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Flexible Estate Planning in Birmingham, Alabama

Estate tax law uncertainty requires options

This year, just as in 2010, even the short-term future of the federal estate tax and other transfer taxes is uncertain. Currently, the exemption for gift, estate and generation-skipping transfer (GST) taxes is an inflation-adjusted $5.12 million, and the top tax rate is 35%. Absent congressional intervention, however, on Jan. 1, 2013, the exemption will drop to $1 million (indexed for inflation for GST tax purposes) and the top tax rate will jump to 55%. One proposal calls for a $3.5 million exemption and a 45% tax rate, but it is not yet clear whether that or some other transfer tax regime will be in place next year.

One thing is certain, though: A wait-and-see approach is risky. As witnessed in 2010, it is difficult to predict how — and when — the tax environment will change. Many people are taking advantage of the generous gift tax exemption by shifting as much wealth as possible to their heirs this year. But it is also important to build flexibility into your estate plan so that you or your family can react quickly to future changes in the law.

Qualified disclaimers

A qualified disclaimer gives your beneficiaries the power to reject inherited assets, allowing them to pass in a more tax-efficient manner to the contingent beneficiary. To qualify, a disclaimer must:

  • Be in writing,

  • Be delivered to the estate’s representative within nine months after the transfer is made (or, if the disclaimant is a minor, within nine months after the disclaimant turns age 21), and

  • Be delivered before the disclaimant accepts the property or any of its benefits.

For qualified disclaimers to provide the desired flexibility, disclaimed assets must pass automatically to the contingent beneficiary according to the terms of your will or trust — without any direction from the disclaimant. So it is important to carefully select a contingent beneficiary for each bequest you are making in your estate plan.

For example, let’s say Robert’s will leaves his entire estate to his daughter, Maggie — or, if she predeceases him or files a qualified disclaimer, to a trust for the benefit of Maggie’s three children. Robert dies in December 2012 with a $5 million estate, all of which is sheltered from estate tax by Robert’s exemption.

On Jan. 1, 2013 — before Maggie has received her inheritance — the exemption amount drops to $1 million and the tax rate goes up to 55%. If Maggie were to die in 2013, the inherited assets would be subject to a $2.2 million estate tax, leaving only $2.8 million for her children.

Maggie is financially independent and does not need the inheritance to support her lifestyle. She files a qualified disclaimer, allowing the entire $5 million to pass tax-free to the trust for her children.

Credit shelter trust

Under current law, gift and estate tax exemptions are “portable” — that is, when one spouse dies, the surviving spouse can take advantage of both spouses’ unused exemption amounts without the need for more-sophisticated estate planning vehicles.

In theory, portability is a valuable benefit. Unfortunately, it is set to expire at the end of 2012 and it is uncertain whether Congress will extend it (or make it permanent). If portability becomes unavailable next year, couples who have been relying on it to preserve their exemptions may face significant estate tax exposure.

The most effective way to protect yourself against loss of portability is to use a credit shelter trust to preserve both spouses’ exemptions. These trusts also provide several other important benefits, including asset protection and GST tax reduction. (The GST tax exemption is not portable.)

If you decide to establish a credit shelter trust — or if you already have one — review its funding provisions carefully to be sure they are flexible enough to adapt to changing laws and circumstances. A trust that is funded with a fixed dollar amount or according to a formula can sometimes produce unintended consequences. (See the sidebar “The trouble with formulas.”)

Many options

There are a variety of other tools you can use to add flexibility to your estate plan, including powers of appointment, trust protectors, powers of attorney and trust provisions authorizing trustees to make discretionary distributions.

Experience has taught us that tax laws and family circumstances can change quickly. These tools allow your family members or trusted advisors to fine-tune your plan to address these changes in the event you die or become incapacitated before you have a chance to amend your plan.

Sidebar: The trouble with formulas

A typical estate plan for a married couple calls for assets up to the applicable federal estate tax exemption amount to be placed in a credit shelter trust, with any excess funneled into a marital trust (or left to the surviving spouse outright) at the first spouse’s death. This strategy preserves the deceased spouse’s exemption while also making the most of the marital deduction.

At one time, the exemption amount varied little from year to year, so it was common to fund a credit shelter trust with a fixed dollar amount. In recent years, however, exemption amounts have fluctuated dramatically, so this approach is no longer appropriate. If you have not reviewed your plan in many years, check to see if it uses a fixed dollar amount to fund a credit shelter trust and, if it does, update its terms to provide more flexibility.

Formulas tied to the applicable exemption amount can do just that, but they can also produce unintended — and undesirable — results if they are not carefully designed.

For example, Ann, who has a $5 million estate, completed her estate plan in 2005. Under the plan, when Ann dies, an amount equal to the then-current exemption amount goes into a credit shelter trust and the excess goes to her husband, Jack.

At the time, this made sense: If Ann had died in 2005, $1.5 million would have gone into the credit shelter trust and Jack would have received the remaining $3.5 million. But if Ann dies in 2012, when the exemption amount is $5.12 million, her entire estate goes into the credit shelter trust, effectively disinheriting Jack (except for distributions of trust income and, in certain limited circumstances, distributions of trust principal that might be provided for Jack under the trust’s terms).

To avoid this result, it is important to carefully draft formula clauses to ensure that they account for every possible contingency. For example, Ann’s plan might have established a minimum bequest for Jack (say, $2 million) before funding the credit shelter trust.

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