Most Estate Taxes Can Be Avoided

Most people don't like paying taxes during their lifetime, so the idea of paying them after death can be particularly loathsome.

Yet the 84-year-old estate tax remains firmly entrenched in the federal tax code, surviving numerous repeal efforts over the years. This year, the 106th Congress actually voted for a 10-year phase-out of the unpopular tax, but failed to muster the votes necessary to override President Clinton's veto.

The issue strikes a nerve with people who think the estate tax — or "death tax," as its opponents call it — is fundamentally unfair, that it's double taxation at extremely high rates, and can devastate a family-owned business or farm.

Defenders, however, claim the tax keeps too few from having too much, and that of all the taxes that should be repealed, this one is low on the list of priorities.

Whichever side one comes down on, the truth is much or all estate tax can be avoided.

"Really, that's why it needs to be changed, because you can get around it with proper estate planning," said Matt Morrison, district manager for American Express Financial Advisors. "So it's really a tax on the uninformed, and that's not very fair."

Only 2 percent of American families are faced with the tax, but polls show that 70 percent of Americans oppose it. There can be no doubt that the pressure to repeal the tax will remain strong, Morrison said. His company estimates that between $7 and $9 trillion will be passed from one generation to the next over the next 20 years. Some estimates put that figure as high as $17 trillion.

"What you're seeing is some huge transfers of assets to the baby boomers that's going to cause some tremendous tax problems," Morrison said. "That's why you hear a lot of squawking."

War Revenue

The estate tax has a long history in this country. Initially it was used as a temporary revenue generator during times of war. The latest version was initiated in 1916 to fund World War I, and then kept on the books to prevent the concentration of wealth.

Technically, every estate is taxable, ranging from 18 percent for a $10,000 estate to 55 percent for $3 million or more. However, every individual qualifies for a $675,000 "unified credit," which exempts that amount from taxation. Under the Taxpayer Relief Act of 1997, this lifetime exclusion will increase to $1 million by 2006.

From a practical standpoint, all estates under the $675,000 mark are currently exempt from estate taxes. All those above $675,000 are taxable beginning at a rate of 37 percent.

While heirs may feel that they are paying the tax, technically they're not. The estate is taxed before any inheritance reaches a decedent's children, or other survivors, and is due nine months after the date of death.

For years, members of Congress have tried to eliminate estate taxes. In the past two years alone, five measures were introduced to either modify, phase out or immediately repeal the tax.

H.R. 8 — legislation to phase out the tax over a 10-year period, was passed by both the House and Senate this past year, but was vetoed by President Clinton on Aug. 31. On Sept. 7, an effort to override the veto failed by a 274-257 margin in the House.

Sen. Tim Hutchinson, R-Ark., a co-sponsor of the bill, calls the estate tax an "un-American" attempt to redistribute the wealth.

"To me, part of the American dream is you work hard, you save, you invest, you do well, and you pass on your estate to your children," Hutchinson said.

The estate tax amounts to "double taxation," he said, arguing that the money has already been taxed as either income or capital gains. Plus, he said, the estate tax is not a big revenue generator, amounting to only between 1 and 2 percent of the government's total revenue.

Worst of all, Hutchinson said, are the horror stories of families who are forced to sell the family business or farm in order to cover their tax burden. Not only is that bad for the families, but it's bad for the economy, he said.

Others, however, don't agree. Rep. Vic Snyder, D-Ark., didn't support H.R. 8, but supported an alternative proposal that would have immediately cut all estate tax rates by 20 percent and raised the exclusion for family-owned farms and businesses to $2 million per individual.

Snyder agrees with President Clinton's estimate that H.R. 8 would have cost the government more than $675 billion over the next 20 years. No matter how small a portion of the federal government's revenue is made up of estate taxes, that money will still have to be made up somewhere and there are other taxes that should be repealed before the estate tax, he said.

And, he said, of the 2 percent of estates that pay estate taxes, only 4 percent of those are made up of family-owned businesses or farms.

"If we completely eliminate the tax, then it will be a benefit literally worth billions of dollars for a few families in the U.S., not small businesses and family-owned farms," Snyder said.

Snyder also said it's not true that an estate's assets have all been taxed. In many cases, the value of those assets has appreciated tax-free over the years and with no taxes paid on that appreciation, he said.

The future of any repeal efforts hinges largely upon the coming presidential election, Hutchinson said. If Vice President Al Gore wins, it's unlikely the tax will be repealed during the next four years because overriding a veto won't get any easier.

"There's a lot riding on this election and the estate tax elimination is part of it," he said.

Preserving Unified Credit

Regardless of future political considerations, planning ahead today can protect much of an estate from taxes, experts say.

For married couples, the first and most important step is to protect each spouse's unified credit, allowing them to pass up to $1.35 million tax-free to their heirs.

Many married couples simply transfer an entire estate to the surviving spouse when one partner dies. This can be done tax-free through an unlimited marital deduction.

The problem is that the spouse who is still living continues to hold all the marital assets and then at death only qualifies for the $675,000 credit. This means the estate must pay taxes on any amount over $675,000.

To avoid this, couples can set up what's known as a bypass trust or an "a/b" trust. This trust allows a spouse to pass on $675,000 to his heirs while still providing for the surviving spouse.

While the trust is set up for the benefits of the decedent's heirs, it can be structured so the surviving spouse can receive interest income from the trust and have access to the principal to cover "health, education, maintenance and support," said David M. Williams, a senior financial planner with Morgan Keegan.

"Support means she's to be given a roof over her head and a pot of beans," Williams said. "Maintenance is to continue her in the lifestyle to which she's become accustomed."

Once both partners die, the remainder of the estate passes on to the heirs along with the assets maintained in the trust. This way, couples can pass the full $1.35 million to their children.

Give It Away

Another method of avoiding estate taxes is by giving away assets before death, said Ashley Phillips, assistant vice president and trust officer with Firstar Private Client Group in Little Rock. Each individual can pass up to $10,000 a year in cash or assets to an unlimited number of people without being forced to pay estate or gift taxes.

For couples, this means they can pass $20,000 a year to each of their children without having to pay taxes on the gifts.

"If you have three kids and give them each $20,000 a year, that adds up pretty quickly," she said.

If a parent doesn't want to give the money or assets to the children right away, he can set up a trust that limits the children's access to the money during the parent's lifetime. Under law, the children must have a current right to that money, so each time funds are placed in the trust, its beneficiaries must be notified that they have 30 days to access the funds as they choose. Thereafter it becomes a permanent part of the trust.

"But most kids know if they touch that money, they don't get any more," Phillips said.

Individuals can also take advantage of the $10,000 yearly exemption by giving away assets they think will appreciate, Phillips said. For instance, a $10,000 gift in publicly traded stock may end up being worth $100,000 by the time the donor dies, and yet it was transferred tax free.

However, Phillips warns that for capital-gains tax purposes, the tax is calculated using the time that the grantor bought the stock if it's transferred during his lifetime. If devised in a will, the capital-gains tax is calculated based on the time of the grantor's death.

Valuation of Assets

Jack Grundfest, a tax attorney with Mitchell Williams Selig Gates & Woodyard, said the key to reducing estate taxes lies in valuation of the assets. A decedent's ownership interest in assets can be "fractionalized" to reduce their value at the date of death.

An example of this is giving away stock ownership in a family-owned business by taking advantage of the annual $10,000 gift exclusion.

If, at the time of death, the decedent's ownership in the business is less than 50 percent, those shares will be worth less than if he owned a controlling stake in the business because he can no longer force a distribution from or liquidate the company, Grundfest said.

"To the extent that there is a lack of control in the business and to the extent that the interest is non-marketable, the value will be less," he said.

There is also a family-owned business deduction, Grundfest said. Right now, the deduction is $625,000, which when combined with the $675,000 unified credit, gives an individual a total exemption of $1.3 million.

But as the amount of the unified credit goes up through 2006, the family-owned business deduction will be reduced so the total exemption remains at $1.3 million.

Although it's a complex provision, there are two primary requirements to qualify for the deduction, Grundfest said. First, the decedent must own more than 50 percent of the business. Second, the business must account for more than 50 percent of the value of the estate.

"The estate can't be flush with liquidity," he said.

Charitable Trusts

Charitable trusts are another way to avoid estate taxes. One is the charitable remainder trust, which can be established to pay out a fixed income for the grantor or a beneficiary over a set number of years. The remainder of the trust then goes to charity, qualifying the estate for a charitable deduction based on IRS tables that determine the remainder value.

The other is the charitable lead trust. This trust works in much the same manner as the charitable remainder trust, except the charity's interest comes first, Grundfest said.

The trust will pay out to the charity for a number of years and then later its assets will transfer to the decedent's heirs, generally tax free.

"The charitable lead trust provides the grantor the opportunity to return property to his children or grandchildren years down the road," Grundfest said. "There's the possibility that the grantor's beneficiaries may not have the same need for the property now as they might 20 years down the road."