PHILADELPHIA -- The estate tax portability provision in the Tax Relief, Unemployment Insurance Reauthorization and Job Creation Act of 2010 could trip up advisors who fail to think ahead.
Kathleen Sherby, a partner at Bryan Cave L.L.P., St. Louis, talked about the Tax Relief Act provision here earlier this week at a clinic organized by the Society of Financial Service Professionals (FSP), Newtown Square, Pa.
"Portability sounds like a great thing," Sherby said at a wide-ranging closing general session. "But there are problems."
The Tax Relief Act is on track to cause many provisions of the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) to expire, or "sunset," at the end of 2012,
The Tax Relief Act portability feature lets a surviving spouse take advantage of the unused estate tax exemption left behind by the spouse who dies first. The surviving spouse must file an estate tax return to capture the unused exemption. Like other EGTTRA provisions extended by the Tax Relief Act, that provision could sunset at the end of 2012.
One of the problems with the exemption portability provision is that it is not indexed to inflation, Sherby warned.
"So--10 or 20 years later--you get whatever the unused exemption amount is," she said. "If the assets of a surviving spouse grow considerably, the exemption might not cover the individual."
Another problem is that a surviving spouse might not be able to use the exemption after remarrying.
Suppose an advisor has a client who is a surivivng spouse and a user of the Tax Relief Act exemption portability provision. The client remarries. The client's second spouse uses up all of his or her estate tax exemption amount and then dies. In that situation, the unused exemption of the deceased spouse from the client's first marriage is no longer available to the client. That's because the portability feature applies only to the last deceased spouse's unused exclusion amount.
"If you marry someone who is a lot richer than your first spouse, and that spouse dies before you do, you lose the benefit of your first spouse's unused exemption," Sherby said. "And you now have the wealthy second spouse's unused exemption--which may be nothing.
"So if you have a poor spouse who predeceases you, you may not want to marry a rich spouse. Instead, you might simply choose to live together. Or you get married and make lifetime gifts of the unused exclusion amount."
Lawrence Brody, Sherby's co-presenter and fellow partner at Bryan Cave, joked that enterprising individuals who plan to remarry now have an unconventional commercial opportunity: Advertising an unused exemption in a classified ad on the Web.
"Here's my proposed heading: 'Old, Poor, Unhealthy Widower: Full Exemption Available,'" Brody said. "'At a reasonable cost, my exemption is available to you. Here's my contact info...'"
Sherby pointed to other problems with the 2010 tax law provision.
Among them: The lack of portability for the generation-skipping transfer (GST) tax, a federal tax imposed on gifts and transfers in trust to or for the benefit of (among others) grandchildren; uncertainty as to the long-availability of portability, given the 2012 sunset provision; and (as regards the process issue) the requirement that an executor of the predeceased spouse's estate file an estate tax return and make an election to permit the surviving spouse to use the unused exemption.
Because of these issues, said Sherby, clients may be well advised to use a credit shelter trust in place of the portability feature. Also referred to as an A/B trust, bypass trust or unified credit trust, the vehicle lets a surviving spouse avoid estate tax at a first spouse's death by using the available federal estate tax credit or applicable exclusion amount.
Turning to life insurance, the speakers noted that the Tax Relief Act's increased lifetime estate, gift and GST exemptions--under the law, gift, estate, and GST rates and exemptions are reunified at $5 million per person ($10 million per couple), with a 35% top tax rate--will avail advisors of opportunities to "fix" broken insurance and estate planning transactions.
Among the arrangements that could be mended: Split-dollar and private premium financing transactions that are "under water," and installment sales to intentional grantor trusts in which the asset failed to appreciate or to generate enough cash to make the required payments.
Where split-dollar or private premium financing arrangements were created without an "exit strategy" to allow the advances or loans to be repaid during an insured's lifetime, the increased gift and GST exemptions could provide "side-funds" for such an exit strategy, Brody said.
"Even if the split-dollar or premium financing arrangement or the installment sale is not under-water, having the lender or seller forgive all or part of the loan, advance, or note would simplify the transaction," Brody said. "And if an installment sale relied on guarantees to give the transaction substance, a gift of the increased exemption may allow the guarantees to be released."
The panelists closed out the general session by prognosticating on forces that might shape the future of estate and financial planning practices.
In comments about the future of the Tax Relief Act, Brody described three possible scenarios: (1) Congress does nothing and allows EGTRRA to expire; (2) Congress extends the 2001 tax law provisions for another 2 years; or (3) Congress "gets its act together" and makes the EGTRRA estate tax provisions, including the provision that increased the exemption cut-offs, permanent.
If Congress makes the Tax Relief Act exemption levels permanent, it may decide to eliminate the estate tax altogether. The reason: Because relatively few returns will be filed at the $5 million per person exemption amount, the cost of administering the estate tax would be greater than the revenue from the estate tax.
Tax law aside, Sherby said a number of factors, including changing demographics and lifestyles, the rapid growth of knowledge, globalization, and the digitalization of information will profoundly impact advisors' practices."
"Most young people now do their banking online and all of their accounts are password-protected," Sherby said. "Should something happen to them and you don't know their passwords, you won't be able to determine what assets they have. So we need to have a way to keep the passwords protected, yet make them available to survivors if something happens to someone."