June 24, 2001

Coping With a Tax That Has Nine Lives


President Bush's idea was simple enough: First thing we do, let's kill all the death taxes. . . .

The execution, alas, was not so simple.

His new tax law, which reduces estate taxes in stages starting next year, repeals them for the year 2010 and then resurrects them in 2011, is laced with many subtle provisions. And they can cause the uninformed to pay taxes unnecessarily, leave a spouse and heirs much more or much less than was intended and, perhaps, prompt litigation among family members.

But there are easy new ways for most people, especially those with more than $1 million and less than about $5 million of wealth, to avoid these problems. Anyone who has a will should review it with a lawyer, even though few wills may need to be rewritten; everyone without a will should get one. And particularly affluent people who have established trusts for their heirs should make sure that those trusts will still achieve what they were intended to do.

For residents of many higher-tax states, including New York, New Jersey and Connecticut, it may come as a surprise that total estate taxes will actually rise over the next few years.

That is because the law that will slowly, and temporarily, eliminate the federal estate tax also will reduce the credit allowed for state-level estate taxes. That potentially costly detail received little attention as politicians trumpeted the tax cut.

The law also poses difficult new questions about when to buy, keep or drop life insurance in a future that may, or may not, include an estate tax.

And what about making gifts to heirs over the coming years, especially gifts that would themselves be liable to tax? What about gifts to charities?

Congress and Mr. Bush have assured Americans of one thing: the coming decade will be rife with uncertainty about estate taxes. Experts on all sides of the debate agree that the new tax law will have to be modified, and some contend that it is so unworkable that it might have to be undone. Whether repeal is real remains an open question.

Most Americans die without a will, and the biggest mistake that even moderately wealthy people can make is to think that, now especially, they do not need to plan for the organization and disposition of their assets. That could be a very costly mistake, especially when a family- owned business is involved, according to business-valuation experts, financial planners and estate-tax lawyers.

In another of its many counterintuitive effects, the repeal of the estate tax is likely to benefit some charities but cost others dearly, often in ways that are difficult to anticipate. And that, in turn, may create new tensions in wealthy families, tensions that will require more planning.

To gauge the complexities of the tax changes and what they may mean to your life, consider this situation: Suppose your parents are among the very rich, with at least $10 million. Under current law, estate taxes would take more than half of that amount if the second of them died this year.

Reasonably, you may be anticipating that, if your parents live until the tax is repealed in 2010, your inheritance will more than double, since all the money that would have gone to taxes can flow to you.

But odds are against such a windfall coming your way, said Douglas K. Freeman of Freeman, Freeman & Smiley, a large tax-law firm with offices throughout California. Just because there is less for the government does not mean there will be more for you. Many rich parents, after all, pick specific sums of money they want to leave to each child, Mr. Freeman and others said. Such decisions, these experts say, have less to do with taxes than with the parents' attitudes about money and the quality of their relationships with their children.

These experts said many wealthy people agreed with the philosophy of the billionaire investor Warren E. Buffett who has said that he will leave his children enough money to do anything, but not so much that they can do nothing. Mr. Freeman said clients had already begun contacting him to "ask what changes they need to make in their wills so that their children do not get more money."

So if heirs will not get the money that would have gone to estate taxes, who will?

"Charities will be major beneficiaries of repealing the estate tax," said Paul G. Schervish, a professor of sociology at Boston College who has spent years interviewing the rich about their behavior. Indeed, Mr. Freeman and a few other estate-tax lawyers say they have received calls from clients who want to make sure that money that does not go to estate taxes is donated to charity.

Veteran fund-raisers, however, say they expect the law to change the way people donate to charity, a shift that may benefit some charities while hurting others.

"Museums are going to lose out, because art they had expected in a bequest is going to stay in the family if the estate tax is repealed," said Robert F. Sharpe, a fund-raising consultant in Memphis.

Consider what happens if you have a $100 million estate $55 million in investments and $45 million worth of art and you want to limit your children's inheritance to $25 million.

Under current law, if you leave it all to your children, they would have to turn over the entire $55 million to pay the estate taxes, leaving them with only the art, which they could enjoy or sell, pocketing $45 million tax-free. Alternatively, you could donate the art to a museum or other charity, reducing the estate tax to a bit more than $30 million and leaving almost $25 million for your children.

Without the estate tax, however, there is no financial incentive to leave art to charities. The children could keep both the art and the entire $55 million portfolio unwelcome news for art museums that count on death bequests to enlarge their collections.

Charities will benefit from the law only if rich parents want to limit the amounts inherited by their children or other relatives. For example, if the parent with the $100 million estate wanted her children to receive only $25 million, she could still donate the art to a museum and give to charity the $30.25 million that would have gone to estate taxes. That would leave the children with the same $24.75 million they would have received before the federal estate tax was repealed.

Accountants and lawyers say a smarter tax strategy, if estate taxes are repealed, would be for the rich parent to give the art to charity during her lifetime and take the income-tax deduction herself, then put the $30 million gift to charity into a donor-advised fund at a community foundation with the children as the advisers. The fund would both teach the children about how to give and provide them with a source for charitable gifts that would not require them to dig into their own pockets.

Here is a guide for the wealthy, heirs and charities to changes in the estate-tax law and issues to discuss with family members and professional advisers.

Wills and Estate Plans

People with estate plans or wills should ask a lawyer to review them to make sure they take best advantage of the new law. Most plans and wills do not need revisions, but wills that use a formula to divide assets among a surviving spouse and children may find that the changes in estate-tax exemptions and the repeal for the year 2010 will result in too much or too little going to the spouse.

People with children from previous marriages need to be especially careful in this area, estate-tax lawyers say, to prevent litigation within the family.

Of course, even people who do not have enough assets to be liable for estate taxes should have a will, experts say, so that their property is disposed of as they intend.

The Moderately Wealthy

Next year, people can leave as much as $1 million without incurring estate taxes, up from $675,000 this year. That change alone will reduce the number of estates subject to estate taxes by about 40 percent. With a little bit of planning starting by making sure that at least $1 million in assets is in the name of each spouse a married couple can pass along $2 million tax-free.

The threshold rises to $1.5 million ($3 million for couples who plan) in 2004, $2 million ($4 million) in 2006 and $3.5 ($7 million) million in 2009. At that point, even considering growing wealth, fewer than 10,000 estates are likely to be subject to estate taxes. In 2011, when the estate tax is scheduled to resume, the threshold will fall back to $1 million a person ($2 million for couples who plan).

Tax-Free Gains

In 2010, the year of the repeal, people can pass along as much as $3 million of investment gains to a spouse and up to $1.3 million to other heirs without having to pay capital gains tax. For the maximum tax break, people should make sure that their wills give spouses the top priority in receiving property that has grown significantly in value, lawyers and other tax advisers say.

In other words, specifically bequeath to your spouse that Exxon Mobil stock that you bought at a split-adjusted $1 a share and now fetches nearly $90, or that Monet you picked up for a song decades ago that is now worth millions, so that you get the maximum benefit.

Wills should also guide executors on how to distribute property to take full advantage of the law. That means considering holdings like retirement accounts that pass outside the will and are not under an executor's control. In giving guidance on dividing tax-free and taxable property among heirs, you should also pay attention to whether an asset is likely to be sold by the recipient or, in the case of a family home on the lake, is likely to stay in the family for generations, said Sanford J. Schlesinger of Kaye, Scholer, Fierman, Hays & Handler, a law firm based in Manhattan.

But people who have some warning of their deaths, usually because of terminal illness, can easily circumvent the limitations on tax-free gifts, said Jonathan G. Blattmachr, who represents hundreds of the richest families in the United States for Milbank, Tweed, Hadley & McCloy, a law firm based in Manhattan. They can borrow against their assets and give cash or new securities bought with the borrowed money to heirs.

Consider someone with a $100 million estate, all of which is appreciated property. By borrowing $90 million and then giving away the borrowed money at death, the heirs would owe no taxes. The original property could then be given to a charity, which would sell the bequest to pay off the $90 million loan and keep the $10 million balance.

Retirement Accounts

The tax-law changes, combined with new I.R.S. rules, create opportunities to avoid or defer taxes on money inherited from retirement accounts. These accounts are not governed by wills, so their transfer must be coordinated with a will to achieve maximum tax savings.

Ed Slott, an accountant in Rockville Centre, N.Y., who publishes Ed Slott's IRA Advisor newsletter, recommends dividing retirement savings into several Individual Retirement Accounts and designating a different heir for each. Under the new I.R.S. rules, money can be moved back and forth among these accounts, without incurring taxes, so that each heir receives exactly the amount exempted from estate taxes. These allocations should change annually as the exempt amount rises to $3.5 million in 2009 from $1 million next year.

Even after you die, your children and grandchildren can split an inherited I.R.A. themselves. If it is a conventional I.R.A., each heir would pay taxes on the money only as they withdraw it. With a Roth IRA, withdrawals are tax- free. Heirs, however, must divide the money into separate accounts before the end of the year after you die. If they miss that deadline, the deferral will be limited to the life span of the oldest heir.

The best new device, Mr. Slott said, is a rule allowing a spouse to reject his or her share of the retirement account within nine months after being widowed. If that is done, those who were named as contingent beneficiaries get the account instead and can make withdrawals over their lifetimes.

Remember, beneficiaries of these retirement plans are not determined by a will, but by the documents governing each account. This means that the will must be coordinated with the retirement accounts to get the maximum tax savings.

If you want to ensure that your grandchild, upon reaching adulthood, does not cash in his inherited account and spend it all on a sports car, you can create a trust for each beneficiary that governs withdrawals, said Seymour Goldberg, an accountant in Garden City, N.Y.

Family Gifts

Congress lets individuals make gifts of up to $10,000 a year to as many different people as they want. Couples may give twice as much. Larger gifts are subject to gift taxes, but those levies are not due until the donor has used up his lifetime exclusion. Next year, this limit will rise to $1 million, from $675,000, and stay there even during repeal of the estate tax and after it is resurrected.

Individuals who can afford it, and who want to, should make additional gifts up to the $1 million limit, said Sherman F. Levey, the senior estate partner at Boylan, Brown, Code, Vigdor & Wilson, a law firm in Rochester. Gifts above the tax-free limit are generally unwise, he said, because of the uncertainly about estate-tax repeal.

Charitable Gifts

Until the estate tax is fully repealed in 2010, people should rely on their conventional Individual Retirement Accounts as their first source for charitable giving, because the balance is subject to the estate tax and withdrawals are taxed as income, said Alan Halperin, an estate tax specialist at Stroock & Stroock & Lavan, a law firm in Manhattan. Donating these assets to charity "avoids both income and estate taxes," he said.

Roth IRA's are not attractive for charitable giving, he added, because withdrawals from those accounts are free of income tax.

If the estate tax is repealed as planned, accountants and lawyers say they will advise clients to donate money while they are still alive, and thus able to deduct their gifts from their income taxes.

Repeal of the estate tax would also make charitable remainder trusts more attractive for the charitably inclined, Mr. Halperin said. These trusts allow the donor to take an immediate income-tax deduction, avoid capital gains taxes on highly appreciated assets, receive a stream of income for life and then leave a charitable bequest.

Medical Care

As cold as it may sound, some people who expect inheritances have already asked tax lawyers about the cost and the legality of keeping a rich relative who has been declared brain dead on life support until the estate-tax repeal takes effect in 2010. Others have asked about terminating life support for a wealthy relative as that year draws to a close.

Mr. Blattmachr said wealthy individuals should carefully review the documents they have signed governing health care and life support in case they become incapacitated. The goal is to ensure that their wishes, not those of greedy relatives, prevail.


Many people buy life insurance and put it into a trust so that their children can receive the proceeds tax-free as a replacement for money paid in estate taxes. Small businesses also use insurance to pay estate taxes and buy out the heirs of partners who die. Second-to-die life insurance, which pays off when the surviving spouse dies, is inexpensive and yet exceptionally profitable for insurers.

Estate-tax lawyers disagree about whether to buy such policies, continue existing ones or let them drop. The most cautious advice is to keep existing policies, because Congress may change its mind about repealing the estate tax, and future illness may make it impossible or prohibitively expensive to buy the same insurance later.

People who have sophisticated strategies in place to pass along wealth before the scheduled repeal, such as Grantor Retained Annuity Trusts and Qualified Personal Residence Trusts, may want to keep their insurance until these transfers are completed.

That way, if the benefactor dies before the gifts are disbursed, a process that could take 20 years, the insurance payout can still help the heirs pay whatever estate taxes are still due.

Falling (and Rising) Taxes

The highest federal estate-tax rate, paid on estates of more than $3 million, falls next year to 50 percent from 55 percent. The rate then falls by one percentage point annually until it reaches 45 percent in 2007.

But in 2004, a special exemption for family-owned businesses will cease to exist. That will mean higher estate taxes through 2009 for some wealthy Americans. (Special exemptions for working farms will continue.)

Further complicating the issue, Congress decided to undo the careful coordination of federal and state estate taxes, by limiting the credit for state-level taxes.

New Yorkers, for example, can apply only part of their state-level estate taxes to offset the federal levy. In the most extreme example, in 2004, on estates valued at more than $10.1 million, New Yorkers will pay 48 percent to the federal government and an additional 12 percent to the state, for a total of 60 percent, instead of the 55 percent total had the law not changed. Similar tax increases will affect those who die in most other states.