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New Tax Law – Game Changer

The American Tax Payer Relief Act (ATRA), enacted into law on January 2, 2013, is a game changer for estate planning. The experts are just now sorting out how much of a game changer it really is.

The new law significantly increased the the estate tax exclusion amount. The estate tax exclusion amount is the amount each US person could die with before the 40% estate tax kicks in. During the last decade, the exclusion amount had been as low as $1M and as high as $3.5M.  ATRA locks the estate tax exclusion amount at $5M, indexed for inflation, Congress says it’s “permanent.” If true, that’s good news. (But is any tax break really going to be permanent?)

For 2014, the estate tax exclusion amount is $5,340,000. ATRA’s big exclusion amount substantially narrows the number of families that will have to deal with the estate tax. Studies show that under ATRA, only one third of one percent of US families will now be subject to the estate tax.

The result is that for almost all of us, Congress has eliminated the estate tax. (Well, at least until they change the law again.) The game changer is that now the focus of estate planning should be on capital gains tax planning and asset protection, instead of estate tax planning.

Under the old regime, estate planning attorneys focused on eliminating or reducing the estate tax. Estate planning attorneys would include A/B or bypass trust provision in living trusts to capture the estate tax exclusion of the first spouse to die. That same strategy could now result in a big capital gains tax.

Many living trusts were written with a mandatory funding formula – provisions that require the trustee to divide assets into a bypass trust and a survivor’s trust when the first spouse dies (which has been the standard practice). The purpose of the bypass trust was to capture the deceased spouse’s estate tax exclusion amount. The downside was that when the surviving spouse died, the assets in the bypass trust would not get a step-up basis. As a result, when the children sold the bypass trust assets, they would have to pay a capital gains tax. The trade off was to eliminate the estate tax (35%-55%) but pay the capital gains tax (15% fed plus 10% California). Since the estate tax was a bigger tax, it was a good strategy.

But now that Congress has all but eliminated the estate tax, it’s time to focus on the capital gains tax.

Rather than using bypass or A/B trust provisions in your living trust, you should consider amending or restating your living trust to include a disclaimer or QTIP (qualified terminable interest property) funding formula. With disclaimer or QTIP provisions, your children would get a step up in basis when the surviving spouse dies – and if they sold your assets soon after your passing, they would not have to pay the capital gains tax.

Under ATRA, you don’t need a bypass trust to capture the deceased spouse’s estate tax exclusion amount. ATRA includes what is called a “portability” election. If the surviving spouse files an estate tax return (IRS Form 706) for her deceased spouse, then an election can be made on the 706 return to “port over” the deceased spouse’s exclusion amount.  The portability election on Form 706 is the method Congress authorized to capture the deceased spouse’s exclusion amount. By filing the 706 and making the portability election, the surviving spouse can add her deceased spouse’s estate tax exclusion amount (at least $5,340,000) to her exclusion amount (at least $5,340,000) for a total estate tax exclusion of over $10,680,000.

Because of the portability option in ATRA, most of us won’t need a bypass or A/B trust. Instead your trust should include disclaimer or QTIP provisions to secure a step-up in basis and eliminate the capital gains tax when the surviving spouse dies.

If your trust has mandatory bypass or A/B provisions, you should review it with your attorney and consider amending it to include a disclaimer or QTIP funding formula.

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