Mr. Schlesinger: That's always been the case.
Mr. Radigan: Yes. And a lot of people, myself included, believe that this is more of a social issue. They don't want to perpetuate the very affluent families. So you have to pay the gatekeeper every now and then if you are talking about passing it from one generation to the next.
InvestmentNews: There are a lot of questions from the audience around the portability concept that you guys raised earlier. Can you explain a little bit more about that?
Mr. Schlesinger: Portability is the use by a second spouse of the first spouse's unused unified credit or applicable exclusion amount. Let's take an example, and this applies only in 2011 and 2012. Both spouses must die during that period, because as of today, portability does not exist in 2013. So that is very serious. I mean, the odds of both spouses dying of natural causes during a 231/2-month period are very low.
Say I'm a spouse who has an estate of $3 million and I take my unified-credit exemption equivalent, $3 million. I can give my wife that extra $2 million and she would have an exemption of $7 million and she can use that as she wishes as long as she dies before 2013.
On the other hand, I can do something else, and this is why portability really was enacted. I have $5 million. I don't put it in the unified credit trust. I give it to my wife and she has $5 million, and though I now pay no estate tax because I gave it to my wife, I didn't use up any of my unified credit. So now my wife has $10 million, and if she dies between 2011 and 2012, she will be able to have a $10 million exemption. The whole purpose of portability is to try to do away with having to divide up an estate so each spouse uses his or her own exemption.
The speakers here are not very big fans of portability, for a bunch of reasons. Forget that it expires in 2011 or 2012, because probably it will be re-enacted in 2013 because it is a concept that Congress has liked for a while because it gets the planners out of the picture, allegedly. But that is not necessarily true. Why?
Number two is that the $5 million, if I leave it to my spouse and she uses a $10 million exemption, the first $5 million is not indexed for inflation. Therefore, when my wife gets it, her unified credit is in this inflation, the one she gets from me is not. So that is one thing.
If I put that $5 million in a unified credit trust, paying no estate tax on it, if my wife lives for many years after me, that $5 million may grow to $25 million, and once I have insulated it from the estate tax, it will never be taxed again under the law as it stands today. And as an aside, a study done for qualified terminable-interest property trusts found that the average life expectancy of a surviving spouse is 16 years. So that is very significant.
Number two is, if I put my unified credit in a unified credit trust, I can determine who gets it when my wife dies, or I can exclude my wife from it. So when you have multiple marriages with children from multiple marriages, again, letting my wife get the benefit of my unified credit or by my leaving my property to her outright may not be the best estate-planning technique.
Number three is — and this is a very interesting one — creditors' claims. My unified credit trust may well insulate that trust and my beneficiaries from creditors' claims. I mean, there are just so many aspects of portability that are sort of misrepresentative of what it really is meant to be, and I think that is a real part of the problem. Again, I do think it is going to be with us permanently.
Mr. Radigan: I agree. And the other thing you have to remember: Although the gift and estate tax exemptions are portable, the GST exemption is not. So you can also use the credit shelter trust as a means of allocating your GST exemption to it.
By the way, getting back to portability, if you basically pass on unused estate tax exemptions to your surviving spouse, even though you might not have to file in a particular state because it is not a taxable state, they still have to show the election of portability. And that is done by the executor, and the executor might not be the same as the spouse. You might have two different people there. Hopefully, there is some short form that is going to be designed where you can show that election of portability. So there are some procedural elements that we have to deal with here as well.
Sandy, you raised an interesting question. You said that portability will probably exist going forward. And why don't we talk a little bit about that, because we know what is going to exist in 2011/2012, but now people are worrying about, “My God, what if the gift tax exemption is reduced somehow? What if all of the sudden there is some sort of claw-back provisions where I made these $5 million gifts because I thought I could, and now it is going to be added to my estate later on?” Personally, I don't think that is going to happen. But we have been wrong before when you are trying to guess what the government is going to do. I mean, there is some unpredictability here as to what happens in 2013 and beyond.
Mr. Schlesinger: Let me focus that a bit more because this is something of an angel-on-the-head-of-a-pin thing. People are saying — looking at the way the estate tax return itself is structured — that if you made a $5 million gift this year, fine, no tax, no nothing, you are OK. But if you die after 2012 and the estate tax unified-credit exemption equivalent is less than $5 million, you may have some sort of recapture of the benefits you got. Then they go into all sorts of wild examples of: “What if you have no estate, where do they get it from, or if there is a marital deduction, does that tax come from that?” Again, this is angel-on-the-head-of-a-pin stuff, but it is something to keep in the back of your mind that there could be a claw-back.
Ms. Kroch: And if I can sort of throw in another angel to dance on that pinhead, when you look at the numbers for the claw-back, no one is ever worse off. In the worst-case scenario, you end up paying the same estate tax as if you haven't made the gift, but you have made the gift at a lower rate than the estate tax, and chances are, even if the claw-back existed, the gift would have a chance to grow.
Mr. Schlesinger: To appreciate, yes.
Ms. Kroch: And so it is a very unlikely set of circumstances where we are expecting that the estate tax would revert to a $1 million exemption, go up to a 55% rate, and the gift that had been made would have not grown at all.
InvestmentNews: Since many, if not most, advisers deal with clients who aren't as wealthy as the ones you deal with, what should they be aware of regarding asset administration and management consideration for people of more modest means? How does this law affect them?
Mr. Radigan: Number one, we are talking about federal estate tax exemptions of $5 million. You still have to look at state estate tax consequences. In New York, for example, there is a $1 million exemption. Now, maybe you have a $2 million estate, $1 million owned by husband and wife, husband dies first, for example. Maybe that is put in a credit shelter trust — not necessarily to shelter the federal estate tax exemption but maybe take advantage of the New York estate tax exemption. But I think it is going to be harder to plan $3 million estates than it is $100 million estates in some respects, because of the disparity between the estate tax laws on the state side as well as the federal side.
InvestmentNews: Do individual retirement accounts and 401(k) plans become part of an estate?
Mr. Schlesinger: Yes. Remember, an estate is not made up just of property that passes under the will. Your estate still includes your IRA, your 401(k), your pension plan, life insurance — unless you do some planning with it as to ownership and beneficiary designations — so when you add up your estate, it is much bigger than one might think and these assets that pass to the designated beneficiaries may well have transfer tax consequences.
Issues with IRAs are very, very important. IRAs are not just subject to estate tax when they come out; they also are subject to income tax. But if you leave it to a spouse, you get the marital deduction, so there is no estate tax till the second spouse dies, but there is income tax on an IRA when it comes out.
The act did reinstitute for 2010 and 2011 the ability to give up to $100,000 from your IRA each year to charity without it being included in your income. You had to be at least age 701/2 at the time of the gift, and it had to be a direct contribution, generally to a public charity. And it even gave you another little break here. If you made it in January 2011 — you give $100,000 to charity in 2011 — it can be treated as if it was a December 2010 transfer to charity, another opportunity.
Mr. Radigan: I just want to make one point about the more moderate estates. All we are talking about now is these tax-driven trusts. How to leverage the gift tax exemption? I would say that 70%-plus of our trusts at U.S. Trust are here for non-tax reasons. And I don't think you can forget that when planning a client's estate. It's not just the tax-driven trusts that we get involved with. There are legitimate non-tax reasons why you are setting up trusts for beneficiaries, if they are appropriate. You might have minor beneficiaries, you might have beneficiaries with creditor problems, with spousal claims, all sorts of things.
So all of that stuff doesn't go away just because we have a $5 million exemption.
Ms. Kroch: I think that is right. I want to turn, Sandy, to the formula clause point that you made before. Many, many wills are set up to create trusts that are based entirely on formulas that are based on federal exemptions. And although it is difficult now to figure out how those formulas should work, it is a great opportunity for advisers to talk to family members about what they would really like to have in those trusts, putting aside the tax issues. Because a lot can be done to try to replicate what people want, taking into account the taxes instead of just letting the tax drive it.
InvestmentNews: What are the biggest estate-planning mistakes, aside from taxes, that advisers should be aware of when they talk to their clients?
Mr. Schlesinger: Let's talk about tax for a moment, and then we will go to the other mistakes. Remember, we can't emphasize strongly enough that this is just 2011 and 2012. There is the other side of the coin if in 2013, the estate tax goes back to $1 million, which, as we sit here today, is what it is supposed to do. If it does, a lot more Americans will have to do estate planning to save taxes, because not just is it $1 million, it is a 55% maximum rate. So let's not discount the world we are in and the world that we may end up in. And it is all going to be political.
One estate-planning mistake we alluded to before: property that has beneficiary designations on it. People tend to say, “Well, I don't have to do any planning with this.” One of the biggest mistakes I find is, people do not have up-to-date beneficiary designation forms on their IRAs, 401(k)s, pensions and life insurance. Ninety-nine percent of the time, if I ask, “May I see your beneficiary designation?” it's, “I haven't seen it; my company has it,” or something like that. Of course, your company has changed ownership four times, and it is lost. Very, very importantly, check beneficiary designations. Make sure they are up-to-date.
One of the most famous divorce cases in history went up to the New York State Court of Appeals. A husband and wife fought like cats and dogs over the divorce, and what happened is, the husband failed to change the beneficiary designation on his pension plan. Guess who got the pension plan? His ex-wife. That was the law at the time. New York has changed the law.
So update your beneficiary designations. But it's important not to stop there. Most people designate their spouse but forget that there is a contingent beneficiary. Very few people take as much detailed time on their beneficiary designations as they do on their will. And very often a client's beneficiary designation will transfer more wealth than his or her will.
Mr. Radigan: I think sometimes it is a mistake to make outright distributions to certain beneficiaries. You can structure a trust in such a way where they can have use of assets, almost like they have them outright, but not be subject to creditor claims.
Carol, you work in a state [Delaware] that recognizes the domestic asset protection trust. There are going to be opportunities where I think asset protection is going to play a larger role in estate planning going forward.
Ms. Kroch: I agree. We have talked to some families who aren't ready to transfer all assets to another family member but would be willing to look at putting them in an asset protection trust where they would have limited opportunity, in the sole discretion of the trustee, to make a distribution to them. And I think that the biggest mistake that anybody could make who is in, say the under- $10 million area right now, is to say, “I don't need a trust. I don't need to do any planning, because I can rely on the fact that we will each have a $5 million exemption.
If this law changes — and it is supposed to — they won't have that, and for all of the reasons that Sandy said before, they may not have put the right amount into a formula clause under a trust. They may not have had a chance to designate the terms and conditions under which they are willing to have beneficiaries receive the assets. They will have lost the benefit of asset protection for their children and grandchildren.
There are just a lot of reasons to think about trust planning and it would be a mistake to think that it is not needed anymore because of what may be a temporary $5 million exemption.
Mr. Radigan: Carol, I agree. Just because we have a $5 million estate tax exemption, and just because we have portability doesn't mean you should get lazy. And as I said before, there are non-tax reasons why you should give serious thought to your estate plan, not just think of tax savings and that sort of thing.
So that is probably my biggest concern about this legislation. I don't want people to get lazy. And I think there is more to estate planning than just saving potential transfer taxes.
Mr. Schlesinger: I agree with everything that has been said so far, but your problem is going to be to convince people to do any of this during these two years. We are back to where we were in 2009 and 2010 in a way. People are going to be frozen in a way, except for making gifts and stuff like that because, “I will wait and see what happens in 2013 because one of the possibilities is repeal of the estate tax.” Many people are saying this is the first step toward repeal. And a lot of people are saying that. Because you are going to come up with an argument in 2012, hopefully before that, “Hey, 60 people are paying tax. What do we need it for? Let's dismantle it.”
And in point of fact, in 2009, only 68 people filed the generation-skipping-transfer-tax return where tax was due. So you are going to pursue the argument that only 3,500 people had taxable estates in 2010 or 2011. So I mean, that is going to be part of your issue here.
As for charitable giving, I can't believe anybody is going to say this is going to have a massive negative effect on testamentary time of death charitable giving. On life insurance, I think people are going to say, “I will wait till 2013 and see what happens, because if my estate is under $10 million with a wife or a husband, I don't need the life insurance for estate tax liquidity. I may need life insurance for different purposes, and that is going to lead to a different type of life insurance product.”
