Federal Estate Tax Reform - Not Happening Any Time Soon

For a while now, I have been telling my clients (and really anyone who asked) that I did not think there was going to be any major change in the Federal Estate Tax regime until after the presidential election. A recent Wall Street Journal article that I read is in line with this thinking. For the complete article written by Tom Herman, goto: What Congress Is Likely To Do to Your Tax Bill.

Under the current federal estate tax laws, a person is allowed to pass on up to $2,000,000 to anyone they choose plus an unlimited amount to a surviving spouse (as long as he or she is a citizen). In 2009, this "exemption amount" is supposed to go up to $3,500,000 per person. In 2010, the federal estate tax is theoretically supposed to disappear, and in 2011, it goes back to the pre-Bush era exemption amount of $1,000,000.

In all likelihood, no one in their right mind will support any exemption amount of less than $2,000,000. In my personal opinion, the exemption amount will settle somewhere between $3,500,000 and $5,000,000 for the years 2010 forward.

Thoughts on Portability of Estate Tax Exemption

Currently the House and the Senate are mulling a proposal to allow married couples to transfer their estate tax exemption amount to a surviving spouse on death. Under the current law, it is a use it or lose it approach.

To give an example of what this would mean, let's take a couple with $4,000,000 worth of assets. The Husband has $3 Million in his name and the wife has $1 Million in her name. Under the current law, it is possible that this family's heirs could be taxed up to $900,000 in federal estate taxes. How you ask?

• Scenario 1. Regardless of whether Husband or Wife dies first, if they have a Will leaving everything to the surviving spouse before it goes to the children (an "I Love You Will"), then when the second spouse dies there will be a $900,000 tax. This is because the surviving spouse dies with assets worth $4,000,000 and an exemption of only $2,000,000. This assumes not increase in the value of the assets and the fact that the ederal estate tax rate stays at its current rate of 45%.
  

• Scenario 2. If Wife dies first and leaves the $1 Million to their children (or in a special trust for Husband), then on the subsequent death of Husband, there will be an estate tax of $450,000. This is because Husband would die with assets worth $3,000,000 and an exemption of only $2,000,000. Same assumptions as above.
  

• Scenario 3. This couple hires an intelligent estate planning attorney and the attorney helps them retitle their assets so that they each own $2,000,000. The attorney then sets up a special trust for the benefit of the surviving spouse so that he or she has access to all $4,000,000 ($2 Million of their own money and $2 Million in trust). However, this special structure makes full use of each spouse's estate tax exemptions - so that regardless of who dies first, there is no estate tax due and owing at the death of the second spouse.

So how would portability of an estate tax exemption affect this? Well, in each of the above scenarios, there would be ZERO tax. The proposals being bandied about would allow a spouse to transfer his or her exemption amount to a surviving spouse. So in scenarios one and two above, rather than the surviving spouse having an exemption amount of only $2,000,000, he or she would be entitled to an exemption amount of $4,000,000. Generally, this fits in line with the current thinking of most tax provisions in that the government wishes to treat a husband and wife as a single unit.

By and large, there is not much downside to this idea for people. In most proposals, the only thing one must do to take advantage of this is to file an attachment to a person's estate tax return or their final income tax return. The people who would benefit most from this proposal would be those with large assets that they cannot transfer to a spouse (e.g. people who own large retirement accounts).

My one word of caution would be that this could lull people into a false sense of security regarding their estate planning. I know that if people are not worried about taxes, they may be less inclined to get the proper documentation in place. This would be particularly worrisome in the event of 2nd marriage situations where the children of a first marriage could potentially be cut out entirely.

A final note on the status of this legislation is that it has passed the House and is currently stalled in the Senate.

Taxing Politics - Part II

In an earlier post, I had mentioned that John McCain wished to eliminate the estate tax. According to his web site, the stance he is currently taking is to increase the Estate Tax Exemption amount to $10 Million per person and reduce the estate tax rate from 45% to 15%.

According to the Tax Policy Center Urban Institute and Brookings Institution, Barack Obama and Hillary Clinton plan to raise the estate tax exemption amount to $3.5 Million per person (the level it is scheduled to go to in 2009) and freeze it at that level. See: http://www.taxpolicycenter.org/taxtopics/election_issues_matrix.cfm

Top Ten Reasons to Have a Will

1. To determine who gets your money (Naming beneficiaries)

2. To determine guardianship (Saying who will take care of you children)

3. To determine who controls the money (Naming of executors and trustees)

4. To minimize estate or inheritance taxes

5. To avoid the cost of an insurance bond (If you do not allow for an executor or administrator to serve without paying for an insurance bond, the court will require one. In New Jersey, this can cost your heirs $500 for each $100,000 of assets you leave them)

6. To develop a trust for your heirs (This controls the timing of payout to beneficiaries)

7. To specify the authority of the Executor and Trustees (E.g. should they run a business, sell your property, or keep certain stocks?)

8. To determine who pays estate taxes (you can actually specify this and frequently should)

9. It provides for a quicker probate process

10. It clarifies your living intentions after your death (in other words, it maximizes the chance that your heirs will respect your wishes)

Helpful Estate Planning Hints for Divorce Attorneys

A. Have your client do pre-divorce estate planning (especially if the split is partially the result of financial matters)

1. Most clients are not aware that if they die during the pendency of their divorce that their soon to be ex may still inherit everything. This can be particularly important if it is likely that the ex will remarry or has kids from another relationship.

2. Generally, your client cannot write a new Will completely cutting out the soon to be ex out due to NJ's elective share statute.

a. Exceptions:

1) The soon to be ex can be cut out if your client and the soon to be ex are separated and not living together.

2) The soon to be ex can be cut out if your client and the soon to be ex have ceased cohabitating as husband and wife.

b. If one of the exceptions does not apply and your client dies before the divorce is final, the soon to be ex can elect to receive up to 1/3 of the augmented estate.

1) In a simplistic way, the augmented estate can be estimated by looking at the net estate (the value of the estate minus the bills that must be paid).

2) Do not factor in estate taxes at this point.

3) Do add back gifts made by the decedent within two years of death.

4) Do add in retained interests held by decedent at the time of death.

5) See N.J.S.A. 3B:8-3 for a true definition.

3. If your client is wealthy, he may wish to consider putting the soon to be ex's 1/3 share in a fairly restrictive trust for the soon to be ex with the remainder going to your client's children.

B. When drafting agreements between the divorcing parties, don't just say that money should be held "in trust" for the benefit of your client's children in the event one of the two die. This agreement can potentially override the terms of any will or trust agreement, so think a bit about some of the terms:

1. Typical terms include:

a. Having the children receive the money in two tiers (1/2 at age 25 and the balance at age 30 is usually good). If there is a lot of money, you can even do three tiers.

b. You should have your client think for a few minutes about who should be trustee. Better the two parties agree than have to get the court involved to appoint one.

2. Do any of the children have special needs and should special provisions be incorporated?

3. How important is it to guarantee that the ex put a provision in his/her Will stating that a certain percentage of his/her estate must go to their children? This can be contractually agreed to.

C. Don't just require that your client's ex purchase $X amount of life insurance on the ex's life.

1. Demand that your client's ex agree to pay for the policy, but have your client actually buy it. This accomplishes multiple goals:

a. It ensures that the policy is in fact in place;

b. In the event the ex runs into financial trouble, your client can continue the payments;

c. It can save a huge amount in taxes;

1) Typically if the ex owns and maintains the life insurance on his life, then regardless of who the beneficiary is, it will be subject to the Federal and State Estate tax upon his death;

2) If your client or an irrevocable life insurance trust (an "ILIT") owns the policy, then it will not be subject to estate taxes upon the ex's death (provided it was not transferred to your client or the ILIT within 3 years of the ex's death).

3) To give an example of real life savings, let's assume that ex is worth $2 million and is required to buy a $1 Million life insurance policy. That policy will cause ex's estate to be subject to approximately a $500,000 tax. This is particularly problematic if most of that is going to your client's children. By having your client or an ILIT own the policy, this estate would completely escape federal estate taxes and only be subject to minimal NJ estate taxes.

D. Do not forget about retirement assets, pension plans and life insurance

1. Most divorce attorneys remember to put a provision in the divorce and separation agreements which will require that their clients receive a portion of the ex's estate, but some forget to require/request that their client receive a portion of the ex's retirement assets or life insurance upon the ex's death. The general trend is to deal with this through a QDRO and let the chips fall where they may upon the ex's death.

2. Moreover, many divorce attorneys forget to include the client's children in this part of the planning. It is imperative for attorneys with clients who's wealth is tied up in retirement accounts deal with where these retirement accounts go on the death of the ex.

3. A common example of the above may be illustrated as follows. H and W, who have 2children, get a divorce. H has a 401(k) worth $1,000,000. The two do a QDRO and split this evenly. H should insist of W, and W should insist of H, that their children be named as the beneficiaries of this 401(k) (AND any IRA that this gets rolled into). Otherwise, if W gets remarried, the new husband could legitimately be named as the new beneficiary of this retirement account. NOTE: They attorneys should leave this open for the clients to amend in an amicable way in the event one of the children should not be named as a beneficiary due to drugs, alcohol or any other legitimate reason.

E. What about possible inheritances?

1. Except to the extent that the parties agree, you should always get the soon to be ex to disclaim all interests that he/she may have in your client's estate, non-probate assets and joint assets.

2. Many times your client's parents will include the ex as a beneficiary of their estates. You should think about trying to get the soon to be ex to disclaim these interests as state law may not always treat the ex as dying on the date of the divorce.

F. Dividing Joint Assets

1. Transfers of property incident to divorce are not treated as taxable gifts for federal gift tax purposes. To qualify, the property must generally be transferred within one year from the date the marriage ends. (Transfers made within 6 years of the date of divorce can qualify if the transfer is made puruant to a divorce or separation agreement. This time frame may be further extended for cause such as litigation surrounding the transfer of a business interest.)

a. Exceptions:

1) Transfers to a non-citizen former spouse;

2) Transfers to a trust for the benefit of the transferee former spouse of property on which liabilities exceed the transferor's basis for the property; and

3) Transfers to a trust for the benefit of the transferee former spouse of installment obligations.

b. If one of these exceptions apply, the transferor spouse may recognize gain or loss.

c. If the transfer is deemed as a transfer incident to divorce, the transferee spouse takes the property with a basis in the property equal to the basis of the transferor spouse. This is known as a carryover basis.

d. Divorce attorneys should be careful in agreeing to take property that has high built in gains as result of this carryover basis.

e. Your client may be required by the settlement agreement to transfer an insurance policy on his or her life to the ex and continue paying the premiums on the policy. It is important to know that the transferor can only deduct those premium payments as alimony (taxable to the recipient) if the transferor makes the transferee both the owner and irrevocable beneficiary of the policy.

2. In NJ there is no gift tax, but in order to avoid the real estate transfer tax for transfers incident to divorce (or the dissolution of a civil union partnership) the property must be transferred no later than 90 days after the date the divorce or dissolution decree is entered. See: http://www.state.nj.us/treasury/taxation/pdf/other_forms/lpt/rtfexempt.pdf

Everything You Ever Wanted to Know About Ancillary Probate in NJ

If you have a loved one who dies owning real property in New Jersey, what do you do? The answer is - an ancillary probate. Generally, this means you will conduct a second probate action in New Jersey after you have done one in the state where the Decedent was domiciled. (If there is no reason to conduct a probate proceeding in the state where the Decedent was domiciled, you can contact the Surrogate on ways to skip steps 1 and 2.)

For most, the process is as follows:

1) If the Decedent had a Will, the named Personal Representative probates the Will in the jurisdiction where the Decedent was domiciled (if there was no Will, someone will likely have to file a complaint to declare an intestacy and request to become Administrator for the estate).

2) The Personal Representative obtains an "Exemplified Copy" of the Will and Letters Testamentary (or Letters of Administration for an intestacy action). Letters Testamentary and Letters of Administration are the documents that the Surrogate gives you to show that you have legal authority to act on behalf of the Estate.

3) You take these documents to the Surrogate of each county where the Decedent owned property and tell them that you want to conduct an ancillary probate. (The fee is nominal, currently only about $5 per page plus $5 for the backing page.)

4) The local NJ Surrogate then gives you Letters Testamentary for NJ, and you can transfer this property legally to the new owner according to the county.

5) BUT WAIT, don't transfer the property yet! You have to know who the property is going to. If all or a part the property (or money from the sale of the property) goes to someone other than a spouse, lineal descendant or lineal ascendant, it is subject to a NJ Inheritance tax! That's right, there is a 11-16% tax on this property which must be paid within 8 months from the date of the Decedent's passing. Failure to do so will result in very large interest and penalty charges which you, as the Personal Representative, may be responsible for. At least there is no NJ Estate tax on the estate of a non-resident.

6) Once the Personal Representative has determined what is owed to the State of New Jersey, he or she should pay the tax, if any, and obtain an inheritance tax waiver from the Estate and Inheritance Bureau. Forms can be found here: http://www.state.nj.us/treasury/taxation/index.html?estatetax.htm~mainFrame

7) Now can the Personal Representative can transfer the property? Probably. Again, if the property was devised to a specific party, it should either be transferred to such party or sold with the explicit consent of that party. If the property was part of the residuary of the estate, then the Personal Representative generally will have the power to transfer the property unless it is denied by the language in the Will - so make sure you check this. Few Wills that I have run into ever limit this, but frequently you do see a right of first refusal which must be honored.

Obviously a knowledgeable probate attorney can help you through these steps.

PROTECTING YOUR LIFE INSURANCE TRUST FROM TAXES

The Importance of Proper Trust Maintenance

The trustee of an irrevocable life insurance trust (ILIT) must follow numerous rules and regulations laid out by the IRS in order to exclude the ILIT’s policy proceeds from federal and state estate tax. The insured and the trustee should check to see that these rules and regulations are in compliance annually because any significant mistake — even an honest one — may lead the IRS to challenge the trust and tax the life insurance proceeds.

Life Insurance Trust Basics
An ILIT holds one or more life insurance policies on your life. Each year, in order to pay the premiums on the life insurance policy, you must gift money to the ILIT and then your trustee uses this money to pay the premiums. After your death, your trustee will distribute the insurance proceeds according to your instructions.

If established properly, you will not have any control over the life insurance policy itself or any of the assets in the ILIT. Normally, if you do not have control over an asset, it is not taxable for estate tax purposes. The IRS is not happy about the ability of people to pass on vast sums of money without paying tax and they may scrutinize your ILIT for mistakes so it can collect the estate tax. Accordingly, even though you have no control over the assets in your ILIT, it is still important that it is properly maintained.

Funding the ILIT
After the trust document is drafted, the trustee will either purchase an insurance policy on your life or transfer an existing policy into the trust. In either case, the trustee must be the policy’s owner and beneficiary. For policy that is not paid in full, the trustee must open up a bank account for the trust and you must deposit money into the ILIT’s account to cover the premium.

Your gift to the ILIT -- whether cash or an existing insurance policy -- qualifies for the annual gift-tax exclusion of up to $12,000 per beneficiary (for calendar year 2007). If you decide to transfer an insurance policy to the trust via gift, you must figure out the value of the policy. A good rule of them is the value of a term policy is approximately the current year’s premium or the cash surrender value for a whole life policy. (This is not exact however and there are exceptions, so you must get an official valuation from the insurance company - this is known as the interpolated terminal reserve plus a portion of that year's premiums paid by the owner.)

If you transfer an existing policy to your ILIT and you die within three years of that transfer, the proceeds will be included in your estate for estate tax purposes. If you are insurable, the three-year rule can be avoided by gifting cash to the trust and having the trustee purchase a new policy. You can then surrender the old policy and use the cash value, if any, to pay the premiums on the new policy.

Premiums and Crummey Notices
Each year you make a gift to the ILIT, whether to pay the annual premiums or otherwise. The gift will qualify for the annual gift-tax exclusion as long as the IRS considers the gift a gift of a “present interest.” In order for the gift to be deemed a gift of a “present interest”, your trustee must give the beneficiaries a right to withdraw the gift. This is known as a demand right or a Crummey power. (If a beneficiary is a minor, your trustee should send a Crummey notice to their parents or guardians of that minor.)

This notice requirement applies to the first year’s gift as well as every subsequent year’s. If your trustee forgets to send the Crummey notices, the IRS may say that the beneficiaries did not have a “present interest” and include the gifts as part of your taxable estate.

As soon as the withdrawal period lapses -- typically after 30 days and assuming the beneficiaries don’t exercise their withdrawal rights – the trustee can use the money to pay the premium. Due to this time constraint, money should be put into the trust account at least 45 days prior to the premium being due.

There is always a danger that the beneficiary will actually take the money, so you should explain to your beneficiaries that allowing the right to lapse each year without withdrawing the cash is in their long-term best interest.

It should be noted that if the trust owns a second-to-die policy on your and your spouse’s lives, the survivor should continue to make gifts to the ILIT so that the premiums can continue to be paid.

Records and Tax Returns
If the ILIT has gross income in excess of $600 for the year, your trustee is responsible for filing annual income tax return. The trustee should also maintain certain records in the event that the IRS chooses to audit the ILIT’s operation. These records include:
· Copies of all Crummey notices sent to the beneficiaries along with any related correspondence;
· Canceled checks from your individual (or joint checking account for a 2nd to die insurance trust) showing the gifts you made to the ILIT; and
· The trust’s checking account records, showing gift deposits and premium disbursements.

Avoid Incidents of Ownership
To maintain your ILIT’s tax-advantaged status, avoid exercising any control over the trust. In IRS terms, the insured party must not have any “incidents of ownership” during the trust’s life. If you violate this rule, the IRS will include the insurance policy in your estate and tax the proceeds. Incidents of ownership include the ability to:
· Change or add a beneficiary,
· Surrender or cancel the policy,
· Assign the policy or revoke a policy assignment,
· Borrow against the policy or pay premiums with policy loans; or
· Pledge the policy as collateral for a loan.

Mistakes Can Be Costly
Any significant mistake -- even an honest one -- may prompt the IRS to challenge the trust and tax the insurance policy’s proceeds. If you or your trustee has any questions about the proper way to handle your ILIT, please call before you act.