The Pros And Cons of Succession Planning for Financial Advisers
It wasn’t that long ago that lawyers were setting up complex trusts to protect the estate from federal taxes, even for those clients with moderate wealth. Recent changes have led lawyers to warn their clients that complex trusts can be a ticking time bomb for heirs on capital gains taxes.
Recent increases in federal estate tax thresholds have created a situation that most of these couples are now free from worry about specific tax levies. However, lawyers are encouraging clients to take a second look at complex trusts and revise them so that beneficiaries avoid the capital gains tax burden. ‘Death taxes’ have not died they have just taken on the form of capital gains taxes, and this issue is as equally important to families of moderate wealth as those high net worth clients.
To fully grasp the potential problem that’s looming over many clients, financial advisors must fully understand the issue that these trusts were created to avoid. Every American taxpayer has credits that shield a certain portion of their assets from the estate tax. Additionally, a marital deduction allows couples to leave unlimited assets to a surviving spouse. However, if one spouse owned more assets than these credits protected while passing an entire estate to the surviving spouse tax-free, this was considered to be wasting the credit—these assets aren’t protected from the estate tax that the beneficiaries would have to pay after the surviving spouse passed.
It’s been a common practice to set up most married couples with irrevocable bypass trusts—a.k.a. Credit shelter trusts, to ensure that the tax credit is used to their advantage and ensuring that a larger majority of the assets can be passed on to heirs tax-free.
In 2012, Congress raised the estate-tax exemption to $5 million per individual, indexed for inflation. As of this year, (2015) the exemption is $5.43, and heirs are looking at a top tax rate of 40%. The new law also includes allowances for the surviving spouse to use any part of the exemption that was unused by their deceased spouse. That’s allowing a couple to protect as much as $10.86 million in 2015.
Assets that are passed through the estate get an enormous tax break. The tax basis is graduated to market value the day that the deceased passed. Capital gains that were built up during the deceased’s lifetime are tax-free. Only the appreciation after the date of death is taxable to the heirs.
Assets that are stashed away in bypass trusts aren’t eligible for the capital-gains tax break, and the heirs of the families that have them don’t enjoy this graduation in basis—posing a large concern to estate planning lawyers.
Before, since estate-tax thresholds were lower, couples had a choice. Using a trust was common—so that a portion of the assets could avoid the estate tax when the second spouse passed. But this means that they also forfeited the graduation—putting heirs at risk of facing a 15% capital gains tax on any appreciation between the time the initial spouse passed and then the death of the surviving spouse. If the couple chose to forego the trust, the heirs would face an estate tax up to 55% on any assets exceeding exemption. This made the choice easy for many couples, but now that puts heirs at risk for a capital-gains top tax rate of 20%
Pouring the Assets Into the Estate
Currently, the major challenge of many estate planning lawyers and financial advisors is determining how and when to move assets out of these trusts and back into the estate so that their clients can earn the graduation that gives them a tax break.
Half of the states in the US now allow surviving spouses to make changes to any trust that’s been set up to all the spouse to get the graduation—presenting an opportunity to save heirs money. This process figuratively pours the assets from the trust into a new one—a process called trust ‘decanting.’
Laws differ by state, but generally speaking, under decanting laws the original trust must include a provision that allows the trustee the legal right to use some of the principal to pay for the surviving spouse’s expenses. If the trust has this provision, the trustee would more than likely be able to set up a new trust.
Doing so allows the surviving spouse to have a ‘power of appointment’—which allows the spouse to give some of this property to the creditors of the estate. By giving the spouse some of the control over trust assets, they are, in effect, pulled into the estate.
This doesn’t mean complete control over assets, either. The new trust could be set up with terms that require a neutral third party (which could include the trustee) to sign off on any expenditures covered by the trust.