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The Economy and Changes in Federal Estate Tax Exclusion: Effect on Your Estate Plan

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Charles A. Janssen
Foster Swift Estate Planning Insights
January 2009

The year 2008 was financially turbulent. The major stock market indexes recorded a decline of over 40%. With the collapse of the stock market, many individuals find themselves entering 2009 with significantly diminished personal wealth.

Increased Exclusions

The new year also brings an increase in the federal estate tax exclusion. Under federal tax law, each individual can transfer a certain value of property free from federal estate tax at death. This is commonly referred to as the “applicable exclusion amount” or “estate tax exclusion amount.” Pursuant to federal tax legislation enacted in 2001, the estate tax exclusion amount increased from $2 million to $3.5 million on January 1, 2009. The federal estate tax is scheduled to disappear completely in 2010, and then return in 2011 with an estate tax exclusion of $1 million. However, most commentators expect Congress will revise the estate tax in 2009 to preserve the federal estate tax with a continued estate tax exclusion of $3.5 million. The dramatic decline in personal wealth and the significant increase in the estate tax exclusion amount may affect a considerable number of estate plans. In light of these changes, you could benefit from reexamining your current estate plan.

Simplify Estate Plans Where Estate Tax is No Longer a Concern

The increased estate tax exclusion amount, coupled with the overall decline in net worth, could eliminate or significantly reduce the potential estate tax considerations for many individuals. A modification to such an individual’s estate plan may be appropriate to eliminate unnecessary estate tax savings provisions from his or her revocable trust. The cost of administering a more complicated estate plan, while worthwhile if it results in estate tax savings, may not be worthwhile if the total asset value is no longer over the estate tax exclusion amount.

For example, a married couple with a combined estate of $2.5 million may have created separate revocable trusts in order to achieve maximum estate tax savings at their respective deaths. These trusts would typically provide for the creation of a “family trust” (or “credit shelter trust”) on the death of the first spouse to die. Even if the value of their combined estate was not diminished by the recent economic crisis, their estate may now be well below the increased estate tax exclusion amount of $3.5 million.

Alternatively, a married couple who had a combined estate of $4 million may also have created separate revocable trusts. Following the recent stock market decline, the couple’s combined estate could now be less than $3 million, below the increased estate tax exclusion amount and fairly certain to stay below the estate tax exclusion amount in the future. In each of these examples, without changes to their estate plan, the surviving spouse would incur the unnecessary expense of funding and administering the family trust, including the expense of accountings and income tax returns. Each couple should strongly consider updating their plan to use a “joint trust” for the husband and wife.

Rethink General Bequests or Devises

Some individuals utilize general bequests to transfer specified dollar amounts to individuals or charities (e.g. “I give to my daughter ten thousand dollars ($10,000)”). This money is paid from the general estate before fulfilling any residuary bequests.

For some individuals, the use of general bequests or the amount of a general bequest may no longer be appropriate. With reduced asset values, a general bequest may be more generous than intended and may leave a smaller amount than intended for residuary beneficiaries. For example, an individual who had an estate of $1.15 million in 2007 and who left $150,000 to her favorite neighbor (a general bequest) and split the residue between her 4 children, would have left each child with $250,000. However, recent market conditions reduced her estate to $700,000. Her neighbor would still receive the full $150,000 general bequest, but each child would now receive only $137,500, which is less than the neighbor. In this situation, the individual may want to reconsider using a general bequest or lessen the amount of the general bequest.

Consider Exposure to Creditors

This economic crisis has increased the risk that individuals may go through bankruptcy, foreclosure, divorce, or other issues. For example, tough economic times may reveal to parents a child’s fiscal irresponsibility. This could create a concern that an outright distribution would be quickly dissipated by the child or by creditor claims, thereby jeopardizing the child’s long-term financial security. Instead, perhaps for this child a bequest in trust with a proper spendthrift provision would be more appropriate. Michigan law permits use of a spendthrift provision so that creditors of a trust beneficiary generally cannot reach trust assets before the asset is actually distributed to the  beneficiary.

Similarly, those estate plans that include a family LLC should be reviewed to ensure that both the LLC and the individual members are adequately protected if a member goes through bankruptcy, foreclosure, divorce, or dissolution. For example, as part of an existing or prior gifting plan, parents may have gifted interests in a closely-held family business to their children. If any child is forced to seek protection under bankruptcy laws, it could result in undesired involvement of the closely-held family business in bankruptcy proceedings.

Therefore, consider reviewing the bylaws, buy sell agreements, or operating agreements of the closely-held family business to ensure adequate protections are in place (e.g., options to purchase the bankrupt member’s interest, right of first refusal for transfers of interests).

Increase Funding of Separate Trusts to Maximize Estate Tax Savings

As a result of the increase in the estate tax exclusion amount in 2009, a married couple can now pass a total of $7 million in wealth free of estate tax, but only if they have properly created and funded a revocable trust for each spouse. Married couples whose combined estate is still valued over the $3.5 million estate tax exclusion amount should consider whether the increased exclusion amount requires additional funding of each separate trust in order to maximize estate tax savings.

For example, a husband and wife who previously funded their respective trusts with $2 million each should now seek to fund each trust with up to $3.5 million, if possible, to maximize estate tax savings under the increased exclusion amount. If each trust is funded with $3.5 million and one spouse dies in 2009, then his or her exclusion amount would be fully utilized. The additional $1.5 million of funding in the deceased spouse’s revocable trust would result in $675,000 or more of estate tax savings upon the subsequent death of the surviving spouse, based upon an estimated marginal estate tax rate of 45%. The recent economic crisis may also have caused the separate trusts to be funded improperly. For example, a husband and wife may have previously funded each trust with equal value, but with different types of assets (e.g., one with real estate, the other with mutual funds).

The assets in the husband’s trust may have declined in value more than the assets in the wife’s trust. The value of husband’s trust may now be under the estate tax exclusion amount, while the value of the wife’s trust may still be above the estate tax exclusion amount. In this situation, the couple may want to consider additional funding for the husband’s trust, which could include transferring assets from the wife’s trust to the husband’s trust.

Consider Gifting Opportunities

A silver lining to the recent economic storm cloud may be found in the historically low interest rates combined with drastically reduced asset values. For example, the January 2009 section 7520 rate is the lowest it has been in 20 years and almost half of last year’s rate: 2.4% compared with 4.4% in January 2008 (see the chart below). The annual gift tax exclusion amount (the amount an individual may gift each year to each recipient) also increased on January 1, 2009, from $12,000 per recipient to $13,000 per recipient. The combination of the low interest rates, higher exclusion amount, and declining asset values presents a unique opportunity for individuals whose assets are still well above the estate tax exclusion amount. An individual can decrease his or her net estate to limit estate tax exposure by transferring more appreciable assets out of the estate through lifetime gifting strategies. Lower 7520 rates allow for more leverage in transferring money out of an estate. Consequently, the economic conditions have created an ideal situation to consider utilizing sophisticated estate planning devices devises, such as a grantor retained annuity trust (GRAT) or an intentionally defective irrevocable trust (IDIT).

To determine how the economic decline and the increased estate tax exclusion may impact your specific estate plan, please do not hesitate to contact us.