PLANNING FOR 2014 AND BEYOND
The Old Paradigm: When In Doubt, Transfer Out
The year 2013, with the enactment of the American Taxpayer Relief Act of 2012 (“ATRA”) and the imposition of the 3.8% Medicare contribution tax on unearned passive income (hereinafter, the “3.8% Medicare tax”) that was enacted as part of the Patient Protection and Affordable Care Act (“PPACA”), will mark the beginning of a significant change in perspective for estate planners.
For years, estate planning entailed aggressively transferring assets out of the estate of high-net-worth individuals during their lifetimes to avoid the imposition of estate taxes at their deaths. Inter-vivos transfers obviously precluded the decedent’s estate from being entitled to a “step-up” in basis adjustment under section 1014 of the Internal Revenue Code of 1986, as amended (the “Code”). Because the estate tax rates were significantly greater than the income tax rates, the avoidance of estate taxes (typically to the exclusion of any potential income tax savings from the “step-up” in basis) was the primary focus of tax-based estate planning for wealthy individuals.
By way of example, consider the planning landscape in 2001. The Federal estate and gift tax exemption equivalent was $675,000. The maximum Federal transfer tax (collectively, the estate, gift, and generation-skipping transfer tax) rate was 55%, and the law still provided for a state estate tax Federal credit. Because virtually all of the states had an estate or inheritance tax equal to the credit, the maximum combined Federal and state transfer tax rate was 55%. The combined Federal and state income tax rates were significantly lower than that.
For example, consider the maximum long-term capital gain and ordinary income tax rates of a highly taxed individual, a New York City taxpayer. At that time, the combined maximum Federal, state, and local income tax rate for long-term capital gains was approximately 30% and for ordinary income, less than 50%. As a result, the gap between the maximum transfer tax rate and the long-term capital gain tax rate for a New York City taxpayer was approximately 25%. In other words, for high income, high-net-worth individuals in NYC, there was a 25% tax rate savings by avoiding the transfer tax and foregoing a “step-up” in basis. Because this gap was so large (and larger in other states), estate planning recommendations often came down to the following steps, ideas and truths:
- Typically, as the first step in the estate planning process, make an inter-vivos taxable gift using the $675,000 exemption equivalent, thereby removing all future appreciation out of the estate tax base.
- Use the exemption equivalent gift as a foundation to aggressively transfer assets out of the estate during lifetime (for example, a “seed” gift to an intentionally defective grantor trust (“IDGT”)—a trust that is a grantor trust for income tax purposes but the assets of which would not be includible in the estate of the grantor—to support the promissory note issued an installment sale to the IDGT).
- Draft the trusts and other estate planning structures to avoid estate tax inclusion for as many generations as possible (for example, leveraging the generation-skipping transfer (“GST”) tax exemption by applying it to the seed gift to the IDGT and establishing the trust in a jurisdiction that has abolished the rule against perpetuities).
- Forego the “step-up” in basis adjustment at death on the assets that have been transferred during lifetime, because the transfer tax savings were typically much greater than any potential income tax savings that might result from a the basis adjustment at death.
- Know that the income tax consequences of the various estate planning techniques were appropriately secondary to avoiding the transfer tax.
- Know that the state of residence of the decedent and the decedent’s beneficiaries did not significantly affect the foregoing recommendations or ideas because the large gap between the transfer tax and the income tax existing consistently across all of the states.
As a result, there was an enormous amount of consistency in the estate planning recommendations across the U.S., where the only differentiating factor was the size of the gross estate. In other words, putting aside local law distinctions like community vs. separate property, almost all $20 million dollar estates had essentially the same estate plan (using the same techniques in similar proportions).
The enactment of ATRA marks the beginning of a “permanent” change in perspective on estate planning for high-net-worth individuals. The large gap between the transfer and income tax rates, which was the mathematical reason for aggressively transferring assets during lifetime, has narrowed considerably, and in some states, there is virtually no difference in the rates. With ATRA’s very generous applicable exclusion provisions, the focus of estate planning will become less about avoiding the transfer taxes and more about avoiding income taxes.
 P.L. 112-240, 126 Stat. 2313, enacted January 2, 2013.
 § 1411 of the Internal Revenue Code of 1986, as amended (the “Code”). Hereinafter, all section references denoted by the symbol § shall refer to the Code, unless otherwise noted.
 P.L. 111-148, 124 Stat. 119, enacted on March 23, 2010.
 Consisting of maximum Federal long-term capital gain tax rate of 28% and ordinary income tax rate of 39.1%, New York State income tax rate of 6.85%, and a New York City income tax rate of 3.59%. The effective combined tax rate depends, in part, on whether the taxpayer is in the alternative minimum tax, and the marginal tax bracket of the taxpayer.
 §§ 671-679.
 See, e.g., Stuart M. Horwitz & Jason S. Damicone, Creative Uses of Intentionally Defective Irrevocable Trusts, 35 Est. Plan. 35 (2008) and Michael D. Mulligan, Sale to Defective Grantor Trusts: An Alternative to a GRAT, 23 Est. Plan. 3 (2006).