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Acting in the Face of Uncertainty

What should you do about your estate plan in light of estate tax repeal, the sunset of that repeal and the uncertainties created by the related law changes?

Unfortunately, no single answer applies to everyone. Sweeping generalizations are dangerous. Among other things, your decisions should consider:

  • Your expectations as to Congress’ future actions – Will repeal become permanent? If not, how will it mutate over time?
  • The size of your estate now and in the future – Will your estate be below the expected higher exemption or will rapid appreciation exacerbate your ultimate tax burden?
  • Personal objectives – Does the new law surreptitiously alter your heirs’ sharing of your estate? 
  • Your and your spouse’s ages and current and future health status - Will you live to see repeal if it happens? Will you be competent to change your will when Congress re-addresses the sunset provision?
  • Willingness to accept tax and financial risk – Can you accept gift tax risk to continue lifetime planning? Can your business afford the estate tax if repeal does not happen and you fail to address the problem in the interim?

These mind boggling uncertainties may push you to inaction. However, inaction might be the worst action for you. Perhaps the best way to resolve this thorny problem is to attack it piecemeal. Start with the basics and, depending upon the size of your estate and your personal situation, progress to the more complex planning strategies.

Testamentary Documents

Congress may have stealthily changed your family members’ economic sharing of your estate, especially if you are married. The only way to make sure that you like the change is to review your will (and revocable trust if you have one).

The increasing estate tax exemption (beginning next year) affects wills that divide the estate between the surviving spouse and other family members (typically via a trust for the children). Many married couples’ wills use a “formula clause” geared to the amount of the estate tax exemption. The exemption amount, which can pass tax-free, goes to a family trust. The remainder is left to the surviving spouse, thereby using the marital deduction to defer estate tax until the survivor’s death.

As the exemption phases up, the family trust’s share of the total estate increases. For example, assume that your estate is worth $3 million. The chart shows the potentially dramatic shift from your spouse to the family trust, depending solely on the year of your death. The amounts in parentheses apply if your estate is larger than $3 million. If your estate is less than $3 million, the marital share is wiped out sooner. For example, if your estate is worth $1.4 million, your spouse gets nothing if you die in 2004.

[Table omitted]

Taking advantage of the increasing exemption makes sense from an estate tax standpoint, but your spouse may not appreciate it! At a minimum, you should determine whether the terms of the family trust permit adequate distributions to your spouse given the decreasing size of the marital share. You simply need to have your will checked to see whether and how the increasing exemption affects your testamentary intent.

Attorneys continue to grapple with drafting wills that deal with the vagaries of increasing exemptions, changing asset values, and estate tax repeal and its sunset. The state death tax credit phase-down and conversion to a deduction, along with guesswork as to the states’ future legislative reactions, also are giving attorneys fits. Many have thrown up their hands with trying to minimize carryover basis issues, or at least have decided to finesse them until someone figures out how to handle the problem.

Many attorneys have started drafting wills with one dispositive plan if there is an estate tax and another if there is no estate tax. I expect that these early “models” will become outdated as the profession comes up with better mousetraps.

Huddle with estate planning and legal counsel and decide how best to proceed. Expect to have to readdress your testamentary documents periodically as the legislative scene changes.

Life Insurance

It probably is unwise to cancel life insurance policies betting on estate tax repeal. Insurance also may continue to be required to fund buy/sell agreements or to pay capital gains taxes due to asset sales under the carryover basis regime.

For new policies, consider term insurance rather than some form of more expensive whole life insurance. However, be sure that the term policy can be converted, without a medical exam, to a more permanent policy if the estate tax does not go away. Have your agent run projections of future years’ premiums assuming conversion at various later dates. That will help you determine whether you can afford the increased premiums should you decide to convert the policy.

Life insurance trusts continue to make sense to protect the proceeds from estate tax. If you use term insurance, consider the gift and generation skipping consequences of future premium increases, whether caused by a future conversion to a permanent policy or simply by keeping the policy in force as you age.

Annual Gift Program

Don’t forget the basic blocking and tackling of using your $10,000 annual gift exclusions, along with the payment of descendents’ qualified medical and educational costs. Failure to do so results in annual lost opportunities to reduce your estate, which will be important unless estate tax repeal becomes reality. There is little downside risk.

Most advisors continue to recommend using the lifetime gift exemption, which increases to $1 million in 2002. In fact, next year’s big exemption increase offers a significant opportunity to use more sophisticated techniques to leverage additional wealth to younger generations. If your estate exceeds (or you expect it to grow to exceed) the estate tax exemption, stay tuned next month for suggestions and additional thoughts.

 

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