By Molly Carey., Esq. It’s not a secret that none of us are going to escape death, but with a revocable living trust that takes advantage of nuanced laws in the Internal Revenue Code, one can escape, or at least significantly limit the hefty top 40% death tax Uncle Sam would otherwise require of one’s estate before funds are distributed to loved ones. Such necessity, when simply electing portability is inadequate for reasons discussed below, is the third rationale beyond the wish to avoid probate, and/or the need for assurances that assets end up with intended beneficiaries, to utilize a well-crafted living revocable trust in an estate plan. But first, when does tax planning become imperative for a married couple in the first place? And once it does, when will the benefits of tax planning specifically through special trust terms supersede the desirable simplicity afforded by electing the Deceased Spousal Unused Exclusion, i.e., portability? Well, in true lawyer fashion, I’ll say it depends. What is clear at the start is that some form of tax planning is pertinent if the total value of a married couple’s assets is anticipated to approach, or already exceeds, the federal estate tax exemption amount.
What creates complexity in this analysis is that the exemption amount is always subject to change, as does net worth throughout the course of a lifetime during which income and assets increase. For instance, tax planning may not be important now, in the case of a married couple with an estimated $6 million-dollar net worth given the current 2023 $12.92 million dollar exemption amount; an amount that is doubled to $25.84 million dollars for married couples when portability is elected on form 706 within 9 months from the first spouse’s death. Under this scenario, portability allows the surviving spouse to “port” his or her deceased spouse’s unused exemption to his or her own subsequent estate. Notably, taxes will never be due, regardless of estate valuation at the death of the first spouse due to the federal unlimited marital deduction, which defers the federal estate tax until the surviving spouse’s death. Because of the unlimited marital deduction, a spouse with a simple “I love you” Will could leave all assets to his or her surviving spouse, without triggering an estate tax regardless of value. For purposes of this hypothetical, let’s say that the husband dies first - his estate is valued at ½ their combined net worth at $3 million. His unused exemption is a whopping $9,920,000.00 given the current 2023 exemption amount. The wife, well advised by her cautious and informed estate planning attorney, timely files tax form 706 on behalf of her late husband's estate wherein she elects to claim his nearly $10 million-dollar unused exemption. Now, should further fortune befall her before death, her estate is passed death tax free up to the full $25.84 million dollar amount, as opposed to just half that amount had she not timely made the election. A great outcome by all accounts except one, when the math is done correctly, and the election is made timely. Had she won the lotto before dying, bringing her estate value up to $20 million, and not previously elected the DSUE, her estate would be hit with a painstaking $4,032,000.00 tax bill, with funds payable to the IRS instead of her mortified children. That’s 40% of $10.08 million dollars, the value of her estate over her $12.92 million dollar exemption amount. Expounding on this example with the aim to demonstrate the importance of thoughtful tax planning, this favorable outcome changes completely depending upon both the amount of appreciation the couple’s assets realize, and upon the actions of Congress. For example, let’s assume that just one year before the husband’s death, Congress reduces the exemption to its prior 2009 amount of $3.5 million dollars. Over the course of this same year, one of their brokerage accounts experiences unprecedented, fortuitous growth in the amount of $1 million dollars, sending the couple’s combined net worth upwards from $6 to $7 million dollars before he dies. Their plan to simply rely on portability of the Deceased Spouse Unused Exemption (DSUE) is risky at best because their assets are now at the threshold of their combined $7-million-dollar exemption amount. If there is any further asset growth at all between the time of their two deaths, estate taxes will certainly be due and paid upon the death of the wife, prior to distribution being made to the couple’s children. At this point, they would do well to tax plan through terms set forth in a living revocable trust, wherein half their combined assets, including the $1 million dollar brokerage account, are allocated to a new and separate irrevocable trust upon death of the first spouse. This irrevocable trust is often termed the B trust, decedent’s trust, or shelter trust. The surviving spouse may act as trustee and may even receive trust income as long as it is used only for his or her health, education, maintenance, and support (an important requirement per the tax code). However, the surviving spouse does not own the assets, and cannot be an ultimate beneficiary of the trust assets; typically beneficiaries of the B trust are the couple’s children. The remaining assets flow to fund the A trust, or what is termed the survivor’s trust and marital trust as it will hold assets for use by the surviving spouse. This trust remains revocable with the surviving spouse acting as trustee with full control. The B trust shelters assets up to the federal exemption amount of $3.5 million dollars, PLUS it would allow any additional value increase resulting from appreciation to grow tax free for purposes of calculating the federal estate tax. Having timely implemented these trust terms before the husband’s death, let’s assume the wife dies one year later. In this year, the brokerage account in the irrevocable shelter trust grows to $2 million dollars, sending the value of these assets from $3.5 to $4.5 million dollars. That’s now a total value of $8 million dollars ($1 million over the joint $7 million exemption amount) when adding in the wife’s $3.5-million-dollar valuation from her own trust. Because this couple brilliantly decided to direct a portion of their growing assets into a separate irrevocable trust upon the husband’s death, the couple’s children will not pay a penny of estate tax after their mother’s death on inherited assets. Notably, assets in the new irrevocable trust generally will not receive the same basis adjustment and reduction of capital gains as they would if included in the deceased spouse’s estate (which would receive two basis adjustments instead of one, an adjustment at each death) so a careful cost benefit analysis should be undertaken. However when significant asset growth is expected, planning through trust is typically more beneficial than the income tax savings that portability can offer. Contrast the above result with the detrimental outcome had portability been relied upon in lieu of trust planning. The couple’s children would pay a hefty $400,000.00 in taxes after the wife’s death, which is 40% of the $1 million that was not sheltered by the couple’s combined exemption amount. So here unless income tax savings worked out to be greater than this astronomical tax bill, the couple made the smart choice in planning through use of a trust. While these numbers are indeed dizzying, they are worth crunching because the tax savings can be monumental. Also, while I used only one set of facts and figures, the realm of possibilities is clearly endless. The analysis is driven by the law at play, namely the 2017 Tax Cuts and Jobs Act, the lifetime estate and gift tax provisions of which are currently set to sunset at the end of 2025, which would revert exemption amounts back to their 2017 amounts at approximately $7 million dollars per individual. Similarly, the nature and extent of a couple’s assets are a huge factor in how much appreciation can be anticipated. Undoubtedly the best tax planning strategy wholly depends on asset values and tax laws at any given time. Staying abreast of changes on both fronts is the best way to effectively plan and re-plan, when necessary, to limit estate tax liability. Questions about your estate plan? Contact PadgettEP today to learn how we can help. Comments are closed.
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