Estate planning, at its heart, is focused on intent. It includes myriad potential tools used to create a structured plan that reassures clients that their intentions will be realized upon their death or incompetency. These tools include wills, trusts, advance health care directives, and instruments granting trusted individuals power of attorney in the event of incompetency. Lifetime gifts can also have a place within estate planning strategies.
Executors of wills and trustees of trusts play a large role in effectuating a decedent’s intentions because they are the ones overseeing estate administration. Helping clients consider who would be a good choice for these positions is an important aspect of the planning process. In some cases, hiring a professional to be the trustee or executor can be a viable option. This could be due to the size and financial complexity of the estate or to avoid interpersonal conflicts.
An important consideration while estate planning is what taxes might be owed and out of what assets any taxes owed should be paid. Under current law, the highest marginal estate tax rate is 40 percent. Depending on the composition of the assets in an estate, some assets may need to be liquidated to pay any estate taxes owed. Clearly providing which assets should be used for the payment of taxes in the estate planning documents can simplify the administrative burden faced by the executor or trustee when administering the estate.
One of the challenges of estate planning is that, when you’re not using an instrument that takes binding effect immediately, such as an irrevocable trust, you don’t know what the legal landscape is going to look like at the time of the decedent’s death. Therefore, drafting documents that can adjust to various contingencies and tax landscapes is an important aspect of estate planning. Even if, at the time the document was drafted, the estate was of a size that estate tax would not be due under current law, that doesn’t guarantee that the law, or even the size of the estate itself, will look the same in a decade or two.
According to the The Internal Revenue Code (I.R.C.), the combined basic exclusion amount for gift and estate taxes is currently $10 million, indexed for inflation, for U.S. citizens or residents (I.R.C. § 2010(c)). For nonresidents of the United States, the exclusion amount is $60,000, a substantially smaller amount (I.R.C. § 6018(a)(2)). For nonresidents, the relatively low threshold and potentially high tax bill make estate taxes a very tangible concern when estate planning. Although the only property considered for nonresidents is property located in the United States, certain assets, such as stock in U.S. corporations, are considered located in the United States even if the stock certificates are sitting in a safe deposit box halfway around the world. The comparatively low property threshold and inclusion of U.S. stock interests may result in a U.S. estate tax liability for someone who would not expect U.S. estate taxes to be a concern. For a nonresident, an additional consideration is whether an estate tax treaty between the United States and the country of residence may apply and offer more favorable terms.
For a married couple, when both spouses are U.S. citizens or residents, the relevant exclusion amount of the couple is, per the Code of Federal Regulations (C.F.R.), operatively twice the lifetime exclusion amount if the appropriate procedures are followed to allow the surviving spouse to use the deceased spousal unused exclusion (DSUE) amount (26 C.F.R. § 20.2010-2). Assets left to a spouse are excluded from the taxable estate of the deceased spouse so long as the surviving spouse is a U.S. citizen or resident (I.R.C. § 2056). The portability election for the DSUE amount allows the surviving spouse to make use of whatever portion of the deceased spouse’s lifetime exclusion amount was not used upon his or her death. Because many spouses leave the bulk of their estate to their partner, the unused exclusion amount is often substantial. This election must be affirmatively made on a timely filed estate tax return on IRS Form 706 (Id.). The portability election for the DSUE amount is an important planning tool to consider in light of potential lifetime exclusion amount changes because this election preserves the deceased spouse’s unused exclusion amount for the surviving spouse’s future use.
The probate process provides for judicial oversight of a decedent’s estate and is intended to prevent fraud from occurring in estate administration. Although the judicial oversight probate provides may discourage fraudulent behavior, probate can be expensive, not just in a financial sense but also in terms of the time required to administer an estate under the probate system. Because probate law is governed on the state level, the specific requirements for probate administration will vary from state to state. When the assets in an estate exceed the probate threshold set under state law, a probate proceeding is required. The judicial oversight required under probate regarding executor decision-making can be especially burdensome if the estate includes a business because operating a business includes many day-to-day decisions regarding expenses and other management decisions. Due to the administrative hurdles posed by probate, it can be beneficial to structure an estate plan so that the assets included within the decedent’s estate are below the probate threshold. However, even when a probate proceeding is not required, it is important to consider what other filing obligations may still be present, such as a small estate affidavit certifying that the assets in the estate are below the threshold for probate (e.g., SDSC Form #PR-132 in San Diego County Superior Court).
Certain types of property, such as life insurance and property held in a revocable trust, are usually not included in the decedent’s property when determining whether or not a probate proceeding is required. This exclusion from the probate estate has made revocable trusts a popular estate planning instrument for those wishing to avoid probate proceedings.
A revocable trust allows an estate plan to maintain a high degree of flexibility because it is simple to amend or revoke later if the trustor wishes to revise his or her estate plan. The trustor is also able to maintain control of the assets placed in trust. An irrevocable trust is less commonly used as an initial estate planning tool because it provides for less future flexibility. Additionally, an irrevocable trust may create a vested interest in trust assets for the beneficiaries of the trust, which may result in gift tax reporting obligations for the trustor.
If an irrevocable trust has been executed but the trustor later wishes to amend the trust, it may still be possible to make the desired amendments to the trust document. This process has been made simpler in states that have adopted the provisions suggested in the Uniform Trust Decanting Act. Whether it is possible to make the desired amendments will vary along with state law, as will the amendment process itself. Because irrevocable trusts can result in completed gifts at the time of execution, any later amendments should only be done after considering the potential tax consequences of the proposed changes.
Upon the trustor’s death or incapacity, a revocable trust becomes irrevocable. Many revocable living trusts are drafted to terminate upon the trustor’s death and the subsequent distribution of trust assets to the beneficiaries named in the trust. This structure allows the estate to avoid the ongoing administrative expenses associated with irrevocable trust administration. Trusts may also be drafted to allow for distribution of trust assets at a later date, as may be preferable when children or young adults are the beneficiaries of the trust. In addition to a beneficiary’s age, there are various other reasons a trustor may wish to provide for someone’s support but not grant him or her immediate control over the trust assets directly. One consideration when drafting an instrument that will be in force for a long period of time is whether the terms as drafted could run afoul of applicable state law regarding the rule against perpetuities.
There are numerous forms trust planning can take, including special needs trusts for persons with disabilities, charitable remainder trusts, and AB trusts for spouses. The choice of trust vehicle is an important part of tailoring an estate plan to best fit the needs of each client. Trusts allow for a lot of flexibility and can be drafted to include customized terms addressing specific, complex tax issues, such as generation-skipping transfer taxes. The size and complexity of the estate will directly impact the type of trust appropriate for the circumstances and the complexity of the trust document itself. Where one spouse is a nonresident and the other spouse is a resident, a qualified domestic trust (QDOT) can help mitigate the less favorable provisions in estate law regarding nonresidents.
One of the benefits of a revocable living trust is that there is no obligation to file a separate tax return for the trust while the trustor is alive and has capacity; because a revocable living trust is a grantor trust, all the trust’s income is taxed as income of the trustor (I.R.C. § 671). An irrevocable trust, on the other hand, is required to file IRS Form 1041, U.S. Income Tax Return for Estates and Trusts. Upon the death or incapacity of the trustor, when a revocable trust becomes irrevocable, the trust must file form 1041. Unlike an individual, trust and estate income is subject to the highest marginal tax rate once the income of the trust or estate exceeds $7,500 (I.R.C. § 1(e)). The amount of income subject to taxation at the trust level is reduced by distributions of current income from the trust to beneficiaries, so long as the income qualifies as distributable net income (I.R.C. § 651). Because trust income held within the trust is subject to such high levels of taxation, provisions regarding the current distribution of trust income can have a large impact on tax liability.
Upon the death of a decedent whose assets were placed into a revocable trust, the executor of the decedent’s will and the successor trustee of the trust should consider whether a section 645 election should be made (I.R.C. § 645(a)). This election, filed on IRS Form 8855, allows the trust and estate to file their taxes together on IRS Form 1041. Making this election can reduce the administrative burden of filing taxes for the estate.
Ideally, all the assets that are meant to be included within a trust will be contemporaneously transferred into the trust when the trust documents are executed. For assets that do not include a formal legal title, including these assets within the scope of the trust and its schedule of assets can be sufficient to transfer ownership to the trust. However, for assets with legally recorded title transfers, such as real estate, all the formal steps for a transfer of title to the trust must be completed. Sometimes, a trustor may include an asset among the schedule of assets meant for the trust but fail to follow through with legally transferring ownership into the name of the trust. Including the transfer of titles within the scope of estate planning services can help eliminate the risk that a client’s property will not be effectively transferred into the trust after the trust’s formation.
Usually, when giving a present, the last thing on anyone’s mind is the tax consequences. For a gift with minimal monetary value, it’s unlikely to have any tax consequences. However, larger gifts can result in either reporting obligations or even a tax liability to the giver. There is both an annual exclusion and a basic exclusion amount applied to gift tax calculations.
The IRC provides for an annual exclusion amount of $10,000, adjusted for inflation (I.R.C. § 2503(b)). The annual exclusion amount is excluded from reporting obligations and does not utilize any of the giver’s basic exclusion amount. Additionally, the annual exclusion amount is applied per recipient, allowing an individual to give an unlimited number of people this amount each tax year without resulting in reporting obligations or any impact on the individual’s basic exclusion amount. In practice, there is generally a limit on the number of people to whom one would choose to give thousands of dollars, regardless of the lack of tax consequences. However, for an individual with a large estate who wishes to give substantial amounts of money away during his or her lifetime, the annual exclusion amount is a relevant consideration when contemplating estate planning strategies.
Gifts greater than the annual exclusion amount must be reported on IRS Form 709. However, even if a reporting obligation exists, there may be no tax liability. Tax is only imposed on gifts once an individual’s total lifetime gifts exceed the basic exclusion amount (26 C.F.R. § 25.2505-1(a)). The basic exclusion amount has been temporarily modified for the period beginning January 1, 2018, until December 31, 2025. For this period, the basic lifetime exclusion amount has been increased from $5 million to $10 million, indexed for inflation (I.R.C. § 2010(c)(C)). It is important to consider that portions of the exclusion amount claimed by gifts made during an individual’s lifetime will reduce the exclusion amount available to that individual’s estate upon his or her death. Once the lifetime exclusion amount is exceeded, any future gifts are taxed as provided for in I.R.C. § 2001, with a maximum tax rate of 40 percent (I.R.C. § 2001(c)).
The IRS released regulations on November 26, 2019, clarifying the treatment of lifetime gifts made while the lifetime exclusion amount was larger at the time of the gift than it was at the time the decedent passed away. These regulations provide that inter vivos gifts made while the lifetime exclusion amount is higher remain eligible for the higher exclusion amount even after a future reduction in the lifetime exclusion amount (26 C.F.R. § 20.2010-1(c)). Because the current statute providing for the increase in the lifetime exclusion amount from $5 million to $10 million is set to sunset on December 31, 2025, this regulation provides potential planning opportunities for clients open to gifting substantial portions of their fortune during their lifetimes.
Because tax law is an area of law subject to change when tax policy objectives shift, estate planning requires careful consideration of not only the current state of the law but also how future changes in tax law could affect the tax consequences of a currently drafted estate plan.
