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Ed Koch's Will: Taxes Take Big Bite Out Of Hizzoner's Nest Egg

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Edward I. Koch, the son of Polish Jewish immigrants and three-term mayor of New York, died rich. His net worth on Feb. 1 when he passed away was between $10 million and $11 million, according to papers filed Monday in New York City Surrogate's Court. Koch's will leaves the greatest portion of that money to his blood relatives. But between federal and state estate taxes, together Uncle Sam and the state of New York will get almost one-fourth of what he left behind.

Most of Koch's wealth was accumulated after he left office in 1989. When he was first elected in 1978, his net worth was $106,890.38, The New York Times reports, and during his last year as mayor his salary was $130,000.

Unlike many people, though, Koch had substantial income producing opportunities during his so-called retirement. A lawyer by training, he was affiliated with the firm Bryan Cave in Manhattan. He also became an author, radio host, and for two seasons, played a judge on the television show "The People's Court." Well practiced at holding forth as mayor, he could command speaker's fees for it after leaving office.

Though Koch enjoyed fine dining in New York, he made his home in a rent-controlled apartment on lower Fifth Avenue near the Forbes offices, and didn't have a car. Because he lived beneath his means, he wound up leaving substantial assets behind.

In his will, Koch left specific sums to certain people: $500,000 to his sister and her husband jointly; $100,000 to his secretary, Mary Garrigan; $50,000 to his sister-in-law; and another $50,000 to each of her two children. He also made a cash donation to charity: $100,000 to set up a program bearing his name to promote public and government service. His residuary estate – what remains after these specific gifts, funeral expenses ($22,450 according to court documents), lawyers' fees and taxes – will go to his sister's three sons in equal shares.

Their inheritance will be substantially reduced by taxes, however. Currently, the amount that can pass free of federal estate taxes is $5.25 million before a tax of up to 40% kicks in, and New York State has an exemption amount of only $1 million, with a top tax rate of 16%.

Assuming the estate is worth $10.5 million, that means $1.45 million will go to the IRS, and $1.1 million will go to New York State -- an effective tax rate of 24% says Gideon Rothschild, a trusts and estates lawyer with Moses & Singer in New York. So figure three nephews will split about $7 million.

In a shrewd tax move, Koch did not leave the residue to his sister. If he had done that, rather than leaving it to his nephews, there might have been additional estate tax to on the same assets when she died, Rothschild notes.

But it would have been even better to leave the residue in a trust to benefit the nephews and their descendants, Rothschild says. That would have protected the assets from creditors, including ex-spouses if any trust beneficiaries get divorced. And up to $5.25 million worth of the amount going into the trust would have been exempt from generation-skipping transfer tax — an additional levy, on top of any estate tax, that applies to assets destined for grandchildren and more remote descendants.

Constantine N. Katsoris, a professor at Fordham Law School who wrote Koch's will and supervised the signing in 2007, would not comment on his client's strategy or the rationale behind it. "Lawyers like to set up trusts, but it's a personal choice," he says.

Another, simpler, thing Koch could have done to lower the estate tax bill was to have made what are called deathbed gifts, Rothschild says. Currently we can each give another person $14,000 per year without it counting against the $5.25 million that we are allowed to give away, either during life or death. (Spouses can combine this annual exclusion, which is available at any time--not just when someone is dying--to double the size of the gift.) By giving that sum, while he was a ailing, to each of the nine people benefited in his will, Koch could have downloaded an additional $126,000 this year. (See my post, "IRS Raises Yearly Limit For Tax-Free Gifts.")

Note to inheritors: The check must be cashed before the donor dies, or it won’t count as a tax-free gift. To alleviate this problem, wise donors make deathbed gifts using certified or cashier’s checks, says Gerry W. Beyer, a professor at Texas Tech University School of Law.

While making annual exclusion gifts on the deathbed could be a helpful strategy for both federal- and state-tax purposes, there's something else Koch could have done at the 11th hour to substantially reduce the New York estate tax bite, Rothschild says: He could have made additional gifts of up to $5.25 million. For federal purposes, these gifts would have completely wiped out what he could pass at death tax-free. But since New York doesn't have a gift tax (Connecticut and Minnesota re the only states that have one), the gifts would reduce the size of his taxable estate without affecting the $1 million New York estate tax exemption. The savings on the state estate tax would be $726,000, says Rothschild.

Paying less state estate tax reduces their federal deduction for state estate tax, though, so they will have to pay an additional $290,400 in federal estate tax. Therefore, the net tax savings from this strategy will be $435,600 ($726,000 minus $290,400).

This strategy would work equally well in the 19 other states and the District of Columbia where there is still a separate estate tax (exemption amounts and rates vary), inheritance tax or both. See my colleague Ashlea Ebeling's post, "Where Not To Die In 2013."

There is one income tax advantage heirs might lose in the process: for assets received as an inheritance, recipients are entitled to a basis adjustment to their value on the date of death. If the assets have appreciated, the basis step-up could reduce or eliminate the capital gains tax heirs have to pay if the property is sold. For assets that have been depreciated (or have declined in value), it wouldn't matter, but if there's been a lot of appreciation, it would be helpful to have a tax advisor run the numbers.

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Archive of Forbes Articles By Deborah Jacobs

Deborah L. Jacobs, a lawyer and journalist, is the author of Estate Planning Smarts: A Practical, User-Friendly, Action-Oriented Guide. You can follow her articles on Forbes by clicking the red plus sign or the blue Facebook “subscribe” button to the right of her picture above any post. She is also on Twitter and Google+