The Future of Estate Planning – As Laws Change, Focus Shifts to Income Tax, State Taxes

Estate Planner Jan-Feb 2006
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The future of the estate tax may be uncertain, but one thing is clear: Rumors
of the death of estate planning are greatly exaggerated. Permanent repeal of the
federal estate tax seems unlikely, but many experts expect legislators to push for even higher estate tax exemptions, reducing the number of Americans subject to the tax.

Whether Congress kills the estate tax or increases the exemption, the need for estate planning will live on. But its focus will shift from federal estate taxes to other issues, such as federal income taxes and state death taxes.

Income tax planning

For many years, when estate tax rates were high and exemptions relatively low, estate planning revolved around avoiding the federal estate tax. But that’s beginning to change. The Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) lowered estate tax rates and boosted the estate tax exemption from $1 million to $1.5 million for 2004 and 2005, to $2 million in 2006, and to $3.5 million in 2009.

As the estate tax becomes less of a factor, income tax issues take on added importance, turning traditional estate planning techniques on their head. Traditionally, taxpayers strive to minimize the value of their taxable estates to reduce or eliminate estate taxes. But taxpayers who are well within the estate tax exemption may benefit by increasing the value of their estates. Why? Because assets transferred at death receive a stepped-up basis in the hands of their heirs, minimizing the effects of income taxes. Here’s an example:

Jean owns a 35% interest in a business worth $4.7 million. Her daughter and sole heir, Julie, owns the other 65%. Jean’s remaining assets consist of $115,000 in cash and marketable securities. Assuming a 25% minority interest valuation discount, Jean’s interest in the business is worth $1,233,750. If Jean dies in 2006, when the federal estate tax exemption is $2 million, there’s no estate tax liability. Julie inherits Jean’s interest in the business with a stepped-up basis equal to its fair market value, or $1,233,750.

Suppose, instead, that Jean purchases a 20% minority interest in the business from Julie in exchange for a $705,000 promissory note, increasing her stake to a 55% controlling interest worth $2,585,000. When this amount is combined with Jean’s remaining assets and the $705,000 liability is subtracted, her estate is valued at $1,995,000, still within the federal estate tax exemption.

But under this scenario, Julie’s basis is stepped up to $2,585,000. If Julie were to sell the business for $4.7 million, the increased basis would save her more than $270,000 in capital gains taxes, assuming a 20% capital gains tax. Bear in mind that this strategy might cause an increase in state death taxes if Jean lived in a state that has decoupled its estate tax from the federal estate tax.

State estate tax planning

In addition to lowering rates and increasing exemptions, EGTRRA also eliminated the state estate tax credit and replaced it with a federal estate tax deduction for state taxes paid. Before EGTRRA, estates received a dollar-for-dollar credit for estate or inheritance taxes they paid to a state.

Rather than create separate tax systems, most states simply imposed death taxes in an amount equal to the federal credit. These were called “pick-up” taxes because the state would pick up the amount allocated as a credit under federal law. Of the states without a pick-up tax, most had death taxes that were coupled in some way with the federal estate tax and exemption scheme.

But by increasing the estate tax exemption and repealing the state death tax credit, EGTRRA reduced or eliminated the tax revenues collected by a state with the pick-up tax. To make up for these lost revenues, many states have decoupled from the federal tax and established their own estate or inheritance taxes.

This phenomenon affects estate planning in two ways: First, depending on your state’s laws, you may be subject to state death taxes even if you’re exempt from the federal estate tax. And second, the lack of uniformity among state death taxes complicates your estate plan, especially if you own property in more than one state or relocate to another state.

Weighing potential tax consequences

Income tax and state death tax issues aren’t new, but until recently these taxes were generally eclipsed by the federal estate tax. If the estate tax is repealed, estate planning will shift its focus to minimizing income taxes and state death taxes. Or, if Congress retains the estate tax but increases the exemption, estate planning will get more complicated as taxpayers attempt to strike a balance between estate tax and income tax concerns.

To evaluate estate planning strategies, weigh the potential estate, income and state tax consequences, and choose the option that provides the greatest benefits to you and your family.