Tax Planning Is Becoming A Vital Component of Estate Plans

Income Tax Planning Is Becoming A Critical Part Of Estate Planning

American Taxpayer Relief Act

American Taxpayer Relief Act

ATRA or American Taxpayer Relief Act was enacted 2 years ago by the Congress. Because of ATRA and its effect on estate and gift tax exemptions and individual income tax rates, the focus of estate planning has shifted towards tax planning as well.

ATRA’s Effect on GST and Gift and Estate Tax

ATRA, soon after it was introduced, affected the GST tax rates by increasing it from 35% to 40% and the exemption amounts of gift tax and federal estate tax by increasing the same to $5 million. In the year 2015, the estate and gift tax’s exemption comes up to $5.43 million for individuals and $10.86 million was married couples, after taking the inflation indexation into account.



ATRA’s Effect on 2010’s Portability Feature

The portability feature from 2010 was also made permanent by the ATRA which allowed married couples to utilize their complete exemptions and let a surviving spouse use their own exemption with their deceased spouse’s unused exemption.

ATRA’s Effect on Federal Income Tax Act and ObamaCare

The top income tax for individuals was increased to 39.6% from 35% by the ATRA and the capital gains tax was increased to 20% from 15% by the same act. Also, the act previously known as ObamaCare added an income tax of 3.8% to the NII and this rate, combined with the income tax rate for individuals comes up to 43.4% while long term capital gains and dividends reach up to 23.8%. It should be mentioned that the 3.8% rate would only apply to taxpayers who are – individuals who have their modified gross adjusted income increasing $200,000 or, in case of joint filing by married couples, $250,000, and trusts whose gross income is more than $12,150.

Estate Tax

Estate Tax

Closing of the Gap Between Estate Tax and Income Tax

Traditionally speaking, the income tax was considerably lower than estate tax but because of ATRA, this gap is closing. This is why individuals are turning towards tax strategies and planning. There are two major approaches to consider in this area – shifting higher tax income to lower tax brackets and avoiding itemized deduction phase out.

Strategy I: Shifting Higher Tax Income to Lower Tax Bracket

This involves assigning income from a high tax bracket taxpayer to a low tax bracket taxpayer. For instance, a complex trust gifting certain assets that produce income to trust beneficiaries would shift the tax burden to the beneficiary who belongs in a lower bracket. While complex trusts would have to be 39.6% of tax plus 3.8% on their NII, when they shift the burden to beneficiaries, latter would not apply to them. Also, distribution of income by a complex trust earns the said trust a deduction on the distributed income and the incomes gets shifted towards the beneficiary.

The income would retain its character and in case the beneficiary falls in the higher tax bracket, the 3.8% rate may still not apply to them.

Itemized deductions

Itemized deductions

Strategy II: Avoiding Itemized Deduction Phase Out

The phase out of personal exemptions and itemized deductions can be avoided by lowering the income. Generally, these deductions are based on the gross adjusted income’s set percentage. For instance, the limit on these deductions is reduced by the phase out of 3% and the miscellaneous deductions would be allowed for the amount that exceeds 2% of their gross adjusted income. If the income of the taxpayer was reduced in some way, then the phase out of deductions could be eliminated or reduced, and this includes charitable deductions.

For example, a CLAT (non-grantor) can be created by those taxpayers who are in the habit of making regular and fixed donations every year because such a creation would lead to their charitable deduction getting completely utilized. Since the said CLAT is considered to be a separate taxpayer from the settlor, the asset contributed to the CLAT and the income generated from it would shift to the CLAT and lead to a deduction from the settlor’s gross adjusted income. At the same time, the CLAT would get deductions that do not phase out or are subjected to % limitations for its yearly donations to charity.

Estate planning

Estate planning

Shift in Estate Tax Planning

Traditionally, the goal of professionals of estate planning has been to shift the gross estate as much as possible to limit estate tax exposure. But, because of increased federal tax rate, the new focus has shifted towards the asset type that the client owns and every asset’s tax basis is now being inquired upon. Because of this review, professionals could determine the assets that should remain in the estate of the client and those that should be shifted for receiving the death based step-up.

ATRA’s enactment has, thus, inflated the importance that individual income tax planning has in respect to estate planning and this is the reason why many individuals are seeking advice from professionals in this arena.

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