The business of estate planning is continually changing. Laws change. Techniques come and go. The IRS issues rulings and regulations designed to clarify the Internal Revenue Code and rebut both legitimate and questionable tax avoidance—and occasionally tax evasion. In response, advisors develop new strategies to offset IRS positions.
While the business is fluid, there are times when more dramatic changes occur. If, as expected, Congress enacts an estate-tax law that adopts federal estate-tax exemptions of $5 million to $8 million per decedent, the changes to the estate-planning profession will be fundamental. Even if these higher exemptions are not adopted in 2005, the phased-in increases in the exemptions will significantly change estate planning. Let me provide a few predictions for this new world:
Here to stay
Estate planning is not going to disappear. On the contrary, because of numerous demographics, estate planning and probate administration could be two of the fastest-growing businesses in the country over the next few decades. Trust and estate litigation will also grow out of the failure to properly plan.
ESTATE PLANNING AND PROBATE ADMINISTRATION COULD BE TWO OF THE FASTEST-GROWING BUSINESSES IN THE COUNTRY OVER THE NEXT FEW DECADES.
Clients will have to be motivated by something more than their death and the avoidance of a death tax they were never going to see. Many clients would rather have successive root canals without anesthesia than think about planning for their incapacity and death. Updating the plan, when you know what to expect, could be worse. Motivating people by using the fear of something that will not affect them simply does not work. Clients can be motivated by the positive legacy they leave behind, in lieu of the fear of their own mortality.
Influencing the legacy. Any significant inheritance will affect the recipient. Clients increasingly want to influence the impact. They often want to place reasonable restraints on inheritances and create incentives and opportunities for heirs. They do not want their families to quit working and enjoy a lavish, unearned lifestyle.
Estate-tax techniques. The reduction in the number of taxpayers subject to a transfer tax will create significant changes in how clients approach their basic estate planning. For example, clients will be more concerned about minimizing income taxes for heirs than about avoiding a nonapplicable estate tax. The perceived discrimination of the marital deduction for married couples will be substantially reduced. With higher exemptions, unmarried couples and couples in second marriages will be freer to transfer assets without being restricted by the imposition of a federal estate tax.
State death taxes. State death taxes will offset at least part of the federal estate-tax reduction. As part of the 2001 tax bill, Congress replaced the state death-tax credit with a federal estate-tax deduction. Thirty-eight states used the federal credit as their state estate tax. Many of these states are working to revise their statutes to avoid a serious loss of revenue.
- Many states will not adopt the high federal exemption amounts, creating a state death tax when no federal estate tax is due.
- Some states will freeze their state death tax at the pre-2001 federal credit, resulting in a top effective state tax rate of 16 percent (i.e., the top rate for the state death-tax credit).
- More states will adopt a state gift tax to stop the loss of transfer tax revenue through lifetime gifts. Currently only Connecticut, Louisiana, North Carolina, Tennessee and Puerto Rico have a state gift tax.
The lack of uniformity in state death taxes will add significant complexity to estate plans. The pressure to “forum shop” will increase as taxpayers attempt to move their tax domicile to less costly states like Florida. Other states will contest these tax-motivated domiciles by trying to demonstrate that, notwithstanding the taxpayer’s assertions, the taxpayer remained a resident of the higher-tax state.
Income taxes. There will be a planning shift from avoiding federal transfer taxes to avoiding state and federal income taxes. Investments in trusts and estates may change to those that are more income-tax effective. For example, fiduciaries will be more prone to use tax-efficient mutual funds and capital gain investments. Instead of using tax deductions on the estate-tax return, clients will increasingly use them to reduce income taxes. More executors will waive their fiduciary fees. Because of the step-up in basis that occurs at death, valuation strategies for nontaxable estates will shift to increasing the fair market value of an estate’s assets. If the estate is not taxable, obtaining a higher valuation may allow a decedent’s heirs a higher step-up in basis, lowering the income taxes paid by the heirs on the sale of inherited assets.
Planning techniques designed to reduce the imposition of federal estate taxes may now be counter-productive by limiting the basis step-up of heirs. Planners will begin to seek ways to bust those GRITs, GRATs, FLPs and other techniques that appeared so advisable just a few years ago.
This change will create an interesting dilemma for the IRS. Previously, its attention was focused on whether taxpayers had purposely undervalued assets (i.e., to avoid transfer taxes). Now it will also have to focus on whether taxpayers are purposely overvaluing assets to obtain a higher basis (i.e., to avoid income taxes).
A pivotal issue will be the proper documentation of the value of nonmarketable assets, especially in nontaxable estates. Because there is no statute of limitations on the basis of assets in nontaxable estates (i.e., no estate tax return is filed), current appraisals will be necessary in order to establish the income tax basis of nonmarketable assets in nontaxable estates.
IRS focus. Because of the substantial reduction in the number of Americans subject to an estate tax, the estate and gift tax division of the IRS will probably be subject to a huge downsizing—to the detriment of the state revenue departments that relied on the federal government to do their auditing. While transfer taxes have been a major focus of the IRS over the last several years, the reduced impact of transfer taxes will cut the number of applicable rulings. The reduction in focus by the IRS will decrease the certainty of some planning techniques for those who remain taxable and the limit of scrutiny paid to most transfers by family members.
Estate planning is not diminishing. Instead, estate planners are refocusing their attention from transfer-tax avoidance to other issues. In my next column, we will examine some of these issues.
John J. Scroggin, AEP, J.D., LL.M. is a speaker and author with more than 300 articles, outlines and books. To get his free email newsletter on estate and income-tax planning, contact LuAnn@scrogginlaw.com.