Unfortunately, the federal estate tax treatment of estates passing from one Maryland same-sex spouse to another remains in doubt.  The Defense of Marriage Act defines marriage as a union between a man and a woman for purposes of federal benefits and application of federal law.  Therefore, regardless of how Maryland or any other state defines marriage, the federal government only recognizes marriages between a man and a woman.  This applies, of course, in connection with federal tax statutes such as those applicable to the federal estate tax.

The United States Supreme Court will hear the case of United States v. Windsor on March 27, 2013.  The issue in Windsor focuses precisely on the constitutionality of the Defense of Marriage Act as it applies to the federal estate tax.  The case concerns two New York women who were legally married in Canada.  Upon the death of the first spouse, the estate was assessed an estate tax of approximately $360,000 because the surviving spouse was not considered a “spouse” pursuant to the Defense of Marriage Act.  If the Supreme Court finds the Defense of Marriage Act unconstitutional, then estates passing to surviving same-sex spouses will pass free of estate tax.

The process of estate planning contemplates many issues, but one of the primary issues is addressing potential estate taxes.  All married couples should engage in the estate-planning process to ensure proper distribution of assets in a tax-efficient manner.  Having a discrepancy, then, between Maryland tax law and federal tax law makes efficient planning a significant challenge.  The federal estate tax does not apply to everyone, but for Maryland same-sex spouses whose net worth exceeds a certain threshold, the forthcoming Supreme Court decision will have a tremendous impact on their estate planning.

In any event, my primary professional concern in this kerfuffle has been the fate of the federal estate tax.  For two years, estate planners have been telling our clients that there was a limited window of opportunity to use some or all of the $5.12 million gift-tax exclusion that was granted via the last can to be kicked down this particular road.  Indeed, many families acted on this advice and made significant gifts and employed advanced planning techniques to benefit their families.

In fact, The American Taxpayer Relief Act of 2012 keeps the current $5.12 million exemption in place.  The difference, though, is that the top estate tax rate has increased to 40%.  So, was all of last year’s hype and urging to “act now” for naught?  The answer is emphatically no.

First and foremost, professional advisors should never recommend making ill-advised gifts solely because the tax code dictates a certain outcome.  Part of the planning that goes into making significant gifts should include discussions of whether the proposed gift will both a) benefit the family in the long run and b) not disadvantage the donors in any way.  As I always say, the tax “tail” should never wag the dog.  Hopefully, all gifts made in 2011 and 2012 in consideration of the increased exemptions were made thoughtfully and carefully.

Second, the increase of the estate- and gift-tax rate to 40% has increased the value of gifts made in 2011 and 2012.  Individuals that have taken advantage of the increased exemption over the past two years have just seen the value of their gifts increase solely by virtue of the higher tax rate that won’t be paid at their deaths.  For families making significant gifts, the dollar value of that savings is considerable.

The final point I’d like to make is that the maintenance of the $5.12 million exemptions (and Maryland’s $1 million exemption) means that individuals and families should continue to be vigilant in their planning.  Those who were contemplating making gifts in 2012, but fell short of the deadline, have a renewed opportunity to consider and complete those gifts.  Those who did not consider making significant gifts might now give greater attention to the matter in light of the increased federal estate-tax rate.  And those who have not recently reviewed their estate plans should make time to consult with their advisors and see if changes are appropriate.

The dispute focused on a poorly drafted clause in the Last Will and Testament of Joanne Click, a resident of Edgewater.  In general, a will may contain both specific bequests and what is typically called a residuary bequest.  Ms. Click’s will contained several specific bequests; for example, she leaves the sum of $1,000 to each of her grandchildren.  A residuary bequest, however, typically specifies how the rest (i.e., the “residue”) of the estate is distributed; for example, “in equal shares to my surviving children.”  The residuary bequest in Ms. Click’s will (if it contained a residuary bequest at all) was extraordinarily unclear.  The clause in question provided “any assets not directly disposed of in this Will shall be given to the surviving members in order of succession.”  To say the least, this is a terrible manner in which to state one’s wishes regarding disposition of the vast majority of her estate.

The primary question before the Court was not necessarily what that clause meant, but whether outside, or extrinsic, evidence could be heard by the Court to determine what Ms. Click intended.  The general rule in Maryland (and most states) is that the meaning of a will is determined by the plain words of the document itself, without resort to testimony given by others after the fact.  If, however, a provision of the will is found to be ambiguous, then the Court may consider such outside testimony.  Ambiguity, in this context, means more than a lack of clarity.  Ambiguity is when a term may have more than one reasonable interpretation.  Different groups of heirs in this matter believed that the clause had different meanings that would serve to benefit them.

The Court ultimately decided that the clause was, in fact, ambiguous and that the Circuit Court would have to conduct further proceedings to determine the meaning of Ms. Click’s will.  Ultimately, the lack of clarity in Ms. Click’s will is costing her heirs a significant amount of time and money, and no one will truly know if her intent is properly honored in the end.  The essential practical problem here is that Ms. Click’s intent would have been clearer if she had retained a qualified attorney or even written the will herself.  Instead, she used a computer program purchased at a retail store to prepare her will.  Although there are typically no “magic words” used in the drafting of a will, no computer program can substitute for the guidance and experience of a qualified attorney.  The most important lesson of the Estate of Steven Click decision, then, is the relative value of good legal counsel in prudent planning.

Careful attention should be paid to your retirement plan and life insurance beneficiary designations. Effective planning can ensure that these assets are directed to your beneficiaries in a way that takes advantage of all available tax benefits.  Unfortunately, when proper planning is not done, opportunities to reactively salvage some benefit are few and far between.

The current environment of low interest rates and the high gift-tax exemption makes 2012 an ideal time to make gifts to or for the benefit of loved ones.  The opportunity is fading fast, however, as the gift-tax exemption will revert to $1 million after this year.  The smart play now is to discuss these opportunities with your estate planner, as the prevailing wisdom is that the $5 million exemption won’t return in 2013.

Finally, you cannot assume that you don’t need a will or don’t need to update your will.  There are many faulty assumptions in the field of estates and trusts, and they can all be easily corrected with a quick phone call.  Assuming that your ten-year old will is still appropriate and effective, though, can lead to unintended consequences.

In 2012, there are  opportunities to plan.  Unfortunately, too many individuals miss the opportunities and are forced into salvage missions.  Be a planner!

That clarity (at least for the moment) has arrived with the release of the proposed FY 2013 federal budget.  The Administration’s budget proposal with respect to the federal estate tax is to restore the $3.5 million exemption and 45% rate that were in effect in 2009.  This would appear to be a sensible compromise between the current law and the 2001 law, but my enthusiasm for such a common-sense decision is tempered by the knowledge that this proposal actually has to make it through Congress.  Does the phrase “one-car funeral” come to mind?  Let’s keep our fingers crossed that Congress will allow us to plan without constantly dealing with moving targets.

In the meantime, keep in mind that the State of Maryland continues to stand by its $1 million estate tax exemption and doesn’t appear to have any intention of raising it.  As I always say, at least Maryland gives us a fixed target…

1.  Who are the trustees?  This may be the most significant factor.  If choosing individual trustees (as opposed to corporate trustees, which I will discuss in a future post), you should consider individuals who either share your values or understand and respect your values when it comes to spending priorities.  For example, if you value private education for your children, your chosen trustees should either value private education as well or at least respect your values on this point.  Your chosen trustees should also have a solid rapport with the children and the children’s guardians.  The circumstances will be difficult enough without inviting conflict.  Ideally, you should also choose trustees who, as the children mature, will engage the children in reaching reasonable decisions on spending questions, as these questions will represent significant learning opportunities.  Note that the trustees and guardians may be the same individuals, but there are also reasons against choosing this dynamic.

2.  What are Acceptable Trust Expenditures?  Although most trust provisions are very broad, you do have an opportunity within your estate planning documents  to emphasize certain acceptable expenditures as a reflection of your values, or to clarify to your trustees what may be permissible.  For instance, most trust provisions state that education costs are acceptable trust expenditures.  But you may be more explicit than that – if private elementary education is important to you, you can emphasize that in your trust provisions.    If your guardian most likely will require supplemental funds to raise your children, your trust provisions should reflect the trustee’s ability to provide such a supplement.    Giving your trustees flexibility is important, but you should also be clear about certain priorities when necessary.

3.  When and How Should the Trust End?  Keep in mind that one of the key reasons for implementing trusts for minors is to allow your children to “grow into” their inheritances.  That is, this structure allows your trustees to manage the trust funds until such time as the children may be able to responsibly manage their own assets.  With very young children, this really becomes a guessing game, as you don’t yet know how your five-year old will handle significant sums of money in the future.  One option allows your children to have the ability to withdraw certain percentages of the trust at certain ages – for example, one third at age 25, one third at age 30, and the remainder at age 35.  Your children may elect to leave the funds in trust, or you may, in fact, keep the child’s funds in trust for the remainder of his or her life.

This list of questions and possible answers is by no means exhaustive, and you can only come to the right decisions through in-depth discussions with your attorneys and advisors.  Hopefully, though, these discussion points can start you in the direction toward good decisions for your family’s future.

After almost an entire year of uncertainty regarding the estate and gift taxes, Congress finally enacted temporary legislation to reinstate the estate tax.  Somewhat surprisingly, Congress also dramatically increased the estate and gift tax exemptions to $5 million. Remember that before the “fix,” the estate tax exemption in 2009 was $3.5 million per person and the gift tax exemption was $1 million per person. As with most of what comes from Congress, however, there are positives and negatives to these adjustments.

On the negative side, these new estate and gift tax provisions are only in effect until the end of 2012. The significant benefits of the increased exemptions are unfortunately temporary. As we learned through the end of 2009 and most of 2010 (oh, and don’t forget the debt-ceiling debacle…), Congress is not in a particular hurry to address time-sensitive issues. So although we would hope for a long-term, comprehensive review of the estate and gift tax regime, it is doubtful that we will see such clarity. Thus, as we look forward in the estate-planning context, it is difficult to predict what the rules will be beyond December 2012.

Benefits of Current Gifting

There are compelling positives, though, in our current climate. First, although we are almost one year into the two-year window of higher estate and gift tax exemptions, there is still plenty of time to take advantage of the $5 million exemption. For families and individuals with the surplus capital to make significant gifts, this two-year window presents a potentially unique opportunity to transfer valuable assets to the next generation with minimal gift tax consequences. Not only does making a significant gift remove the asset from the donor’s estate, but it also removes the future appreciation of that asset from the donor’s estate as well.

Historically Low Interest Rates

Second, IRS official interest rates are at historic lows. The 7520 rate and the Applicable Federal Rates, which are integral to many interest-sensitive estate and gift-planning techniques, are literally as low as they’ve ever been.  For individuals seeking to make a transfer to the next generation (or generations) using intra-family loans or sales to grantor trusts, the low interest rates may enhance the extent to which such gifts can be leveraged.

These historically low rates are of particular advantage to an individual or family considering selling a business in the coming years. There are many effective means by which interests in a family business can be transferred to the next generation (or, say, a trust for the benefit of future generations) in a tax-efficient way prior to the contemplated sale. Such transfers can be structured so that the gift is discounted for gift-tax purposes. When the business is ultimately sold, the beneficiaries of the gift end up with considerably more than the appraised value of the gift. This type of planning requires careful advance consideration, but can prove to be extremely beneficial to the family business owner.

The Maryland Estate Tax

Third, for Maryland residents, the increased ability to make significant gifts under the Federal gift tax exemption allows individuals and families to further reduce their estates for Maryland estate-tax purposes. Remember that despite the increases to the Federal exemptions, the State of Maryland has retained its $1 million exemption for Maryland estate-tax purposes. There is no Maryland gift tax, so reducing the Maryland estate-tax base through gifting can save significant amounts of Maryland estate tax.

The existence of the Maryland estate tax also underscores the continuing need for trust planning within the context of basic estate planning. One of the features of the new estate and gift-tax legislation is the concept of “portability” of estate-tax exemptions – meaning that if one spouse dies and his or her entire estate-tax exemption is not used, the surviving spouse may assume the rest of that exemption. For example, Husband dies in 2011 with an individual estate of $2 million. The $3 million of his estate-tax exemption that goes unused can be transferred to Wife, who now has an $8 million exemption of her own. Because of this new feature, many families may think that there is no further need for tax-planning trusts within their basic estate planning.

Despite the potential benefits of portability, significant reasons remain to consider using tax-planning trusts. First, there is no guarantee that portability of exemptions will remain part of the estate and gift-tax planning regime.  Although the White House has mentioned making the portability feature permanent in its 2012 revenue proposals, there is no guarantee that this easily manipulated provision will become permanent. Second, leaving all of your assets to your surviving spouse outright does not guarantee that the value of those assets will always be covered by your combined exemptions. When assets are distributed to a properly structured credit-shelter trust, the value of those assets is not taxed in the donor’s estate and is not subject to estate taxes at the survivor’s death. If those assets are left outright to the surviving spouse, though, they are subject to the Maryland estate tax on the survivor’s death, and the appreciation on those assets may ultimately exceed the spouses’ combined exemptions for Federal estate-tax purposes. Finally, all of the traditional benefits of using trusts – enhanced asset management, spendthrift protection, protection from financial predators – still hold true and are of significant benefit in planning.

Conclusion

We head into the latter part of 2011 knowing that the estate and gift-tax climate is far from certain. However, what we do know about current circumstances presents significant possibilities to transfer wealth to future generations in a tax-efficient manner. Current law has provided individuals with an increased ability to make gifts, which, combined with low Federal interest rates, presents a unique opportunity to make significant leveraged gifts. The time is right for advanced planning, but be aware that the window of opportunity may be closing.