End of Year Planning: 2013 Does Not Look Very Pleasant

With September almost over, I thought it would be a good time to take a look at what the 2013 tax landscape will look like. Most people have heard the pundits talk about the "fiscal cliff" and "taxamaggedon," but, what does that mean with respect to estate taxes and income taxes if no changes are made.

Income Tax Changes:

• Income tax brackets for all groups will increase. Tax payers in the 10% bracket jump up to 15%. Tax payers in 25% tax bracket returns to 28%. Tax payers in the 28% return to 31%. Tax payers in the current 33% tax bracket go to 36%. The top tax bracket goes from 35% to 39.6%. Ironically, only those tax filers currently in the 15% tax bracket stay at the same tax rate.
• Long-term capital gains for most people will rise from the current 15% to 20%. (But, see below.) Those tax filers currently in the 10% and 15% tax range that currently pay no long-term capital gains will pay a 10% rate.
• Taxes on qualifying dividends (most dividends received by investors) will rise from 15% to the person's ordinary top marginal tax rate, i.e. if your tax bracket rate is 36%, the taxable dividends you receive will be taxed at 36%.
• Phase-out of the $3,800 per dependent exemption will return. For tax filers with higher levels of income, this deduction will begin to disappear. The phase-out starts at approximately $260K for married tax filers and $175K for single tax filers.
• Phase-outs return to itemized deductions. For high income level earners, their itemized deduction will begin to shrink to as low as 80% of stated deductions. The reduction starts at approximately $175K for all filers. (I guess there is a marriage penalty after all.)
• The standard deduction for married taxpayers filing jointly will decrease to 167% (rather than the current 200%) of the standard deduction for unmarried taxpayers (currently $5,950). Based on the 2012 standard deduction dollars, this would lower the standard deduction for joint filers from $11,900 to $9,900.
• The employee's portion of FICA goes back to 6.2% from 4.2% on income up to approximately $110K.
• The above-the-line student loan interest deduction will apply only to interest paid during the first 60 months in which interest payments are required, whereas no such time limitation applies under current law. The deduction will also phase out over lower modified AGI amounts, which are projected to be $75,000 for joint filers and $50,000 for all other returns.
• The "patch" on AMT expires and the standard deduction for AMT goes down significantly. This will primarily affect those taxpayers with high income living in high property tax states and taxpayers in the $150K to $1M income level.
• The credit for household and dependent care expense, child credit, income exclusion for employer-provided educational assistance and the earned income tax credit are schedule to either decrease or expire.

Estate Tax Changes:

• The Federal Estate Tax exemption level drops from $5.2 million with a tax rate of 35% to $1.0 million with a tax rate of 55% and a 5% surtax on very high-level estates.
• The Lifetime Gift tax exclusion amount drops from $5.2 million with a 35% gift tax rate to $1.0 million with a 55% rate. The same goes for Generation Skipping Taxes.
• Heirs, estates, and qualified revocable trusts (trusts that were treated as owned by the decedent immediately prior to death) will no longer be able to take advantage of the $250,000 exclusion of gain from the sale of the decedent's principal residence.

Changes as a result of Affordable Care Act (aka Obamacare):

• A new 3.8% Medicare surtax on unearned income of individual and trusts starts. The tax will be imposed on the lesser of the individual's net investment income or the amount by which the individual's modified adjusted gross income (AGI) exceeds certain thresholds ($250,000 for married individuals filing jointly or $200,000 for unmarried individuals). This will apply only to interest, dividends and capital gains. (Note: For married tax filers making over $250K and single filers over $200K, the long-term capital tax rate will be 23.8 % and qualified dividend tax rate will be 43.4%. Who wants those qualified dividends anyway?)
• A new Medicare surtax increase of 0.9% (rising from the current 1.45 percent to 2.35 percent) on incomes over $250K for married tax filers or $200K for single tax filers. This will only apply to the employee side of the payroll tax. The employer portion of the payroll tax for Medicare will.
• Flex spending accounts will now be capped at $2,500. That is down from either $3,000 or $4,000. So, if you planned on having an elective surgery, not covered by insurance, better have that procedure this year.

There are also numerous revisions raising taxes, removing deductions and exclusions or applying new taxes that only apply to businesses. I am sure taxes on business will be passed onto clients or consumers as an indirect tax. But, those are more niche issues.

Lastly, I will admit that much of this will likely change. However, I have heard several experts say that given the current political climate, anything can happen. You can certainly take steps over the next several months to position yourself to limit the impact of the above but meeting with your estate planning attorney or CPA is advised.

Basics of Estate Planning: Probate Asset v. Non-Probate Asset

After going through the various concerns for people using joint tenancy with the right of survivorship (JTWROS) as an estate plan, the next step is to look at the differences between a probate asset and a non-probate asset. As you can read below in this month's estate of the month, not correctly accounting for probate assets can lead to problems.

Probate assets are assets that are in the sole name of the decedent at the decedent's passing without any other owners or without a payable on death or similar type of beneficiary designation. Individual assets include bank accounts, investment accounts, stocks and bonds, cars, boats, airplanes, business interests, and real estate. Any portion of an asset owned by the decedent as tenants in common would be a probate asset, too. Probate assets are controlled by a person's Last Will and Testament and the Will dictates to whom that asset will be bequeathed.

Non-probate assets are the assets not controlled by the decedent's will and are distributed in some other fashion. Examples of non-probate assets include:

1. Property owned as either as JTWROS with another person or tenants by the entirety for a husband and wife. A will also does not control JTWROS assets because the decedent loses ownership of the asset upon the decedent's death. Wills only control assets after the testator dies.
2. Assets in which you retain a life estate and the remainder passes to a non-charitable beneficiary other than yourself.
3. Assets owned by your Revocable Living Trust.
4. Assets that pass by operation of law when a decedent has designated a beneficiary to receive the asset e.g. a husband lists his wife as the primary beneficiary to receive his life insurance on his death. Other designated beneficiary examples include:
   • Payable on death (POD) accounts, transfer on death (TOD) accounts, in trust for (ITF) accounts and Totten trusts;
   • Retirement accounts, including IRAs, 401(k)s and annuities; or
   • Health savings accounts (HSAs) or medical savings accounts (MSAs).

The decedent can take also passive steps for the non-probate asset to become a probate asset. In a very common scenario, the decedent will not name a beneficiary on a POD account and, thus, the estate is considered the beneficiary. Another passive way is for the decedent to not update designated beneficiaries, if the primary and secondary beneficiaries have passed away. The non-probate asset will flow to the estate since no beneficiary is there to receive the non-probate asset.

Making sure how your assets are transferred can go a long way to preventing the situation discussed below…

Estate of the Month: Make Sure Your Plan Works

I am wrapping up a matter advising a personal representative administering the estate of one of their children. As a father, I would not wish it on any parent to have to deal with overseeing a child's estate and complications in the estate have made the administration especially trying. But, it is a good teaching point for the average American. Do not worry I get back to a celebrity screwing up their estate next month.

I will not get into too many specifics but will run through the common estate planning errors that created all the complications. The decedent was the adult son of the personal representative and the son died without a will, or died intestate. Under D.C. Code, his entire probate estate passes up to his parents as the closest living relatives since the son had no children.

The son was not married but was involved in a long-term relationship. The relationship did not meet the requirements for a common-law marriage. The partner died several months before the son died.

The partner had a will naming the son as personal representative. The son had not opened an estate administration for the partner at the time of the passing of the son. The partner had minimal assets in his probate estate. The partner's will included several bequests to family, friends and several charities that would come out of probate assets. The bequests easily exceed any probate assets. The partner and son still owned several assets as joint tenants with the right of survivorship ("JTWROS"). The partner also had life insurance and retirement accounts naming the son as the primary beneficiary. Do you see the problem?

There is no money in the partner's estate to meet any of the bequests. The life insurance death benefits, the retirement accounts and the JTWROS assets all passed outside of the probate estate to the son. The partner's will did not control or own those assets. The bequests in the partner's will are unlikely to be fulfilled.

Once the partner passed away, the son owned those assets by JTWROS or was the beneficiary of the assets. When the son passed away, all of the son's assets including anything he received from his partner passed, via intestacy, to his parents. Even if the son was still alive, and was the personal representative, he would be under no obligation to use the assets he received, as the beneficiary of the life insurance death benefits, to meet the bequests of the partner's will. It is the son's money, not the estates. The heirs of the partner will have likely received nothing.

There are a couple of things to learn from this estate.

First, make sure your will and designated beneficiaries on non-probate assets conform. The partner could have easily avoided this situation by correctly designating beneficiaries to receive the life insurance death benefits or retirement accounts that align these accounts with the bequests of the will. Alternatively, the partner could have had his estate listed as the beneficiary of his life insurance and retirement accounts. The money from the life insurance/retirement accounts would go into probate flowing into the estate. Then, the assets would be controlled by the will and the bequests fulfilled. The drawback is the assets would have to go through probate.

As another option, the son and partner each could have drafted an estate plan and synced it with the other. They each could have had a will naming their various bequests to family, friend and charities. Of course, that would have required the son to draft up a plan - not something everyone is comfortable doing. Having an estate plan would at least have tried to ensure the correct heirs received the partner assetsⁱ .

From reviewing the partner's estate plan it was evident that the will was drafted by either an on-line company or out of a "form" book. Meeting with an attorney would have ensured the correct people would inherit from the partner's estate.

I hope after reading this "average" American's estate problem you are looking at your entire estate to ensure the same mistakes are not made.

ⁱEven if the son and partner had wills drawn up and executed, there is no guarantee that the son would not change his plan after the partner's passing.