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Estate Planning in Uncertain Times

Our estate tax laws are currently in flux. The estate tax rules will be changing if Congress acts or if Congress fails to act. As a result of this uncertainty, everyone should take a few seconds to think about whether his or her estate plan will be effective.

Here are the three estate tax regimes that we may likely see in the future:

Scenario 1: If Congress fails to act, the federal estate tax will be repealed in 2010 and reenacted in 2011 and in 2011 the unified credit or applicable exclusion amount (the amount that can be passed to non-spouses estate tax free) will decrease from $3.5 million to $1 million. Also, individuals who inherit property will receive only a limited or no stepped-up basis in the property that they inherit (so a child that inherits a million dollar real estate property will take the parents taxable basis in the real estate, causing the child to have to pay an income tax on the sale of the real estate that the child currently would not).

Scenarios 2 and 3: If Congress acts, it is believed that Congress will (1) repeal the estate tax (but not the gift of generation skipping transfer taxes) or (2) the estate tax will remain but the unified credit will be increased by several million (possibly to $5 million) and the estate tax rate will decrease from 46% to something closer to 20%.

Here are some examples of common estate planning pitfalls that may occur given these three regimes:

For married couples, many basic estate plans that were drafted in the last ten or so years provide for a credit shelter trust (AKA a marital deduction trust). A credit shelter trust provides that the assets of the first spouse pass to a trust and the trust will be split into two shares. One share will include assets equal to the first spouse,s unified credit ($2 million if they die this year) and the remainder will be held in a separate share.

The unified credit amount typically is held in trust (that is irrevocable once funded) with the income payable to the surviving spouse for his or her life and on the surviving spouses demise this share is paid outright to the couple,s children. The other share is held in a revocable trust that the surviving spouse can use as he or she sees fit. When the second spouse passes away only the assets remaining in this revocable trust will be taxed in his or her estate. The other share that was set aside in the irrevocable trust will pass to lower generations estate tax free.

In the past six years the unified credit amount has increased from $675 thousand in the year 2000 to $2 million in the year 2006 and it will increase to $3.5 million in the year 2009. Thus, if a married person were to pass away today with a $2 million dollar estate and they had established a credit shelter trust in the year 2000, the entire $2 million dollar estate would pass into an irrevocable trust to pay income to the surviving spouse and upon the demise of the second spouse the assets would pay out to the couples children.

This may be fine, but what if the first spouse to pass away owned almost all of the couple’s assets, the assets were not income producing assets, and the first spouse to pass away died at a relatively young age? In that case, the surviving spouse would basically have no means of support for what could be a long lifespan. Back when the credit shelter trust was created, both spouses believed that only $675 thousand would pass to the irrevocable trust and the remaining $1.325 million could be used by the surviving spouse as he or she pleased. That is not what happened. The couple should have updated their estate plan.

Now imagine that Congress increases the unified credit to $5 million in 2007 and all years thereafter and a married person with anything up to $5 million in assets passes away in 2007 or later. This increase in the unified credit will increase the number of people who will be negatively impacted by having outdated credit shelter trusts.

A second example: An owner of a family business, on the advice of his or her tax advisors, creates a family limited partnership (FLP). The FLP provides that there are two classes of interests in the FLP. One class (which is equal to 2% of the total ownership) has the right to control the entity and the second class (which is equal to 98% of the total ownership) has no right to control the entity. The owner begins transferring the second-class interests to his or her children. The owner can use up his or her $1 million dollar lifetime gift tax exemption amount to facilitate this transfer and he or she can use his or her $12 thousand annual gift tax exclusion each year to make these transfers. These transfers occur over a number of years. The owner completes the transfer of all of the 98% of the second-class interests in 2008. The owner is 50 years old in 2008. Congress permanently repeals the federal estate tax in 2008. Congress did not repeal the federal gift tax (Congress has never proposed repealing the federal gift tax).

The business owner has transferred a lot of the value to his or her children and retained control over the corporation. So what is the problem? What if the business subsequently becomes less profitable (say foreign competition and high income taxes makes it hard to earn a profit)? Will lenders be willing to help bail out a business whose owners only own 2% of the business? What if the owner,s children pass away or have outstanding debts (what if they are found to have negligently caused an automobile accident) or, worse yet, the children start divorcing their spouses. Who will actually end up owning the business interest? What if there is discord among the family members. The parents come to dislike one or more children. One or more children come to dislike one or more of their siblings. The business owner created the FLP to avoid estate taxes. If the estate tax was repealed, the fifty-year-old business owner might rather try to get the shares back from his or her children, but doing so would require the children to make a taxable gift to transfer the interest to the parent (or use up the child’s lifetime gifting amount). Thus, the children can now gift less to their children (or others) using their lifetime gift tax exclusion amount.

A third example: parent owns a significant amount of property that has a low tax basis (real property that has been depreciated over time or other property that has significantly appreciated in value since the property was purchased in the early 1900,s). Parent has never sold the property because they do not want to pay the tax on the gain inherent in the property. Parent plans on passing the property to his or her children upon his or her demise so that the children get a stepped-up basis in the property. Thus, the children can sell the property and not have to pay tax on the gain that the parent would have to pay if he or she sold the property during his or her lifetime. What if Congress cannot get anything done and the estate tax laws on our books today take effect? Assume parent dies in 2011. The unified credit in 2011 will be reset to $1 million. The parent,s low-basis property is valued at $100 million. The children will be in a position of not being able to sell the property that they inherit because they will have to pay tax on the gain inherent in the property. Yet, part (if not most) of the property will have to be sold to pay the parent,s estate tax. Thus the parent held on to property that they would probably have preferred to dispose of long ago most likely because it is an under performing asset, i.e., the dog stock or the real property money pit. The parent gave up the opportunity to earn more from their property all of those years. There were several years were tax rates were at historically low levels and there is a good chance (because of our country,s current economic condition) that the sale occurs in a time when our tax rates are at historically high rates. Missed income and higher taxes.

These types of tax issues will impact more and more taxpayers, especially with the Baby Boomer generation about to make the largest transfer of wealth that the world has ever seen. There are numerous ways to plan for these issues. Given these uncertainties, estate planning is imperative.

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