By Robert B. Wolf, Esq.

Tener, Van Kirk, Wolf & Moore, Pittsburgh, PA

There is something about our new Tax Law - American Taxpayer's Relief Act - that reminds me of the opening scene in the original Star Trek series where William Shatner describes the mission of the Starship Enterprise, and if I may paraphrase his description for the estate planners of today:  "our mission, is to explore strange new tax worlds, to seek out new techniques and new approaches, to boldly go where no estate planner has gone before."  Today we live in a tax world where for many of our clients the force of gravity has literally been reversed. Things that used to fall down now fall up!   It is a world where for many clients having an asset included in her estate may be a good thing rather than a bad thing, whereas for others, it will continue to be a very bad thing.

Nothing this revolutionary to the field of estate planning has occurred during my career as an estate planner starting in 1974.

In 2013, we now have the ability to give away up to $5.25 million per person without fear of US gift tax, federal estate tax or generation-skipping transfer tax.

And those limitations are both "permanent" and indexed so they will not be eroded by inflation.

Now whether the changes are really permanent or whether this in fact depends upon what the meaning of the word "is" is, we just don't know. But clearly the tax rules are at least not scheduled to change, or expire, or sunset, or whatever, by their very terms.

And now we have the ability to give to a surviving spouse any of that applicable exclusion amount we have not used or needed for federal gift tax or federal estate tax. This is called "portability" and may radically change many clients estate planning needs and the best tools and techniques to address those needs.

On the other hand, while the generation-skipping transfer tax will have the same $5.25 million indexed exemption as does the gift tax and federal estate tax,  it is not portable between spouses, and this significantly affects long term dynasty trust planning.

At the same time, the federal estate tax rate for those over these limits  rises to 40% from 35% last year. A significant increase, but a far cry from the 55% rate and $1 Million Exclusion amount awaiting us at the bottom of the fiscal cliff.

Most importantly, the income tax on higher income taxpayers will go up significantly, and as we have come to expect, very confusingly:

• At a threshold of $400,000 for a single taxpayer or $450,000 for a married taxpayer filing jointly, the top income tax rate goes from 35% to 39.6% and the capital gains top rate goes from 15% to 20%.
• Interestingly, there is a 0% capital gains tax bracket for lower income taxpayers like, for example some of our kids. My daughter, who is in medical school, rather enjoyed being a tax shelter for appreciated stocks I gifted her while she was earning no money. I must confess though that the tax benefit is not sufficient to extinguish the joy I expect at her graduation in a few months.
• The 3.8% investment income Medicare Tax, or for the conservatives in the crowd, the Obama Care Tax has a threshold of $200,000 for a single taxpayer and $250,000 for a married taxpayer.
• The 3% phaseout of itemized deductions up to 80% of affected itemized deductions is reintroduced at a level of $250,000 for a single taxpayer to $300,000 for a married taxpayer. Excluded from this limit are medical expenses above the increased threshold, casualty and theft losses and I wouldn't have bet on this, gambling losses.   This will be very significant and bad for the very high income philanthropist and particularly strange for the one time large gift in a very high income year. A taxpayer who makes $1,000,000 in an extraordinary year may be better off delaying the charitable gift until a lower income year and spreading it out over several years, rather than losing 80% of the benefit of the deduction. There is that reversal of gravity again! Unfortunately, this may have a very significant effect on planned major gifts. Why didn't they just raise the rates for these high income taxpayers and incentivize, rather than discourage, charitable giving?
• The threshold for deductible medical expenses has been raised from 7-½% of adjusted gross income to 10% in 2013.

You may notice that the thresholds which politically define "middle income" Americans are essentially all different, so our political leaders can all point to some change that they believe in or at least for which they can take credit.

We have already this year noted the effects of these income tax increases on a client of ours of very modest means who has an opportunity to sell a valuable piece of family real estate whose gain on sale would push her into an almost 27% bracket on the long-term capital gain counting the 20% higher capital gains tax rate plus the 3.8% Medicare Tax and the 3.07% Pennsylvania tax, not to mention wiping out her deductible medical expenses and extinguishing the rest of her itemized deductions with the gross income phaseout.

The income tax effects of the new taxes and phase-outs that a chart is attached that may be useful to visualize the 2013 tax rates on qualified dividends and capital gains. Because of the phase-outs and thresholds, there are important "bubbles" in the tax structure for our higher (but not highest) income clients. A married couple with three dependent children with AGI of $350,000 gets a marginal capital gains tax or qualified dividend tax rate of 24.82%, about 5% of which comes from the personal exemption phase-out between $300,000 and $425,000.  

Collectively, these changes are huge for the estate planning and tax planning community:

1. Exemptions for gift, estate and generation-skipping tax are very large and flexible with portability.

2. The higher tax rates for long-term capital gains significantly increases the value of the step up in cost basis to date of death value where the asset is includable in a decedent's estate.

3. As a result, in many cases, and this is counterintuitive, we may want an asset to be included in a decedent's estate for moderately well-to-do clients who may otherwise be sheltered from the federal estate tax because their assets may not exceed the $5.25 million per person or $10.5 million dollars available between husband and wife.
4. None of that is true however for retirement accounts, though other factors will tend to move our process towards simpler solutions for these assets.   In many cases, we should shift our focus to the income tax benefits of the stretch IRA payout, where the asset does not need to be sheltered from federal estate tax, or in a second marriage situation where we need a trust to bypass not the tax but the stepchildren.

5. There will be many irrevocable trusts out there today where the trust would be more tax efficient if it were taxable in the beneficiary's estate rather than non-taxable, because we want to get the step up in cost basis on the investment assets in the trust and the imposition of federal estate tax is unlikely.

6. This will mean that in many cases, we may want to insert general powers of appointment into trusts that had none if the beneficiary's estate is no longer taxable under ATRA. This will be particularly appropriate for trusts where a life beneficiary has the broad power to appoint by will except to the fearsome four-the beneficiary, the beneficiary's creditors, the beneficiary's estate, or the creditors of the beneficiary's estate.  The Uniform Trust Act should be helpful in many of these cases where the prospect of avoiding higher capital gains taxes in long term trusts with very low cost basis assets.  But, of course, "Be careful out there!"
7. For the first time, or at least for the first time in a very long time, we may have real stability and some level of permanence to the thresholds and the basic rules governing our transfer tax system. If so, that will be a good thing since a great deal of time and effort is expended every year just trying to adjust to the almost yearly changes, leaving little time and energy for adapting our techniques to better address other human and financial needs.

Bottom line changes:

• For the clients who are still within the federal estate tax regime - those whose wealth is well beyond the $5.25 million or the $10.5 million for a married couple, and who have not taken advantage of the greatly expanded transfer tax exemptions over the last 2 years, this is a wonderful opportunity to do careful, thoughtful estate planning that is not under a calendar watch deadline. However, no matter how much the client wants to put it off forever, it must nonetheless be done while the client is still alive and, generally, while they are still competent.
• For the clients that are clearly below those thresholds, there may be an opportunity to simplify their estate plans, but this should be done carefully to make sure that many of the other reasons for creating a trust are not being disregarded - such things as creditor protection, protection against the less-than-perfect spouse, protection against loss of government benefits, and the old reliable, protection from the beneficiary herself. The considerations and discussion surrounding these plans will be significantly different than in past years.

Remember that today the divorce rate is now higher than the federal estate tax rate and trust planning and prenuptials are the first line of defense for the financial consequences of divorce. 

Formula marital and credit shelter trusts have become much less popular in our recent age of uncertainty.  Going forward, they should be used with considerable caution.  The virtues of flexibility have been critical in this protracted age of extraordinary uncertainty, and should not be ignored.  

The use of disclaimers in trusts and estate planning may increase.

The use of income tax stretch benefits for IRAs and other retirement accounts will assume increasing importance.

And then there are the families for whom we cannot really tell whether or not the federal estate tax may be important later. In those mezzanine situations, careful consideration must be given and discussions conducted with the client to determine goals, discuss risks and to select planning techniques and documents which address those goals and minimize those risks.

We certainly live and are practicing law in interesting times.

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