©2019 by Jonathan G. Blattmachr & Daniel J. Scott. All Rights Reserved.
For decades, the primary focus of estate planning lectures and publications was about preserving the maximum value of an estate, primarily through estate tax planning. The emphasis was paying less tax in order to transfer more wealth to future generations using techniques such as irrevocable life insurance trusts, corporate and partnership “freezes,” grantor retained income trusts (GRITs), qualified personal residence trusts (QPRTs), grantor retained annuity trusts (GRATs), installment sales to grantor trusts, (family) limited partnerships (FLPs) and making lifetime gifts under the protection of the gift tax annual exclusion or to avoid transfer tax on gift tax paid. This seemed to make sense for many Americans when the estate and gift tax exemptions hovered around $600,000 or $1,000,000. In some states, the combined state and federal estate tax could exceed 50%. As a result, an individual dying with $1 million in assets could end up leaving her heirs less than $500,000. Virtually all of these arrangements involved changing the nature of what was owned by the time of transfer, whether during lifetime (by sale or gift) or at death. For example, the value of a limited partnership received in exchange of other assets, such as market securities, likely was lower than the value of the assets transferred to the partnership. The adage was: lower the value and thereby lower the tax.
Through the years, starting in the early 2000s, however, the estate and gift tax exemptions substantially increased initially topping out at $5 million (with an inflation adjustment) until today when it is over $11 million, although scheduled to drop back to $5.5 million (again inflation adjusted) after 2025. As a result, today less than a fraction of 1% of Americans are expected to owe any estate tax when they die. Suffice to say, estate tax planning has become a non-issue for nearly all Americans.
More important, recent studies now show that merely employing traditional estate planning techniques primarily aimed at avoiding estate taxes and preserving the maximum value of an estate simply do not work. The unfortunate reality is that, despite having an estate plan and using the methods described above, there is still a 70% chance that an individual’s estate will be gone by the second generation (i.e., by the time their children are adults) and a 90% chance it will be gone by the third generation (i.e., when their grandchildren are adults). In other words, it does not matter how much estate tax is saved today because it will all most likely be gone tomorrow. Something is missing.
It begs the question: what is the true goal of estate planning and, therefore, what is the real job of estate planners? For most Americans, avoiding estate taxes is not the main goal of estate planning. Rather, most Americans simply desire to leave their assets to their children and relatives to accomplish a variety of purposes: to care for the elderly, pay for school, provide a comfortable, fulfilling life, etc. In other words, estate planning is less about preserving an estate and more about applying an estate towards one or more specific purposes. Of course, even if not the main goal, minimizing taxes should still continue to be a major part of estate planning.
There Is Still a Basis for Tax Planning in Estate Planning
The traditional estate planning technique of reducing the value of estate assets or lifetime gifts actually adversely affects estate planning for most as it squanders at least part of the major favorable tax effect of death: the income tax free change in basis to current fair market value which washes away, for most assets, the inherent capital gain in property.
Neither the right to income in respect of a decedent (IRD) dealt with in IRC 691 nor property given away during lifetime enjoys the basis change in most cases. For property given away during lifetime, one plan is to try to recover the gifted assets back into the decedent’s gross estate to wash away the inherent gain. That may not be easy as a sale back to the donor may well trigger gain recognition. A gift back might work and, until at least 2026, most need not be concerned with making taxable gifts. An alternative in making lifetime gifts is to do so in trust and allow the trustee to grant the donor the power before death to control the beneficial enjoyment of the gifted assets, causing estate tax inclusion and thereby securing the automatic change in basis.
Moreover, a taxpayer may gift assets to a spouse (unless the spouse is not a US citizen) in an attempt to have them included in the gross estate of the spouse anticipated to die first and thereby secure the automatic change in basis. But the law attempts to prevent that if the gift to the deceased spouse occurred within one year or his or her death and is inherited back by the donor spouse. Although it may be possible to avoid the impact of this denial of basis change by careful planning, there are two short comings. First, the planning may not work as there is little developed law in the area. Second, the order of deaths of the spouses may not be predictable or the advice may not be followed for emotional or other reasons. An alternative is for the spouses to convert all assets that would be entitled to the automatic change in basis to community property, a type of common ownership between spouses.
Under IRC 1014(b)(6), both the deceased spouse’s half of a community property and the survivor’s half enjoy the automatic change in basis when the first spouse dies. Louisiana, Texas, New Mexico, Arizona, California, Nevada, Washington (state), Idaho and Wisconsin have community property. So, the couple could move to such a state prior to death to obtain that benefit. But making such a change in domicile probably is not realistic for most couples. Alaska, however, permits couples to create community property by agreement. Most important, for those who do not live in and who not wish to move to a community property regime, Alaska permits non-residents to create community property by transferring assets to a community property trust and declaring it to be community property. Because IRC 1014(b)(6) applies to any asset that is community property under the law of any state, the bases of assets in an Alaska community property trust should be changed when the first spouse dies. Tennessee has a similar rule.
Income in respect of a decedent (IRD), is taxable income “owed” to the decedent at the time of death but not properly included on a pre-death income tax return. It includes unpaid salary, accrued interest, proceeds of sale of certain property under contract for sale before death, among dozens of other items, the main one in most estates being unpaid retirement benefits in a qualified plan (such as a section 401(k) plan) or an individual retirement account (IRA). The inherent income tax liability, unlike most appreciated assets, such as land, business interests and securities, is not forgiven at the death of the owner or participant under IRC 1014. Rather, payments from the plan or IRA (other than a Roth IRA) are included in gross income of the recipient almost always as ordinary income. Although the employee of a qualified plan or owner of an IRA has significant opportunities to postpone that taxation during lifetime, the opportunities diminish at death.
Because ordinary income may be taxed at 37% (which will become 39.6% beginning after 2025) and may also be taxed by a state (or state and local government), it is critical to plan to try to reduce or at least postpone the taxation of plan and IRA distributions after death. In most cases, the effect of the IRD tax time bomb can be reduced by spreading the distributions over the longest period of time the law allows. That will not usually happen automatically but needs to be implemented with care. Some plans require distributions soon after death and failing to name an appropriate successor beneficiary to the plan or IRA will accelerate the income taxation.
Moving Beyond Estate Planning
Traditional estate planning has focused on the transfer and preservation of property (i.e., the individual’s estate) on death and the minimization of estate taxes. In other words, it’s focus is on what—the things owned—as opposed to why—the “purpose” behind those assets. Simply handing over assets to heirs, whether directly or through a trust, without also giving those assets purpose and direction may be a recipe for disaster, and the reason traditional estate planning fails to successfully preserve wealth for multiple generations. Without purpose or direction, families often quickly squander their wealth or become litigious and fall apart fighting over assets.
What is it that most parents want for their children? Is it simply for them to have a lot of money? Of course not—we have all seen how money can be destructive to an individual or family if not properly used. What most parents really want is for their children to be happy, and to have the opportunity to live a fulfilling life. Being wealthy, if properly applied, can help facilitate that opportunity. But the key is how the wealth is applied. In other words, wealth represents opportunity. Rather than talking about generational wealth—which reflects merely the transfer of assets over time—we should be talking about generational opportunity. That is, the ability for your life’s work and your wealth to benefit future generations and empower them with the opportunity to pursue a happy, fulfilling life. In other words, we need to move beyond mere estate planning and towards something much, much bigger. We need to stop focusing on the transfer and preservation of assets (i.e., the “what”) and to start focusing on the purpose behind those assets and the owner’s life (i.e., the “why”).
Enter legacy planning. When someone dies, his or her legacy can be described as the totality of the life he or she lived. It consists of the property left behind and, more important, what that individual stood for and accomplished during his or lifetime. That person’s legacy represents his or her “why.” Rather than focusing on creating legal structures that simply preserve assets owned during lifetime, estate planners (better called “legacy planners”) need to focus on legal structures that preserve the purpose of an individual’s life and infuse that purpose into the assets left behind so that they can be properly communicated and transferred to future generations.
There has been much written in recent years about the various forms of capital that individuals possess. They are: financial capital (i.e., money, investments, etc.), intellectual capital (i.e., knowledge/wisdom), human capital (i.e., skills and talents), social capital (i.e., relationships) and spiritual capital (i.e., core beliefs and values). To date, estate planners have focused solely on the preservation and transfer of financial capital. Legacy planning takes a more wholistic view and focuses on the preservation and transfer of all five capitals.
Estate planning for most has never had estate tax avoidance or reduction as its primary focus. Today, with the extremely high estate and gift tax exemption, that is even more true. However, some areas of taxation, such as the income taxation of interests in qualified plans and IRAs, often are of critical importance as is seeking the automatic change in income tax bases of other assets passing from a decedent. That said, the diminishing relevance of estate tax planning has created an opportunity for estate planners to re-access their own purpose and role. The reality is, while effectively saving taxes, traditional estate planning has failed to effectively transfer and preserve wealth for multiple generations. Estate planners need to do better, to adopt a more wholistic approach and focus on the bigger picture. We need to stop focusing on what individuals own and start focusing on who they are and their life’s purpose. It is time estate planners evolved into legacy planners.
Jonathan G. Blattmachr, Editor-in-Chief & Co-Author of Wealth Transfer Planning™
A retired Partner in, and former leader of the Trusts, Estates, and Exempt Organizations section of, the New York law firm Milbank Tweed Hadley & McCloy, LLP—Mr. Blattmachr is recognized as one of the most creative trusts and estates lawyers in the country and is listed in The Best Lawyers in America.
He has written and lectured extensively on estate and trust taxation and charitable giving. Mr. Blattmachr is also widely respected for his dedication to always sharing his expertise and ideas with other lawyers, as well as mentoring less seasoned lawyers. These contributions are recognized in his receiving the Hartman Axley Lifetime Service Award.
Mr. Blattmachr graduated from Columbia University School of Law cum laude, where he was recognized as a Harlan Fiske Stone Scholar, and received his A.B. degree from Bucknell University, majoring in mathematics. He has served as a lecturer-in-law for the Columbia University School of Law and is an Adjunct Professor of Law at New York University Law School for its Masters in Tax Program (LLM). He is a former chairperson of the Trusts & Estates Law Section of the New York State Bar Association and of several committees of the American Bar Association. Mr. Blattmachr is a Fellow and a former Regent of the American College of Trust and Estate Counsel and past chair of its Estate and Gift Tax Committee. He is author or co-author of eight books and more than 500 articles on estate planning and tax topics.
His professional activities, include having served as an Advisor on The American Law Institute, Restatement of the Law, Trusts 3rd; and as a Fellow of The New York Bar Foundation and a member of the American Bar Foundation.
Daniel J. Scott is founder and principal of Scott Law, PLLC, in New York, New York. Dan spent over 12 years at some of the best law firms in the world. Determined to bring that same level of expertise and service to a broader range of clients at a fixed and more affordable cost, Dan set out to launch his own practice in 2014. His unique style and brand of providing legal services and advice is refreshing, effective and greatly appreciated (many clients call him the “un-lawyer”.) As a musician and writer, Dan uses his creativity and personal experience to find innovative solutions and assist clients in achieving their own greatest success. Dan is also devoted to educating and serving the creative community and focusing on the needs of musicians, actors, and other entertainers, and is a pioneer in the realm of artist legacy planning. Dan recently wrote about celebrity intestacy for Forbes: The Real Reason Why Artists Like Prince and Aretha Franklin Die Without a Will.