Changes in Federal, State Estate Tax Laws Should Warrant a Shift in Your Strategies

Estate planning was long dominated by estate tax planning. In the not-too-distant past, state and federal estate taxes were applicable to a broad spectrum of clients, and the taxes themselves were constantly in flux because of legislative changes. Now, most state estate taxes have been eliminated (including in Kansas and Missouri), the federal estate tax exempts a very high percentage of the population, and there is more overall certainty with the federal estate-tax structure for those that are not exempt from it. Most of the changes that now affect estate tax planning are now scarce and primarily limited to inflation adjustments.

As the estate tax has become less relevant for some clients and there is more certainty for others, there has been a prominent shift in focus from the estate tax to maximizing asset protection and income-tax benefits for the beneficiaries inheriting at a client’s death.

Traditionally, ongoing lifetime trust structures for beneficiaries were primarily used for beneficiaries who had failed to attain financial maturity in adulthood, exhibited a pattern of substance-abuse issues or suffered from other permanent disabilities. Financially-mature beneficiaries were generally left outright bequests that were not subject to any ongoing trust terms.

Perceptions of a more litigious society, less-stable marital situations, and increased attempts at undue financial influence over the elderly have led to asset protection being now commonly considered for even financially mature beneficiaries. A properly structured lifetime trust for a beneficiary can provide protection from the beneficiary’s creditors, including divorcing spouses, professional claims, lawsuits and even bankruptcy actions.

Asset protection is achieved through a spendthrift clause, which prohibits a beneficiary’s creditor from attaching the beneficiary’s interest in the trust, and a lack of mandatory distributions that could be attached by a creditor when due to the beneficiary. This protection can often be obtained for a beneficiary without substantially inhibiting the beneficiary’s control. The beneficiary can retain investment control, the ability to change the trustee and even direct where the remaining trust funds go at the time of the beneficiary’s death. The trust can even be structured to prevent the trust funds from being subject to the estate tax at the beneficiary’s death.

A lifetime trust for a beneficiary can implement several income-tax benefits in addition to asset protection. The most prevalent being (1) a step-up in basis at the death of the beneficiary for the trust assets if it will not result in an increase in federal estate tax or generation-skipping transfer tax, both of which will generally carry a greater tax cost than the benefit of the step-up; (2) continued tax-deferral for retirement accounts, such as IRAs, left payable to a trust; and (3) decreasing the income tax applicable to trust income.

As an example of the benefit of a basis step-up, assume you have a share of stock for which you paid a $1 and is now worth $100. If you sell that share of stock, you will recognize a taxable gain of $99. If you die holding that share of stock when it is worth $100, the tax basis will be stepped up to $100. The result is that the share can be liquidated after your death and no gain is recognized. This will generally apply to trust assets that are includible in the beneficiary’s estate for federal estate tax purposes. If this inclusion would not result in an increase in estate or generation-skipping transfer tax at the beneficiary’s death, the step-up is a beneficial tax feature to include.

Generally, an IRA left payable to a trust must be distributed and taxed within a 60-month period. However, a properly drafted trust can enable an IRA payable to it to be a “stretch” IRA. This allows the required minimum distributions to be based on the life expectancy of the oldest trust beneficiary. Depending on the age of the oldest beneficiary and the investment return, the stretch IRA may provide exponential tax savings over the general default. There has been some legislative discussion for terminating the ability to stretch IRAs,
but it is presently still an available option.

With respect to most trusts established for a beneficiary upon a client’s death, the trust’s income will either be taxable to the trust, or if distributed to the beneficiary, taxable to the beneficiary. If the beneficiary has a lower overall income tax rate than the trust, it can be beneficial to distribute income from the trust to the beneficiary and shift the income to the lower tax rate. If the beneficiary has a higher tax rate than the trust, it is more beneficial to leave the income in the trust to be taxable to the trust.

This can often be the case for high earners residing in a high income tax rate state. In order to leverage the tax-savings when leaving income taxable to a trust, some trusts can be set up in a state with no fiduciary income tax. An example is using a trustee located in Nevada, a state which does not impose a fiduciary income tax, for a trust established for a Kansas beneficiary by a Kansas client.

The primary focus for an estate plan should be ensuring that the plan reflects the client’s ultimate wishes for his or her family and charitable interests. Beyond that, estate tax savings and implementing asset protection and income tax planning for the client’s beneficiaries should be considered to maximize and preserve assets in furtherance of those wishes.