GUIDE TO ESTATE PLANNING FOR OUR CLIENTS

The estate planning process involves tax and property law concepts that often are unfamiliar and confusing to the layperson. To assist our clients in better understanding this process, we have prepared the following guide to the major issues involved in estate planning. We welcome your questions and comments.

THE ESTATE PLANNING PROCESS
In general, the term "estate planning" means planning for the disposition of a person's property during life and at death in a tax efficient manner. Typically, an estate plan includes a will. A will is a document by which a person (the "testator") transfers ownership of his or her probate property at death to desired beneficiaries (see "The Probate Process" below). The testator designates a person to serve as executor of his or her will. The executor is responsible for collecting the testator's probate assets, paying taxes, debts and expenses, and distributing the balance of the estate in accordance with the terms of the will. A testator with minor children also may nominate in his or her will a person or persons to serve as guardian of those children.

Often, an estate plan also includes one or more trusts. A trust is an agreement between the donor of the trust property and the trustees, by which the trustees agree to hold and manage the property in accordance with the terms of the trust. The donor may fund the trust either during life or at death. A trust often is used where the donor does not wish to make an outright gift of property, but wants to make the enjoyment of the property subject to certain conditions for a specified period of time. A trust sometimes may be used to obtain advantageous tax results (see, for example, the "Family Trust" below).

Other documents commonly used in estate planning include a health care proxy and a power of attorney. In a health care proxy, the client describes his or her wishes with regard to health care in the event that the client is unable to communicate those wishes at a later date. The client also designates a health care agent to carry out the client's wishes as expressed in the proxy. In a power of attorney, the client names a person to serve as his or her attorney-in-fact to perform on the client's behalf any of the financially-oriented actions listed in the document.

TRANSFER TAXES
The transfer of property from one person to another may involve one or more of the following transfer taxes: the gift tax, the estate tax and the generation-skipping tax. The gift tax applies to transfers during life and the estate tax applies to transfers at death. The generation-skipping tax applies to transfers, either during life or at death, which skip a generation (e.g., from a grandparent to a grandchild). The generation-skipping tax is levied in addition to any applicable gift or estate tax. There have been extensive changes to the transfer tax system recently which have created a significant amount of uncertainty and confusion. These changes are detailed below.

FEDERAL TAX RATES
As a general matter, one unified rate schedule is used to compute both the gift tax and the estate tax on transfers of property during life and at death. Under current law, there will be multiple changes made to the rate schedule over the coming years; the top tier rate will slowly decrease until it reaches 45% in 2007. In 2010, the estate tax and generation-skipping tax are scheduled to be repealed, only to be reinstated in 2011 at their 2001 rate levels, although Congress may act in the interim to change this. The gift tax is not scheduled to be repealed; rather, its top rate will decrease in conjunction with the estate tax top rate, and in 2010 the top gift tax rate will equal the top income tax rate for individuals then in effect, which is slated to be 35%. In 2011, the gift tax will also return to 2001 rate levels, again assuming no changes to the law prior to then. The reduction and reinstatement of rates is detailed on the schedule below. A credit against gift or estate tax is set at a level that permits each person to transfer a certain amount of property during life or at death, free of gift and estate taxes. The amount that each person may transfer free of gift, estate and generation-skipping transfer taxes will be referred to in this guide as the "Exemption Equivalent." The Exemption Equivalent for gifting purposes is $1 million. For property passing at death, the Exemption Equivalent is currently being increased in stages as shown below. The Exemption Equivalent for the generation-skipping tax is scheduled to grow at the same rate as the estate tax Exemption Equivalent. The following table details the decreases in top rates and increases in Exemption Equivalents that are scheduled under current law:

(* Assumes Congress does not make the repeal permanent.)

For gift tax purposes, if a transfer exceeds the $1 million gift Exemption Equivalent, the tax rate starts at 41% and increases to the top rate shown on the above table. For estate and generation-skipping transfer tax purposes, the tax rate for excess transfers is the top rate shown on the above table.

MASSACHUSETTS DEATH TAX.
Over a ten year period, Massachusetts enacted three major changes to its estate tax. The current Massachusetts exemption equivalent is $1 million and, unlike the federal exemption, this is not scheduled to change. This means that some estates may have to pay Massachusetts estate tax even though no federal estate tax would be due, depending on the value of the estate and the year of death.

Massachusetts does not impose a gift or generation-skipping transfer tax.

MARITAL DEDUCTION
An important device for avoiding transfer taxes is the unlimited marital deduction. During life or at death, a person can transfer an unlimited amount of property to his or her spouse, free of gift or estate tax. Both the federal government and Massachusetts allow such a deduction.

USE OF THE EXEMPTION EQUIVALENT
Simply leaving all of one's property to one's spouse will waste the first spouse's Exemption Equivalent. For example, a husband who leaves all of his estate to his wife will not pay any estate tax on his death by virtue of the unlimited marital deduction. However, he will have added all of his estate to his wife's taxable estate, where it will be taxed on her death according to the rules then in effect. The Exemption Equivalent will be sheltered from federal estate tax in her estate, but the balance will be subject to tax and the husband's Exemption Equivalent will have been wasted. With estate plans that properly use both spouses' Exemption Equivalents, a married couple can double the amount that passes free of federal estate tax.

In order to use a married couple's Exemption Equivalents, each spouse should have assets in his or her own name (i.e., not jointly owned) equal to the Exemption Equivalent. If one spouse owns the majority of the couple's assets, it may be advisable for that spouse to transfer assets to the other spouse to enable both of them to use their Exemption Equivalents.

FAMILY TRUST
A common technique for using both spouses' Exemption Equivalents is to include a provision for a family trust (also known as a credit shelter trust) in each spouse's estate plan. At death, the first spouse's family trust will be funded with the maximum amount that can be sheltered from federal estate tax by the spouse's available Exemption Equivalent. Assets in excess of that amount can be passed to the surviving spouse, either outright or in trust, and not be subject to estate tax until his or her subsequent death (by virtue of the marital deduction). The assets in the family trust will be sheltered from estate tax in the first spouse's estate by that spouse's Exemption Equivalent; furthermore, the assets in the family trust will not be subject to estate tax in the surviving spouse's estate because he or she will not have had a taxable interest in the trust. As the estate tax Exemption Equivalent increases to $3.5 million by 2009, clients who are married may want to consider whether they are comfortable with the amount of property that will be held in a family trust relative to the amount distributed outright to a surviving spouse or held for the exclusive benefit of the surviving spouse.

The terms of the family trust typically provide that the trustees may distribute so much of the income and principal of the trust to any one or more of the decedent's spouse and children as the trustees determine to be necessary or advisable. The surviving spouse may serve as a trustee of the family trust. Thus, in many cases, the surviving spouse may obtain the same economic benefits from the property as he or she would have had if he or she had inherited the property outright.

The trust agreement also will specify how the assets of the family trust will pass upon the surviving spouse's death. For example, the trust may be split into equal shares for each of the couple's surviving children, to be distributed outright to the child either immediately or when the child reaches a specified age.

USE OF THE MARITAL DEDUCTION.
As described above, an estate plan typically is structured so that assets in excess of the first spouse's available Exemption Equivalent will pass to the surviving spouse in a manner that will qualify for the estate tax marital deduction. An outright gift to the surviving spouse will qualify for the deduction, but the first spouse may not want to relinquish total control over how the property will be used for the surviving spouse or who the ultimate beneficiary of the property will be after the surviving spouse's death.

A trust is an appropriate vehicle to ensure that the first spouse's wishes will be honored. Generally, two types of trusts will qualify for the marital deduction. The first, a general power of appointment trust, requires that all of the income of the trust be paid to the surviving spouse during his or her life and that the surviving spouse have the power to appoint all of the trust property either to himself or herself during life or to his or her estate upon death. The second trust, a qualified terminable interest property (or "QTIP") trust, requires only that all of the income be paid to the surviving spouse. The trust may be written to give the trustees the power to make principal distributions to the surviving spouse, but that is not a requirement for qualification. The surviving spouse also may be given the power to appoint the trust property by will to a limited class of people, but again that is not required.

Special considerations are involved when a person's spouse is a non-U.S. citizen.

THE PROBATE PROCESS
A person's will governs the disposition of probate property only; i.e., property that is owned solely in the decedent's name. Joint property is a form of non-probate property because the property passes upon death to the surviving joint owner, regardless of the terms of the decedent's will. Other forms of non-probate property include life insurance, IRA's, 401(k) accounts, and most other forms of retirement plans or accounts (unless they are payable to the decedent's estate).

"Probate" refers to the process by which ownership of probate assets is transferred from the name of the decedent to the beneficiaries designated in the decedent's will. The process involves petitioning the probate court to have the will allowed and the executor appointed, the executor filing with the court his or her inventory of the estate's probate assets and later his or her interim and final accounts, and the court's allowance of those accounts (subject to rights of the beneficiaries of the estate and other interested parties to object).

Although joint ownership of property is convenient from an administrative viewpoint, it often creates problems from an estate planning perspective. That is because property owned jointly between spouses, although qualifying for the marital deduction, may result in wasting of the first spouse's Exemption Equivalent.

IRREVOCABLE LIFE INSURANCE TRUSTS
If the assets of both spouses exceed twice the Exemption Equivalent, further estate tax savings may be obtained through the use of an irrevocable life insurance trust. The trust is designed to be the owner and beneficiary of policies of insurance on a spouse's life, thereby removing the policy proceeds from the spouse's taxable estate. The dispositive terms of the insurance trust typically mirror the terms of the spouse's family trust. The transfer of life insurance policies into the trust and the payment of policy premiums may have gift and generation-skipping transfer tax consequences which should be considered. The likelihood of actual repeal of the estate tax at the time of estate planning should also be considered, as it will impact the efficacy of life insurance trusts.

LIFETIME GIVING
A person can further reduce his or her taxable estate by making gifts during his or her life. Under the so-called gift tax annual exclusion, a person may make gifts of up to $12,000 per donee per year free of federal gift tax. If a spouse joins in the gift, a total exclusion of $24,000 is available, regardless of which spouse actually owns the property. Since such transfers are excluded from the donor's taxable gifts, the donor's Exemption Equivalent is not affected. The tax code also allows a person to pay another person's tuition and medical bills directly to the provider of those services, free of gift tax and without affecting the donor's Exemption Equivalent.

Lifetime gifts in excess of the annual exclusion amount will reduce the donor's available Exemption Equivalent, but the amount of the gift, plus the subsequent income from and appreciation of the gift, will have been removed from the donor's taxable estate. For most, making taxable gifts, which are gifts in excess of the donor's remaining Exemption Equivalent, is not currently advisable due to the scheduled repeal of the estate tax. With the possible reinstatement of the estate tax, however, owners of certain types of assets that have explosive short-term growth potential may still want to consider making taxable gifts in order to remove the asset from the donor's taxable estate and to take advantage of discounting techniques that reduce the value of the gift for tax reporting purposes.

GENERATION SKIPPING
Transfers which skip a generation are another method of saving transfer taxes. Ordinarily, property is taxed when it passes from a parent to a child and again when it passes from the child to the grandchild. However, by skipping a generation, the property will avoid a level of taxation and more of the assets may be preserved for the family unit.

For example, if a person were to transfer $1 million (after any applicable gift or estate tax) to his or her grandchildren, a significant federal estate tax (possibly as much as $460,000) at the children's level would be saved, thus making more assets available to the grandchildren. A generation-skipping transfer tax is imposed on such a transfer, but each transferor is allowed an Exemption Equivalent from the generation-skipping transfer tax. For transfers that occur between 2005 and 2009, the generation-skipping transfer tax Exemption Equivalent will grow at the same rate as the estate tax Exemption Equivalent as shown on the table on page 2. Moreover, the flat rate applicable to generation-skipping transfers will be reduced in conjunction with the top estate tax rate shown on the same table. Unless Congress acts in the interim to change the law, the generation-skipping transfer tax is due to be repealed in 2010 and reinstated in 2011 with the rate and Exemption Equivalent returning to 2001 levels.

CHARITABLE GIVING
There are various ways to design a charitable gift to meet a donor's own particular purposes. A donor may choose to make a gift with appreciated property, earning a full deduction for the value of the property given, while avoiding payment of capital gains tax on the appreciation. Alternatively, a donor may combine private interests with a gift to charity. For example, a donor may set up a charitable remainder trust and reserve the income from the gifted property for the donor or another family member for life or a period of years, after which the property will pass to charity. Conversely, a donor might establish a charitable lead trust which pays income to charity for a period of time, after which the trust property will revert to the donor's family or other beneficiaries that the donor selects.

RETIREMENT PLANNING
Retirement plan benefits are increasingly becoming a significant portion of many estates. Unfortunately, retirement planning also is an extraordinarily complex area of the tax law. We can work with clients to ensure that their retirement plans are properly coordinated with their estate plan so as to achieve the most favorable results. Recent changes in the law provide more tax deferral opportunity for retirement assets but also make enforcement of penalties more likely. As retirement approaches, we can advise the client as to the correct timing and amounts of distributions that the client should receive from his or her retirement plans in order to minimize income taxes and avoid the 50% excise tax for failure to comply with the minimum distribution rules.