By Ariel Marin, JD, LL.M., CFP®, CLU®
Despite the changes introduced by the Tax Cuts and Jobs Act of 2017, tried and true estate planning strategies centered on federal estate tax mitigation continue to be a focal point for ultra-high net worth clients. For wealthy households that are under the current combined federal exemption level, however, the de-emphasis of estate tax planning has not obviated the need for concerted planning nonetheless. In fact, many crucial planning needs can be overlooked or ignored if estate planning is viewed largely as a rote exercise in tax mitigation.
Multifaceted tax planning for estates
Estate planning is frequently viewed as the conservation and distribution of wealth according to the owner's objectives in a tax efficient manner. Estate planning should furthermore address threats to wealth on multiple tax fronts. While several states impose a state level death tax, the larger tax priority for many individuals involves income tax planning. As a result, trust arrangements that are very common under traditional estate tax-focused estate plans should be reviewed with respect to income tax efficiency. For example:
- Large IRAs and qualified plans passing to children and/or further descendants can continue to maximize tax deferral based on the beneficiaries' own life expectancies. However, if a trust is named as a beneficiary of such account, optimal tax deferral may not be available. Conversely, a beneficiary receiving proceeds from a plan directly may elect to withdraw all funds and trigger taxes at a much higher marginal rate. In such circumstance, a properly designed and designated trust may be more appropriate.
- For closely held business interests passing under a common estate tax savings trust, trust ownership should not otherwise interfere with an S election, eligibility for the qualified business income tax deduction, or subject business income to higher income taxation than is necessary.
- State income taxation can also arise (or potentially be avoided) depending on a variety of factors, including: situs of a trust (applicable state law), domicile of trustee, and domicile of beneficiaries.
- It may be necessary to weigh the income tax savings of mandatory distributions of income (common under many trust arrangements) with the suitability of such distributions from an incentive and creditor protection standpoint. Income accumulated inside a trust is generally subject to compressed income tax brackets, resulting in a higher effective income tax rate. Trust income distributed to a beneficiary may be taxed at a beneficiary's lower income tax rate but may also be counterproductive if such distributions would be misspent or claimed by creditors.
Need for flexibility
Flexibility is the hallmark of modern plans. Although one's estate planning documents (wills, trusts, power of attorney documents, living wills, etc.) should be updated regularly to reflect the current legal environment, additional tools are available to provide sensible modifications to documents that can no longer be changed.
Inclusion of trust modification provisions, disclaimer planning, decanting, the possibility of state sanctioned modification agreements, or the appointment of special fiduciaries can ensure that the estate plan can adapt after implementation or after death to account for changes in the law, objectives, family circumstances and dynamics.
For example, disclaimer trust planning offers a “wait and see” approach to trust planning for married couples. Upon the death of the first spouse to die, a qualified disclaimer can be exercised to shift all or part of assets from the originally intended person or trust to another.
Circumstances that may merit a disclaimer would include asset protection, estate tax planning, and/or income tax basis planning.
Wealth Distribution Planning
Hazards to wealth may also stem from beneficiaries themselves. Potential creditors, spendthrift habits, anti-social behavior and divorce can all pose a greater threat to one's wealth than taxes. Even with the best of intentions, the mismanagement of trust property can quickly erode the wealth a family has taken a lifetime to create. Modern plans may incorporate safeguards to such occurrences without imposing excessive rigidity.
- For example, “directed trusts” incorporate trust advisors and distribution committees to bifurcate and oversee some of the traditional functions of the trustee.
- An appointed trust protector can, amongst other powers, veto trust distributions, settle disputes between co-trustees, oversee and hire/fire a trustee and increase/decrease the interest of any beneficiaries of the trust.
The increasing prevalence of blended families can make estate planning more complex. For example:
- While many states' laws automatically revoke a will with respect to dispositions to a former spouse, some do not, and those which do may not remove former in-laws from being appointed as fiduciaries and/or receiving an inheritance.
- A simple all-to-spouse will can result in the disinheritance of children of the first spouse to die. Conversely, failure to provide for a spouse can result in a challenge under spousal elective share laws.
- Planning around the spousal election may be crucial in these contexts, which can include a formal waiver of the election by the spouse or use of a qualified terminal interest property trust for his or her benefit. To the extent assets are left in trust, appointing a professional trustee such as a bank or trust company to oversee the management of a trust may be the best practice to reduce family friction.
- Lastly, because individuals not otherwise bound by a blood relation may be even more prone to rancorous will contests, probate avoidance through the use of a revocable living trust may be critical.
Although the life insurance discussion usually begins with the establishment of a specific insurance need, certain products offer benefits beyond death protection, and can therefore address multiple planning needs simultaneously. While life insurance death proceeds are generally received by the beneficiary income tax free, permanent products offer tax deferred growth (and potentially tax preferred access) on cash values that can act as a buffer in a turbulent market. Additionally, cash values and death proceeds may be exempt from creditor claims under state exemption laws, though such laws vary dramatically from state to state. Trust planning can enhance creditor protection regardless of the jurisdiction, while access to cash value can be preserved through techniques such as loan arrangements and spousal lifetime access trusts.
Additionally, certain life products offer additional long-term benefits and protection in the event a need arises for a policy owner in the future. Of course, life insurance is also oftentimes necessary as a wealth creation vehicle to mitigate against the estate dilution effects of a large and growing family and to support fair and equal allocation of inheritances.
While estate tax laws are constantly changing, the priorities involved in planning an estate should be viewed holistically and designed to meet the unique needs of a family's specific situation. Furthermore, a truly comprehensive plan requires coordination with all advisors, as no single discipline has the expertise to adequately address every facet of an estate plan. As General Dwight D. Eisenhower once said, "plans themselves are useless, but planning is essential."
Ariel A. Marin, JD, LL.M., CFP®, CLU®,received his law degree from the City University of New York, and his LL.M. in taxation with a certificate in estate planning from Villanova Law School, Graduate Tax Program. He received his bachelor's degree in arts from The George Washington University. Prior to joining Nautilus, Ari worked with a family office developing customized, comprehensive wealth plans for high net worth clients; prior to that he worked as a trust and estate associate for a large national trust company. He is licensed to practice law in Pennsylvania, and currently holds FINRA series 7 and 66 licenses.
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