Building on Shifting Sands
ESTATE PLANNING IN UNCERTAIN TIMES

With the Senate's refusal to consider a full estate tax repeal and several bills in the works to find a compromise on reform, the fight over the federal estate tax remains unresolved. Regardless of what happens in the end, you need to know what the changing situation means to you as you build or remodel your estate plan.

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As Congress continues to debate the federal estate tax issue, there is much speculation about what may happen and when, but little certainty. As the law is written currently, federal estate tax rates decrease and exemption amounts increase until 2010, when the estate tax is repealed for one year. In 2011, the repeal sunsets, and the rates and exemption amounts bounce back to their 2001 levels. (See A Moving Target below.)

Last year, the House of Representatives voted to permanently repeal the tax, throwing the debate to the Senate, which refused to consider the option. Most recently, the House passed a compromise measure that would provide:

• A $5 million per person exemption under the estate, gift and generation-skipping taxes,
• A rate equal to the maximum long-term capital gains rate (currently 15%, but set to increase to 20% in 2011) on the first $25 million in an estate, and double the capital gains rate for any amount exceeding $25 million, and
• A stepped-up basis at death for all the estate’s assets.

Changing Rules, Future Impact
This compromise measure drew criticism from both sides of the political line in the Senate, where it did not receive enough votes for approval. Conservative Republicans were unhappy linking the estate tax rate to the capital gains rate, arguing future increases could lead to a high rate on wealthy estates, while many Democrats contended the plan was still too generous. Eventually, a compromise may be ironed out that will meet with enough support to pass the Senate, but when and at what levels the new rates and exemptions will be set remain unknown.

With all this uncertainty, building an estate plan that will help you meet your goals can be very
challenging. Regardless of the final outcome, your plan will require regular reviews as federal and state legislators adjust the tax going forward.

Be Flexible and Review Regularly
Rather than using the uncertainty as an excuse to put off planning, or gambling on a permanent repeal, the keys to successful estate planning today are flexibility and regular reviews.

With federal estate tax exemptions scheduled to increase again in 2009, building flexibility into your plan is crucial, particularly if you don’t live in a community property state. The executors and trustees named in your plan should be given enough discretion so that, no matter what Congress decides, your plan can be adapted to best meet the needs of your beneficiaries.

All the flexibility in the world won’t help you, however, if you don’t pay attention to how your assets are titled.

For example, if you are married, you should review your plan regularly to assure you’re taking full advantage of the increased estate tax exemption. To be certain you and your spouse each are able to take advantage of the full exemption amount, you each must have assets equal to the exemption amount titled in your name. Neglecting this step could leave your family facing hundreds of thousands of dollars of additional taxes.

Kathy Brockston’s family learned this the hard way. She and her husband, John, had a combined net worth of $10 million, $1 million of which was in Kathy’s name. Because Kathy was much younger than John and in good health, they assumed John would die before her, and built their estate plan around that assumption. But when Kathy died unexpectedly at the beginning of 2006 (when the exemption amount was $2 million), the Brockstons were only able to use $1 million of Kathy’s federal estate tax exemption amount. This left an extra $1 million in John’s estate, which ended up costing the family an additional $450,000 in taxes ($1 million x 45%) when he died a year later.

Watch Formula Bequests as Well
Many people’s wills are written using what are known as formula bequests to take advantage of both the estate tax exemption and the ability to pass an unlimited amount to a spouse estate-tax free. Yet formula bequests must be designed carefully to avoid unintended consequences.

For example, your documents might call for a trust for your children to be funded with the entire exemption amount, with the remainder of your assets going to your spouse. If you died in 2006 with an estate valued at $4 million, your children’s trust would be funded at $2 million and your spouse would receive $2 million. But if you died after Congress changed the exemption to $4 million, your entire estate would pass to the children and your spouse would get nothing.

As undesirable as such an outcome can be, it could be an even thornier situation if, for example, your spouse isn’t the parent of your children. “Your plan needs to take into account your real beneficial priorities, so tax law changes don’t leave a lopsided estate plan,” says estate attorney Joseph Rubinelli Jr.

Farm and Business Owners Face Special Issues
If a large portion of your family’s net worth is in the form of real estate or a business, you may face other estate planning issues. For instance, changes in the tax law also may change your family’s liquidity needs after your death. One common estate planning strategy for families who own farms or family businesses is to purchase additional life insurance to cover the estate tax. But if the estate tax reform becomes permanent, your family may not need that big payoff.

It’s best not to be too hasty in canceling or modifying a life insurance policy, however. Congress can be notoriously mercurial when it comes to the tax law. And depending on age or health considerations, policies may not be reinstated once canceled. Of course, these insurance policies often serve other valuable purposes in an estate plan. But if Congress enacts more permanent estate tax legislation, you may want to consult with your estate planning attorney to reassess your liquidity needs.

Rethinking Your Gifting Strategy
Another common estate planning strategy — giving gifts beyond the annual exclusion amount — may also bear rethinking in light of the current estate tax situation. Gifts given with a value up to the annual exclusion amount (currently $12,000) are tax-exempt. Larger gifts are taxable at the same rate as the estate tax. But giving larger gifts of $1 million or more is still a common estate-planning strategy because it removes the asset, and its subsequent income or appreciation, from your estate. However, this option may seem less appealing now, given the chance that the estate tax will be scaled back or repealed.

Keep on Planning
The uncertainty around the estate tax’s future has only complicated the choices involved in estate planning, a burden many people would rather not bear. But don’t let that provide an excuse for avoiding working on your estate plan.

No matter the fate of the tax, planning remains vital. Inadequate planning can greatly reduce the size of your estate. Your heirs could be forced to sell valuable family assets — and your legacy could end up out of your control.

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