September 01, 2014

The ATRA-Math—Estate Planning After the 2012 American Taxpayer Relief Act: An Interview with Thomas J. Pauloski

R.D. “Don” Estes

The American Taxpayer Relief Act of 2012 (ATRA) changed the face of estate planning considerably. For example, the “applicable exclusion amount” that each person may exclude from federal gift and estate tax was scheduled to revert to a fixed $1 million effective January 1, 2013. Instead, ATRA permanently established a $5 million exclusion that is indexed for inflation; today, the applicable exclusion stands at $5.34 million per person and $10.68 million for married couples. As a result, it is estimated that only 1 in 700 families currently has enough wealth to need tax-driven estate planning. How has ATRA changed planning for those families? And what should the other 699 families do? Thomas J. Pauloski, national managing director in the Wealth Planning and Analysis Group of Bernstein Global Wealth Management, Chicago, answers these and other questions. The opinions expressed are those of Mr. Pauloski, not those of Bernstein Global Wealth Management or the ABA.

Estes: Tom, at a high level, how has ATRA changed the way you advise clients about estate planning?

Pauloski: ATRA really has forced estate planning professionals to rethink how they advise their clients. There are many reasons for that. First and foremost, very few families now need estate-tax-driven plans, which will allow most plans to be driven by family needs and goals, rather than by the Internal Revenue Code. But it’s not always clear which side of the line a particular family falls on. For example, I’ve met couples who currently have considerably less than the combined applicable exclusion amount of $10.68 million who absolutely should do tax-driven estate planning because it’s likely, in my assessment, that they will pay some estate tax at the second death if they don’t plan. On the other hand, I’ve met families with estates of more than $20 million who are likely to “spend their way out” of their estate tax problem during their lifetimes. The key drivers are time horizon, projected returns on investment, and future spending coupled with inflation.

Estes: That’s interesting. How do you advise wealthy clients who, for lack of a better term, are “big spenders,” and how does the inflation adjustment play into your advice?

Pauloski: Prodigious spenders may have an estate tax problem now but may not have that problem in the future due to the combined effect of inflationary increases to the applicable exclusion amount and the possibility of a diminished investment portfolio from which they are spending. In such a case, big current gifts to children and grandchildren probably are not advisable because, as a result of lost investment returns on those gifts, members of the senior generation may run out of money during their lifetimes. On the other hand, early death is a risk—they may not have adequate time to spend down their estate—so a mortality hedge like life insurance or private annuity may be in order. And the family needs to consider the possibility that future investment returns may be better than expected. A grantor-retained annuity trust or similar strategy that involves the transfer of future growth, rather than actual capital, often provides an excellent hedge against better-than-expected future returns—without significantly impairing future spending.

Estes: Tom, you mention inflationary increases to the applicable exclusion amount. Where do you believe those increases might take us and when?

Pauloski: Based upon Bernstein’s quantitative models, we expect the applicable exclusion to grow to about $9 million over the next 20 years, with a one-in-10 chance that it will be $15 million or more by that time. This assumes, of course, that the law doesn’t change between now and then—a big “if.”

Estes: What about the other case—families that don’t have an estate tax problem now but may have one in the future?

Pauloski: That’s a little tricky because the thinking of the senior generation may be anchored to their current portfolio value and they therefore may not realize that they are likely to have an estate tax problem in the future. For those families, I would recommend flexible strategies that can be throttled back or turned off. Short-term “rolling” grantor-retained annuity trusts can work well for these families. And when dealing with a married couple whose marriage is very secure, having one spouse make the other a permissible beneficiary of any trust that is created—a so-called “spousal lifetime access trust” or “SLAT”—can be a very attractive option. But there is no single or easy answer for these families. Flexibility is the key.

Estes: You mentioned that there are other aspects of ATRA that drive estate planning recommendations today. Can you give our readers an example?

Pauloski: Yes. Aside from the unexpectedly high applicable exclusion amount, another key factor is the relatively greater importance of income taxes in today’s planning recommendations. Until ATRA came along, we thought estate tax rates were going to revert back to 55 percent. But that didn’t happen; under ATRA, the federal transfer tax rate is just 40 percent—still quite high, but not as bad as it could have been. At the same time, the federal long-term capital gain tax rate is as high as 23.8 percent for passive investments. The income tax rate is even higher than that for collectibles, and higher still for short-term capital gains and ordinary income. And some states, like California, New York, and your home state of Minnesota, have very high income tax rates on top of those higher federal rates. As a result of all this, the “gap” between transfer tax and income tax rates has closed considerably for many families. And in some odd cases—like when families own, say, depreciated real estate—the cost to the family of losing a step-up in basis at death is actually greater than if mom simply kept the asset on her balance sheet, paid the estate tax, and got the basis step-up. It would have been heresy to say this 20 years ago, but today, for certain situations, the best gift that a parent can make to his or her children may be no gift at all.

Estes: Can you give us an example?

Pauloski: Sure. Let’s assume that mom owns $2 million of a publicly traded stock that has zero basis. Say that she doesn’t need the stock or the dividends it produces, so she’d like to give that stock to her daughter as a lifetime gift. Let’s further assume that both mom and daughter live in California, where there is no state estate tax but which has the highest marginal income tax rate in the country—13.3 percent. We know the benefit of a lifetime gift is that all future appreciation in the value of the stock will avoid a 40 percent estate tax. But we also know that, with a lifetime gift, the donee “inherits” the donor’s income tax basis in the stock—which in this case is zero. Under this set of circumstances, mom would be transferring an asset that has a built-in income tax liability of $266,000. Is that a good idea?

Well, if mom were to die tomorrow without having made this gift, her estate would have gotten a step-up in basis and her daughter could have received the stock through her mom’s testamentary estate plan with no income tax liability. But if mom made the gift, the daughter will pay a lot of additional income tax when she ultimately sells the stock due to the loss of the step-up.

Here’s the key. Whenever someone wants to transfer an appreciated asset to a family member (other than a spouse), there is a built-in tax liability that has to be “burned off” before the donee can realize a financial benefit. The transfer tax benefit of a lifetime gift takes time to manifest. The key drivers are the donor’s time horizon; the “tax gap” (that is, the difference between the donor’s estate tax rate and the donee’s effective income tax rate); the donor’s basis; and the asset’s prospects for future growth. Keep in mind that the tax gap depends on a host of factors, including where the donor and donee live, the donee’s tax bracket, whether the subject matter of the gift is a capital asset or something else, and a host of other factors. Suffice it to say that, thanks largely to ATRA, we live in a very complicated world.

Estes: I’ll say. A zealous estate-tax-oriented planner could easily stumble into malpractice for lack of income tax planning. Scary. Is there any silver lining for those families who have relatively small estates?

Pauloski: For the most part, the answer is yes. For example, ATRA made portability of the applicable exclusion amount a permanent feature of the federal tax law. As a reminder, “portability” is the notion that, for a married couple, the applicable exclusion of the first spouse to die can be ported over to the surviving spouse by making an election on the deceased spouse’s federal estate tax return. As a result, a couple in a common law jurisdiction may not need to split up assets or adopt an estate plan that creates a credit shelter trust upon the death of the first spouse to die. Instead, the estate plan can provide that each spouse leaves all his or her assets to the survivor, and the executor of the first spouse to die can elect to port that spouse’s applicable exclusion to the survivor.

When the dust settles, the surviving spouse has all the couple’s assets and a combined exclusion of as much as $10.68 million. Aside from simplicity, one benefit of this method is that the entire estate will get a step-up in basis at the second death. That’s going to be much more difficult to achieve in an estate plan that calls for a credit shelter trust to be established at the first death.

Estes: Portability seems tailor-made for situations where the first spouse to die has substantial assets in a qualified retirement plan or IRA.

Pauloski: I agree. Before portability, couples with substantial qualified plan balances faced a real dilemma: whether to leave such benefits to the surviving spouse and get potentially great income tax treatment but no estate tax relief at the second death, or to leave such assets in a credit shelter trust to avoid estate taxes at the second death but with potentially lousy income tax treatment due to acceleration of required minimum distributions. With portability, leaving qualified plan benefits to a surviving spouse provides the best available income tax treatment and enhances the survivor’s ability to shelter those assets from estate taxes at the second death. Plenty to like there.

Estes: That sounds like a terrific gift that cannot be ignored. What are the downsides?

Pauloski: Portability is helpful, but it’s not perfect. For one, the portability election has to be made on a federal estate tax return, regardless of the possibility that the estate of the first spouse to die may be well below the applicable exclusion amount—and there is no such thing as Form 706-EZ. Further, while the surviving spouse’s applicable exclusion is indexed for inflation, the deceased spousal unused exclusion—or DSUE—amount is not. So the longer the surviving spouse sits on the DSUE amount, the less purchasing power that DSUE will have upon her death. And only the applicable exclusion is portable; the generation-skipping transfer (GST) tax exemption for federal GST purposes is not. While it’s possible to do GST tax planning with portability, it’s messy and inefficient.

Estes: Filing a Form 706 may dredge up issues on audit that were better left alone. On the other hand, the practitioner would want to document reasons for failing to file. Momma could win the lottery and need the extra DSUE. Any final thoughts?

Pauloski: Just a few. When I have the opportunity to speak publicly on these issues, I tell audiences that great advice has never been more valuable than it is today. We live in a complicated world, and ATRA has only added to that complexity. The questions clients face are not always easy to answer. Are they actually going to avoid estate taxes? Is a step-up in basis likely to be more valuable to the family than avoidance of estate taxes? What role will state death and income taxes play in the overall plan? How much does future spending matter? What role, if any, should life insurance play in today’s world? And there are many more. As a result of this complexity, it’s extremely important for all of the key advisors—the estate planning attorney, CPA, investment advisors, insurance professionals, and others—to talk about these issues openly and get on the same page. That, it seems to me, is the best way to get clients the answers they need.

Estes: Agreed. It seems to me that the downside of using yesterday’s template can be disastrous for all parties, the planner included.

Pauloski: Amen.

R.D. “Don” Estes

R.D. “Don” Estes, an estate planning specialist, is principal of the Estes Law Firm, P.A., in Minneapolis. He belongs to a number of ABA entities, including the Senior Lawyers Division, where he is a member of the Investment Strategies Committee.