What Price Love? Try $1.75 Million

Think you can’t put a price on love? President Obama and congressional Republicans got together this week and came up with $1.75 million.

Granted, they were not thinking in those terms. They were thinking of the federal estate tax. Last year, the tax was 45 percent on estates greater than $3.5 million. In 2010, there is no estate tax. But in the absence of new legislation, the tax is set to return on New Year’s Day at a rate of 55 percent for estates greater than $1 million.

That would hit a lot of people – not most Americans, but more than the relative handful at whom Democrats and some Republicans want to aim the tax – so there is considerable interest on both sides of the aisle in changing the law. There is also considerable interest in getting rid of the estate tax, but that interest is pretty much confined to Republicans.

So, as part of their bargain to extend the Bush-era income tax cuts for an additional two years, Obama and the GOP negotiators agreed to restore the estate tax (and a separate generation-skipping transfer tax) at the 35 percent rate next year. The rate, which is the lowest since 1931, matches the gift tax rate that took effect this year.

You may be wondering what love has to do with this. To understand, you have to realize one thing: Love often gets in the way of good estate tax planning. Highly trained professionals can accommodate love, but it’s going to cost you.

Under the proposed law, a married couple can pass a combined $10 million to heirs without paying estate tax. That’s enough to keep all but a tiny fraction of households from having to worry about estate taxes, at least until inflation brings down the real value of $10 million. But the married couple has to plan carefully, and avoid what estate planners call the “I love you” will.

An “I love you” will basically says, “I leave everything I have to my darling spouse, because, honey, I love you.” Very touching. Very expensive.

Assume that under the new rules, a couple has a combined net worth of $10 million. The husband dies first and leaves everything to the wife. There is no estate tax at the husband’s death because, as long as the wife is a U.S. citizen, Uncle Sam figures he can wait until both spouses are deceased. A few years later, the wife dies, leaving everything to their children. Her exemption protects $5 million from estate tax. But the other $5 million gets taxed at 35 percent, resulting in a bill of $1.75 million.

In Estate Planning 101 we learn to avoid “I love you” wills, except for couples with very little wealth (because the estate tax exemption can go down as well as up), in favor of more complex approaches such as a “credit shelter trust.” In our example, the husband’s will could have put $5 million in a credit shelter trust that would have remained outside his wife’s estate. His wife and his kids could have benefited from that trust while she still lived, and the trust would have been protected from tax by the husband’s $5 million estate tax exemption. At the wife’s death she would only have owned $5 million, which would have been protected by her exemption. Total estate tax bill: zero. Professional fees to draft the will, handle probate, and run the trust: A lot more than zero, but a lot less than $1.75 million.

Some of the most passionate and articulate defenders of the estate tax are professional estate planners who get paid to do this stuff.

Having set up a sophisticated will, are our hypothetical couple and their offspring protected from the estate tax as the law contemplates? Not necessarily.

Wills only apply to property that is subject to probate. Lots of things are not. Jointly owned property can pass outside a will and automatically become the sole property of a surviving spouse. We can get such property into a credit shelter trust, but only if we correctly execute a procedure known as a “disclaimer” after the first spouse’s death. Make a mistake, and it can cost plenty.

People often have a lot of money in retirement plans that designate the surviving spouse as the beneficiary. This, too, passes outside a will, and can be very tricky to fix. Make a mistake, and it can cost plenty.

People buy life insurance policies to protect their surviving spouses and children. When held in a correctly designed and operated trust, the life insurance benefit is not subject to estate tax. But if you simply buy a policy and designate your spouse or other family members as beneficiaries, you might waste the first spouse’s exemption, or you might consume all or part of the exemption needlessly. Make a mistake, and it can cost plenty.

Businesses, collectibles and real estate can make up a large part of a prosperous family’s wealth. Those assets are not easy to value and, often, not easy to sell. Taxpayers regularly battle the Internal Revenue Service over the taxable value of such assets, with unpredictable results. Sometimes people buy life insurance to provide a source of cash to avoid a forced or untimely sale of illiquid assets to pay estate taxes. (Life insurance companies and agents also are vocal supporters of the estate tax.) Make a mistake, and…you get the idea.

The rule that allows spouses to pass wealth to one another without paying estate tax only applies to people recognized by the federal government as being married. Under the Defense of Marriage Act, same-sex couples cannot qualify, even if they are legally married in the state where they live. Because the gift tax also would apply to transfers between members of a same-sex couple, it may not be possible for a family that builds a net worth of $10 million to pass it all to the children tax-free. Though there are things you can do to mitigate its effects, DOMA can cost you plenty even if you don’t make a mistake.

The estate tax has been called a “voluntary tax” because there are so many planning techniques that can reduce its impact. But the inverse also is true: It is a tax not just on accumulated wealth, but on the structures that most people rely upon in everyday life to organize their affairs and pass on what they have built. It is a tax on thrift, because it penalizes saving and encourages the dissipation of wealth. It is a tax on hypothetical values, because it so often depends on estimates that are unreliable and unrealizable. Just try asking the IRS to accept as payment some of an estate’s assets at the values assigned by the IRS to compute the tax.

It is a tax that sets a price on love. Under this week’s proposal, that price is $1.75 million.

About Larry M. Elkin 525 Articles

Affiliation: Palisades Hudson Financial Group

Larry M. Elkin, CPA, CFP®, has provided personal financial and tax counseling to a sophisticated client base since 1986. After six years with Arthur Andersen, where he was a senior manager for personal financial planning and family wealth planning, he founded his own firm in Hastings on Hudson, New York in 1992. That firm grew steadily and became the Palisades Hudson organization, which moved to Scarsdale, New York in 2002. The firm expanded to Fort Lauderdale, Florida, in 2005, and to Atlanta, Georgia, in 2008.

Larry received his B.A. in journalism from the University of Montana in 1978, and his M.B.A. in accounting from New York University in 1986. Larry was a reporter and editor for The Associated Press from 1978 to 1986. He covered government, business and legal affairs for the wire service, with assignments in Helena, Montana; Albany, New York; Washington, D.C.; and New York City’s federal courts in Brooklyn and Manhattan.

Larry established the organization’s investment advisory business, which now manages more than $800 million, in 1997. As president of Palisades Hudson, Larry maintains individual professional relationships with many of the firm’s clients, who reside in more than 25 states from Maine to California as well as in several foreign countries. He is the author of Financial Self-Defense for Unmarried Couples (Currency Doubleday, 1995), which was the first comprehensive financial planning guide for unmarried couples. He also is the editor and publisher of Sentinel, a quarterly newsletter on personal financial planning.

Larry has written many Sentinel articles, including several that anticipated future events. In “The Economic Case Against Tobacco Stocks” (February 1995), he forecast that litigation losses would eventually undermine cigarette manufacturers’ financial position. He concluded in “Is This the Beginning Of The End?” (May 1998) that there was a better-than-even chance that estate taxes would be repealed by 2010, three years before Congress enacted legislation to repeal the tax in 2010. In “IRS Takes A Shot At Split-Dollar Life” (June 1996), Larry predicted that the IRS would be able to treat split dollar arrangements as below-market loans, which came to pass with new rules issued by the Service in 2001 and 2002.

More recently, Larry has addressed the causes and consequences of the “Panic of 2008″ in his Sentinel articles. In “Have We Learned Our Lending Lesson At Last” (October 2007) and “Mortgage Lending Lessons Remain Unlearned” (October 2008), Larry questioned whether or not America has learned any lessons from the savings and loan crisis of the 1980s. In addition, he offered some practical changes that should have been made to amend the situation. In “Take Advantage Of The Panic Of 2008” (January 2009), Larry offered ways to capitalize on the wealth of opportunity that the panic presented.

Larry served as president of the Estate Planning Council of New York City, Inc., in 2005-2006. In 2009 the Council presented Larry with its first-ever Lifetime Achievement Award, citing his service to the organization and “his tireless efforts in promoting our industry by word and by personal example as a consummate estate planning professional.” He is regularly interviewed by national and regional publications, and has made nearly 100 radio and television appearances.

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