Six years ago, Congress shook up the estate planning world by passing the Economic Growth and Tax Relief & Reform Act of 2001 (EGTRRA).

In brief, the EGTRRA put in place estate tax exemptions that gradually increase over time (from a pre-EGTRRA cap of $675,000 to $2 million in 2007 and 2008, $3.5 million in 2009, and a complete phase-out in 2010). Under current law, the exemption would revert to a base level of $1 million in 2011. For those who want to gift assets while still living, the law allows individuals to give away up to $1 million before transfers are subject to a gift tax of 45 percent.

Those excited about the possibilities of higher estate and gift tax exemptions, however, need to beware of a little-known “take back” that can trigger substantial capital gains taxes. An existing law that allows an estate’s heirs to “step up” the value of inherited property—such as real estate, collectibles or other tangible items—is scheduled to end in 2010.

To illustrate, if someone inherits property originally bought for $1 million that is now worth $3 million, that person would be able to sell it and pay no capital gains tax. But if the change holds, in 2010 that same person would have to settle for the lesser of two things: a step-up in basis limited to $1.3 million or the market value of the property at the donor’s date of death. So, for some situations, the potential hit on capital gains—not estate taxes—could be sizable.

Consider How Assets Can Define a Legacy

Everyone has heard stories of estates that were tied up for years in bitter probate battles or situations where a donor’s final wishes were not translated into the will or trust instrument that guided how assets were distributed. With that in mind, it’s important to first consider key non-tax objectives, including:

• Who should receive the assets? This list may include children, grandchildren or others. It should also take into account how key family values or possessions—such as support for favored cause or the disposition of a family cabin—will be handled after death.
• The grantor needs to decide when the heirs will receive the assets. This will define the financial or legal tools needed so the assets are delivered according to the grantor’s wishes.
• The estate may need to engage a trustee with specific skills or provide funds to ensure the beneficiaries get proper training on handling newfound wealth.

Once those big-picture objectives are in place, an effective estate plan can be designed to weather various tax scenarios. For example, by transferring appreciated assets into estate structures such as family limited partnerships (FLPs) or grantor retained annuity trusts (GRATs), the grantor can effectively reduce the estate’s value for tax purposes. Similarly, charitable gifts to charities or approved non-profits allow individuals to help favored causes while avoiding major tax hits—regardless of potential changes to estate or income tax rates.

There’s a choice between making a charitable gift to Uncle Sam or to people or causes of your own choosing. When you make this kind of gift to a charitable cause, the size of the gift can be unlimited. Many people are choosing to do this with their retirement plans or IRAs because those assets would otherwise be subject to both income and estate taxes.

Disclaimer clauses in an estate plan are another way to help preserve flexibility in an evolving tax climate. For example, assume that a grantor’s intent is to leave the entire estate to his spouse. However, at the time of death, the spouse decides she doesn’t want some of the estate’s assets or property. With disclaimer clauses in place, the spouse could choose to “claim” all assets contained in the estate or accept only those with the most favorable tax consequences.
This allows the beneficiary to look at the tax picture in the year the grantor dies and have the flexibility to disclaim certain assets to ensure the wealth transfer is only for a tax-exempt amount. It all depends on a person’s unique situation.

While estate planning often focuses on distribution of wealth after death, experts say many grantors don’t make good use of tax-favored tools that can be used during their lifetime. A consistent approach to making regular small gifts can be a great way to transfer substantial wealth tax-free over time.

Many people still don’t know that a married couple can gift up to $24,000 every year tax-free, which makes it one of the little jewels in the estate planning world. If the recipients invest that money—which is often the expectation—those smaller gifts can turn into a sizable amount of money down the road, without it ever causing a blip on the estate tax radar screen. IBI