How many of you plan on your clients dying in 2010 when the current estate tax is briefly eliminated?
Not many of us have control over the timing of our death. This creates amazing financial-planning opportunities because of the uncertainty of the type of tax a client will pay when he dies. An answer to this uncertainty is life insurance.
The IRS keeps statistics on the number of adults who die during a calendar year, the number of parties required to file an estate return, the value of the total estates and the estate taxes paid. In 1999, the last year the statistics were available, the IRS table shows that more than 2,330,000 adults died while approximately 53,800 people filed estate returns. With the changes in the estate-tax exemption in 2002 and continuing through 2009, the number of taxable estates is expected to decrease. No estate-tax returns will be necessary in 2010, while a substantial increase in estate liability will return in 2011 as the exemption returns to the 2001 level. This will occur unless Congress modifies the law. Capital-gains taxes will increase from 2010 and beyond, with the reduced basis in inherited property in 2010.
CLIENTS ARE OFTEN RELUCTANT TO BUY INSURANCE TO FUND TAXES THAT MAY OR MAY NOT COME DUE.
Presently, when an individual dies and passes on his assets to his heirs, the heirs receive a stepped-up basis. This means that the assets are valued at the time of death. This process will continue through 2009, be eliminated in 2010 and return in 2011. For assets inherited in 2010, the basis is a carry-over basis. This means that the assets are valued at what the deceased paid for them. If the information is not readily available, then research will be necessary to estimate or compute the basis.
For example, consider an estate in which the only asset is an investment property purchased in 1956 for $75,000 and valued at $2 million in 2005. The property has a stepped-up basis of $2 million in 2005-2009 and 2011. The basis in 2010 is $75,000.
In 2005, the estate would have a taxable value of $500,000, while there would be no taxable estate for the years 2006-2010. In 2011, plans call for returning the estate exemption to the 2002 rate of $1 million. In this example, the taxable estate would be $1 million. The estate would pay taxes of $225,000 and $552,500 in 2005 and 2011, respectively. (This assumes that the 2011 rate returns to the pre-2001 tax act rates. Actual rates will probably be modified as we approach 2011.)
Heirs don't always sell property immediately. When the property is inherited in the years with estate exemptions, the capital gain upon future sale is computed on the difference between the sales price and the stepped-up basis of $2 million. The capital gain on property inherited in 2010 would be computed on the difference between the sales price and the basis of $75,000.
Let's assume the property is sold for $2,200,000 in the year in which it is inherited. In 2005, the capital-gains tax on the sale of the property would be computed on the $200,000 gain at a maximum federal rate of 15 percent, or a tax of $30,000. If the property is inherited between 2006 and 2009 and sold for $2,200,000, then the gain would be $200,000, and a federal capital-gains tax of $30,000 would be due. In 2010, the capital-gains tax would be $637,500, assuming a federal and state rate of 30 percent ($2,200,000-$75,000). In 2011, the capital gains would be taxed also at a rate of 30 percent, but the gain would be $200,000 due to the stepped-up basis as the reduced capital-gains rate phases out in 2010.
The changing estate-tax and capital-gains tax rules make it a challenge for financial advisors to assist their clients with adequate and comprehensive planning. The best way to take care of the taxes, both estate and capital gains, would be to establish an irrevocable trust that is funded by insurance.
Term life to the rescue
No one likes to pay taxes, and many of your clients do not understand the tax implications if the current capital-gains and estate-tax laws "sunset" in 2011. At the same time, clients are often reluctant to purchase insurance to fund taxes that may or may not ever come due.
Your role as a financial advisor is to protect your clients' interests (and reduce your professional liability) by ensuring they understand the possible future ramifications if estate and/or capital-gains taxes come roaring back in the future.
One possible approach that covers the bases is to suggest convertible term life insurance to your clients. Since there are guaranteed level premiums and insurability, this approach allows you to cover your liability and your clients' future (possible) taxes.
Pam Feely, CPA, is the owner of Feely and Associates, PC, a Lakewood, Colo., CPA firm. She can be reached at firstname.lastname@example.org.