Does Your Will Still Have What It Takes?

For most people, estate planning is a "one of these days" task. That's understandable considering it is time consuming, complicated, and involves lots of tax law. Besides, it forces you to confront an unpleasant inevitability, the last and most serious taxable event in your lifelong relationship with the Internal Revenue Service: Death.

But while you're stalling, events in the here-and-now are making estate planning more important than ever. The Taxpayer Relief Act of 1997 made sweeping changes in the laws governing estate and gift taxes. For example, the new rules hike the amount you can pass on to heirs free from federal inheritance tax. This year promises more skirmishing as President Clinton's desire to squeeze revenues out of some popular planning devices collides with a GOP push to cut the estate tax (table). Throw in some recent IRS rulings, and lawyers and financial advisers agree that now's the time to give your estate plans a checkup.

Start with the basics. Estate planning is a struggle to ensure that your assets go to the recipients of your choice while leaving as little as possible to the heir you didn't choose--the IRS. For most couples, the two main tax shields are the unified credit, which excludes the first $625,000 in an estate's property from federal tax for deaths in 1998, and the marital deduction, which lets unlimited assets pass to a spouse tax-free. A couple's wills are usually drafted so the assets of the first spouse to die are split by a formula: Children or other heirs get as much as can be passed on tax-free under the credit, while the surviving spouse gets the rest. Thus, a man who dies in 1998 with $2 million in assets would leave $625,000 to his children and $1,375,000 to his wife.

But the 1997 law puts the unified credit, which has long excluded $600,000, on an escalator. By 2006, it will shield an estate's first $1 million in assets from tax. So you want to make sure your will takes advantage of the increase. "If you see a fixed dollar amount, that's a red flag," says Mark Watson, an Atlanta-based partner at KPMG Peat Marwick. But couples whose net worth is $600,000 to $1.2 million should be careful. If their wills use the rising credit to determine how assets are split, the first spouse to die might leave too much to children and not enough to support the spouse. These couples might want to place a fixed limit on the first spouse's bequest to children, even if that means passing up some tax savings.

Middle-class couples get an additional break from new IRS regulations. Many of them have been accidentally undermining their estate plans by holding property--especially homes--in joint ownership. That's convenient for the couple but bad for heirs. If the home constitutes a large share of the estate, joint ownership means that ultimately less of the estate will be sheltered. The new regs offer an escape: A surviving wife, say, can "disclaim" her late husband's share of joint property. That share can then be sheltered by the husband's unified credit. "Lawyers who've been hammering on clients not to keep joint property can breathe a sigh of relief," says Pam Schneider, partner at Philadelphia law firm Drinker, Biddle, & Reath.

The '97 law also gives a boost to revocable trusts, which some attorneys say are better than wills for estate planning. The bill removes the stricter IRS limits on deducting charitable gifts made through such trusts, putting them on a par with gifts granted under a will. Revocable trusts, which let property pass on without probate, are popular in states with community property and burdensome probate rules. Now, they may catch on elsewhere.

The law isn't kind to all estate-planning vehicles. It cracks down on charitable-remainder trusts, which let a donor enjoy the income from property that eventually will be passed on to a charity. One big appeal is that CRTs let the donor collect income from stocks or other property that has appreciated in value without paying capital-gains taxes.

The trouble is, tax planners were selling clients on CRTs that produced plenty of tax savings and lifetime income but not much of a charitable gift. The new law says trusts won't qualify for tax deductions unless the designated charity ends up with at least 10% of the trust's initial value. That rule essentially bars donors who are younger than 45--and even some older donors--from setting up new CRTs, says Evelyn Capassakis of accountant Coopers & Lybrand. Owners of existing CRTs must also be careful: If they add funds to their trusts, the plans will become subject to the new standard and may lose their favored status.

Small business was a major force pushing estate-tax cuts in last year's budget battle. But even six months after the law passed, it's unclear whether the main break aimed at smaller firms--an extra exclusion that lets a family-owned business protect up to $1.3 million in assets from estate taxes--is a boon or a bust. The extra exclusion can be worth a lot: A $2 million estate could save almost $304,000 in taxes. But to use the exclusion, it has to clear high hurdles. A business owner's estate can't qualify unless the business' value makes up at least half of the estate, as calculated under a complex new formula. That could rule out many older business owners who have diversified or built up liquid assets in preparation for retirement.

LONG HAUL. Even if an estate qualifies, heirs have a tough decision to make: Unless a family member or, in some cases, a longtime employee runs the business for the next 10 years, the IRS will reclaim the tax break, with interest, from the heirs. "Let's say the daughter agrees to run Dad's business--but she quits after five years," says attorney Schneider. "The widow is left with a tax bill that could be more than the business is worth."

The choice of whether to claim the special exclusion is left to the business owner's executor. But owners should decide whether they want to pursue the option now and structure their succession to meet the rules. "Everybody who owns a business will have to look at it," says Len Mertz, a cattle rancher and CPA in San Angelo, Tex. "But darned few of them are going to get to use it."

Whatever its flaws, the small-business exclusion "places a marker of Congress' intention to relieve family businesses of the death tax," says James Wickett, a tax specialist for the National Federation of Independent Business. Indeed, 1997 may have just been the opening skirmish in a series of annual tug of wars over the estate tax. President Clinton, for one, is trying to crack down on estate plans that his Treasury Dept. sees as abusive. The Administration's budget targets family limited partnerships, which parents use to mark down the value of assets passed on as gifts or bequests to their children. It also takes aim at personal residence trusts, which create similar discounts when parents give their homes to heirs; and "Crummey" trusts, which are often used to pass on large life-insurance payouts.

Family partnerships appear most vulnerable. A parent can place, say, $1 million in stock in a partnership and give each child a limited partnership share. But since the children can't exercise control over the stock, their shares are discounted by as much as 40% for gift or estate taxes. Such plans have exploded in popularity, to the IRS' displeasure. Planners defend the deals and the discounts as valid--but admit that partnerships have been abused. "Greed may kill off something that didn't deserve to be killed," said Harvey Berger of accountants Grant Thornton. As a result, anyone who's considering setting up a family partnership might want to speed up the process, to ensure that the package is in place if Congress changes the law.

Arrayed against Clinton's proposals are powerful lobbies--including the housing and insurance industries. And many Republicans would rather cut or eliminate the estate tax than crack down on tax dodges. Senate GOP Whip Don Nickles of Oklahoma proposes to replace the tax's 17 brackets with two, cutting the top rate from 55% now to 30%, applied to estates of $10 million or more.

Don't count on losing the IRS as your silent heir yet, however. Republicans have many tax-cutting ideas--and of all of them, attacking the estate tax, which is paid by the wealthiest 2% of Americans, probably ranks lowest on the populist scale. But the legislative turmoil guarantees that estate planning will remain in the news--and at the forefront of your financial concerns--for years to come.

Before it's here, it's on the Bloomberg Terminal.