Matrimonial Planning and the 2012 Tax Act

The gift and estate tax exemption is the value of assets that a taxpayer can gift or bequeath, in aggregate. That amount has varied significantly since the 2001 tax act. The uncertainty as to what the exemption amount would be in the future drove much of the estate-planning activity. That uncertainty has been permanently resolved. ATRA has fixed the exemption at $5 million. And that amount is inflation-adjusted annually. Those adjustments are significant. In 2011, the inflation adjustment was $120,000. This year, it was $130,000. This permanent high exemption has changed the face of estate and asset protection planning.

Just as important, modern trust drafting techniques have evolved and become more commonplace as estate planners guide clients to take maximum advantage of this high exemption. These will affect prenuptial agreements and divorces, but should also mandate a more significant involvement by matrimonial practitioners when new estate planning is undertaken, not only at the time of a prenuptial agreement or divorce.

2. Portability

Portability has been made a permanent feature of the estate tax system. It permits a deceased spouse's exemption to be “ported” to the surviving spouse.
This change too will have profound implications for matrimonial planning. One of the most obvious implications, which is addressed in more detail below, is that provisions addressing portability will become required in prenuptial agreements. It will also change how most clients may choose to hold assets, which will have profound implications on the quantum of assets that may retain the protective status of immune property.

3. Income Taxes

ATRA also made significant changes to the income taxation of high-income taxpayers. Income tax rates have been increased at higher levels, the tax benefits of itemized deductions and personal exemptions can be phased out, and a new 3.8% Medicare tax on passive investment income became effective (this latter change was enacted prior to ATRA but became effective Jan. 1, 2013, the same date as most ATRA changes). These changes have already affected how many trusts are structured to facilitate taking advantage of lower family income tax rates. These structural changes, which will grow more common, will affect matrimonial negotiations for all families so affected.

Exemption Impact

Ignoring Planning

One of the most likely consequences to follow from the new high-exemption amounts is that many clients will simply ignore estate planning. With such high-exemption amounts, clients domiciled in states that do not have an estate tax will often assume that they do not need planning. That will mean less rational planning, fewer trusts (see below), and planning that will more frequently be completed by general practice attorneys and even online websites like www.legalzoom.com. Without the fear of the confiscatory federal estate tax, the number of general practice lawyers handling planning and drafting will increase, and more clients will opt for cheap do-it-yourself approaches, because they think there will not be a tax consequence. The result will be many clients with far worse planning, dispositive schemes that violate prenuptial agreements, trusts that are defective or simply unworkable, and worse.

SLATs and DAPTs

The evolution of modern trust drafting compounded by the new high exemptions will result in a growing number of more sophisticated trusts for those wealthier clients who do engage in planning. The permanent exemptions justify a more comprehensive approach to estate and trust planning. Two general types of trusts that may receive the most use are spousal lifetime access trusts (SLATs) and Domestic Asset Protection Trusts (DAPTs).

SLATs are akin to the bypass trusts that have commonly been used at the core of most wills and estate plans for decades, but with some “twists” that practitioners will need to understand. Why will these trusts grow in popularity among the moderate-wealth and wealthier clients? Because the estate tax is permanent, asset protection worries remain, modern trust drafting approaches (see below) are becoming more widespread, and many states that have decoupled from the federal estate tax system do not have a gift tax.

Thus, in states like New York, New Jersey and Massachusetts, for example, a client can gift assets to an irrevocable trust before death and simply avoid state estate tax. Given the asset protection benefits these trusts afford, growth is likely.

The technique, and matrimonial planning implications, can be illustrated as follows. In a SLAT, the husband may establish a trust for the benefit of the wife during their lifetimes. The incentives to create and fund these trusts during life rather than in wills at death are asset protection during peak earning years (which often are also peak risk years). Important, for the many clients that reside in the approximately 20 decoupled states, funding trusts during lifetime (subject to gift tax considerations in Connecticut and Minnesota, the two states which have them) will grow assets outside state estate tax systems.

The modern SLAT will differ, however, in important ways from the more traditional bypass trust. Practitioners will need to address these nuances when negotiating divorces. Very important, matrimonial practitioners should more commonly be advising clients where either or both spouses are engaging in SLAT planning because of the potentially significant matrimonial implications of these trusts. Estate planners creating trusts with certain types of clauses may owe an obligation to their clients to recommend that each retain independent matrimonial counsel before implementing this type of plan. Consider:

• To maximize income tax planning options (see below), most modern SLATs will include discretionary distribution provisions that could benefit all descendants as current beneficiaries, not merely the spouse. Consider the difficulties (impossibility) of a spouse being able to claim any rights to distributions from such a trust post-divorce.
• A growing number of wealthy ' and even moderately wealthy ' families establish these trusts in trust “friendly” jurisdictions whose laws are extremely supportive of trust planning (meaning more difficult to pierce in a divorce). The most common of these states are Alaska, Delaware, Nevada and South Dakota. Dealing with the jurisdictional issues will make any matrimonial matter more complex and costly (unless of course any challenges to the trust are simply forgone).
• To create nexus to a trust-friendly state, these trusts will name an institutional trustee. That will greatly increase the likelihood that the trust will be administered properly, eliminating the ability of many family trustees to challenge a trust by alleging gross mismanagement of trust affairs.
• It is becoming more common to see “floating spouse” clauses in these trusts. If that type of clause appears, the ex-spouse may be removed as a permissible beneficiary, thereby cutting off any potential access to the trust.
• These trusts are invariably structured as “grantor” trusts, which means the grantor is responsible for the income tax on the trust earnings. If the couple divorces, the husband may continue to be responsible for the income tax on the trust, benefiting the now ex-wife.
• These trusts often include a multitude of fiduciary functions, and other power holders. There might be a general or administrative trustee, a separate distribution trustee, another person designated to make investment decisions in the capacity as investment trustee. There might be a person given powers to replace trustees and change the situs of the trust. In order to achieve grantor trust status, someone might be designated with the power to loan trust assets, swap trust assets or other powers. In the context of a divorce, practitioners might be advised to endeavor to negotiate the replacement of certain of these fiduciaries, or even the relinquishment of some of the powers involved. If both spouses created these trusts (one for the other), which is also common (but far from universal), the negotiations might entail resignations from each ex-spouse's trust.

DAPTs are self-settled trusts for which the grantor is also a discretionary beneficiary. The timing and manner in which the grantor may appear as a beneficiary arises in a host of different ways, depending on client preference and draftsperson style. These trusts will be established with greater frequency to accomplish the goals of asset protection, minimizing state estate tax and avoiding an estate's becoming subject to the federal estate tax (i.e., maintaining the estate below the federal exemption threshold). Many of the same considerations noted above for SLATs may apply to evaluating the impact of these trusts in a prenuptial or divorce context.

However, a growing use of DAPTs, one that is likely to accelerate and with which more matrimonial practitioners should gain familiarity, is the use of a DAPT in lieu of (or to backstop) a prenuptial agreement. If a client transfers assets to an irrevocable trust prior to marriage, those assets will be far more difficult to reach in a divorce as compared to assets that are simply retained in that client's name as immune assets. The permanent high exemption should make this a far more common fixture of premarital planning.

Portability Impact

Prenuptial Agreements

Portability permits a deceased spouse's estate to transmit, or “port,” to the surviving spouse the entirety of that deceased spouse's unused federal estate tax exemption. That amount in 2013 is $5,250,000 and it will increase in future years by an inflation adjustment. The example below illustrates how some practitioners have addressed this matter, and some of the issues they overlook. A later example illustrates an even more advantageous and comprehensive approach that practitioners should consider.

Example One: An elderly woman has a net worth of $10 million. She is contemplating marrying a man much older than she, who has very modest assets. On his death, she anticipates inheriting his unused estate tax exemption of $5,250,000 and using it to protect her own estate for her children. Critical to these goals is whether her fianc' does in fact have a $5,250,000 unused exemption. That means that he must not have made any prior taxable gifts. Representations to that effect and exhibits of any prior gift documentation and gift tax returns may be essential to attach to the prenuptial agreement to protect this important financial interest of the wife. But more is required. On the husband's death, the wife will not be able to inherit his unused exemption (referred to as the Deceased Spouse Unused Exemption, or DSUE) even if it does exist, unless the husband's estate meets the requirements to port that exemption to her.

The requirements are to file a federal estate tax return, Form 706, that is complete and on a timely basis, and which does not opt out of porting his exemption. Absent an express agreement, the husband might just designate his children as his executors and they may choose because of the small size of his estate not to file a federal estate tax return. Why should they incur the cost to benefit a new spouse's children? So a further provision addressing the payment of these expenses will commonly be negotiated. A better understanding of how estate planning in the new post-ATRA environment will actually be handled is important to negotiate a prenuptial agreement more advantageously. A somewhat different example below illustrates this point.

Example Two: An elderly woman has a net worth of $15 million. She is contemplating marrying a man who has very modest assets. After the marriage, they will live in New York, which has decoupled from the federal estate tax system and has a mere $1 million exemption. New York, however, has no gift tax. If the prenuptial provisions described above are used, the wife might in fact inherit the husband's unused exemption amount. But if she bequeaths her estate at death, there will be a substantial New York estate tax because portability does not apply for state estate tax purposes in any state at present. A better approach would be for the wife, after the marriage, to make a $10 million gift to a trust for her children, and through a tax election called “gift splitting,” use her new husband's exemption to avoid any current tax.

The husband's willingness to use his gift exemption in this manner, as well as the existence of that gift exemption (i.e., corroboration of no prior use of his exemption) is essential. This gift would use up almost all of both of their exemptions, grow the assets so given outside their taxable estates, and completely avoid any New York estate tax on the second death.

Title to Assets in Estate Planning

A common step for almost every estate plan had been to divide assets approximately equally between spouses. This was done so that whichever spouse died first, he or she would have assets sufficient to fund a bypass trust under his or her will. Often, when this was done, the juggling of the title to assets was handled without regard to provisions in any existing prenuptial agreement. In many cases there was no prenuptial agreement, and estate planners simply advised clients to retitle what had been separate or immune assets into the other spouse's name. Thus, basic and common estate planning was often at odds with prudent matrimonial planning. With portability, this conflict has to a degree been obviated. Now, it is irrelevant in whose name assets are titled for purposes of using the couple's estate tax exemption. Whichever spouse dies first, if there are inadequate assets to fund a bypass trust in that spouse's name, the deceased spouse's unused exemption, or DSUE, can simply be ported to the surviving spouse.

Reduced Use of Trusts

As noted above in the discussion of the higher exemption, many clients will simply ignore estate planning because they will not view themselves as facing an estate tax risk that requires planning. Similarly, of those clients who do address planning, many will refuse to accept the cost and complexity of trusts because portability will not require it. The consequence of this will be simpler outright bequests under many wills. When a surviving spouse establishes a new relationship, assets that would have more commonly been protected by trusts under the first to die spouse's will (or revocable trust) will be exposed to the reach of the new paramour. Practitioners should endeavor to educate clients about the increased need for living together agreements and prenuptial agreements in light of what will undoubtedly become a trend to poorer planning for most clients.

Next month, we conclude this article with a discussion of higher tax rates and their impact on marital planning.

Martin M. Shenkman, CPA, MBA, PFS, AEP, JD, a member of this newsletter's Board of Editors, is an attorney in private practice in Paramus, NJ, and New York City. He concentrates on estate and closely held business planning, tax planning, and estate administration. He is the author of more than 40 books and 800 articles.

In Jan. 1, 2013, Congress enacted the American Taxpayer Relief Act of 2012 (ATRA), which will have a profound impact on several significant areas of matrimonial practice. Although the changes are likely well known at this stage, the first part of the article herein provides a brief overview to set the foundation for a discussion of the practical implications of the changes fo matrimonial practitioners. Then it addresses the impact of exemptions and portability. The conclusion, which will appear in next month's issue, discusses the impact of higher tax rates.

Overview of the Impact of ATRA on Matrimonial Matters

1. Exemption

The gift and estate tax exemption is the value of assets that a taxpayer can gift or bequeath, in aggregate. That amount has varied significantly since the 2001 tax act. The uncertainty as to what the exemption amount would be in the future drove much of the estate-planning activity. That uncertainty has been permanently resolved. ATRA has fixed the exemption at $5 million. And that amount is inflation-adjusted annually. Those adjustments are significant. In 2011, the inflation adjustment was $120,000. This year, it was $130,000. This permanent high exemption has changed the face of estate and asset protection planning.

Just as important, modern trust drafting techniques have evolved and become more commonplace as estate planners guide clients to take maximum advantage of this high exemption. These will affect prenuptial agreements and divorces, but should also mandate a more significant involvement by matrimonial practitioners when new estate planning is undertaken, not only at the time of a prenuptial agreement or divorce.

2. Portability

Portability has been made a permanent feature of the estate tax system. It permits a deceased spouse's exemption to be “ported” to the surviving spouse.
This change too will have profound implications for matrimonial planning. One of the most obvious implications, which is addressed in more detail below, is that provisions addressing portability will become required in prenuptial agreements. It will also change how most clients may choose to hold assets, which will have profound implications on the quantum of assets that may retain the protective status of immune property.

3. Income Taxes

ATRA also made significant changes to the income taxation of high-income taxpayers. Income tax rates have been increased at higher levels, the tax benefits of itemized deductions and personal exemptions can be phased out, and a new 3.8% Medicare tax on passive investment income became effective (this latter change was enacted prior to ATRA but became effective Jan. 1, 2013, the same date as most ATRA changes). These changes have already affected how many trusts are structured to facilitate taking advantage of lower family income tax rates. These structural changes, which will grow more common, will affect matrimonial negotiations for all families so affected.

Exemption Impact

Ignoring Planning

One of the most likely consequences to follow from the new high-exemption amounts is that many clients will simply ignore estate planning. With such high-exemption amounts, clients domiciled in states that do not have an estate tax will often assume that they do not need planning. That will mean less rational planning, fewer trusts (see below), and planning that will more frequently be completed by general practice attorneys and even online websites like www.legalzoom.com. Without the fear of the confiscatory federal estate tax, the number of general practice lawyers handling planning and drafting will increase, and more clients will opt for cheap do-it-yourself approaches, because they think there will not be a tax consequence. The result will be many clients with far worse planning, dispositive schemes that violate prenuptial agreements, trusts that are defective or simply unworkable, and worse.

SLATs and DAPTs

The evolution of modern trust drafting compounded by the new high exemptions will result in a growing number of more sophisticated trusts for those wealthier clients who do engage in planning. The permanent exemptions justify a more comprehensive approach to estate and trust planning. Two general types of trusts that may receive the most use are spousal lifetime access trusts (SLATs) and Domestic Asset Protection Trusts (DAPTs).

SLATs are akin to the bypass trusts that have commonly been used at the core of most wills and estate plans for decades, but with some “twists” that practitioners will need to understand. Why will these trusts grow in popularity among the moderate-wealth and wealthier clients? Because the estate tax is permanent, asset protection worries remain, modern trust drafting approaches (see below) are becoming more widespread, and many states that have decoupled from the federal estate tax system do not have a gift tax.

Thus, in states like New York, New Jersey and Massachusetts, for example, a client can gift assets to an irrevocable trust before death and simply avoid state estate tax. Given the asset protection benefits these trusts afford, growth is likely.

The technique, and matrimonial planning implications, can be illustrated as follows. In a SLAT, the husband may establish a trust for the benefit of the wife during their lifetimes. The incentives to create and fund these trusts during life rather than in wills at death are asset protection during peak earning years (which often are also peak risk years). Important, for the many clients that reside in the approximately 20 decoupled states, funding trusts during lifetime (subject to gift tax considerations in Connecticut and Minnesota, the two states which have them) will grow assets outside state estate tax systems.

The modern SLAT will differ, however, in important ways from the more traditional bypass trust. Practitioners will need to address these nuances when negotiating divorces. Very important, matrimonial practitioners should more commonly be advising clients where either or both spouses are engaging in SLAT planning because of the potentially significant matrimonial implications of these trusts. Estate planners creating trusts with certain types of clauses may owe an obligation to their clients to recommend that each retain independent matrimonial counsel before implementing this type of plan. Consider:

• To maximize income tax planning options (see below), most modern SLATs will include discretionary distribution provisions that could benefit all descendants as current beneficiaries, not merely the spouse. Consider the difficulties (impossibility) of a spouse being able to claim any rights to distributions from such a trust post-divorce.
• A growing number of wealthy ' and even moderately wealthy ' families establish these trusts in trust “friendly” jurisdictions whose laws are extremely supportive of trust planning (meaning more difficult to pierce in a divorce). The most common of these states are Alaska, Delaware, Nevada and South Dakota. Dealing with the jurisdictional issues will make any matrimonial matter more complex and costly (unless of course any challenges to the trust are simply forgone).
• To create nexus to a trust-friendly state, these trusts will name an institutional trustee. That will greatly increase the likelihood that the trust will be administered properly, eliminating the ability of many family trustees to challenge a trust by alleging gross mismanagement of trust affairs.
• It is becoming more common to see “floating spouse” clauses in these trusts. If that type of clause appears, the ex-spouse may be removed as a permissible beneficiary, thereby cutting off any potential access to the trust.
• These trusts are invariably structured as “grantor” trusts, which means the grantor is responsible for the income tax on the trust earnings. If the couple divorces, the husband may continue to be responsible for the income tax on the trust, benefiting the now ex-wife.
• These trusts often include a multitude of fiduciary functions, and other power holders. There might be a general or administrative trustee, a separate distribution trustee, another person designated to make investment decisions in the capacity as investment trustee. There might be a person given powers to replace trustees and change the situs of the trust. In order to achieve grantor trust status, someone might be designated with the power to loan trust assets, swap trust assets or other powers. In the context of a divorce, practitioners might be advised to endeavor to negotiate the replacement of certain of these fiduciaries, or even the relinquishment of some of the powers involved. If both spouses created these trusts (one for the other), which is also common (but far from universal), the negotiations might entail resignations from each ex-spouse's trust.

DAPTs are self-settled trusts for which the grantor is also a discretionary beneficiary. The timing and manner in which the grantor may appear as a beneficiary arises in a host of different ways, depending on client preference and draftsperson style. These trusts will be established with greater frequency to accomplish the goals of asset protection, minimizing state estate tax and avoiding an estate's becoming subject to the federal estate tax (i.e., maintaining the estate below the federal exemption threshold). Many of the same considerations noted above for SLATs may apply to evaluating the impact of these trusts in a prenuptial or divorce context.

However, a growing use of DAPTs, one that is likely to accelerate and with which more matrimonial practitioners should gain familiarity, is the use of a DAPT in lieu of (or to backstop) a prenuptial agreement. If a client transfers assets to an irrevocable trust prior to marriage, those assets will be far more difficult to reach in a divorce as compared to assets that are simply retained in that client's name as immune assets. The permanent high exemption should make this a far more common fixture of premarital planning.

Portability Impact

Prenuptial Agreements

Portability permits a deceased spouse's estate to transmit, or “port,” to the surviving spouse the entirety of that deceased spouse's unused federal estate tax exemption. That amount in 2013 is $5,250,000 and it will increase in future years by an inflation adjustment. The example below illustrates how some practitioners have addressed this matter, and some of the issues they overlook. A later example illustrates an even more advantageous and comprehensive approach that practitioners should consider.

Example One: An elderly woman has a net worth of $10 million. She is contemplating marrying a man much older than she, who has very modest assets. On his death, she anticipates inheriting his unused estate tax exemption of $5,250,000 and using it to protect her own estate for her children. Critical to these goals is whether her fianc' does in fact have a $5,250,000 unused exemption. That means that he must not have made any prior taxable gifts. Representations to that effect and exhibits of any prior gift documentation and gift tax returns may be essential to attach to the prenuptial agreement to protect this important financial interest of the wife. But more is required. On the husband's death, the wife will not be able to inherit his unused exemption (referred to as the Deceased Spouse Unused Exemption, or DSUE) even if it does exist, unless the husband's estate meets the requirements to port that exemption to her.

The requirements are to file a federal estate tax return, Form 706, that is complete and on a timely basis, and which does not opt out of porting his exemption. Absent an express agreement, the husband might just designate his children as his executors and they may choose because of the small size of his estate not to file a federal estate tax return. Why should they incur the cost to benefit a new spouse's children? So a further provision addressing the payment of these expenses will commonly be negotiated. A better understanding of how estate planning in the new post-ATRA environment will actually be handled is important to negotiate a prenuptial agreement more advantageously. A somewhat different example below illustrates this point.

Example Two: An elderly woman has a net worth of $15 million. She is contemplating marrying a man who has very modest assets. After the marriage, they will live in New York, which has decoupled from the federal estate tax system and has a mere $1 million exemption. New York, however, has no gift tax. If the prenuptial provisions described above are used, the wife might in fact inherit the husband's unused exemption amount. But if she bequeaths her estate at death, there will be a substantial New York estate tax because portability does not apply for state estate tax purposes in any state at present. A better approach would be for the wife, after the marriage, to make a $10 million gift to a trust for her children, and through a tax election called “gift splitting,” use her new husband's exemption to avoid any current tax.

The husband's willingness to use his gift exemption in this manner, as well as the existence of that gift exemption (i.e., corroboration of no prior use of his exemption) is essential. This gift would use up almost all of both of their exemptions, grow the assets so given outside their taxable estates, and completely avoid any New York estate tax on the second death.

Title to Assets in Estate Planning

A common step for almost every estate plan had been to divide assets approximately equally between spouses. This was done so that whichever spouse died first, he or she would have assets sufficient to fund a bypass trust under his or her will. Often, when this was done, the juggling of the title to assets was handled without regard to provisions in any existing prenuptial agreement. In many cases there was no prenuptial agreement, and estate planners simply advised clients to retitle what had been separate or immune assets into the other spouse's name. Thus, basic and common estate planning was often at odds with prudent matrimonial planning. With portability, this conflict has to a degree been obviated. Now, it is irrelevant in whose name assets are titled for purposes of using the couple's estate tax exemption. Whichever spouse dies first, if there are inadequate assets to fund a bypass trust in that spouse's name, the deceased spouse's unused exemption, or DSUE, can simply be ported to the surviving spouse.

Reduced Use of Trusts

As noted above in the discussion of the higher exemption, many clients will simply ignore estate planning because they will not view themselves as facing an estate tax risk that requires planning. Similarly, of those clients who do address planning, many will refuse to accept the cost and complexity of trusts because portability will not require it. The consequence of this will be simpler outright bequests under many wills. When a surviving spouse establishes a new relationship, assets that would have more commonly been protected by trusts under the first to die spouse's will (or revocable trust) will be exposed to the reach of the new paramour. Practitioners should endeavor to educate clients about the increased need for living together agreements and prenuptial agreements in light of what will undoubtedly become a trend to poorer planning for most clients.

Next month, we conclude this article with a discussion of higher tax rates and their impact on marital planning.

Martin M. Shenkman, CPA, MBA, PFS, AEP, JD, a member of this newsletter's Board of Editors, is an attorney in private practice in Paramus, NJ, and New York City. He concentrates on estate and closely held business planning, tax planning, and estate administration. He is the author of more than 40 books and 800 articles.