Advanced forms of wealth transfer and estate planning are more complicated, and consequently more expensive to implement. However, their costs and complexity are almost always dwarfed by the tax savings, and capital preservation, they achieve.
NEW TAX EXEMPTION LAWS
On January 1, 2011, the estate tax exemption increased to $5,000,000, meaning that a married couple can now pass $10,000,000 to their heirs estate-tax free by the simple expedient of establishing a fully tax-planned living trust. Coupled with the probate-avoidance features of a living trust, everyone should have a living trust where an estate of any substantial size is involved.
Consequently, most affluent families in California have established a living trust as well as an adequate life insurance portfolio by this time. To the extent that they have (or believe they have) sufficient assets, many adults are also making yearly gifts to their children and grandchildren to take advantage of the annual $13,000 exclusion. Some have also made gifts up to the $5,000,000 gift tax lifetime exemption. Although various technicalities attend these steps, they are relatively easy to implement and not very expensive.
The use of an irrevocable trust to purchase life insurance on the grantor, or the grantor and spouse (“second-to-die” policy), permits funds to be accumulated free of income tax, and eventually be transmitted to heirs estate-tax free. In addition, such a trust can also enable the funds in the trust to remain insulated from a beneficiary’s financial problems arising out of debts, divorce or lawsuits. Premiums on the life insurance can be paid by the trust using gifts from the grantor and grantor’s spouse in a manner which qualifies for the annual gift exclusion of $13,000. These types of gifts are commonly known as “Crummey gifts.” (Thus, a married couple with three children can use annual exclusion gifts of up to $78,000 per year to pay premiums through a life insurance trust). This is far preferable to having a couple purchase a large “second-to-die” policy for the express purpose of paying estate taxes on the death of the second spouse, and then having the death proceeds from that policy included in their taxable estate.
GRANTOR RETAINED TRUSTS
A qualified personal residence trust (“QPRT”) permits its owners to give their family residence to others (presumably their children), but continue to occupy it for a number of years. This is a good vehicle for moderately wealthy people. For example, a home can be placed in trust for the children, with the parents retaining the right to live there for 10 to 12 years. The gift tax on such a transfer is calculated on the value of the house minus the present value of the retained residential rights. Transferring a $1,000,000 house to a QPRT can result in a gift valued at far less than $500,000. If a parent dies before the term of the trust expires, the house goes back into his or her estate; however, this also nullifies the gift tax component. Parents can lease the home back from the children, who own the property after the parents’ term of use has expired, so long as there is no pre-existing agreement to do so. For parents reluctant to be in a tenant-landlord situation with their children (99.9% of all parents), a solution is for the house to remain in trust for the benefit of the children, but with a parent as trustee. Then the parent as trustee can lease the house to the parent or parents as tenant, and thus remain in control, subject to the requirement to pay fair market rent. In addition, the trust can be structured in such a way that the payments that the parents make under the lease agreement are neither rent (taxable income) or gifts to the children, which further diminishes the parents’ estate without income or gift tax consequences.
GRANTOR RETAINED ANNUITY TRUST (GRATS)
Short term (2 year) GRATS have become a popular technique for wealth transfers to children and particularly to grandchildren. The payout on the annuity is designed to “zero out” the value of the remainder so there is no gift when the trust is established. If the trust out-performs the Section 7520 rate, then there will be an actual remainder at the end of two years, which will usually pass into an intentionally defective grantor trust for the benefit of heirs. The grantor trust status requires the grantor to pay the income tax on the earnings of the trust, thus permitting the remainder funds to grow free of tax. The amounts received back from the GRAT can be used to fund another two-year GRAT, and the process can continue over the years.
FAMILY LIMITED PARTNERSHIPS
A family limited partnership (FLP) permits the original owners of investment assets to retain management control, retain income from the transferred property for some period of time, and also provides asset protection features. Typically an FLP involves the transfer of an interest in a family business or real estate portfolio to the FLP, although securities trading accounts can also be added to an FLP. Thereafter, gifts of partnership interests can be made to family members. Because of the discounts that result from fractionating the ownership interests, and various restrictions in the partnership document itself, a significant portion of the value of the property transferred to a FLP is excluded from the original owners’ gross estates at death.
Management and control of the FLP assets remains with the general partners, who can be the parents, their children, or a combination of the two groups. This permits parents to retain control for some time, even though limited partnership interests may be given to their children. It is desirable from both a tax and a management standpoint to have the parents relinquish the general partner interests when they believe there are competent general partners in the next generation, since a FLP is most likely to be successful when the non-tax benefits of the entity are well documented, and legitimate. Business formalities should be carefully observed, books and records are meticulously kept, and there should be no commingling of personal and investment assets in the partnership. It is also advisable that a that a substantial amount of a single taxpayer’s assets not be transferred to the FLP, and that his or her living expenses be primarily met from sources other than partnership distributions.
It should be noted that the Internal Revenue Service continues to question FLP structures, so failure to establish and operate a FLP correctly can be very expensive. (Because the Internal Revenue Service and the Courts continue to look for a legitimate “business purpose” in approving these partnerships, those which contain only publicly traded securities are apt to be challenged. However, if consolidated with other “working assets,” such as business or real estate interests, they frequently pass muster.) Moreover, if a FLP is properly established and maintained, the estate tax savings can be considerable.
CHARITABLE REMAINDER TRUST
Most clients with children do not have a strong desire to leave a large part of their estates to charity. For those who do, this can be readily accomplished through a charitable foundation, or by leaving funds directly to a charity in their will. For clients with low basis assets, a charitable gift through a charitable remainder trust can not only provide a good lifetime income, it can also increase after-tax estates as well. A charity can (and will) pay a pre-established return (which can be between 5% and 10%) on assets donated to it for the remainder of the donor’s life. The donor will receive a charitable deduction at the time of the gift based on its fair market value, and will incur no capital gains tax on the assets’ appreciated value. If the charitable remainder trust sells the assets, it will pay no income tax due to its tax-exempt status. Some portion of the difference between the income received by the donor from the charity, and what would have been the earnings on a lesser amount available to invest after the payment of capital gains taxes if the asset had been sold, can be used as gifts for premium payments on insurance held in an irrevocable life insurance trust to “replace” the assets going to charity.
For example, if you sell a capital asset (business or real estate) with a basis of $1,000,000 for $5,000,000, if you pay about 25% (state and federal) in capital gains taxes on the $4,000,000 profit, and receive a net $4,000,000 from that sale. If the same asset is donated to a charitable remainder trust, the annuity payment will be based on the entire $5,000,000. Assuming a 5% return on either amount, the CRT would pay you $250,000 a year, while you would earn $200,000 on your after-tax assets from the sale. If the $50,000 differential is used to pay life insurance premiums, that will support a large insurance policy, the death proceeds from which can pass to your heirs tax-free under most circumstances. The $5,000,000 lifetime gift will also generate a substantial income tax deduction.
CHARITABLE LEAD TRUSTS
This is a variation on a charitable remainder trust. In a charitable lead trust the income produced by an asset is donated to charity for a specific number of years, with the remainder to go to the donor’s children (or others). Similar to a QPRT, the gift portion is represented only by the remainder interest in the trust, which can be fairly modest. It is said that Jackie Kennedy used this technique to shelter almost 90% of her trust assets, and it is particularly useful for making gifts to grandchildren.
Integration with Generation-Skipping Trust. Each taxpayer can now give $5,000,000 to grandchildren and great-grandchildren without incurring the generation-skipping estate tax. To the extent such gifts are leveraged by making a lifetime exclusion gift which is then put into a life insurance trust, substantial savings can accrue. A charitable lead annuity trust also provides this type of leverage as the $5,000,000 can be allocated to the remainder interest only, and still protect the value of whatever passes to the grandchildren.
Predicting the future is a difficult business, but it is something that estate planners are now called upon to do. As indicated above, on January 1, 2011, the lifetime exemption (and GST exemption) increased to $5,000,000. After 2012, the estate and GST exemptions will be redetermined by legislation at that time.
I am not acquainted with anybody who claims to know exactly what will happen. Given the increasing federal deficits, it is a good bet that the estate tax will be around for quite some time, and that skilled and careful planning will continue to be important.