It’s Time to Review Your Will and Estate Plan
by Rick Henderson CPA, CFP® AIF®
When the Tax Cut and Jobs Act of 2017 was signed into law, the estate and gift tax exemption, which is the amount you can pass to your heirs estate tax free, was raised to $11.18 million per person ($22.36 million per couple), increasing annually with inflation. The good news is that because of this change, most people’s estates will now be estate tax free. However, because of the way that many people’s wills have been written over the years, especially people with tax planning wills, the new tax law can potentially cause significant unintended consequences in how your assets are distributed, as well as cause your heirs to incur additional capital gains taxes on assets that they inherit. If, by reading this article, you only remember one thing, please remember that with the implementation of the new changes in the estate and gift tax laws, it is very important for you to review your will and estate plan with your advisor team to make sure that the new rules have not disrupted the asset flow of your plan and that the plan is still how you want it to be. Also, relook at your will and your estate plan to make sure they are taking advantage of the latest tax rules and will not cause any unintended tax consequences. For those of you who are interested in a more detailed explanation and some examples, I’ve outlined them below.
Let’s begin with the basics
For many years, every taxpayer has had a credit that, when they die, can be used to shield a certain amount of assets from estate taxes. Table 1 shows, by year, the amount of assets that are sheltered for each person by the credit and the estate tax rate for that corresponding year on assets that exceed the credit amount.
Table 1: Historical and Future Federal Estate Tax Exemptions and Rates1
Here's how the estate tax has broken down over the years:
|Year||Estate Tax Exemption||Top Estate Tax Rate|
|2010||$5,000,000 or $0||35% or 0%|
The heirs of decedents who died in 2010 had a choice. They could use the $5,000,000 estate exemption at the 35 percent estate tax rate, or they could elect to use $0 estate tax exemption at a zero percent tax rate, coupled with the use of modified carryover basis rules.
Please keep in mind that a married couple has one credit for each person, and therefore can shelter double the amount of assets from estate taxes. The way that credit usually gets utilized upon the first death in a couple is that their tax planning will is drawn up by their attorney and includes a formula that ensures that the maximum amount of assets that can qualify to pass to their heirs estate tax free goes into an irrevocable bypass trust, also called a credit shelter trust. This credit shelter trust is often held for the benefit of their children, or their children and their surviving spouse, or maybe other people like children from a prior marriage.
Many people have approached the planning of their estates and the distribution of their assets based on the amount of the credit available at the time they were doing their most current wills, regardless of how long ago that was. For example, if a person had a $2.5 million estate when they were doing their planning in 2003, their approach at that time might have been to use a formula in their will to give the maximum amount (at that time $1 million) to their children through their credit shelter trust, with the remaining amount ($1.5 million) going to their spouse. Then, at the death of the surviving spouse, that spouse’s credit would be used to shelter an additional $1 million for a total of $2 million sheltered from estate taxes between both of them, leaving only $500 thousand subject to estate tax. And, if the clients had both died in 2003, the plan probably would have worked exactly that way.
Where is the Problem?
There are two major potential problems, both caused by the same culprit. That culprit is that many, if not most tax-planning wills done over the last 20+ years use a formula in order to maximize the usage of the credit shelter amount that is available at the time of death. The very large credit amount provided by the new tax law ($11.18 million per person) combined with the formula(s) commonly found in many tax planning wills has the potential to cause:
- Unintended distribution consequences, with assets going to places inconsistent with the original intent leading to potential disinheritance, under inheritance, or over inheritance
- Unintended income tax consequences, including triggering additional capital gains taxes
Unintended Distribution Consequences
Take the person in the example above that has the will and planning that was done in 2003, when the credit shelter amount was at $1 million. Remember, in our example they thought they would be leaving $1 million to their heirs in the credit shelter trust and $1.5 million to their spouse when they died, sheltering most of their $2.5 million estate from estate taxes. Fast forward 15 years to 2018 under the new tax law. Assume the estate has grown at 7% per year and now totals approximately $6.7 million. If that person with the same will (which contains a formula to maximize the usage of the credit shelter amount that is available at the time of death) dies in 2018, all $6.7 million of the assets will go into the credit shelter trust for the heirs because the credit amount under the new tax law equals $11.18 million and the will states to maximize the assets going into the credit shelter trust. This leaves nothing for the surviving spouse, most likely not what was intended.
Unintended Tax Consequences, Paying Additional Capital Gains Taxes
Continuing with the example above, assume there is $6.7 million in the credit shelter trust with a cost basis of $6.7 million established at the first spouses’ date of death. Next, let’s assume that the credit shelter trust had provisions to provide for both the spouse and the children, so the spouse receives funds from the trust each year, and the trust still grows 5% each year for the next seven years. Also, let’s assume that the $11.18 million credit shelter amount remains the same. Under those assumptions, the trust will have grown to approximately $10 million in seven years. If the surviving spouse dies in the seventh year, there will be no step up in basis because the assets are in the credit shelter trust. So, when they are distributed to the heirs and liquidated, they retain their original $6.7 million cost basis and the heirs will pay capital gains tax on the $3.3 million difference. At 20% capital gains rate, that would be about $660,000 of capital gains taxes. If the whole $6.7 million had not gone into the credit shelter trust in 2018 and some or all of the money had been left to the surviving spouse, any assets held by the surviving spouse at death would receive a step up in tax basis thus reducing or possibly eliminating capital gains tax resulting from the heirs liquidating the assets after the second death. Because the whole estate was under both $11.2 and $22.4 million, there would be no estate tax under current law in either scenario.
Once again, your action steps are to coordinate with your advisor team to review your will and estate plan and to understand how they work together under your current situation and current law, and then make any necessary changes to help make sure that your assets go where you want them to go in the most cost and tax efficient manner possible.