Estate Planning in the Current Economic and Tax Environment
The Need for Estate Tax Planning Still Exists
Unfortunately, with the downturn in the economy, many Americans have watched years of hard work and savings plummet along with the stock and real estate markets. This decrease in assets, coupled with Congress’s enactment of the Tax Relief, Unemployment Insurance Reauthorization and Job Creation Act of 2010, may lead many to reconsider the need for revocable trusts and other estate tax planning devices. Under the 2010 Act, the federal estate tax only applies to those estates in excess of $5,000,000. However, presuming that estate tax planning is no longer needed may be incorrect for at least two reasons. First, many experts are now predicting a surge in the stock market that could replace, or even surpass, the losses of the past few years allowing reduced value gifts. Second, while the federal estate tax applies to only those estates in excess of $5,000,000, many states still have estate tax systems that apply to much smaller, and more typically-sized, estates. For instance, Massachusetts taxes all estates in excess of $1,000,000, while Rhode Island taxes all estates in excess of $892,865.
The Current Economic Climate
On March 9, 2009, the Dow Jones industrial average hit a low of 6,547. However, in the 21 months between March, 2009 and December, 2010, the Dow increased by 76%. While investments such as corporate bonds, CDs and mutual funds provide security, potential returns are much less compared to stocks. At present, corporate earnings are rising. Also, corporations are now holding more cash, which increases dividends. Together, these factors, and others, make stocks an increasingly appealing investment.
Moreover, the Great Recession officially ended in June, 2009. Reviewing historic trends, experts have noted that expansion following a recession, since World War II, has taken an average of five years. Thus far, expansion since this last recession has not been significant. Comparing this slow turnaround with past recoveries, the start of real improvements and gain could be right around the corner. While problems such as high unemployment and a weak housing market linger, the stock market has continued to improve. This is likely because investors tend to focus on present immediate factors, rather than more broad issues. In any case, if the predictions are correct, significant growth is on the horizon.
The result is that individuals who have lost significant amounts and seen the size of their estates dwindle may now see a substantial turnaround, and with that upswing the need for estate tax planning. While some may focus on the present value of their estate, the proper analysis for building an estate plan is to look not only at the current size of an estate, but also its expected growth
State Estate Taxes
Residents of several states, including Massachusetts and Rhode Island, should remember that there is still a state estate tax. In Massachusetts, estates in excess of $1,000,000 are subject to the Massachusetts estate tax. In Rhode Island, estates in excess of $892,865 are subject to the Rhode Island estate tax. Furthermore, the federal $5,000,000 exemption is only in effect for 2011 and 2012. It is unknown whether the federal estate tax exemption will remain at the $5,000,000 level after 2012, or decrease to some lower amount. Therefore, although one may feel secure that there estate is well below the federal estate tax threshold at the moment, one must consider the estate tax system in their state, as well as that the federal estate tax system is by no means permanent.
Estate planning attorneys utilize a number of different techniques in order to reduce or eliminate both federal and state estate taxes. The following is a discussion of some of the more common approaches used. This list is not exhaustive, and it provides only a brief overview of each of the different options. The estate plan ultimately chosen is dependent upon a individual or couple’s particular needs, which, typically, involves concerns and wishes beyond simply planning for estate and gift taxes.
Annual Exclusion Gifts
For gift tax purposes, a gift is broadly defined as a transfer from one person (the donor) to another (the donee) without adequate and full consideration in money or money’s worth. In order to make a complete gift, there must be a gratuitous transfer of property, that is accepted by the donee, and that divests the donor of dominion, control, and title over the property transferred. Treas. Reg. 25.2511-1(c); Treas. Reg. 25.2511-2(b).
Under the United States gift tax system, a donor is currently allowed to make gifts of up to $13,000 to any number of persons each year without having to either pay gift tax or use a portion of his or her gift tax exemption. Rev. Rul. 59-357, 1959-2 CB 212. For instance, a person with one brother, one sister, and one child, can each year give up to $13,000 to his brother, $13,000 to his sister, and $13,000 to his child. In order to qualify for the annual exclusion, the gift must be of a present interest in property. A present interest gift is one in which the donee’s possession or enjoyment begins at the moment that the gift is received. Straightforward examples of present interest gifts are cash or a fee simple interest in land. In comparison, a non-present interest, or future interest, is one in which the donee’s use, possession, or enjoyment will not begin until some time after the gift is made. Future interests include reversions, remainders and any other similarly delayed interests.
Individuals make gifts to beneficiaries during life, rather than waiting until death, for a number of reasons. People tend to make gifts during their lifetime to be able to see the donee benefit from the gift or to help assure the financial security of the donee. Also, if an asset is likely to appreciate, it is better to make the gift when it is still at a lower value, because, in turn, a lower gift tax will be applied. In addition, if a gift of income-producing property is made, the donor is able to shift taxable income from him or herself to the donee.
The primary tax benefit of annual exclusion gifting is the ability to transfer assets to intended beneficiaries without any tax consequences whatsoever. Not only are the gifts not taxed, but so long as the gifts are below $13,000 per year, the donor’s gift tax exemption will not be consumed. However, because the annual exclusion is limited to only $13,000 per year, individuals with substantial estates must seek other techniques when planning to reduce estate and gift taxes.
A-B Revocable Trusts
The “A-B” Revocable Trust is an estate planning arrangement designed to provide individuals full use of the family’s economic wealth, while at the same time minimizing, to the greatest extent possible, the total amount of federal and state estate tax payable at the death of both spouses. A married couple can eliminate estate taxes on the death of the first spouse by using a combination of the unlimited marital deduction and the estate and gift exemption. In addition, the approach allows for there to be no, or at least significantly minimized, estate tax on the death of the second spouse. (The marital deduction is a limited deduction allowed for property that passes by gift or inheritance to a person’s spouse only.)
The A-B Revocable Trust contains a series of steps, and ultimately results in the creation of multiple trusts. First, a person, known as the grantor, creates a revocable trust. If the trust is created during the grantor’s lifetime, the grantor then transfers all of his high worth assets into the trust (remaining assets will pass into the trust at the time of the grantor’s death). During the grantor’s lifetime, assets may be freely transferred into and out of the trust, and any income from trust assets is taxed directly to the grantor.
The trust is structured so that, upon the death of the grantor, the trust assets are divided in accordance with a formula into two separate trusts. The first trust (the “A trust” or “marital trust”), is for the benefit of the surviving spouse and the second trust (the “B trust” or “credit shelter trust”) is for the benefit of the grantor’s children or other beneficiaries, and the surviving spouse if desired. The assets are distributed between these two trusts by first putting the amount equal to the estate tax exemption into the B trust (currently $5,000,000 at the federal level, $1,000,000 in Massachusetts, and $892,865 for Rhode Island), and any remaining amount into the A trust. The estate tax exemption will remove any estate tax on the assets transferred to the B trust because it applies regardless of to whom assets are transferred. Therefore, assets in the B trust will pass estate tax free and can further appreciate without being subject to estate taxes in the future. Then, the marital deduction is applied to the assets transferred into the A trust, because that trust is solely for the benefit of the surviving spouse.
Irrevocable Gifting Trust
The Irrevocable Gifting Trust, commonly referred to as a “Defective Irrevocable Trust,” is an estate planning tool that takes advantage of the lack of coordination between the estate and gift tax provisions in the Internal Revenue Code (I.R.C.), and its income tax provisions. This lack of coordination makes it is possible to structure a trust so that the income from any trust property is taxable to the grantor, while the transferred property is considered to be a completed gift for gift and estate tax purposes. In other words, trust assets are not included in a grantor’s estate for estate tax purposes and transfers of property to the trust are complete gifts for gift tax purposes, but trust income is taxed directly to the grantor who is still deemed the “owner” for income tax purposes.
At first glance, such an arrangement may appear both confusing and unnecessary. However, for certain situations, transferring assets for estate and gift tax purposes, but retaining those same assets for income tax purposes, can be highly advantageous. For instance, Irrevocable Gifting Trust, because income is taxed directly to the grantor, the grantor is entitled to any resulting income tax deductions or credits. Also, by paying income taxes him-or-herself (rather than the trust), the grantor is able to reduce his or her estate without having to make additional gifts of property.
Furthermore, from a pure tax standpoint, taxing trust income directly to the grantor almost always results in a lower overall income tax than if the same income were taxed to the trust. Trusts are taxed using a compressed, higher rate than the individual income tax system. Also, individuals are allowed many more deductions and credits than trusts, which further reduces an individual’s income tax compared to a trust. In addition, because assets transferred into an irrevocable trust are treated as completed gifts, such assets are not subject to any federal gift or estate tax. Massachusetts and Rhode Island do not have a state gift tax, but making a completed gift to an irrevocable trust still has the benefit of permanently removing transferred assets from the grantor’s estate for state estate tax purposes.
As already discussed, lifetime annual exclusion gifts are one option for reducing a person’s estate. However, many issues arise when the intended donee is a minor because many people do not feel comfortable giving significant assets to a minor, brokers and others are reluctant to deal with minors, and a guardianship appointment may be needed. The solution to this problem is gifting assets to a particular type of trust, a Minor’s Trust, authorized under I.R.C. § 2503(c). In addition to making annual exclusion gifts and reducing the size of one’s estate, Minor’s Trusts are useful when an individual in a high income tax bracket wishes to shift the income to a minor with a lower income tax bracket. In addition, it is usually more desirable to fund a Minor’s Trust with a lower value asset that is likely to appreciate in the future, thereby shifting the potential appreciation out of the donor’s estate.
In order to properly establish a Minor’s Trust, the precise requirements listed under I.R.C. § 2503(c) must be followed. First, the income and principal in the trust must be available to the child after he or she turns 18, but no later than the age of 21 (while income and principal must be available to the child, it is not required that all amounts be distributed to the child). Second, if the child dies while assets are still held in trust, the remaining assets must be distributed to the child’s estate (and not to some other beneficiary).
As an example of the use of this type of trust, suppose Father creates three Minor’s Trusts, one for each of his three daughters. Each year, Father can contribute up to $13,000 (or the annual exclusion amount) to each of the three trusts. Because the gifts will qualify for the annual exclusion, the size of Father’s estate will be reduced without any gift tax implications, the income generated by the assets will be shifted to the daughters, and any further appreciation in the value of the assets will take place outside of Father’s estate.
Irrevocable Life Insurance Trust
Irrevocable Life Insurance Trusts (or “Crummey Trusts”) are a type of trust used to make lifetime gifts. The major benefits of a Irrevocable Life Insurance Trust is that gifts do not have any negative estate or gift tax implications, and by making gifts to a trust, minor children are prevented from gaining immediate access to all of the trust property.
First an individual establishes and funds a Irrevocable Life Insurance Trust with cash and/or other assets. These gifts of cash are not taxable, and also will not consume the individual’s gift tax exemption so long as the amount is below that year’s annual gift tax exclusion. The trust assets are then held in trust and are used to purchase life insurance policies on the life of the donor. Subsequent transfers to the trust are used to pay the premiums on the policies owned by the trust.
It is important to note, however, that in order for these transfers to be treated as gifts and thereby qualify for the gift tax annual exclusion, it is required that the trust gives the beneficiaries a temporary, but unconditional, right to demand a withdrawal from the trust of a specified amount. If the demand right is not exercised within the withdrawal period, the annual transfer for that year remains in trust to be managed by the trustee. If on the other hand the demand is made, than the amount must be given to the beneficiary. However, beneficiaries are advised and almost always recognize that making such a demand is not in their best interest, as the individual will stop making future transfers to the trust. From the perspective of the beneficiary, this ultimate potential inheritance outweighs a much smaller immediate distribution, which will equal the cost of the year’s premium payments, more or less.
Grantor Retained Annuity Trust
A Grantor Retained Annuity Trust (GRAT) is an irrevocable trust into which a grantor transfers income generating assets that have substantial value and appreciation potential, while retaining an annuity from the trust for a specific period of years. Under the terms of a GRAT, the grantor receives a fixed amount from the trust each year. Any portion of the trust assets not paid back to the grantor by way of the annuity instead passes to the trust’s remainder beneficiaries at the expiration of the trust term. Therefore, a GRAT contains two separate interests, the annuity which is returned over time to the grantor and the remainder which is distributed to the remainder beneficiaries at the end of the annuity payment period.
For gift tax purposes, only the portion of the assets that will pass to the remainder beneficiaries is taxable (since the grantor retains an interest in the annuity portion, that amount is not a completed gift). If the grantor dies before the end of the trust term, the remainder interest will be included in his or her estate. Also, if the grantor survives the term of the trust, the value of any remaining property in the trust (the non-annuity portion) is not subject to the grantor’s estate tax. I.R.C. § 2036. As a result, when choosing the length of the trust, the length should be less than the estimated life expectancy of the grantor. In order to properly create a GRAT, the strict guidelines of I.R.C. § 2702 must be followed. The GRAT annuity amount must be either a fixed dollar amount or a fixed percentage of the initial value of the trust. Treas. Reg. § 25.2702-3(b)(1)(ii). Also, once a GRAT is created and funded, subsequent contributions by the grantor are prohibited.
GRATs are often utilized by single clients with substantial estates, who cannot benefit from the estate tax marital deduction available to married individuals. GRATs are beneficial on the basis of two major tax principles. First, gift taxes are applied to the remainder portion of the trust assets at the time the property is transferred to the trust, as opposed to when the remainder amount is distributed to the remainder beneficiaries. This means that the value of the gift has to be estimated by the IRS years before the actual value will be known. The goal of a GRAT is for its investments to perform above the IRS estimate, so that the excess performance avoids taxation. The second principle is that the federal estate tax does not apply to an asset unless the decedent has a certain level of ownership or control over it. At the time of the expiration of the trust term, the remainder interest portion of the property transferred into a GRAT no longer has the level of connection that will result in it being treated as part of the grantor’s estate.
Given the different areas of the I.R.C. that are involved in the GRAT technique, perhaps the best way to illustrate the functioning and benefits of this type of trust is through an example. Assume that at the time a GRAT is created, the applicable IRS interest rate is 5.0%. I.R.C. § 7520. Also assume that the grantor transfers $500,000 into the trust, and under the trust terms is to receive annual payments at a rate of 6% per year, for a term of 15 years. The grantor’s annual annuity under such an arrangement will be $30,000.
Under these conditions, when the GRAT is formed with $500,000, the IRS will value both the annuity portion of the transfer and the remainder portion. Using the applicable IRS rate of 5%, the present value of the annuity is $311,391. This means that the remainder interest’s value is $188,609 (the difference between the value of the property transferred and the value of the retained annuity). Therefore, because the gift tax is only applicable to the remainder portion, the value of the gift is $188,609.
Because the remainder interest is valued and taxed at the time that the trust is funded, the transferred assets are now free to appreciate in the trust without any further gift tax. The grantor will still be entitled to the same, set annuity valued at $311,391. However, any appreciation of the assets greater than the rate of 5% (the rate used to value the expected appreciation of the remainder interest) will pass to the trust beneficiaries without being subject to further gift tax. At present, the IRS applicable interest rate is around 3%, though it has been as low as 1.8% and has kept below 3.5% for several years. Properly invested GRAT assets should appreciate at a greater rate than 3%, with that difference in appreciation passing to the trust beneficiaries free of both gift and estate tax.
Family Limited Partnerships
Today, the Family Limited Partnership (FLP) technique is one of the most disputed and heavily scrutinized areas in estate planning. A FLP can be used to transfer property with significant valuation discounts for transfer tax purposes. The technique offers the potential for tremendous savings when shifting wealth to younger generations. However, because of both real and perceived abuses by taxpayers, the Internal Revenue Service (IRS) has repeatedly attacked the validity of FLP transactions, scoring some victories while more often facing setbacks. For both practitioners and clients, it is important to understand when the FLP can, and cannot, be used and how to structure a partnership agreement and subsequent transfers so as to both comply with federal tax law, as well as decrease the potential for conflict with the IRS.
The term FLP is used generally to describe a business entity taxed as a partnership, with interests of which are held entirely, or predominantly, by family members. Entities falling under the FLP umbrella include general partnerships, limited partnerships and limited liability companies (LLCs), with the limited partnership being the most popular choice for asset transfer purposes. FLPs offer a number of incentives that include shifting the income tax burden to less wealthy family members, maintaining control and management in the hands of the older generation, asset protection, simplification of ownership, out-of-state probate avoidance, and the retention of ownership within the family.
However, perhaps the most popular use of the FLP is its ability to reduce a person’s estate by making gifts of partnership interests at a significantly discounted value for gift tax determinations, along with ease of family management and gifting, and liability protection. When the limited partnership is created, a parent (or older family member) transfers assets into the partnership, taking general and limited partnership interests in return. Then, over time, the parent gifts his or her limited interests to the younger generation. The value of the gifts is decreased by applicable discounts, including those for lack of control and marketability. The result is a possible discount of approximately 30 to 35%. By using this method, a parent is able to transfer a large percentage of partnership interests at a lower value, while at the same time decreasing the parent’s taxable estate.
To illustrate, suppose a couple owns real estate worth $10,000,000 that they wish to leave to their children. The parents can transfer the property to a limited partnership, taking a 10% general partnership interest and a 90% limited partnership interest. Later, the parents begin to make gifts totaling half of the limited partnership interests to their children (45% of the entire interests). While it might be assumed that the value of the gifts equals 45% of the partnership’s net worth (which would be $4,500,000), because the gifts are of minority interests in a closely held business, the value of the interest is discounted for lack of control and marketability. These discounts reduce the total value of the gifts to approximately $3,000,000 (the 30 to 35% reduction), a difference of $1,500,000 in taxable gifts.
In the coming years, the stock and real estate markets should (hopefully) rebound, resulting in increased wealth for investors. This increased wealth, in turn, may cause estates that are currently below the estate tax threshold to be pushed upward and subjected to federal estate taxes. Also, while the current federal estate tax exemption is $5,000,000, the estate tax exemption in states such as Massachusetts and Rhode Island is one-fifth (1/5) that amount. Furthermore, the current federal estate tax law is likely to change after 2012, and it is not safe to assume that the present law is permanent. Therefore, many individuals should seriously consider some form of estate tax planning, to push low value assets out to the next generation which will grow free of estate or gift taxes.