Be Ready for Big Estate Tax Changes

The estate tax is due to expire after the end of 2009. Control of Congress and the White House have changed since that law was enacted, so it is a safe bet the estate tax won’t be allowed to expire.

Congress might be too preoccupied with other matters to agree on the details and extend the current law for another year or two. But in time the law will be changed, and change is likely to occur this year. There are some actions you should take in anticipation of the change, and others you should postpone but be ready to take when the details are settled.

A new permanent law, when enacted, will have several features. The lifetime exemption amount for estates will be raised from this year’s $3.5 million to $5 million or even $7 million. The top estate tax rate will be either 45% or 50%.

At this point, I do not have a feel for whether the lifetime gift tax credit will stay at the current $1 million or return to being the same amount as the estate tax exemption. I expect the annual gift tax exemption to remain at the current $13,000 and still be indexed for inflation, but we have to be prepared for that to change.
If your estate plan has not been updated for 18 months or longer, you need to update it. I do not recommend waiting until the law is revised. The major changes in asset values the last two years alone are a good reason for a review. You might be surprised how much asset value shifts affect your plan.

Any estate plan that is written or revised now should be flexible, address likely tax law changes, and try to avoid needing an automatic update when the law changes.

Here are ideas and strategies that should receive particular attention now.

Credit shelter trusts and use of the marital deduction need careful attention. These are the key elements of most estate plans and are affected the most by recent and future tax changes. Markets changes also affect them.

A credit shelter trust takes advantage of the annual lifetime estate tax exclusion amount. The marital deduction provides the estate a deduction for the value of all property passing to the surviving spouse. The combination can make an estate of any size pay zero estate taxes.

In a standard estate plan for a married couple, the will of the first spouse to pass creates a trust, commonly called a credit shelter trust or A/B trust. The trust receives from the estate an amount equal to the lifetime estate tax exemption. The trust usually provides that the surviving spouse is paid all the trust income for the rest of his or her life and can receive principal for specific needs or at the trustee’s discretion. The rest of the estate goes directly to the surviving spouse. After the surviving spouse passes away, the children receive the remainder of the trust. They also are likely to receive the rest of the estate through the surviving spouse’s estate through his or her will.

There are variations, but that is the basic strategy.

The advantages of this strategy are no taxes are imposed on the estate of the first spouse to pass away and full use is made of each spouse’s lifetime exemption.

In a will that uses the credit shelter trust details are important because of the way the exemption amount changed and might change again. If your will is worded one way, the credit shelter trust might absorb more of the estate than intended.

For example, if the will states that the trust will receive the full estate tax exemption amount, the trust might receive the bulk of the estate or even the entire estate. Today’s exempt amount of $3.5 million will absorb the bulk of most estates. If the exemption rises next year, the trust will receive all or most of the vast majority of estates, especially after the sharp declines in stock and real estate prices. The surviving spouse could receive a mere pittance in his or her own name. Even multi-millionaires could leave a minority or none of their wealth to their spouses.

A solution, as we have discussed in past visits, is for the will to contain a flexible formula for funding the credit shelter trust.

The will could state that the trust will receive the lower of the estate tax exemption amount and a fixed dollar amount. A variation is for the trust to receive the lower of the exempt amount and a percentage of the estate. Either formula ensures the tax law alone does not determine the amount received by the spouse.

For example, the credit shelter funding clause could state that the trust will receive the prevailing estate tax exemption amount or $1 million, whichever is less. Or the clause could state the trust will receive the estate exemption amount up to 30% of the gross estate.

Given the extreme changes in asset values in recent years, you might want to add another clause. You might want the will to say that in no event will the surviving spouse receive less than a specific amount. This ensures your spouse is taken care of first, regardless of how much the markets might shrink the value of your estate.

These clauses will serve you well as the markets and tax laws change.

Estate owners also should take a fresh look at their gift giving strategies.

Gifts are a tax free way to transfer property from the estate. Properly planned gifts remove not only the current value of the assets but also future income and appreciation.

Many people suspended gifts to children and grandchildren when the estate tax was scheduled to be eliminated. Those with estates above the current exemption amount and near the likely new amounts should review gift giving strategies.

Gift giving is especially timely because of the decline in asset values. If you believe the assets you own have good long-term growth prospects, you can take advantage of the annual gift tax exclusion and lifetime gift tax exemption to move them out of your estate tax free at today’s values. The future appreciation will be in the hands of your loved ones at no tax cost.

Another reason to reconsider the gift giving program is your children and grandchildren might need help now. If you have the wealth available, you might look for ways to give it to them at little or no tax cost.

Owners of estates that are likely to exceed the new exemption levels need to review their overall estate plans. Keep in mind the estate tax is imposed on the value of assets. Your estate might be less than or barely above the likely new exemption amounts now. But in a few years it might be above the limit, and if economic growth returns to normal levels you could be above the limit by a substantial amount. You and your estate planner should consider steps to take now.

Business owners and those with substantial estates should reconsider estate planning strategies that were put on the back burner when the estate tax was scheduled for elimination. These strategies include family limited partnerships, irrevocable trusts, life insurance trusts, and charitable trusts. Other strategies include self-canceling install-ment notes and intentionally defective grantor trusts.

In recent months we also mentioned strategies that are especially valuable in light of today’s low interest rate and asset values. These include grantor retained annuity trusts, grantor retained income trusts, charitable lead trusts, low-interest and no-interest loans, and qualified personal residence trusts.

The estate tax is about to change, but you should not wait to act. Begin planning now. Be sure your will and the rest of your estate plan will meet your goals under today’s law and are flexible enough to adapt to changes. Also, begin to develop longer-term strategies. RW April 2009.