Going, Going, Gone?

Estate planning strategies in uncertain times.

WITH UNCERTAINTY ABOUT WHETHER THE ESTATE TAX will actually be repealed in 2010 and the possibility it will return in 2011, CPAs need to help their clients plan carefully to make sure they take maximum advantage of all of the estate tax changes.

THE ESTATE TAX EXEMPTION INCREASES GRADUALLY from 2002 to 2009. Married couples should make sure they arrange their estate plans to take full advantage of tax relief available in the year they die. This means a periodic review of estate documents and having enough assets titled in separate names to use the full exemption.

THE GIFT TAX REMAINS. CLIENTS SHOULD CONTINUE making gifts that fall within the $11,000 annual exclusion and consider other gifts as appropriate. Other more sophisticated techniques such as the grantor retained annuity trust and the family limited partnership could also be useful to some clients.

DESPITE THE APPARENT ESTATE TAX REPEAL, life insurance will remain a critical part of most estate plans. Coverage types however, may change for some clients. Until it’s certain the estate tax is gone for good, CPAs should not recommend clients let existing life insurance coverage lapse.

AMONG THE IMPORTANT TASKS EXECUTORS WILL have is allocating the step-up in basis among beneficiaries in 2010. Executors will have to allocate the general $1.3 million step-up and the special $3 million spousal step-up. Clients should consider naming a corporate executor or trustee instead of a family member.

PAUL J. PIERGALLINI, CPA, CFP, is a vice-president with PNC Advisors in Camp Hill, Pennsylvania, where he is a financial and estate planner. His e-mail address is paul.piergallini@pncadvisors.com . The author would like to thank Lois Fogg, Esq., for her contributions to this article.
ill the death tax!” Supporters used this political slogan to encourage passage of the Economic Growth and Tax Relief Reconciliation Act of 2001—signed into law on June 7, 2001. But was that really the final result? Although the legislation calls for the estate tax to decline gradually through 2009 and be repealed in 2010, the act sunsets unless Congress extends it. That means the estate tax returns in 2011. However, some clients, hearing the word “repeal,” will believe there is no need for any future estate and gift planning. Nothing could be further from the truth.
This situation presents some unique challenges for CPAs providing estate planning advice in the coming years. This article suggests strategies accountants should consider when helping clients understand the implications of the new law and how to minimize the transfer tax bite over the next decade (For more information on the act’s estate tax provisions, see “The Uncertainty of Death and Taxes,” JofA , Oct.01, page 95. )


To briefly summarize what the 2001 act does or does not do with regard to estate and gift taxes, consider the following provisions:

The estate tax is scheduled to be repealed for only one year, 2010, unless Congress extends the repeal or makes other changes before that time.

The exemption amount (the amount of transfers at death free of federal tax) increases gradually from the 2002 and 2003 amount of $1 million as follows:

2004 to 2005 $1.5 million
2006 to 2008 $2 million
2009 $3.5 million
2010 No tax
2011 $1 million

Even with the estate tax repeal, the tax basis of inherited assets will no longer be stepped up to fair market value on the date of death, except for a limited step-up of $1.3 million on selected assets and an additional $3 million on property passing to a surviving spouse.

The act did not repeal the gift tax but rather froze it at a $1 million lifetime exclusion.

Before repeal in 2010, the top estate tax rate on assets above the exemption amount will steadily inch down to 45% in 2009 from 55% today.

Some observers have characterized the new provisions as a “strange new world.” The complexity of the situation is magnified when you consider that at the time of this writing, federal budget surpluses are vanishing as the United States moves into a wartime economy, rendering the 2001 act vulnerable to the winds of political change and economic necessity. Moreover, there will be two presidential elections and four congressional elections by 2011. No one can predict accurately the future political climate. One popular prediction is that future legislation will freeze the estate tax rates and exemptions at some point during the phaseout period. This possibility increases the need for CPAs to encourage their clients to plan for all eventualities.

Exemption Equivalents: 2001 to 2015
Source: Phoenix Life Insurance Co., Hartford, Connecticut, www.phl.com .


With the increasing exemption amounts through 2009, it’s more important than ever for CPAs to advise married couples to make sure each spouse has sufficient assets titled in their own names. (Assets in joint name can’t be used to fund an exemption bypass trust.) Equally important is for the client’s attorney to conduct a timely review of the couple’s estate planning documents. Many married couples have testamentary plans with trusts to be funded by the maximum exemption amount. As that amount increases through 2009, so should the amount of assets the spouses maintain in separate names. This will maximize the assets that can pass to beneficiaries estate-tax-free during the phaseout period. The cost of wasting a spouse’s exemption by not having enough assets titled separately is magnified as the exemption grows over the next eight years. However, the new law may make certain estate planning provisions inconsistent with the testator’s intent, as the following example demonstrates:

Example 1. John and Mary have a $4 million estate with asset ownership split equally. The will of the first spouse to die, with a $2 million estate, passes the full exemption amount to the couple’s children, with the balance passing to the surviving spouse. This allocation will work well in 2002 with a $1 million exemption, leaving the surviving spouse $1 million. However, this allocation could effectively disinherit a surviving spouse in 2006, when the exemption amount reaches $2 million.

With the uncertainty the new law creates, legal counsel may need to review revocable documents such as wills and living trusts more frequently than in the past—as often as once a year during the phaseout period. Clients are free to modify these documents as often as they wish until death, for example, by a codicil or by an amended trust agreement. Clients will need to have their wills address multiple scenarios depending on the estate tax rules in effect at the time of the their death. For example, John and Mary might add a provision to their wills capping the amount passing to their children at $1.5 million regardless of how high the exemption amount climbs.

CPAs may also want to suggest clients make increased use of disclaimer provisions. In well-drafted wills and related documents (such as beneficiary designations for IRAs and other retirement plans) such provisions offer the flexibility of postmortem planning to the surviving spouse or other beneficiaries in light of existing tax laws and circumstances at the time. Disclaimers permit the survivor to disclaim certain assets if it is beneficial to do so based on the laws in effect when the spouse dies or on family needs. Returning to John and Mary, their estate plan could continue to pass the maximum exemption amount to their children, who could disclaim any assets the surviving parent needs.


Congress froze the gift tax exemption at $1 million for 2002 and beyond, thus uncoupling the current unified gift and estate tax system in 2004 (when the estate tax exemption goes to $1.5 million). The top marginal gift tax rate will match the declining estate tax rate through 2009, and then switch to the highest marginal income tax rate (scheduled to be 35% in 2010).

Retaining the gift tax will deter donors from making large transfers of appreciated property to taxpayers in a lower marginal capital gains bracket. While repeal of the federal estate tax means no estate tax on testamentary transfers, a gift tax on lifetime transfers in excess of the gift tax exemption will remain. Therefore, as a general rule, CPAs should advise clients to strive to avoid making gifts that would trigger gift taxes. However, they should continue recommending that clients use the $11,000 annual gift exclusion (up from $10,000 in 2001 based on inflation adjustments), which is unchanged under the act. Developing gift tax strategies that maximize use of the $1 million gift tax exemption will also be important for some clients. In 2002, a client who has already used his or her 2001 exemption amount of $675,000 can give approximately $325,000 more without incurring gift tax. This is the difference between the 2002 exemption and the 2001 exemption ($1,000,000 minus $675,000 equals $325,000.) Such gifts remove both assets and future appreciation from the client’s estate in the event the estate tax is not ultimately repealed.

Because of the gift tax changes, CPAs will find techniques that leverage the lifetime gift exemption—including grantor retained trusts and the family limited partnership—to be popular. A grantor retained annuity trust (GRAT) is irrevocable; the grantor transfers assets to it and retains the right to receive an annuity for a fixed term of years. At the end of that term, the remaining principal is paid to the individual beneficiaries, removing it from the grantor’s estate. The grantor is considered to be making a current gift to the remaindermen of the right to receive trust assets at a specified future date. The amount of the gift is based on the value of the transferred property less the value of the annuity.

A grantor who survives the trust term can realize significant tax savings. The biggest risk of using a GRAT is the possibility the grantor will not survive. If this happens, all or part of the GRAT property might be included in the grantor’s estate for estate tax purposes.

A December 2000 case, A. J. Walton, 115 TC 589 (2000), provides support for creating a GRAT without any gift tax liability. Previously, the IRS maintained it was impossible to “zero out” a GRAT (which happens when the actuarial present value of the right to receive the annuity is equal to the beginning trust principal) because there was always the possibility the grantor might die before the trust expired (Treasury regulations section 25.2702-3(e), example (5)).

In Walton , the Tax Court unanimously held that the retained annuity should be valued for a term of years, not for the shorter of the term or the grantor’s prior death. To zero out a GRAT, the annuity payout rate must be set high enough to result in no gift. Using a zeroed out GRAT eliminates the risk of paying gift taxes on property that will be included in the grantor’s estate if he or she does not survive the GRAT term. A zeroed out GRAT that outperforms the applicable federal rate for gifts over its term (5.6% for February 2002) can result in even more transfer tax savings for the grantor.

Example 2. Milton establishes a GRAT to benefit his nephew. The initial value of the trust principal is $1 million. The IRC section 7520 annuity rate is 6%. To zero out a 10-year GRAT, the required annuity payment would be $135,868. According to IRS publication 1457, table B, the annuity factor for a 6% rate and a 10-year period is 7.3601. Under these assumptions CPAs can compute the required annuity payment as follows: $1,000,000 7.3601 = $135,868.

There are other ways CPAs can recommend clients leverage the lifetime gift exemption. Gifts of family limited partnership interests allow taxpayers to make prudent use of discounts from fair market value that often apply to gifts of such interests. CPAs should urge clients to be cautious in making these gifts, however, because the IRS has raised questions about the magnitude of the discounts. Treasury regulations section 25.2512-3 requires appraisals from independent experts on hard-to-value assets. It is best for clients to assume the IRS will challenge the valuation.


In 2010 the act replaces the current “step-up” in basis for appreciated property transferred at death with a modified “carryover” basis—the lesser of the decedent’s original basis or the property’s fair market value on the date of death. Under the new law if the estate tax repeal takes effect in 2010, an executor can generally step up the basis of assets of the executor’s choice totaling $1.3 million. The surviving spouse is entitled to an additional $3 million in basis step-up. Although no tax would be due at the time of the transfer, the beneficiary would incur capital gains taxes at the time he or she sold the asset. Careful tracking of the cost basis of assets by taxpayers is essential now to prepare for postrepeal carryover basis.

Example 3. At the time of her death in 2010, Donna has an estate composed entirely of marketable securities valued at $4.8 million. Her cost basis is $500,000. If she leaves these securities to her nephew, her executor will be able to increase the cost basis of certain securities (selected by the executor) by a total of only $1.3 million. If Donna leaves the securities to her husband, her executor will be able to increase the cost basis by $4.3 million, eliminating any immediate income tax problems.

CPAs should advise clients to anticipate the impact of the carryover basis in their estate planning documents by leaving their spouse enough appreciated property to make full use of the $4.3 million step-up. For spousal assets to qualify for this provision, the transfer must be either outright or through a qualified terminable interest property (QTIP) trust. (QTIP trusts are used where the decedent wants the surviving spouse to enjoy certain estate assets during the survivor’s lifetime, but also wants to control the ultimate disposition of the property to children or others.) In example 3, Donna could have put her estate in a QTIP trust for her husband with her nephew as the ultimate beneficiary, thereby taking full advantage of the spousal basis step-up.

Personal residence. In 2010 a decedent’s personal residence can qualify for the $250,000 gain exclusion (IRC section 121(d)(9)) if the estate, an heir or a qualified trust sells the home. If the sale takes place within three years after the owner’s death, the qualified seller may be able to use the two-out-of-five-years rule for capital gains exclusion. (The taxpayer’s estate can exclude the gain if, during the five-year period that ends on the date of sale, the decedent owned and used the property as a principal residence for periods totaling two years or more.) Therefore, CPAs may want to advise clients to avoid giving away a home during their lifetime so the house is available to make use of this tax relief.


The generation skipping transfer (GST) tax applies to property transfers made to an individual more than one generation younger than the transferor. The tax rate equals the highest federal estate tax rate. Each individual currently has a GST exemption of $1.1 million (up from $1.06 million in 2001 based on inflation adjustments). In 2004 that exemption goes to $1.5 million and then begins to track the estate tax exemption amount.

It’s important for CPAs to be certain that a client’s testamentary intentions are known and carried out in his or her estate documents. Because of the increasing GST exemption (as with the estate tax exemption) a trust for grandchildren contemplated as a $1.1 million bequest might increase if the client’s current testamentary plan uses a funding formula based on the maximum exemption. If the client continues to use such a formula, the result could be more assets put in trust for the children (and grandchildren, ultimately) than he or she intended.

Example 4. Addison’s will, drafted in 2000, sets aside an amount equal to the maximum GST exemption (currently $1.1 million) for his grandchildren (his so-called “skip” persons). Since the funding formula for this bequest equals the maximum GST exemption, the allowable, or tax-free, amount passing to Addison’s grandchildren will increase to $3.5 million by 2009. This may be more than he intended them to have and, based on the size of his estate, could effectively disinherit his children. If Addison dies in 2010, his grandchildren will get nothing since there is no exemption amount in that year. To avoid these problems, his CPA should advise Addison to reformulate his bequest to leave his grandchildren a percentage of his estate or a specific dollar amount, capping it at the unused GST exemption amount.

CPAs should also remember that generation-skipping or “dynasty” trusts provide useful ways to protect assets for beneficiaries in case of a divorce or a lawsuit by the beneficiary’s creditors. Dynasty trusts can provide incentives to encourage (or discourage) descendants to behave in certain ways. The trust can be written to distribute funds when the beneficiary attains specific goals such as graduating from college with a certain grade point average, earning an advanced degree or pursuing a certain career. The trust also can be written with the flexibility to adapt to changes in the law and to unanticipated changes in family situations.


With so much talk about the death tax repeal, to some clients and CPAs life insurance as an estate planning tool may appear obsolete. On the contrary, the uncertainty concerning complete repeal suggests many estate plans still need insurance support to cover estate settlement costs. It may still be a good idea for clients to make prudent use of life insurance to hedge their bets of either not surviving until 2010 or of living beyond the point when the tax is reinstated. Some practitioners suggest that permanent life insurance is still advisable given the loss of basis step-up on appreciated assets and a potential future income tax to beneficiaries. Letting a client’s insurance coverage lapse may not meet his or her needs if the law’s sunset provisions prevail.

Irrevocable life insurance trusts also may still make sense for some clients, although the type of life insurance product used in the trust may change. Ten-year guaranteed term insurance might be suitable to match the current tax repeal schedule. If the trust uses permanent insurance, it may be prudent for the client to add trust provisions allowing distribution of the policy during the grantor’s lifetime. Such a provision might be carefully drafted to allow the trustee to distribute the policy as he or she determines (but not to the grantor). In addition to being effective in removing life insurance death benefits from an estate, irrevocable insurance trusts also protect the policy proceeds from the beneficiary’s creditors.


It has always been important for CPAs to help clients select the right fiduciary. While most clients typically choose family members, a corporate executor or trustee (such as a bank or trust company) may be better suited to the task of selecting assets to receive the limited step-up in basis after 2010. But where family members often serve without compensation, a corporate fiduciary will charge a fee generally based on estate size.

Unless the decedent’s will provides specific directions, executors will have to allocate assets among different beneficiaries and decide which of those assets will receive a step-up in basis using the general and spousal allocations. Such decisions will have important income tax ramifications. The trustee’s basis decisions will also have an impact on how much a beneficiary receives. An heir who gets $10,000 of stock with a basis of $10,000 will receive his or her full bequest. An heir who gets the same amount of stock with a $1,000 basis could lose nearly $2,000 to income taxes.

If a client decides to name a family member as executor or trustee, the family member may wish to seek professional advice from a CPA or attorney before making these difficult basis choices. CPAs will be able to identify any special income tax situations and advise the executor accordingly. In some cases the fairest decision the trustee can make is to allocate the $1.3 million basis step-up equally among the estate’s beneficiaries.


Under the new law, a client could die in one of three distinct periods: during the phaseout through 2009, upon repeal in 2010 or after reinstatement in 2011. Each period has different rates and exemptions and, accordingly, different planning needs unique to each client. Even if Congress does permanently repeal the estate tax, the need for good estate planning won’t end. The issues will simply change. The effective disposition of assets is the crux of estate planning and will remain the central focus for individuals, their CPAs and attorneys.

With the uncertainty in the 2001 act, CPAs should advise taxpayers struggling with estate planning issues to consider a variety of strategies including: using a revocable document, avoiding gift taxes, maximizing the use of exemption amounts and using disclaimers. The best advice CPAs can give clients during these complex times is to remain flexible. In so doing, clients will be ready for whatever news Congress may bring—good or bad.


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