Planning Under the New Rules

If your estate is currently $1 million or more, explore these estate-reduction and tax-saving moves.

April 26, 2005

The estate tax is supposed to kick the bucket by 2010 and then come back to life in 2011 unless Congress amends the law. In the meantime, you'll probably be scratching your head trying to figure out how the changes in estate-tax rates, exemptions and other types of taxes will affect you.

No matter how big your estate is, now is a good time to review your plans with your lawyer and financial planner. Consider adjusting your will and trusts to make them work better as rates and limits change. But don't let tax concerns override appropriately providing for your heirs.

Take time to review your plans

The amount each individual can pass free of federal estate tax climbs from $1.5 million in 2005 to $3.5 million in 2009. It's then unlimited in 2010, but reverts to $1 million in 2011. Meanwhile, the top estate-tax rate sits at 47% in 2005, and falls gradually to 45% by 2009, then roars back to its previous 55% level (for more details, see The New Estate-Tax Rules).

Nevertheless, if you believe your estate will exceed the expanded safety zones you may want to take the following steps.

• Explore estate-reduction and tax-saving moves. Such exploring is especially important if your estate is currently $1 million or more. If that's your situation, says Benjamin Ledyard, vice-president and private client adviser at Wilmington Trust, in Delaware, the best approach may be to take a wait-and-see attitude before you adopt an aggressive estate-reduction strategy.
  
  You probably shouldn't give away a lot of assets to your kids or lock holdings in irrevocable trusts; you or your spouse may need the money, or the rules may change again. But familiarize yourself with the various strategies available that could help you reduce your estate and save taxes. Also, make sure you have named an executor who will be able to cope with the changing rules.
  
  
• Build in flexibility and implement useful strategies. These are the keys to planning under the new estate-tax rules -- unless, of course, you time your demise for 2010, when the tax goes on its one-year hiatus. For example, if you haven't already created a bypass trust to hold the amount you may pass free of federal estate taxes, consider doing so. (A bypass trust is often called a credit-shelter trust.) This type of trust is often used to supplement the income of a surviving spouse. On the death of the survivor, the assets in the trust also bypass his or her estate.
  
  Why not leave everything to your spouse, using the unlimited marital deduction? Your estate would pass free of taxes, but leaving it all to your spouse bulks up his or her estate and generally increases the overall tax that will ultimately be paid on your combined estates.

Make sure your bypass trust won't backfire

If your estate plan currently contains language that automatically pegs the amount that flows into the trust to the exemption amount, consider changing it. As the exemption amount rises to $3.5 million, an increasingly large percentage of your total estate could wind up in the trust. Depending on the terms of the trust, your spouse could be deprived of the income or financial flexibility he or she desires.

One way to handle the potential problem is to insert the appropriate language into wills and trusts so that a surviving spouse can disclaim an appropriate amount into a bypass trust and thus keep it out of the estate.

To make this work, however, you must educate your spouse on the merits of the plan and make sure he or she would feel financially secure about disclaiming property once you're gone. Newly widowed spouses are often afraid to disclaim assets they have inherited, says Martin Shenkman, an estate lawyer in Teaneck, N.J.; educating them now will save on taxes later.

Look into a dynasty trust

If you have a substantial taxable estate you don't anticipate needing, ask your lawyer about the merits of creating a perpetual "dynasty" trust, which is legal in Alaska and Delaware, among other states. The primary purpose of this kind of trust is to reduce your estate -- and future estate-tax liability -- by giving away assets to the trust and to protect assets from creditors.

Generally, you name your heirs and descendants (and their descendants) as beneficiaries of the trust, but you can also name yourself, says Shenkman. In most cases, the trustee (or co-trustee) is an institution, such as a bank or trust company, and the trustee typically has complete discretion over distributions from the trust.

If you later need assets you've given to the trust, you can tap them if the trustee agrees. But assets you take back from the trust will be included in your estate unless spent. And when you made the gift to the trust, you used all or part of your federal estate-tax and generation-skipping tax exemptions.

Family partnerships remain useful

Wealthy families will still find use for family limited partnerships (FLPs) because very large lifetime gifts will be subject to the gift tax. Basically an FLP works like this: You transfer assets, such as real estate, to the partnership and serve as controlling general partner. You then give interests or shares to heirs, who are usually your children. As you make the gifts, their value is removed from your estate. The extra fillip: The shares you give away are discounted in value because they are not liquid -- that is, they can't be easily sold. And that in turn boosts what you can remove from your estate each year without incurring a gift- or estate-tax liability.

"By creating a family limited partnership, the general partner really hasn't given up anything, such as access to money," Ledyard says. "All he's done is transfer ownership of the asset to a different form."

Trustees: Hold on to insurance policies for now

Many retirees with large IRAs or other illiquid assets, such as a family business or investment real estate, have set up life insurance trusts to help their heirs with estate taxes. At this point, do nothing. It's premature for a trustee to consider selling the policy, unless your estate has been radically reduced for reasons that have nothing to do with the tax law changes.

The estate tax is scheduled to reappear, and the exemption amount returns to its 2002 level of $1 million in 2011. If the estate tax is permanently repealed, the trustee will still be able to help your heirs. For instance, he or she could lend them money to pay capital-gains taxes on stock you leave them after the automatic step-up in basis on inherited property ends. (For more information on the new carry-over-basis rules, see The New Estate-Tax Rules.)

Generosity is still a virtue

Keep on making annual gifts; it's still a great way to pare a taxable estate. You can give up to $11,000 a year to as many individuals as you wish, $22,000 if your spouse joins in. And don't overlook making charitable gifts of appreciated property. You may be able to write off the fair market value on your income taxes and cut your estate for estate-tax purposes.

If you've been giving to a charity or cause that has special meaning to you, continue being generous: Your gift may be more important than ever before. The National Council of Nonprofit Associations reports charities are worried that donations will drop as some donors take a wait-and-see approach about tax changes or simply stop making charitable donations during their lifetimes.

Gazing into the crystal ball

The rule changes simply aren't simple. Down the road, for example, you can expect your executor to develop migraines trying to determine which assets in your estate should receive the $1.3-million step-up in basis. And if heirs believe an executor's decision has cost them money, costly court battles could ensue. Without planning, heirs you intend to treat equally may fare far differently.

The New Estate-Tax Rules

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