Estate Planning: Now More Important Than Ever

Given the control of both House and Senate by the Democrats following the midterm elections – and daily discussions in the media of the increasing gap between the middle class and the wealthy – a permanent repeal of the estate tax does not appear to be on the horizon. The incoming chair of the House Ways and Means Committee, Charles Rangel, has announced that his first priority will be a reformation of the alternative minimum tax (AMT). Without such a reformation, the Wall Street Journal projects that the number of taxpayers affected by the AMT will increase from 3.5 million in 2006 to 23.4 million in 2007. The resulting reduction in revenues from the AMT, absent other offsets, will put increasing pressure on the existing budget deficit. However, as we approach the next presidential election, both parties will be loath to enact new taxes to bridge the gap. All these forces combined are likely to scuttle estate tax repeal.

At the same time, there is widespread agreement that the existing estate tax law, enacted by Congress in 2001, was ill-conceived and is also in need of reformation. This law provides for the current federal estate tax exemption of $2 million per person ($4 million per couple) through 2008, an increase to $3.5 million ($7 million per couple) in 2009, a one-year repeal in 2010, and a reversion to $1 million ($2 million per couple) in 2011.

Congress’ most recent attempt at a compromise on estate tax reform called for a $5 million individual estate tax exemption ($10 million per couple); a reunification of the estate, gift and generation-skipping transfer tax exemptions; and a reduction in the applicable rates. Whether such a compromise can be achieved in the current climate in Washington remains to be seen.

The prospect of estate tax repeal and the uncertainties posed by the existing estate tax law have caused many clients to take a “wait and see” attitude toward their estate plans. Such procrastination may be more costly than ever. Indeed, as the estate tax exemptions increase, a married couple’s failure to plan for the effective use of each spouse’s exemption can cost close to $1 million even before taking into account applicable state estate taxes. For married taxpayers whose estates exceed $4 million – or for single taxpayers whose estates exceed $2 million – the failure to pursue strategies designed to reduce their taxable estate can cost millions in estate taxes that could have been significantly reduced or avoided altogether with proper planning.

Estate Planning Is an Investment

“Estate planning” is an amorphous term commonly used to describe a wide variety of activities. The spectrum ranges in complexity from simple wills with no tax reduction features to sophisticated combinations of lifetime and testamentary transactions designed to save millions in taxes. Most people view estate planning as an exercise in deferred gratification: spending time, money and emotional energy now for future benefits, some of which accrue to their family only after their death. Such an approach ignores the real and immediate gratification estate planning can provide in knowing that you have discharged an important responsibility to yourself and your family and have limited the share of your estate which will inure to the benefit of the federal and state government at the time of your death.

You can approach estate planning as a bitter pill to be swallowed, and procrastinate until something or someone “forces” you to swallow it, or you can approach it as an investment that will give you greater peace of mind. What you put into and get out of estate planning can even be subjected to a cost-benefit analysis similar to the following:

The Larger Your Estate, the More Your Planning Is Likely to Be Tax-Driven

Estate planning involves simultaneously juggling four complex, separate but overlapping federal tax structures:

1. income tax

2. gift tax

3. estate tax

4. generation-skipping transfer tax

These taxes are designed to take a large proportion of your wealth away from you and your heirs and “redistribute” it for the benefit of the population at large. The more wealth you have accumulated, the greater the percentage the government seeks to redistribute. Separately and together, these interrelated taxes provide ample motivation to take action now to intelligently minimize the toll they exact on the accumulation and transfer of wealth.

The estate planning process should start with the outline of a plan appropriate to meet your non-tax goals and objectives, and only thereafter should that plan be skillfully integrated with various estate planning vehicles designed to minimize these four taxes.

Levels of Estate Planning

For high net worth clients, there are essentially three levels of estate planning:

• Level I: Testamentary Planning
• Level II: Lifetime Transfers
• Level III: Valuation Reduction

Level I – Testamentary Planning. Anyone with more than a modest estate needs to do the following:

(a) provide for post-mortem administration and disposition of his/her estate

(b) if married,

(i) avoid estate tax on the first $2 million of his or her assets (the “applicable exclusion amount” currently in effect) through use of the “unified credit”

(ii) defer tax on amounts transferred at death to a surviving spouse, in many cases through use of the marital deduction

(iii) preserve various options for “post-mortem estate planning,” such as use of the decedent’s generation-skipping transfer tax exemption of $2 million

Basic Documents

Level I estate planning involves the preparation of the basic estate planning documents, including the following:

• Last Will and Testament (and, if desired, Revocable Trust)
• Living Will
• Health Care Proxy
• Durable Power of Attorney

These documents are all revocable and amendable during life.

Once transfer taxes become a material factor, the required level of sophistication escalates dramatically. The main factors driving the cost in Level I will be the following:

• the uniqueness of the client’s wishes and assets
• the size of the tax exposure
• the types of measures the client wishes to employ in the will or revocable trust to reduce that exposure

Level II – Lifetime Transfers. Level II estate planning involves irrevocable lifetime transfers and transactions which are intended to achieve the following:

• minimize one or more of the four taxes by shifting assets and future income and appreciation to the client’s intended beneficiaries by using available tax exclusions, credits and deductions, and gift tax rates which are lower than estate tax rates
• solve liquidity problems during lifetime or at death

Transactions available at this level typically include gifts within the $12,000 “annual exclusion” and $1 million “lifetime exclusion amount” (outright or in trust), irrevocable life insurance trusts and charitable remainder trusts. It is important to note that the lifetime gift tax exclusion is frozen at $1 million, whereas the death tax exclusion is now $2 million and is scheduled to increase as described above. These transfers are usually of a size and type which do not require the payment of gift tax. Taking advantage of these opportunities can be beneficial to anyone with an estate of more than $4 million.

The “Simple Trust” Is a Fallacy

After speaking to friends or reading articles in the popular press, clients often seek to create a trust as a part of their estate plan with the mistaken notion that trusts work magically to reduce estate taxes. In reality, there are many different forms of trusts, and the tax benefits that can be achieved come from the effective use of various deductions, exemptions and leveraging strategies. The determination of which trust vehicle is most appropriate for a given client is an essential part of the planning process. Because such trusts are irrevocable and are often intended to continue for decades, the agreement drafted to govern the trust must be flexible and must be tailored to the client’s individual circumstances.

The irrevocable life insurance trust is perhaps the most common trap for the unwary. Each trust agreement must be carefully drafted to provide for alternative contingencies that may arise well into the future. Moreover, great care must be taken to administer the trust properly during the lifetime of the insured(s) in order to make certain that the benefits originally sought are ultimately achieved.

The costs of Level II planning are entirely a function of the selections chosen from the menu of Level II estate planning vehicles; although, again, both the investment and the potential savings increase as the estate increases.

Level III – Valuation Reduction. Level III estate planning generally involves irrevocable lifetime transfers and transactions which are employed, often in combination with Level II activities, to reduce the valuation of assets for transfer tax purposes. These vehicles include:

• family limited partnerships or limited liability companies
• personal residence trusts
• charitable lead trusts
• generation-skipping “dynasty” trusts
• family foundations

These are often substantial transactions designed to save millions of dollars in transfer taxes and may require the payment of some gift tax. Cooperative planning with children can be important here, especially when using family limited partnerships. Clients who need Level III planning are usually in the $10 million-plus range, although it is not unusual for a client with $5 million to $10 million who is concerned about taxes to use one or more of these measures.

The estate planning attorney serving the wealthy client usually must be both architect (often in cooperation with other advisors) and builder. Unfortunately, some clients, and even some estate planning attorneys, seem inclined to gloss over the planning process and to start construction without adequate planning. Thoughtful clients recognize that the attorney, just like the architect, needs to learn the details of the client’s financial and personal situation, to take the time to educate the client about the estate planning options and vehicles potentially useful in that situation, and to help the client decide among them. Because this process depends so much on the client, the time required varies greatly from client to client.

Include Estate Planning Among Your New Year’s Resolutions

For high net worth individuals, estate planning has the potential to be one of the best investments they will ever make. A modest commitment of time and money can yield millions in estate tax savings and, at the same time, create a well-designed structure for the preservation and management of wealth for generations to come. The establishment of your first estate plan, or the review of your existing estate plan, should be at the top of your list of resolutions for the New Year.