Death and Taxes:

You Don’t Have To Do Both

 

“How You Can Cut the IRS Out of Your Will!”

 

A Special Report By

Kenneth S. Jacobs

Attorney at Law

(707) 829-7303

 

          In a 1789 letter to Jean-Baptiste Leroy, Benjamin Franklin wrote, “In this world nothing is certain but death and taxes.”

 

          Ben was only partially correct.

 

          Yes, death is certain.  I can’t offer much counsel on that point other than “eat your vegetables and get plenty of exercise.”

 

          Taxes, however…now that’s a whole different story.  Especially when it comes to the subject of death taxes.

 

          You see, Ben was wrong.  Dead wrong!  Death Taxes are NOT CERTAIN!  There are many methods, some simple and some complex, which can be used to minimize and in many cases eliminate Death Taxes.

 

          This Special Report summarizes some of those methods.  Some can be done on your own.  Others will require professional assistance.  All are certain, however, to result in more money passing to your family, and less (or none) going to the IRS.

 

 

The Death Tax, technically called the Estate Tax, is actually a tax on transfers of wealth.  It is a tax imposed by the federal and state governments on both gifts and inheritance. 

 

Generally, most people don’t make large enough gifts during their lifetime to trigger the Gift Tax portion of the law, so we will assume, for the purposes of this Special Report, that the tax will only be imposed at death.

 

          First, some good news.

 

          During the summer of 2001, President Bush signed into law the Economic Growth & Tax Relief Reconciliation Act of 2001.  A major aspect of this new Tax Law is the so-called repeal of the Federal Estate Tax. 

 

In short, the new law phases out the Estate Tax, concluding with the total repeal of the Estate Tax in 2010.  Effective for individuals dying on or after January 1, 2007, an estate of up to $2.0 million will pass tax free.  This $2.0 million is called the “Exemption Amount”—the amount that can be passed free of Estate Tax.  The Exemption Amount is scheduled as follows:

 

Year

Top Estate Tax Rate

Exemption Amount

2002

50%

$1 million

2003

49%

$1 million

2004

48%

$1.5 million

2005

47%

$1.5 million

2006

46%

$2 million

2007

45%

$2 million

2008

45%

$2 million

2009

45%

$3.5 million

2010

repealed

N/A

2011

55%

$1 million (New law expires 12/31/2010)

 

          Now, the bad news.

 

Note that the new Tax Law expires in 2011, when the Estate Tax is reinstated for estates in excess of $1.0 million.  In other words, the new law “sunsets” on December 31, 2010, and the previous (2001) Estate Tax Law comes back into effect, with a $1.0 million Exemption Amount.

 

Furthermore, it is almost certain that we will see further revisions to the Estate Tax.  In fact, as this article is being written, new versions of the Estate Tax are working their way through Congress. 

 

Will the repeal be extended beyond 2010?  Will the law in fact be allowed to sunset?  Will the Estate Tax be reinstated but with a higher (or lower) Exemption Amount?  Will Congress come up with something entirely different?

 

I don’t know.  All I can say is “stay tuned”.

 

However, given that there is an Estate Tax until at least December 31, 2009, and given that the so-called Estate Tax repeal is scheduled to sunset on December 31, 2010, and given that the government is likely to do just about anything between now and then….it make sense to plan your estate to avoid possible estate taxes. 

 

One Important Note:  For the rest of this Special Report I will refer to the Exemption Amount as the amount available to your estate in the year of your death.  Of course, we don’t know when this will be.  And of course, the government may change the rules at any time.

 

Therefore, as a practical matter, assume the Exemption Amount will be $1.0 million.  Although it could be more, don’t count on it.

 

So, how do we avoid or at least minimize Death Taxes.  Here’s some ideas:

 

 

1.  Die in 2010.

 

No kidding.  Under the current law there will be no Estate Tax for deaths occurring in 2010.  While this law may change, it could be a good strategy.  Not necessarily one that I would recommend however………

 

 

2.  Spend it! 

 

I see far too many clients who have saved, saved, saved their whole life.  If your estate exceeds the Exemption Amount (again, remember to assume it is $1.0 million but subject to change), a good chunk of every dollar you save will go to the IRS.  Go on vacation.  Go out to eat.  Go to shows.  You get the idea?

 

 

3.  Give it Away (they’ll love you for this one). 

 

The idea is to get your estate down to a level below the Exemption Amount.  For example, if you are going to bequeath your estate to your kids when you die, why not give them some now to avoid (or at least reduce) government’s share upon your death? 

 

There is one important limit.  This is new.  You can give up to $12,000 per person per year without tax consequences (which I will discuss below).   

 

Technically, this $12,000 is called the “Annual Gift Tax Exclusion Amount.”  Note that it is $12,000 per recipient per year.

 

This means you can give $12,000 to as many people as you want.  Just don’t give more than $12,000 to any one person in any one calendar year.  Furthermore, a married couple can pool their gifts and give $24,000 per year.  For example, mom and dad can give daughter and her husband $24,000 each, for a total of $48,000 per year.

 

Gifts can be made to anyone.  Consider education accounts (e.g. 529 plans) for your grandkids.  Help your favorite nephew with tuition.  Help your children with a down payment on a new home. 

 

Remember, you can’t take it with you, and the IRS is eagerly waiting for their share.

 

IMPORTANT HINT

 

Make your annual gifts on January 1 each year.  There is a tendency to make holiday gifts in December.  But I can tell you one thing for certain:  Everyone dies at some point during the calendar year. 

 

So, if you wait until Christmas or Hanukkah to make your $12,000 gifts, you are missing out on one “round” of gifting.  This is because odds are that in the year of your death you will die before the holidays.  Instead, as a holiday gift, give a check post-dated January 1, and instruct the recipient to deposit the check on the first business day of the year. 

 

Depending on the size of your estate, this method can save your family thousands of dollars which would otherwise go to the IRS.


4.  Prepare a Living Trust. 

 

If you are single (divorced, widowed, never married) you can skip this section.  While you should still prepare a Living Trust to help your family avoid the expense and hassles of probate, there are no Estate Tax savings for a single person with a Living Trust.

 

If you are married, besides allowing your family avoid the expense and hassles of probate, a Living Trust also doubles your Estate Tax Exemption Amount. 

 

A Living Trust achieves this by splitting the community property trust into two shares upon the first to die.  This allows the couple to utilize both the Exemption Amount available to the first to die and the Exemption Amount available to the second to die.  Without a Living Trust, and assuming the entire community estate passes outright to the surviving spouse, the Exemption Amount of the first to die is wasted. 

 

A Living Trust is one of the simplest and most straightforward methods to “cut the IRS out of your will”.  It also allows you to pass your estate without the high costs and long delays associate with probate.  You will, however, need a qualified Estate Planning Attorney to assist you with preparing the correct type of Living Trust for your situation.

 

 

5.  Charitable Gifts.

 

Gifts to qualified charities are 100% deductible on your Estate Tax Return.  Don’t overlook charities when preparing your Living Trust or Will.

 

Even more attractive to may people are Charitable Remainder Trusts.  These trusts allow you to make a gift to charity to take effect upon your death, but allow you an immediate income tax deduction for the gift when the trust is established. 

 

For example, you place a parcel of highly appreciated real estate in a Charitable Remainder Trust.  You will receive an immediate tax deduction based on the actuarial determine “future value” of the property based on your life expectancy and other factors.  You can then sell the property capital gain tax free (because it is in a charitable trust).  Next you reinvest the entire proceeds of the sale and receive income for the rest of your life.  Upon your death, the charity gets the trust assets which are not part of your taxable estate.

 

 

6.  Freeze It.

 

          Let’s say you have a rapidly appreciating asset such as a parcel of real property or stock.  Further, let’s say you don’t need it anymore.  Why not give it away to your children? 

 

Well, you might say, “What about the $12,000 annual gift limit?”  It is true, you can only give away $12,000 per person per year without reporting it to the IRS.  But if you give more than $12,000 you do not necessarily owe tax, you just use up some of your Exemption Amount. 

 

For example, assume that in 1990 mom had a property worth $210,000, which she gave outright her daughter.  Also assume that the property is now worth $500,000.

 

In 1990, the first $10,000 in value was covered by the then-annual gift tax exclusion of $10,000.  The next $200,000 in value was reported to the IRS, but the only consequence was that mom used up $200,000 of her Exemption Amount.  So, if mom died in 2002, a year when the Exemption Amount is $1.0 million, her estate only had $800,000 worth of “exemption dollars” left to apply towards her estate tax. 

 

But…and this is the good part…her daughter got the property when it is worth $210,000, not when it had appreciated to $500,000.  This means her daughter never pays estate tax on the $300,000 increase in value between 1990 and now.

 

Mom and her daughter “froze” the value in 1990 for estate tax purposes. 

 

Also, even if mom made lifetime gifts which exceeded her Exemption Amount, the “Gift Tax” due is paid by mom based on the net value of the gift.  Compare this to Estate Tax which is based on the value of the whole estate, including the portion of the estate that will be used to pay the tax.  In other words, with Estate Tax you pay tax on the tax, while with Gift Tax the dollars used to pay the tax are not taxed. 

 

Yes, this is complicated, but it is a valuable key point for planning larger estates.

 

Please note that there are income tax consequences when you gift appreciated assets.  Professional tax advice is recommended.

 

 


7.  Two + Two = Three

 

Question:  Assume Bob and Charlie are equal partners in a property worth $1,000,000.  How much is Bobs share worth?

 

If you said $500,000 you’re wrong.

 

You see, the market value for Bob’s one-half interest is not one-half of the value of the property, because no knowledgeable buyer would pay that amount for a property he or she does not exclusively control.  Instead, a buyer might give Bob $400,000 for his one-half interest in the property.  In other words, a partial interest in real estate receives a discount valuation for Estate Tax purposes.

 

This idea works two ways. 

 

Let’s illustrate with another example:  Assume Bob owns 100% in a small ranch property worth $1.2 million.

 

First, say Bob wants to use his $12,000 annual gift tax exclusion amount by giving his son an $12,000 share in his ranch.  If you get out your calculator you might compute that Bob should deed his son a 1% share ($12,000 divided by $1.2 million).  Wrong answer.

 

In fact, an appraiser applying discount valuation principals might determine that an $12,000 share in the property is actually 1.5%.  This is because son’s small percentage share is discounted in value by approximately 30% due to the lack of a real market for that share.  This allows Bob to give away a gift that has an appraised value on $12,000, but a “true value” (if the whole property was sold) of more that $12,000.

 

Second, the share remaining to Bob will be discounted in value when he dies due to the fact that his less than 100% interest would not be attractive to a buyer at full price, and a discount is thus appropriate.

 

This method is often used in conjunction with limited partnerships and LLCs to allow parents to give away equity shares in real estate, discounted in value, but retain lifetime management control over the property.

 

 

8.  Insure It.

 

Has an insurance agent ever told you, “Life insurance is not taxable when you die”?  Unscrupulous insurance agents love to tell you this…all the way to the bank to cash their commission check.

 

Life insurance is not taxable as income to the beneficiary.  However, life insurance is taxable as part of a person’s estate when they die. 

 

For example, assume Bob has a life insurance policy worth two million dollars when he dies.  He tells his kids that Vinnie, his life insurance agent, said they do not have to pay taxes on that insurance when Bob dies

 

Vinnie better have a good malpractice policy.

 

Bob owns his life insurance.  He pays the premiums.  He named the beneficiaries.  Accordingly, when Bob dies his estate must pay Estate Taxes on the death benefit from that policy.  No income tax is due, but everything a person owns or controls is taxable in his or her estate.  Since Bob owns and controls the policy, it must be included on his Estate Tax Return. 

 

Bottom line:  The kids and the IRS are joint beneficiaries of Bob’s life insurance policy.

 

Suppose, however, that Bob did not own and control the policy.  For example, let’s say the kids own the policy, and that they pay the premiums.  When Bob dies he has no ownership interest in the policy, so the kids get the whole thing estate and income tax free!

 

I know:  If your kids owned the policy, they would (1) forget to pay the premiums, (2) fight about it, (3) cash it in and buy a new truck, or (4) all of the above.

 

There is another solution.  You can create a trust called an Irrevocable Life Insurance Trust. 

 

In this case, this trust is the legal owner of the policy.  The trustee of the trust pays the premiums.  You don’t own it, so it is not included in your estate when you die.  Your kids don’t own it, so they can’t mess it up.  However, when you die, the trust pays the death benefit to the beneficiaries income and estate tax free.

 

In fact, the insurance proceeds can be used by your family to pay the Estate Tax due (if any) on the rest of your estate—which is due nine months after your death—rather than resorting to a “fire sale” of property to raise cash  for the taxes.

 

However, you must be careful.  If you pay the premiums on the policy, the IRS says it is part of your taxable estate.  So, the trick with any Irrevocable Life Insurance Trust is to pay the premiums without actually paying the premiums. 

 

For example, if Bob directly pays the premiums on the policy, even if a Life Insurance Trust legally owns it, he is deemed by the IRS to be the “owner” for estate tax purposes.  But if Bob gives cash gifts to the Irrevocable Life Insurance Trust, and the trustee “just happens” to use the money to pay the premiums on a life insurance policy on Bob’s life, Bob is not the legal owner.  Just call this “Free Money!”

 

An Irrevocable Life Insurance Trust is often coupled with a Charitable Remainder Trust to replace the value of the charitable gift for your family…tax free.  The charity wins.  You win (income tax deduction).  You family wins (kids love inheritance).  Who loses?  The IRS.

 

An Irrevocable Life Insurance Trust will only work with a new policy or an existing policy transferred into the trust at least three years before you die.  Also, there are numerous technical details that must be addressed when establishing and managing an Irrevocable Life Insurance Trust, especially with regard to the “gift to pay the premiums” scheme.  Professional legal and tax advice is a must.

 

 

9.  Buy the Farm.

 

There are special estate tax benefits for family farms, family businesses, and conservation easements.  These topics are complex and will require professional tax and legal advice.

 

 

         

As mentioned, there are many simple do-it-yourself methods to avoid or at least minimize death taxes.  Other methods are more complex, and will require professional legal and tax advice. 

 

The tax savings, however, can be astronomical. 

 

I’ve personally watched executors write multi-million dollar checks to the IRS.  I hate it, and of course they hate even more. 

 

I’ve also, on many occasion, been proud to tell a deceased client’s children that because of proper Estate Planning their parents saved them hundreds of thousands of dollars in Estate Taxes and Probate Fees.

 

          One final word of advice.  The Estate Tax laws are in a state of flux.  The new law has many, many flaws, and both Democrats and Republicans in Congress have expressed serious concerns.  It is likely, even certain, that we will see radical changes to the Estate Tax in the next decade. 

 

So stay informed, be flexible, and maintain contact with your professional advisors.

 

          Death and taxes do not need to go hand-in-had.  You can avoid (or at least minimize) death taxes.  There is some work involved, and some cost.  But who would you rather see get the estate you worked a lifetime to build:  Your family or the IRS?

 

          Please call if you have any questions about this Special Report or any other Estate Planning matters.  My direct number is (707) 829-7303.

 

Sincerely,

 

 

 

Kenneth S. Jacobs

 


Attorney Kenneth S. Jacobs is certified by the State Bar of California Board of Legal Specialization as a Certified Specialist in Estate Planning, Trust & Probate Law.  For more information please call (707) 829-7303, or find us on the web at www.kenjacobs.com.