Changes in Delaware Trust Law

Clients with complex estate planning needs, including those with significant liability exposure who need to take "asset protection" measures, will often set up their trusts in the state of Delaware, which is the home of some of the nations oldest trust companies and has a highly developed law of trusts. 

Delaware has made some significant changes to its trust laws which take effect this coming Monday, August 1, 2011.  The changes include improved protection from creditors for assets held in trust, and revisions to the "decanting" statute which allows a trustee to create another trust and transfer assets to it.  You can read or download a detailed summary of the changes here.

Federal Estate and Gift Taxes -- the Unified Credit, Today and Tomorrow

The federal wealth transfer taxes are imposed on any gift (with certain exceptions), and any estate, no matter how small. In order that these taxes only actually get paid by "the wealthy," everyone is given a "unified credit" against these taxes.  We usually do not talk about the credit itself; rather, we refer to the "exemption equivalent," which is the amount of wealth that the credit "pays" the tax on.

When I started practicing law, and for a long time thereafter, the exemption equivalent was $600,000; that is, the credit was equal to the tax on $600,000 of lifetime gifts and/or wealth transmitted at death. Once the credit ran out, the tax rate on the 600,001st dollar was 37%, and the rate brackets topped out at 55% once you got to $3 million.

By making full use of both spouse's credits, a married couple could transmit $1.2 million to the next generation before incurring a federal tax.  At the time these numbers were established, $1.2 million was a net worth that few couples could attain.  After fourteen years of cumulative inflation and rising standards of living, however, the tax was starting to hit a lot of farmers, small business owners, and other upper middle class taxpayers who were rich enough, in terms of assets, to be hit by the tax, but who often weren't liquid enough to raise the cash with which to pay the tax without selling or borrowing against their main assets--the house, the farm, or the business.

The 1997 tax act.addressed this by scheduling a series of irregular increases in the unified credit that would eventually raise the exemption equivalent to $1 million.  The increase was "back-loaded" so that most of it occurred in later years.  By 2001, we were about halfway through the process, and the exemption equivalent was $675,000.

The 2001 tax act--which enacted what reporters, pundits, and politicians like to refer to as the "Bush tax cuts"--provided for the complete phase-out of the federal estate tax over a ten year period.  The exemption equivalent for estates was increased immediately to $1 million, and scheduled to go to $1.5 million in 2004, $2 million in 2006, and $3.5 million in 2009.  In 2010, the estate tax was scheduled to disappear completely.  While this was going on, the top rate was decreasing from 55% to 45% in a series of irregular jumps.  The exemption equivalent for lifetime gifts was capped at $1 million, and after the estate tax went out of existence there would still be a 35% tax on lifetime gifts, with a $1 million exemption equivalent.

The 2001 tax act also contained a "sunset" clause under which all the changes it worked in the tax code would be undone on January 1, 2011, which would un-repeal the estate tax and cause a return to what the 1997 tax act was working toward: an estate and gift tax with a $1 million exemption equivalent and a 55% top rate.  The reason for this is because one of the rules governing the federal budget process provides that no legislation affecting revenue can be in effect for more than ten years unless it passes with at least 60 votes in the Senate.  As you might remember, we had a closely-divided Senate at that time, and the 2001 tax act passed by only a small majority.

Those of us in the estate planning business expected that Congress would change things again well before 2010 so we wouldn't have that strange temporary repeal, but that didn't happen.  In late 2009, there had been several bills introduced to extend the estate tax past 2009 with a $3.5 million exemption equivalent (and one that would have reduced it to $2 million!), but none of these got through the legislative process because Congress was then focused intensely on the pending "Obamacare" health care reform bill.

Consequently, there was no estate tax for nearly all of last year, but with a scheduled automatic reinstatement of the tax (and a lot of other changes to other parts of the tax code) on January 1, 2011.  In December, Congress passed, and the President signed into law, legislation which prevented the sunset from taking place.  For the most part, it provided that the changes to the tax code made by the 2001 tax act would continue in effect through the end of 2012--what the media, pundits, and politicians described as "an extension of the Bush tax cuts."  Part of this bill reinstated the estate tax--but with a $5 million exemption equivalent, a 35% top rate, and a new "portability" provision which allows a widowed spouse to make use of any unified credit the deceased spouse did not use on his estate tax return or on lifetime gifts.  This is the most taxpayer-friendly that the federal estate tax has been since 1931.

However, things may soon change for the worse.  The 2010 tax act was a bundle of compromises, and one of those compromises was a provision that "sunsets" the 2010 act at the end of 2012.  Unless Congress changes the tax code again before the end of next year, we will "snap back" to the 1997 version of the estate tax--an estate and gift tax with a $1 million exemption equivalent and a 55% top rate--on January 1, 2013.

There are many members of Congress who have come out in favor of making the 2010 estate tax scheme permanent.  President Obama has stated on numerous occasions that he is opposed to "further extensions" of the "Bush tax cuts," which seems a pretty clear signal that he would oppose making the 2010 estate tax scheme permanent.  It is probable that any legislation to address the estate tax would be introduced and debated next year--in the middle of a long and contentious national election campaign.

No one can safely predict what will happen next, and estate planning for families with small businesses and farms has gotten a lot more complicated as a result.

Federal Estate and Gift Taxes -- Trusts for the Non-Citizen Spouse

As mentioned in the last installment of this series, the unlimited marital deduction is only available if your spouse is a U.S. citizen.  If your spouse is not a U.S. citizen, transfers to that spouse at death will be subject to the estate tax unless you use a "qualified domestic trust," or "QDOT."

A QDOT trust must pay all of its income to the surviving spouse, and can have no other beneficiaries while the spouse is living.  So far, this looks a lot like a QTIP marital deduction trust, but a QDOT is subject to additional restrictions intended to prevent the non-citizen spouse from leaving the country with the assets and thereby escaping estate taxation:

• At least one of the trustees must be an individual U.S. citizen or a U.S. trust company.
• No more than 35% of the assets of the trust may be foreign real estate.
• The U.S. trustee has the power to withhold taxes from any distribution of principal.

That last power is very important, because the principal of the QDOT trust (but not the income) is subject to an estate tax if it is distributed while the spouse is living (other than for reasons of "hardship"), and any principal remaining in the trust is taxed at death.

How do you prevent taxation of principal distributions?  If the spouse becomes a U.S. citizen, the special QDOT restrictions and the tax on lifetime principal distributions no longer apply.

Federal Estate and Gift Taxes -- the Marital Deduction

A baseline policy of the federal estate and gift taxes is to tax wealth once every generation. For that reason, transfers from one spouse to another are made deductible, and therefore not taxed--subject to some important qualifications.  You'll often see this referred to as the "unlimited marital deduction."

The unlimited marital deduction applies to any outright transfer to a spouse, and any transfer in trust where the assets of the trust will be included in the spouse's gross estate, and subject to tax, at the spouse's death.  Before 1988, there were three trusts that qualified for the marital deduction:

• Any trust where the spouse has a lifetime right to income and a "general power of appointment"--a right to withdraw assets from the trust, or direct them to his estate or creditors at death.  Often called a "life estate plus power of appointment" trust, this was the most common arrangement.
• A trust where the spouse has a lifetime right to income and the property passes at the spouse's death to charity.  (In this instance, there will be no tax on the second death because the property will qualify for a charitable deduction.)
• An "estate trust," which accumulates income while the spouse is living and pays it to her estate at death.  These were used as investment vehicles back in the days when trusts paid income taxes at much lower rates than individuals. In about 20 years of private practice, I have yet to encounter one.

Most married people want to devote assets to the care of their spouse, and then pass them on to the next generation after both spouses are deceased.  If, in order to take advantage of the marital deduction, you left property to the spouse outright or in a trust with a general power of appointment, you ran the risk that the spouse might divert the assets to someone else--this was a particular concern of spouses in blended families, or in situations where a relatively young widow remarries.  If you designed the trust to prevent this by restricting the spouse's control, or providing for a forfeiture of benefits if the spouse remarried, you gave up the marital deduction and incurred a tax.

The response to this was the "qualified terminable interest property" election added to the tax code in 1988, which is nicknamed "QTIP.".  To qualify for the QTIP election, a trust must meet three criteria:

• The spouse must receive all of the income of the trust while living.
• The trust may not have any other beneficiary while the spouse is living.
• The estate must make a "QTIP election" on the estate tax return.

The QTIP rules allow for a fair bit of flexibility in trust design.  The spouse can have no right to principal at all, or a right to principal distributions in the trustee's discretion, or even a limited right to make annual withdrawals.  The right to principal distributions can terminate, or be restricted, on remarriage.  Because it allows for more control than the old life estate plus power of appointment trust, the QTIP trust is the one I use the most in my practice.

One last little detail: the marital deduction is only available if the spouse is a U.S. citizen.  For non-citizen spouses, there is still a marital deduction of sorts, but the rules are a lot more complicated.  We'll discuss that topic in our next installment.

Federal Estate and Gift Taxes -- the Gross Estate

The federal estate tax is a tax imposed on the "privilege" of transferring property at death.  Because it's imposed on transfers of property, it taxes more than just the property in your probate estate.  The "gross estate," as we call it, consists of the probate estate, plus all sorts of arrangements that are intended to avoid probate, such as:

• Joint and survivorship assets.
• Payable-on-death and transfer-on-death assets.
• A revocable trust.
• Any irrevocable trust you've created, if you retain control over the disposition of wealth at your death--what we sometimes call a "taxable string" power--either as trustee or by some other means.
• Retirement accounts and annuities with a death benefit or survivor benefit.
• Assets which you have technically given away, but retain the right to use during lifetime.  The classic example of this is a life estate in real property.
• Assets whose disposition you control through a power of appointment, but only if that power lets you appoint the assets to yourself, your estate, or your creditors.  Powers of appointment have a lot of uses in sophisticated estate planning, and we'll go into detail about how they work in a future post.

Life insurance is something of a special case: it's only part of your gross estate if you hold what are called "incidents of ownership" in the insurance policy--the right to name beneficiaries, or the right to borrow against or take out the cash value of the policy.  If you don't hold the incidents of ownership, it doesn't matter if you're the insured, or if you pay the premiums--it's not in your gross estate.  For many of my higher net-worth clients, we take advantage of these rules in a way that allows the family the benefit of the life insurance proceeds without having to pay estate tax on them.  The insurance is held in trust by an independent trustee, and the insured has no power to change the terms of the trust.  We'll go in to how these "irrevocable life insurance trusts" work in more detail in a future installment.

Breaking News: Ohio Estate Tax repealed!

The Ohio estate tax will disappear on January 1, 2013, under a provision of the Ohio budget bill singed into law yesterday by Governor Kasich.

Only 22 states still have some sort of death tax, and the Ohio tax has the lowest exemption amount of any of them. It hits any estate in which $338,333 or more will be passing to beneficiaries other than a surviving spouse. This means that a lot of middle class families and small business owners end up paying an estate tax in Ohio who would not have to worry about it in most other states. Eliminating the tax will simplify the process of settling estates for Ohio families who aren't affected by the federal estate tax.

Read more about recent changes in state estate tax laws here.