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Tax Proposal would Mean the Practical End of the Most Popular Estate Planning Trust


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A Senate bill would allow the unused portion of the first-to-die’s estate tax exemption to be used by the second-to-die spouse. This eliminates the primary reason for most estate planning trusts. The bill makes other important estate planning changes, and makes permanent many of the existing rates and tax benefits outside of the estate planning area that are scheduled to sunset. As expected, outside of the estate planning changes, those making more than $171,550 will not get these tax goodies.
The Taxpayers Certainty and Relief Act of 2009 (S 722) was introduced by Senate Finance Committee Chairman Max Baucus (D-MT). S 722 contains the following important changes to the estate tax:

1. Section 301 of the Bill makes permanent (i) the 2009 estate tax exemption of $3.5 million,(ii) the 2009 generation-skipping tax exemption of $3.5 million, and (iii) the 45% top tax rate, instead of the changes to these amounts that are currently scheduled to take effect. Beginning in 2011, the $3.5 million exemptions would be indexed for inflation.

2. Section 301 of the Bill unifies the gift and estate tax exemptions at the $3.5 million – Although the estate and gift tax exemptions were once set at the same amount, these two exemptions were decoupled, causing the odd result that one could give to heirs without tax more than one could give during life. With this change, one’s gifts over the annual exclusion will reduce the amount one can give to heirs at death, with the combined limit being $3.5 million.

3. Section 302 of the Bill allows the unused portion of the first-to-die spouse’s $3.5 million tax exemption to be portable to the second-to-die spouse. This is an important change that would allow the second-to-die spouse to use whatever potion of the $3.5 million tax exemption that the first-to-die spouse did not use. Currently, any portion of the exemption amount that is not used by the first-to-die spouse is lost. Consequently, under S. 722, up to $7 million can be transferred free of estate taxes upon the death of the second spouse with only a simple election on the estate tax return.

Currently, the objective of most credit shelter or bypass trusts (which also go by other names) is to ensure the full value of the tax exemption belonging to the first-to-die is not lost. Unless other objectives are required (more on this in the next paragraph), bypass trusts would no longer needed under S 722.

Irrevocable trusts can still useful to obtain management control and protection from creditors. Further, if the assets being transferred are appreciating and the value of the estate is certain to be sufficient to meet the needs of the surviving spouse, then it may still make sense to remove those assets from the estate at an earlier time. However, from a practical viewpoint, this purpose is not sufficient for most married couples to create a bypass trust because:

1. With a unified estate and gift tax exemption, there is no reason to wait to make transfers only in connection with a death event. Lifetime gifts will accomplish the same objective. A trust may still be desired to retain some control over the gift, but this need not incorporate a bypass trust.

2. Any trust requires additional administration and forfeits some control over the assets placed into the trust. For all but the most affluent, these disadvantages will probably outweigh the need to remove appreciating assets from the estate. For those who have sufficient wealth that these disadvantages are not a concern, lifetime gifts (see #1 immediately above) will probably be preferred.

S 722 does not make legislative changes to valuation discounts commonly used to reduce the value transfers. The Certain Estate Tax Relief Act of 2009 (H.R. 436) introduced in January 2009 by House Ways and Means Committee member Earl Pomeroy (D-ND) would statutorily eliminate the use of such discounts. H.R. 436 also is different from S 722 in that the House bill adds a 5% surtax to the 45% rate for estates in the $10 million to $41.5 million range. See this article for a further discussion on HR 436 and its chances for passage.

Tax Proposals outside of the Estate Planning Area

S 722 also makes other changes to address phase-out tax provisions. The scope of these provisions would take substantial space to address, and are beyond the scope of this article. Although exceptions and complications exist, these other changes generally (i) make permanent tax provisions that were scheduled to be phased-out, and (ii) for more affluent taxpayers, increase tax rates to those that existed in the Clinton era.

These other tax proposals include:

1. Make permanent the 2008 alternative minimum tax personal exemptions, with these amounts being indexed for inflation. These exemptions are $46,700 for individuals, and $70,950 for those with the married filing jointly status.

2. Individual tax rates are made permanent for the current 28% and lower tax brackets. Those in the 33% and 35% federal two brackets get a tax increase.

3. Current dividend and capital gain tax rates would be made permanent for taxpayers in the 28% or lower tax brackets. Again, those in the upper two brackets get a tax increase.

4. Various earned income, child, and child care credits will be made permanent at the current levels.

5. Marriage penalty protections that were passed as part of the 2001 tax cuts would be made permanent.

6. Adoption Credit and adoption assistance programs to make the $10,000 credit per child permanent, in $10,000 increments.

The 33% tax bracket currently starts at $171,550. The sponsors of the legislation indicate “that would make existing tax breaks permanent for working families and individuals”. According to the PR machine supporting these various bills, those making more than $171,550 (and therefore are in the 33% and 35% tax brackets) must not be “working”.

ABOUT THE AUTHOR: David Nolte
Mr. Nolte has 30 years experience in financial and economic consulting. He has served as an expert witness in over 100 trials. He has also regularly served as an arbitrator. Mr. Nolte has achieved the following credentials: CPA, MBA, CMA and ASA.

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While every effort has been made to ensure the accuracy of this publication, it is not intended to provide legal advice as individual situations will differ and should be discussed with an expert and/or lawyer.
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