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The Increase in the Federal Estate Tax Exemption Does Not Eliminate the Need for a Sophisticated Estate Plan

June 2003

By: Jay J. Lander, Esq.

On January 1, 2004 the federal estate tax exemption increased from $1,000,000 to $1,500,000 for each individual. This $500,000 increase represented the largest single increase in the federal estate tax exemption in the history of the tax. Many individuals may wonder whether sophisticated estate planning strategies are no longer required with this generous exemption increase. Some think that a husband and wife each having a $1,500,000 exemption may together avoid federal estate taxes for up to $3,000,000 of assets and therefore why should any family with $3,000,000 of assets or less need a sophisticated estate plan.

The simple answer to that question is that a sophisticated estate plan, comprised of a marital deduction and credit shelter trust is still needed in order to shelter a total of $3,000,000 of family assets. If a family relied upon simple reciprocal wills then on the death of the first spouse the survivor would have a $3,000,000 gross estate with only a $1,500,000 exemption. This would cause $1,500,000 to be taxed at approximately 48% for a total tax of approximately $750,000.

Thus for families with total assets of $3,000,000 it is essential to create a sophisticated estate plan to shelter $1,500,000 from tax on the death of the first spouse, thus reducing the surviving spouse\'s estate to an amount equal to his or her federal exemption and therefore avoiding the federal estate tax in full.

In point in fact, if the family\'s assets are between $2,000,000 and $3,000,000, greater estate tax savings will be achieved in 2004 with a sophisticated estate plan than were achieved in 2003. For example, a family with $2,500,000 of assets in 2003 would still have $500,000 of assets subject to tax on the death of the surviving spouse, resulting in an estate tax of approximately $250,000. Whereas in 2004 the same sophisticated plan would save that additional $250,000 tax.

Arguably the only situation in which a sophisticated estate plan would not be necessary to reduce federal taxes would be in those cases where the entire family wealth was $1,500,000 or less, since a single estate tax exemption would equal or exceed the assets. Even in the situation of a family with assets of less than $1,500,000 however there still could be a substantial Massachusetts estate tax liability to the extent that the total family assets exceeded $850,000. In fact, the excess over $850,000, assuming a $1,500,000 family estate, could produce a Massachusetts estate tax of $50,000, all of which could be avoided with the sophisticated estate plan.

Finally a decision to abandon a sophisticated estate plan because of the $500,000 increase in the federal exemption could turn out to be premature if the clients were to live until 2011 when the federal exemption is scheduled to return to $1,000,000 and the top federal estate tax rate will return to 55%. The above analysis gives no consideration for the possibility that the client\'s assets will increase in value once the sophisticated estate plan has been abandoned thus requiring a reinstatement of such a plan.

In addition to the variables and uncertainties in the federal estate tax law already referred to there are non-tax reasons for maintaining a sophisticated estate plan which is designed to cause substantial assets of the first spouse to bypass the taxable estate of the survivor. Those assets that are sheltered from tax on the second death will in all likelihood be sheltered from the creditors or second spouse of the survivor should he or she remarry. In addition the typical provisions of a credit shelter trust which allow for discretionary payments of income and principal to the family group consisting of the surviving spouse and children or grandchildren would create repeated opportunities for income tax reduction by the distribution of trust income to lower bracket taxpayers such as children or grandchildren.

An irrevocable life insurance trust which has seen great use during the last twenty years in order to provide funds for estate taxes is still an appropriate vehicle for the ownership of life insurance particularly with the possibility of the return of the federal exemption to $1,000,000 in 2011 as well as the possibility of a substantial increase in the value of the client\'s non-insurance assets. The fact that an insurance trust is irrevocable should not pose a problem if the terms of the trust are carefully drawn to reflect the dispositive goals of the family in any event. The typical irrevocable insurance trust provides for the needs of the surviving spouse and upon the death of the surviving spouse for the continued needs of the children and grandchildren for their comfort, maintenance, support and education until an agreed age.

In conclusion, good estate plans drawn to reflect the basic dispositive needs of a family should not become obsolete because of changes in the estate tax law even if such changes result in the elimination of a probable estate tax liability. The continuing need to provide for the client\'s family after death and to assure the management of assets in a prudent and professional manner will continue to be compelling goals of any family with substantial assets.

Many of the other irrevocable gifting strategies that have been used in the past may require a more cautious approach in light of the anticipated estate tax changes as such vehicles do require the irrevocable divestment of control over substantial assets during lifetime. If your estate plan has not been reviewed during the last five years you owe it to your family to undertake such a review in light of both of the federal and state estate tax revisions.