Estate Planning: New Hazards

Kelly Greene for the Wall St. Journal writes: You thought your estate plans were finally set? Not so fast.  It turns out the "permanent" $5 million estate-tax exemption enacted earlier this year could change after all, sending families back to the drawing board to sort out their strategy.

A provision in President Barack Obama's fiscal year 2014 budget calls for lowering in 2018 the estate-, gift- and generation-skipping-transfer-tax exemption limits.

Those limits were just made "permanent" in January at $5 million and indexed for inflation. (This year's exemption is $5.25 million.)

The Obama administration proposed lowering the exclusion to $3.5 million for estate and GST taxes, and to $1 million for gift tax. Those amounts—a return to 2009 levels—would no longer be indexed for inflation.

All three tax rates would go up, too, with the top rate rising to 45% from the current 40%.

But wasn't the $5-million-plus exemption made permanent just four months ago?

"Permanent doesn't mean Congress will never revisit it. It just means there's no expiration date built into it," says Bruce Steiner, an estate-planning lawyer at Kleinberg Kaplan Wolff & Cohen in New York.

If the proposal gathers steam and is enacted, he predicts "the same thing as last December, with another big flood of people giving away assets because they can," he says.

If you feel like the estate-tax exemption limit has bounced around a lot, you're right. It has been changing every few years since 2001. Even some lawyers who get to charge by the hour are frustrated.

"We just need stability," says Christine Finn, a lawyer at Marcum LLP, a New York accounting and advisory firm. "With the $5 million limit now [for estate and gift taxes], it's going to be hard to get people back to thinking about the planning they'd need to do if the gift-tax rates go back down to $1 million."

Still, ratcheting down the three exemptions and closing other "estate-tax loopholes" would raise $79 billion over 10 years, according to the budget proposal.

The budget includes other ways to cut the deficit that could affect family inheritance planning as well. Here's what to watch.

• Discounts could disappear. Now, if you give a family member a minority share in your business, an appraiser legally can discount its value.

The reasoning: A minority owner lacks control of the asset, can't liquidate it, can't get income from it unless the business makes a distribution and can't sell it easily.

Mr. Obama's annual budget proposals have called for limiting, or getting rid of, such discounts to family members—until now. Gordon Schaller, an estate-planning lawyer in Irvine, Calif., contends that the provision's absence from this year's proposed budget could mean that "they're getting ready to issue regulations to do it, so they don't need to talk about legislation anymore."

If that happens, families wouldn't be able to transfer as much wealth effectively tax-free, Mr. Schaller says. So families who have been considering such transfers should make them now.

• GRATs could get watered down. So-called grantor-retained annuity trusts, or GRATs, let people give a portion of an asset's future profits to heirs tax-free. The trusts have been popular tools for passing along battered stocks, especially because GRATs work best when interest rates are low.

But GRATs also have been a target in Mr. Obama's budget proposals for several years.

The person who sets up the trust gets annual payments adding up to the asset's original value, plus a return based on a fixed interest rate set by the Internal Revenue Service. That rate currently is only 1.4%.

When you give an asset to a GRAT, you retain the right to regular payments for a set time period. What you actually are giving away is any future appreciation on the asset—free of taxes.

When the GRAT's term ends, the asset goes to the beneficiaries free of gift or estate tax on the appreciation, even though it has been transferred.

The biggest risk is that the owner will die before the trust expires, generally subjecting its entire value to estate tax. Because of that risk, GRATs typically are set up with shorter terms, such as two years.

But the proposed budget would require GRATs to have a minimum term of 10 years. The change is expected to generate $3.9 billion in 10 years.

"If you're thinking about setting up a GRAT, do it now while you know you can, because you may not be able to do it as favorably tomorrow," Mr. Steiner says.

• Thousand-year trusts could get shortened. In the 1980s, many states adopted a statute that limited family trusts to a 90-year span. But since then, about half the states have repealed that rule or lengthened the "permissible perpetuities period," in some cases to as long as 1,000 years, Mr. Steiner says.

Such lengthy trusts can keep large chunks of wealth out of the tax man's reach for decades, or maybe even forever, he adds.

But Mr. Obama's budget proposal, echoing provisions called for in previous years, would have the generation-skipping-transfer exemption expire after 90 years, making the assets subject to taxes at that point.

Since the proposal would apply only to new trusts created after its enactment, you might want to set up your trust now, Mr. Steiner says.

• Individual retirement accounts could get emptied faster. People who inherit IRAs and other tax-deferred retirement accounts are allowed under current law to "stretch" their withdrawals across their life expectancy, paying income tax only on distributions.

The budget proposal would require most heirs, other than widows or widowers, to empty retirement accounts within five years. The measure would raise almost $5 billion in 10 years, the budget proposal claims.

The move already has prompted some older adults whose wealth is concentrated in IRAs to consider moving them into trusts to help their families keep up with, and follow, the rules correctly.

And people who had planned to convert IRA holdings to Roth IRAs are starting to reconsider. IRA owners have to pay income tax on any tax-deferred assets being converted, but future withdrawals are income-tax-free, even for heirs, as long as they meet holding requirements.

If stretching the withdrawals past five years is no longer possible, there could be less advantage to paying the upfront tax bill, says Jeffrey Levine, a certified public accountant at Ed Slott & Co. in Rockville Centre, N.Y.