The Estate Tax Nightmare

The federal estate tax may pose a threat to your beneficiaries, if the value of your estate exceeds the allowable personal exemption.

For instance, if you die in 2007 or 2008 and the net value of your estate (assets minus debts) is more than $2 million, your tax liability is at the 45% rate.

If you are married, your living trust can include a provision that will let you and your spouse leave up to $4 million tax-free to your loved ones, saving up to $900,000 in tax.

The above example is premised on estate tax legislation that is set to expire on January 1, 2011.

The problem today is to accurately estimate the estate tax liability beyond that sunset.  The only thing we know for sure is that we may revert back to the 2001 rules.

Prudent estate tax planning should consider a return to a lower personal exemption and a higher overall tax liability.

Another fly in the ointment is the issue of state taxes.  In the past, most states benefited from a federal credit that offset dollar-for-dollar the amount of state death taxes.

By 2005, this credit was eliminated completely and replaced with a deduction, which meant states were forced to either lose the revenue they had received from the prior credit... or, impose their own new state death tax.

Roughly 38 states had been using this credit and many of them have introduced legislation to establish their own estate tax.  Many more are expected to follow shortly.

The writing is clearly on the wall... your total (federal plus state) estate tax will increase.

So, how are you supposed to plan... especially when no one inside or outside of Washington has any real idea what is going to happen to the transfer tax rules in the next four years?

And, how do you prepare for a currently unknown forecast that could effectively wipe out up to 60 percent of your estate before it passes on to your beneficiaries?

Here are some suggestions:

1. Your revocable living trust should provide for the maximum use of the personal exemption.  For instance, if the current exemption is $1,000,000, then you should personally own (as an individual or as trustee... but not jointly) up to $1,000,000 of assets.

   Since the exemption amount will likely vary over time, your trust document should not specify a dollar amount.  It should be worded to compensate for a potentially changing amount.

2. If you own rental property, consider moving the ownership into a family limited partnership together with a limited liability company. The objective would be to remove high valued assets from your estate without necessitating a loss of personal control.

3. Consider gifting assets to charity without restriction... or, use your $1,000,000 lifetime gift exemption to remove highly valued items from your estate.

4. Fund any projected estate tax liability with second-to-die life insurance, if you are married.  Since the estate tax is not due until after the second spouse has died, the cost savings of the 2nd-to-die policy can be meaningful.

   This policy should be owned by an irrevocable life insurance trust and you must have no incidents of ownership.  Use your annual gift tax exemption to pay the premium.

The best you can do is to work within the bounds of what you know to be true.  For example,

• What is the current value of your assets and liabilities?
• What is the anticipated value of these at your expected mortality?
• Is the net amount (assets minus liabilities) higher than the current personal estate tax exemption?
• What is the tax on that higher amount?
• Will your loved ones have enough liquidity from your estate to pay that tax without being forced to sell precious assets?
• If the answer is "no"... consider buying life insurance and either pay the premium yourself, or let your loved ones share in the cost.