Wills and Trusts

Wyatt, Tarrant & Combs, LLP

The New Tax Landscape

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The new tax landscape for estate planners in 2013 and beyond is transformed by increased income tax rates, and the falling transfer tax liability, at both the Federal and state level.  On the Federal side, the income and transfer tax provisions that became effective January 1, 2013, were enacted as part of ATRA and PPACA (the Medicare tax).  In the states, many states increased their income tax rates,[1] and a number of states continued the trend of repealing their state death tax (estate and inheritance tax).[2]

A complete discussion of all of the provisions of the Federal laws and the state laws is beyond the discussion of this outline.  So, we have limited the discussion to the most salient provision

Pertinent Provisions of ATRA

Federal Transfer Tax Landscape

First a summary of the Pertinent Income Tax Provisions:

(a)  The top estate, gift, and GST tax rate is 40%.[3]

(b)  The basic applicable exclusion amount[4] (sometimes referred to as the “Applicable Exclusion Amount” or the “Applicable Exclusion”) for each individual is $5 million,[5] indexed for inflation after 2011[6] ($5.25 million for 2013 )[7] and $5.34 million for 2014.

(c)  Reunification of the estate, gift and GST tax system (providing a GST exemption amount equal to the basic Applicable Exclusion Amount under § 2010(c) of the Code).[8]

(d)  Permanent instatement of the “portability” of a deceased spouse’s unused exclusion amount (“DSUEA”).[9]

(e)  Repeal of the “sunset” provision with respect the foregoing transfer tax provisions.[10]

Changes to the Applicable Exclusion Amount:

(a)  As mentioned above, ATRA “permanently” provides for a cost-of-living increase to the Applicable Exclusion Amount.   When one considers that the inflation adjustment cannot be adjusted downward even in deflationary environments,[11] it becomes clear that the Applicable Exclusion Amount can grow to a very large number.

(b)  The following table is a forecast of the resulting Applicable Exclusion Amount, 1 year, 10 years and 20 years from now:[12]






Low Inflation




Median Inflation




High Inflation




*Applicable Exclusion Amount for 2014 is $5.34 million.

Pertinent Income Tax Provisions

(a) Increase of the highest Federal ordinary income tax bracket to 39.6%.[13]

(b)  Increase of the highest Federal long-term capital gain bracket to 20%.[14]

(c)  Increase of the highest Federal “qualified dividend income” rate to 20%.[15]

The 3.8% Medicare Tax on Net Investment Income

A full and complete discussion of the 3.8% Medicare tax is beyond the scope of this outline but a general understanding is important.  Fortunately, there are a number of better resources for that discussion.[16]

The application of the tax to trusts that own closely-held business interests is controversial.  In Mattie K. Carter Trust v. U.S., 256 F. Supp.2d 536 (N.D.Tex. 2003) the court held that in determining material participation for trusts the activities of the trust’s fiduciaries, employees, and agents should be considered.  The government argued that only the participation of the fiduciary ought to be considered but the court rejected that argument.

Notwithstanding the only reported case on the issue, the IRS ruling position is that only the fiduciary’s activities are relevant.  The IRS reaffirmed this ruling position in TAM 201317010.  The ruling explains the IRS rationale as follows:

The focus on a trustee’s activities for purposes of § 469(h) is consistent with the general policy rationale underlying the passive loss regime. As a general matter, the owner of a business may not look to the activities of the owner’s employee’s to satisfy the material participation requirement. See S. Rep. No. 99-313, at 735 (1986) (“the activities of [employees] . . . are not attributed to the taxpayer.”). Indeed, because an owner’s trade or business will generally involve employees or agents, a contrary approach would result in an owner invariably being treated as materially participating in the trade or business activity. A trust should be treated no differently. A trustee performs its duties on behalf of the beneficial owners. Consistent with the treatment of business owners, therefore, it is appropriate in the trust context to look only to the activities of the trustee to determine whether the trust materially participated in the activity. An interpretation that renders part of a statute inoperative or superfluous should be avoided. Mountain States Tel. & Tel. Co. v. Pueblo of Santa Ana, 472 U.S. 237, 249 (1985).

At issue in the ruling were the activities of “special trustees” who did the day to day operations and management of the companies in question but lacked any authority over the trust itself.  The ruling states:

The work performed by A was as an employee of Company Y and not in A‘s role as a fiduciary of Trust A or Trust B and, therefore, does not count for purposes of determining whether Trust A and Trust B materially participated in the trade or business activities of Company X and Company Y under § 469(h). A‘s time spent serving as Special Trustee voting the stock of Company X or Company Y or considering sales of stock in either company would count for purposes of determining the Trusts’ material participation. However, in this case, A‘s time spent performing those specific functions does not rise to the level of being “regular, continuous, and substantial” within the meaning of § 469(h)(1). Trust A and Trust B represent that B, acting as Trustee, did not participate in the day-to-day operations of the relevant activities of Company X or Company Y. Accordingly, we conclude that Trust A and Trust B did not materially participate in the relevant activities of Company X or Company Y within the meaning of § 469(h) for purposes of § 56(b)(2)(D) for the tax years at issue.

The need for a trustee to be active may affect the organization of business entities held in trust.  For instance, a member-managed LLC may be more efficient than a manager-managed LLC unless a fiduciary is the manager.

For taxable years starting in 2013, § 1411 of the Code imposes a 3.8% Medicare tax on “net investment income”[17] (“NII”) which includes:

(1)  “Gross income from interest, dividends, annuities, royalties, and rents,”[18] (passive income), other than such passive income that is “derived in the ordinary course of a trade or business”[19] that is not a “Passive Activity or Trading Company” (as defined below);

(2)  Gross income derived from a “Passive Activity or Trading Company,” which is defined as:

(a)  A trade or business that is “a passive activity (within the meaning of section 469) with respect to the taxpayer;”[20] or

(b)  A trade or business that trades in “financial instruments or commodities (as defined in section 475(e)(2)).”[21]

(3)  Gain “attributable to the disposition of property other than property held in a trade or business not described”[22] as a Passive Activity or Trading Company; or

(4)  Gross income from the investment of working capital.[23]

In arriving at NII, the Code provides for “deductions . . . which are properly allocable to such gross income or net gain.”[24]

For individuals, the 3.8% Medicare tax is imposed against the lesser of:[25]

(1)  NII; or

(2)  The excess of:

(a)  “modified adjusted gross income for such taxable year”[26] (“MAGI”), over

(b)  The “threshold amount”[27] ($200,000 for individual taxpayers, $250,000 for joint taxpayers, and $125,000 for married taxpayers filing separately).[28]

For estates and trusts, the 3.8% Medicare tax is imposed against the lesser of:[29]

(1)  The undistributed NII for the taxable year, over

(2)  The excess of:

(a)  Adjusted gross income (as defined in § 67(e) of the Code),[30] over

(b)  “the dollar amount at which the highest tax bracket in section 1(e) begins for such taxable year”[31] ($11,950 of taxable income for 2013).[32]

With respect to a disposition of a partnership interest or S corporation shares, the net gain will be subject to the 3.8% Medicare tax but “only to the extent of the net gain which would be so taken into account by the transferor if all property of the partnership or S corporation were sold for fair market value immediately before the disposition of such interest.”[33]

The following are excluded from the definition of NII:

(1)  Distributions from “a plan or arrangement described in section 401(a), 403(a), 403(b), 408, 408A or 457(b),”[34] specifically referring to: [35]

(a)  A qualified pension, stock bonus, or profit-sharing plan under section 401(a) of the Code;

(b)  A qualified annuity plan under section 403(a) of the Code;

(c)  A tax-sheltered annuity under section 403(b) of the Code;

(d)  An individual retirement account (IRA) under section 408 of the Code;

(e)   A Roth IRA under section 408A of the Code; and

(f)   A deferred compensation plan of a State and local government or a tax-exempt organization under section 457(b) of the Code.

(2)  Gain or other types of income that generally would not be taxable under the Code, including: [36]

(a)  Interest on state and local bonds (municipal bonds) under § 103 of the Code.

(b)  Deferred gain under the installment method under § 453 of the Code.

(c)  Deferred gain pursuant to a like-kind exchange under § 1031 of the Code and an involuntary conversion under § 1033 of the Code.

(d)  Gain on the sale of a principal residence under § 121 of the Code.

Disparity Among the States

The state estate and inheritance tax (collectively, “state death tax”) landscape has dramatically changed since 2001.  In 2001, almost every state had an estate and/or inheritance tax that was tied to the then existing Federal state death tax credit.[37]  As the law stands today, the Federal state death tax credit has been replaced by a Federal estate tax deduction under § 2058 of the Code, and only 17 states still retain a generally applicable death tax.[38]  To complicate matters, even in those states that still retain a death tax, the rates and exemption can vary significantly.  For example, Washington’s estate tax provides for a top rate of 20% and an exemption of $2 million per person (indexed for inflation starting January 1, 2014 but only for the Seattle-Tacoma-Bremerton metropolitan area).   Pennsylvania, on the other hand, provides for an inheritance tax rate of 4.5% for transfers to descendants, with virtually no exemption.   When taken in conjunction with the transfer tax provisions of ATRA (both the top Federal tax rate at 40% and the large Applicable Exclusion Amount), the combined Federal and state transfer tax cost to high-net-worth individuals has significantly fallen, when compared to 2001, by way of example.

On the income tax side of the coin, each state obviously has its own state and local income tax laws and rates.  A number of states have no state and local income tax (Florida, Texas, Nevada, New Hampshire, and Washington) yet other states (California, Hawaii, Minnesota New Jersey, New York, and Oregon) have relatively high income tax rates.  When taken in conjunction with the income tax provisions of ATRA and the 3.8% Medicare tax, the combined Federal and state income tax cost to most taxpayers has significantly risen, when compared to 2001, for example.

As a result, the new estate planning landscape is characterized by significantly lower transfer costs, higher income tax rates, and significant disparity among the states when one compares the two taxes.  You will find a summary of the current state income and death tax rates in Appendix A (Summary of State Income and Death Tax Rates) of this outline.

As mentioned above, in 2001, for a New York City resident there was a 25% difference between the maximum transfer tax rate and the long-term capital gain tax rate.[39]  Today, that difference is approximately 13%.  In contrast, consider the tax rates in California.  Because California does not have a state death tax, but currently has the highest combined income tax rate in the U.S., the difference between the transfer tax rate and the long-term capital gain tax rate is less than 3%.[40]  Notably, the top combined ordinary and short-term capital gain tax rate in California is greater (approximately, 45% to 53%) than the transfer tax rate.

If one considers the “gap” (the difference between the transfer tax and the income tax rates) as a proxy for how aggressively estate planners will consider transferring assets out of the estate during lifetime, then one can see large differences among the states.  On one side, there is California, where there is a very small or negative difference, compared to Washington where there is very large gap (approximately 28% difference above the long-term capital gain tax rate).[41]

As a result, we hypothesize that the consistency that existed a decade ago across the U.S. for similarly situated clients (distinguished only by the size of the potential gross estate) will no longer exist.  As a result, one will see large disparities among estate plans based on the state of residence of the client.  For example, it can be argued that California residents should be much more passive in their estate plans, choosing more often than not, to simply die with their assets, than Washington residents.  This is because the income tax savings from the “step-up” in basis may, in fact, be greater than the transfer tax cost, if any.

Turney P. Berry

Louisville, Kentucky

[1] For example, the California enactment in 2012 of the Temporary Taxes to Fund Education, commonly known as Proposition 30 that raised the highest marginal income tax bracket to 13.3%.

[2] For example, on July 23, 2013, North Carolina repealed its estate tax (effective date of January 1, 2013), The North Carolina Tax Simplification and Reduction Act, HB 998, and on May 8, 2013, Indiana repealed its inheritance tax (effective date of January 1, 2013), Indiana House Enrolled Act No. 1001.

[3] § 2001(c) (for transfers above $1 million) and § 2641(a)(1).

[4] § 2010(c)(2); Temp. Treas. Reg. § 20.2010-1T(d)(2).

[5] § 2010(c)(3)(A); Temp. Treas. Reg. § 20.2010-1T(d)(3)(i).

[6] § 2010(c)(3)(B); Temp. Treas. Reg. § 20.2010-1T(d)(3)(ii).

[7] Rev. Proc. 2013-15, 2013-5 I.R.B. 444, Section 2.13.

[8] § 2631(c).

[9] § 2010(c)(4). Enacted as part of the Tax Relief, Unemployment Reauthorization, and Job Creation Act of 2010, Pub. L. 111-312, 124 Stat. 3296 (“TRA 2010”). § 101(a)(2) of ATRA struck the “sunset” provisions of TRA 2010 by striking § 304 of TRA 2010.

[10] § 101(a)(1) of ATRA provides for a repeal of the “sunset” provision in the Economic Growth and Tax Relief Reconciliation Act of 2001, Pub. L. 107-16, 115 Stat. 38, (“EGTRRA”).  The “sunset” provision of EGTRRA is contained in § 901 (“All provisions of, and amendments made by, this Act [EGTRRA] shall not apply… to estates of decedents dying, gifts made, or generation skipping transfers, after December 31, 2010,” and the “Internal Revenue Code of 1986 … shall be applied and administered to years, estates, gifts, and transfers … as if the provisions and amendments described [in EGTRRA] had never been enacted.”).

[11] Temp. Reg. § 20.2010-1T(d)(3)(ii).

[12] Low, average, and high inflation are defined as the 90th, 40th, and 10th percentile of inflation over the relevant time periods.  The projections are based on Bernstein Global Wealth Management’s estimates of the range of returns for the applicable capital markets. Figures are rounded to the nearest $10,000.  Data do not represent past performance and are not a promise of actual future results or a range of future results.  See Appendix B (Notes on the Wealth Forecasting System) for additional details.

[13] § 1 (for individuals with taxable income over $400,000 and married individuals filing jointly with taxable income over $450,000). See Rev. Proc. 2013-15, 2013-5 I.R.B. 444, Section 2.01.

[14] § 1(h)(1)(D) (for individuals with taxable income over $400,000, married individuals filing joint returns with taxable income over $450,000, and for estates and trusts with taxable income over $11,950).  See Rev. Proc. 2013-15, 2013-5 I.R.B. 444, Section 2.01.

[15] § 1(h)(11) (allowing such income to be considered “net capital gain”).

[16] See Richard L. Dees, 20 Questions (and 20 Answers!) On the New 3.8 Percent Tax, Tax Notes, Aug. 12. 2013, p. 683 (8/12/13), and Blattmachr, Gans and Zeydel, Imposition of the 3.8% Medicare Tax on Estates and Trusts, 40 Est. Plan. 3 (Apr. 2013).

[17] § 1411(c).

[18] § 1411(c)(1)(A).

[19] Id.

[20] § 1411(c)(2)(A).

[21] § 1411(c)(2)(B).

[22] § 1411(c)(2)(C).

[23] § 1411(c)(3), referencing § 469(e)(1)(B), which provides “any income, gain, or loss which is attributable to an investment of working capital shall be treated as not derived in the ordinary course of a trade or business.”  See Prop. Reg. § 1.1411-6(a).

[24] § 1411(c)(1)(B).

[25] § 1411(a)(1)(A).

[26] § 1411(a)(1)(B)(i).  Modified adjusted gross income is “adjusted gross income” as adjusted for certain foreign earned income. § 1411(d).

[27] § 1411(a)(1)(B)(i).

[28] § 1411(b).

[29] § 1411(a)(2).

[30] § 1411(a)(2)(B)(i).

[31] § 1411(a)(2)(B)(ii).

[32] See Rev. Proc. 2013-15, 2013-5 I.R.B. 444, Section 2.01.

[33] § 1411(c)(4)(A).

[34] § 1411(c)(5).

[35] REG-130507-11, Preamble and Proposed Regulations under section 1411 (December 5, 2012), Fed. Reg. Vol. 77, No. 234, p. 72612-33 (hereinafter, “Preamble to § 1411 Proposed Regulations”).

[36] See Preamble to § 1411 Proposed Regulations.

[37] §§ 531 and 532 of EGTRRA provided for a reduction of and eventual repeal of the Federal estate tax credit for state death taxes under § 2011 of the Code, replacing the foregoing with a deduction under § 2058 of the Code.

[38] Connecticut, Delaware, District of Columbia, Hawaii, Illinois, Maine, Maryland, Massachusetts, Minnesota, New Jersey, New York, Oregon, Pennsylvania, Rhode Island, Tennessee, Vermont, and Washington.  Iowa and Kentucky have an inheritance tax, but the exemption to at least children and grandchildren is unlimited.

[39] New York has a maximum estate tax rate of 16%, when added to the maximum Federal tax rate of 40% and deducted pursuant to § 2058 of the Code, the combined maximum transfer tax rate is 49.6%, compared to a maximum long-term capital gain tax rate of 36.5% for New York City taxpayers in the alternative minimum tax (20% Federal, 3.8% Medicare tax, 8.82% state, and 3.88% local).

[40] Combined long-term capital gain tax rate of 37.1% for California taxpayers in the alternative minimum tax (20% Federal, 3.8% Medicare tax, and 13.3% state).

[41] Washington does not have a state income tax.


Leave a reply. Please note that although this blog may be helpful in informing clients and others who have an interest in information privacy and security, it is not intended to be legal advice. The information on this blog also should not be relied upon to form an attorney-client relationship.

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