The estate tax system and gift tax system were historically very similar, but that similarity ended under current law. Charitable gifts and gifts between spouses are both protected by the charitable and marital deductions just as they are protected under the estate tax.  Under the current tax system, the exemption of the gift tax will remain the same, $1,000,000, going forward. This is so even though the estate tax exemption will be rising.  The gift and estate tax will each operate independently of one another therefore. The gift tax is never scheduled to be repealed.  The maximum rate on the gift tax will fall as the estate tax rate falls.  During the time the estate tax is repealed, the maximum rate on the gift tax will be equal to the maximum income tax rate, currently 35%.  Some have suggested that the retention of the gift tax indicates that the government’s plan is to bring back the estate tax.  They won’t want gifting to be used to avoid estate tax in the interim.

 

           One additional benefit provided under the gift tax, but not in the estate tax system, is the annual gift tax exclusion. This allows each individual to give $13,000 each year to as many individuals as he or she wants.  With a married couple, each spouse has a separate annual gift tax exclusion so they can be considered together.  This would shelter a $26,000 transfer to each individual each year.  For example, if a couple has five descendants, then gifts totaling $130,000 could be made to them each year without any adverse gift or estate tax consequence.  This doubled annual gift tax exclusion applies to gifts from a married couple, even though only one of the spouses may write the checks from his or her separate property.  The annual gift tax exclusion is indexed for inflation. 

 

           The gift tax system also allows the direct payment of certain educational expenses and medical expenses to be sheltered. These expenses must be paid directly by the person making the gift and they are not limited in dollar amount. They are in addition to the amount that can be given under the annual gift tax exclusion.  Also, see the special treatment of “529 Plans” explained at page 14.

 

           D.       New York Estate and Gift Tax. 

 

           New York had repealed its estate tax for those dying February 1, 2000 and after.  It has repealed its gift tax for all gifts made after 1999.  New York expected to have revenue limited to a credit provided under the federal estate tax.  As part of the federal changes, the credit which provides revenue to the states was repealed.  New York’s estate tax now equals the amount which would have been due under the state death tax credit, allowing an exemption of $1,000,000.  It will stay at that level until the state legislature decides to change it.  Since there is no longer any payment of the credit amount from the federal government to the state, the tax has become an expense of the estate.  If the federal law sunsets as scheduled, the New York tax will be a transfer from the federal government to the state and will no longer be an expense of the estate.  In other words, the New York tax will be repealed (again).

 

           E.       Tax Credit as Planning Tool. 

 

           When a husband and wife have substantial assets and have not adequately planned their estates, the total estate tax due when the property passes from the last spouse to die to the children can be dramatically larger than with the planned estate.  For example, let us assume both spouses die when the credit equivalent protects $1,000,000.  Further assume, the couple has combined assets of $2,000,000, and all property passes from the first spouse to die to the second.  If that surviving spouse dies with the same property in 2011, estate tax would be due in the amount $435,000.  The major reason for this substantial tax is that the second spouse had only one estate tax credit to protect the property.  This prevented the federal tax from applying to the first $1,000,000, but the excess $1,000,000 was subjected to a marginal tax rate of over 47%.  The problem in the unplanned situation was that the estate tax credit available to the first spouse to die was wasted.  By leaving everything outright to the survivor the marital deduction sheltered the first estate from any tax, but also caused the combined assets to be accumulated and taxable in the second estate. 

 

           A key element of the planning to reduce the tax is the diversion of some of the property at the first death so that it does not become part of the surviving spouse's estate for tax purposes.  This could be done as simply as leaving property outright to children in the first estate.  In the example, if each spouse owned $1,000,000 of separate property, and if the will of the first spouse to die left everything to the children, there would be no federal tax on the $1,000,000  passing to the children because of the protection of the estate tax credit. When the second spouse later dies with the remaining $1,000,000, the combined tax in both estates would be zero. This is a savings of $435,000 in tax. The prospect of leaving half of your combined assets to the children at the first death has obvious drawbacks however, even with such a substantial tax savings. 

 

           The same result can be gained by creating a trust at the death of the first spouse.  This trust can be created in a will or under a trust agreement established during life.  The trust would be designed so that it does not qualify for the estate tax marital deduction. At the same time, it could provide that all of the income of the trust could be paid to the surviving spouse and that the trustee could have discretion to distribute the principal to the spouse if needed.  The spouse could even be given the right to change the ultimate beneficiaries following his or her death.  For example, if a child had financial problems, health problems, or marital problems, the surviving parent could cause that child to be cut out of any share or could restructure the share without losing any of the tax benefit. Such a trust maintains all of the combined assets of the couple for the benefit of the surviving spouse, while at the same time receiving the substantial tax benefit available. Because this technique does not require any action to be taken before one spouse dies, does not require substantial gifting of property out of the couples assets, and is relatively inexpensive to implement, it tends to be the most practical and often used technique to reduce estate tax.  Its effect is to protect up to twice the estate tax credit amount passing to the children.  If assets exceed this total, the limit of the benefit has been reached.  It is then that other techniques are considered.

 

           In the past, the size of the trust created at the first spouse’s death was defined as being the largest amount which could pass free of federal estate tax.  That language would create a new problem when applied to the estate of someone dying prior to 2011.  That new problem would be the New York estate tax.  If a trust were created for someone who died in calendar year 2010, and it was defined as the greatest amount which could pass free of federal estate tax, that trust could contain everything the decedent owned.  Because of the reduction in the federal credit for state death taxes, an estate of $3,500,000 which has no marital deduction protection would be subject to a New York estate tax of $229,200.  That New York tax could be avoided by a change in the language defining how large the trust is to be.  Would it be wise to eliminate the New York tax?  That would depend upon a number of circumstances. For example, the size of the estates of husband and wife together would be very important. The age and health of the surviving spouse would be important, as well as knowing whether the surviving spouse might leave New York and move to Florida or other state without an estate tax. It is most important that everyone who has provided for trusts to reduce the estate tax review all of their documents as soon as possible so as to avoid any unnecessary tax. 

IS FLORIDA A BETTER PLACE TO BE?

 

           As we age, the unpleasant climate of New York State begins to wear on us.  When there is time to spend substantial periods away, we naturally think about warmer places.  Although some say our winter weather is improving, it is unlikely that Florida will stop being an attractive alternative anytime soon.

 

           Apart from the weather, Florida has also been perceived as a tax haven by older New Yorkers.  That perception has come from two historic tax advantages for Florida residents.  First, there is no income tax imposed on Floridians.  Second, Florida has no state estate or gift tax on their residents. 

 

           A.       Estate/Gift Tax.    

 

           New York’s repeal of its estate and gift tax went a long way to leveling the playing field between the two states. There was no tax advantage to dying a Florida resident verses New York.  New York has reimposed a state estate tax which will cause the cost of dying in New York to be higher, at least until 2011. Florida will not reimpose its estate tax, unless an amendment is first made to its constitution, which is unlikely.

 

           B.       Income Tax.    

 

           The lack of a Florida income tax is a more significant issue.  If your income is derived from interest and dividends, or capital gains, the advantage can be substantial. That advantage is lessened however, when the source of income is pension and social security income.  New York provides a $20,000 exemption from income taxation for pension income.  If the pension derives from federal or New York governmental service, it is totally exempt.  New York has also taken the position that it is entitled to income tax on a pension if it resulted originally from New York employment, even though the taxpayer now lives in another state.

 

           The New York income tax applies to someone who is “resident” in the state.  If the advantage of changing residency to escape the income tax is sufficient, it must still be done very carefully.  New York will continue to consider you subject to its income tax, if either of the following apply:

 

                                 ●       If you are domiciled in New York, maintain a personal place of abode outside New

                                          York and if you spend more than thirty (30) days per year in New York. Domicile

                                          for this purpose is established by a series of tests, such as, where you maintain

                                          residences, where you earn income, where you spend time during the year, where

                                          your family connections are and other personal issues.

 

                                 ●       Even if you are successful in changing your domicile to Florida or another state,

                                          your residency would remain in New York if you maintain a permanent place of

                                          abode and spend more than one hundred and eighty three (183) days per year here.

 

C.            Intangible Tax.

 

            Florida has a tax which has no equivalent in New York.  It is called the Florida intangibles tax.  It applies generally to intangible personal property.  This would not include real estate, household contents, automobiles and other tangible property.  The tax also excludes interest in partnerships (other than your investment partnerships), cash and federal or Florida debt obligations, such as bonds.  The rate of this tax is fairly low.  On assets up to $100,000, the rate of tax is 1/10 of 1%.  Everything in excess of $100,000 is taxed at 15/100 of 1%.  The tax, at its maximum rate, would amount to $1,500 for each $1,000,000 of intangible property subject to it.  The tax is due each year, and is computed upon the value of the property on January 1st.  Someone with substantial investment assets must look carefully at the cost of this tax when changing residency to Florida.  The intangibles tax would apply to the contents of a trust also.  In applying the tax, Florida looks to the domicile of the trustee.  It is possible, therefore, to be subject to New York income tax, and at the same time have a trust which is exposed to the Florida intangibles tax. This would occur, for example, where a Florida trustee had charge of a trust for a non-Florida resident. Special care is required therefore, in planning an estate where there are substantial Florida contacts.

 

D.            Spousal Rights.    

 

           Another substantial difference between the laws of New York and Florida has to do with the rights of a surviving spouse.  Both states have statutes which provide that a surviving spouse may inherit something, so long as he or she has not waived it in a pre-marital agreement or otherwise.  This right is commonly referred to as the “elective share”. In New York, the surviving spouse is guaranteed to receive the greater of $50,000 or 1/3 of the estate of the deceased spouse, regardless of the terms of the will.  In computing this amount, the probate estate is enhanced by adding in several assets which pass outside the will. Examples of these would be pensions payable, jointly owned property, the contents of certain trusts and gifts which were made shortly before death. The entitlement of the surviving spouse in New York cannot be satisfied by any type of trust.  The survivor’s right is to an outright distribution of the computed amount. 

 

           Florida’s approach to the problem is much different. Currently, the surviving spouse’s elective share is 30% of the fair market value of property that is subject to administration, other than real property located outside of Florida. Only the spouse of a decedent who is domiciled in Florida is entitled to an elective share.  This would mean that a residence owned by a New York domiciliary in Florida could totally avoid the imposition of the elective share. 

 

           A sweeping revision was made to the Florida elective share statute.  Florida now computes the elective right based upon a new augmented estate calculation. Once computed, the Florida elective share can be satisfied by the surviving spouse being made a beneficiary of a trust, rather than receiving the amount outright.  If a trust is used, the principal of the trust will have to be larger than the elective share.  For example, if the trust gives the spouse only an income interest in the trust, it would have to be twice as large as the elective share.  If the spouse is given income  and/or a discretionary power to receive principal, then the trust would have to be 125% of the elective share.  If the trust gave the surviving spouse a general power to choose the beneficiary at the survivor’s death, then it could satisfy the right of election on a dollar-for-dollar basis. 

 

           The weather continues to be an attraction to Florida, but the tax advantage calls for very careful thought.

GIFTING TO OFFSPRING

 

           When the family assets exceed $2,000,000 (in 2011 and after), the careful use of the estate tax credit is not sufficient to eliminate federal estate tax.  It is necessary to look beyond that solution to other opportunities to reduce or eliminate the tax.  One of the options is gifting to offspring.

 

           The simplest, but not always most attractive opportunity lies in the use of the annual gift tax exclusion to gift up to $13,000 per year to each child (and even grandchildren and non-relatives). If done regularly over many years, the gifting of $13,000 per person can reduce even a very large estate dramatically. The disadvantage with such gifting of course is that once given, the property cannot be retrieved if needed by the parent. Another problem is that the gifting parent is left to witness what the recipient decides to do with the gift.  A frugal parent who sees a spendthrift child "wasting" the property might prefer to forego the whole process and let the tax take its share at death.

 

           As a general rule, the annual gift tax exclusion is available only for transfers of "present interests".  A trust, on the other hand, is a future interest. The benefit of a trust may come to the child only years in the future.  A trust can, with very careful drafting, allow contributions to it to qualify for the gift tax annual exclusion.  If a trust can be used to control what the children can do with the gifted property, the parent may feel more comfortable making the gift.

 

           A.       Gifts to Minors. 

 

           When the recipient of a gift is less than age 21, there are several considerations and techniques which can enhance the control over the property, reduce possible adverse income tax effects and provide maximum tax shelter to the donor. 

 

           When a person under the age of 18 has annual investment income (unearned income) over $900, the excess income is taxed at the top marginal rate of his or her parent.  This rule is commonly called the "kiddie tax".  Under current federal income tax rates, this could result in the child's excess taxable income being taxed at a federal rate as high as 35%.  That is the highest rate at which the parent could be income taxed.

 

           One commonly used technique to prevent the adverse effects of the kiddie tax and to maintain some level of control is for the donor to purchase a U.S. Savings Bond, series "EE", registered in the name of the child.  Such a bond does not generate taxable income until the bond is cashed.  Interest accrues, however, during the time it is held and the current rate of interest is better than most bank accounts.  Even when the interest is taxed at redemption, it is exempt from New York income tax.  Once purchased, the bond can be held by a responsible adult and then cashed in by the child when the need arises for college expenses or other suitable needs.  Cashing it after the child's 18^th birthday avoids application of the kiddie tax.  While the return on such an investment is limited, its flexibility and simplicity are attractive to many.  Other investments may also be used to limit the child’s income, such as tax deferred annuities or stocks which pay very little dividend income.

 

           Another method of structuring gifts to minors is through the use of a trust which has special treatment under §2503(c) of the Internal Revenue Code.  While trusts are not usually eligible for full use of the annual gift tax exclusion, an exception is provided for a trust which meets certain requirements.  Such a trust must benefit only one child, and all income or principal payments must be to that child.  If the child dies, there must be an opportunity for the property to pass pursuant to the child's will.  Upon reaching age 21, the child must have an opportunity, at least for a limited time, to withdraw and terminate the trust.  So long as the requirements are met, the full $13,000 per year annual gift tax exclusion may be used for funding the trust.  In fact, flexibility can be designed into such a trust which would protect the funds even beyond age 21, and would control where the trust principal would go if the child dies.  A married couple could contribute $26,000 per year to such a trust.

 

           B.       Gift Tax Exclusions and Other Trusts. 

 

           When a trust like that just described is created for a very young child, there may be a concern that the child will develop medical, psychological or behavioral problems later on which will make the gift giver regret having made the gift, even in trust.  The preference then may be to create a single trust which would benefit a number of family members, and possibly different generational levels of the family.  The benefits available from the trust could then be concentrated on those whose needs meet the priorities of the donor. 

 

           Such a trust can be structured to qualify for the annual gift tax exclusion, but not necessarily fully.  No annual gift tax exclusion is allowed for a trust which can "sprinkle" its benefits among several individuals.  The method used to allow some protection from the exclusion is commonly called the "crummey power".  This name arises from the name of the taxpayer whose case established the principal, and does not reflect its cleanliness.  The "crummey power" is a provision put in the trust which directs the trustee to notify all beneficiaries whenever a contribution is made to the trust.  The beneficiaries are given a right to demand and withdraw their proportionate share of any contribution, but the right lasts only for a short period. If they fail to make the withdrawal, the right to take it expires and the property is not within their reach again until the trust terminates.  Because the donor can control all future contributions to the trust as well as the disposition of other property to the beneficiary, it is very unlikely that a beneficiary would exercise the power because of a fear of loss of future benefits from the parent.

 

           The "crummey power" could shelter the full amount of the annual gift tax exclusion from taxation.  There are limitations on its full use, however. Depending upon the long term objectives of the trust and how it is drafted, at least $5,000 could be contributed for each beneficiary, each year, without any adverse gift tax consequence. Since married donors could give $26,000 under the gift tax rules, this is a dramatic reduction.  If there are enough beneficiaries in the family, however, it could still shelter a very significant annual contribution.  As the trust gets larger, the amount of the annual contributions can also increase.  In order for this type of trust to work properly, it must be very carefully planned and drafted.  It can be equally useful whether beneficiaries are adults or minors.

 

 

           C.       529 Plan.

 

           Internal Revenue Code §529 created a state sponsored college savings plan which has very generous tax benefits.  It is an excellent alternative to consider when saving for the education of your children or grandchildren.

 

           A 529 Plan is an investment account owned by one individual.  It must have a single beneficiary.  So long as the benefits are paid out for tuition, fees, room and board, books, supplies and required equipment of the beneficiary, then the earnings in the account are totally income tax free.  Such expenditures may be paid at public or private colleges or universities in or out of New York State.  They also may be paid for trade or vocational schools.

 

           Presently under the annual gift tax exclusion, a gift made to a minor beneficiary would be limited to $13,000 annually (from one donor) before there is an effect on the estate tax of the donor.  An exception is made for 529 Plans which allows 5 years of annual gift tax exclusions to be put into the plan at one time.  In other words, one individual could contribute $65,000 to the plan of one beneficiary without any adverse tax consequence.  So long as the donor lives through the 5 years following such a contribution, it would be totally gift tax free.  If death occurs prior to that, then some of the gifting would have an impact on the donor’s estate tax.

 

           The sponsors of such plans include most major mutual funds.  The official sponsor of the State of New York plan is Upromise and Vanguard.  If the account is opened with Upromise, then the donor can deduct up to $5,000 per year from New York taxable income (or $10,000 on a joint return).  If it is opened with a different sponsor, then that New York deduction is lost, but all other benefits continue.  For more information on the New York plan, go to nysaves.uii.upromise.com.

 

           Apart from the tax benefits, there is a substantial amount of flexibility in such plans.  First, the beneficiary can be changed by the owner.  If such an account was opened for a newborn, and as the child reached his or her teens, decided that continued education was not likely, the owner could change the beneficiary of the account to another child who did have educational plans.  Only if the funds came out other than for education would there be income tax on the growth in the fund.  In such a case, there would also be a 10% penalty.  If the need arose however, the owner of the account could even take the funds back by paying the income tax on the growth and suffering the 10% penalty.

 

           Overall, the attraction of the §529 Plan is:

 

           $   More substantial gifts can be made for the education of each child.

           $   The beneficiary of the account can be changed to a different child if necessary.

           $   A New York income tax deduction for contributions may be available.

           $   The earnings in the account will be income tax free if they come out for education.

           $   The money may be taken back by the owner.

LIFE INSURANCE PLANNING

 

           We all understand the importance of life insurance in protecting the young family from the economic loss caused by the death of a parent.  Unless a working parent's income can be replaced from some other source upon death, then the surviving family members must necessarily suffer a fall-off in lifestyle.  In the larger estate, planning considerations give life insurance an array of additional new purposes.

 

           A.       Access to Cash. 

 

           Since the larger estate must anticipate the payment of estate tax, the availability of cash for the tax may be a problem. For example, if an individual owns illiquid assets such as real estate or stock in a closely held business, those assets may not be able to be sold quickly enough to pay the estate tax, which is due nine (9) months after death. Life insurance can provide an easy source for the needed cash, without the necessity of having to sell an asset in a "distress" sale.

 

           B.       Business Purchase. 

 

           Another advantage of life insurance is to fund the purchase of a decedent's interest in a business or other asset.  For example, if several individuals own a business as partners or in corporate form, there is an incentive to all of the participants, including the decedent's estate, to allow the surviving owners to continue the operation of the business with the decedent's interest being purchased by them, or by the corporation.  This sale of the decedent's share takes cash that most businesses do not have at the time. Again, life insurance comes to the rescue.  Life insurance received by the business may allow cash necessary to hire a replacement for the work of the deceased owner.

 

           In the next chapter, we discuss charitable giving techniques, including charitable remainder trusts.  Dramatic tax savings can be enjoyed by use of such trusts, but the one drawback is that at the end of the trust the property in it must pass to charity.  A properly structured life insurance trust can effectively replace the lost inheritance for the children, while still allowing the other tax savings created by the plan.

 

           On occasion, the purchase of life insurance can be justified simply upon its tax savings attributes.  For example, the total premiums paid over the entire life of the policy will usually be far less than the proceeds collected at death. This internal build up in value is not subject to income taxation, making it unique. It is also possible to shelter the life insurance proceeds from estate taxation through a life insurance trust. Even if the purchase of life insurance doesn't represent the best investment return, its tax benefits can make it much more attractive.

 

           C.       Charitable Giving.  

 

           Some families are charitably inclined and want to leave something to the organizations they have been involved with through life.  Through the careful structuring of the gift, a charitable deduction can be obtained for estate tax purposes while effectively replacing the lost inheritance of the children through life insurance.  By use of the life insurance trust, explained in the following paragraphs, the insurance can be excluded from taxation in the estate.

 

           D.       Life Insurance Trusts. 

 

           Life insurance proceeds of a policy owned by a decedent are estate taxable in his estate at death.  The amount taxable would be the proceeds collected on the policy. This creates a very serious problem when the need for life insurance is to provide cash liquidity for payment of the tax.  If one needs $500,000 of cash to pay the expected tax liability, purchasing a policy with that death benefit will not satisfy the need. The reason is that the insurance itself will cause the tax to rise.  For example, if the deceased has sufficient assets so that his estate is taxed at a marginal rate of 50%, one-half of the insurance proceeds would be needed to pay the tax on the insurance itself.  In other words, to have the $500,000 of needed cash, it would be necessary to purchase $1,000,000 of insurance.  This problem is frequently dealt with by having someone other than the insured own the policy.

 

           As pointed out earlier, the greatest impact of the estate tax comes upon the death of the second spouse.  If insurance on the life of the husband was owned by the wife, it would not be taxable in his estate, but she would collect the proceeds and own them at her death.  Since the bulk of the tax is due at her death, there would be no benefit at all to having the wife own the policy. 

 

           A policy on the life of a parent could be owned by the children, and the proceeds could be kept out of estate taxation, so long as the benefits are not paid to either parent.  There are a number of logistical problems with having children own insurance on the parent's life, however.  How will the premium be paid?  If the parents gift an amount equal to the premium to the children, will the children, in fact, pay the premium, or do something else with the money? What happens to ownership of the policy if a child dies, has matrimonial problems or goes through bankruptcy?

 

           The method preferred by most for dealing with life insurance in the taxable estate is to create an irrevocable life insurance trust, and to gift the policy into it.  The first advantage of using a trust is that the parents can control who will receive the benefits from the insurance, and when.  For example, proceeds from policies on one spouse’s life could be held in trust for the benefit of the surviving spouse.  At the second death, the remainder could either be paid out to the children, or held even longer.  The trust can allow the parent to make special arrangements for a child who has physical, mental, financial or marital problems.  The surviving spouse can even be given the right to change the final plan of disposition to a limited extent if the children have a change in circumstances.

 

           The tax advantage enjoyed by a life insurance trust is that the proceeds of the policies will not be included in the taxable estate of either parent.  One qualification to this rule, however, is that if a policy is owned by the parent and then transferred into the trust (as opposed to a new policy being purchased directly by the trust), then the parent must live for three (3) years following that transfer in order to get the benefit of the estate tax exclusion.

 

           The life insurance trust is necessarily a very complex document.  The trust must be irrevocable, meaning that it is difficult or impossible to change its terms.  At the same time, the tax law is constantly changing.  The Internal Revenue Service has a strong dislike for the life insurance trust, primarily because it constitutes such a substantial tax shelter.  The trust agreement must therefore address a number of different issues in great detail, in order to minimize the risk of losing the tax benefit, even under future changes in the rules.  The complexities are worth it however when the tax savings is looked at.  If one has sufficient assets to be subject to estate tax rates of 50% (approximately $2 million), and if a life insurance policy with death benefit of $500,000 is held in trust rather than outright, then there would be an immediate estate tax savings of $250,000.  If the life insurance is purchased in order to provide cash for estate needs, then the avoidance of tax on the insurance proceeds themselves would reduce the amount of insurance needed by one-half.

 

           All types of life insurance can be held in a trust.  This can even include group insurance provided through an employer.  Generally, it is unwise to put term insurance only into a trust. Since the premium on term insurance increases dramatically with age, the likelihood is that the policy will be canceled long before death.  That would make the expense and the maintenance of the trust pointless.

 

           When the insured owns a corporation, or is a senior officer in a corporation, there is an opportunity to have the corporation pay the premium on his insurance, with the corporation's money rather than the individuals.  This is commonly called "split-dollar insurance."  It is not a separate type of insurance, but rather a financing technique.  Basically, the corporation pays the premium on the insurance and then receives the amount it has paid back when the insured dies.  Since the premium paid on a policy is typically only a fraction of the death benefit, the balance in excess of the premium goes entirely to the benefit of the insured.  This method can be used in conjunction with the life insurance trust so that the proceeds are sheltered.

 

CHARITABLE GIVING

 

           A.       Benefits of Giving to Charity. 

 

           Hopefully charitable giving has its own rewards. Most who have enjoyed substantial financial success during life want to give something back, and they have favorite charities to become involved with.

 

           Aside from "doing good" we look to the structure of charitable giving to provide some tax savings.  Lifetime giving entitles the donor to an income tax deduction in the year in which the gift is made.  Provisions for charity contained in a will would entitle the estate to an estate tax charitable deduction.  The estate tax deduction has no limit, but the income tax deduction does.

 

           A lifetime gift of $1,000 to a charity would entitle the donor to a deduction in that amount from his current income tax. While that is advantageous, some additional benefit may be available. For example, if the donor owned a marketable security with a value of $1,000, but which he had purchased for only $100, he could donate that security to the charity.  It would receive the same benefit as the cash contribution. The donor, however, would have avoided the capital gain tax which would apply eventually when he sells that security. The donor could benefit by almost $600 from future tax savings by giving the security.  Similar tax savings could be enjoyed by giving tangible property such as appreciated art work, or even shares of a closely held business. There are some limitations on the amount of charitable deduction that can be taken in any one taxable year, and charitable gifts which would exceed 1/3 of the giver's income in one year need to be carefully planned out.

 

           Those with a very strong and permanent desire to benefit a particular charity could consider the gift of a personal residence while retaining the life use of the property to the donor.  This guarantees that the charity will eventually receive the property at the death of the donor, while at the same time preserving the house as a place to live for the life of the donor.  At the same time, a charitable income tax deduction can be enjoyed.

 

           B.       Charitable Remainder Trusts. 

 

           The tired cliché says that nothing in life is free.  In certain special situations involving charitable contributions, however, the theory may be false.  The use of a charitable remainder trust combined with the well structured life insurance trust can sometimes allow you to increase your income, enjoy the benefit of a charitable income tax deduction, provide a substantial benefit to your favorite charity, and greatly increase the amount of benefit passing to your children at your death.  Sounds too good to be true?

 

           Consider a married individual (Mr. Jones) who has marketable securities with a current market value of $3 million.  Let us assume that these securities were acquired or inherited by Jones with an income tax basis for capital gains purposes of $1 million.  Further assume that the securities are common stock and have a very low (2%) dividend rate.  Mr. Jones is therefore now receiving dividends of $60,000 per year.

 

           In anticipation of retirement, Mr. Jones would like to increase the cash received from the securities.  He has proposed that he sell 1/3 ($1 million) of his securities so as to invest the proceeds in a higher income asset, or, in the alternative, to spend the proceeds of the sale to supplement his income.  The first effect of selling the securities will be to create a taxable capital gain of $666,667.  Assuming the gain is all taxed at a 20 percent rate, the resulting income tax on the gain would be $133,333.  After payment of that tax he would have approximately $866,700 remaining of his original $1 million investment.  Now let us assume that he invests the remaining funds in bonds or other investments which yield 5 percent per year.  His income from that point from the new investments would be $43,335 (plus the $40,000 from the dividends on the unsold shares).  At the later death of Mr. and Mrs. Jones, we will assume the investments from the sale proceeds are still owned, with the same value ($866,700).  The property will then be subjected to a 50 percent federal estate tax.  The net amount which will eventually pass to his children from the original $1 million asset will therefore be $433,350. Needless to say, this is not a very attractive scenario.

 

           Now let us consider an alternative approach to the problem.  Instead of selling the securities now, Mr. Jones creates a charitable remainder unitrust and contributes the securities to it.  A "unitrust" is a trust created to qualify for the charitable income and estate tax deduction, while providing an annual payment to one or more individuals for life.  At the death of the last individual beneficiary, all remaining assets in the trust must pass to charity.  The payment each year to the individual beneficiary of the trust is a percentage of the trust principal (at least 5%), so that if the principal grows, so will the payment.  It is therefore somewhat inflation sensitive.  A high or low percentage may be chosen for the payment.  The higher the percent, however, the lower the amount of the charitable deduction which will be available (since less will ultimately pass to charity).  Mr. Jones' trust will provide that he is to receive an annual "unitrust payment" equal to 5 percent of the principal value of the trust as it is revalued each year.  After his death, the same 5 percent will be paid to his wife for her life.  At the second death, the entire remainder of the trust will pass to his favorite charity.   He could even fashion the trust so that he could change the charities sharing in the trust remainder after the trust has been created.

 

           An important aspect of a charitable remainder trust is that capital gains generated by sale of trust assets are not taxed to the person who created the trust.  This is because the gain accrues to the benefit of the ultimate charity which is tax exempt.  When the trustee sells the $1 million of securities, there would be no taxable capital gain because the seller is a charity rather than an individual.  The 5 percent unitrust payment each year would be calculated on the entire $1 million which would result in an annual payment of $50,000 to Mr. Jones.  This is an improvement in income of $6,665 per year over the proposal to sell and a $30,000 improvement over the present dividend situation for those securities.

 

           In addition to the improved income, the creation and funding of the trust would entitle Jones to an income tax deduction. If we assume both spouses to be 55 years of age, the charitable contribution would be approximately $236,660. This deduction may be limited in certain circumstances, or it may have to be taken over several years.  We do, though, have a second substantial benefit which was not available in the first scenario.

 

           The obvious problem with the charitable trust is that the $1 million of securities will not pass to the children after death, even in its depreciated condition after taxes.  One solution to that problem lies with life insurance. Assuming Mr. and Mrs. Jones are insurable, the next step in the plan would be to create an irrevocable unfunded life insurance trust.  That trust will apply for and own a second-to-die life insurance policy on the lives of both spouses in the face amount of $500,000. Second-to-die insurance pays only upon the death of the second spouse.  Because having two lives insured together somewhat reduces the risk to the company of premature death, that coverage is typically much less expensive than similar coverage on one life.

 

           For our 55 year old spouses, we will assume that the premium on the coverage would be approximately $5,500 per year, and that after a period of approximately 10 or 11 years, the dividends on the policy could be expected to carry the cost of the premium without further premium needs. No premium would be required therefore after that time.  If we consider the premium which must be paid each year as reducing the income from the unitrust for the first several years, the Jones are still at a higher income level than would have been the case had he sold the securities and invested the proceeds.  The premium, however, can be expected to end, and then the income will be much higher through the unitrust plan.

 

           When the second spouse dies, the life insurance trust will terminate and the balance in it, (the $500,000 insurance proceeds), will pass to the children.  Because the life insurance trust was properly structured and funded, the property in it, including the insurance proceeds, will not be taxable in either spouse's estate for estate tax purposes. 

 

           The charitable trust has provided several substantial benefits to the Jones':

 

           $   They have benefitted their favorite charities

           $   They receive a current charitable income tax deduction

           $   They avoid substantial current capital gain tax

           $   They enhance the income for life

           $   They increase the net benefit their children will receive after they die

 

 

           C.       Charitable Lead Trust. 

 

           A charitable lead trust is just the opposite of a charitable remainder trust.  Instead of the charity receiving what is left of the trust at conclusion, it receives an annual income in the form of a percentage annuity or unitrust amount.  At the end of the trust term, the remainder of the trust would pass to children or other non-charitable beneficiaries.  The person who creates and funds such a trust would be entitled to a gift tax charitable deduction as well as income tax deduction for the benefit passing to the charity.  A charitable lead trust, however, is not protected from capital gains tax, and its utility is quite different from the charitable remainder trust. 

 

           A charitable lead trust would be considered most often by someone who is in the following circumstances:      

 

           $    Has cash or other non appreciated assets which would not create a capital gain on sale.

            $    Wishes to make a large gift to children or other individuals, but is willing to

                 delay the receipt of that gift by the beneficiaries for some years.

           $    Has an interest in benefiting one or more charities in the meantime.

 

         The longer a charitable lead trust runs, the deeper the discount applied to the gift.  For example, assume $1,500,000 is transferred to a charitable lead trust lasting for 10 years, paying 7% to charity each year.  The gift might be discounted, for gift tax purposes, to $689,000.  If the income and appreciation on the trust for its term is at least as great as the amount going to the charity each year, the individual beneficiaries would receive the full $1,500,000 (or more) at the end of the term.                

         Because of the problem created with capital gains, a charitable lead trust is most often used in a will, to be created at death. The same discount will reduce the estate tax, provide for charity, and only delay the receipt of the estate property by the children for the time the trust lasts.

 

         D.        Retirement Plans.  

 

         As discussed in more detail later, pensions and IRA’s are subject to a number of tax disadvantages at the death of the participant.  Income tax may be due on the plan balance of over 40% of the total (combined federal and New York). In addition, estate tax can be assessed on the same balance at a rate up to 50%.  In the worst case, only about 27% of the balance in such an account would be available to children after taxes. Looked at another way, it costs the children only 27 cents for the parents to give a dollar to charity as death beneficiary of an IRA.  If giving these “cheap” dollars to charity is still considered too much of a burden on the children, then life insurance could be considered to replace the inheritance the children do not receive.  The life insurance in that case would typically be owned by a life insurance trust described in the last chapter.

 

SPECIAL TECHNIQUES TO "SHRINK" THE ESTATE

 

           In the larger estate we face the likelihood of the estate tax taking as much as 60% of the property upon the death of the second spouse.  A tax exposure of that magnitude causes most estate owners to consider dramatic methods to reduce or avoid it.  Life insurance trusts, charitable remainder trusts and some of the other techniques discussed elsewhere in these materials are efforts to reduce the tax.  After those techniques are used, thought is usually given to annual gifting.  Estate tax credits and deductions, gifting to offspring, life insurance planning and charitable giving have been discussed so far.  After those techniques have been explored, we look to some additional special techniques to "shrink" the estate.

 

           A.       Internal Revenue Code - Chapter 14. 

 

           When the objective is to give as much away as possible, using as little of the unified credit as possible, there are techniques which can "leverage" a gift.  Leverage means that a gift valued at $1 eventually protects assets valued at $3, $4 or more from estate tax.  A life insurance trust is an example of a leveraging technique because the premium paid on the insurance is much less than the insurance proceeds which eventually pass to the children free of tax. 

 

           One historic method of leveraging a gift was for a parent to make gifts into a trust which provided income to be paid back to the parent for a period of time.  At the end of the trust term whatever is in the trust would pass to the children.  The transaction is a completed gift at the point the parent transfers property into the trust.  The "leverage" of the gift comes from the fact that the value of the gifted property for tax purposes is reduced by the present value of the parents' income right which they keep in arriving at the amount of the taxable gift.  For example, if the parent transferred $100,000 to such a trust, and assuming that the retained income right is valued at 50% of the total, the taxable gift would be only $50,000.  At the end of the trust term, however, the full $100,000, plus appreciation, would pass to the children. 

 

           There were numerous methods of using this retained income right in reducing taxable gifts.  Internal Revenue Service strongly disapproved of the tax savings opportunity, and they influenced the passage of Chapter 14 of the Internal Revenue Code. This very complex section of the tax law severely restricts the opportunity to discount the value of gifts by retaining rights.  While the opportunities have been restricted, they have not been eliminated. The law leaves several opportunities open to reduce the value of a gift by using a trust with retained rights.

 

           B.       Personal Residence Trusts. 

 

           The Qualified Personal Residence Trust (commonly referred to as QPRT) is authorized by the current tax law.  The only asset which may be held by a QPRT, however, is a personal residence.  This could be the primary residence or a vacation or secondary home.  The trust could not hold commercial real estate or a third home.  The trust agreement for a QPRT would provide that the person who contributed the home, the "Grantor", would retain the right to live in the house for a period of years.  At the end of that time, ownership of the house would pass to the Grantor's children or to others.  In valuing the gift of the house into the trust, the present value of the retained use by the Grantor would be subtracted from the full value of the house.  That is the tax advantage being pursued in creating a QPRT.  For example, if a Grantor transferred a camp into a QPRT which had a fair market value of $150,000, and retained the right to use of the property in the trust for ten years, the retained use might have a value of $60,000 (40%) under the IRS regulation tables.  The taxable gift would therefore be $90,000.  If the trust runs its term, and the property passes to the children, the camp could have a value of $200,000, $300,000 or more at the time the Grantor dies.  None of that value would be includable in the estate.  The eventual estate tax savings could be dramatic.

 

           There are a number of requirements and problems associated with creating a valid QPRT.  The trust agreement creating it must conform in all respects to the regulations created under the tax code.  Such a trust could be for any number of years, and the longer the trust term, the more the discount for the retained use.  Why then doesn't the Grantor provide in the trust that it is to go on for 20 years or more?  This would discount the gift very dramatically, but there would be a tax risk involved.  If the Grantor dies before the end of the trust term, then the whole plan fails.  The full value of the house would be includable in the Grantor's estate at its value on the date of death.  The appreciation would therefore be fully includable in the estate.  Such an occurrence would not make the estate worse off, than if the trust were never created.  Any gift tax paid at the time or any unified credit used would be returned to the estate in computing the estate tax.  If the Grantor died before the end of the trust, there would be no harm done, but there would also be no good.  In choosing a trust term therefore, it is important to try to have it short enough to hopefully avoid the Grantor dying before the trust terminates.

 

           One concern a grantor might have in creating a QPRT is the possible loss of the home at the termination of the trust. Since the home would pass to the children, where would the grantor live? This problem can be addressed by the grantor renting the home from the children after the trust ends.  The house could also be purchased from the children, but that might incur capital gain tax for these children.  For this reason, a QPRT is a very attractive technique when the residence would not normally be sold.  Such as in the case of a vacation home the children will keep after the trust ends.

 

           C.       Grantor Retained Annuity Trusts.  

 

           Chapter 14 of the Code allows for the transfer of assets other than a house into a trust from which the grantor receives something back.  Currently, the most popular method of making use of this opportunity is the Grantor Retained Annuity Trust, or GRAT.  The retained interest of the grantor in such a trust is limited however to an annuity interest.  An annuity interest is a fixed dollar amount which is received by the grantor each year during the term of the trust.  It is computed at the formation of the trust, and is usually a percentage of the beginning trust principal. For example, a trust of $100,000 with a 5% annuity payment would yield $5,000 per year to the grantor during the term of the trust.  This annuity amount would be payable regardless of whether the income earned is greater or less than the computed amount.

 

           A GRAT provides a very good tool when a parent is interested in getting ownership of shares in a business to children, who are involved in its operation (or even sometimes to those who are not). Gifting by the use of a GRAT allows the parent to:  (a) get an effective discount on the amount of gift tax credit needed to give property to children; (b) avoid future appreciation on stock from accruing to parent and being taxable in the parent's estate; and (c) leaving an opportunity for the parent to stay in control of the operation of the business, even after giving a substantial part of it away.

 

           The business owner may also be looking for a way to bring one or more of the children into leadership of the corporation. If the children work in the business, the owner may have some idea of who he would like to manage it when it passes to them.  For example, there may be one child who has the skills to run the business, while the others have limited abilities in management.  By parent retaining voting shares (control), he can give that control to the appropriate child much later than the gift of the non-voting stock through the GRAT.

 

           D.       Grantor Retained Unitrusts and Annuity Trusts. 

 

           The unitrust (GRUT) is another style of trust which satisfies the tax law for trusts with retained rights.  A unitrust payment is computed in somewhat the same way as an annuity trust, but it is adjusted each year as the principal of the trust grows or shrinks.  For example, a 5% unitrust payment on a $100,000 trust would result in a payment of $5,000 in the first year.  If the trust principal had grown to $120,000 in the second year, the unitrust payment would become $6,000.  GRUTS have very little utility today.  If the assets put in the trust are growing at a substantial rate, a GRUT would require an ever-increasing annual payment back to the grantor.  Administratively, the GRUT would also require that the assets of the trust be revalued each year in order to determine what the unitrust amount should be.  This could require expensive appraisals each year.  The GRAT is the favored tool in most estate planning circumstances, particularly when a (closely held) family business is involved.

 

           Like the QPRT, a GRAT or GRUT must have a fixed term.  In order to accomplish its tax purpose, the grantor must live longer than the term of the trust.  An example would be appropriate at this point. Consider again the business owner whose business is presently worth $2 million, and is growing at a 10% annual rate. He is 55 years old and considers it safe to assume that his life expectancy is more than ten years.  If he were to create a GRAT which has a ten year term and which pays him an annuity of $100,000 per year (5% of the beginning trust principal), the taxable gift to the trust would be about $1,270,000, depending on the exact ages of the owner and spouse.  This transaction could save the estate over $2 million in tax if he outlives the trust term.

 

           In considering such a plan, the business owner's first question is going to be "how do I keep control of the corporation during my working years if the stock passes to the children in ten years?"  One method of doing this might be for the owner to retain some of the stock in the corporation instead of putting it all in the trust.  If he retained over 50% of the stock, he would have voting control.  He would have foregone a substantial benefit, however, since the retained shares would continue to appreciate in his estate. Another method of retaining control is to recapitalize the shares so that some have the power to vote and some don't.  The voting shares would be the only ones which could be used to elect the directors of the corporation. In all other respects, the shares of stock would be identical.  If there are 1,000 shares, and ten of them are designated as voting, with 990 being nonvoting, the owner could gift all of the nonvoting shares into the trust without losing control.  There would be a premium applied in valuing the voting shares versus the nonvoting (the voting shares would be worth more), but that premium is not nearly as substantial as one would expect.

 

           Computing the tax effect of creating a GRAT or GRUT has a number of variables.  Valuation of the gift and of the retained right depends upon the age of the grantor, the percentage being retained, the interest rates published by IRS at the time of the gift, and the length of time the trust runs.  All of these variables can be manipulated to create a taxable gift as small as you would like.  This would be done by increasing the percentage used for the annuity payment or lengthening the term.  If the percentage is high enough, the term can be made very short and still reduce the gift to a very small value. 

 

           E.       Family Partnerships. 

 

           The GRAT can be a useful tool in planning for the family business in a corporate form.  It is not necessarily as useful when the asset to be protected is unincorporated, such as a family farm, or when the asset to be protected is marketable securities and other investments.  The family partnership presents another opportunity for these cases.

 

           A partnership is like a corporation in the sense that the partnership agreement can provide for centralized management of the operation of the business and can define units of ownership which one partner is capable of transferring to another by gift.  It would be essentially impossible for a farm owner to transfer a small percentage of the farm land to children each year because of the number of deeds involved and the risk of a child having financial problems which would impact the title to the farm land.  If the farm is transferred into a partnership, however, the partnership interest can be transferred each year in amounts that could be sheltered by the annual gift tax exclusion.  At the same time, the children could be excluded from management decisions in the partnership until the parent deems them ready.  Additionally, if a child has financial problems, creditors may be hesitant to try to get at the ownership share in the partnership because of certain income tax attributes of a partnership which could damage a creditor.

 

           The partnership also provides an opportunity for estate tax discounts which would reduce the value of the property owned by the parent at death.  One discount which would be available is a minority discount.  As partnership share is transferred to children, that share is also eligible for a discount because of minority lack of control.  If the parent has transferred more than 50% of the ownership in the partnership to the children, he might have insufficient control to force a sale.  This is justification for an estate tax discount.  Another discount could be generated by the fact that the partnership interest is unmarketable.  A buyer would be very hesitant to purchase a share of a partnership over which the buyer has little or no control.

 

           Such partnerships are also becoming popular among individuals who have substantial wealth, but are concerned with potential creditors.  For example, a doctor whose specialty involves a high risk of malpractice liability might consider a partnership as a method of preserving family assets from some disastrous verdict in a malpractice action.  Similarly, people who invest in high risk real estate ventures may fear the effect of a future venture on family assets accumulated in the past. 

HANDLING PENSIONS AND IRA'S

 

           Retirement plans and individual retirement accounts (IRA's) are favorite vehicles for high income individuals to accumulate wealth. The obvious reason for this is that the money put into the plan is income tax deductible, and is allowed to accumulate tax free until it has to be withdrawn in retirement.  These income tax benefits can allow such a fund to grow much faster than would be the case if tax had to be paid on the savings and income it earns.

 

           While the pension and IRA provide valuable benefits, there are also serious tax risks and complexities involved.  When the amount in such a plan is large, very careful thought and planning must be used at a early point so as to maximize the benefit and avoid the tax traps.  We will review some of those issues here.

 

           A.       Income Tax Considerations. 

 

           The pension or IRA provides an excellent opportunity to save income tax.  This is done first because the contribution to the plan is tax deductible.  Further savings come from the fact that the accumulations within the plan are before tax, so it grows faster.  Another benefit for income tax purposes is that there may be an opportunity to "income average" when a plan is terminated.  This is a special treatment for lump sum distributions whereby the tax is computed as if the payment was received in five or ten equal annual installments, as if no other income were earned in any of those years.  In certain cases this can save substantial income tax, but each situation must be calculated carefully before making the decision to average.  Recent changes have taken away some of the advantage of income averaging, but there may still be benefit in certain cases.

 

           Plan withdrawals must begin by April 1st of the year following the participant's reaching age 70 ½ or by April 1 of the year following retirement (whichever is later).  The minimum amount which must be taken out each year to avoid the penalty is arrived at from tables provided by IRS for the purpose.  Those tables have recently been liberalized to make them simpler and more generous.  The withdrawals can be stretched over a longer period of years than was previously the case. 

 

           B.       Spousal Rights. 

 

           An employee is not free to make all changes in the beneficiary designation of a qualified retirement plan.  Federal law requires that a participant's spouse be entitled to a benefit at the participant's death unless the spouse has consented otherwise in writing.  In particular, the spouse is entitled to a joint and survivor annuity from the plan upon the participant reaching retirement date.  Under such an annuity, the participant would receive payments for life and the spouse would receive payments after death which are at least 50% of the participant's payment.  The spousal right can create difficulty in the planning of an estate, particularly in a second marriage where each spouse has children by a prior marriage.  The spousal right can be waived, but only after marriage.  Such spousal beneficiary rights do not apply at all to IRA's.

 

 

           C.       Tax Penalties. 

 

           Because of the tax savings involved in the plan, many people put more into their plans or take more out than perhaps they should. There are penalties which apply in certain circumstances which can be very costly. 

 

           For instance, a penalty applies to premature distributions. When an amount is withdrawn from a plan or IRA prior to the participant reaching age 59 ½, income tax would have to be paid on the withdrawn amount and there would be a penalty of 10% of the amount withdrawn added to the tax.  There are some narrow exceptions to this penalty.

 

           Beginning on April 1 of the calendar year following the year in which a plan participant reaches age 70 ½ or retires, the participant's benefits in all IRA's and all qualified plans must begin payment. These payments are calculated based upon the life expectancy of the participant, and there is, of course, a penalty if the required payments are not made in full. That penalty is very onerous, being 50% of the minimum distribution amount not actually distributed.

 

           The complexity and interrelationship of these penalties and taxes on qualified plans and IRA's has the potential for creating a disaster.  Upon the death of a plan participant, for example, the funds coming out could be subject to income tax (35%) and estate tax (up to 55%).  The sum of these tax percentages would be 90%.  Because the estate tax is  deductible against the income tax, the government has graciously consented not to take everything, but the tax can exceed 75%.  For the largest estates, the net benefit passing at death to children may be as small as 25% of the plan balance.  All the rest goes to taxes.

 

           D.       Charitable Giving. 

 

           When a plan participant wants to benefit a charity at death, it makes good sense to consider using plan or IRA benefits to give to the charity.  Because of the combination of estate tax, income tax and excise taxes which may apply, naming a charity as a beneficiary in a plan could cost the other beneficiaries very little in lost inheritance.  At the same time the charity would receive a larger benefit because it receives the plan money free of all tax through its exemption.  If there is a surviving spouse, a charitable remainder trust to receive the pension benefits may actually leave the family members as well of as if the plan had been left directly to them.  At the same time, a charitable organization can receive a substantial benefit.

 

           E.       Options Available To Spouse. 

 

           When a participant dies, leaving the surviving spouse as the beneficiary, the spouse generally has two options.  First, the spouse can continue to receive the annual plan benefits for life.  The better choice, most often, is for the spouse to transfer the balance in the account into an IRA established for the benefit of the spouse.  If the survivor is significantly younger than the participant, this would allow the spouse to continue to accumulate within the account until the surviving spouse reaches the age where distributions must be made.

 

           Sometimes the plan benefits are so substantial that they constitute almost all of the participant's assets.  At the same time, the participant's estate may be large enough that a credit shelter trust is important to be created to save estate tax. In those cases, it will be advantageous to have some or all of the plan proceeds pass into the credit shelter trust. The trust can be named as a direct beneficiary in the plan, or the spouse can be named as beneficiary with a provision that allows the spouse to divert some of the plan, after the participant's death, into the trust.

 

           Generally, a qualified plan or IRA is not a good asset to fund the credit trust.  This is because every dollar coming out of the plan must bear income tax.  If the income tax rate is 33%, that means that 1/3 of all funds coming out of the plan would go to tax, leaving only the remaining 2/3 to fill a credit trust.  Stated another way, if the objective is to have $600,000 in a credit trust, and qualified plan proceeds are going to be used, paying $600,000 of plan proceeds into the trust would leave the trust with only $400,000 after the income tax is paid.  It would be better, therefore, to use other assets, but that is not always possible.  Planning distributions from pensions into trusts is complex and can be costly in income tax.  It must be very carefully planned and considered before proceeding.

 

           The pension and IRA asset can constitute one of the best opportunity to save taxes and enhance your future income.  Special care must be taken, however, to avoid the mine field of taxes and penalties planted around such plans.

SPANNING THE GENERATIONS

 

           Small businesses (those employing 25 or fewer people) represented the greatest part of the expansion in employment in the United States in the past decades.  Those were considered "boom" years for business, but very little employment growth came from big business.  Most small businesses are family owned and operated. Family owned businesses which survive into a third generation of family ownership are rare.  One major reason for the failure is the imposition of the estate tax each time the property passes from generation to generation. The estate tax makes the government a partner in the business with the family. This greedy partner insists on withdrawing its share each time the business is ready to be passed down. The tax draws the life blood (its capital) out of the business.  Eventually, when there is not sufficient liquid capital to pay the tax, the business fails.

 

           Previously we have looked at many techniques designed to help pass property from parent to child at a minimum tax cost.  Those effectively avoid one imposition of the tax (between two generations).  When the assets are sufficient to warrant it, it is possible to structure transfers so that they may avoid taxation through many generations instead of just one.

 

           Early in the century, when the estate tax was first adopted, many industrialists would fashion trusts under their wills or through trust agreements which would hold the property for the benefit of the family, but at the same time avoid the estate tax as later generations used the property and passed it on.  This was the first common use of the generation skipping trust.  Some of those trusts continue on even now. There is a limit on how long a trust can continue, but with careful drafting, the period could be extended well beyond 100 years if desired.  Such a trust can be testamentary (created under a will) or living (created by a trust agreement during life).  When property is given or left to the trust, a gift tax or estate tax would be due. The tax savings anticipated by such a trust would occur when the children die, when the grandchildren die and so on through the generations.

 

           Our "partner", the federal government, found the opportunity of multi-generation estate tax avoidance very unattractive.  After one failed attempt, a law was passed in 1986 creating a generation skipping transfer tax (GST).  This was intended to apply a tax to those transfers which would have avoided taxation in a generation skipping trust or gift.  It is not an addition to the estate tax, but rather a new, separate transfer tax.  The GST applies to transfers, whether outright or in trust, where the beneficiary is more than one generation removed from the donor or the gift.

 

           Since the government wanted to destroy incentives to making generation skipping transfers, it set the rate of the GST tax at a rate equal to the highest estate tax rate.  In the large estate, fully utilizing the GST exemptions can cause dramatic tax savings.  Let us assume that the parents' estates are sufficiently large that the maximum estate tax would be applied at the death of the second spouse (50%), and that the same level of tax would be applied when the children die.  The grandchildren would receive 50% of 50%, or only 25% of what the parents started with.  Said another way, $2,000,000 out of a larger estate left to children and then left by them to grandchildren would be reduced to $500,000 by the imposition of two maximum estate taxes.  In such a case, the benefit of creating a fund which escapes estate tax for several generations is substantial.  There are no lower brackets to the GST tax, but there are some very significant exemptions.

 

           The most substantial protection from the GST tax is a personal exemption each donor has of $3,500,000 for transfers in 2009. In 2011 and after, this exemption is scheduled to fall to $1,000,000.  A donor could, for example, create a generation skipping trust and leave up to the exempt amount to the trust at death or by lifetime transfers, without triggering the GST tax.  Since this exemption is personal, a husband and wife could conceivably shelter at least $2,000,000 using their combined exemptions. This substantial exemption eliminates the risk of the generation skipping tax from almost all estates because it is only the rare estate which is larger than $1,000,000.  However, because of the very high rate of the tax, GST must be very carefully considered in the estate plan of any family where the wealth exceeds $1,000,000.

 

           Unless the impact of the GST is kept in mind, it is possible that its effect would be imposed "by mistake".  For example, consider a couple with combined estates of more than $1,000,000.  If they had one child, it would not be unusual for them to provide that the child is to receive the total estate outright, but only upon reaching a certain age.  A Will in that event would call for a trust for the child until the chosen age is reached.  If the child dies before reaching the age to receive the funds, then the estate would pass to the child's children (grandchildren). If the child died before the trust termination, the transfer of the property out of the trust to the grandchildren would constitute a generation skipping transfer and would be subjected to the tax.  As the size of the combined estates grows, the possibility of the tax "surprising" the family with a substantial additional tax bill becomes much greater. 

 

           Another significant exemption from GST is found in the annual gift tax exclusion.  As you will recall, an individual is allowed to give $13,000 per year per donee without the imposition of gift tax.  That same amount could be given to a grandchild, great grandchild, or other recipient without using up any of the GST exemption.  Similarly, tuition and medical expenses, which can be paid free of the gift tax, can also be paid free of GST tax. 

 

           A special opportunity presents itself where the parents are contemplating life insurance as a source of liquidity to pay estate tax.  Usually, such a policy would be held in an irrevocable life insurance trust, and the parents would pay the premiums as gifts to the trust.  Such a trust can be structured as a generation skipping trust.  It has advantages over a comparable GST trust created by will or by gift to a non-insurance trust.

 

           If a life insured person lives to a normal life expectancy, the sum of the premiums paid on the policy will be much less than the death benefit which will be paid to the beneficiary.   Fixed premium insurance (not term insurance) charges a higher premium in the early years than would be the case with term insurance. In the later years of the policy, however, the premium is much lower than term insurance. These early year premiums allow an internal build-up of value in the policy that would not be the case with term insurance.  It is this internal buildup which causes the proceeds to be much higher than the sum of the premiums.  By analogy, if you deposited regular amounts to a savings account over a number of years, the balance in the account would far exceed the sum of the deposits as a result of the build-up of interest in the account.

 

           Applying this concept of the nature of life insurance policies to the GST problem, we find that an opportunity is created. The parents must draw on their "bank" of GST exemptions in order to fund a GST trust.  By using that exemption to pay premiums, they may protect a greater amount from GST taxation using insurance.   Another benefit is that they do not have to give up control of cash or other assets which they might need during life. Consider a trust holding a $1,000,000 life insurance policy, created by the parents, which has an annual premium of $8,000.  Assume that the premium must be paid for 20 years after which the cash value of the policy will allow the policy to be self sustaining.   The sum of the premiums will be $160,000.  The proceeds payable at death, however, will be $1,000,000.  The parents are only required to apply GST exemption equal to the premium in order to shelter the entire trust.  They will therefore use up GST exemption of $160,000 in order to create a trust which is protected from the estate tax for many generations, and which will hold $1,000,000 at their deaths.  They could use the balance of their GST exemption for other trusts or transfers.

 

           The Generation Skipping Transfer tax currently represents the highest marginal tax applied to any transfer.  It is therefore well worth the effort to structure an estate in a way that will avoid it.  On the other hand, it represents the most complex set of rules and regulations we have to deal with in the estate planning.  This complexity causes it to be a potential trap in any substantial estate. It is critical that the traps be avoided and that the opportunities be taken advantage of. This insures that descendants will enjoy the maximum benefit of their legacies for the longest possible time.

 

GLOSSARY OF TERMS