This year’s passing of a new tax law has raised many estate planning questions that require your consideration. At the end of 2012, the nation approached what was popularly known as the “fiscal cliff”, as the Bush-era tax cuts were set to expire on December 31st. If that had been allowed to happen, the applicable estate tax exclusion amount would have dropped from $5 million to $1 million per person, and the tax rate for most estates would have shot up to 55%.

Congress averted this with the last-minute passing of the American Taxpayer Relief Act on January 2nd, 2013, which made the Bush-era tax cuts permanent. The new law kept the estate tax exclusion amount at $5 million and also adjusted it for inflation. For 2013, the estate tax exclusion amount is $5.25 million. Additionally, the gift tax exclusion amount was also set at $5 million and is likewise adjusted for inflation.

What If We Had Gone Over the Fiscal Cliff?

If the American Taxpayer Relief Act had not been passed, it would have been rather easy for the average estate to surpass the applicable exclusion amount of $1 million dollars. When you consider that estate tax is levied upon the death benefits of life insurance proceeds, it is easy to see why many more estates would have been subject to estate taxes. The $1 million exclusion would also have affected 401(k)s and IRAs, which many estates contain. These assets are already subject to a deferred income tax. The deferred income tax would have been compounded by additional estate taxes if the estates had exceeded $1 million. Due to the uncertainty that surrounded the exemption amount being lowered to $1 million beginning in 2013, many estate plans were drafted with an eye towards a “preparing for the worst and expecting the best” scenario. Since the uncertainty regarding the amount of the estate tax exemption has now been resolved, many estate plans will need to be amended to reflect the new higher amount of the $5 million estate tax exemption. The following chart illustrates the changes in the estate tax exemption over the years.

As recently as November of 2012, President Obama proposed that the estate tax exemption amount be set at $3.5 million, with a 45% tax rate for estates that exceeded that amount. The new estate tax exclusion amount of $5 million was truly an unexpected blessing for the American taxpayer.

The Permanence of Portability

The Tax Relief Act of 2010 introduced the concept of “portability” regarding the unused portion of the estate tax exclusion of a predeceased spouse. To utilize this provision, an estate tax return must be filed. Portability was due to expire on December 31st, 2012, together with the estate tax exemption amount of $5 million. Consequently, many estate plans had to ignore it. However, the new Taxpayer Relief Act of 2013 makes the portability provision permanent.

Weighing Family Trusts Against Portability

Now that the concept of portability has been made permanent, its merits must be compared with the merits of family trusts that many estate plans include. If you are married, please review the Table of Contents of your living trust. You might find an Article that calls for a division of assets between a family trust, survivor’s trusts, or perhaps a QTIP trust. Many estate plans had to utilize family trusts because no one could guarantee that he or she would pass away before December 31st, 2012, to utilize the portability of the unused estate tax exclusion. Now, however, you have the option of using a family trust (also known as a bypass trust) or the portability provision (which involves filing an estate tax return upon the first spouse’s passing).

One of the advantages of the family trust is the step-up in basis for capital gains tax purposes for the assets that are transferred into it. Another advantage is that the family trust is an irrevocable trust and the first spouse to pass away can take comfort in knowing that the assets will transfer to the beneficiaries named by that spouse. Additionally, the assets in a family trust are protected from creditors. Another advantage is that should the assets in the family trust appreciate, they will not be subject to estate taxes. However, due to the increase in the estate tax exclusion amount to $5 million, many estate plans will need to be reviewed to determine if a family trust is still appropriate based on the facts of each individual estate. In some instances, a family trust may be overly complex for the estate plan. Please do not hesitate to call our office.