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Estate tax takes less of a bite – but planning now is still critical
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Starting in 2009, you can leave $3.5 million to your heirs before the federal estate tax kicks in – up from $2 million previously. And in 2010, the estate tax is slated to be repealed altogether.
But contrary to what some people think, that doesn't mean you don’t need to worry about estate planning!
This is true for three reasons:
Reason #1: Unless Congress changes the rules, the estate tax will return with a vengeance for anyone who dies in 2011 or beyond.
At that point, the amount people can leave to their heirs tax-free will be reduced back to $1 million in most cases (the same as it was in 2001). Even worse, the maximum estate tax rate will increase at the same time from the current 45% to 55%.
That means careful planning is more important than ever, because the consequences of not planning carefully will be magnified greatly in 2011. And you don't want to wait until then to start, because many successful estate planning techniques take time to implement.
Reason #2: While the estate tax is scheduled to disappear in 2010, the "step-up in basis" will disappear at the same time. So even if someone dies in 2010 and there's no estate tax, the person's heirs could still face a huge capital gains tax that could be reduced with some thoughtful planning.
Here's why: Suppose Fred bought shares of stock many years ago for $100,000. Today they're worth $600,000. He wants to leave those shares to his daughter Jane. If Fred died today, the value of those shares would be included in his estate, and the estate might be subject to the estate tax. However, when Jane receives the stock, her "basis" in the stock will be "stepped up" to the current value of $600,000.
Now suppose Fred dies in 2010. There's no estate tax – hooray! However, Jane inherits the stock with a basis of only $100,000. That means that if she sells the shares, she'll have a capital gain of $500,000, on which she'll have to pay capital gains tax.
In other words, in many cases the repeal of the estate tax could result in more taxes, not less. In fact, a House Ways and Means Committee report suggested that in 90% of cases, the net tax burden on a family will increase
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rather than decrease in 2010.
Of course, Congress might change the law before this happens. There have been many estate-tax proposals circulating in the House and Senate. But we don't know for sure what Congress will do.
In case Congress doesn't act, there are steps you can take to deal with the capital gains problem. For one thing, under the current law a stepped-up basis can be assigned to $1.3 million of assets (plus an additional $3 million of assets going to a surviving spouse). If you're leaving more than $1.3 million to heirs other than your spouse, you might want to consider carefully how to allocate this $1.3 million step-up. Ideally, you'll want to apply it to assets that have appreciated the most in value and that your heirs are most likely to want to sell.
(This gets even more complicated because certain types of assets, including property given to you within three years of death by someone other than your spouse, are not eligible for the step-up. And since you don't know exactly when you'll die, it may be hard to know whether an asset was given to you within three years of death.)
You might want to create different provisions in your will regarding who gets what assets if you happen to pass away in 2010, because in that one year an asset with a high basis is worth more than an asset with a low basis. You might also want to reconsider which assets you plan to donate to charity.
Reason #3: Estate planning is about a lot more than saving taxes. It's about protecting yourself as you grow older with a health care proxy or power of attorney. It's about protecting your heirs against financial mistakes and creditors. It's about making sure your assets are distributed the way you want them to be, and reducing headaches and conflicts for your loved ones.
Ultimately, it's all about peace of mind for you and your family.
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How to leave a vacation home to your children
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You might think it's easy to leave a vacation home to your children in your will. But there are many issues that can arise. For instance, over time children might squabble over who will pay for major repairs or renovations, especially if some children use the property more than others. Children might disagree about whether to sell the property. And there are tax, liability and asset protection issues and opportunities as well.
If you haven't thought a great deal about how a vacation home fits into your estate plan, we can help you come up with a plan that best fits your family's needs, both now and down the road.
There are many ways to handle a transfer of a vacation home:
• You can sell the home to your children before you die, if you reach a point where you no longer want the responsibility of ownership. However, this could result in hefty capital gains taxes.
• You can leave the home in equal shares to your children in your will. But this can lead to arguments between the children over handling major expenses that come up in connection with the property, particularly if some children are financially better off than others.
• You can leave the home to a trust. This can be a good idea because you can create rules for the children's use of the property, contributions to maintenance and expenses, etc. Also, a trust can help shield the property from creditors if one child runs into financial difficulties.
• You can put the home into a limited-liability company or a limited-liability partnership. This requires a more formal corporate-type structure than a trust, but in some cases this can be a good thing. Also, an LLC or LLP can limit the children's liability. For instance, if a child brings a friend to the property and the friend slips and falls and has a serious injury, the child's liability might be limited to the value of the property.
• You can put the home into a "Qualified Personal Residence Trust," or QPRT. Basically, you give the home to your children, but retain the right to use it for a set term. This can help reduce your gift tax, because although you are making a gift of the home to your children during your lifetime, the value of the gift isn't the full value of the home – it's the value of the home minus the value of your right to live there for whatever the term is. The only problem with a QPRT is figuring out what the term should be. A longer term will produce more tax benefits, but you don't want to make it too long, because if you happen to die before the term is up, then all the tax benefits will be lost.
Another issue is what rules and provisions you can make for the home that will prevent problems from arising in the future.
One question is whether all your
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children really want a share of the home. If one child isn't very interested in using it, or plans to move to another part of the country where he or she won't have much opportunity to use it, that child might prefer to have the home shared by the other children and to receive other assets from you instead.
If children are very enthusiastic about using the home, you might want to place a limit on how much time any one child can spend there. You might want to require that a child give notice, such as two weeks or one month, before using the property, so other children get a fair chance to use it as well. You might even want to specify who gets to use the home at different holidays.
As for expenses, you might provide (or ask the children to agree) that expenses will be divided equally among the children, or apportioned according to who uses the property more.
Another idea is for you to establish, with a gift or bequest, an endowment that will pay for taxes, insurance and repairs. Such an endowment could be in the form of a trust that will be funded with the proceeds of a life insurance policy.
In case one child no longer wants to use or pay for the property – or runs into financial problems and has creditors who want to attach it – you can provide that the other children have the right to buy his or her interest.
If you do so, it's wise to come up with a procedure to value the property so this doesn't become a bone of contention between the children. One idea is to get two appraisals – one from an appraiser hired by the buying children (or the trust or LLC), and one from an appraiser hired by the seller.
You can simply provide that the sales figure will be the average of the two appraiser's numbers. Or, if the numbers are wide apart (say, more than 10%), the two appraisers can select a third appraiser and that appraiser’s number will be binding.
If it's important to you, you might want to include a financial disincentive to selling the property outside the family.
Realistically, though, by the time the third generation takes control of the property, the family may well be far-flung geographically and less interested in the home. Often, a smaller group of family members will want to buy the property from the others, so it's a good idea to include provisions that make this as easy as possible.
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Gift tax exclusion increases to $13,000 in 2009
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The amount that you can give to someone without having to pay the federal gift tax has been increased to $13,000 a year, effective for 2009.
The previous maximum was $12,000 a year.
Many people will want to take advantage of this new limit to increase their annual giving as part of their estate plan.
The limit is the amount that any one person can give to any other person. So
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for instance, if a married couple has three children, each spouse can give each child $13,000 in 2009. That's a total of $78,000 that can be transferred to the next generation completely tax-free each year.
You can increase this total further with gifts to sons-in-law, daughters-in-law, grandchildren, etc.
The change is the result of an inflation adjustment by the IRS.
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Family limited partnership saves family $120,000
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If you've been wondering how a family limited partnership can save your family taxes, here’s a good example.
Bianca Gross was a widow who invested in stocks. She had two daughters. She decided to create a family limited partnership, in part so she could involve her daughters in her investment decisions and teach them about investing.
Bianca became the general partner, and the daughters became limited partners. Bianca had complete management control over the partnership, and the daughters were not allowed to sell their shares or dissolve the partnership.
After the partnership was created, Bianca contributed a little over $2 million worth of stocks to it. Eleven days later, she gave away about 45% of her partnership interest, divided into equal shares for the two daughters. Each daughter in effect got about $480,000 worth of stock.
However, when Bianca filed her gift tax return, she listed gifts to each daughter of only $312,500. Why? Because she "discounted" the value of the stock by 35% to reflect the fact that the daughters didn’t receive it outright. Instead of receiving stock that they could immediately sell, the daughters received partnership interests that they couldn't sell, reflecting assets over which they had no control.
The IRS disagreed. It said Bianca had really just made an indirect gift to the daughters of the full $480,000, and it demanded an additional $120,000 in taxes.
But the U.S. Tax Court sided with Bianca. It said what she did was proper and a legitimate transaction.
Among other things, the court noted
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that 11 days passed between the time the stocks were given to the FLP and the time the FLP interests were given to the daughters. During that time, it said, the value of the stocks could have changed considerably, so it wouldn't be proper to consider the two gifts simply as one indirect gift.
(The court did note that if Bianca had done the same thing with an asset that wasn't likely to change in value in 11 days, such as a long-term government bond, the result might be different.)
This case is a good example of how a family limited partnership can enable you to transfer assets to your children while saving taxes.
Of course, creating a family limited partnership requires some effort. You have to legally create a partnership and follow the partnership rules. You need to have some legitimate business purpose (such as Bianca's purpose of teaching her daughters about investments). And you can't just put all your assets into the partnership, because it must be a "real" partnership – you can't "dip into" it for personal expenses.
But if you’re willing to observe the formalities, an "FLP" can be a great way to reduce gift and estate taxes – and perhaps pass along some valuable business or investing know-how at the same time.
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This newsletter is designed to keep you up-to-date with changes in the law. For help with these or any other legal issues, please call our firm today.
The information in this newsletter is intended solely for your information. It does not constitute legal advice, and it should not be relied on without a discussion of your specific situation with an attorney.
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