Estate Planning for Shifts in the Estate Tax Law

Big changes are due in the estate tax law, but no one can be sure what those changes will be. Yet, all estate owners need to have Estate Planning strategies in place, and that plan needs to meet the owner’s goals whatever the tax law is. The plan should be flexible, address the most likely changes, and not require frequent updates as the political and legislative outlook shifts.

The estate tax exemption for 2007 and 2008 is $2 million per person. Under current law, the exemption will rise to $3.5 million in 2009. In 2010, the estate tax will be eliminated. In 2011, the law will return to what it was before the 2001 reforms: a top rate of 55% and only a $1 million exemption per person.

When Republicans held the majority in Congress, it seemed likely that the estate tax eventually would be eliminated for most people before the 2011 reversion to prior law. With the change in control of Congress, elimination of the tax is much less likely. Yet, the Democrats are unlikely to allow either the 2010 elimination of the estate tax or reversion to the 2001 law to be their legacy. Congress should take action in 2008 or 2009.

I suspect that the 2009 provisions will be made permanent: a 45% top rate and a $3.5 million exemption per person.

Here is how estate plans should be written to reflect the uncertainty and potential changes.

The part of the estate planning that is most affected by the potential changes and that needs the most attention is the provision for funding a credit shelter trust. This is a critical part of most estate plans.

The standard estate planning for a married couple creates a trust for the couple’s children, commonly called a credit shelter trust or A/B trust. The trust receives from the estate of the first spouse to pass away an amount equal to the estate tax exemption. The trust usually provides that the surviving spouse receives income for the rest of his or her life and can receive the principal for specific needs. After the surviving spouse passes away, the children of the marriage receive the remainder of the trust. The rest of the estate goes to the surviving spouse.

The advantage of this strategy is that full use is made of the lifetime estate tax exemption and no taxes are imposed on the estate of the first spouse to pass away.

The standard use of the credit shelter trust can create two potential problems as the estate tax changes.

One problem is that the will of each spouse might have to be changed each time the law changes. If the will provides that a specific dollar amount or the prevailing estate tax exemption amount be shifted to the credit shelter trust, taking full advantage of the law requires that the will be amended or rewritten with each change in the law.

Another and more serious problem is that the credit shelter trust might absorb more of the estate than intended. If the will states that the trust will receive the estate tax exemption amount, the trust might receive the bulk of the estate. Today’s exempt amount of $2 million will absorb the bulk of most estates. When the exemption rises to $3.5 million, the trust will receive all or most of the vast majority of estates. The surviving spouse could be left with a mere pittance in his or her own name. Even multi-millionaires could find themselves leaving a minority of their wealth to their spouses.

A solution 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 that the surviving spouse receives the amount intended and that the tax law does not determine the estate distribution.

For example, the credit shelter funding clause could state that the trust will receive the prevailing estate tax exemption amount or $2.5 million, whichever is less. Or the clause could state that the trust will receive the estate exemption amount up to 40% of the gross estate.

Another change in light of the legal uncertainty is that gift giving should be restored to many estate plans.

A number of estate owners reduced or suspended their estate planning gift giving as the exempt amount rose and it seemed likely that the tax would be eliminated. They reasoned that there was no tax reason to remove property from the estate early, since all or most of the estate was likely to avoid taxes anyway.

With elimination now doubtful and the exemption unlikely to top $3.5 million, many estate owners might want to resume their giving.

A person can give up to $12,000 annually (indexed for inflation) to any person free of gift taxes. A married couple jointly can give $24,000 annually. The gifts reduce the estate, removing not only the value of the assets given but any future appreciation.

In addition, some gifts given for education or medical purposes are free of gift taxes regardless of the amount given. Some requirements must be met.

Education gifts are tax free for an unlimited amount if made directly to an education institution for direct tuition costs. Gifts that pay for other education expenses, such as books, supplies, board, lodging, or other fees, do not qualify. Your $12,000 annual exclusion can be used to pay for those items, and then you can pay the tuition directly to the education institution.

Medical expenses also are tax free gifts in any amount. Qualifying payments are those made for any medical expense that meets the definition of a deductible itemized medical expense. Again, the payments must be made directly to the medical care provider.

In addition, each person has a lifetime $1 million gift tax exemption for gifts that exceed the annual gift exemption. The estate tax exemption is reduced to the extent that the lifetime gift tax exemption is used. The advantage of giving large gifts early is it removes future appreciation of the assets, making it possible to give more assets free of estate and gift taxes.

Gifts, of course, should not be given to the extent they would reduce or endanger one’s standard of living. But people with estates greater than $3.5 million should consider a gift giving program to minimize estate and gift taxes.

Owners of businesses or significant estates should reconsider traditional estate planning vehicles that fell out of favor in recent years. These include family limited partnerships, irrevocable trusts, life insurance trusts, and charitable trusts.

Estate owners should not sit idly waiting for Congress to decide what it will do with the estate tax law. There are only a few likely outcomes, and estate owners can work within this narrow range of potential changes. October 2007.