Sophisticated Estate Tax Planning Options for Wills of Married Couples
Historically, for wealthy individuals, mandatory credit shelter trusts were routinely established under Wills or revocable trusts as part of an overall estate plan. However, following important changes in the law over the past several years, it is critical that individuals revisit their Wills or revocable trusts.
For clients with estates of significant value, the American Taxpayer Relief Act of 2012 (ATRA) made estate planning more complex, as it made "portability" permanent; thereby providing yet another variable that will have to be considered in a well-structured plan. Furthermore, it is important to note that, if a married couple relies solely on portability (described in more detail below) for their estate plan, the couple will lose the benefit of using the first deceased spouse's state exclusion amount. Below is an overview of the estate tax laws, as well as a general discussion of the estate planning options available to married couples (U.S. citizens) in New York. In most instances, drafting a flexible estate plan (such as through qualified disclaimer planning and the use of certain qualified terminable interest property ("QTIP") elections) will allow circumstances at death to be considered before making the choice between options and, thus, may just be the most effective option of all.
Gift Tax. The tax-free “annual exclusion” amount is $15,000 in 2021. The cumulative lifetime exemption is $11,700,000 in 2021. The tax rate on gifts in excess of $11,700,000 is at 40%. The increased gift tax exemption is scheduled to expire on December 31, 2025, when the exemption amount will be reduced to $5,000,000 (indexed for inflation).
Estate Tax. The federal estate tax exemption (reduced by certain lifetime gifts) is also $11,700,000 in 2021, and the tax rate on the excess value of an estate is also at 40%. All of a decedent’s assets (other than “income in respect of a decedent,” such as IRAs and retirement plan benefits), will have an income tax basis equal to the fair market value of those assets at the date of death [“stepped-up (or down) basis”]. The increased estate tax exemption is scheduled to expire on December 31, 2025, when the exemption amount will be reduced to $5,000,000 (indexed for inflation).
New York Estate Tax. The New York estate tax exemption is $5,930,000 for individuals dying after January 1, 2021. If an individual dies with just 5% more than the New York estate tax exemption amount, the individual faces a cliff. That means that the individual will be taxed on the full value of his or her estate, not just the amount over the exemption amount. The top New York maximum marginal estate tax rate is 16%.
Generation-Skipping Transfer Tax (“GST Tax”). For 2021, the GST tax rate is also at 40% and the lifetime exemption is also $11,700,000. The increased GST exemption is scheduled to expire on December 31, 2025, when the GST exemption amount will be reduced to $5,000,000 (indexed for inflation).
Estate Tax Marital Deduction. There is no federal or state estate or gift tax on transfers between spouses, whether during lifetime or at death. Those gifts and bequests can be outright transfers or can be made via trusts (although not all types of trusts will qualify for the marital deduction). There is no limit on the amount that may be transferred. The vast majority of married couples combine the estate tax exemption granted to each person with the unlimited marital deduction to assure that no estate taxes are payable until the death of the surviving spouse.
Portability of Federal Estate Tax Exemption. The “portability” rules provide for the transfer of a deceased spouse’s unused estate tax exemption (“deceased spousal unused exclusion amount” or “DSUEA”) to a surviving spouse (without inflation adjustments). Thus, if a 2021 decedent’s taxable estate is not more than $11,700,000, and the decedent leaves all of his or her assets to the surviving spouse using the unlimited marital deduction, the DSUEA can be used by the surviving spouse with respect to both gift taxes and estate taxes (but not state estate taxes or GST taxes). Portability may allow some couples to forgo a more complex estate plan while still taking advantage of both spouses’ federal transfer tax exemptions. Portability must be irrevocably elected on a timely filed (including extensions) estate tax return, even if a return is not otherwise required to be filed.
Although portability is available for estates of decedents for federal estate and gift tax purposes, portability is not allowed for the state estate tax exclusion amount. Therefore, if spouses want to simplify their estate plans by leaving everything to the surviving spouse and opting for portability, the deceased spouse’s estate will not be able to take advantage of the state’s estate tax exclusion amount. This may increase the amount of state estate taxes incurred by the surviving spouse’s estate (see further discussion below).
Historically, prior to the introduction of the portability law, a typical estate plan for a married couple generally provided for the establishment of several trusts at the death of the first spouse, one of which was a “Credit Shelter” (or “CST” or “Exemption” or “Bypass”) Trust. One of the reasons for the CST was to use the deceased spouse’s estate tax exemption to the fullest extent possible. Under the portability law, however, if one spouse dies and leaves assets to persons (other than the surviving spouse and charity) in an aggregate amount less than the basic exclusion amount ($11,700,000 in 2021), the surviving spouse may be able to use the DSUEA as well as the surviving spouse’s own exemption.
The portability provision may eliminate the need to create a “CST” at the first spouse’s death, depending on the size of the combined estates of the married couple. For example, if this year the first spouse to die leaves all of his or her assets to the surviving spouse, no part of the deceased spouse’s exemption is used because of the marital deduction available for assets passing to a surviving spouse at the first spouse’s death. Unless the surviving spouse remarries and survives his or her new spouse, he or she will have an aggregate federal exemption of (i) $11,700,000 (“DSUEA”) and (ii) his or her own inflation-adjusted $11,700,000 exemption ($23,400,000 total in 2021).
In many cases, however, it is nevertheless advisable to continue to use a CST (or, instead, a "Disclaimer Trust" or "QTIP Trust", see discussion below) as part of one’s estate plan for both tax and non-tax reasons. Specifically, in states such as New York, which have exemption amounts that are lower than the federal applicable exemption amount, state estate tax planning must be considered. To avoid the disadvantageous effects of planning with portability in New York (namely, the surviving spouse’s estate’s paying a larger state estate tax or an estate tax that could have been avoided), a married couple can provide that, on the first spouse’s death, the first spouse’s estate would fund a CST with the New York exemption amount, thereby sheltering $5,930,00 from New York estate tax on the death of the first spouse. On the death of the surviving spouse, the surviving spouse’s estate can use the surviving spouse’s New York exemption amount, thereby sheltering an additional $5,930,000 from New York estate tax. For example, if a New York married resident died with an estate of $10,000,000 (and made no prior taxable gifts) and the couple wanted to defer taxes until the death of the surviving spouse, the plan would provide for the funding of two trusts on the deceased spouse’s death: (1) a CST with $5,930,000, using part of the deceased spouse’s federal applicable exclusion amount exemption and the full New York exemption amount; and (2) a federal and state QTIP trust with $4,070,000, for which federal and New York state QTIP elections would be made. The deceased spouse’s executor would then make a portability election on the federal estate tax return to transfer the spouse’s DSUEA to the surviving spouse. This plan, thus, will eliminate the state estate tax in the first spouse’s estate and may even avoid state estate tax in the surviving spouse’s estate in the event the surviving spouse moves to another state or the state estate tax is repealed during the surviving spouse’s lifetime.
In a larger estate, the first spouse might want to shelter the federal exempt amount, even though that will result in some state estate tax at the first spouse’s death. That may be a significant cost to bear, given the uncertainties as to whether a state or federal estate tax will be incurred. The inflation adjustments of the surviving spouse’s estate may make an estate that was marginally taxable non-taxable. On the other hand, in larger estates, sheltering the federal exempt amount is more important because, as noted above, portability isn’t indexed for inflation, and there’s no portability for the GST tax exemption.
If the estate is sufficiently small that there’s no need for portability, the first spouse can shelter the state exempt amount and leave the rest of the estate in a QTIP trust, and the executor can make a state QTIP election for that trust. However, sacrificing portability incurs the risk that the surviving spouse’s estate will be subject to estate tax, either because it turns out to be larger than anticipated or because the federal estate tax-exempt amount is later reduced.
Aside from the state estate tax reasons discussed above, other tax reasons to continue to use a CST include the following: (i) the DSUEA is not indexed for inflation; (ii) eliminating estate tax on any appreciation of CST assets at the surviving spouse’s death, regardless of the value of the surviving spouse’s assets; (iii) allowing for an allocation of the deceased spouse’s GST exemption to the CST; (iv) the surviving spouse could remarry and be limited to using the unused exemption of his or her second predeceased spouse, if any (and thereby wasting the DSUEA of the first spouse); and (v) an estate tax return must be filed timely to qualify for portability. Note, however, that the GST exemption is not portable. Therefore, an allocation of a decedent’s GST tax exemption to the CST at death must be made to avoid GST taxes if assets are left to grandchildren, either directly or in a trust benefiting both children and grandchildren.
Non-tax reasons to continue to use a CST include the following: (i) limiting (or eliminating) the ability of the surviving spouse to direct the disposition of the deceased spouse’s assets on the surviving spouse’s death; (ii) restricting the surviving spouse’s right to use principal (perhaps only for health, support, and maintenance); (iii) providing creditor protection (creditors generally cannot reach the assets in an irrevocable trust established by another person); and (iv) providing professional management for a spouse who is not financially savvy.
CST disadvantages include the following: (i) annual costs for the preparation of CST income tax returns and maintaining separate records for the CST; (ii) the possible loss of a further stepped-up basis on the surviving spouse’s death; (iii) lack of surviving spouse ability to change the estate plan to adapt to changed circumstances, unless the surviving spouse is given a limited power to change the CST distribution provisions; (iv) lack of ability to offset capital gains and losses realized by the surviving spouse and the CST; (v) CST assets generally cannot be used to implement further estate planning techniques; (vi) the surviving spouse cannot use the $250,000 exclusion from capital gain upon the sale of a residence held in the CST; and (vii) possible need to accelerate taxable distributions from retirement accounts.
Disclaimer Trust. If a client does not find the reasons for establishing a mandatory CST significant in terms of his or her estate planning goals, but nevertheless wants to provide for maximum flexibility through the possible establishment of a CST in the event that circumstances at the time of death prove it advisable to do so, the first spouse’s estate plan can provide for distribution of his or her estate to the surviving spouse, but include a provision that would allow the surviving spouse to “disclaim” all or a portion of his or her inheritance and arrange for the disclaimed assets to be allocated to a CST (“Disclaimer Trust”). The surviving spouse must make his or her decision to disclaim during the nine-month period following the first spouse’s death.
A Disclaimer Trust is a technique for taking a “wait and see” approach to credit shelter planning for married couples. It differs from a standard CST in that it will be used only if it is needed. The goal is to give the surviving spouse a second look, based on the circumstances that exist after the death of the first spouse.
Here’s how a disclaimer will works:
Each spouse’s estate plan has a “Plan A” scenario that disposes of assets as if there is no estate tax. For most married couples, Plan A typically leaves everything to the spouse outright with alternate distributions to the children or other relatives if the spouse is deceased.
The estate plan also includes a Disclaimer Trust as a “Plan B.” The Disclaimer Trust has all of the provisions of a CST. It is usually designed to make the assets available to the surviving spouse while taking advantage of the first spouse’s exclusion amount (credit shelter).
After the death of the first spouse to die, the surviving spouse can choose between Plan A (outright to spouse) or Plan B (CST/Disclaimer Trust). If there are no pressing estate tax considerations, the spouse can accept Plan A by default. Alternatively, if there is a need to use Plan B for tax purposes, the spouse can “disclaim” some or all of the assets into the CST/Disclaimer Trust.
If a Disclaimer Trust is used, the full extent of the tax planning occurs upon the death of the first spouse. At that point, the surviving spouse can either accept the trust assets or disclaim them. If he or she disclaims them into the Disclaimer Trust, the trust will function like a CST that will “shelter” the assets from inclusion in the surviving spouse’s estate. But if there is no tax reason to use credit shelter planning, the spouse can simply receive the assets outright. This allows tax-planning flexibility without creating unnecessary complication.
Disclaimer Trusts are particularly attractive when, as in the current estate tax environment, there is uncertainty as to what the federal estate tax exemption will be in the future. By the time that the first spouse dies, this question may be answered. At a minimum, the surviving spouse will know the size of the marital estate at that time. A Disclaimer Trust allows the spouse to take into account these variables before finalizing tax decisions.
QTIP Trust. A qualified “Marital Trust” (“QTIP Trust”), which qualifies for the marital deduction, enables a deceased spouse to maintain control over the distribution of the trust assets upon the death of the surviving spouse, can preserve the deceased spouse’s unused GST exemption through a “reverse QTIP election,” and provides a greater degree of creditor protection than would be afforded by an outright bequest to a surviving spouse. Using a QTIP Trust to accomplish these objectives (rather than a CST) may allow the trust assets to receive a step-up in basis upon the death of the surviving spouse and, in some cases, may postpone payment of state level estate taxes until the death of the surviving spouse. In addition, the surviving spouse may wish to elect portability and subsequently use the deceased spouse’s remaining estate and gift tax exemption (DSUEA) to make lifetime gifts tax-free.
In order to determine which of the above options will be best in any particular case turns on an analysis of many factors, including:
the total value of the estate
types of assets in the estate
ages of the spouses
likely period of time between deaths of first spouse to die and surviving spouse
anticipated increase in the value of the estate assets before death of first spouse
anticipated increase in value of the estate between deaths of first spouse and surviving spouse
anticipated estate, income and capital gains tax rates applicable to the estate, the surviving spouse and the beneficiaries of the estate
rate of inflation
need for asset protection
changes in New York state estate tax laws
whether a surviving spouse is likely to remarry
whether a surviving spouse is financially savvy
whether the couple has children from prior marriages
whether the beneficiaries of the estate includes grandchildren.
We would be happy to meet with you to create an estate plan that best meets your circumstances and planning objectives, or to review your current estate planning documents to insure that they accomplish your goals and comply with the recent changes in the law.