The Death Tax Not Gone 

The death tax? Sounds funny, but it’s anything but.  There are still a great number of questions about estate taxes.  Unfortunately, many people believe the sound bites that have pronounced the death of the death tax.  These have been greatly exaggerated, to say the least. 

Many people have the mistaken impression that the federal estate tax has been repealed. In reality, the impact of the tax is being substantially reduced over the next few years, though in 2010 the tax will be “repealed” for a single year. In 2011 it is scheduled to return with all its old force.

Death Taxes Still Live

As a result of the Economic Growth and Tax Relief Act of 2001 (“the Tax Act”), federal estate taxes will decrease between now and 2010-the top marginal estate tax rate is gradually lowered from 55 percent to 45 percent, and the amount of money that can be transferred tax-free gradually rises from $1 million in 2002 to $3.5 million by 2009. 

There is no federal estate tax if someone dies in 2010, but a “sunset” provision of the Tax Act basically repeals all its provisions after the end of 2010. As a result, in 2011 the federal estate tax will be back with a top marginal rate of 55 percent and an exemption equivalent amount of $1 million. 

Of course, Congress could always act to extend the repeal beyond 2010, but a more realistic question is whether opponents of the whole idea of repeal of the “death tax” might be successful before then in overturning the main provisions of the law.  

These are issues that most Americans are not familiar with but any competent elder law attorney or estate attorney deals with every day.  While it is important that anyone create a will, people with moderate to large estates need to be sure that they regularly engage an estate planning attorney who does a complete review of their finances to determine what changes have occurred and how they are affected by any changed tax law.

Keeping Wealth Intact

As Congress fights openly over the future of the tax, more people are becoming conscious of estate taxes and their potentially devastating impact. As trillions of dollars will be passing between the generations over the next few years, people want estate-planning arrangements that will help maintain the value of their estates so they can pass on more of their wealth to their heirs.

In short, estate taxes-both federal and state-can cripple an estate unless there is a mechanism in place to pay them. That’s where second-to-die life-a policy expressly designed to pay estate taxes may play a unique role. 

The basic feature of a second-to-die life insurance policy is that two deaths must occur before the death benefit is paid. Because the death benefit is not payable until two people die, the annual premium is much smaller; permitting a much larger face amount for the same premium outlay compared to individual life insurance policies on each of them.

What makes a second-to-die life policy a potential fit in paying estate taxes is the marital deduction, which permits a husband or wife to leave an unlimited amount of property to the survivor completely free of federal estate tax. 

Regardless of the size of their estates, the tax of the first to die can always be reduced to zero. Unless the estates are relatively small, zero taxes upon the first death will often result in a much higher tax when the second person dies.

This isn’t to say that a second-to-die policy is for everyone.  As with various trusts and other financial planning mechanisms, each is created with certain advantages and disadvantages.  Your estate planning attorney will recommend the most appropriate tax vehicles for your individual situation and circumstances.

EVERYONE WANTS TO SAVE TAXES, BUT ONLY UP TO A POINT. While a husband and wife may want to take maximum advantage of the marital deduction upon the first death, they may not like the idea of having to set up a trust arrangement to hold about half of their total assets during the survivor’s lifetime in order to save taxes at his or her death. 

At best, the survivor would only have limited control over these assets, even as to business interest or real estate in which both took a great deal of interest during their joint lifetime.

MAINTAINING FULL CONTROL. Rather than use such tax-sheltering devices, they may prefer to leave everything to each other outright, even if this increases the estate taxes due upon the second death. 

They may like the idea of a trust to manage the assets after both of them are gone and the children are still young-but not for each other. 

Recognizing that this will probably increase the total estate taxes substantially, they provide the additional cash that the estate may need by taking out a second-to-die life insurance policy.

Although a second-to-die policy by itself won’t avoid or save estate taxes, it will provide cash to pay the taxes in an economical and efficient way. 

With this approach, parents can be assured that what they had hoped to pass on to their children and grandchildren will be used for that purpose.

Tax-Sheltering the Tax Money

Simply buying such a policy is not enough; the parents want to be sure that the death proceeds won’t be subject to tax in either estate. 

Otherwise a policy with a $1 million death benefit, for example, would have an after-tax value of only $500,000 if the survivor’s estate is in a 50 percent tax bracket.

But if you set up a properly designed irrevocable trust and the trust buys the policy, the death benefit won’t be taxed in either estate. 

One way to do this is to have the trust agreement authorize, but not direct, the trustee to use the death benefit to purchase assets from your or your spouse’s estate, or to lend money to these estates. Thus, if cash is needed to pay taxes, the death benefit will be available to the executors without being taxed.

AN IRS RULING. A recent private letter ruling suggests another way to accomplish this. Here, the trust agreement, also involving a second-to-die policy, provided that the trustee was not required to pay any amount of the estate taxes of the spouse (the one who died last) or use the life insurance death benefit to satisfy the spouse’s debts or obligations. 

The trustee, however, was given the discretionary power to pay the estate and other taxes and estate expenses of either of them, but it was under no compulsion to do so.

In its ruling the IRS stated that the insurance proceeds were not subject to tax because they were not received by the executor of the estate nor was there a legally binding obligation on the trustee to use them for the benefit of the estate. (PLR 200147039). 

Since this is a private letter ruling, it is binding on the IRS only as to the taxpayer who requested it; nevertheless, such rulings are usually indicative of the position of the IRS.

Setting up the trust agreement requires careful planning with your attorney. Keep in mind that since the agreement must be irrevocable, one you fix its terms you cannot change them.