McNees Insights – Estate Planning June Newsletter
June 2, 2016
There are two tax credits available to help you offset the costs of higher education: the American opportunity credit and the lifetime learning credit. Tax credits are more favorable than deductions because a tax credit reduces the amount of income tax you may have to pay. Unlike a deduction, which reduces the amount of income subject to tax, a credit directly reduces the tax itself. The two education tax credits have different features, requirements, and restrictions. Neither credit can be claimed if your filing status is married filing separately. In any particular year, you can only claim one of the two credits, but not both. Choosing the right one will depend on several factors.
Under the American opportunity credit, you can claim a tax credit of up to $2,500 for qualified education expenses for each eligible student. Forty percent of this credit may be refundable. This means that, if the refundable portion of your credit is more than your tax, the excess is refunded to you.
The American opportunity credit is available only for the first four years of postsecondary education. In addition, the credit cannot be claimed if your modified adjusted gross income is above $180,000 (for 2015 and 2016) if your filing status is married filing jointly, or $90,000 (for 2015 and 2016) if your filing status is single, head of household, or qualifying widower. You must be pursuing an undergraduate degree or other recognized education credential in order to claim the credit.
Qualified education expenses for which the credit is allowed include tuition and fees required for enrollment and course-related books, supplies, and equipment.
The lifetime learning credit is allowed for all of your postsecondary education, not just the first four years. It is also allowed for all courses taken to acquire or improve job skills. However, the credit is limited to $2,000 per tax return and cannot be claimed if your adjusted gross income is above $131,000 (for 2016) or $130,000 (for 2015) if your filing status is married filing jointly or $65,000 (for 2015 and 2016) if your filing status is single, head of household, or qualifying widower.
If there are qualified education expenses for your dependent during a tax year, either you or your dependent, but not both of you, can claim one of the education credits for your dependent’s expenses for the year. For you to claim the credit for your dependent’s expenses, you must also claim an exemption for your dependent.
In addition to these tax credits, you can deduct up to $2,500 of student loan interest in computing adjusted gross income. This means you do not have to itemize to take this deduction. For 2015 and 2016, the deduction phases out, however, if your modified adjusted gross income is between $65,000 ($130,000 for joint returns) and $80,000 ($160,000 for joint returns), and there are a number of requirements that apply to the deduction. For further information, see IRS Publication 970 – Tax Benefits for Education.
The death of the musician Prince brought to the attention of many people what it means to die without having a valid Last Will and Testament. Pennsylvania, like Minnesota and other states, has an “intestacy statute” which determines how a decedent’s estate is disposed of if there is not a Last Will and Testament. Contrary to the common misconception, a decedent’s property will “go to the state” only in the rarest of circumstances.
It is important to understand that your Last Will and Testament only controls the disposition of individually owned assets (except for “non-probate” assets as explained below). Property that is owned jointly with a right of survivorship will pass automatically to the surviving owner (for example, bank accounts or real estate jointly owned by spouses).
If you do not have a Will, Pennsylvania’s Intestacy law provides that an estate will be disposed of as follows:
- If there are no surviving children or parents, then the entire estate goes to the surviving spouse
- If all the surviving children are the children of the decedent and the surviving spouse, then the surviving spouse receives the first $30,000 of the estate and 50% of the excess and the surviving children receive the other 50% of the excess
- If there are surviving children with different parents, then the surviving spouse receives 50% of the estate and the children receive the other 50%
- If there is no surviving spouse, then the estate goes entirely to the following classes of persons (in order of priority): (a) children, (b) parents, (c) grandparents, and (d) aunts and uncles and children and grandchildren of deceased aunts and uncles
- If there is no one who falls into one of these categories, then the Commonwealth of Pennsylvania receives the decedent’s property
Needless to say, there are a variety of issues with the intestate scheme of distribution.
The statutory distribution may or may not fulfill the decedent’s intent. Most people generally want to benefit a surviving spouse to the exclusion of children. If there is a second marriage situation, the decedent may want the surviving spouse’s share held in a trust.
Without a Will there are no guardians appointed for minor beneficiaries. As a result, there may be litigation among family members over who will serve in this important role. As equally important is the management of the inheritance of a minor beneficiary and other beneficiaries who, although not a minor, may not be capable of managing an inheritance. In the absence of a Will a minor receives his or her inheritance outright at the age of majority, which in Pennsylvania is eighteen years of age. The absence of trust provisions means a beneficiary who is incapable of responsibly managing an inheritance will have outright control over the inheritance and likely will waste it.
Business interests, real estate, and other assets that will not be sold present additional challenges. The intestate heirs will end up as joint owners of these assets. You could have, for example, a situation where the surviving spouse and children are equal owners of the family business or the marital residence. Neither the spouse nor the children will have majority control (e.g., 50/50 if there is a spouse and one child or thirds if there is a spouse and two children). Deadlocks between equal owners or two owners abusing their majority position could lead to litigation.
Finally, you cannot appoint a personal representative for your estate (an executor) without a Will. Therefore, any person entitled to a share of the estate has the right to serve as the personal representative of the estate. Any disagreements or in-fighting among heirs will be magnified if the heirs are all serving as personal representatives. An individual personal representative will likely need to provide a bond in order to serve (the bond requirement typically is waived in a Will).
As can be seen, a Last Will and Testament is recommended no matter your level of wealth or the complexity of your estate. A Will provides certainty for loved ones and the decedent and will minimize disputes and other challenges of administering an estate.
When the President signed the American Taxpayer Relief Act of 2012, some observers thought that certain provisions would sound the death knell for a popular legal tax shelter strategy known as Credit Shelter Trusts (CST).
Although the need for CSTs may have been reduced, this kind of trust is still a valuable tool to consider in an estate plan that you and your attorney, accountant or estate planner should consider.
Prior to passage of the Taxpayer Relief Act, the first $5.12 million in assets of a decedent’s estate was exempt from Federal estate tax. However, in the case of a married couple with a sizable estate, both spouses could establish a CST, effectively doubling their exemption amount. This strategy allowed up to $10.24 million to pass to beneficiaries tax-free after both partners passed away.
Consider the following example of a husband and wife with two children. Husband had assets totaling $6 million and his wife had assets of $3 million, thus their combined estate would be worth $9 million.
Upon the death of husband, assets totaling the amount of the exemption (i.e. $5.12 million) would be held in a CST for use by his wife during her lifetime with the remaining assets of the husband (i.e. $880,000) passing directly to his wife free of trust. When the wife passes away, money in the CST would pass tax free to the children. In addition, the wife’s entire estate of now $3.88 million would pass directly to the children tax free given the amount of her estate is below the exemption amount.
The failure to utilize a CST in this situation would result in wife receiving $6 million dollars outright upon the death of her husband, thus increasing the size of her estate to $9 million. Upon her death the entire $9 million would pass to the two children; however, $3.88 million would be subject to federal estate tax because her husband’s exemption has been lost.
The Taxpayer Relief Act made the federal estate exemption “portable” for both spouses, which means that a surviving spouse could utilize any unused portion of the deceased spouse’s exemption simply by filing the appropriate tax return without the need to use a CST as outlined in the above example.
While “portability” may have minimized the need for many couples to establish a CST, a number of circumstances still make it smart to consider creating one, such as the following:
- When one or both spouses have children from a previous marriage
Under the “Brady Bunch” scenario in which one or both spouses have children from a previous marriage, the surviving spouse would typically stand to inherit all of the partner’s assets in the event of his or her death. Establishing a CST ensures that if one partner passes away, the surviving spouse will still be able to use certain assets subject to the terms of the CST with the bulk of his or her assets being preserved for the children of their previous marriage.
- When a couple has children and one spouse dies and remarries
Under this scenario, the couple has children and one spouse passes away. Creating a CST ensures the surviving spouse would be provided for during his/her lifetime, while at the same time guaranteeing that, upon the death of the surviving spouse, the children receive the remaining assets. Not utilizing a CST in this situation would permit the surviving spouse to pass the assets as he or she saw fit, which may include distribution to a new spouse if the surviving spouse chose to remarry.
- When an inheritance skips a generation
While the federal exemption is portable when passing an estate to a couple’s children, “portability” does not apply when the couple wishes to provide for multiple generations of the family. Setting up a CST is necessary in this case to ensure that both partners’ exemptions can be utilized.
- Creditor Protection
An additional benefit to a CST is that the assets that are held in trust are protected from the creditors of the surviving spouse, which is not the case with “portability.”
- Asset Appreciation Protection
Another possible reason to consider utilizing the CST structure is to protect the appreciation of assets from being subject to estate tax, as opposed to “portability,” which only protects the deceased spouse’s exemption.
While CSTs still retain a certain utility as an estate planning tool, one continued negative of utilizing a CST, as opposed to relying on “portability” under the Act, relates to the “stepped-up basis.”
For example, husband owns stock with a basis of $10,000 and that asset is worth $100,000 at the time of the husband’s death. If the husband has a CST, the value of that stock when it becomes part of the CST is $100,000. When the CST is terminated (i.e. upon the passing of the wife), the stock is worth $140,000, and, if sold at that time, the beneficiaries of the CST would pay capital gains tax on the difference between the final sale price of the stocks and the $100,000 stepped-up basis following the husband’s death.
In this case, the heirs would pay tax on $40,000. By relying on “portability” in the same situation, the stock would pass to the wife upon the death of the husband, and the basis of the stock would be $100,000. Upon the death of the wife, the stock would be worth $140,000, and the beneficiaries would receive that value as their basis, thus saving capital gains tax on $40,000.
While these examples are simple in nature, hopefully they illustrate the importance of understanding the intricacies of the estate planning process and the need to engage qualified practitioners to assist in said process.
© 2016 McNees Wallace & Nurick LLC
McNees Insights is presented with the understanding that the publisher does not render specific legal, accounting or other professional service to the reader. Due to the rapidly changing nature of the law, information contained in this publication may become outdated. Anyone using this material must always research original sources of authority and update this information to ensure accuracy and applicability to specific legal matters. In no event will the authors, the reviewers or the publisher be liable for any damage, whether direct, indirect or consequential, claimed to result from the use of this material.