Changes to the Estate and Gift Tax Laws - January 2004

As you have undoubtedly read, the 2001 tax act made numerous changes to the estate and gift tax laws, including the complete repeal of the estate tax for calendar year 2010 only. While we are still quite some time away from that year, the amount that can be passed to one’s heirs is increasing. The dawn of 2004 saw this amount increase from $1,000,000 to $1,500,000. This means that, between them, a husband and wife with a properly constructed estate plan can pass $3,000,000 to their loved ones free of federal estate tax. 

While the increased exemption is certainly good news for many people, it also creates complications that should prompt most of us to review our estate plans to make sure they will still work as expected. In particular, it is quite common for an estate plan to call for an amount equal to the lifetime exemption to be left not to the spouse directly but rather to a trust for the spouse’s benefit. Since the surviving spouse has only an income interest in this so called "bypass trust," its assets are not included in the estate of the second spouse when they die. This type of trust is one of the fundamental building blocks of sound estate planning; but the increasing estate tax exemption can result in some unintended consequences that may or may not be welcome.

To illustrate, let’s look at the estate plan for Jack and Diane. Their investment assets, held in Jack’s name total $1.6 million. In addition, they have a house, owned jointly, worth $800,000. If Jack dies, his estate is $2.0 million, consisting of the investment assets in his name plus one-half the value of the house. If his will provides for funding a bypass trust to the extent of the maximum estate tax exemption, then $1.5 million will into the trust and Diane will be left with the house and very little in the way of investment assets in her own name. That may be just fine, but it might not be what they had in mind when they set up the plan and expected only $1.0 million to go to the trust.

Now let’s change the facts a little by adding a $500,000 life insurance policy to Jack’s assets. Now their total assets on Jack’s death are $2.9 million, consisting of the house ($800K), the investment assets ($1,600K), and the life insurance proceeds ($500K). They should still be able to eventually pass all of that value to their kids, with the proper estate plan. However, if Jack’s will calls for only $1,000,000 to go to the bypass trust, then Diane’s assets held outright will total $1,900,000 – more than the maximum exemption. In other words, not using all of Jack’s exemption on his death means that Diane’s estate may owe some federal tax when she dies. It is doubtful that this outcome is what they had in mind.

Finally, note that they way in which Jack and Diane’s assets are owned, mostly by Jack, means that all of Diane’s estate exemption is wasted should she pass away first. Clearly, it is time they revisited their estate plan, and you probably should too.

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