An Estate Liquidity Timebomb Is Ticking

State estate taxes could drive the effective tax rate even higher. Prior to EGTRRA, the federal estate tax was offset by a dollar-for-dollar credit for state death taxes. Roughly 38 states used the amount of the credit as their state estate tax. However, pursuant to EGTRRA, in 2005 the state death tax credit was fully phased out and replaced with a deduction. States were forced to either lose the revenue they had received from the credit or “decouple” themselves from the federal estate tax and impose new state estate taxes. Today, roughly half of the states have state estate taxes which are decoupled from the computation of the federal estate tax. Many decoupled states have lower estate exemptions than the federal exemption. For example, New Jersey has a $675,000 exemption. In many of these states, the combined state and federal estate taxes could exceed 60% because state estate taxes will exceed the federal state death tax credit.

ira and Retirement Assets. With the higher exemptions and new rules permitting heirs to make withdrawals from inherited IRAs over their lifetimes, many estate plans have provided that the retirement plan will pass to younger families members (to take advantage of the longer life expectancy) while passing other assets to a surviving spouse. However, these plans could create a number of problems if we return to the lower estate tax exemptions in the pre- EGTRRA rules.

For example, assume a client in a second marriage had a $1.5 million IRA and $2 million in other assets. Under his current planning, the IRA passes by trust to his young children from a prior marriage while the $2 million is held in a QTIP trust for the second wife. At the current exemptions, no estate tax would be due at the client’s death, assuming his spouse survives him. However, if the client dies after 2010, there could be a federal estate tax of approximately $210,000 on the IRA transfer to the children. If the trustee reaches into the IRA to pay the $210,000 in estate taxes, the trustee will create taxable income of $210,000. If the trustee then reaches back into the IRA to pay the income taxes, they incur additional income taxes. Each withdrawal from the IRA to pay tax will create a new tax. The plan should be revised to either:

–reduce the IRA bequest to the available exemption (whatever it may be at death),

–pass other assets (e.g., a life insurance policy, preferably in an ILIT) to the children to pay the estate tax liability, or

–pass non-IRA assets to the children while passing the IRA to the surviving spouse, perhaps in trust.

This area has an interesting conflict. For several years Congress has been encouraging the growth and creditor protection of retirement plans, particularly for baby boomers. However, the combination of estate taxes and income taxes on retirement plans in poorly planned estates after 2011 may create a significant tax windfall for the federal budget.

It should be noted that while retirement assets are the most likely assets to be subject to both income taxes and estate taxes, there are other assets (e.g., an installment note) that could create a similar double taxation issue when the exemptions are lower.

Demographics and Family Businesses. Not only will the increased estate taxes create liquidity problems for family businesses, but the increasing number of retiring family business owners and the passage of family businesses are going to create an increased need for life insurance. In a 2002 Mass Mutual study, 40% of the family businesses surveyed expected a leadership change in the following 5 years.

Many business owners intend to pass their businesses to one or more designated family members who will run the business after the entrepreneur’s death or retirement. However, because the business is often the largest single asset of the estate, the owner often passes part of the business ownership to other family members who are not involved in the business. This is an incredibly bad idea that creates family conflict.

The conflict is virtually inevitable, as each family member attempts to direct his or her own financial destiny and feels increasingly unable to do so because of the common business ownership with other family members. This is not a matter of “good” and “bad” family members; it is a matter of different life goals–a normal part of life. Many family businesses have paid huge legal fees because of these conflicts and/or have been forced to sell the business to alleviate the problem.

The solution lies in setting up a structure in the estate plan that assures those in the business own and control as much of the business as possible while giving outsiders other assets so that they can effectively control their own financial destiny. Life insurance is often a necessary element of this “equalization planning.” Often the entrepreneur will recognize the contribution to the business of those who have had long term involvement by passing a greater part of the business to them.

Treatment of Insurance. Many advisors have a wait-and-see attitude about what Congress is going to do. However, if a client is going to move an existing life insurance policy out of his or her taxable estate by 2011, the 3-year look back provisions of Internal Revenue Code Section 2035(a) mean that the transfer should occur at least 3 years prior to the beginning of 2011. Thus, by December 31, 2007, clients who do not currently have a taxable estate (but who may have a taxable estate in 2011) will be forced to consider the use of life insurance trusts or the transfer of insurance policies directly to heirs.

Without question, new life insurance for clients with estates over $1 million should be kept out of the taxable estate, using life insurance trusts or direct ownership of heirs.

Anyone who says he or she knows what transfer tax legislation will be enacted in the next 4 years is either clairvoyant or deranged. Unfortunately, no one inside or outside of Washington has any real idea what is going to happen to the transfer tax rules in the next 4 years.

What is certain is that any expectation of an elimination of the estate tax is DEAD! Clients and their advisors should run projections that take into account the possibility that the 2001 laws could return in about 42 months and project the resulting tax cost and available liquidity in the estate. Forty-two months is a very short time for planning.