Funding of Trusts Critical to Use New Higher Estate Tax Limits

Many estate plans were established at a time when the Federal Estate Tax Exemption was somewhere between $600,000 and $675,000. In the last 2 ½ years the estate tax exemption has risen dramatically first to $1 million and now to $1.5 million per person.

The current law would send the estate tax exemption on a roller coaster ride, first up and then down, according to the following schedule.

Year Exemption Amount
2001 $675,000
202 $1,000,000
2004 $1,500,000
2006 $2,000,000
2009 $3,500,000
2010 No estate tax (but replacement tax)
2011 $1,000,000

The reason for the reappearance of the $1 million exemption in 2011 is that when these estate tax changes were enacted, only a 50% majority was obtained for passage of the legislation. In order to make these tax reductions permanent, a 60% majority was required. We believe that Congress will once again modify the estate tax laws to correct this highly unusual and unworkable situation. It is fairly likely that Congress will freeze the estate tax exemption somewhere between $2 million and $4 million. There is also a possibility that they will repeal the tax altogether. The ultimate course of action will depend upon many factors including the economy, the budget, and the deficit.

Using the Exemption

For the moment it is important to deal with the increased $1.5 million exemption. With proper planning a married couple can protect $3 million worth of assets. For many individuals (subject to future growth and inflation) this should greatly reduce or eliminate their estate tax obligation at death. Without proper funding, however, a large estate tax could still be due.

Some married individuals made sure that each of the spouses held at least $675,000 in their trust. Assets over that amount may have been held by one or the other but were not necessarily balanced. If those individuals do not reallocate the assets, then at the first death, the deceased individuals may not use the full exemption amount. Thus despite the higher available exemptions, the first spouse may only protect what has actually been placed in the trust. This mistake can cost hundreds of thousands of dollars of unnecessary tax.

Solution-Review of Assets

The best way to make sure that trusts are properly funded and balanced is to periodically make an asset list noting the value of each asset and its ownership or beneficiary designation. Remember that if life insurance, IRAs or 401(k)s are paid directly to the survivor, that will not assist in the funding of the trust.

Income Tax Issues

Some assets, such as IRAs, have both income tax and estate tax consequences. It is not always easy to determine whether these assets should be paid to the trust or the surviving spouse. A payment to a spouse may help defer income tax. A payment to a trust will help avoid estate tax. Income tax can sometimes be deferred on payments to trusts but the rules are more complicated. Each situation is different. The answer will depend on the specific circumstances for each individual. We often are able to draft designations that allow for some flexibility after death.

If you have any questions regarding funding of revocable trusts, please contact any of our attorneys in the Estate Planning and Tax Group.