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Clinton Estate Tax Proposals Would Slam Middle Class

By Albert B. Crenshaw
Washington Post Staff Writer
Sunday, February 8, 1998; Page H01

President Clinton's budget for next year contains a series of bombshells aimed at the nation's upper middle class -- proposals that if enacted would throw traditional estate planning into disarray and cut the government in for a much larger slice of these families' wealth in the future than would be the case under current law.

The president's proposals would move tax policy in a direction diametrically opposed to that advocated by congressional Republicans. While GOP leaders on Capitol Hill talk of eliminating the estate tax -- the "death tax," as they prefer to call it -- Clinton proposes sharp restrictions to a number of widely used devices for reducing estate taxes or in some cases providing cash to pay them.

At least one of the proposals, which would restrict irrevocable insurance trusts, would hit the moderately well-off hard, while having essentially no impact on the truly wealthy, according to lawyers and accountants who specialize in estate planning.

These provisions, as well as some others on annuities and other insurance products, have galvanized the insurance industry, and its lobbying clout, along with Republican opposition, may well block them.

"Last year Congress, in a very bipartisan way, voted to alleviate the death tax because many people think it's very unfair," said a spokesman for House Ways and Means Committee Chairman Bill Archer (R-Tex.). "Chairman Archer supports continued efforts to reduce the burden of the estate tax."

But nothing in tax policy is certain these days, so well-off taxpayers -- or taxpayers with well-off parents -- should be aware of the administration's thinking. Proposals that go nowhere during flush times have a way of returning when the government needs revenue.

The key estate tax provisions in the budget are:

Repeal of the "Crummey rule." This rule, named after a taxpayer who employed it and had it sustained in court, effectively allows use of the annual gift tax exclusion to fund a trust. It works this way:

Any individual can give $10,000 to any other individual each year, tax-free. But the gift has to be a "present interest," something that has immediate value, such as cash. Gifts of a "future interest," the right to get something of value in the future, don't qualify and are subject to gift tax. Thus, gifts of money to a trust for the future benefit of someone, such as a gift to a trust that is used to pay life-insurance premiums, wouldn't qualify under the $10,000 annual exclusion.

The Crummey rule, however, gets around that. It holds that if the beneficiary has the right to take the money out of the trust right away, then the gift becomes a present interest and qualifies for the gift tax exemption. Because few beneficiaries actually do take the money out -- it would defeat the purpose -- the Treasury Department calls it a "legal fiction."

Crummey powers are used in a number of ways, but the most popular is in insurance trusts. Because life-insurance death benefits are not subject to income taxes and are subject to estate taxes only if the policy is owned by the dead person, placing a policy in a trust allows heirs to receive the payout tax-free.

Such trusts are often used by families that have illiquid assets, such as real estate or business ownership interests, that heirs might wish to retain or find difficult to sell.

Repeal would "wreak havoc" with insurance trusts, said Evelyn Capassakis, director of trusts and estates at Coopers & Lybrand LLP in New York. Families using them would be forced to decide whether to use part of their unified estate and gift tax exclusion (up to $625,000 for a single person or $1.25 million for a married couple if the estate is properly structured), pay gift tax or dismantle the trust, assuming the trust instrument allows that, she said.

The unified credit is a lifetime amount, separate from and in addition to the $10,000-a-year gift tax exclusion.

Some policies might have enough cash value to sustain them, but most recently purchased ones would not.

"If this rule were to go through, I think you'd see a tremendous cutback in the number of insurance trusts and a subsequent drop-off in the amount of life insurance that people buy," said Frederick J. Tansill, a McLean lawyer who specializes is estate law.

Buying insurance that could be subject to estate tax, which ranges up to 55 percent, would be far less appealing, he said.

Tansill noted, though, that another strategy used by the truly wealthy would remain.

People with huge estates often set up an insurance trust and use their entire unified estate and gift tax exclusion to buy a multimillion-dollar policy.

"The conventional thinking is if compared to the vast size of your estate [the unified credits] are really insignificant and if you can leverage them," you use them during your lifetime rather than waiting until death, Tansill said.

Leverage means, for example, "if you can take a $1 million insurance premium and turn it into $10 million or $15 million worth of insurance," he said.

But "the only people in a position to do that are those who have a million dollars sitting around that they don't need," Tansill said.

The Clinton proposal would thus hit upper-middle-class families who use the $10,000-a-year exclusion to buy $500,000 or $1 million policies. "The very wealthy tend to use their annual exclusion for outright [cash] gifts for their kids," Tansill said.

Curbing family limited partnerships. Currently, many well-to-do families are forming special limited partnerships to hold assets. Such partnerships can be used to hold assets such as business interests, stocks and bonds. Typically the parents contribute the assets and then give partnership interests to the kids.

The key is that under present law, when given to the child, the partnership interest is usually valued at less than its proportionate share of the underlying assets. This is because minority interests or other restricted ownership rights are typically discounted because it is assumed that a buyer would not pay a proportionate price for a such a limited interest.

That is usually realistic with active businesses, but in the family limited partnership it allows families to give away assets using less of their unified credit or paying less gift tax than they otherwise would.

The administration says this "disappearing value is illusory" and proposes that such "valuation discounts" be eliminated except for active businesses. In other words, said Capassakis, if the partnership held stocks and bonds, a gift of a half interest would be valued at half the value of the stocks and bonds.

The administration says family limited partnerships are growing rapidly and "eroding the transfer tax base."

The administration plan would cover transfers after the date of enactment of the change, so planners suggest that families contemplating a family limited partnership or a contribution to one might want to get moving.

Curbing qualified personal residence trusts. An exception to general trust law allows a homeowner to give his or her personal residence to a trust while retaining the right to live in it for a period of years. The value of the gift, for purposes of assessing the gift tax, is reduced by the value of the homeowner's right to live in it (called a retained interest). The longer the term, the greater the reduction.

At the end of the term, the homeowner has to move out or pay rent, but for someone planning to move anyway -- retire to Florida, for example -- that's not much of a burden.

The deal not only transfers the house at less than 100 percent of its value, it means that any future appreciation is out of the estate. The heirs, as beneficiaries of the trust, get the property with no further levy besides the gift that has been paid.

These trusts "are very popular," Tansill said. "They are relatively simple and straightforward to set up. There's not a lot of burdensome record keeping, and you get good leverage," three to one on the current value plus appreciation, so that the total can be six, seven or even eight to one.

He said they are often used by families with second homes or "heirloom properties," that they wish to keep in the family.

The Clinton plan would require the trust to make certain payments to the homeowner or else the value of the retained interest would be zero.

© Copyright 1998 The Washington Post Company

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