Matrimonial Planning and the 2012 Tax Act

Very few clients will face a federal estate tax in light of the permanent high inflation adjusted exemption, but many of those otherwise wealthy clients will face higher income taxes, as will their heirs. So the focus of most estate plans will shift from avoiding federal estate tax to maximizing the increase in income tax basis (basis “step-up”) on death. Assets included in a decedent's estate will have their income tax basis (generally the amount paid) increased to the fair value at death.

To achieve this goal, a number of changes are occurring in how testamentary trusts are planned or drafted. There will be a greater tendency to use outright marital bequests or bequests to trusts that qualify for the estate tax marital deduction. The most common of these trusts is a Qualified Terminable Interest Property (QTIP) trust. The assets in a marital trust are included in the taxable estate of the surviving spouse and therefore qualify for an increase in tax basis on the second spouse's death. The shift in the nature of how testamentary trusts will be planned, i.e., from bypass trusts that may have included children ' even children from prior marriages ' as beneficiaries, to marital trusts that mandate an annual payout of income to the surviving spouse, will change the dynamic of many matrimonial actions.

When more traditional bypass trusts are still used, and they often will be, some will begin to include new provisions to address basis step-up concerns. One approach is to authorize an independent trustee to distribute appreciated assets to the surviving spouse/beneficiary so that those assets will be included in his or her estate for step-up purposes. Another approach is to grant the surviving spouse a general power of appointment over appreciated assets or portions of a trust to designate to whom the assets of the trust may be distributed. This, too, will cause estate inclusion. Matrimonial practitioners need to be cognizant of these changes in drafting estate planning provisions in prenuptial agreements, and in evaluating trusts post-divorce.

Trust Beneficiaries

Higher income tax brackets and the new Medicare tax on passive investment income have created the widest spread between maximum effective tax brackets and the lowest effective tax brackets. To take advantage of lower rates it will become more common to see entire family lines, not just spouses, named as beneficiaries of trusts. This, when combined with a discretionary distribution power (i.e., the power to sprinkle income to any of the larger class of beneficiaries) will provide trustees the flexibility to shift income to the lowest bracket family members. Again, matrimonial practitioners need to be cognizant of these changes in drafting estate planning provisions in prenuptial agreements and in evaluating trusts post-divorce.

Trust Distribution of Capital Gains

If a trustee of an irrevocable non-grantor trust distributes income to a particular beneficiary, the income of the trust will generally flow out to, and be taxed to, that beneficiary. That is the theory behind the inclusion of a broader array of family members as beneficiaries of trusts discussed in the preceding paragraph. However, this rule often will not apply to the distribution of capital gains. Many trusts prohibit the distribution of capital gains and many trusts and state laws define capital gains as allocable to corpus. In order to provide trustees the power to distribute capital gains and move the capital gains tax outside of the trust to a lower tax bracket beneficiary, many new trusts are being drafted with express provisions to permit this. It might be possible when a beneficiary of such a trust is later divorced that the language in the trust instrument permitting principal distributions and capital gains distributions may open a wider door to attacking that interest.

Conclusion

The 2012 tax act, ATRA, and the Medicare tax on passive investment income have changed the landscape of estate planning forever and in profound ways. Each of these implications can have important implications to matrimonial practitioners at many different phases of 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, who 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.

Part One of this article, which ran in last month's issue, presented an overview and discussion of the impact of exemptions and portability offered by the American Taxpayer Relief Act of 2012 (ATRA), which became effective Jan. 1, 2013. The conclusion herein discusses the impact of higher tax rates.

Impact of Higher Tax Rates

Maximizing Basis

Very few clients will face a federal estate tax in light of the permanent high inflation adjusted exemption, but many of those otherwise wealthy clients will face higher income taxes, as will their heirs. So the focus of most estate plans will shift from avoiding federal estate tax to maximizing the increase in income tax basis (basis “step-up”) on death. Assets included in a decedent's estate will have their income tax basis (generally the amount paid) increased to the fair value at death.

To achieve this goal, a number of changes are occurring in how testamentary trusts are planned or drafted. There will be a greater tendency to use outright marital bequests or bequests to trusts that qualify for the estate tax marital deduction. The most common of these trusts is a Qualified Terminable Interest Property (QTIP) trust. The assets in a marital trust are included in the taxable estate of the surviving spouse and therefore qualify for an increase in tax basis on the second spouse's death. The shift in the nature of how testamentary trusts will be planned, i.e., from bypass trusts that may have included children ' even children from prior marriages ' as beneficiaries, to marital trusts that mandate an annual payout of income to the surviving spouse, will change the dynamic of many matrimonial actions.

When more traditional bypass trusts are still used, and they often will be, some will begin to include new provisions to address basis step-up concerns. One approach is to authorize an independent trustee to distribute appreciated assets to the surviving spouse/beneficiary so that those assets will be included in his or her estate for step-up purposes. Another approach is to grant the surviving spouse a general power of appointment over appreciated assets or portions of a trust to designate to whom the assets of the trust may be distributed. This, too, will cause estate inclusion. Matrimonial practitioners need to be cognizant of these changes in drafting estate planning provisions in prenuptial agreements, and in evaluating trusts post-divorce.

Trust Beneficiaries

Higher income tax brackets and the new Medicare tax on passive investment income have created the widest spread between maximum effective tax brackets and the lowest effective tax brackets. To take advantage of lower rates it will become more common to see entire family lines, not just spouses, named as beneficiaries of trusts. This, when combined with a discretionary distribution power (i.e., the power to sprinkle income to any of the larger class of beneficiaries) will provide trustees the flexibility to shift income to the lowest bracket family members. Again, matrimonial practitioners need to be cognizant of these changes in drafting estate planning provisions in prenuptial agreements and in evaluating trusts post-divorce.

Trust Distribution of Capital Gains

If a trustee of an irrevocable non-grantor trust distributes income to a particular beneficiary, the income of the trust will generally flow out to, and be taxed to, that beneficiary. That is the theory behind the inclusion of a broader array of family members as beneficiaries of trusts discussed in the preceding paragraph. However, this rule often will not apply to the distribution of capital gains. Many trusts prohibit the distribution of capital gains and many trusts and state laws define capital gains as allocable to corpus. In order to provide trustees the power to distribute capital gains and move the capital gains tax outside of the trust to a lower tax bracket beneficiary, many new trusts are being drafted with express provisions to permit this. It might be possible when a beneficiary of such a trust is later divorced that the language in the trust instrument permitting principal distributions and capital gains distributions may open a wider door to attacking that interest.

Conclusion

The 2012 tax act, ATRA, and the Medicare tax on passive investment income have changed the landscape of estate planning forever and in profound ways. Each of these implications can have important implications to matrimonial practitioners at many different phases of 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, who 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.