Estate Planning

Estate planning helps you minimize estate taxes and distribute your assets according to your wishes. While most people will need the help of professionals, we’ve included several articles on the topic:

• Estate Planning under the 2001 Tax Act
• Making Lifetime Gifts
• Do You Still Need Life Insurance for Estate Purposes?
• Distributing Money to Your Children
• Integrating an Inheritance

If you have any questions or would like to discuss your estate planning situation in more detail, please contact us at
248-858-2723.

Estate Planning under the 2001 Tax Act

The Economic Growth and Tax Relief Reconciliation Act of 2001 has made the estate planning process more complicated. The estate tax is scheduled to phase out gradually from 2002 to 2009, be repealed in 2010, and then reinstated in 2011 based on 2001 tax laws. That, of course, assumes that there will be no further tax legislation during this time. Before reviewing how this may impact your estate planning strategies, you should understand the major changes:

The estate tax phase-out will occur as follows:

When the estate tax is repealed, the provision allowing inherited assets to receive a step-up in basis to market value at the decedent’s date of death will also be repealed. Inherited property will then generally have a basis equal to the lesser of the decedent’s adjusted basis or the property’s fair market value at the decedent’s date of death, with three exceptions: 1) $1,300,000 of basis can be added to assets. 2) Unused capital losses, net operating losses, and certain built-in losses can increase this cap. 3) An additional $3,000,000 of basis can be added to assets inherited by a surviving spouse.

The lifetime gift exemption increased from $675,000 in 2001 to $1,000,000 in 2002 and will remain at that amount. The maximum gift tax rate will equal the maximum estate tax rate through 2009 and after that will equal the maximum individual income tax rate.

The generation-skipping transfer (GST) tax exemption will increase from $1,100,000 in 2002 (adjusted for inflation in 2003) to $1,500,000 in 2004 and then will follow the estate tax exemption schedule. The GST tax will also be repealed in 2010 and reinstated in 2011. The GST tax rate will equal the maximum estate tax rate.

Your estate planning strategies should now encompass the possibility that you may die during three periods — the phase-out period, the year of estate tax repeal, and after reinstatement in 2011. What impact will all of these changes have on your estate planning strategies? Consider the following tips when reviewing your estate plan:

• Examine your current estate planning documents carefully. Many documents indicate that trusts should be funded with assets equal to the unified credit applicable exclusion amount or GST tax exemption amount. With the exemption amount increasing significantly between 2002 and 2009, this may result in too large a percentage of your estate going into trusts. The higher exemption amounts may leave more than you intended to your grandchildren or may place so much in a credit shelter or other trust that your spouse receives very little of your estate outright. Be sure to examine your estate planning documents every couple of years during this transition period.

• Remember that there are also non-estate-tax reasons for planning your estate. Even if the increases in exemption amounts mean that your estate won’t be subject to federal estate taxes, there are still reasons to plan your estate. You probably still need a will to provide for the distribution of your estate and to name guardians for minor children. You should also consider a durable power of attorney, which designates someone to control your financial affairs if you become incapacitated, and a health care proxy, which delegates health care decisions to another person when you are unable to make these decisions.

• Watch for any changes to your state’s estate taxes. The state death tax credit allowed against the federal estate tax will be reduced by 25% in 2002, 50% in 2003, 75% in 2004, and completely repealed in 2005. It will be replaced with a deduction for death taxes actually paid. Many states have tied their estate taxes to this federal estate tax credit, so that total estate taxes were not increased for any amounts paid to states. With that credit being phased out and repealed, current formulas may result in the payment of more estate taxes or states may increase their estate tax rates to make up for the lost revenue. Make sure to watch for state changes, which could have a significant impact on your estate.

• Review documents dealing with your potential incapacity. You may want to give family members more flexibility in determining what life support measures to use. While it may sound morbid, family members of individuals with large estates may have differing views about how to handle a serious illness during the 2009 to 2011 period.

• Consider allocating specific assets to heirs. Due to the three exceptions for adding basis to assets in 2010, you may want to specifically allocate assets with low basis to your spouse and assets with a higher basis to other heirs.

• Continue an annual gifting program, since it does not result in the payment of gift taxes. (See the article “Making Lifetime Gifts” for more details.)

• Be cautious of undoing any estate planning strategies already in place. If these strategies were viable for your estate before the new tax act, they probably are still viable. Those strategies could include life insurance purchased to pay estate taxes or trusts established for estate planning purposes.

• Plan for potential capital gains taxes. With the loss of the step-up in basis in 2010, heirs of larger estates may find that their tax burden has shifted from an estate tax burden to a capital gains tax burden. You may want to make provisions to help your heirs pay those taxes.

• Keep records to comply with the new carryover basis rules. Heirs may have difficulty calculating the original basis of assets that have been owned for years or even decades. If the step-up in basis is repealed, you can help your heirs by keeping detailed records for basis calculations.

Instead of eliminating the need for estate planning, the eventual repeal of the estate tax has made estate planning more complicated.

Making Lifetime Gifts

Since estate taxes are scheduled to be phased out gradually and then reinstated in 2011, you may still want to make gifts during your lifetime to reduce your taxable estate. Some tips to consider include:

• Use your annual gift tax exclusion amount. In 2002, you can gift up to $11,000 ($22,000 if the gift is split with your spouse) to any individual free of gift taxes. This amount is adjusted annually for inflation, in $1,000 increments. You can make these gifts to any number of individuals. Any future appreciation or income generated on those gifts is also removed from your estate.

• Pay medical and education expenses for your heirs. Certain amounts paid directly to institutions for these expenses can be made gift-tax free.

• Consider using your lifetime gift exclusion. This exclusion increased to $1,000,000 in 2002 and is in addition to the amount you can gift annually without paying gift taxes. Thus, those with estates large enough to be subject to estate taxes may consider using this exclusion to remove assets from their taxable estate.

• Look into ways to maximize the benefit of your exclusion amounts. For instance, individuals who transfer noncontrolling interests in businesses, farms, real estate, and other assets during their lifetime may be able to assign a minority interest discount to the gift’s value. Gifting assets to certain types of trusts, such as qualified personal residence trusts and grantor retained annuity trusts, allows you to place an asset in trust now, use the asset for a period of time, and thus place a lower value on the gift.

• Avoid making taxable gifts to heirs for now. The scheduled phase-out and repeal of the estate tax means that more estates will be able to minimize the payment of estate taxes.

• Gift property that has the potential to increase in value, but has not already done so. A lifetime gift’s tax basis remains your original basis plus any gift tax paid. Thus, if you gift an asset with a low basis, your heirs could owe significant capital gains tax when the asset is sold.

• Make charitable contributions during your lifetime. Charitable contributions made after death are free of estate taxes. With the future of the estate tax uncertain, you may want to make charitable contributions during your life. Those contributions still lower your taxable estate and will also allow you to receive an income tax deduction for the contributions.

• Keep your own needs in mind. While gifting can be a valuable estate planning strategy, you don’t want to gift so much of your estate that you have difficulty making ends meet later in life.

Do You Still Need Life Insurance for Estate Purposes?

One of the more popular reasons to own life insurance is to use the proceeds to help fund estate taxes. If the policy is properly structured, the proceeds will not be included in your taxable estate and your beneficiaries will not have to pay federal income or gift taxes. However, with the eventual repeal of the estate tax in 2010, you may wonder if there is still a need for life insurance for estate purposes.

Since the estate tax won’t be repealed until 2010, your estate plan should consider strategies to deal with estate taxes in the event you die before then. Thus, life insurance may be an appropriate estate planning strategy until at least 2010. Even after that, however, there is no certainty that the estate tax repeal will be permanent. Due to the sunset provisions of the Economic Growth and Tax Relief Reconciliation Act of 2001, the estate tax will be reinstated in 2011, based on 2001 tax laws, unless further legislation is enacted.

Even if the estate tax repeal is permanent, there are still situations where the use of life insurance will be an appropriate estate planning strategy. Some of those situations include:

• To provide liquidity to an estate. If your estate consists primarily of illiquid assets, such as real estate or a business, you may want to use insurance so your family won’t be forced to sell or mortgage assets.

• To equalize inheritances. Perhaps your primary asset is a family business, which is run by one of your children. You may want to leave the business to that child, but need additional funds to equalize the inheritance for your other children. Insurance proceeds can be used for that purpose.

• To transfer wealth to heirs. Even if the estate tax is permanently repealed, life insurance proceeds still retain their income tax advantage — proceeds are paid to beneficiaries free of federal income taxes. Thus, life insurance may still be an appropriate way to increase your bequest to your heirs.

• To leave a large charitable contribution. You may want to leave a large charitable contribution to a charity without depleting the assets left to your heirs. To do this, you could designate the charity as beneficiary of a life insurance policy.

• To help heirs fund future tax liabilities. After the estate tax is repealed, inherited assets will no longer receive a step up in basis to the market value at the date of the decedent’s death. Instead, inherited property will generally have a basis equal to the lesser of the decedent’s adjusted basis or the property’s fair market value at the date of the decedent’s death. To that basis, three items can be added: 1) $1,300,000 of basis; 2) unused capital losses, net operating losses, and certain built-in losses; and 3) an additional $3,000,000 of basis to assets transferred to a surviving spouse. If you leave substantial assets with low basis to your heirs, they may face significant future tax liabilities. You may want to help them with those tax liabilities through the use of life insurance.

Distributing Money to Your Children

Turning wealth over to children or grandchildren can raise some troubling issues. While a large inheritance can alleviate financial concerns for your heirs, you probably don’t want that inheritance to remove the incentive to work hard or to lead a productive life. You also don’t want your heirs to spend the money irresponsibly, obtaining no long-term benefits from the inheritance.

To help you assess how your heirs would handle an inheritance, consider making lifetime gifts to them. Every year you can make gifts, up to $11,000 in 2002 ($22,000 if you split the gift with your spouse), to any individual tax free. You can then assess how well they handle these gifts. Do they waste the money on extravagant purchases or set it aside in savings? Are they appreciative of the gifts or feel it is their right to receive the gifts? Their actions can help you decide whether you need to control the distribution of their inheritance.

If you want to control distributions, you can set up a trust, attaching conditions to those distributions. Those conditions could include:

• Spreading the income over many years or decades. You don’t have to turn your entire estate over to your children when they turn 21. You may want to distribute pre-determined percentages of your estate when your children reach certain ages. Or you can distribute only income from the trust until your children reach a certain age, then distribute the remaining assets.

• Making distributions contingent on achieving certain goals. You can designate that distributions be made when your child finishes college, gets a job, or has children. You can also base distributions on how much income your child earns. For instance, you can allow the child to take 50¢ from the trust for every $1 he/she earns. Or you may wish to supplement the incomes of heirs who choose careers in government, educational institutions, or charitable organizations. These types of distributions can help encourage behavior you feel is important.

• Designating some funds for health problems, education funding, or emergencies. That way, a child who is confronted with serious health problems or other emergencies will have financial resources to help deal with these problems. You can allow your trustee to decide when the funds should be distributed.

You can’t totally control how your heirs spend their inheritance, but you can control when and how they receive it. By doing so, hopefully you can help teach them how to handle their inheritance responsibly.

Integrating an Inheritance

When you receive investments as part of an inheritance, you must integrate them into your overall portfolio. In many cases, that will require changes to your portfolio. Consider the following:

• Review each inherited investment as if it were a prospective investment. Retain those that fit your financial goals and have good potential. Consider selling any that won’t meet your financial goals or that you don’t have the expertise to manage.

• Evaluate the costs before selling. For tax purposes, the inherited investment’s tax basis is stepped up to market value on the date of death. Thus, selling inherited assets soon after receiving them typically won’t result in large capital gains taxes. However, review the transaction costs for both selling the existing investment and reinvesting in a new one. Some investments may also have a deferred sales charge.

• Your asset allocation percentages may change drastically when you add the inherited portfolio to your existing investments. Decide whether to move back to your original allocation immediately or gradually over a couple of years.

• Don’t keep inherited investments for sentimental reasons. Selling those investments doesn’t mean that you’re questioning the investment capabilities of the person who gave you the assets. You just have different financial goals than that individual.

Copyright © 2002. These articles intend to offer factual and up-to-date information on the subjects discussed, but should not be regarded as a complete analysis of these subjects. The appropriate professional advisers should be consulted before implementing any options presented. No party assumes liability for any loss or damage resulting from errors or omissions or reliance on or use of this material.