KEEPING IT IN THE FAMILY Even if the bull market and rising house prices have fattened your net worth, you can still avoid taxes on much of your estate.
By Cynthia Hutton

(FORTUNE Magazine) – NO MATTER HOW successful an investor you are, you still can't take it with you. But the long bull market in stocks and real estate means that you may have more to leave behind than you thought. In the past five years the Dow Jones industrial average has climbed by 230%; the median price of existing homes has risen 25%. Today some two million of the more than 91 million U.S. households have estates worth over $1 million. Smart planning is the best way to preserve those assets from your grasping Uncle Sam. The short course on federal estate taxes is this: You can leave everything to your spouse, no matter how much you have, completely free of taxes. In addition, every taxpayer is entitled to a unified credit that can be applied against the taxable gifts you make while you are alive and the estate you leave when you die. In 1987 the unified credit rose to $192,800, which offsets the federal tax due on an estate of $600,000. Together you and your spouse can leave $1.2 million tax-free. This year the government will tax estates in excess of $600,000 at a minimum rate of 37% and a maximum of 55%. The maximum drops to 50% next year. A number of states also try to get their fingers in your honeypot (see box, page 116). Some impose an estate tax just as the federal government does, while others levy an inheritance tax. Estate taxes are generally deducted from the assets in your estate; your heirs owe inheritance taxes on the share of your estate they receive.

The 1986 Tax Reform Act that changed your life so drastically did very little about your death. Only minor alterations were made in the estate tax laws, which were substantially revamped in 1976 and 1981. The most important of the 1986 revisions was the enactment of a new generation-skipping transfer tax to close a loophole that allowed vast wealth to pass through several generations in trust -- and untaxed -- until the principal from the trust was finally distributed. Any lawyer worth his fee could keep a trust going, yea unto the fifth generation. Now taxes are imposed on the death of each generation. If you are single and have an estate of less than $600,000, you probably don't need tax planning. Just keep your will current -- a will is the only way you can make sure that the friend or lover you want to inherit your possessions really does -- and relax. Married couples and single people with assets in excess of $600,000 should consult a tax lawyer and possibly a financial planner as well. Says planner John Train, author of Preserving Capital and Making It Grow: ''Estate planning has gotten so complicated that a private individual cannot conceivably know all the available combinations.'' The goals of estate planning are to avoid death taxes altogether by removing assets from your taxable estate, or at least to make certain that the government gets as little as possible. In theory there are two ways to accomplish these ends: setting up irrevocable trusts and giving money away. Reality is generally more complex, but a rundown of the more obvious options should help. Bear in mind a warning from Paul Zuckerman, a New York City lawyer who specializes in estate planning: ''Every tax-saving device has a cost, and I don't mean legal fees. The cost is loss of control of the assets.''

PUTTING ASSETS IN A TRUST A trust is a legal arrangement through which you give property to a trustee to manage and use for the benefit of whomever you name. It allows you to spell out how the funds should be spent and when the principal should be distributed. There are two main types of trusts -- testamentary, which are set up in your will and go into effect when you die, and living, or inter vivos, as the lawyers like to call them. Living trusts take effect during your lifetime, so the assets in them do not go through probate on your death. Such trusts may be revocable or irrevocable, but irrevocable trusts are the only kind that offer tax savings. The reason is that you, the grantor, relinquish control of the assets for your lifetime and, in return, the assets are removed from your taxable estate. By contrast, if you set up a revocable trust, you have complete control over the assets -- but they remain part of your estate. If you are married, you may wonder why you should bother with trusts at all since you can leave everything to your mate tax-free. True, but unless your spouse takes another spouse, he or she will be able to leave only $600,000 tax-free. (Actuarial statistics say it is likelier that a wife will be left a widow than that a husband will become a widower. But the rules are the same no matter which is the survivor.) Besides, do you really want to see your hard- earned money go untaxed to your wife's second husband so that after she dies he can pass it on to his second wife? Married people must plan two estates simultaneously, and you must think about not only what you can pass along tax- free but also what your spouse will be leaving after she dies. SAY YOUR COMBINED estate amounts to $1.2 million, divided equally between you and your spouse. You put your $600,000 in a bypass trust. She gets the income from this irrevocable trust, and on her death the principal can be divided as she wishes among the beneficiaries you designate. The money will pass tax-free because it is exempt under your unified credit. When she dies, your mate can leave her $600,000 tax-free using her lifetime credit. Had you left her your $600,000 -- or any other amount -- outright, it would be subject to estate taxes at her death because it would put her estate over the $600,000 limit.

A bypass trust can permit your spouse to receive 5% of the principal or $5,000, whichever is greater, each year. Moreover, you can instruct the trustee to give her additional principal for such expenditures as medical bills or living expenses. This flexibility makes the bypass trust an attractive tax-saving tool, but your highest priority should be to leave your widow financially independent. Says David Gerson, a tax planning partner at Ernst & Whinney in New York City: ''In estate planning, sometimes you get carried away with the tax effects and forget the family situation. The question I ask first is, 'Leaving aside tax considerations, what would you want to happen to your money?' '' If, for example, you have young children whom your wife would have to raise by herself, she should probably be left the whole $1 million, regardless of taxes, to use as she sees fit. Jan and Bill Smith, both 39, are attorneys practicing in San Francisco. Since they drew their wills up three years ago, their circumstances have changed. The value of their estate has increased by half a million dollars, and Jan went back to work full time when their second child, Kathryn, was 2. The couple's net worth is now about $1.5 million, and their marginal estate tax bracket is 45%. Their estate planner has recommended that they put $600,000 in a bypass trust, which could reduce taxes on their estate by over $500,000 if one spouse outlives the other by ten years, and assuming that the $600,000 set aside in the trust doubles in that time (which it would if invested at an annual return of just over 7%). Why a bypass trust now? Says Jan: ''Before I went back to work full time, Bill was the prime breadwinner. Now that I'm earning about the same as he is, we have considerably more to shelter and I could support our children.'' JOINT TENANCY frustrates the aim of a bypass trust because the surviving spouse automatically inherits jointly held assets, so there would be nothing to fund the trust with. If you hold everything jointly, transfer the title to some property to each spouse, and try to make both estates the same size so each survivor can take advantage of the $600,000 exclusion. If your estate is larger than $1.2 million, there is another reason to balance the ownership. Says John Connell, national director of financial planning with Touche Ross in Denver: ''Because estate taxes are progressive, you should make sure that you use up the lower tax rates for both spouses' estates instead of having one spouse's estate taxed at the highest marginal rate and the other not even using all the lower rates.'' A sometime companion of the bypass trust is the QTIP (qualified terminable interest property) trust. It allows you to control the destiny of more than the $600,000 you can put in a bypass trust. After you and your spouse die, assets in a QTIP go to beneficiaries you have named. As with the bypass trust, your widow will collect the income generated by the trust, but she will not be able to tap the principal except as specified in the trust agreement. When she dies, however, these assets are considered part of her taxable estate. Says Anne Lieberman, a financial planner in Larkspur, California: ''QTIPs are an especially important planning tool now because there are so many second marriages.'' The most common use of a QTIP trust is to help provide for a second spouse but to leave your wealth to the children of the first marriage. Life insurance may be the largest part of your estate, particularly if you are young. But as you begin to acquire other assets, you may want to get the proceeds of your policy out of your estate, particularly if they threaten to put you over the $600,000 mark. You can create an irrevocable life insurance trust, assign your policy to it, designate the beneficiaries -- ideally your children -- and have the trustee pay the premiums out of money you have contributed to the trust. Since the policy has little or no value when you transfer it to the trust, you do not trigger any gift tax, and all you give up is the ability to borrow against it. This type of trust is often used to transfer money to children, because at the policyholder's death, the proceeds go into it untaxed. If you die within three years of transferring the policy to a trust, however, the proceeds are taxed as part of your estate. Says attorney Charles Groppe of Putney Twombly Hall & Hirson in New York City: ''Assigning a life insurance policy to an irrevocable trust is a valuable technique for a senior employee of a company where group life insurance is an important part of the compensation package. If the group policy is coupled with double indemnity if the employee dies on company business, putting those assets in a trust is an even better idea.'' But Congress is considering including life insurance proceeds in the insured's estate no matter who owns the policy. That would redress the inequity of allowing hefty life insurance proceeds to pass to your beneficiaries untaxed, while your stock portfolio cannot if it pushes your estate over the $600,000 limit.

GIVING ASSETS AWAY Every year you can give as much as $10,000 to as many people as you can afford, tax-free. You can hand out more -- for example, you could bestow $60,000 on a child -- but your unified tax credit will be reduced by the taxes due on the amount over $10,000. You would not pay taxes on a $60,000 gift, but you must report it to the IRS. When you die, the $50,000 excess over the $10,000 limit is subtracted from your $600,000 exclusion. That's why the credit is called unified, because it combines gifts you make while you are alive with assets you give away at your death. Estate planners recommend parting with assets that are likely to appreciate in the future, such as real estate or an interest in a business. Such a gift may reduce your exclusion, but if you continue to hold on to the asset, the tax bite could be much bigger later on. Says Alexander Sanger, a partner in the New York City law firm of White & Case: ''Big dealmakers cut their kids in at the beginning. When they finance a leveraged buyout they use debt, so common stock is cheap and the parent can register 10% to 30% in the child's name. It's not worth much then, so it won't be taxed heavily. But it can soar in value.'' Before you make any gifts, however, you should carefully consider your retirement needs. Says Gerson of Ernst & Whinney: ''You don't ever want to go back to your children for money later in life.'' Even if gift giving makes sense as a tax-saving measure, it can be disastrous to family relationships. An older couple in a San Francisco suburb, with a net worth of over $4 million, considered giving their daughter and her husband $40,000 this year. If they wait until they die to leave the money to their child, the government will take half. But their son-in-law feels awkward accepting such bounty from them, and the couple worry that the gift might hurt their daughter's marriage. In the end they decided to give $20,000 to their daughter only, and to see how this worked before they gave more. Observes John Train: ''Contrary to what one might think, it isn't doing them a favor to load children with possessions early in life. You just start their sails flapping.'' It may be better to let them wait until you die, when they are older and better able to manage what you leave them. You can give your gift and have it too with a grantor retained income trust, or GRIT. You transfer assets to this trust -- stocks, money, whatever -- and collect the income or use the property for the term of the trust. At the end of this period, the principal is distributed to the beneficiaries you have named. The effect of a GRIT is to freeze the value of the assets in the trust as well as remove them from your estate. A gift tax is assessed against the assets at the time you place them in the trust, but any future appreciation is tax-free. THE IRS values the portion of the trust that goes to your beneficiaries according to a formula that now tends to understate the amount in the trust when your heirs get it. The tax folks' tables assume that had you given away your riches outright, your heirs could have invested the loot at 10% annually. Because you put your holdings in a GRIT, you deprived your heirs of that opportunity to invest for the duration of the trust, and so the future value of their inheritance is diminished by that opportunity cost. Thus, depending on the duration of the trust, the $1 million you put into it may be worth only $400,000 in the eyes of the IRS by the time your beneficiaries get it, and no tax is due because it is covered by the $600,000 exclusion. That's the beauty of a GRIT -- that you may be able to pass on amounts substantially larger than $600,000 to your heirs tax-free. Says John Train: ''The GRIT is purely mathematical. It's sort of a cat's cradle game based on the IRS table of the day and the resulting appraisal of the value of the remaining portion.'' You must be astute in figuring out the duration of the trust, however, because if you die while you are still receiving income from it, the assets are subject to tax as part of your estate. After a lifetime of giving gifts to your children, you may want to turn % over most of your estate to your grandchildren. Although the generation- skipping trust is no longer ''the garden-variety estate planning tool for people with wealth and large families,'' in Charles Groppe's words, one form of it is available until 1990: Grandparents can put up to $2 million in trust for each grandchild free of tax. The law also allows a permanent exemption for $1 million that you can place in a trust for future generations, provided the trust lasts no longer than state laws permit. AFTER YOU HAVE taken care of your family, you may want to leave a little something to your favorite charity. The federal government encourages this by exempting charitable donations from estate and gift taxes. In addition to ordinary bequests, you can set up a charitable trust; there are two types, remainder and lead. With a remainder trust, the principal is invested and an annual payment goes to a beneficiary you name, often your spouse or a child. It can even be yourself. When the trust is dissolved, either after a specified time or at the death of the beneficiary, the charity gets outright ownership of the assets. You can establish a remainder trust while you are alive, or you can do it in your will. If you do it while you are alive, you will probably get an income tax deduction the year you fund the trust, though not for the full amount. If you create a testamentary trust, the assets will be included in your estate, but your executor deducts a portion of them before any estate tax is levied. A lead trust is the inverse of a remainder trust. In this case the income goes to charity until the trust ends -- in, say, five to 20 years -- and the principal then goes to your heirs, perhaps a grandchild. Although you can fund one of these trusts with any amount of money, you'll find that planners recommend you consider doing so when you have an estate of $1 million or more. (One reason is that administrative costs can eat up smaller trusts.) James L. Knight, 78, chairman emeritus of Knight-Ridder Inc., established a charitable lead trust with about $25 million in May 1986. The trust, managed for him by an Akron bank, will pay out an annuity equal to 8.3% of the initial principal of the trust. Over 30 years the trust will pay more than $62 million to Massachusetts General Hospital in Boston and the University of Miami. When the trust dissolves in 2016, the remaining principal will go to Knight's family. Don Vander Heyden, 44, an independent businessman in Denver with assets of more than $1.5 million, is considering establishing a testamentary charitable remainder trust. The trust income would go to his parents if he dies before them, or to other family members and friends if the parents die first, and the remainder to several churches or to a scholarship fund in a small community ''where it won't get lost,'' he says. Because he is single, Vander Heyden is not interested in sheltering his estate with any other tax-saving ploys. ''I'm too independent to put my assets in an irrevocable living trust and not have all the flexibility I want,'' he says. IN THE FINAL ANALYSIS, estate planning should aim at avoiding friction in families as well as avoiding taxes. The first thing to do when planning your estate is to sit down by yourself, or with your mate, and think about your heirs and what you want for them. Says John Train: ''There are close families, there are diffused families, and alas, there are quarrelsome families.'' With the countless combinations of tax-saving tools and the help of an estate planner, you can minimize both friction and taxes no matter which kind of family you belong to.