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The Return of the Estate Tax

As Connections was going to press, the federal estate tax system doesn’t exist for citizens dying in 2010. Thus late billionaire owner of the New York Yankees and numerous other businesses and investments, George Steinbrenner, passed his megae state to his family members and other beneficiaries free of federal estate tax. Had he died in 2009 or 2011, his estate would probably have owed (assuming he did not pass the majority of his estate to a charitable organization).

Old Is New Again

In a total about-face, the estate tax will be resurrected in 2011, but its exact form is yet to be determined. And a final law may be years away as current policy discussions are focusing on short term (two- to three-year) fixes.

According to a recent Wall Street Journal article, many believe a change in the law will take place to relieve the burden on the middle class, possibly increasing the credit or doing away with the estate tax altogether. In any event, the estate tax landscape appears to be entering a state of constant change.

With the law being in flux, it’s difficult to know how to structure your estate plan from a tax standpoint. As planners and advisors, we also struggle with giving sound advice that doesn’t require our clients to constantly revise their documents. However, if you know the current law and pay attention to the coming changes, you can make the right decision for your circumstances to avoid unanticipated tax hits on your estate.

Selecting Your Strategy

Several tax strategies can be implemented to save federal estate taxes. For a married couple, a will or trust that employs a “credit shelter trust” is most common. This type of planning creates a family trust on the death of the first spouse in an amount equivalent to the maximum amount that can pass free of federal estate tax with the balance passing to the spouse, either outright or in trust.

Another popular and useful tool is the Irrevocable Life Insurance Trust or “ILIT,” a trust formed by the creator, or “grantor,” designed to own and be the beneficiary of a life insurance policy on the life of the grantor. Typically, this policy would be a term life insurance policy. The grantor makes annual “gifts” to the ILIT, enabling the trustee to pay the life insurance premiums. If properly set up and funded, the proceeds of the policy would not be included in the estate of the grantor at death.

Otherwise, insurance that the decedent owns or has “incidents of ownership over” can be included in the estate upon death. The inclusion of the proceeds from a large insurance policy can lead to a family incurring an estate tax when one might not be expected. Therefore, the ILIT can be used to keep the value of the insurance policy out of the estate.

The ILIT can also be used to provide liquidity to the estate by purchasing otherwise illiquid assets, allowing the estate to then pay estate taxes. If the ILIT is set up to benefit the grantor’s grandchildren, it can be used to avoid the Generation Skipping Tax. It can also provide protection from future creditors of the beneficiaries if it contains a “spendthrift provision,” which prohibits the trust assets from being levied on by a creditor or pledged as collateral for a loan by a beneficiary.

Because the terms of the trust have been predefined, the ILIT enables the grantor to retain more control over the ultimate disposition of the assets. Typically, a young couple with children wants assurance that their insurance proceeds ultimately benefit their surviving spouse and children. Thus, the ILIT can provide that the surviving spouse be a beneficiary (for his or her lifetime) together with the children being the beneficiary after his or her death. In the event the surviving spouse remarries, the benefits of the ILIT can be limited or eliminated altogether. This provides more certainty for the grantor than having the life insurance proceeds paid directly to the surviving spouse.

Beware: Be Aware

Although the ILIT can be a very useful tool in estate planning, it does come with some “warning labels.” First, it’s irrevocable, so once established, it generally can’t be changed. However, because it’s designed to hold a specific asset, the grantor could simply stop funding the ILIT and allow the insurance policy to lapse.

A reliable, independent trustee should be responsible for administering the ILIT during the grantor’s lifetime. This duty includes coordinating the transfer of an insurance policy or purchase of a new policy, creating a bank account, obtaining a taxpayer identification number, paying the premiums, filing a tax return, and giving certain notices to the beneficiaries after a gift is made to the ILIT. Careful considerations should be paid to selecting this individual and multiple alternatives and successors.

More Than “The Rich” Affected

An ILIT could be a viable option for a typical two-income upper- middle class family. For example, assuming the $1 million exemption applies for 2011, a family with two working parents each making $125,000 annually and funding 401k plans, has the following assets: Home $500,000 (subject to a $250,000 mortgage); stock portfolio of $500,000 (most of which came from an inheritance); and 401k accounts of $200,000 each and other assets (net of debts) of $50,000. In addition, one spouse holds an $800,000 life insurance policy provided by his or her employer and the other spouse owns a $1,000,000 life insurance policy. The couple also has three children under the age of 18.

If the husband and wife were to die in a common accident in 2011 and no change in the estate tax law occurs, and the couple had done a simple will, leaving everything to the surviving spouse and then in trust to their kids (until they reach age 30), the total taxable estate would be $2,000,000 ($3,000,000 gross estate less the $1 million exemption). The total tax on this estate would be close to $1 million.

On the other hand, if the couple had each set up an ILIT and purchased new policies through the ILIT, the taxable estate would be reduced to $200,000 with a total tax liability of less than $100,000. Some rather simple planning would save this family about $1 million in taxes even without implementing a credit shelter trust.

Many people have always viewed the estate tax as a tax on the rich (and politically speaking, perhaps that’s what it should be). However, the current law makes it applicable to many more Americans, most of whom consider themselves middle class. That’s why it’s important to monitor the estate tax bill as it goes through Congress and to be prepared to act.

Scott Glazier is partner at Glazier & Glazier, P.A. in Jacksonville. He can be reached at (904) 977-1033 or sglazier@glazierlawfirm.com.