The Current State of [Estate Tax] Affairs

In 2001 the Congress passed legislation by which the estate tax exemption gradually rose from $675,000 to a peak of $3.5 million, with a tax rate of 45 percent, then was completely "repealed" as of January 1, 2010. The gift tax exemption remains $1,000,000 (i.e., you have to die to transfer more than $1,000,000 tax free). 

However, the 2001 legislation will "sunset" at the end of 2010, meaning the 2001 legislation will expire. As of January 1, 2011, without further action in Washington, the law as in effect prior to the 2001 legislation snaps back into place with an estate tax exemption of $1,000,000.  Thereafter, everything you own at death over $1,000,000 would be taxed at around 45% to 55%.

There is no estate tax this year, so no estate tax planning is needed, right? 

Wrong!  First, political and legal analysts seem to agree that we might see a retroactive estate tax imposed, even after you die.  Congress could pass a law in December that says, "all deaths since January 1 are subject to tax on everything over $XX."  Therefore, you need planning that will address the "what if there is a tax at my death" question, even if it is enacted retroactively.  Otherwise, your family can end up owing a huge tax that could have been avoided.

Let’s do a reality check here: do you think the 2010 "repeal" will be extended beyond 2010?  In other words, do you really think that there will be an act of Congress and a signature of the President, cutting taxes on large estates, i.e., for "the rich"?  OK, I was just checking.  So we can all agree that even if it is not re-imposed during 2010, there will be an estate tax imposed for deaths in 2011 and after.  All we don’t know is whether it will be on estates over $1,000,000 (as law currently says it will be) or some increased amount.

So given that fact, let’s look at the second tax planning issue.  Many people are positioned so as to waste a tax exemption and assure a large tax later.  This would happen one of two ways:

•1.       Joint tenancy ownership of assets: A financial professional I heard the other day is advising married clients to hold assets as joint tenants with right of survivorship to best deal with the 2010 tax situation.  A very, very bad idea, as you’ll see.

•2.       Many couples have outdated plans that never anticipated a year of no estate tax.  Wills or trusts often include formulas based on the applicable estate tax exemption in effect at death.  Such formulas can work in reverse when there is no estate tax.  As a result, when the first spouse dies, all assets pass to the survivor.  The result is much like joint tenancy.  [PLEASE NOTE THAT THE TRUSTS PREPARED BY MORE OFFICE FOR THE PAST FOUR YEARS HAVE TAKEN THIS SITUATION INTO ACCOUNT AND DEAL WITH THE FACT THAT THERE IS PRESENTLY NO ESTATE TAX IN PLACE THIS YEAR].

In either event, when the first spouse dies (assume husband for the illustration...it could be either) all assets pass to the wife.  "So what’s the problem, as long as at the death there is no tax?" you ask.  Well, instead of taking advantage of the tax repeal window, your "plan" actually defers the taxable event until the tax returns.

Imagine you have a $7 million estate.  All assets are held in joint tenancy (or your wills or trusts that leave as much as possible to the survivor).  Husband dies in 2010.  Everything passes to the wife.  No tax.  She lives into 2011.  She dies.  Everything in excess of $1 million is taxed at around 50%.  The IRS gets a cool $3,000,000!

The tragedy is this: you could plan so that if the first one dies in a year like 2010 the entire $7 million estate would pass into a trust controlled by and for the benefit of the survivor to manage and use as needed.  All $7 million would be protected from lawsuits.  And the assets of the trust would not be counted as part of the survivor’s estate at death.  If the survivor lives beyond this temporary repeal of the estate tax (i.e., you make it to 2011) no problem!  The entire $7 million, plus any appreciation, would pass tax-free to the children.

What about smaller estates? Even on a $1,500,000 estate, planning that leaves "everything to spouse" would cost your heirs over $200,000 in taxes. 

So let’s just summarize: in this year of "unlimited estate tax exemption" and the "repeal of the estate tax" every couple who will leave $1,000,000 or more to heirs (remember, it is not just their "probate estate" we are talking about, but their taxable estate, which includes annuities, IRAs, life insurance, etc.) should have an estate tax plan!

Capital Gain Tax Trap.

A second tax trap lies for the unwary, unplanned estate: capital gain taxes.  If you die in 2010, your estate plan must provide for allocation of a limited "step up" in basis on your estate.  Otherwise, you will saddle your children with as much as $5,600,000 in taxable gain...all of which could be avoided!  This is especially important again for a married couple.  With capital gain tax rates set to go up in coming years, it would be truly tragic to miss the opportunity to avoid that tax altogether. 

You must have planning in place before death to take advantage of the capital gain "step up," then have careful, professional help in the settlement of your estate in order to maximize the benefits of the current tax law.  At 15% federal and 3% state, failure to take advantage of the unique 2010 capital gain tax law could cost your heirs well over $1,000,000.

Summary of 2010

Estate Planning Tax Law Essentials

An effective estate plan-one that will accomplish maximum tax planning benefits-must have an "if-then-but-and" approach!  It must cover

If there is no estate tax in effect on my death (and no such tax is retroactively applied!) then I want my estate divided and administered so as to maximize CAPITAL GAIN TAX reduction;

But I still want to assure that my spouse has the least possible likelihood of paying taxes when he or she dies, even if that is in a year when the estate tax is in effect;

And I want to make sure that while I am living, I can still easily adapt my plan to take advantage of new laws and opportunities that arise!

This is possible, even practical...or I wouldn’t bring it up.  Our clients are prepared for whatever happens!

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We, as estate practitioners, believe in and preach deferral for such accounts. However, the world of a 25-year-old doesn’t readily accommodate such concepts, who is more likely to value the benefits of a shiny new car, fancy stereo system, and great parties. We regularly assist our clients in establishing strategies to avoid young and financially immature beneficiaries having full control of IRA’s, yet maintain full compliance with all minimum distribution rules. This strategy involves the use of sub-trusts to receive the qualfied plan distribution, giving the Trustee the ability to defer the distribution to the heir while complying with the minimum distribution rules of the IRS code.

The State of Arizona has adopted a new trust code effective January 1, 2009. The code expands our trust law in a number of respects.