written by Brenda Logsdon
In the following guide you will find an assortment of recommendations to reduce or shift value from a personal estate. These techniques will reduce the potential estate tax upon death. Topics will include gift planning, a variety of trusts and much more.
An implemented gift program is one of the best ways to reduce the value of a person’s overall estate, thereby, reducing the person’s potential estate tax upon death.
Making annual gifts utilizing the $13,000 annual exclusion per donee is an effective way to reduce a person’s estate. Because the annual exclusion is applied on a per donee basis, a donor can leverage the exclusion by making gifts to multiple members of the same family including the spouse of a son or daughter. The donor’s spouse can also make gifts, therefore, doubling the gifts to $26,000 per donee. If the donor makes a gift of his or her separate property in the amount of $26,000, the donor and spouse can elect to split the gift on the annual gift tax return.
In addition to the annual gift tax exclusion, a person can make tuition payments for any individual without incurring any gift tax or use of his lifetime gift and estate tax exemption ($5,000,000 for 2011 and $5,120,000 for 2012). Though the amount that may be excluded as a gift is not limited, all payments must be made directly to a tax-exempt school of any grade level for the purpose of education. The exclusion applies only to tuition. Thus, payments for room and board, books, required equipment and related expenses are not an excludable gift.
Another payment that is not treated as a taxable gift is the payment of medical expenses. Again, the payments must be paid directly to the medical provider. These medical expenses can be made on behalf of any individual but must be of the type that qualifies for a medical deduction. The exclusion for medical payments would also include the payment of medical insurance premiums. The payment of medical expenses is an efficient means of making a tax-free gift that does not use either the annual exclusion or the lifetime gift tax exclusion. And if the person is a dependent, the donor can claim the medical expenses as an itemized deduction.
Larger Gifts for 2011 and 2012
The lifetime gift tax exclusion has substantially increased from $1,000,000 in 2010 to $5,000,000 in 2011 and $5,120,000 in 2012. The exclusion will revert back to $1,000,000 in 2013 unless Congress enacts legislation. Thus, there is a two year window for making substantial gifts. With the new portability rules for deceased spouses, a surviving spouse can utilize the unused lifetime exclusion of the deceased spouse, thus potentially obtaining$10,000,000 lifetime exclusion. This is only effective for spouses who have deceased in 2011 and 2012 and for which an election has been made on the deceased spouse’s timely filed estate tax return. The portability rule does not apply for generation- skipping transfers, thus the donor only has his $5,000,000 ($5,120,000 in 2012) lifetime exemption for making gifts to grandchildren or great-grandchildren.
Discounts have been widely used in valuation of closely held businesses or partial interests in property. A family partnership organized as a limited partnership has been regularly used in the estate and gift tax planning context. A family limited partnership (FLP) is more preferable than a closely held corporation because of the flexibility of a partnership regarding the non-taxability of capital contributions and distributions and the availability to “step-up” the basis of the partnership’s assets on the death of a partner, which is not available to a corporation that is taxed as an S Corp or C Corp. The parents can maintain control of the partnership by being the general partners of the partnership and gifting only limited interests to the children and grandchildren.
Only business assets should be transferred to the partnership. The courts have only allowed small discounts for liquid assets in a FLP, such as publicly traded stock. If small minority gifts are made, for valuation purposes, a minority discount can be applied, and if the assets in the FLP are illiquid, a marketability discount can be applied. The discounts allowed generally range between 20%-50%, depending on the circumstances and the type of assets held. Discounts can also be applied to partial interests in property such as real estate.
The objective for estate tax purposes would be to assure that the transferred partnership interests are not includible in the estate of the transferor. The partnership agreement should specify that the general partner is bound by fiduciary duties in managing and operating the partnership. The transferor must not retain possession or control or the right of the income from the transferred assets. It would be preferable to make periodic distributions to all partners so that it is evident that the donees are receiving benefits from the transferred partnership interests. The IRS has had only partial success in disallowing valuation discounts for gift and estate purposes, usually if the FLP was created shortly before death.
Legislation was introduced in 2009 to disallow discounts in valuing the closely held interests. The 2010 Tax Reform Act did not contain any restrictions on discounts, so it is still a viable estate planning tool for 2011 and possibly 2012.
Grantor Retained Annuity Trusts
A common estate planning technique is to use Grantor Retained Annuity Trusts (GRATs) to shift value out of the person’s estate. The use of two or three year GRATs are common. The objective is to transfer the asset to an irrevocable trust and to make the gift a nontaxable gift or a “zeroed out” GRAT. The donor will receive an annuity, annually, plus interest using the current IRS interest rate, which is relatively very low in 2011. Thus, for a two year GRAT, one-half of the asset contributed to the trust plus the amount of the computed interest would be distributed back to the grantor from the trust after year one. If the asset does not appreciate in value by the end of year two, the donor will have received the entire asset back from the trust.
However, if the asset has appreciated, the amount of the appreciation less the computed interest for the two years will be transferred to the beneficiaries of the trust at the end of year two. This is a technique used to transfer wealth without using any annual gift tax exclusion or lifetime exemption. Publicly traded stock is commonly transferred to this type of GRAT.
If the donor dies prior to the termination of the trust, the assets in the GRAT are included in the estate of the donor. This is why the short-term GRATs are so popular. There has been legislation introduced to eliminate short-term GRATs, requiring a GRAT to contain a term of at least ten years. There was no such legislation in the 2010 TRA, so the short-term GRAT should remain viable for 2011 and possibly 2012.
Longer term GRATs can be a very effective estate planning tool to transfer wealth if the assets transferred are income producing and the income produced is much higher than the long term AFR rate. For example, if commercial real estate valued at $1,000,000 was transferred to a GRAT with annual cash flow of 7%, the trust terms could require a 7% annuity to be paid to the grantor. If the term of the trust was set at 15 years and the long term AFR rate was 1.6%, the value of the remainder interest, which is the taxable gift, would only be $53,833. The grantor has removed $941,167 plus any appreciation of the real estate from his taxable estate. At the end of the trust term, the remainder beneficiaries will receive title to the commercial real estate. It is important to make the term of the trust less than the life expectancy of the income beneficiary, so that the likely hood of the grantor dying prior to the termination of the trust is remote.
Qualified Personal Residence Trusts
A qualified personal residence trust (QPRT) is a vehicle whereby the donor gifts his home to a trust reserving the right to live in the home for a fixed number of years. After the term of the trust is complete, the donor’s beneficiaries, generally the children, will have ownership of the home. The donor can continue to live in the home after the termination of the trust, but must pay rent to the children at a fair market value rental rate, which is also another technique used to reduce the donor’s estate. The advantage of the QPRT is the delay in the gift, so that the value of the remainder interest is the amount of the taxable gift. Depending on the term of the trust, the taxable gift is generally a fraction of the current fair market value of the home. If each the husband and wife transfer a one-half interest in the home to separate QPRTs, a discount for a fractional interest could be warranted.
If the home is sold and not replaced or destroyed and not replaced, the trust turns into a GRAT as previously described, and the donor must receive an annuity. Again, if the donor dies during the term of the trust, the value of the trust assets will be included in his estate. A taxpayer is allowed to create two QPRTs during his life, one for his primary residence and one for another personal residence. The disadvantage to the beneficiaries is that the basis of the residence is the carryover basis equal to the donor’s cost basis.
Charitable Remainder Annuity Trust and Charitable Remainder Unitrust
A charitable remainder annuity trust (CRAT) is similar to a GRAT except the remainder interest is transferred to a qualified charitable organization at the end of the term. If set up during life time, the donor will receive a charitable income tax deduction for the value of the remainder interest given to charity. The donor must receive an annuity of not less than 5% for the life of himself or with other beneficiaries, or for a term which cannot exceed twenty years. No additional contributions can be made to the trust. If the donor does not have any children, this might be setup at death, with his spouse receiving the annuity for her life and the remainder to charity. The value of the annuity will qualify for the estate tax marital deduction and the remainder value of the CRAT will qualify for the estate tax charitable deduction, avoiding any estate tax.
A charitable remainder unitrust (CRUT) is similar to a CRAT except that the trust is valued annually and the annuity is recomputed each year. The CRAT has a fixed annuity and the CRUT annuity will vary each year. Unlike a CRAT, the donor can make additional contributions to a CRUT. If the donor dies without a surviving spouse, the value of the trust assets will be included in the donor’s estate, however, the donor will receive a charitable deduction for estate tax purposes, escaping any estate tax on the value of the CRAT or CRUT.
One of the benefits of the CRAT or CRUT is that the trust is exempt from income tax. If the donor transfers an asset with a low cost basis, the trust can sell the asset and pay no income tax. This is a popular technique when the asset is not producing any income and the donor wants to reinvest the assets into income producing assets. The annuity paid to the donor will be taxable to the donor with ordinary income taxed first, such as interest, dividends and short-term capital gains, then long-term capital gains and finally tax exempt income.
This taxation structure avoids the taxation of the entire gain in the year of sale and defers the taxation until each annuity is paid. Some taxpayers will buy additional life insurance equal to the value of assets transferred to the CRAT or CRUT, with the children as beneficiaries to make up the amount that was transferred to charity. If structured without incidents of ownership to the donor and insured, the life insurance will not be included in the donor’s estate.
Charitable Lead Trusts
A charitable lead trust is a trust set up for a term of years with a fixed amount or fixed percentage payable to one or more charitable organizations. After the trust terminates at the end of the term, the remainder will be payable to beneficiaries, generally younger family members of the donor. This effectively enables the donor to benefit charity and retain the asset in the donor’s family. The trust can be set up as a charitable lead annuity trust (CLAT) with a fixed annuity, or a charitable lead unitrust (CLUT) with the trust revalued annually. The trust can be set up during the donor’s life-time or at the donor’s death. If set up during life-time, in order to receive a charitable income tax deduction, the donor must be considered the owner of the trust under the grantor trust rules. The donor would be taxed on the income of the trust and receive a charitable income tax deduction equal to the present value of the income interest payable to the charity. An alternative to this structure is to set up the trust as a nongrantor trust. The donor will not receive an income tax deduction, but he will also not be taxed on the trust’s income each year. The trust pays the tax on its taxable income but the trust also receives an income tax deduction for the annuity paid to the charity.
Because a taxable gift occurs in the year the trust is created, equal to the present value of the remainder interest which will be transferred to the donor’s beneficiaries, these types of trusts are not as widely used. If the trust is set up at the time of his death, the donor’s estate will receive an estate tax deduction equal to the present value of the income interest paid to the charity. Depending on the term of the trust and current interest rate, a substantial charitable estate deduction can be taken by the estate in computing the donor’s taxable estate. For instance, if a CLAT was created on death in December 2001 with $10,000,000 for a term of twenty years with a 5% annuity, the donor’s estate would receive an estate tax deduction in the amount of $8,669,550. This technique is widely used by high net worth taxpayers, especially when their children have substantial assets of their own. If the trust out performs the annuity rate, the accumulated income plus the principal will pass to the beneficiaries. The assets can also be transferred to grandchildren, but there are special rules relating to the allocation of the generating skipping exemption to a CLAT, which doesn’t apply to a CLUT.
Another charitable gift option that is similar to a charitable remainder annuity trust is a gift annuity. Under a gift annuity, the donor transfers assets to the charity in exchange for a promise to pay the donor an annuity for life. The donor will receive a charitable income tax deduction equal to the assets transferred less the present value of the annuity payments. The transfer is treated as a bargain sale to the charity, so that a transfer of appreciated assets will create a taxable transaction. If the asset is a long-term capital asset, a portion of the annuity payment will be treated as long-term capital gain. The remainder of the payment will be considered principal and interest.
Credit Shelter Trusts AND Marital Trusts
A valuable estate planning tool is the use of the marital deduction when the decedent has a surviving spouse. There is an unlimited marital deduction available to the decedent for assets given outright or in trust. To ensure that the decedent’s assets will eventually transfer to the beneficiaries of the decedent’s choice, the assets are often times transferred to a trust for the benefit of the surviving spouse. To qualify for the marital deduction for assets transferred to the trust, the estate must make an election, and the trust must be required to distribute the income at least annually for the life of the surviving spouse. No other person can have an interest in the trust until the death of the surviving spouse. This trust is known as a marital deduction qualified terminable interest trust (QTIP). The trust can contain a discretionary power to make principal payments based on the needs of the surviving spouse.
In order to utilize the decedent’s lifetime estate tax exemption, the remainder is generally transferred to a credit shelter trust or bypass trust. The amount transferred generally is the amount of the decedent’s unused lifetime estate tax exemption. Many times the terms of the trust is the same as the marital trust, but this trust is not required to distribute income or principal to the surviving spouse.
Life Insurance Trusts
Life insurance is a valuable estate planning tool, which can be used to create more wealth on death or used to pay the estate tax on larger estates with illiquid assets. If the life insurance was owned by the decedent on death, the life insurance proceeds would be includable in the decedent’s taxable estate. Therefore, the life insurance is often purchased by an irrevocable trust with an independent unrelated trustee, so that the decedent will not have any incidents of ownership in the life insurance. Upon death, the life insurance is received by the trust and can be distributed to the beneficiaries to pay the estate tax. Alternatively, if the trust is not to terminate at the decedent’s death, the trust could loan the money to the estate or purchase illiquid assets from the estate.
The grantor will have to transfer sufficient income producing assets to the trust to pay for the annual premiums. The transfer would be considered a completed gift for gift tax purposes. To qualify for the gift tax annual exclusion of $13,000, the beneficiaries of the trust must have a present interest in the trust. Instead of transferring sufficient assets to the trust to pay the premiums, the grantor usually will transfer an amount equal to the annual premium. The trust terms will give multiple beneficiaries the right to withdraw the amount transferred for a short period time the equal to the annual exclusion amount or less, depending on the amount of the premiums. This limited power to withdraw by the beneficiaries is known as a “Crummey Power”. Because the income of the trust can be used to pay life insurance premiums, the trust will be treated as a grantor trust with income taxed to the grantor.
A few states have enacted new statutes that will allow a trust to remain in existence on a perpetual basis, which is known as a “dynasty trust”. Prior to the new statutes, the trust was required to terminate after the death of a person living at the time of creation of the trust plus 21 years, known as the “rule against perpetuities”. Many states still have the rule against perpetuities in effect. Missouri has abolished the rule against perpetuities, and therefore, a grantor can set up a trust to benefit not only his children and grandchildren, but also future generations. As long as the grantor has sheltered the trust from generation skipping tax by utilization of his lifetime generation skipping tax exclusion ($5,000,000 in 2011 and $5,120,000 in 2012), the trust will avoid any future federal estate tax. In addition to the estate tax benefit, the trust will provide protection against judgments from lawsuits, including bankruptcy and divorce, of the trust beneficiaries.
Inter vivos revocable trusts, also known as living trusts, are the most commonly used trusts in estate planning. The grantor has control over the trust during his lifetime and can revoke the trust or amend it as many times as he likes. Many times the will is drafted so that if some assets are not titled in the name of the trust, these assets will “pour over” to the trust at the grantor’s death. The living trust will contain the dispositive provisions similar to a will. There is no income or estate tax benefits by setting up the revocable trust because the grantor will be taxed on the income from the trust assets, and the assets will be included in his estate upon death.
There are many benefits to the inter vivos revocable trust. The assets will avoid probate which is slow and costly. The trust will have uninterrupted trust administration after the grantor’s death. Since the trust assets will not be probated, the trust will avoid publicity unlike that of assets subject to probate through a will. If the grantor becomes incompetent or incapacitated, the successor trustee can take over the administration of the trust without interruption. If the grantor is the trustee, the trust will not be required to have a separate federal ID number or file a separate income tax return.
We hope that the information in this article is useful in your gift and estate planning. If you wish to take advantage of any of the planning techniques that we have described, please feel free to call.
Brenda is a partner at The Whitlock and has worked in public accounting with a specialization in taxation since 1975. She has significant experience in tax strategy planning regarding mergers and acquisitions and serves as practice partner-in-charge of income, gift and state taxation. Brenda provides planning and consulting services for clients in a variety of industries including not-for-profit organizations, financial institutions, wholesale and retail distribution, manufacturing, medical practices, construction and real estate development companies. She also provides tax planning for complex corporations, partnerships and trusts.