Resting in peace just got tougher.
In June, after months of rancorous debate, the U.S Senate voted not to abolish the sunset provision of the death tax (also known as the estate tax). The vote, which split down party lines, all but killed hopes for a permanent repeal of the death tax.
Granted, the estate tax is scheduled to be gradually rolled back over the next few years, then disappear entirely in 2010. But thanks to the Senate vote, the tax will merely be dormant, not dead: it returns in full force in 2011.
For high net-worth executives, that bizarre bit of scheduling makes for some extremely complicated estate planning. As the law stands, the estate tax exemption of $1 million in 2002 gradually rises to $3.5 million in 2009. The top estate tax rate, which is 50 percent in 2002, gradually declines to 45 percent over that time. In 2010, the death tax disappears. But get this: once the death tax comes back from its one-year holiday, it reverts back to the 2002 exemption, or $1 million at a 55 percent rate.
Congress’s unusual approach to estate planning — that is, creating a moving target — has financial planning experts flummoxed. Says Craig Janes, national director of estate gift and trust services at Deloitte & Touche: “You now have to have documents that are sufficiently flexible that handle death right around 2009 and what happens if the estate tax that we knew last year springs back into existence.”
At the very least, financial planners say estate owners should review and update the language of their will — repeatedly. And they say high-net worth individuals should evaluate trusts to take into account the tax law changes.
Consider, for example, a happily married CFO with an estate of $5 million. The finance chief wants to leave his wife at least $3 million, but also doesn’t want his issue (also known as children) to have to pay any federal estate tax. If the CFO happens to die in 2002, those heirs would get $1 million (the full death tax exemption), while his wife would get $4 million and avoid taxes because of the unlimited marital deduction. This implies our executive hasn’t made large gifts in the past because that will eat up the $1 million exemption, too.
If our CFO dies in 2009, and his will still says that he wants his children to benefit from the full estate tax exemption that the law permits, the progeny would get $3.5 million. But his spouse would only receive $1.5 million from the estate — well below the $3 million the CFO had intended to leave his loving wife. Maybe she could go work for the kids.
Formula clauses, which take into account changes in rates and exclusions, may be one fix for the problem. For instance, as the death tax exclusions rise, the children’s contribution could be capped at $2 million. “But because there’s such variations in what the law will be in the next nine years and what it will be after 2011,” notes Janes, “it’s becoming incredibly difficult to accurately draft formula clauses, and they have become extraordinarily complicated.”
A disclaimer is another legal strategy to consider when willing assets to children and spouses. In a disclaimer, a named heir refuses to accept property, and the will therefore redirects said property to another person or another trust. Heirs who have rights to property under a will or trust are required to execute a disclaimer within nine months of receiving an interest in the property.
But disclaimers come with a disclaimer: they rely on the eschewer of the property to actually eschew the property. “A lot of times those disclaimers are never done and tax efficiency goes out the door,” Janes says. “In some families those assumptions are alright to make, in others it’s not, particularly second marriages. I would be very careful of that.”
What’s more, surviving family members can be reluctant to take the role of trustee or executor because the financial decision-making flexibility that is needed in the coming years also increases legal liability. “That makes them nervous,” concedes Janes. “They would rather have the document tell them expressly what to do.” An exculpation clause can be inserted into the will so when trustees exercise their discretion in good faith, they won’t be sued.
But the future leavers of an estate may have even more reason for concern. “For executives who may have a lot of money tied up in retirement plans,” notes Christine Fahlund, senior financial planner at T. Rowe Price, “the decision becomes whether to have assets diverted to a bypass trust or just leave it all to the spouse, and have the spouse roll it over.” For the latter, the funds grow tax-deferred and are tax-free at sale because of the unlimited marital deduction.
If a piece of a pension plan is carved out to fund the bypass trust (also known as a credit shelter trust), the funds would eventually go to the children. The advantage here is that the children would not have to wait for the spouse to die to inherit the wealth. The wife can also have access to the bypass trust’s funds while she is living. The downside is that the amount in the bypass trust would no longer grow tax-deferred, and only property given outright to a spouse qualifies for a marital deduction.
Moreover, retirement plans, stock option plans and life insurance are not controlled by a person’s will — they’re contract property. And if the will is not coordinated with the beneficiary designations of the contract property, Janes says, executives could inadvertently leave a taxable estate because the amounts exceed the exemption.
Financial planners admit that some estate planning strategies may prove ineffectual in the future — if Congress acts again. Consider irrevocable life insurance trusts, or ILITs. An ILIT is typically designed to help estate beneficiaries pay off estate taxes. The advantage of an ILIT is that the policy is removed from the estate, which means the benefits won’t be taxed. By law, insurance benefits are not taxable income or estate, but benefits that are part of an estate are taxable.
The problem with irrevocable life insurance trusts? They’re irrevocable. If Congress ultimately repeals the estate tax, explains Rod Atherton, shareholder at law firm Greeberg Traurig in Denver, “you are cloaked with a trust that you may not want.” And you’ve paid a hefty premium for the privilege.
And that’s the problem with much estate planning under existing law: attempts to skirt the death tax can backfire. For instance, financial planners say some estate strategies can affect current liquidity or retirement plans. “Look at the estate plan in light of your overall financial situation” advises Donn Sharer, vice president of financial planning at MetLife Financial Services, “so that you don’t solve estate planning issues but create issues in other areas.”
Moving to other areas could cause just as many problems. Before the 2001 tax act, the federal estate tax return provided a tax credit to an estate for any state estate taxes paid (up to a limit). But that federal credit is being reduced, and will be phased out completely by 2005, replaced with a deduction. “The states in essence are paying a portion of the tax benefits that were enacted last summer,” explains Susan Schoenfeld, principle at Bessemer Trust’s legacy planning group. “So the states now have to find a way to raise the revenue that they’ve lost.”
As a result, states that would historically conform to the federal code are creating legislation that raises or freezes estate tax rates, allowing them to collect tax that they would have received the day before the 2001 act was past. So there’s a greater chance that the state estate tax rate will be higher than what the federal government makes eligible for credit.
“If you die in 2004, your combined federal and state tax rates will be higher than if you died in 2001,” Janes says. “A lot of people don’t appreciate that. You have to look at the whole picture. In some states, it’s going to be as high as 58 percent,” compared with the typical 55 percent limit. What’s more, estate documents don’t generally anticipate differences between states with respect to their tax laws.
Upshot? Executives who relocate a lot need to visit their will a lot. “I’ve seen several clients with the will drafted by one person in one state and the living trust by another in another state,” Janes notes. “Both are incompatible.”
Nirvana Has a Flip Side
It would seem that an estate tax law that eliminates the death tax, and then brings it back the next year, would be incompatible with common sense.
And indeed, given the sunset provision of the current estate tax, 2010 does look like the perfect time to die. But estate beneficiaries could still get socked that year, thanks in large part to a change in the capital gains tax. “There’s a mistake in assuming that 2010 is kind of nirvana,” Janes says. “Its not — it’s got a flip side.”
That flip side is a change in the treatment of the cost basis of assets (things like stock and property). That change, which kicks in 2010, requires a carryover basis instead of a step-up from fair market value.
Hence, if a CFO bought a stock at $1 a share, and after her death on December 31, 2009 the stock is sold at $140, the heir’s cost basis is $140 (stepped-up to fair market value). In that case, no capital gains taxes would have to be paid — unless, of course, selling the shares puts the heir over the death tax exemption for 2009 ($3.5 million).
If the same CFO were to die on January 1, 2010, and the stock shares were sold, the heirs wouldn’t have to worry about paying any federal death tax — no matter how large the estate. But the cost basis for the stock (for capital gains tax purposes) would be $1 for the stock because of the carryover for the year. Thus, there would be a $139 gain — and that gain would be subject to capital gains tax when the shares are sold.
“I’m surprised there’s not more of an uproar,” Janes says. “There will be some estates in 2010 that will actually lose more money to the federal government because they will lose the step-up in the basis.”
Most Feathers, Least Squawking
That is, if Congress doesn’t intervene again. The estate tax law is likely to undergo further scrutiny as power shifts on Capitol Hill. “Estate tax is scheduled to be repealed by 2010, but between now and then there are four congressional elections and two presidential elections, so the political balance may change a number of times,” says Bessemer Trust’s Schoenfeld. “And certainly the country’s economy may have a major impact on how Congress may want to move on this.”
The death tax repeal may even rise from the grave in the next six months. “The Republicans are still very committed to getting estate tax off the books permanently,” adds Doug Rothermich, vice president of the TIAA-CREF Trust Company, part of the TIAA-CREF group. “They were very close to the 60 votes they needed [in the Senate].” Rothermich believes that the tax issue could be revisited as early as the November elections, with a new vote in January.
While Rothermich is advising clients to plan for the current law, he notes, “None of them believe that the changes to the estate tax laws as they currently exist will be left alone. What is the unknown is in what direction.”
Others aren’t so sure. “The art of taxation is like the art of plucking the goose,” explains Atherton. “The government’s job is to pull the most feathers out with the least amount of squawking.”
Atherton says the estate tax is not a tax that generates a lot of complaints because you’re taxing a dead person. “That’s why it’s difficult to see the government taking it away.” But Atherton adds: “I do think it will get modified from its current structure, which becomes extremely unworkable in a few years.”
That’s why flexibility remains key in estate planning. “If you want to plan your death, plan it for 2010,” says Atherton. But, he adds, “I suspect you will have to change your calendar in the next few years, so don’t write that date in pen.”