From the April 2007 issue of Wealth Manager Web • Subscribe!

High Stakes

The change in control of Congress probably dooms Republican efforts to kill off the death tax. As a result, it looks like legislators will leave in place a moral hazard they created in 2001.The estate tax will disappear in 2010--but only for one year. Therefore, if a wealthy person is on life support in late 2009, how many healthcare proxies will attempt to keep the patient alive until January 2010? Worse yet, with millions of dollars at stake, how many relatives will be tempted to "pull the plug" in late 2010, before the tax kicks back in at confiscatory rates? What's an advisor to do?

Today, estates valued above the $2 million exemption amount are taxed at 45 percent. The exemption rises to $3.5 million in 2009, after which the estate tax vanishes for one year. As the law now stands, it returns in 2011--but with a paltry $1 million exemption and a punitive 55 percent maximum tax rate. Dying in 2010 won't be a totally free lunch, however. To compensate for the loss of estate tax revenue that year, Congress eliminated the step-up in basis on death for capital gains tax calculations. Still, for estates large enough to render the exempt amount irrelevant, a 15 percent capital gains tax on appreciated assets would represent huge savings from a 45 percent estate tax, even if the cost basis is minimal.

No wonder financial advisors and estate-planning lawyers are getting headaches. How can they help clients plan when the goalposts keep moving, and Congress is playing peek-a-boo with the estate tax?

Truth be told, neither financial advisors nor most clients believe Congress will permit the 2010 train wreck. "The unfairness of somebody dying five minutes before the end of 2009 versus somebody who dies 20 minutes later is just immoral, unconscionable," says Michael Barnes, vice president of Cincinnati-based Johnson Trust Company. "It's going to lead to really disgusting actions. That is not what the tax code should encourage." Johnson Trust and its parent, Johnson Investment Counsel, have about $3.5 billion under management and provide investment consulting services to another $9 billion.

In retrospect, Congress never intended this 2010 nightmare to happen when it passed the 2001 tax cuts. At the time, Republicans and Democrats alike winked at a ruse that allowed Republicans to trumpet estate tax repeal while adhering to Senate budget rules in force at the time. Attempts to fix the estate tax since then have foundered. The most recent effort, a bill proposed last summer that would have raised the individual exemption to $5 million, then taxed estates of from $5 million to $25 million at 15 percent, and anything above $25 million at 30 percent, died over Democrats' objections that the cost--an estimated 80 percent of total repeal--was too high.

The bizarre existing law has forced Barnes to make actuarial assessments about whether his clients are likely to die before 2010. He assumes those well into their 80s will face the tax and recommends irrevocable estate planning based on either a $2 million or $3.5 million exemption. He finds younger clients--those likely to survive to 2011 or beyond--often resist irrevocable solutions, particularly if their estate is less than $10 million, because a false move could impact their lifestyle if they live beyond planned expectations. For these clients, Barnes favors a qualified personal residence trust which allows clients to give away their home. "We can structure it so that they can still use the house after the trust term ends. It's always going to transfer the house at a lower taxable value than if they held on to it to the end of their lives."

In the traditional estate plan for a married couple, the exemption amount on the first death is transferred to a credit shelter trust outside of the survivor's estate, from which he or she draws income for life. Additional assets either pass directly to the surviving spouse under the marital exemption or to a second trust over which the survivor has a general power of appointment. In either case, the additional assets accrue to the survivor's estate, and any excess over the estate tax exemption will be taxed on the second death. By taking advantage of the exemptions applicable at each death, this plan allows the combined exempted amounts in the trust to pass on to designated beneficiaries free of estate tax.

The escalating exemption can trip up couples who have estates in the $5 million range, according to Barnes. If the first spouse dies in 2009, with the exemption at $3.5 million, the survivor may not be comfortable having a family member or corporate entity exercise control over a trust that holds most of their assets. Some clients have chosen to cap the amount that passes to the credit shelter trust and forgo part of the first decedent's exemption. Barnes keeps a close watch on the cap because the family may give up significant tax savings if the estate value or the exemption amount increases.

Other clients don't limit funding of the credit shelter trust, but incorporate greater flexibility into the trust documents--including the ability to withdraw capital. Provided the right to withdraw does not cross the line to become a general power of appointment, the trust will remain outside the survivor's estate. "Attorneys are giving the surviving spouse power over the trust right up to that line and then specifically making it clear that he or she doesn't have power of appointment," Barnes says.

Ran Holladay, managing partner of Holladay, Lia and Mukamal LLC, an estate planning firm based in New York, recommends a third option that relies on a legatee's right to disclaim an inheritance. The credit shelter trust no longer stands first in line; instead, the assets all pass to the surviving spouse except for whatever he or she renounces, typically up to the exemption amount. Although the strategy is more flexible than a funding cap and does not require trust documents, it might not withstand IRS scrutiny. In fact, Holladay still harbors doubts that it would.

A disclaimer requires paperwork that must be completed within nine months of the first death. "So many spouses are in shock after the death that nine months go by very quickly. Advisors don't always get it done in time," Holladay says, "Even more often, beneficiaries take the use of the money and thereby don't allow themselves the possibility of renouncing." For example, if a couple has a joint account, the survivor can renounce half the assets--but only if he or she makes no withdrawals between the date of death and the date the disclaimer becomes effective.

Holladay advises clients to keep sufficient assets--up to the exemption amount--in their own name to ensure they can meet their financial obligations without touching assets they may wish to disclaim. For clients who prefer to hold everything in joint names, he tries to help the survivor choose one account to use right after the first death. "You have to have a strong relationship so the client calls you the day of death or the next day," he says. "You may have said something in planning meetings a couple of years ago, but that's not what they are thinking about at the time of death."

In many ways advisors face the biggest planning challenge with estates under $10 million, where the exemption amount has a dramatic impact on the effective tax rate. For the largest estates--$50 million and up--whether the exemption is $1 million or $5 million--is usually not an issue. Advisors who focus on the super wealthy, like Mitchell Eichen, CEO and chief wealth strategist of The MDE Group, Inc., a $1.5 billion wealth manager in Parsippany, N.J., spend more time planning transfers of assets during clients' lives using freeze and discount techniques.

Because the IRS has not blessed the more aggressive strategies Eichen uses, his clients have to decide whether they are willing to risk a challenge. Eichen particularly likes the "flip into GRAT routine" in which assets are first placed in a family limited partnership (FLP) and then gifted to a grantor retained annuity trust (GRAT) in exchange for a stream of income paid over two or three years. The FLP structure justifies a discount to the market value of its assets (30 percent to 50 percent, depending on their nature, e.g. liquid stocks and bonds vs. real estate) when passed to the GRAT. A $10 million FLP might constitute a $6 million gift, for example. That $6 million is paid back with interest over two or three years, which reduces the gift value to zero but leaves $4 million trapped in the GRAT. Once the statute of limitations expires, three years after the GRAT files a gift tax return, the $4 million escapes the client's estate tax-free.

Eichen admits the IRS may well succeed if it challenges the arrangement, but he argues that the audit probability is low. He says gift tax returns were rarely audited even before the latest budget forced the IRS to cut its legal staff almost in half. In addition, IRS agents prefer to go after techniques that will yield immediate tax revenue if struck down; the IRS stands to gain no current revenue from a successful challenge to a GRAT. "They'd say you made a $10 million gift and you have to take $10 million in GRAT payments back. Your gift is still zero going in," Eichen explains. "The estate planning technique has failed, but the only benefit to the IRS is that down the road, and it may be many years, the taxpayer's estate has been enhanced by $4 million." A successful transaction requires at least four years to implement, and if the donor dies in the interim, the IRS is almost certain to challenge the transaction because it will get an immediate estate tax payoff.

Like Johnson Trust's Barnes, Eichen also favors qualified personal residence trusts, which he considers "the great no-brainer estate planning technique of all time." (See Oct. 2006, page 24.)It involves both a freeze--on the value of the house at the time of gifting--and a discount arrived at by an actuarial calculation dependent on the length of time the donor retains the right to live in the house. Moreover, if the house is placed in a trust or owned as tenants in common, a further discount will apply. "A 65-year-old couple who retain the right to live in a house for 10 years might get rid of it for 35 percent of fair market value," Eichen says. In many cases, the discount will reduce the value below the $1 million lifetime gift threshold so donors incur no out-of-pocket tax cost.

The qualified personal residence trust takes time to work, as do most inter vivos transfer techniques. Should the donor die before the term of the trust expires, the house returns to the estate as if nothing had happened. Eichen suggests that couples own their house as tenants in common--rather than joint tenants with right of survivorship--so that each spouse retains a 50 percent interest in the house. That way, they still get half the estate tax benefit if one dies before the trust expires as long as the other survives for the full term. After the trust expires, the house can pass into a continuing trust with their children--or other designated legatees--as beneficiaries. The couple can live in the house for the rest of their lives at market rent, out of which the trust pays property taxes and upkeep. Upon the second death, Eichen says the house typically is sold and the proceeds, net of capital gains tax, distributed to the beneficiaries. "You don't get step-up in basis," he says, "but I'd rather pay 15 percent long-term capital gains tax than 45 percent estate tax. It's still a good deal."

Many lifetime gifting mechanisms become less attractive as clients age, according to attorney Shari Levitan, a partner in the Boston office of Holland & Knight. For example, a private annuity, which involves the sale of an asset in exchange for a stream of income payable for either a fixed term or for life, doesn't work as well when life expectancy is short. Older clients typically want the income for life, Levitan explains, and if they die earlier than expected the buyer acquires the asset cheaply--for the annuity payments made up to the date of death. Of course, if the seller survives beyond normal life expectancy, the buyer may pay more than the asset is worth. The seller must be in reasonable health; someone determined to be terminally ill cannot use IRS mortality tables to calculate annuity payments. "It's not appropriate for most clients," Levitan says, "but it allows someone to surrender an asset if they need cash flow or don't have enough unified credit left to give it away."

Lifetime gifting is not just a question of how best to do it, but also whether and when. Michael Walther, a managing director at Chicago-based Altair Advisers has some clients in their 30s and 40s whom he feels may be giving away too much too soon to be able to sustain their accustomed lifestyle into old age. He is trying to help them understand what their cash flow needs will be, taking into account inflation and medical advances that could enable them to live to be 100.

Walther is currently advising another couple in their 70s who face a moral dilemma over gifts. They have two sons in their early- to mid-40s, each of whom has four or five children all planning to go to college. The expense of raising large families has left their sons with relatively little savings. The parents can well afford to pay for their grandchildren's education, but they are wrestling over whether they should. Walther asked them which is more important: To know that their grandchildren can attend whatever school they want, regardless of cost, or to establish the principle that if they want something, they have to save for it.

Walther has encountered similar circumstances before and expects to see more in the future. He points out that paying for college is an efficient wealth-transfer vehicle because direct payments of educational and medical expenses do not count toward the $1 million lifetime gift tax exemption. That doesn't resolve the dilemma, however. "We as advisors can only present the question," Walther says. "It's not our decision to make."

Of course, the decision to fix the estate tax rests squarely on Congress, although Jeffrey Manley, a partner in the Phoenix office of law firm Greenberg Traurig, believes legislators have little incentive to act before 2009. Life insurance companies and charities are lobbying hard to retain some form of estate tax, while a group of 20 to30 wealthy families is bankrolling the campaign for repeal. "If legislators can get money from both sides and just grandstand, I think they will do it," Manley says.

He suggests healthy clients with $2 million to $3.5 million estates can afford to sit tight for now, although he does recommend planning for larger estates. Manley applies a "DC-10 test:" If clients die in a plane crash, what happens to their estate, what taxes will they have to pay, and who will manage their affairs? He believes advisors should plan based on today's exemption rather than speculate on what it may be in two or three years' time. If they guess wrong, and the estate faces a higher than expected tax bill, they risk lawsuits from aggrieved heirs. "You can plan based on today's numbers and see where things go," Manley says, "or you can call Dr. Kevorkian and schedule an appointment in 2010 to make sure there is nothing subject to tax."

Legislative Gridlock

Hurricane Katrina may have blown away the best opportunity Congress had to repeal the estate tax, according to Sam Batkins, deputy press secretary of the National Taxpayers Union. "Republicans were quite confident they had the votes of Senators Mary Landrieu (D-La.), Mark Pryor (D-Ark.) and Blanche Lincoln (D-Ark.)," he says. "After Katrina, they lost some support." Democrats had to face not only the wrath of party leaders but also primary election opponents who could accuse them of giving tax relief to millionaires while their devastated constituents were up on rooftops trying to stay alive.

Batkins doesn't expect any progress in the 110th Congress. The estate tax isn't part of House Speaker Nancy Pelosi's (D-Calif.) 100 hours agenda, and although Batkins says the new chairman of the Senate Finance Committee, Max Baucus (D-Mont.), wants to work on the estate tax, he may not be willing to act without support from the leadership. And Rep. Charles Rangel (D-N.Y.) has made it clear he wants to fix the alternative minimum tax (AMT), a Democratic priority because the burden falls disproportionately on core supporters in the northeast and on the west coast.

Joan Claybrook, president of Public Citizen, an organization that favors an estate tax, agrees it is not a priority for the new Congress. However, she does expect legislators to reform the tax before 2010, but not repeal it.

In a 2005 survey, the Financial Planning Association found that 58 percent of its financial advisor members oppose permanent repeal of the estate tax. Of the 28 percent who favored repeal in principle, 60 percent opposed repeal if it eliminates the step-up in basis. As a result, the FPA formally supports increasing the exemption amount, indexing it to inflation and retaining the step-up in basis upon death. Stephen Johnson, president of Johnson Marotta, a $150 million wealth management firm based in Palo Alto, Calif. and 2006 chairman of the FPA's national Tax Subcommittee, emphasizes that both political parties understood from the outset that eliminating the estate tax and basis step-up in 2010 and reviving them in 2011 was merely a technique to satisfy Senate budget rules. "I don't believe 2010 will happen as written," he says.

Most people expect Congress to act in time--but not everyone. Grover Norquist, president of Americans for Tax Reform and a strident advocate for estate tax repeal, does not anticipate any substantial tax legislation from the current Congress. Under pay-as-you-go rules Democrats adopted for the new session, any revenue loss from reforming the AMT must be offset with increased revenues elsewhere in the budget. "Why would the Republicans agree to a tax cut for the blue states in order to screw the red states?" Norquist asks. Meanwhile, he believes the Republicans will not let the Democrats fix 2010 without significant reform to the estate tax. It's a stalemate Norquist believes may be so entrenched, that legislators won't compromise before 2010. "Don't count on Congress to act because there is a moral hazard," he says, "I think the Democrats' commitment to the politics of envy is so complete that they just won't feel they have to do something on the death tax." --NO

Neil A. O'Hara is a financial writer familiar with domestic and international markets from an earlier career in money management. A native of England, he resides with his wife in Lincoln, Mass.

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