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Estate
and Tax Planning
Pending tax law changes will significantly affect how much of a couple's assets will be left for the survivor and for distribution after the survivor's deaths. The computations that follow project the effect of these changes in three scenarios, in order to illustrate the basic decisions the couple must make. Each scenario assumes that the client will die before his wife, that he will die during the period from 2006 through 2008 and that he will leave all of his assets to his wife, either outright or in trust for her benefit. The projections
demonstrate mathematically the effect of the increase in the exemption
from Federal estate tax that was enacted in 2001 and is scheduled
to become affective in 2006 and the possibility that, under the same
legislation, the tax would be repealed in 2010. A few comments about
each scenario are in order to identify the decisions that must be
addressed. In fair paraphrase,
the computations show there would be more property for distribution
at the death of the survivor if less property is given outright to
the surviving spouse. If a trust is created for that spouse, then
the more property that is placed in the trust the greater will be
the amount for ultimate distribution. However, this result requires
an advance payment of New York tax. The Federal (and
possibly New York) rules are in flux. It may not be advantageous to
pay any NY tax in advance. It might be better to compensate for uncertainty
in the law and in the needs of the surviving spouse by building in
flexibility. We would like
each client to consider these points and give us instructions on what
is to be achieved. In that way we can advise whether a new Will is
required. Scenario #1:
All of the client's assets would pass to his wife outright, either
under the terms of his will (as to non-retirement assets in his own
name), under beneficiary designations (as to retirement accounts or
life insurance proceeds) or by virtue of the property being held in
their joint names. Under this scenario no Federal or New York estate
tax would be payable upon the client's death because all of the assets
that passed from him to his wife would qualify for the estate tax
marital deduction. However, the estate tax liability upon his wife's
subsequent death (assuming she died before 2009) would be substantial.
The estate tax
liability upon the wife's subsequent death could be reduced if our
client were to provide for the creation of a "by-pass trust"
for her benefit under the terms of his will. A by-pass trust is a
trust that is funded with the maximum amount that can pass free of
Federal estate tax in the estate of the first spouse to die. Currently
that amount is $1,500,000. Starting in 2006 it will increase to $2,000,000
and will continue at that amount until 2009, when it is scheduled
to increase to $3,500,000. What makes a by-pass
trust attractive from an estate planning perspective is that the assets
used to fund such a trust are not subject to Federal estate tax in
either spouse's estate. They are not taxed in the estate of the first
spouse to die, because they are protected by that spouse's Federal
estate tax exemption. They are not taxed in the surviving spouse's
estate because they are held in a trust that is not includible in
her gross estate for Federal estate tax purposes. This is true even
if the value of a by-pass trust should increase substantially over
the life of the surviving spouse. Scenario #2:
The client's Will provides for the creation of a by-pass trust for
his wife's benefit in the amount of $2,000,000 (the Federal estate
tax exemption) and the combined Federal and New York estate taxes
on the death of the client's wife is shown. This illustration shows
that New York estate tax in the amount of $99,600 would be payable
upon the client's death. The reason for this is due to the fact that
while the Federal estate tax exemption is $2,000,000, the New York
estate tax exemption is only $1,000,000. Thus, if the client were
to create a by-pass trust in the amount of $2,000,000, $1,000,000
of that amount would be subject to New York estate tax (assuming that
the rest of his estate passed to his wife and qualified for the estate
tax marital deduction). At current rates, the New York estate tax
on a taxable estate of $1,000,000 is $99,600. If the Federal
estate tax is not permanently repealed, the payment of NY tax will
be advantageous. It will protect $2,000,000 from both Federal and
New York estate tax at the survivor's death. However, if the 2001
Act does repeal the Federal tax for years after 2009, the payment
of NY tax will be disadvantageous. It will act as an advance payment
of New York tax. The amount of the payment might be better spent by
the surviving spouse. Anticipating repeal, the client would not want
a by-pass trust in the amount of the Federal exemption, but rather
a by-pass trust in the amount of the more modest New York exemption. Scenario #3:
The client has decided that he prefers to maximize the assets passing
to his wife upon his death; even at the expense of minimizing the
combined estate taxes that would be payable upon her subsequent death
should the Federal repeal not become permanent. If this is the case,
the client could maximize the assets passing to or for the benefit
of his wife upon his death and still reduce to some extent the estate
taxes that would be payable upon her subsequent death. He would provide
for the creation of a by-pass trust for her benefit in an amount equal
to the New York estate tax exemption, namely $1,000,000. The creation
of such a trust would not be subject to New York estate tax upon the
client's death but would still reduce the combined estate taxes payable
upon his wife's subsequent death to less than would be the case in
Scenario #1. Flexibility:
It has always been very difficult to decide between these scenarios
when the identity of the survivor (and with it the future financial
resources and the health needs of the survivor) is unknown. It may
seem impossible to decide between these scenarios because the incomplete
and unstable tax regime adopted in 2001 must be taken into account.
Facing such difficulty,
the client should know that he could postpone and shift the decisions
on the existence and size of the by-pass trust. There are at least
two ways to postpone a decision; that is, to be flexible. First, the tax
law allows the size of the by-pass trust to be decided after death
if a marital deduction trust is used. A bequest of the client's residuary
estate to a trust for his wife's benefit would qualify for the estate
tax marital deduction at the election of the executor, provided all
the net income of the trust would be payable to the client's wife
at least quarter-annually for her life, and any power to pay principal
could be exercised only for her benefit during her life. (The power
to distribute principal could be exercised, of course, to terminate
the trust.) The disposition of such a trust upon her death could be
governed by the terms of the client's Will, or his wife could be given
a limited power to appoint the principal of the trust upon her death
by the terms of her Will. More importantly, the executor may elect
to qualify all or any portion of the trust for the marital deduction.
Any portion that is not so qualified for the marital would constitute
the by-pass trust in Scenarios #2 and #3. Second, the decision
on the size of the by-pass trust could be deferred by giving the surviving
spouse the entire estate and stating in the Will that, if a renunciation
is made, the renounced property would go into a by-pass trust. The
principal drawback to a renunciation trust of this sort becoming the
by-pass trust is that the renunciation will not be effective for tax
purposes if the surviving spouse can control the disposition of the
remainder of the trust at her death. Each of the latter options should be discussed with the draftsman if the client seeks flexibility. We would be pleased to speak with you about how you might prepare for the tax law changes that will occur after the first of the year. ***** This report is distributed as general information only. No action should be taken solely on the basis of its contents. To ensure our compliance with requirements imposed by the IRS, we inform you that any U.S. tax advice contained in this document cannot be used for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter that is contained in this document. We welcome requests for more detailed information on any topic discussed in this report. © Dunnington, Bartholow & Miller LLP 477 Madison Avenue
©2006 Dunnington, Bartholow & Miller LLP. All Rights Reserved. |