Spring 2003: DB&M Reports to Clients

Estate and Tax Planning March 2003

In This Issue:
- Five Easy Pieces in Uneasy Times

Five Easy Pieces
In Uneasy Times

As geopolitical threats and corporate excesses have scourged the economy, the practice of estate planning has undergone its own upheaval. New leg-islation on both the state and Federal levels, enacted as the nation's economic strains began to affect equities and fixed-income investments, has established a new environment for the taxation of estates and the administration of trusts. For example, the rates, credits and exemptions under our Federal estate, gift and generation-skipping transfer tax rules have been revised drastically, creating complexities not only in the way the Federal tax is computed but also in the way states impose their local transfer taxes. In addition, some states, such as New York, have enacted legislation requiring Trustees to administer traditional trusts in a fashion that accommodates modern portfolio theory.

Coordinating the components of a sound estate plan is like assembling the pieces of a jigsaw puzzle. As a result of the recent changes in the tax law and the marketplace, arranging those pieces in a way that produces a tax-effective yet emotionally satisfying result is more of a challenge than ever.

In spite of the uncertainty in the present economic climate and the vagaries of the tax laws, certain estate planning basics can help an estate owner put his or her personal jigsaw puzzle together in a meaningful, enduring way. In this Report, which is addressed to conscientious estate owners who wish to do their very best in planning for the disposition of their assets, we refer to those basics as the "five easy pieces" of a sound contemporary estate plan:

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1. Updating the estate plan should be about making it flexible.

Over the next seven years, the Federal estate tax system will be riddled with a series of phased-in changes in the amounts of available exemptions, credits and rates as set forth in the 2001 Tax Act. These changes are generally favorable for taxpayers, since exemptions will increase in stages until the Federal estate tax is repealed (at least temporarily) and replaced with a carryover-basis income tax regime in 2010. Unfortunately, however, absent further legislation, the Tax Act restores the transfer tax system in 2011 (after its brief repeal in 2010) at the higher rates that were in effect prior to 2001. The Tax Act also gradually decreases the credit for state death taxes which, due to local budget deficits, has already produced a variety of different reactions (or non-actions) at the state level that can actually increase the death taxes payable to some states. Because many existing estate plans were formulated on the basis of the pre-2001 Tax Act exemptions and credits, the failure to review and modify those plans may produce unintended results as estate and generation-skipping exemptions are automatically adjusted upward while assets values continue to be subject to volatility.

The advisable course of action in this climate is to opt for the kind of estate plan that incorporates a measure of flexibility. One example of flexibility is incorporating specific language in a Will to allow beneficiaries to disclaim (or forfeit) the receipt of assets so that they will pass in an alternative fashion to take advantage of future changes in the tax laws. Another is providing language in trust documents to allow Trustees greater discretion in making elections and distributions in light of the status of the trust, the circumstances of the beneficiaries or the nature or value of assets. A third is authorizing an Independent Trustee to amend an inter vivos trust instrument in appropriate circumstances. These and similar options may give those individuals charged with the ultimate responsibility for executing a contemporary estate plan the freedom to take actions that will avoid unintended consequences and/or maximize the benefits available under future tax laws.

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2. Take advantage of conditions in the current marketplace.

With interest rates at a record low and equity holdings generally depressed, estate owners wishing to benefit junior family members may now be able to implement certain estate strategies that thrive in the present climate. One such strategy is the Grantor Retained Annuity Trust ("GRAT"). In a GRAT, an estate owner transfers assets to a trust created during lifetime, retaining the right to receive an income stream or annuity from the transferred property. This technique is provided for by statute, and there is now judicial support for utilizing this strategy to virtually zero-out the grantor's gift tax consequences. The cur-rent low interest rate prescribed by the IRS to value transfers to GRATs (3.8% for March, 2003) makes this an especially useful technique for an estate owner who holds financial assets likely to appreciate in the next few years and who desires to benefit junior family members sooner rather than later.

Another strategy favored in this climate is the Charitable Lead Trust, where an income flow can be provided for a favored charity for a term of years, after which the trust ends and the remaining assets are distributed to the grantor's heirs. When the IRS interest rate is low, the actuarial value of the charity's term interest is enhanced, so the remainder interest that will ultimately pass to the heirs is assigned a lesser value, thereby reducing the grantor's up-front gift tax cost.

And for anyone who intends to use his or her Federal gift tax exemption (worth $1 Million less any portion previously used) to make an outright gift of an asset that is likely to appreciate, there is little downside risk right now.

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3. Consider new options for administering old trusts.

Many existing trusts were created as traditional "income-only" trusts and granted little or no discretion to Trustees with respect to distributions to the current beneficiary. To maintain a consistent cash flow for the beneficiary, Trustees traditionally invested a portion of the portfolio in bonds, often forgoing the handsome appreciation historically available in equities. Due to falling interest rates over the last few years, investing in bonds has become a far less attractive means of providing a consistent cash flow for the current income beneficiary. Now, at least 30 states have enacted legislation to enable Trustees to either convert a traditional income-only trust to a "Unitrust" (where a fixed percentage of the value of the trust assets is paid out annually to the current beneficiary) or to exercise a "power-to-adjust" (where the Trustee adjusts the income and principal balances in a manner that is fair to all beneficiaries.) A few states, like New York, have authorized both options. Converting to a statutory Unitrust, or using the power-to-adjust to administer a trust as if it were a Unitrust, aligns the interests of the current and future beneficiaries because they will both benefit from "total return" investing that grows the trust fund.

In deciding whether to utilize the new Unitrust or power-to-adjust options, Trustees must consider many factors, since these options are not advisable in all situations. Nevertheless, Trustees ought to at least review every eligible trust with a view to taking advantage of the new options when appropriate. In fact, some state laws make it incumbent upon them to do so. Professional trustees in New York have been engaged in this process since early 2002 when the new law became effective. The easy decision is to review all existing trusts that affect an estate plan and seize fresh opportunities in appropriate circumstances.

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4. Focus on the personal, non-tax planning objectives.

The goal of minimizing estate taxes when passing assets to future generations has been the primary driving force underlying many planning decisions. With the present tax landscape in its uncertain state, the human aspects of estate planning remain of great importance. Conscientious estate planners should not lose sight of the emotional goals that are presented in the estate planning process.

Consideration may be given to trust structures designed to educate junior family members and other beneficiaries, to help them develop in ways that are appropriate for them, or to avoid needless disputes. A growing interest in the "incentive trust" is not driven by complex tax-sensitive issues but instead by a desire to foster personal growth and development. Special trust provisions that recognize a beneficiary's health, educational or other needs can reflect the creator's truly personal concerns.

Private Family Foundations, while they have a current tax benefit for the creator, are generally created more for educational or purely charitable reasons. Likewise, attention to proper succession planning for a family business, or for the management of family trusts, will often be more important than the prevailing tax considerations.

A Personal Residence Trust is a type of statutory trust in which the grantor transfers residential property in trust, retaining the right to use and occupy the property for a period of years, after which it will pass to or in further trust for junior family members. As in the case of the GRAT, the grantor's retained interest reduces the up-front gift tax cost. When the subject of a Personal Residence Trust transfer is a family homestead or vacation home the heirs will likely retain, both tax and emotional objectives may be satisfied.

Junior family members often have intense feelings about certain items of tangible personal property such as jewelry, artwork and collections. Careful attention to the ways in which such property is to be distributed under a Will can avoid hard feelings among family members after death.

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5. Update estate planning documents that address immediate or emergency needs.

Much of contemporary estate planning revolves around elaborate instruments like Wills and Trust Agreements where certain provisions -- sometimes precise words and whole paragraphs -- must be incorporated to achieve vital tax goals. Another body of important planning documents, which deserves attention and ought not be affected by pending changes in the tax law or the volatility of asset values, addresses the estate owner's immediate needs and emergencies.

In a Health Care Proxy, an individual can specify the person or persons authorized to communicate health care decisions for her or him in the event of an emergency or a disability. It should be reviewed periodically. A Living Will expresses an individual's wishes with respect to medical treatment in different conditions, including a terminal illness In some states, the Health Care Proxy and Living Will declarations are two different documents, and in others they are combined in one.

A Power-of-Attorney is a separate document in which the "principal" authorizes another person or persons to act as her or his "agent" on financial matters. This authority is generally reserved for a situation in which the principal is incapacitated, but can be effective in other circumstances such as when the principal is abroad or otherwise unavailable.

A Testator's wishes can be communicated to Executors, Trustees or family members in a document referred to as a "Letter of Intentions." So, while the contemporary Will may create a flexible plan for the administration of assets, the Letter of Intentions (which is usually held in safekeeping with the Will) stands to provide important guidance in how this should be done and what factors the Testator considers most important, from general feelings to the minute details.

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These "five easy pieces" are aspects of an estate plan not generally affected by future changes in the value or nature of assets and need not await certainty -- if there is such a thing -- in our applicable transfer tax rules. They can be used to build a foundation that will withstand a variety of unanticipated circumstances.

This report is distributed as general information only. No action should be taken solely on the basis of its contents. We welcome requests for more detailed information on any topic discussed in this report.

©2003 Dunnington, Bartholow & Miller LLP. All Rights Reserved.