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We’re approaching a crossroad in estate planning, and those who might be affected need to take action before we reach it.
Few people today have to worry about federal estate and gift taxes, because of the high level of exemptions. But there’s a high probability of significant changes in the estate tax law in coming years, and that’s the crossroad we are approaching.
If Congress doesn’t take action, the lifetime exemption will be slashed in half automatically after 2025. If there’s a major change in power after this November’s elections, the exemption could be reduced sooner and could be reduced by more than half.
The result is that in a few years estates with values as low as $3 million to $5 million could be subject again to estate and gift taxes. If you wait until the election to take action, you’ll likely find estate planners are booked through the end of year. You want your plan in place and documents ready to execute by election plan.
Your estate plan needs to be structured to achieve the results you want under today’s law. Also, it should be flexible enough to adapt to changes in the law that take effect before you’re able to revise the plan.
Here are key issues to consider.
Eliminate outdated formula clauses. This is the most important action and has been needed for several years. Estate planners routinely used formula clauses in wills for many decades, and those old formulas or their remnants still are in many wills. The clauses can be very detrimental to a surviving spouse.
A formula clause splits the deceased’s property between the estate and a trust using a simple formula. The strategy was developed to take full advantage of the lifetime estate and gift tax credit when it was much lower than it is now.
Suppose an estate was worth $1.5 million when the lifetime exemption was $600,000.
Under a standard formula clause a portion of the estate would be transferred to a trust, usually known as a credit shelter trust or bypass trust, up to the maximum amount of the lifetime federal estate and gift tax exemption in effect at the time. The rest of the estate would go to the surviving spouse.
In this case, $600,000 would go into the trust, and the surviving spouse would inherit $900,000. The estate would avoid federal taxes, and the surviving spouse would be provided for.
Today, under such a formula clause the entire estate would go to the trust, and the surviving spouse would inherit nothing outright. Most states have laws preventing such a complete disinheritance of a spouse without a pre- or post-nuptial agreement, but many of them would give the surviving spouse only one-third of the estate.
Unless your intent is to disinherit your spouse, have any formula clauses revised or eliminated.
Don’t forget state taxes. About 20 states still have some form of estate or inheritance tax, or both. Some have exemption amounts that are much lower than the federal exemption.
When your state has these taxes, discuss possible strategies with your estate planner, such as QTIP trusts and lifetime gifts. You’ll need an estimate of the potential taxes, so you can decide if the cost and restrictions of a strategy are worth the tax reduction.
Lifetime gifts. When an estate might be taxable, lifetime gifts are a good way to transfer wealth to the next generation without incurring estate and gift taxes. Talk with your estate planner about which assets would be good for you to transfer now and the best wys to make those gifts. Gifts can be made directly or through trusts. You also can give gifts that allow you to retain some income or have the assets returned to you, such as through grantor retained annuity trusts (GRATs).
Add flexibility to the plan. As I said earlier, we don’t know what the federal estate tax will be in a few years. You can prepare the plan for uncertainty by inserting a few provisions, especially in trusts, that increase flexibility.
For example, a trust can include powers of appointment. Generally, these powers allow the trust creator or one or more beneficiaries to name who will receive part of the trust, even someone who wasn’t originally a beneficiary. There are many different types of powers of appointment, and they are very flexible.
A power of appointment can save estate or gift taxes if the federal exemption amount is reduced in the future. For example, an adult child who is scheduled to receive distributions from the trust might appoint his or her children to receive distributions instead so the entire inheritance isn’t in his estate.
Another form of flexibility is to give the trustee or a group of trustees discretion to determine distributions. Among other factors, they would consider how to structure distributions to reduce taxes.
Another good idea, if state law allows it, is to provide for decanting of a trust. Decanting is a process in which the trust assets are shifted to a new trust. This can be valuable when the old trust is irrevocable and either the tax law or family circumstances change, making the old trust less than an optimum solution.
Trust decanting is relatively new, but a number of states now have adopted laws in recent years that allow it under certain circumstances.
You also can name one or more trust protectors and empower them to change key provisions of the trust. A trust protector also can monitor the activities of the trustee and replace the trustee if that seems warranted.
The right tools for you will depend on your situation and goals.
Now is a good time to take a fresh look at your estate plan with the potential changes in the next few years in mind. Already, many people are reviewing their plans because of inadequacies highlighted by the coronavirus pandemic. While doing that, consider how the federal estate tax might change in the next few years and add some flexibility to cope with potential changes.