To Our Clients and Friends:

On June 7th, President Bush signed the new tax bill into law. As you probably know, it includes big changes in the federal estate tax rules, including a promised complete repeal of the tax in 2010.

So does that mean you can forget all about the federal estate tax? Sure, if you’ve received a guarantee that you’ll live until at least 2010 and believe Congress will actually allow the scheduled complete repeal of the tax to stand. If you are less than 100% confident about either of those things, planning to minimize estate taxes should still be an important part of your overall financial plan. In fact, the changes that kick in next year demand that you take a fresh look at your plan. You’ll probably find that an update is in order.

The remainder of this letter explains the major estate tax changes and includes some tips on amending your current estate plan to ensure you’ll benefit from the new law.

Estate Tax Changes in a Nutshell

Until 2010, the federal estate tax will continue to exist. That’s the bad news. The good news is the estate tax exemption will be increased in stages between now and then, starting next year.

These increases will completely eliminate the tax in many cases and substantially reduce the bite on everyone else. In addition, the current maximum estate tax rate of 55% will gradually be reduced before being zeroed out in 2010.

The table below shows the scheduled increases in the exemption amount and the scheduled decreases in the maximum tax rate.

Year		Exemption		Maximum Rate
2001		$ 675,000		55%
2002		$1,000,000		50%
2003		$1,000,000		49%
2004		$1,500,000		48%
2005		$1,500,000		47%
2006		$2,000,000		46%
2007		$2,000,000		45%
2008		$2,000,000		45%
2009		$3,500,000		45%
2010		unlimited		Estate tax is repealed

The Most Likely Reason Your Estate Plan Needs Work

If you have an existing estate plan, it probably includes a bypass trust arrangement. This is intended to ensure both you and your spouse take full advantage of your respective estate tax exemptions. When the first spouse dies, his or her will should stipulate that assets with a certain value be used to fund the bypass trust. The ultimate beneficiaries of the trust (typically the children) are named by the decedent. This means the amount that goes into the trust gets included in the decedent’s gross estate for estate tax purposes. The decedent’s estate tax exemption then fully shelters the trust fund from any federal estate tax. The surviving spouse can dip into the trust as needed to meet reasonable expenses.

So far, so good. Here’s the problem. Most wills simply call for the bypass trust to be funded with an amount equal to the current federal estate tax exemption without naming a specific figure. Effective the first of next year, the exemption suddenly jumps from $675,000 to $1 million. So, if you pass away, the trust might end up with much more money than you intended while your spouse ends up with less.

For instance, say you have a $1.4 million estate. You probably originally intended for $700,000 to go into the bypass trust if you died next year ($700,000 was the old-law exemption for 2002). That would leave a comfortable $700,000 to go directly to your spouse. But, if your will stipulates the bypass trust is to be automatically funded with the full estate tax exemption amount, $1 million would go in the trust if you died next year. That would leave your spouse with only $400,000. While your spouse can dip into the bypass trust if necessary, he or she may be reluctant to do so, figuring the money is really meant for the kids. Here’s the solution to avoid any uncomfortable situations for your heirs. Simply revise your will to state the bypass trust will be funded with a set amount, say $700,000. That way your spouse is sure to have enough after you are gone.

You can also run into the opposite problem of too little money going into the bypass trust after the new tax law. Say your current estate plan says exactly $700,000 (the old-law exemption amount for 2002) of your $1.4 million estate would go into the bypass trust if you died next year. The bypass trust beneficiaries are your children. Your spouse would get the remaining $700,000, even though he or she already has a substantial estate and really doesn’t need or want the money. Here, your will should be amended to take full advantage of the increased exemption amount. That gets more to your kids and less to your spouse, which is consistent with your family circumstances. In addition, unless you make this change, you gain no benefit from the increased exemption amount granted by the new law.

Review Your Life Insurance Coverage

Part of your existing estate plan may be carrying life insurance solely to pay the federal estate tax bill that will come due when you pass on. Well, the amount of coverage you need will go down effective next January 1st. Why? Because your estate tax exemption rises by a hefty $325,000, as opposed to the puny $25,000 increase that was scheduled to take effect under the old law. In addition, the maximum rate drops from 55% to 50%. So, consider reducing your life insurance coverage accordingly (assuming there are no other reasons to continue carrying what now appears to be excess coverage), and live it up with the premium savings.

You May Need a New Scheme for Your Valuable Home

Here’s another common scenario where the new tax law demands a change in your existing estate plan. Say you have a valuable home worth between $700,000 and $1 million. Your current estate plan probably leaves the home to your spouse. Why? Because under old law, that was the easier way to avoid an immediate estate tax hit since the home is worth more than the old-law exemption amount. A side effect is you may be forced to leave most of your liquid assets to your children if you want to leave them anything at all. The end result: your spouse might end up with one big illiquid asset (the house), while your children receive a bunch of liquid assets (investments, retirement accounts, life insurance proceeds, etc.). Unfortunately, that may be the opposite of what you would prefer.

The new law allows you to make a change for the better. Beginning next year, you will be able to leave a home worth up to $1 million directly to your kids with no federal estate tax due. You can then generally leave an unlimited amount of other assets (including all the liquid assets) to your spouse estate-tax-free. That way, he or she will have cash for living expenses. And your spouse can always continue living in the house by renting it from the kids. Meanwhile, giving the house to your kids gets an appreciating asset out of your estate and your spouse’s estate too. Finally, the basis of the home will be "stepped up" to its date-of-death fair market value which means your children can later sell it with minimal or no capital gains taxes due. The exact same considerations apply if you own a valuable vacation home.

What About That Basis Step-Up?

Contrary to what some believe, the current-law basis step-up privilege for most inherited assets will continue unchanged until the estate tax is completely repealed in 2010. So, if you pass on before then, your heir’s basis in an inherited asset will generally equal its date-of-death fair market value instead of your probably much-lower historical cost basis. The basis step-up is taxpayer-friendly, because it means an inherited asset sold shortly after your death won’t trigger a substantial capital gains tax bill for your heir, even if your basis was tiny in comparison to current value. (Tax-deferred retirement accounts are a notable exception to the basis step-up rule.)

Once the estate tax is completely repealed in 2010, the basis step-up privilege will be partially repealed. Specifically, non-spousal heirs in total will be entitled to a basis step-up of up to $1.3 million. Spousal heirs will be entitled to a basis step-up of up to $4.3 million (assuming they are allocated the $1.3 million step-up plus an additional $3 million step-up available only to them). So, in 2010 and beyond (assuming Congress actually lets the estate tax stay repealed), there won’t be any federal estate tax and the partial basis step-up will still wipe out any federal capital gains tax in many cases. Heirs of relatively large estates (the Bill Gates of the world) might owe some capital gains taxes when they sell inherited assets, but generally at only a 20% rate (or whatever the current rate is at that time). That’s a huge improvement over the tax results under the old system.

Conclusion

We hope this letter answers all your questions about the new federal estate tax regime. If not, please give us a call for more details. As you can see, your estate plan probably needs some modifications in order to benefit fully from all the favorable changes. Of course, we are ready to assist you in tackling that task. The sooner, the better.

Best regards,

Carol Barsness, CPA

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*This artilce is presented for information and educational purposes only and is not intended to constitute legal, tax or accounting advice. The article profices only a very general summary of complex rules. For advice on how these rules may apply to your specific situation, contact a professional advisor.

All Content Copyright ©2002 - CW Barsness, CPA