How to Reduce or Eliminate Taxes or Property You Leave to Your Heirs

I. Estate Tax/ Capital Gains Tax Update

A. Brief History.

A brief overview of what has happened over the last few years will help you to better understand what is happening now.

In 2001 President Bush signed a law which gradually reduced the federal estate tax rate from 55% to 45%. It also gradually increased the amount of property that you could pass free of federal estate tax from $675,000 per person in 2001, to $3.5 million per person in 2009. If you had your will or trust set up right during those years, and you were married, you could actually protect twice as much as the exemption amount. That means that with a properly set up estate plan, a married couple could pass up to $7 million free of federal estate tax, if they both died in 2009.

B. What is the law now and how will it affect you?

In 2010 only, the 2001 tax act repeals the estate tax- but only for one year! That sounds good for this year, but its really just smoke and mirrors --the reality is the estate tax is simply replaced with an additional income (capital gains) tax.

Before 2010, any assets you owned when you died would be valued at fair market value at the date of your death. Then when your surviving spouse or heirs sold any of the assets they inherited from you, they would not have to pay capital gains tax on any of the appreciation that occurred during your life. (This is referred to as a “step-up in basis.”) For many heirs this means huge capital gains tax savings, often tens of thousands of dollars or more.

But in 2010 property that passes at death does not automatically receive this step-up in basis. Instead, each individual has a limited amount of property that can be “stepped-up” in value at the time of death. Property that does not receive this stepped-up value will be subject to tax on all increase in value from the date you first acquired the property. This means that the property could be exposed to tens of thousands of dollars of income tax liability for your heirs!

C. Why this change in the law can blow up existing plans!

For more than 50 years it has been common to use a written mathematical formula to divide the assets of a married couple when the first spouse dies to maximize estate tax savings. Now, in 2010 when there is no estate tax, these formulas will not work. They are based on estate tax concepts that don’t exist anymore.

The formula clause forces you to use an additional trust when the first spouse dies, commonly known as the “B” Trust, or Family Trust. Depending upon what the law is at the time the first spouse dies, there may be no benefit to using this additional trust, but the plan will force your spouse to set up anyway! This creates an additional unnecessary layer of complication and paperwork! As noted in Section D. below, one of the proposals before Congress that has a strong likehood of passing, would eliminate the need for the “B” trust altogether.

Even worse, if your spouse is not your sole beneficiary (for example, if you have children from a prior marriage), the existing formula could result in the disinheritance or substantial reduction of resources provided for the surviving spouse.

D. What happens in 2011 and Beyond?

Unless Congress acts soon, the estate tax returns in 2011– only at a much lower $1 million exemption and a higher maximum 55% tax rate!

There are multiple options for change being considered by Congress. In December of 2009, the House passed a bill to extend the law as it was in 2009, with a 3.5 million dollar exemption and 45% tax rate. Republicans in the Senate defeated the bill, in large part because they were holding out for a 5 million dollar exemption. A Bill to permanently repeal the estate tax was defeated in the Senate during July, 2010. Most experts, including me, believe it is likely that some version of the law as it existed in 2009 will eventually be passed. One change that may be made is to make the exemption amount “portable”. This means that a married couple can protect double the exemption amount, without being forced to set the “B” trust described above.

II. What to Do Now!

A. If You Already Have A Plan- Get It Reviewed! If you have a will or trust, get it reviewed to make sure it set up so that the changes in the law don’t force the surviving spouse to use an additional, unnecessary trust; create additional taxes for your family; or disinherit or reduce the amount that goes to the loved ones of your choice. Your plan must be flexible enough to work with any of the foreseeable changes to the law!

B. If You Don’t Have Will Or Trust Get One!

C. Work with a Qualified Attorney. Attorneys without specialized training don’t know the intricacies involved in the laws of taxation. Lack of that sort of knowledge is what caused the loss of most of my grandmothers estate, as described in my bio. It was because of that catastrophe that I vowed putting off becoming an estate planning attorney until I attained my Masters in the Laws of Taxation, in addition to my regular law degree.

It is because of that lack of knowledge, that over 95% of the plans that I review that are drafted by other attorneys were not only not set up right to work in 2010 and 2011 --- they didn’t even work well in 2001 – 2009. They forced money into the “B” trust – even in cases where it wasn’t needed to avoid taxes ---- adding an additional layer of complication that could have been avoided altogether. For several years, I’ve been including provisions in my plans to deal with every single variation in the tax law we just discussed. Very few of my clients will need to redo their plans because of changes in the law.

D. If You Have a Large Estate, Work with your Attorney to Implement Additional Strategies to Protect Your Family from Taxes. If there is an estate tax, which there will almost certainly be, you will want to protect as much as possible from that tax. The following are only a few of many different techniques that can be used to eliminate or reduce the estate tax burden placed upon your heirs. One strategy is to reduce the amount the assets you own at your death are valued by the IRS. One technique to accomplish that goal is to use a Family Limited Liability Company, which can create estate and gift tax discounts. In addition to tax reduction the FLLC provides an added benefit of protecting the assets owned by the FLLC from your creditors! The FLLC is discussed in more detail in the Business Planning section of this website.

Another strategy is to remove assets from your estate before you die. You probably know whom you want to have your assets after you die. If you can afford it, why not give them some assets now and save estate taxes? Appreciating assets are usually best to give, because the asset and future appreciation will be out of your estate. Just a couple of the most commonly-used strategies to remove assets from estates are explained below. Note that these are all irrevocable, so you can't change your mind later.

a. Tax-Free Gifts. Each year, you can give up to $13,000 ($26,000 if married) to as many people as you wish. This amount is now tied to inflation and may increase every few years. So if you give $13,000 to each of your two children and five grandchildren, you will reduce your estate by $91,000 (7 x $13,000) a year - $182,000 if your spouse joins you. You can give more, but it will use up some of your estate tax exemption. Charitable gifts are unlimited. So are gifts for tuition and medical expenses if you give directly to the institution.

b. Irrevocable Life Insurance Trust (“ILIT”). Life insurance can be used to pay your estate taxes at your death. Anything left over can go to your heirs. Unfortunately, life insurance is counted as part of your taxable estate at death, unless you use an ILIT. The ILIT owns the insurance, so the insurance is not counted as part of your taxable estate. If you have a whole life policy, the ILIT can be structured as a Spousal Access trust, which allows the spouse who is not the insured to be in charge of the trust and withdraw cash value if it is needed.