Estate Planning Update for Fall of 2012

Here is an interesting portion of an article by Michael D. Whitty discussing some estate planning considerations for the latter part of 2012.


Conditions Remain Favorable for Lifetime Gifts and Other Estate Planning Transactions


As covered in our August Estate Planning Notice, the combination of a higher gift tax exemption through 2012 and low interest rates for many powerful leveraged estate planning techniques makes this year the best environment for lifetime gifts, intrafamily loans and other estate planning transactions that planners have ever seen. Persons interested in taking advantage of these conditions should contact a member of the Estate Planning group at Vedder Price soon, while there is still time to act.


Deadline to Remedy Roth IRA Conversions


For those taxpayers who extended their 2011 income tax returns, the deadline to recharacterize Roth IRA conversions is October 15, 2012. Due to unstable market conditions, many individuals have seen their portfolios significantly decline in value. As a result, individuals who converted their retirement accounts to Roth IRAs in the past year may face a tax liability on an amount no longer in their accounts. To remedy this problem, the IRS allows taxpayers to reverse their Roth IRA conversions by recharacterizing them, so long as such recharacterization is complete before the deadline for filing the individual’s tax return for that year, including extensions. Any recharacterized conversion will be treated as though the conversion had not occurred.


Individuals who converted their Roth IRAs in the past year and have decided that a recharacterization would be beneficial should contact their individual tax return preparers to determine the necessary steps to report the recharacterization.


New 3.8% Investment Income Surtax Applicable to Estates and Trusts


To help finance the Patient Protection and Affordable Care Act, a new 3.8% surtax will apply to certain passive investment income of individuals as well as estates and trusts, beginning January 1, 2013. The amount subject to the tax is determined by a somewhat complex calculation.


For individual taxpayers, the 3.8% surtax will be imposed on the lesser of (1) net investment income, or (2) the amount by which modified adjusted gross income (MAGI) exceeds the threshold amount in that tax year.


For estates and trusts, the 3.8% surtax will be imposed on the lesser of (1) the undistributed net investment income of a trust or estate, or (2) the amount by which adjusted gross income exceeds the top inflation-adjusted bracket for estate and trust income, which is expected to be approximately $12,000 in 2013. This threshold is substantially lower than the threshold for individual taxpayers, so the tax impact on an estate or trust will be greater than for an individual with the same income. Because distributed net income is not taxed at the trust level, this may create an incentive to distribute the trust income out if the beneficiaries who receive it are below the threshold for the surtax to apply.


In general, the surtax does not apply to active trade or business income, or to distributions from IRAs and qualified plans. In addition, trusts dedicated to charitable purposes are not subject to the new tax, while grantor trusts (which are treated as the grantor’s own property for income tax purposes) will not pay the tax directly, instead passing through the taxable income to the grantor’s own tax return. However, the surtax does apply to individuals who receive distributions of net passive income from trusts and estates.


This new surtax creates many planning considerations and complexities when it comes to decisions such as whether to create a new trust as a grantor trust, or whether estate and trust income should be retained or distributed out to beneficiaries. Individuals should contact their Vedder Price attorney to determine how the surtax will affect their trusts and estates.


Estate Tax Portability Guidance and Clarification


The Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 (the 2010 Tax Act) added a feature known as “portability,” which allows the unused estate tax exemption of a deceased spouse to be transferred to the surviving spouse. Note that a surviving spouse is only entitled to the unused exemption of the “last deceased spouse.” In other words, a surviving spouse may not use the DSUE of multiple deceased spouses.


The IRS recently issued much-anticipated temporary and proposed regulations, offering guidance and clarification on the requirements for electing portability and for establishing the amount of estate tax exemption that is transferred. Previously, the IRS had issued Notice 2011-82, which provided that a deceased spouse’s estate is deemed to elect portability by timely filing an estate tax return, Form 706. Before portability, the Form 706 estate tax return was prepared only when an estate exceeded the exemption amount. Accordingly, in order to take advantage of portability, estates must now prepare and file Form 706 even when the return would not be required but for the portability election.


In anticipation of the portability regulations, estate planners speculated that the IRS would issue a simplified Form 706 for estates of less than $5 million that were filing only to elect portability. Instead, the portability regulations adopted the solution of allowing executors of estates that need not otherwise file the Form 706 to use the same form, but to avoid reporting the value of property that qualifies for the marital or charitable deduction. Some executors will choose not to take advantage of this exemption from full reporting, because the Form 706 also serves to document the step-up in basis for capital gains taxes.