President Obama signed the American Taxpayer Relief Act of 2012 (ATRA) on January 2, 2013. Whether ATRA is a “relief” to taxpayers depends on how you look at it. Things aren’t as good as they were under prior law, but they aren’t as bad as they could have been if Congress had not acted.
On the plus side, ATRA set the exemption for federal estate, gift, and generation-skipping transfer taxes at $5 million, indexed for inflation since 2011. It also made portability a permanent feature of the tax law. For 2013, that means that taxpayers can pass $5.25 million ($10.5 for a married couple using credit shelter trusts or portability) to the next generation free of all transfer taxes.
But not all changes were positive. ATRA raised the maximum transfer tax rate from 35 percent to 40 percent. ATRA also added a 39.6 percent high income tax bracket and raised the capital gains rate to 20 percent for taxpayers with income in excess of the high-earner threshold ($400,000 for single filers, $450,000 for joint filers, and $425,000 for heads of households). These higher tax rates are in addition to the 3.8 percent tax on net investment income required under the Patient Protection and Affordable Care Act.
How ATRA Affects Estate Planning in 2013 and Beyond
ATRA didn’t make any revolutionary changes to the way estate tax planning is done. Many of the same techniques that worked in 2012 still work under ATRA. But ATRA did affect the estate planning environment in several ways:
- Unlike its predecessors, ATRA is permanent. There is no automatic sunset provision that will cause ATRA to expire automatically if not extended. ATRA gives a much-needed reprieve from the uncertainty that has plagued estate and gift tax planning for the past decade.
- Very wealthy taxpayers who haven’t already used their exemption still have an opportunity to do so through lifetime gifting. Even though ATRA doesn’t automatically sunset, Congress may still lower the exemption or raise the tax rates. The only way to lock in the current favorable exemption is to fund the exemption amount now. Making the transfer now will also move all future appreciation out of the taxpayer’s estate.
- Very wealthy taxpayers might also consider making taxable gifts in excess of their exemption amount. Due to the tax inclusive nature of the estate tax, lifetime transfers are more tax-efficient than transfers that take place at death.
- Given the higher capital gains rates, the use of intentionally-defective grantor trusts (which allow the grantor to continue to pay the tax on completed gifts) may no longer be the right choice. If the transferee is in a lower tax bracket, the better choice may be to terminate the grantor trust status. This would allow the beneficiaries to pay tax on the trust income at lower rates (assuming that the grantor’s spouse is not a co-beneficiary of the trust). The trust could make distributions to the beneficiaries to cover the additional tax liability.
Perhaps the biggest takeaway is that the vast majority of Americans need not be concerned with federal transfer tax issues. Only individuals with gross estates (defined very broadly) worth more than $5.25 million are potentially subject to estate tax. This means that most people can forget about estate tax planning and focus on what truly motivates them, including:
- Ensuring that their assets are distributed to the people that they want to have them and at the time that they want them to have them;
- Protecting estate assets from actual or potential creditors of family members and loved ones (or from their own bad decisions);
- Planning for the possibility of their own incapacity; and
- Protecting assets from frivolous lawsuits.
These non-tax goals are at the heart of most estate planning decisions for everyday clients. Advisors can now focus on accomplishing these goals without the unnecessary complication of estate tax planning.
What ATRA Didn’t Do
ATRA is also significant for what it doesn’t include. President Obama’s budget proposals (including the recently-released budget proposal for 2014) continue to include provisions that would curtail the use of taxpayer-friendly planning techniques. Specifically, the President would:
- Require a minimum term for grantor-retained annuity trusts (GRATs);
- Limit the duration of the generation-skipping transfer (GST) tax exemption;
- Include the assets of an intentionally-defective grantor trust in the grantor’s estate; and
- Impose additional consistency and reporting requirements relating to basis in property inherited from a decedent.
Whether any of these proposals will become law is a matter of speculation. It seems clear that the Obama administration will continue to propose these changes, especially in a time when the issue of tax reform pervades most political discussions. But for now, there are still opportunities for estate tax planning for taxpayers with estates that exceed the $5.25 million (2013) threshold.