Estate Planning

Avoiding The First Death
Tax Disaster
by David Mandell, J.D., M.B.A.

If you are in a marriage where only one spouse is a U.S. citizen, you may be in a terrible tax surprise when the first spouse dies. without the proper planning, the tax cost could be in the $100,000 or more, and the funds may be vulnerable to lawsuits and creditor claims.
The potential financial disaster was created by the IRS in 1989, when it radically altered how non-citizen surviving spouses would be treated for estate tax purposes. For couples where both spouses are U.S. citizens, the "un-limited marital deduction allows any property left to a surviving spouse to be exempt from estate taxes when the first spouse dies. In 1989, the IRS took away this deduction for couples where the surviving spouse is not a U.S. citizen.
By eliminating this deduction, the IRS now taxes any property left to the non-U.S. citizen surviving spouse. After an exempt amount, this estate tax begins at 37% and quickly rises to 55%. For a physician leaving a large estate, the taxes can easily reduce a family's estate in half. Let's see how this tax works for the unprepared physician and what type of planning strategy makes sense.
Let us take the example of Dr. Steve Wong, an orthopedic surgeon who is a U.S. citizen. Steve's wife, Wei, is a Chinese citizen and their children are U.S. citizens. Using a conservative 7% rate of return, Steve and Wei will have amassed an estate of approximately $4 million when he turns 73, mostly consisting of $2.5 million in rental estate and about $1.5 million in stocks and bonds. The $4 million in property is almost entirely titled in Steve's name because he has been the U.S. citizen. Assume that Steve dies at age 73 and that he leaves all $4 million to Wei.
Because Steve and Wei are not familiar with the special tax rules for non-U.S. citizens, they wrongly assume that the marital deduction would cover them, so there would be no tax due on Steve's death. In reality, Wei will owe $1,295,000 in cash, 9 months after Steve dies.
How will Wei pay this $1.3 million tax bill? she may have to sell their best piece of real estate at a fire-sale price just to raise the money. Even worse, she might have to sell her only liquid assets, the stocks and bonds. And remember, she'll have to sell more than just $1.3 million worth - because those sales is subject to capital gains taxes as well.
To avoid this "1st death disaster" tax hit, and to protect their assets from lawsuits as well, Steve and Wei should establish three trusts: (1) a credit shelter trust, (2) a Qualified domestic Trust (QDOT) and (3) a family income trust.
The credit shelter trust is a common estate planning trust. it allows Steve to pass his lifetime exemption amount - $625,000 as of 1998 - estate tax free to Steve and Wei's children. Wei would also be able to collect income on the $625,000 during her life without paying estate taxes.
The QDOT is a trust with certain special provisions for non-citizen surviving spouses. These provisions allow any property left to the trust of the non-citizen spouse to qualify for the unlimited marital deduction. However, the QDOT can only pay income to the surviving spouse estate tax-free, distributions of principal will be subject to estate tax.
If Steve and Wei properly create the credit shelter trust for their children, $625,000 will go to their children estate tax free. Moreover, if Steve leaves the rest of his estate to Wei through the QDOT trust, all $3.375 million of Steve's estate will be covered by the marital deduction - there will be no estate tax due on his death. This is a total estate tax saving of $1.3 million.
This planning will keep Wei from having to sell stocks or real estate to come up with the cash for the IRS. Further, the $3.375 million in the QDOT will be protected from all types of lawsuits - extremely important when the surviving spouse is the physician and he/she is still practicing.
While a credit shelter and QDOT are always needed in this situation, more planning may be required. Because the surviving spouse cannot invade the principal without incurring estate taxes, he/she may have to live off income alone. for Wei, this is nor a concern because the estate is so large, but for physicians with smaller estates, this can be difficult for the surviving spouse.
To combat this problem, the couple should establish an irrevocable family income trust to purchase a 1st- to-die life insurance policy on the U.S. citizen spouse. In Steve and Wei's case, they could use part of their $1.5 million in stocks to purchase the policy which would pay off when Steve dies. If they buy the policy when Steve is 60, it would pay off about 10 to 1 upon Steve's death (about 5 to 1 when Steve is 70). Assuming they use $500,000 from the stocks to purchase the policy, this trust will pay out $5 million to Wei at Steve's death. and because the policy is owned by the irrevocable trust, Wei will owe $0 in estate taxes on the entire $5 million...and that $5 million is asset-protected as well.
In this way, Steve and Wei were able to (1) reduce their present estate tax liability by $1.3 million; (2) prevent a fire-sale of their valuable assets; (3) pass $625,000 to their children now estate tax free; and (4) provide Wei with an additional $5 million on Steve's death.
The cost of this planning are the insurance policy, the taxes on the stocks sold to pay for the policy, and the legal fees to institute the plan. In total, such costs will be below $800,000 - less than 15% of the value of the plan's benefits.
The main challenge in creating this type of strategy is finding the experienced advisors who can implement it. To create a strategy that works for you, these advisors must have a powerful financial modeling program which can analyze and forecast your financial condition under all circumstances, taking into account your retirement and estate planning goals. This is where most attorneys fail.
Still, though, attorneys are important to this planning and your advisors should have both financial expertise and quality legal counsel at their disposal. In the end, then, the ideal advisors have both financial expertise and legal counsel. these are the ingredients of a sound retirement and estate plan.

Editor's note: Mr. Mandell is an attorney, lecturer, and CME author who consults with physicians throughout the country on asset protection and estate planning issues. He is the author of The Doctor's Asset Protection Kit ©. You may speak with Mr. Mandell directly by calling him at 1-800-554-7233, and you may also ask him about how to receive the audiotape portion of the kit.