Overview
While income tax planning focuses on the short term,
transfer tax planning takes a long-term view of preserving
your family wealth for generations to come. Whatever your
age, health, or net worth, you should look to the future,
keeping an up-to-date will and planning the disposition of
your estate. If you plan properly, you can provide security
for your family and potentially reduce the gift and estate
taxes you or your estate must pay. The new tax law did not
make a lot of changes in the transfer tax area, but it did
enhance your ability to minimize transfer tax by doubling
the lifetime exemption amount.
Temporarily Increased Lifetime Exemption Amount
Federal law provides a lifetime exemption which allows
you to transfer an amount of assets without having to pay
transfer tax. Under the new federal law, from 2018 through
2025 the exemption is doubled to $10,000,000 from its
prior amount of $5,000,000. This amount is adjusted
annually for inflation. Thus, for 2018, the lifetime exemption
amount is $11,180,000 per person. This means that you
may give up to $11,180,000 ($22,360,000 collectively
with your spouse) of assets over the course of your life
or at your death without incurring a gift or estate tax.
The generation-skipping transfer (GST) tax exemption is
also $11,180,000 for 2018. The lifetime exemption and
the GST exemption will increase (by virtue of inflation
adjustments) to $11,400,000 for 2019. After 2025, barring
further changes in the law, the exemption will revert to
$5,000,000 (adjusted for inflation).
The below table shows the increase numbers for their respective years, adjusted for inflation:
Under the new law, Treasury is directed to promulgate
regulations to address any potential difference between
the exclusion amount at the time of a gift and the
exclusion amount at the time of the death of the donor
of the gift. Without regulations, a gift that was covered
by the enhanced exclusion (during the eight-year period)
might result in estate tax liability at the donor’s death
if the exclusion has reverted to a lower amount given
the cumulative nature of the transfer tax system. This is
sometimes referred to as a “clawback” of the gift. It is
anticipated that the regulations will confirm that use of the
enhanced exemption during the eight-year period results in
a permanent transfer tax benefit.
Planning Tips:
The increased exemption might be used in
connection with the following:
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Equalizing gifts to children or grandchildren
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Forgiveness of outstanding loans to children
or grandchildren
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Gifts to dynasty trusts
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Gifts to new intentionally defective grantor trusts
in connection with a subsequent sale to the trust
for a note—benefits can be magnified since gift
of the seed property can be much larger now
without any additional gift tax exposure
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Gifts to trusts that have pre-existing sales in
place to improve the equity to debt ratio or allow
beneficiary guarantees to be terminated or allow
the note balance to be paid off in full
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Gifts to older individuals with excess exemption
in order to obtain a basis increase in the
gifted assets at their death without increasing
transfer taxes
Overview of Federal Transfer Tax System
Subject to certain exclusions and deductions, a transfer of
assets for less than full and adequate consideration either
during the owner’s lifetime or at death may be subject to
transfer tax. During lifetime, transfers may be subject to a
gift tax; at death, transfers may be subject to an estate tax;
and both during lifetime and at death, transfers that “skip”
a generation may be subject to a GST tax. Each of these tax
regimes will be explored in further detail below.
In addition to the lifetime exemption discussed above, each
year, you may make gifts up to a certain dollar amount to
as many people as you choose without exposure to gift tax
(as long as these gifts are of present interests rather than
future interests); this benefit is called the annual exclusion.
For {}, this amount is $15,000 (or potentially $30,000
with the consent of your spouse) per recipient. Moreover,
amounts paid for educational or medical expenses directly
to the relevant institution (not to the individual beneficiary)
are excluded from gifts subject to the gift tax. Finally,
certain transfers to spouses qualify for the unlimited marital
deduction, and certain transfers to charities qualify for
the unlimited charitable deduction. Spousal transfers will
be discussed in more detail in the next section. If the gift
exceeds these excludable and deductible amounts, the
excess is subject to a tax rate of 40%.This tax is due from
the donor and is paid with Form 709, United States Gift (and
Generation-Skipping Transfer) Tax Return.
The gift and estate tax systems are unified; this means that
at your death, any taxable gifts are added back to your estate
for purposes of calculating your estate tax. To the extent
your lifetime exemption was utilized for or a gift tax was paid
on these gifts, your estate will not be subject to tax on these
same gifts. If you fully utilize your lifetime exemption during
your lifetime, you will not have any exemption remaining at
your death, and any excess value included in your estate
will be subject to estate tax at a rate of 40%. At your death,
Form 706, United States Estate (and Generation-Skipping
Transfer) Tax Return, must be filed if your gross estate
(including any taxable gifts made during life) exceeds the
lifetime exemption (as adjusted for inflation each year - see table above).
Deductions for spousal transfers and charitable transfers
are also available for estate tax purposes, but even if these
deductions reduce your taxable estate to zero, a return must
still be filed for your estate.
Although the gift and estate tax regimes form a unified
system, transfers may still have different tax consequences
depending on when they occur. For instance, if you make a
gift of appreciated property, the recipient will generally have the same basis as you did in the asset. Alternatively, if the
transfer is made from your estate, then the tax basis in the
asset will generally be “stepped up” to the fair market value
(FMV) of the asset at your date of death. This is true whether
or not your estate has to pay estate tax.
Planning Tips:
Given today’s higher exemption amount and
historically low transfer tax rate compared to the
combined federal and state income tax rate, you
may want to consider postponing the transfer of
high-value, low-basis assets (especially when they are
not appreciating rapidly) until your death. That way,
your heir would be able to sell the asset and incur a
lower capital gains tax due to the resulting step-up in
basis at your death
In addition to any potential gift or estate tax, if a transfer
is made to a “skip” person (such as a grandchild or an
unrelated person more than 37½ years younger than you),
the transfer may also be subject to GST tax. As mentioned
above, there is a similar exemption from
this tax that can be used during your life or at death.
Any GST tax due is reported on Form 709 or Form 706
(depending on whether the GST tax is incurred during life
or at death) and paid along with any gift or estate tax due.
Unlimited Marital Deduction
As mentioned earlier, transfers to your U.S. citizen spouse
will not be subject to the gift or estate tax because of
an unlimited marital deduction. The marital deduction is
available for outright transfers to your spouse and transfers
to certain types of trusts. A common trust set-up for the
spouse that qualifies for the marital deduction is a qualified
terminable interest property (QTIP) trust.
Among other requirements, a QTIP trust must pay all net
income to the spouse at least annually, cannot be used to
benefit anyone other than the spouse during the spouse’s
lifetime, and must be includible in the spouse’s estate at
the spouse’s death. A QTIP trust can be set up during your
lifetime (as an inter vivos trust) or set up at your death (as
a testamentary trust). The reasons for using a QTIP trust
instead of transferring assets outright to your spouse
are generally not tax-related; they include maintaining
financial control for a spouse who may need assistance
in managing money and making sure the assets pass to
your descendants when your spouse dies. This may be
particularly important to you if this is not your first marriage
and you have children from another marriage whom you
wish to benefit while still making the assets available for
your surviving spouse should they be needed.
Planning Tips:
If an estate establishes both a QTIP and a trust
funded with the taxpayer’s lifetime exemption
amount (also known as a bypass trust), to the extent
possible the surviving spouse should generally use
the assets in the QTIP trust rather than the bypass
trust. This is because the QTIP trust assets will be
included in the surviving spouse’s estate while the
bypass trust assets, including any appreciation since
the date of death of the first spouse to die, will pass
tax free at the death of the surviving spouse.
Portability
The traditional approach to estate planning involved the
creation of a bypass (or credit shelter) trust to hold the
amount of the decedent’s unused exemption for the
benefit of the children and the spouse and a QTIP trust to
hold the balance of the decedent’s assets for the benefit of
the surviving spouse. This approach created a non-taxable
estate at the death of the first spouse to die by virtue of
the lifetime exemption and marital deduction, and also
enabled the couple to transfer assets equal in value to
both spouses’ exemption amounts to their heirs without
paying gift or estate tax. In contrast, if the assets of the
first spouse to die were transferred outright to the survivor,
although no tax would be due at that time by virtue of
the marital deduction, only the surviving spouse’s lifetime
exemption would be available to protect the remaining
assets from estate tax when the second spouse died.
Legislation allowing for the portability (or transferability) of
the lifetime exemption to the surviving spouse has made
this planning less critical in some cases. Now, a decedent
leaving everything to the surviving spouse (either outright
or in trust) can pass on his or her unused exemption
amount to the surviving spouse so that both spouses’
exemption amounts can still be utilized at the second
spouse’s death without using the two-trust structure
described above. In order to pass on the unused exemption
amount, the executor of the first deceased spouse’s estate
must make an election by filing Form 706 (even if it is not
otherwise required).
Although portability was meant to simplify estate planning
(particularly for those with estates with a total value
between one and two times the lifetime exemption
amount), it adds another variable in determining the
most appropriate estate plan. Creating a bypass trust
instead of relying on portability has the added advantage
of shielding the additional appreciation on those assets
that takes place between the first and second deaths
from the estate tax; however, for income tax purposes,
assets in a bypass trust would be inherited with only a
carryover basis at the death of the second spouse instead of a step-up (assuming appreciation) to their FMV at that
later date. In addition, to the extent that you want to utilize
both spouses’ GST exemptions, the GST exemption is not
portable. Finally, there may be non-tax benefits to creating
one or more trusts—asset protection, protecting someone
who is not financially savvy, and making sure assets
are preserved for later generations, to name a few.
Individuals must carefully consider the benefits and
burdens of relying on portability versus employing a more
traditional estate plan and determine which approach would
best meet their objectives.
Planning Tips:
Depending on the desired goals, an alternative to
creating a bypass trust would be to rely on portability
and then have the surviving spouse create a trust
with the deceased spouse’s unused exemption
amount. This type of planning would shield additional
appreciation on those assets similar to a bypass
trust and, as an added benefit, would allow the
surviving spouse to pay income tax on the trust
assets, passing even more estate-tax-free assets to
the heirs. Disadvantages of this type of planning as
compared to the bypass trust are that the surviving
spouse may not be able to be a potential beneficiary
of the trust without risking estate tax inclusion and
that the deceased spouse’s unused GST exemption
cannot be utilized.
Income in Respect of a Decedent
In some cases, certain property owned by a decedent
may be subject to both estate tax and income tax. Called
income in respect of a decedent (IRD) property, this
property may include bonuses paid after death, individual
retirement account balances, pension plan balances,
savings or thrift plan balances, and nonqualified employee
stock option spreads. A beneficiary who inherits an asset
subject to both income and estate tax is entitled to an
income tax deduction for the amount of estate tax “paid”
on the asset.
While the income tax deduction is beneficial, if you are
planning to make charitable contributions, it is more
tax-advantageous to give IRD assets to a charity that will
not have to pay taxes on the amount in any event.
In other words, if you have two items, one that involves
IRD and another one that does not have a built-in income
tax liability, it would be advisable to give the item without
the income tax liability to a non-charitable beneficiary and
the IRD item to a charity, which will not have to pay income
tax on it. To do this, specify in your will that the charity is
to receive the IRD items, so that neither income tax nor
estate tax will be due on those items.
Consider transferring IRD assets to your spouse. While
this amount will be taxable to your spouse for income tax
purposes, the marital deduction will ensure that it is not
subject to estate taxes.
It is preferable not to fund a credit shelter trust with
IRD assets when other assets are available. Otherwise,
the built-in income tax liability associated with those assets
may reduce the effectiveness of the credit shelter trust.
Importance of Your Will
One basic building block of a proper estate plan is your
last will and testament. In drafting your will with legal
counsel, you should provide for the disposition of your
property, name an executor, and designate guardians for
your minor children. If you fail to take care of these items
in your will, the state will do it for you, distributing property
in accordance with state law and appointing an executor
and guardians for your children. Although the court acts in
good faith, the outcome may not match your intentions.
You may also want to have other basic but often essential
documents, such as a medical directive and a power of
attorney, drafted at the same time.
Planning requires a comprehensive approach, including
succession planning for your business and determining
the appropriate beneficiaries for life insurance and
compensation plans. At the heart of the process, however,
is your will. Not only is it the primary instrument for
determining the distribution and management of your
property, it may also help you to manage estate and
GST taxes.
Some people may prefer to use a revocable living trust
(RLT, along with a shorter pour-over will) to dispose of
assets. The advantages of an RLT include avoidance of
probate, confidentiality, and an easier transition in the case
of disability. RLTs and other types of trusts are discussed
further below.
Once your document is properly drafted, it is important
to keep it up to date. Certain events should trigger a
re-examination of your document to ensure that it still
fulfills your intentions. For example, you should revisit your
document when there is a marriage, divorce, birth of a child
or grandchild, death of someone named in your document,
purchase or sale of major assets, change in state of
domicile, or change in the tax law.
Planning Tips:
While the additional lifetime exemption is helpful
from a tax perspective, some estate plans may
not work as planned with such a large exemption
amount. If the estate is to divide into a credit shelter
trust and the remainder to a marital trust, the large
exemption might not leave any assets for the marital
trust. It may be wise to revisit your basic estate
planning documents in light of the new tax law.
Planning Tips:
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Examine your will to make certain that it reflects
your current intentions and that all appropriate
provisions have been included. Significant changes
to the tax law have occurred in the past several
years, so make sure that your document’s provisions
are still appropriate and effective under current law.
The manner in which you hold property and whether
you reside in a common law or a community property
state are important factors in your estate plan.
Generally, joint ownership provides the benefits of
survivorship, avoidance of probate, and immediate
access to the asset. However, joint ownership may
result in increased estate taxes and loss of control
over the ultimate disposition of the property.
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Analyze your will to make certain that there is a
proper interface between your will and the type
of property you own. Generally, your will controls
only probate property (that which comes into the
hands of the executor). Property held jointly with
someone else and property that has a designated
beneficiary (for example, life insurance or a
pension/ profit-sharing plan) will not be controlled
by your will. For example, if you and your spouse
structure your wills to take advantage of the marital
deduction and your lifetime exemptions, but retain all
your property in joint names, the wills will have
no effect. While the ability to transfer your exemption
amount mitigates this problem to some extent,
you will potentially lose planned tax benefits and
the ability to control the disposition of the property
because all property passes outright to the surviving
spouse by operation of law. In short, no matter
how good the will, it will fail to achieve its intended
purpose if the ownership of your property does not
correlate with the provisions of the document.
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Remember to address the issue of simultaneous
death if your net worth exceeds lifetime exempetion and your
spouse’s net worth is less than lifetime exempetion.
The Uniform Simultaneous Death Act provides
that if two persons die at the same time, each is
presumed to have survived the other. For example,
the husband’s will is read as if his wife died before
him, and the wife’s will is read as if her husband
died before her. The marital deduction would
be unavailable to either spouse, eliminating the
opportunity of using both spouses’ lifetime
exemptions to the extent they do not each own this
amount of property. Relying on portability may not
help in this situation either. To avoid this scenario,
you can override the provisions of the simultaneous
death law in your will. Simply provide that if you die
together, the spouse with less than lifetime exempetion of
assets will be deemed to have survived the spouse
with more than lifetime exempetion of assets. In combination
with a bypass trust or portability, this will help ensure
that both lifetime exemptions will be utilized.
Choosing the Right Executor
One of the important issues you should address in
your will is the identity of your executor (or personal
representative)—the person responsible for managing your
estate and distributing assets as you direct. This individual
will have various responsibilities, including conserving the
assets, preparing them for distribution to beneficiaries, and
making required government filings.
Planning Tips:
Choose your executor carefully. You may designate
a family member, trusted friend, or associate. If your
estate is particularly complex, you may prefer to
name a professional adviser or an organization such
as a financial institution as executor or co-executor.
As you contemplate the choices, consider the
responsibilities, the required time commitment, and
the capabilities of the individual. Also remember that
your executor will be working with your family during
a time of stress and grief. An ability to navigate family
personalities and issues may be an important factor
in your decision. Also, consider indicating a second
choice, in case the person you name is not in a
position to serve when it becomes necessary.
Shifting Assets to Heirs
Shifting assets to your heirs (or trusts for their benefit)
during your life offers both long-term and short-term
financial benefits. First, by transferring income-producing
assets, you can possibly reduce total family income
tax liability associated with the property (although this
advantage may be diminished by the “kiddie tax” and
compressed trust tax brackets). Second, you can help your
children build wealth of their own. Finally, you can reduce
the size of your estate and, ultimately, the tax on that
estate. If properly planned, shifting assets can accomplish
your objectives and ensure that the rewards of a lifetime of
work pass to your heirs.
Current tax law allows you to make individual present
interest gifts of $15,000 annually to any number of persons
without being liable for gift tax. If your spouse agrees
to split gifts, you can give $30,000 gift-tax-free to each
person (however, your spouse would not be able to make
additional annual exclusion gifts to that same person).
Note: Estates with positive estate tax liability are required
to report to both the IRS and the appropriate heirs the
value of bequeathed property as of the owner’s death,
allowing the IRS to track the basis of the inherited property
more easily
Planning Tips:
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Consider the impact of a planned giving program.
For example, you and your spouse can give
$300,000 to each child free of gift tax over a 10-year
period, reducing your taxable estate and building
wealth for the next generation. Your children will not
be subject to income or gift tax on the receipt of the
gifts, and any subsequent appreciation in value will
avoid transfer tax at your level as well. If this same
$300,000 passes to your children under your will,
it could be subject to as much as $120,000 in federal
estate tax (and potentially much more when taking
into account appreciation that might occur before
death. For example, assuming a 5% growth rate per
year, the assets would be worth nearly $400,000 at
the end of 10 years and the planned giving program
would have potentially saved you over $160,000
in taxes)
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If you pay certain tuition or medical expenses on
behalf of another person, you will not have to
consider those amounts as gifts subject to gift
tax if you make payments directly to the service
provider. Please note that this exclusion does not
apply to contributions to a qualified tuition program
(that is, a 529 plan).
-
However, contributions to a 529 plan do qualify for
the annual exclusion ($15,000 per year). In addition,
a special election for 529 plans would allow you to
make one large lump-sum contribution (up to five
years’ worth of the annual exclusion) to a 529 plan.
In other words, you could make a larger upfront
payment without incurring gift tax, but then you
would not be able to make any additional tax-free
annual exclusion gifts to the 529 plan or the plan
beneficiary until the end of the five-year period.
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To ensure that your year-end gifts qualify for the
annual gift tax exclusion, make certain that the
transfers are completed in time. A gift by check is
not considered a completed gift until it is cashed.
If you think the donee might not cash the check
by year-end, consider using a cashier’s or certified
check, since the funds will be irrevocably removed
from your account when the check is issued.
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If your children are minors, consider setting up
custodial accounts for them. Under the Uniform Gifts
to Minors Act (UGMA), you can give a child gifts of
cash, securities, bank and money market accounts,
and (in some states) insurance policies.
Certain states have adopted the more flexible
Uniform Transfers to Minors Act (UTMA).
Under UTMA, you also can transfer other types of
property, including partnership interests.
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With a custodial account, you transfer the assets and
the income they produce to your child. Contributions
you make to these accounts may also qualify for
the $15,000 annual gift tax exclusion. Although
the assets belong to your son or daughter, your
designated custodian controls and manages these
assets for the minor’s benefit until the child is 18,
21, or 25 years old, depending on state law. At that
time, all the assets in the account are required to
be passed out to the child. As already noted, if you
and your spouse have been making annual exclusion
gifts to the account each year for the prior 10 years
(assuming a 5% rate of return on the assets in the
account), that would mean that your 18-, 21-, or
25-year-old would receive almost $400,000. Some
parents might feel that such a significant sum is too
much for their child to handle at a relatively young
age; in that case, a trust may make more sense.
Note that if you are the donor and also control the
assets as custodian, the assets will be considered
part of your estate if you die before the assets
pass to your child. This result can be avoided if you
appoint your spouse as custodian of assets you
transfer to your minor children.
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Another way to preserve your family wealth is to
decrease the number of times assets are subject
to transfer tax. Skipping a generation (or two)
by transferring property to your grandchildren
or great-grandchildren is a way to avoid estate
tax liability at the intervening generation or
generations. However, you could be subject
to the GST tax described above. The GST tax
is designed to eliminate the tax advantages of
transmitting wealth through succeeding generations
without each generation paying a transfer tax.
However, as mentioned above, there is a GST
exemption (same as lifetime exemption amount) and a GST tax
annual exclusion, $15,000, that may
mitigate GST tax exposure.
Establishing Trusts
A trust is a legal entity that is established for a given
period. It separates legal title (the powers of ownership)
from equitable title (the benefits of ownership). The trustee
has legal title to the trust property but holds it for the
benefit of the beneficiaries who have equitable title to the
trust property.
Federal income tax rates on trust income parallel individual
tax rates but with more compressed brackets. While an
unmarried individual will not reach the top tax rate of 37%
for 2018 until he or she has over $500,000 of income, a
trust will reach that rate with just $12,501 of income. In
addition, the 3.8% Medicare tax and capital gains and
qualified dividend rates, now 20% for those in the 37%
bracket, may also apply. The combined effect could be
severe for those trusts and estates that do not distribute all
of their income each year.
The below tables outlines the respective years taxes on trust income:
Planning Tips:
It may be wise—especially when the recipient
beneficiaries are in a lower tax bracket than the trust
or living in a low tax state—to minimize trust taxable
income by increasing distributions to beneficiaries
to the extent allowed in the trust instrument and
consistent with the grantor’s intent.
It may also be possible to minimize income taxes
by virtue of a nongrantor trust’s ability to utilize the
$10,000 state and local tax deduction (in addition
to the $10,000 deduction available to the grantor
individually), as well as the trust’s deduction for
amounts of gross income paid to charity pursuant to
the governing instrument.
Individuals living in high-tax states may also want to
consider creating a nonresident nongrantor trust if
income on the assets would otherwise be subject to
tax in the high-tax state.
Trusts can be utilized to achieve both tax and non-tax goals
of the creator of the trust. For example, a trust might be
established to:
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Avoid the cost and administrative effort associated
with probate
-
Minimize gift, estate, and GST tax on the transfer of
wealth to your descendants
-
Arrange for proper management of assets until children
or grandchildren reach a certain age
-
Provide income and ease of management for your
surviving spouse
-
Maintain income for your surviving spouse while
naming children as ultimate beneficiaries
-
Contribute current income to a charity with yourself or
others named as beneficiaries after a given period
-
Provide current income for yourself or others with the
remainder going to a charity when the trust terminates
-
Retain income from assets for a period of years and
then pass on remainder interest to others
-
Ensure professional management of assets
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Prevent creditors or former spouses of your children
and grandchildren from reaching assets held for their
future benefit.
One of the most popular trusts is the RLT (discussed
above), which can be established to manage assets and
avoid the difficulties and costs associated with the probate
process with respect to the assets transferred to the trust
before death. Because it is revocable, you can change the
terms and beneficiaries at will. You can be as involved or
uninvolved as desired in managing the assets, serving as
trustee personally or naming another trustee. Upon your
death, the assets that have been titled in the name of the
RLT pass to your beneficiaries as designated in the trust
agreement without going through probate. An RLT thus
allows you to retain control of the trust assets during your
life and allows your trustee to access funds immediately
at your death instead of being tied up in probate. But keep
in mind that the assets held in the RLT are still included as
part of your estate for estate tax purposes.
Other trusts are irrevocable and involve a permanent
transfer of assets. Although you relinquish all control
and may have to pay gift tax on the transfer, the income
and appreciation attributable to the transferred assets
are owned by the trust and are not subject to estate tax
upon your death, unless you retain a beneficial interest in
the trust.
Some common irrevocable trusts are described below.
Irrevocable Life Insurance Trusts (ILITs)
Life insurance proceeds can be used to pay estate taxes
or otherwise enhance your wealth. You should determine
the amount of insurance you need, and then decide on the
type of policy that is best for you.
Although the death benefit from a life insurance policy is
not taxable to the beneficiary for income tax purposes, the
value of the death benefit will be subject to estate tax in
the estate of the insured if the insured owns the policy at
death or within the three years preceding death. This will
occur unless you relinquish, more than three years before
death, all incidents of ownership, including the right to:
-
Name or change the beneficiary
-
Surrender or cancel the policy
-
Assign the policy
-
Revoke an assignment
-
Pledge the policy for a loan
-
Obtain a policy loan
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Elect the time or manner of the payment of proceeds.
In some instances, the inclusion of a life insurance
policy could cause the value of the estate to exceed the
exemption amount. If this were to occur, the beneficiary of
the policy could be forced to use life insurance proceeds
to pay an estate tax caused by the presence of that very
policy. As a result, it generally is more beneficial to have
someone else (such as an ILIT) own the policy
An effective way to keep life insurance proceeds out of
your estate is to establish an ILIT. You can either transfer
a current policy—individual, split-dollar, or group term—to
the ILIT or empower the ILIT trustee to purchase a new
policy on your life. You can gift to the ILIT the amount
needed each year to pay the premiums. By using a trust,
you will have greater flexibility in handling distributions of
life insurance proceeds and income than would be possible
under insurance settlement options. Note that if you assign
a current policy to the ILIT (as opposed to having the ILIT
purchase a new policy), you must live for at least three
years after the transfer is complete or the proceeds will
still be included in your estate. Assignment of a policy will
be considered a gift at FMV and will be subject to gift tax.
In most cases, term insurance has a negligible value except
to the extent of prepaid premiums.
Planning Tips:
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You, as the covered individual, can pay the
premiums on the policy in the life insurance trust
without jeopardizing its estate-tax-free status.
By allowing trust beneficiaries a temporary
withdrawal right with respect to contributions to
the trust (known as a “Crummey power”), you
may even be able to use your annual exclusion to
avoid gift tax on the premium.
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With a second-to-die—or survivorship—life
insurance policy, the death benefits are not paid
until the second spouse dies (regardless of the
order of death). They pass to your heirs free of
income tax and can be used to pay the estate
taxes on the remainder of the inheritance.
Intentionally Defective Grantor Trusts (IDGTs)
The tax rules regarding what qualifies as a completed
transfer for income tax purposes and for estate tax
purposes are not identical. Because of these differences,
an irrevocable trust can be structured so its assets are
excluded from the grantor’s estate (and considered
completed gifts) but its income is taxed to the grantor (as
if the gift had not been made). An IDGT takes advantage
of these differences, allowing the trust assets to grow
undiminished by income tax (because the tax liability
associated with such growth is paid by the grantor of the
trust rather than the trust itself) for the benefit of future
generations while also removing growth on assets gifted or
sold to the trust from your estate for estate tax purposes.
A trust that is disregarded as separate from the grantor
for income tax purposes has another advantage: sales of
appreciated assets by the grantor to the trust are ignored
for income tax purposes and generate no capital gain.
Nor does a sale to the trust result in gift tax liability, as
the transfer of additional assets to the trust is for full and
adequate consideration.
Planning Tips:
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An IDGT will generally purchase assets using
a promissory note as consideration. Typically,
“seed” money should be gifted to the IDGT
before the sale to give it some equity (generally
at least 10% of the total asset value). Although
the promissory note (or the proceeds) would be
includible in the grantor’s estate at death, any
appreciation on the assets after the sale would be
excluded. Thus, this technique works best with
assets expected to appreciate significantly and
those that can generate an income stream to pay
off the note.
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An IDGT can also be structured as a “Dynasty
Trust” that may benefit children, grandchildren,
great-grandchildren, etc. without inclusion of the
trust assets in the estate of the grantor or any of
the trust’s beneficiaries.
Grantor Retained Annuity Trusts (GRATs)
For those who have already utilized or wish to minimize
use of their lifetime gift tax exemption, a GRAT may be a
way to shift additional assets to children without generating
a gift tax. The GRAT pays you back an annuity amount each
year, and any remaining assets in the trust at the end of the
annuity term pass to the remainder beneficiaries (typically,
the creator’s children).
If the grantor retains a sufficiently large annuity payment
during the term—equal in value to the assets originally
transferred to the GRAT plus an assumed rate of return, the
value of the remainder gift can be “zeroed out”, such that
no taxable gift is made.
If the assets in the trust outperform the assumed rate
of return (which has ranged from 2.4% to 3.4% over the
past year), the excess passes to the beneficiaries free of
gift tax.
Planning Tips:
A popular way to do GRAT planning is to set up
“rolling” GRATs. These are short-term GRATs
(e.g., two-year terms) that are staggered (e.g., one
set up per year). The distributions from earlier GRATs
fund the later GRATs. Setting up rolling GRATs
instead of one longer-term GRAT may minimize the
effects of a reduction in value of the assets.
Qualified Personal Residence Trusts (QPRTs)
A QPRT involves the transfer of ownership of your
residence or vacation home to a trust but the retention
of the right to live in that home for a term of years.
The remainder generally passes to your children.
The benefit of this type of trust is that the gift is reduced
by the value of your retained income interest. Therefore,
you are able to leverage your gift tax exemption and
exclude a valuable asset from your estate. The longer the
term of years, the greater the reduction in the value of the
gift. However, if you do not survive the term of years, the
entire value of the property is includible in your estate.
So it is in your interest to choose a term that you think you
will survive.
Planning Tips:
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When the house is transferred to the children at
the end of the QPRT term, your cost basis carries
over. If instead you passed away with the house
still in your estate, the house would receive an
FMV basis. Although this difference in income
tax may be more than offset by the savings in
estate tax, it is something to consider, especially
if it is likely your children will sell the house after
your death.
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Many people still want to live in the house after
the QPRT term expires, particularly if they have
transferred their primary residence to the trust.
Although you are prohibited from purchasing
the house back from your children, as long as
your children agree, you can live in the house if
you pay them FMV rent. Paying rent is actually
beneficial for getting additional assets out of your
estate but you do have to be comfortable with
your children as your landlords.
Charitable Remainder Trusts (CRTs)
By using a properly structured CRT to transfer highly
appreciated, long-term gain property, you can improve your
own financial situation in addition to benefiting a charity.
A CRT allows you to transfer assets to a trust with the
stipulation that you receive distributions for a specified
period. Property in the trust is transferred to the charity at
the end of the trust term. You can choose generally one
of two options (although there are variations on both of
these types): (1) a charitable remainder annuity trust that
provides a fixed amount of annual income irrespective of
fluctuations in value within the trust from year to year; or
(2) a charitable remainder unitrust that remits an amount
based on a fixed percentage of trust assets valued annually.
With either option, the trust term can last for your lifetime,
for beneficiaries’ lifetimes, or for a designated period not to
exceed 20 years. You also can name more than one income
beneficiary in either type of trust.
Planning Tips:
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The sale of property held by the trust has no
immediate tax effect on either you or the trust.
CRTs are exempt from federal income tax
(although subject to an excise tax on unrelated
business income). Because of this exemption,
many people transfer appreciated assets to their
established CRTs prior to sale. If structured
correctly, you are liable for taxes only on the
distributions you later receive from the trust.
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Also, making charitable gifts through a CRT
provides a charitable income tax deduction at
the time of the transfer to the trust even though
the charity will not receive anything until the end
of the term. Transferring appreciated assets to
such a trust lowers your income taxes, avoids
generating taxable capital gains, and helps
accomplish your charitable goals.
Charitable Lead Trusts (CLTs)
A CLT is an arrangement whereby the donor gives an
annuity or unitrust interest to a charity for a term of years
(or for the donor’s lifetime), after which the remaining value
is paid to the donor or some other remainderman. This type
of trust is the reverse of a CRT since the charity is the
first party to enjoy an interest in the trust. It is generally
preferable that the assets transferred to a CLT produce
sufficient income to pay the annuity due to the charity.
A CLT can be either a nongrantor or a grantor trust.
A grantor trust allows you to receive an immediate income
tax deduction; however, you will then be taxed on all
income generated by the trust each year without any
offsetting charitable income tax deduction for the amounts
going to charity. A nongrantor CLT does not provide an
upfront charitable deduction, but the trust will receive an
income tax deduction each year for amounts transferred to
the charity out of the trust’s gross income.
While a CRT can help accomplish current financial
objectives, it may not be as beneficial to your heirs. If you
want to support your heirs as well as a charity, a CLT might
be an option. A CLT can pass assets to your heirs whileminimizing the estate
.taxes due on a large estate. This is
done by setting up a testamentary CLT and “zeroing out”
the trust. This means that the percentage payout to the
charity and term of the trust are set so that the charitable
estate tax deduction equals the amount going into the trust.
Assuming the trust outperforms the assumed appreciation
rates, the remaining amount passes to your heirs free of
estate tax
Business Succession Planning
Passing on the family business to your successors involves
many issues: transferring responsibility for running the
business to the next generation, guaranteeing future
income and financial resources, and minimizing income and
estate taxes. A few planning ideas that may assist you in
meeting your objectives are set forth below.
Buy-Sell Agreements
Establish a buy-sell agreement that will provide a
mechanism to buy out an owner upon retirement, disability,
or death. This keeps the company’s ownership in the hands
of those most involved, while providing liquidity to the
selling owner or the owner’s estate
Two types of buy-sell agreements are popular. With a
redemption-style agreement, the corporation buys out the
owner. If properly structured, the funds used to purchase
shares are not considered a taxable dividend to the selling
owner or the owner’s estate. In a cross-purchase type
of agreement, the owners themselves agree to buy out
each other.
In either case, the buy-sell agreement places a value on the
company, typically using a formula based on capitalization
of earnings. The formula arrangement may be respected
for estate and gift tax purposes provided it is a bona fide
business arrangement, comparable to similar arrangements
entered into by persons in an arm’s-length transaction,
and not a device to transfer assets to family members at
less than FMV. The buy-sell is often funded through the
purchase of life insurance.
Note: that if you had an agreement in place on October 8,
1990, you should consult your tax adviser before you make
any modifications. Some modifications may make you
subject to more stringent statutory rules.
Employee Stock Ownership Plans
Create a ready market for your company’s stock with
an employee stock ownership plan (ESOP). An ESOP
is a tax-qualified employee retirement plan designed to
invest primarily in employer securities. This benefit plan
offers major advantages to you as a business owner,
primarily because it provides a market for the closely held
company’s stock.
An ESOP funds employees’ retirement accounts with
shares generally purchased from the previous owners.
Both C corporations and S corporations can have ESOPs
(a partnership cannot), and both have advantages, but the
rules are different for the two types of entities. Under an
ESOP, the employer establishes a qualified retirement
plan trust with trustee. This is a tax-exempt trust, if all
of the requirements are satisfied. The trust purchases
shares of the employer, often using a loan from the
employer. The sale must be for full FMV, generally with
an independent valuation. The trustee thus becomes the
“owner” of the shares in the trust, and the company has
a tax-exempt owner or partial owner. To the extent of the
ESOP ownership percentage, any increases in company
value tied to shares held within the ESOP are not taxable
until cash or shares are distributed to an employee,
generally on termination from service with the company.
Also, shares paid from an ESOP may fit the net unrealized
appreciation rules and thus may be partly subject to
capital gains and partly subject to ordinary income rates
when distributed from the plan to any employee or
former employee (in contrast to the treatment of any
other property transferred out of a qualified retirement
plan, which is generally subject to ordinary income
tax treatment).
With proper planning, the rules permit you to sell your
own C corporation shares (but not S corporation shares)
to the ESOP and receive the proceeds without current
taxation (the capital gain tax is deferred until you sell the
qualified reinvestment property in the future). To obtain this
benefit, you need to enter into a section 1042 arrangement,
sell your shares at FMV, and then purchase marketable
securities as replacement property. The employee and
employer must follow a number of other tax rules and
other tax law requirements must be met. In addition, you,
as the seller, can meet personal liquidity objectives without
selling all of your shares at once. If you die holding the
replacement securities, capital gains tax is never paid.
Valuation issues are critical in selling shares to an ESOP or
obtaining shares from an ESOP. As noted above, an ESOP
must obtain independent valuations in order to hold
shares of a private company. The IRS does not require an
independent valuation each year, but the ESOP trust must
determine the FMV when distributing shares to employees
or participating in a transaction involving shares to see if a
new valuation is needed.
This is not only true for the original sale to the ESOP.
Instead, independent valuations must be obtained every
year or so under this sort of plan.
ESOPs are subject to a significant number of restrictions
and do not work for all sales, but they can be a good
way to monetize your holdings while providing an
employee incentive.
Installment Sales
Consider an installment sale to transfer company stock
to family members. Properly structured, an installment
sale can “freeze” the value of closely held stock even
though a family member pays for shares over a period of
time. If assets are rapidly appreciating, you can lock in the
current value for estate tax purposes while transferring
appreciation to the buyer. In addition, you can spread
out receipt of gain on the sale, delaying payment of
income tax until the year specific payments are received.
However, certain installment sales may create an interest
expense on a portion of the deferred gain.
Similar benefits can be achieved through a sale to an IDGT
(described above).
Planned Gifting
Through a planned gifting program, you and your spouse
could transfer a significant portion of your holdings
without incurring any gift or estate tax. As noted above,
current tax law allows you to make $15,000 annual
gifts ($30,000 collectively with your spouse) of cash or
property to any number of recipients gift-tax-free. In some
situations you could use this technique to pass on shares
of the family business, transferring appreciation and
ownership to the next generation (along with some of
the techniques discussed above such as an IDGT, GRAT,
etc.). Note, however, that if you have typical restrictions on
transfer of interests in your business operating agreement
such that economic benefits are not presently accessible,
a gift of these interests may not qualify for the annual
exclusion. You may also use your lifetime
exemption to make gifts of your ownership interests
without having to pay transfer taxes.
