The estate tax lives: here's how to minimize its impact on your heirs

Chief Executive, The, Jan-Feb, 2005 by Jennifer Pellet

Think the Republican sweep at the polls spells a swift demise for the so-called death tax? Think again. While President Bush is pushing for a permanent repeal of the estate tax, financial gurus fully expect the resulting tug of war only to complicate an already convoluted tax-planning picture. "The more the budget deficit increases, the harder it will be to get away with cutting revenues," argues John Goldsbury, director of executive advisory services at Bank of America. Even a defunct tax could be resurrected. "The estate tax has already been repealed three times and brought back to life three times," says Goldsbury, "so you have to wonder how long a repeal would last."

[GRAPHIC OMITTED]

The good news? Thanks to the election results, even if an outright repeal proves impossible, the estate-tax rate reductions and personal exemption hikes ushered in by Bush's 2001 Economic Growth Tax Relief Reconciliation Act are likely to remain in place during his second term. That law whittles the estate-tax rate down to 45 percent by 2007 while simultaneously ratcheting up personal exemptions--the amount taxpayers can pass to heirs free of estate tax--over the next four years. The tax law currently bumps the exemption ceiling to $3.5 million in 2009, then climinates estate taxes altogether in 2010 only to return them in 2011 to the 2001 levels--a 55 percent tax rate and $1 million exemption.

"If you're 'lucky' enough to die in 2010, there's no tax, but you can't exactly plan on that," says Joseph W. Spada, cofounder of the Parsippany, N.J.-based Family Wealth Institute. He cautions taxpayers against hoping for permanent repeal. "Most people are pretty confident that there will be some sort of estate tax. So estate tax planning is still the prudent thing to do."

The idea behind the current Byzantine structure is to enable Congress to balance the budget in 2010, or to reform the tax law prior to then. But the bottom line is that taxpayers must now revise their estate plans to adapt to an ever-morphing tax picture, or risk having their assets be misdirected. "In effect," says Goldsbury, "if you haven't rewritten your will. Congress has rewritten it for you."

Because spouses inherit tax-free, the typical estate plans call for leaving to heirs the maximum amount that can be shielded and the remainder to a spouse, he explains. "For someone with a $4 million estate, for example, that means a will that originally intended to leave the 2001 maximum of $675,000 to heirs and the remaining $3,325,000 to the spouse would, in 2009, give $3.5 million to the heirs and just $500,000 to the spouse."

Fortunately, there are several approaches to guard against that unintended outcome. Designating a specific dollar amount is the most direct, but if you want to retain the flexibility of linking the inheritance amounts to the exemption level, setting an inheritance cap is a better bet. You can, for example, leave the most one can shield, but no more than $2 million, to a family trust or to your heirs. Known as the disclaimer will, a third option allows for even greater flexibility to adapt to both estate-tax law or fluctuations in the size of your estate.

"This approach involves leaving everything to your spouse, with the provision that any amount he or she disclaims is put in a trust for your heirs," explains Goldsbury, who points out that this option may not always be appropriate. "It lets the surviving spouse make the call with 20-20 hindsight, but you need a certain kind of marriage for that

to work."

The will's wording should also address the possibility, however remote, of no estate tax. "I don't think anyone believes it will go away altogether," notes Goldsbury. "But in the case of a very large estate of, say, $50 million, given the possibility of even a temporary one-year reprieve, the will should include a statement that says, 'If there is no estate tax when I die, then leave my kids $25 million and the other $25 million to my spouse.'"

Altering the wording of your will alone, however, is only half the battle. If all assets are held jointly, the instructions of a will are overruled, and everything goes to the surviving spouse; the opportunity to use the personal exemption to pass a portion of assets to heirs tax-free is lost. The same is true if one spouse holds the bulk of assets and the less affluent spouse is the first to pass away.

Estate balancing, whereby assets are divided so that each spouse has holdings in his or her own name, guards against wasting an exclusion. "In 2005, for example, when the personal exemption amount is $1.5 million, my wife and I can shield $3 million in assets if assets are held properly," explains Goldsbury. "Whereas if we hold everything jointly and I die first, I don't shield anything with my exemption."

To ensure that your heirs--rather than Uncle Sam--are the primary beneficiaries of your life's work, you and your spouse should ratchet up these individual holdings in tandem with the rising personal exemption. "By 2009, you should each have $3.5 million in your own name so that together you're shielding a total of $7 million," explains Goldsbury, who asserts that estate-tax planning is all about adaptation. "Ultimately, you want to plan for every possible outcome."