Practical analysis for investment professionals
24 March 2014

Post-ATRA: The New Planning Paradigm for Wealthy Families

A little over a year ago, when President Obama signed the American Taxpayer Relief Act of 2012 (ATRA), wealthy families across the country heaved a collective sigh of relief. The reason, as many of you already know, is that Congress permanently set the estate and gift tax exemptions at $5 million, indexed for inflation. With indexing, the exemption will rise at a rate that means most Americans will continue to avoid paying any federal estate tax.

As one observer noted shortly afterward: “ATRA allows the largest permanent tax free transfer of assets since the inception of the estate tax.”

No wonder then that Samuel A. Donaldson, professor of law at Georgia State University College of Law, believes ATRA is “perhaps the most significant tax legislation in nearly 12 years.”

In a presentation at CFA Institute’s recent Wealth Management conference, Donaldson said it was important to reflect on wealth transfer strategies in this new era. What is the “new normal” of estate and gift tax planning under ATRA? What are the new planning paradigms?

As a result of ATRA, clients are going to go into one of three buckets, he said. What’s important for financial advisers (and the tax and estate attorneys they work with) to understand, is how this affects planning for the $5 million family that walks into the office.

“Our wealth transfer planning strategies have changed for that $5 million family,” Donaldson said. “And when the $8 million family comes into our office, we are actually using a completely different template for them than what we are using for the $5 million family. And when the $30 million family walks in, we are going to use a completely different template for them than the one we are going to use for either of the first two.”

Given the volume of information that Donaldson covered in a very short amount of time, we are taking a different approach with this post. What follows here is a lightly edited transcript of Donaldson’s remarks regarding the planning for these three buckets.

So, for those of you who missed the conference but are interested in the topic — or attended but couldn’t write fast enough — here you have it: Donaldson in his own words.

Bucket one families are the families where the husband and wife’s combined assets do not exceed one exclusion amount, combined they don’t exceed $5.34 million. This is the $4 million family that comes into your office. As recently as six or seven years ago, when a $4 million family came into your office you’d say, ‘You’re going to have to do the same kind of planning that a $40 million family is going to have to do, at least at a rudimentary level.’ Such is no longer the case, because for the people who are in bucket number one, estate and gift taxes aren’t a concern.

“Estate and gift taxes aren’t an issue any more. What’s the plan? Once upon a time, $4 million was bigger than a single exclusion amount, and you had to do some tax planning (e.g., a trust such as credit shelter trust, bypass trust, A-B trust). Now when those families come into the office you are free to say: ‘What do you want to do with the wealth?’ Because it won’t be driven by taxes so much anymore. Now when you have the discussion of ‘Do you leave the money outright to the surviving spouse? Or do you put it in trust for the benefit of the surviving spouse?’ you’re doing it for the old-fashioned reasons of forming a trust, and not for the tax reasons.

“And when you think about why would you choose outright versus trust? Why do they call it a trust? Because it supplies the thing that’s missing in the relationship. If you already trust the surviving spouse, and trust the surviving spouse’s acumen in managing the funds, you probably don’t need a trust if you are a bucket one family.

“By the same token, though, if you are worried that there could be favoritism of some beneficiaries over the other, that the spouse might be vulnerable to the claims of creditors, or to new paramours who may come into the picture, or the surviving spouse may not simply want to be in charge of managing a relatively affluent kind of estate, trusts then make sense.

“So step one is: You’ve got consider creditor protection, you’ve got to consider trust vs. outright, and you have to answer that question without regard to taxes.

“Step two, after you’ve made the decision outright or transfer, here’s the key tax planning principle: We absolutely, absolutely, absolutely have to make sure that there is a step-up in basis on the death of the surviving spouse.

“Of course we get a step-up in basis in the assets on the death of the first spouse, and if you’re lucky enough to be in a community property state, both halves of the community property get that step-up in basis on the death of the first spouse.

“But I want a step-up in basis on the death of the surviving spouse, too. If I make an outright gift of the assets to the spouse, no problemo, because to the extent the assets are still around, they are owned by the spouse, they are going to get the step-up in basis.

“But if I put those assets instead into an irrevocable trust, even if the spouse is the beneficiary of that trust, if it’s just an ordinary irrevocable trust, since those assets are not included in the surviving spouse’s gross estate, they don’t get a step-up in basis on her death.

“I will submit that when we do that kind of planning, where we fail to get that step-up in basis on the death of the surviving spouse, we are going to create a new class of junior beneficiaries called plaintiffs who are going to come after us and say, ‘Why was there not a step-up in basis when Mama died?’

“So what are the types of trusts that I can create for the benefit of a surviving spouse that ensures a step-up in the basis of those assets?

“For the bucket one clients, I want gross estate inclusion in the surviving spouse’s gross estate, because we are not going to pay any estate tax anyway. There are two different types of trusts.

“One is what’s called a 2056(b)(5) trust, after the Internal Revenue Code section, it’s also called a general power of appointment trust, it’s also a form trust that you probably will have to dig deep to find forms and samples of because we’ve lived for generations saying, ‘You don’t want this kind of trust because it causes gross estate inclusion,’ and we are always trying to avoid that for these people. The general power of appointment trust simply has a trust with all the regular dispositive provisions that you would want, but it has a little provision that gives the spouse a testamentary power to appoint all or any portion of the trust at her death to the creditors of her estate.

“It is an optional power, she doesn’t have to exercise it. Indeed, what’s the likelihood that she is going to prefer her creditors to the kids and to the grandkids and to the other beneficiaries? Highly unlikely that she would ever exercise that power. But boy, under Section 2041 of the Internal Revenue Code, if you die holding a power to appoint property in the favor of the creditors of your estate, that’s a general power of appointment, which means all of the property subject to that power, everything sitting inside the trust, is included in your gross estate for estate tax purposes, and under 2014(b) — BINGO! — that’s what gives you your step-up in basis for income tax purposes. I am deliberately engineering gross estate inclusion because I want the step-up in basis. And a 2056(b)(5) general power of appointment trust gets me that.

“Second alternative: a qualified terminable interest property trust, or QTIP trust. All of us are familiar with QTIP trusts because we’ve been doing that for the last few generations — that was how you were supposed to get a marital deduction for assets that were passing into the trust even though technically the spouse’s interest was going to terminate at her death. You made qualified terminable interest property election with respect to that property.

“The consequence always was that under Section 2044, the assets of a QTIP trust are included in the surviving spouse’s gross estate. DING! DING! DING! That’s what we want now. Are those assets being included in the surviving spouse’s gross estate? If you can’t find a form that has that testamentary general power of appointment, or you and the attorney that you are working with are too nervous about drafting what that kind of clause would look like, or you worry about its exercise, just do a QTIP trust and you get your step-up in basis.

“Third component of planning for the bucket one clients: I am going to make a portability election. It’s a protective portability election. Why? Because the one time I don’t for that bucket one client on the death of the first spouse, the surviving spouse is going to hit Powerball, and is suddenly going to have a taxable estate where it would benefit to have that unused exclusion from the death of the first spouse. So I’m going to make that portability election, I’m going to file a Form 706.

“If you are filing a Form 706 just for portability purposes, there is actually simplified reporting requirements so it isn’t as expensive and shouldn’t be as expensive as a regular Form 706, but it’s a cheap insurance policy because just in case the surviving spouse comes into wealth, just in case that $4 million estate explodes into a $40 million estate and we wish we would have had the unused exclusion of the husband, we’ve got it. So for cheap insurance, I am going to do that.

Bucket two is the married couple with combined assets that is between one and two exclusion amounts, so between $5.34 million and $10.68 million; the $8 million family. The $8 million family presents different issues and thus a different planning template in your mind for the basics of how their estate plan will be structured.

“These are the ones that are fun. What do you do when the $8 million estate comes in?

“Depending on what happens, the portability election may be enough. Our traditional model would come in and say ‘well geez, if you have an estate that’s too big for just one spouse’s exclusion amount, you have to create a credit shelter trust, or a bypass trust, or an AB trust, or whatever you call it, so you can use each spouse’s exclusion’ and you would make sure that if you weren’t living in a community property state, you would make sure that you would divide up assets so that you could fully fund a credit shelter trust on the death of the husband, and then the wife would have the assets — her own assets — to be able to apply her exclusion to, and that’s how you are going to make sure you are not paying any tax.

“And of course we always liked the credit shelter trust because everything you put in to that trust, if it appreciates in value, you never pay any transfer taxes on it, because of course none of the assets in the credit shelter trust are included in the surviving spouse’s gross estate.

“The $8 million estate might benefit from the traditional credit shelter trust. On the other hand, though, credit shelter trusts are a bit of a hassle. They’re a little bit more expensive to create, and if you have a portability election, that says, ‘Well to the extent that the spouse doesn’t fully utilize the exclusion amount on his death, we can port over his unused amount over to her,’ she can have a $10.68 million exclusion amount. Maybe that’s enough.

“I can actually identify some situations in which I think a portability election is better than a credit shelter trust. It’s not just a safety net for the people who fail to plan.

“For example: If wife is going to die shortly after husband such that there’s not going to be a whole lot of appreciation anyway, why go to the hassle and trouble of putting everything into the trust when ultimately you didn’t need to do it because the portability election, that amount exemption, amount adjusts for inflation, so you can deal with it accordingly.

“If the bulk of the estate consists of assets that don’t sit well in a credit shelter trust, and here I’m thinking pension plans and homes don’t usually work well in credit shelter trusts because we can’t get as long of a stretch out, we lose the Section 121 exclusion and various other things, if that’s the bulk of the estate, portability isn’t nearly as discriminating against those assets. It might be a much better way to go.

“Here’s the deal, though. How am I supposed to know when the clients come into the office in their mid-40s healthy . . . I don’t know when they are going to die. I don’t know what the time gap is going to be between the death of the first spouse and the death of the second spouse. I don’t know what tax rates are going to be at that time. I don’t know what the likelihood of appreciation is going to be at that time. And yet they expect me to make a choice between credit shelter trust and portability? Well, you don’t have to.

“If your plan would have been leave everything outright, here’s what you do: You leave everything outright but then provide a mechanism, either under the trust or under the will, that if the surviving spouse disclaims that outright bequest to any extent, the disclaimed amount passes into a credit shelter trust. That way if you want the credit shelter trust, you disclaim everything and it goes into the credit shelter trust and you’re fine.

“If you want portability for everything, you just hold onto the assets and you make your portability election, and everything is fine.

“If you want a little bit of both, you can do a little bit of both. It gives you the flexibility.

“If your choice would be ‘I’m going to do a trust no matter what,’ then you create something called a Clayton QTIP — an ordinary QTIP trust that has a clause in it that says, ‘To the extent the executor doesn’t make a QTIP election with particular assets, those unelected assets port over into a credit shelter trust.’ Then again, if I want portability, I leave everything inside the QTIP, and it takes care of itself. If I want a credit shelter trust, I don’t make a QTIP election, and all of those assets pass over into the credit shelter trust. And if I want a little bit of both, I’ve got a little bit of both.

Bucket three is for the combined wealth in excess of $10.68 million.

“The planning is the same for what we used to do for the $5 million family. I would submit that zeroed out gifting is probably even more important there, because any unused exclusion represents free basis step-up on the death of the surviving spouse; grantor trusts probably continue to be very effective wealth transfer devices for those very high-net-worth individuals now if anything else, because we can probably further avoid the application of the 3.8% surcharge, particularly as regards closely held business interests.”

NOTE: If you would like to read more about this subject, Bessemer Trust’s Steve R. Akers has written a very comprehensive article (available as a PDF): Estate Planning: Current Developments and Hot Topics.


Please note that the content of this site should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute.

Photo credit: ©iStockphoto.com/Pgiam

About the Author(s)
Lauren Foster

Lauren Foster is a content director on the professional learning team at CFA Institute and host of the Take 15 Podcast. She is the former managing editor of Enterprising Investor and co-lead of CFA Institute’s Women in Investment Management initiative. Lauren spent nearly a decade on staff at the Financial Times as a reporter and editor based in the New York bureau, followed by freelance writing for Barron’s and the FT. Lauren holds a BA in political science from the University of Cape Town, and an MS in journalism from Columbia University.

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