If you have a client who's dragging his feet on estate planning, the good news is that he may have more time than you think. Given the right circumstances, his executor or personal representative can continue to fine-tune an estate plan for up to nine months after the client's death. A ghoulish thought, perhaps, but an important point because deathbed and postmortem estate planning can result in significant tax savings.
"I would say that around 15 to 20 percent of our clients do some sort of postmortem planning," says Nichole Fitzgerald, an attorney in the Miami office of Holland & Knight. "Of course, you cannot solve every problem by postmortem planning, but it's definitely worthwhile to talk to your attorney and consider your options."
As with a deathbed confession, deathbed estate planning is cutting things close. Still, it's worth a shot, particularly if your client is about to die in a state that has decoupled its estate or death tax system from the federal estate tax system (see SIDEBAR). In fact, according to Susan Abbot, an attorney with the Boston law firm Goodwin Procter, "You can save up to $88,000 in state estate taxes, depending on the size of your estate, by making a $1 million dollar deathbed gift."
Such savings are possible in so-called decoupled states because estate taxes in those states are based on the old federal state death tax credit that phased out over a three-year period after President Bush signed the Economic Growth and Tax Relief Reconciliation Act of 2001. Prior to EGTRRA--winner of the most unpronounceable acronym award--many states limited their estate tax to the amount of that credit, in effect taking their slice of the estate tax action from the federal pie..."At no cost to the deceased," Abbot explains.
The problem was, by coupling their estate tax regime to the federal system, those states ran the risk of losing that revenue if Congress eliminated the credit. Since EGTRRA did just that, states either decoupled or lost out. According to Abbot, 14 states chose to decouple, including her home state of Massachusetts. "In those states that have decoupled, the state estate tax is usually based on the amount of the old federal estate tax credit," Abbot continues. "Depending on the size of the estate, that credit could be as high as 16 percent of the taxable estate."
Decoupling works to the benefit of the decedent because unlike the federal government, state departments of revenue typically don't pull pre-death gifts back into the estate for purposes of calculating the state estate tax. "And because they calculate the tax without regard to the amount of gifts that a decedent had made during his or her lifetime, it is possible to remove assets from the estate and thus lower the state estate tax bill, by making pre-death gifts," Abbot says. "However, you're not likely to get any significant federal estate tax savings," she points out.
Deathbed gifts can also reduce the state estate tax cost of funding your client's credit shelter trust post death by as much as $72,222 in 2008 and $103,595 in 2009. To do this, your client should set up and fund a separate, lifetime credit shelter trust with his state exemption amount ($1 million in Massachusetts, for example) before he dies--one with terms similar to the credit shelter trust that is already part of his estate plan. Upon his death, his executor will then fund the original credit shelter trust with his remaining federal exemption amount. The net result is the same: The decedent's $2 million lifetime exemption is sitting in credit shelter trusts, safe from estate taxes upon the death of the second spouse. "Plus you've reaped significant tax savings because of the gift," Abbott says.
It is also important to fund the lifetime credit shelter trust with cash or high-basis assets because the assets in that trust will not receive a step-up in basis at death. "Or the client could borrow to fund the trust, using low-basis assets as collateral; then his estate could pay back the loan once the pledged assets have received the step-up," Abbot says. This is a good example of the type of house cleaning and fine-tuning a personal representative can accomplish even after the client passes away.
With persistence and luck, your client will have done ongoing and substantial estate planning throughout his or her life. The necessary documents will be in place, and the assets titled properly when the lights go out. However, because one or both of those elements is often unfinished, postmortem planning comes in handy. "What we try to do is look at the overall picture," Fitzgerald says. "Here are the assets, here is where the assets are passing, and then we get the beneficiaries or the personal representative and make sure that everyone is on the same page. If they're not, then we try to rearrange the interests."
If it turns out that assets are not in the right place--by accident or on purpose--disclaimers are often the first tool attorneys reach for. One family that came to Fitzgerald explained that the decedent wife had left no will; consequently, under Florida law, the first $60,000 plus half of the estate was going to her husband and the remainder to the children. Without postmortem planning, the estate could not take advantage of the wife's $2 million exemption equivalent. To remedy that, Fitzgerald had the children disclaim their interest in the estate. She then put those assets into a limited partnership, with the father acting as general partner. "So the father had control, but the children still had the economic interest," Fitzgerald says. "And the disclaimers allowed us to take full advantage of the exemption in the wife's estate."
The tax savings resulting from a simple disclaimer can be huge, says Louis Pierro of Albany-based Pierro Law Group. Assume, for instance, that the Florida couple's estate was valued at $10 million when the wife died. As a consequence of not using disclaimers, the nearly $5 million passing to the children would have generated immediate estate taxes of approximately $1.5 million. Instead, by disclaiming $3 million, the children end up with $2 million, the surviving spouse gets $8 million, "and there is zero estate tax because they could use up the late wife's $2 million exemption," Pierro says.
Disclaimers also work well when, for example, a surgeon titles his home as tenancy by the entireties and maintains his bank and brokerage accounts in joint tenancy with his wife for asset protection purposes. Unfortunately, such an arrangement is not very good for estate tax purposes--especially if the surgeon predeceases his spouse. In that case, at his death, everything would pass to the wife leaving nothing with which to fund the by-pass or family trust. By using a disclaimer, that can be amended postmortem. "Of course, it must be a qualified disclaimer," Fitzgerald warns, "--one where the disclaimant does not direct where the funds go."
Finally, disclaimers are often necessary when dealing with assets that pass outside probate and are not usually held in a living trust--items like homes, qualified plan assets and life insurance, says Emily Karr of Portland, Ore.-based Stoel Rives. Examining the surviving spouse's situation postmortem and knowing exactly what the estate tax exemption is at that moment, Karr says she is often in a better position to advise the client. "So the wife might look at the life insurance or the pension plan and decide she's comfortable disclaiming those assets and letting them pass to the children," Karr says. "She may even disclaim her interest in the by-pass trust."
You don't want to rely on disclaimers, however. Funny things happen when people get their hands on a lot of money. As much as a son loves his mother, he could easily decide that he'd rather buy a new Ferrari with his newfound wealth than help her save on estate taxes. "If the kids are agreeable, then they will disclaim. If they are not, then you have mom owning half the home and the kids the other half," Fitzgerald says. "So disclaimers are not always the best solution."
In fact, it's always better to do some planning pre-mortem, to allow for better postmortem planning. For example, Pierro suggests setting up a Qualified Terminable Interest Property (QTIP) Trust in order to make post-death election planning without potentially messy disclaimers. The logic is the same; however in this case the grantor/spouse designates someone--generally not the surviving spouse--to "elect" to put the grantor's assets into either the nontaxable marital deduction portion of the QTIP or into the taxable, but sheltered portion of the trust. "I especially like the new Clayton QTIP that allows you to create both a credit shelter or by-pass trust and a marital deduction trust," says Pierro.
To illustrate the Clayton QTIP, assume the decedent spouse dies in 2008, leaving $10 million in a QTIP trust for the benefit of the surviving spouse. To maximize tax savings the survivor would direct $8 million into a marital deduction trust and $2 million into a credit shelter trust. The surviving spouse could then draw on the marital deduction trust and, if needed, on the credit shelter trust, at the discretion of the trustee. If the survivor doesn't need to draw on the credit shelter trust, those assets continue to accumulate for the future benefit of children and grandchildren--free from any future estate taxation. "We typically do not have the surviving spouse make the QTIP election," Pierro explains. "By having someone else make the election, we free up the surviving spouse to be trustee of both trusts, allowing her to manage her own money, yet protecting the assets in the trusts from creditors, in most jurisdictions."
If your clients--or their heirs--love nature, postmortem conservation easements can also trim the estate tax bill beyond recognition (see "The Good Earth," May 2007). To encourage the conservation of undeveloped and little-developed land, Congress made it possible for estates to receive a charitable deduction for the value of the conservation easement transferred to a qualified charity and to take a deduction for 40 percent of the value of of the land subject to the conservation easement (up to a maximum of $500,000). For instance, assume a wooded section of land is worth $6 million before the easement, but only $3 million afterwards. If the estate takes full advantage of the conservation easement benefits, the value of the property for estate tax purposes would be $2.5 million because it can deduct the value of the $3 million conservation easement as a charitable deduction under Section 2055(f) and an additional $500,000 (40 percent of $3 million, capped at $500,000) under Section 2031(c). In short, the postmortem conservation easement election reduces the value of the property for estate tax purposes from $6 million to $2.5 million--and the land stays in the family. "Of course, the family is restricted as to what they can do with the property from then on," explains Karl R. Anderson with the Chicago law firm McGuireWoods.
There are other, even more focused ways to save or defer taxes postmortem. IRS Code Section 6166, for example, allows an estate to pay the tax attributable to a family business in installments over 10 years. Among other qualifications, the business must make up 35 percent of the estate and generally, must continue to run as a family business for 10 years. Yes, the estate is paying the tax, but a tax deferral usually represents tax savings. Likewise, Section 2032(a) of the tax code provides for an alternate use valuation of farm and other property, so that they are not taxed at their highest and best use. "I've used this section on lakefront property where someone owned a general store and a small gas station," Pierro says. "If you developed that property, it would be worth millions more."
On the other hand, if that lake dries up after your client dies, causing land values to plummet, Section 2032 allows the personal representative to value the land as of a date six months after the death. However, there is one catch, Pierro says: "You have to value all the assets in the estate as of the alternate valuation date. Still, if that land made up a large fraction of the estate, the alternate valuation date could save the estate a lot of money."
But a word to the wise: The early bird gets the big tax savings. Nothing replaces advance planning unless it is ongoing planning--particularly given the current uncertainty surrounding the tax code. And because of that uncertainty, Karr suggests that even those who love their estate plans should revisit them. "The trend is for estate plans to contain more flexible provisions," she says. "That flexibility allows the people involved to make better deathbed and postmortem decisions." Apparently, the only thing certain is death.
Gregory Taggart (email@example.com), a former practicing attorney who has worked in insurance and financial planning, teaches writing at Brigham Young University.