Fine Wine and Estate Planning

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As financial planners, we routinely model estate plans to determine if they meet the goals and objectives of our client. Typically those goals fall into one of three areas: minimizing taxes, providing liquidity for survivors, and optimizing the disposition of one’s estate. Fair warning, my editor said that this topic is convoluted. But then the tax code is quite convoluted. Please persevere.

One of the big mistakes that we see being made regarding estate planning is the client’s assumption that because there is a $5 million plus exemption per person, there is no reason to do any estate planning. To refresh your memory, last December the big debate was whether Congress would leave the large exemption for estate and gift taxes in the law. They did, and they made it “permanent” in the American Taxpayer Relief Act of 2012. They also indexed it so that it would go up in the future. For 2013 the exemption is $5,250,000 and for 2014 it will be $5,340,000 due to indexing. Thus, a married couple can pass $10,500,000 in 2013 or $10,680,000 in 2014. Another important provision of the law made portability of the exemption permanent. Portability refers to the ability of a spouse to bequeath his or her unused exemption to the surviving spouse. To take advantage of the current situation, good estate planning is still essential. It may therefore be logical, but incorrect, for many to think that they don’t need to bother with estate planning.

Many people have trusts (either living trusts or trusts created in a will) that were developed years ago when the rules were different. Trusts may be created to serve purposes other than simply reducing or eliminating estate and gift taxes—i.e. they usually contain important control issues. At the time of drafting a trust it is difficult to anticipate all the changes that a family may undergo at some point in the future. As the future becomes reality, the well-drafted trust from yesteryear may no longer serve its intended purposes. We believe that trusts, especially irrevocable ones, should be reviewed each year by qualified legal counsel to determine if changes are warranted. Wait a minute, you say. Aren’t irrevocable trusts just that, irrevocable, and therefore unchangeable? How then can an irrevocable trust be revised?

A court can certainly order that a trust be modified so long as certain state requirements are met. In addition, many trusts contain provisions for termination when the trust assets fall to a certain level. Kentucky has enacted a statute to deal with trusts under $50,000; however, these too need court approval. Of course, another way to modify a trust is to distribute all the assets, but only if it’s in the Trustee’s power to do so. Beneficiaries probably need to consent; and such consent could be hard to come by. If you are a trustee, distributing assets could also carry substantial legal liability. Even unborn potential beneficiaries should be considered when making distributions of trust assets.

For years, one of the key provisions of the tax code has been the step-up in tax basis of assets includable in a decedent’s estate. Step up refers to revaluing the asset for tax purposes to its date of death valuation. Ordinarily the tax basis for calculating capital gains is the purchase price paid for an asset. For assets that go up in value before they are sold, a capital gain tax is imposed on the gain at the time of the sale. However, for assets that are included in your estate, basis may be reset (i.e. stepped up) to the date of death valuation and the capital gains tax on the appreciation goes away.

For those years when estate taxes were high and capital gains tax low, estate planners often put in place credit shelter trusts or generation skipping trusts that kept the assets of those trusts out of the taxable estate of the beneficiaries upon their death. Unfortunately, this also had the effect of eliminating the step up in basis. That saddles the receipt of those assets with a potential capital gains tax as well as the new Medicare Contribution Tax imposed by the Affordable Care Act. Taken together, the 2012 Act and the ACA have the effect of lowering, or even eliminating, estate taxes but potentially raise income taxes via higher capital gains tax and the Medicare Contribution tax. Once again, do not assume that there is nothing that can be done because granddad’s trust became irrevocable upon his death. Consult with legal counsel and ask him or her about decanting the trust.

Decanting, as applied to trusts, is the act of emptying the assets in a current trust and placing them in a different container, a new trust, with a new trustee. The new trust can have more flexibility than the old one. When handled correctly, decanting can even allow for inclusion of the trust assets in the estate of the beneficiary. Doing so may exempt those assets from estate taxes altogether due to the higher limits now in effect. At this writing, 20 states allow decanting. Kentucky’s provision took effect in 2012. And you thought that decanting only applied to your favorite libation. As you have probably surmised, this maneuver, or any other estate planning should only be undertaken with the help of qualified legal and tax counsel. The moral is: never say never, even when irrevocable is in the title.

AND YOU THOUGHT DECANTING ONLY APPLIED TO YOUR FAVORITE LIBATION.

Scott Neal, CPA, CFP is the President of D. Scott Neal, Inc., a fee-only financial planning and investment advisory firm with offices in Lexington and Louisville. Visit the website www.dsneal.com or email Scott at scott@dsneal.com.