March 1999 Issue



By Alan D. Kahn, CLU, ChFC, CPA, The AJK Financial Group

Most taxpayers are very much aware of the confiscatory nature of our estate tax system. Sometimes the estate tax on large estates approaches 50% to 80% of their value. These rates are exclusive of the 15% pension excess distributions and accumulations tax that was repealed in 1997. Before that, it was even worse.

Nevertheless, it's easier to put off estate planning than to deal with the inevitable--our mortality. What most people don't realize is that the cost of their procrastination is, in many cases, the almost complete devastation of their years of hard work. Many children find that their parents have left the bulk of their estate to an unintended heir--the IRS. Within nine months of the date of death, those incomprehensible, devastating taxes become due. And what do the children say? "How could our parents do this? Why didn't they spend the appropriate amount of time planning their estate distribution scheme, instead of just building and accumulating an estate--within nine months, they gave almost everything to Uncle Sam."

It is often said that the best estate plan is to spend it all. Go on vacations, buy gifts for the children and grandchildren, pay for their college educations, buy those furs and jewels you've always wanted, or just start to give it all away. Yet, how many people are willing to give up control of their assets and risk destitution just to protect their children's inheritance? Not many.

Life insurance will allow the taxpayer to keep total control of her assets and, at the same time, preserve the estate for pennies on the dollar. Estate tax rates can effectively be reduced to 10% or 15% by utilizing life insurance. However, many people say they dislike insurance because they are paying a lot for something they will never see.

What we are trying to do is leverage a portion of the taxpayer's assets through the utilization of life insurance. By placing such insurance in an irrevocable life insurance trust or by having the children own it directly, the death benefit can be passed on to heirs--income and estate tax free. This will provide the liquidity to pay for the estate taxes and allow the bulk of the estate to pass directly to the intended beneficiaries. In effect, the insurance company will pay estate taxes for the cost of life insurance premiums--in many cases this is only 10% or 15% of the death benefit. What was expensive at first, becomes very reasonable nine months after the date of death--when the taxes are due.

The following are some important things to remember when utilizing life insurance to prepay estate taxes:

* Since the estate tax is due upon the second spouse's death, second-to-die insurance should be utilized. This type of insurance is payable upon the second death and is much less expensive than insurance on one life. If one spouse is uninsurable, however, an insurance program can be developed that still makes sense to help preserve the estate.

* A trust or the children should own the life insurance. Otherwise, the complete death benefit may be subject to estate taxes.

* "If it's too good to be true, it probably is." There are many different types of life insurance products. Premiums differ based upon product assumptions and guarantees. Purchases of life insurance should be based upon an educated and informed decision.

* The utilization of life insurance in an estate plan should be viewed as a long-term solution to a long-term problem. The plan should be designed to last an entire lifetime.

* The insurance carrier selected must be financially secure and stable. Ratings from major rating services are a source of evaluation, and the company should be registered to do business in the state of New York.

* The life insurance specialist should be chosen with care. Professional credentials, such as the Chartered Life Underwriter (CLU) and the Chartered Financial Consultant (ChFC) advanced degrees, can help in the evaluation.

Team Approach

An estate plan is an evolving process that should be created and customized to meet specific family needs and goals. The plan should be supported by a team of advisors: a financial planner, insurance specialist, attorney, and accountant. *


By Michael J. Schaffer, JD, CPA, KPMG Peat Marwick LLP

Editor's note: The discussion in this article is based upon a unified credit or lifetime giving exclusion of $625,000, the level established by the Taxpayer Relief Act of 1997 for 1998. The amount of the exclusion increases incrementally until 2006, at which time it will be $1 million. For 1999, the exclusion is $650,000. The calculations using the $625,000 exclusion illustrate the benefits that can be derived in subsequent years.

W ills may contain language which could ultimately cost a family $10,000 to $15,000. However, correcting this problem is usually a simple and inexpensive procedure.

Families with taxable estates of between $625,000 and $1.5 million are most at risk. (A taxable estate includes the family's home, life insurance, 401(k) plans, IRAs, and savings.) These assets can add up very quickly. On August 7, 1997, New York State passed a new law which phases out its estate tax. The New York State estate tax will be completely phased out on February 1, 2000, and replaced by a new tax, which is equal to the state death tax credit allowable for Federal estate tax purposes. Many New York wills, however, have been drafted to maximize Federal and state estate tax savings based upon the prior law. These wills may not contain language flexible enough to deal appropriately with the relationship between the Federal and state estate taxes after the law change. Unfortunately, this may be costly to many families if they do not update their wills.

Under Federal rules an individual may give away or leave $625,000 (for 1998) to anybody he or she wishes without incurring Federal estate tax. Commonly, individuals use this lifetime exemption to fund a trust (a bypass trust) giving an income interest to their surviving spouse with a remainder interest to the children. This effectively removes the $625,000 from the surviving spouse's estate. For a family with $1.2 million, the use of a bypass trust funded with $625,000 will result in tax savings at the death of the second spouse of approximately $225,000. [No bypass trust: tax on $1.2 million = $225,000. With bypass trust, tax on $575,000 = $0.]

Under New York State's separate estate tax regime, a domiciliary (a person who makes their permanent home in New York) who passes $625,000 to a bypass trust at death will incur a tax of $27,000 prior to or after phaseout.

Due to the interrelationship between the Federal and New York statutes, it was possible for a New York State domiciliary to structure her will in such a way that if the individual died in 1998, the bypass trust would have been funded with an enhanced amount of $670,456 without incurring additional Federal estate tax. This would have resulted in additional New York State estate tax of only $2,727 at the death of the first spouse. For a family estate of $1.5 million, however, the additional $45,456 ($670,456­625,000) in the bypass trust would be kept out of the second spouse's estate, resulting in an additional U.S. estate tax savings of approximately $18,000.

Many New York wills have been drafted to automatically fund a bypass trust with the additional $45,456 to take advantage of the savings. The problem occurs when the new law goes into effect on February 1, 2000. If the first spouse dies after the new law goes into effect, passing the additional $45,456 to a bypass trust will cost the taxpayer approximately $17,000 more in state estate tax. This may appear to be a good deal. However, the estate of the first spouse to die must pay the $17,000 within nine months after the death of the first spouse. If the surviving spouse lives for ten years, the $17,000 could have grown to $52,000 (assuming a 10% rate of return). Even after estate tax, the heirs would still receive $32,000. In such cases, it is not worth tax savings of $18,000.

Fortunately, this result is easily avoided. Generally, a review of the will will determine whether there is a problem. If the will has the previously common language, it should be remedied by executing a short codicil. The cost of the revisions should be minimal. *

Eric M. Kramer, JD, CPA
Farrell Fritz

Alan D. Kahn, CLU, ChFC, CPA
The AJK Financial Group

Contributing Editors:
Richard H. Sonet, JD, CPA
Marks Shron & Company LLP

Frank G. Colella, LLM, CPA
Own Account

Lawrence M. Lipoff, CPA
Rogoff & Company, P.C.

Jerome Landau, JD, CPA

James B. McEvoy, CPA
The Chase Manhattan Bank

Nathan H. Szerlip, CPA
Edward Isaacs & Company LLP

Lenore J. Jones, CPA
Jacobs Evall & Blumenfeld LLP

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