Under current federal tax laws, in 1999 you and your spouse can each pass $650,000 of assets to your heirs free from federal estate taxes, if proper estate planning has been done. This amount will gradually increase to$1,000,000 each in the year 2006.

With an estate plan that establishes a Credit Shelter Trust at death, (also known as a Bypass Trust or Widow’s Trust), both individuals with sufficient assets can take advantage of their $650,000 estate tax credit and at the same time minimize estate taxes for their heirs. Unfortunately,because many individuals leave their entire estate to their surviving spouse rather than to a trust, the $650,000 which is exempt from estate taxes when the first spouse dies, becomes part of the surviving spouse’s estate. This means that when the second spouse dies, the heirs receiveonly $650,000 free from estate taxes rather than the $1.3 million theycould have received if both mother and father had utilized their $650,000 credit.

Essentially, when an estate plan creates a Credit Shelter Trust, at the time of the first spouse’s death, assets of that spouse equal to the federal estate tax exemption (currently $650,000 for 1999) are transferred to the Credit Shelter Trust, thus removing those assets from the surviving spouse’s estate. Then, upon the surviving spouse’s death, the assets in thetrust are transferred to the heirs free from estate taxes. In most cases,assets above the federal estate tax limit are passed on to the surviving spouse free from estate taxes because the law allows an unlimited amount of assets to be inherited by a surviving spouse without estate taxes.

To illustrate, let’s assume you and your spouse have a combined estate worth $1.3 million. Each of you can leave everything to the other withouttriggering estate taxes. However, if the value of the estate is still $1.3million when the second spouse dies, the federal tax collector will get $258,500-the estate tax on the amount in excess of $650,000. However,if each of your estate plans leaves $650,000 in a Credit Shelter Trust to be used by the surviving spouse, the assets will eventually pass to the heirs and there will be no estate tax when the second spouse dies. Inaddition, during his or her lifetime, the surviving spouse may receive 100 percent of all income from the trust and may have access to the principal for health, education, maintenance and support. Of course, the estate taxsavings will be even greater if the assets are allowed to appreciate in value during the time they are held in trust.

The Credit Shelter Trust is an ideal estate planning tool for most joint estates worth $650,000. But in situations where the value of the estateexceeds $1.3 million, especially where the estate consists of a closely-held business or large real estate holdings, an irrevocable trust that purchases life insurance may be needed as an additional estate planning tool. This is because estate taxes are due after the death of the secondspouse on the amount of assets held in the spouse’s name above the federal exemption (currently $650,000 for 1999).

To illustrate, let’s consider the case of business owners Cindy and Chris.

Although Cindy and Chris are both alive and well, their attorney has projected a tax bill upon the second death of $10 million, and they are afraid the family will have to sell the business to pay the estate taxes.

But Chris and Cindy have put 50 years into their business and they don’t want to give it up. In fact, they want to pass it on to their children. One alternative would be to pay the tax bill over time in accordance with Section 6166 of the Internal Revenue Service (IRS) code which allows a family that owns a closely held business to pay estate taxes over an extended period. The disadvantage to this alternative is that the familywould have to pay the IRS and would dictate the terms of the arrangement which would mean that Chris and Cindy’s family would no longer be in complete control of their business.

A second alternative is for Chris and Cindy to buy life insurance in an irrevocable trust. With this alternative, the irrevocable life insurancetrust will purchase an insurance policy on Chris and Cindy’s lives in an amount that will be determined by Chris and Cindy (perhaps $10 million to pay the estate taxes). The insurance policy will be a second-to-die policy(i.e., payment is not made until both spouses are deceased) because theestate tax burden is generally not due until the death of the second spouse.

It also lessens the annual insurance premium. Because the trust owns thepolicy and not Chris and Cindy, the death benefit will be excluded from both of their estates. The proceeds from the policy can remain in the trustfor the benefit of the children until they reach a certain age and will provide the children (or their guardian) with liquidity to pay any estate taxes that might be due at the death of Chris and Cindy.

Naturally, Chris and Cindy decided to go with the second alternative.

Of course, because your financial needs are unique, you should consult with your tax and/or legal advisor before implementing any of these strategies.

(Alan Moore is a financial advisor at Legg Mason Wood Walker, Inc., asecurities brokerage and financial services firm and member of the New York Stock Exchange, Inc. and SIPC.)

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