Your Magic 8 ball has a better chance of predicting the outcome of the current estate tax enigma then you do. Couple that with the uncertainty of the stock market, and you have the making of some panicky clients.
While you can't predict the future, you can help plan for it. And the key to planning in these uncertain times is flexibility, especially in the estate-planning arena. Unless your client is lucky enough to die in 2010, the only year that we will not have an estate tax, there will most likely be some bill that must be paid to Uncle Sam at the time of death.
Currently, the federal lifetime estate and gift tax exemption for an individual is $1 million. The estate tax exemption will jump to $1.5 million in 2004 and 2005 and will continue to increase to $3.5 million by 2009. If you die in 2010, your estate will be tax-free. The $1 million exemption is scheduled to come back again in 2011. And then who knows from there.
The gift tax exclusion will remain at $1 million until Congress tells us otherwise. Remember that your client can give $11,000 to as many people he wants each year without incurring gift tax. If he decides to give an amount over that $11,000 freebie, it may cut into his lifetime gift exclusion.
Keep in mind these are just the federal rules. Many states have not increased their rates to match the federal rules, says Scott Johnston from Holland & Knight in New York City.
I Don't Want Your Money!
Unless your clients can plan their deaths for 2010 (hey, stranger things have happened), they will most definitely have some sort of estate tax issue. Since the amount of that estate tax is unknown, it is imperative that survivors are given the ability to make some post-mortem decisions.
Most people just assume that they should leave everything to their spouse. And while the surviving spouse will be just tickled, it's not the most beneficial move from an estate tax perspective. “Keep things flexible,” says David Caruso, senior vice president and wealth advisor at Morgan Stanley.
Let's say Husband dies and leaves his entire $5 million estate to his wife. She will not pay an estate tax dime on that $5 million thanks to the “marital deduction,” which allows anything passed between spouses, dead or alive, to be estate tax free.
Great, you say. No!
They never took advantage of the husband's lifetime estate tax exclusion. He was able to pass on $1 million estate tax free at his death, and he didn't. Instead, he took his exclusion to the grave.
There are a few ways to fix this. If your client is in a traditional family — mom and dad got married, had kids and stayed married until death — consider giving the surviving spouse the right to “disclaim” some assets. If not, or if the survivor is not trusted to make the right decisions, include more detailed language in the will and create additional trusts.
First, the disclaimer. Disclaiming bequeathed property almost sounds contradictory. Someone leaves you $1 million, and you say, “No, thank you.” (You have nine months from the husband's death to do this.)
But let's say that in our example the wife did “disclaim” $1 million at her husband's death. The money would then go into a disclaimer trust, estate-tax-free thanks to the husband's lifetime exclusion. By disclaiming the money, the wife essentially “fixed” their estate planning post-mortem.
That's why Martin Nissenbaum, national director of income tax planning at Ernst & Young calls it an “after-the-fact Band-Aid.” Call it what you want. No estate tax was paid, and the exclusion was used. If the wife also dies this year, she'll pass that $4 million on to the kids, but only $3 million will be subject to estate tax because she too can give $1 million estate tax-free.
While establishing a disclaimer trust in a will offers the ultimate in flexibility, it also requires lots of trust between spouses. The survivor, along with her estate tax professional, will be called upon to make the right decision after the first spouse is gone.
Create A Trust When There is None
If, on the other hand, that spouse isn't trusted enough to make the appropriate decisions (and we mean that with all due respect), create a bypass trust and include additional language in the will instructing how to fund that trust.
A bypass trust, also called a credit shelter trust, is a great way for a client to, well, “bypass” estate tax at the time of death and still have control of his assets. To receive the tax benefits of this trust though, there are some rules that must be followed, courtesy of the IRS.
The surviving spouse has limited access to the principal. The provisions rules of the bypass trust say that the surviving spouse can only use the principal for health, education, maintenance, or support. But the surviving spouse can have the right to all interest and dividends annually earned in the trust.
The trust can also be written to offer the surviving spouse the right to withdraw up to $5,000 of principal per year for any purpose, or 5 percent of the total principal, whichever is greater. Another benefit to the bypass trust is that the creator can also dictate whom the money will go to after the surviving spouse is gone.
That said, a bypass trust offers control and flexibility at the same time, two thing clients are looking for in this ever-changing changing environment. Beware: It's very important that the trust be drafted accurately. While the IRS takes no issue with the creation of this trust, it is quite the stickler when it comes to the language need to draft one.
Language detailing how to fund the trust is just as important. As an example, Johnston suggests the following: “The maximum amount that can pass free of federal estate tax should go to a bypass trust and the remainder will go to your spouse,” suggests Johnston. This way, your client can take full advantage of the exclusion, regardless of what it is at his death.
To take an example of this, assume your client's estate is worth $5 million when he dies in 2005. The exclusion for that year is $1.5 million. Since the above language was in the will, $1.5 million immediately will go to a bypass trust, and the remaining $3.5 million will pass to the spouse. Your client was able to use his full exclusion; even though he didn't know what that exact number would be when he drafted his will.
For clients looking for even more control from the grave, consider a Qualified Terminable Interest Property Trust, or a QTIP trust. This trust gives them the ability to support their surviving spouse financially without having to fret about her investment choices. In addition, he can ensure that his kids (or someone in particular) get the remainder of the account after your surviving spouse is gone.
With the QTIP, the surviving spouse will qualify for the marital deduction so she won't pay estate taxes when the money is passed, but there are a few requirements. The surviving spouse can be the only beneficiary of the trust during her lifetime. And with this trust, the surviving spouse cannot touch the principal and income generated must be distributed to the surviving spouse.
Get Going Now
There are some techniques that remove assets from your client's estate while he is still alive. The Grantor Retained Annuity Trust, a.k.a. GRAT, can be used to minimize estate taxes on income-producing assets or an appreciating stock portfolio. And the Qualified Personal Residence Trust, or QPRT, will get your client's house out of the estate.
With a GRAT, clients essentially are loaning themselves money. Your client will transfer his stock or real estate into an annuity and pay himself back over a period of time with interest. The IRS dictates that amount of interest. It's around 4.2 percent these days, according to the IRS tables. That's why the GRAT is great for low-interest-rate environments, says Johnston.
The bigger benefit to the GRAT is that there is no gift tax due when it is established. In addition, any earnings the GRAT's investments make above 4.2 percent will be passed onto beneficiaries without estate or gift tax.
But like everything involving this tumultuous market, these GRATs are not bulletproof. If the stock does not return more than the interest rate, the GRAT was a waste of time and money. The shares, or the cash equivalent, simply go back to your client at the end and the money spent to set the GRAT up is sunk.
(Caution: If the client dies before the end of the GRAT's term, the stock/cash automatically goes back into the estate and again, the whole thing was a waste.)
If your client is living in an appreciated home, consider putting it in a qualified personal residence trust to get that value out of the estate. Again, this will only work if the trust comes to an end while your client is still alive. If he dies, the house becomes part of the estate.
A QPRT is an irrevocable trust that allows clients to give their home away at a discounted price. The home is transferred to the QPRT for a determined number of years. Funding the QPRT will cut into their lifetime exclusion, but for many people, their home is their biggest appreciating asset. Getting it out of the estate can save them loads of money at death.
During the length of the QPRT, the client retains the right to use the home but the value of the house is discounted over those years. So when the trust expires, the house is worth nothing on paper (even though its market value may be much higher). When the house is turned over to the kids at the trust's expiration, the gift-tax bill will be zero. Keep in mind, if the clients want to stay in the house, they will have to start paying the children rent.