L. MORE SOPHISTICATED PLANNING

As if the discussion above were not complex enough, tax planners have developed many types of devices designed to reduce or eliminate the federal estate tax and the complexity of administration at the death of an individual.  Most of these planning tools are only useful for individuals with estates that equal or exceed one million dollars, (and for many of the more sophisticated structures, are of a value substantially higher).  If your estate has a value of this magnitude, you clearly should be dealing with a professional estate planner.

To cover some of the basics, however, the following is a list of some of the planning concepts with a brief summary as to their application.  This is not intended as an exhaustive summary of these devices.

1. Gift Planning.

Giving property away is a very effective method of reducing your estate because you will pay tax on the value of your estate as it exists the time of your death.  See "FEDERAL ESTATE TAXES".  Gifts can be made either outright or in trust into a properly structured trust for the benefit of the recipient.

a. Annual Exclusion Gifts

Generally speaking, every person is able to gift $10,000 a year to as many people as is desired.  You obviously want to be sure that you have adequate funds to care for yourself before you begin making gifts of this nature.  These gifts, so long as they constitute a present interest in the property, are ignored by the internal revenue service, and it is not necessary to file a gift tax return to report them.  In more sophisticated planning (where property other than cash is transferred) practitioners often will file a gift tax return to start the statute of limitations for tax purposes running. 

b. Unified Credit Gifts

Gifts can also be made of amounts in excess of $10,000 per recipient per year, but when you make gifts of this nature they begin to consume the exemption equivalent amount available at the time of death.  See discussion at "FEDERAL ESTATE TAXES".  While no tax will be necessary until you exceed the exemption equivalent amount, returns must be filed and gifts must be reported. 

c. Why Make Gifts Now?

Since the exemption equivalent amount is available to you either at death or during your lifetime, there are only a limited number of reasons for gifting the property now as opposed to waiting until your death.  These reasons, while simplified, are as follows:

1. Making the gift now removes future growth or appreciation from your estate.

2. Making the gift now means that the income from the property will be in the hands of the recipient.

3. When making very substantial gifts, the gift taxes is an obligation of the person making the gift rather than the person receiving
    it, while the estate tax operates to reduce the amount of the gift in most instances.


2. Family Limited Partnership or Limited Liability Companies.

Forming a family limited partnership or family limited liability company is generally done, in addition to the business reasons for having family members become involved in management of property, to obtain discounts in the value of property.  Assume, for example, that you own a piece of real estate worth one million dollars.  If you transfer a 10% interest to a child, you would assume that the child would receive a gift worth $100,000.  Because of the fact the child receives a minority interest, however, you would probably discount the 10% gift saying that, because he has only a portion of the property, his interest may be worth less than $100,000.

By transferring the property into a family limited partnership or family limited liability company, you can contractually restrict the recipient of the gift so that the recipient does not have the ability to sell the interest in the partnership or limited liability company.  Because such an interest has little or not control under the terms of the agreements creating the partnership or limited liability company, and because there is a restriction on marketability, you would normally discount the value of the 10% interest even further.  If you are aggressive, and discount the interest by 40%, a 10% interest in a million dollar property would be worth only $60,000.  By utilizing these techniques you can transfer by gift substantially greater interests in property while minimizing the gift or estate tax.  Properly structured you can also transfer property while retaining control.

3. Personal Residence Trust

A personal residence trust is a vehicle that will allow you to transfer your residence into a trust, retaining the right to use it for a number of years, and treating the future right to receive the property in the hands of your children as a present gift.  Because the children will only realize this right after a specified term of years, you can utilize the actuarial tables to value their interest.  Utilizing this technique, if you survive the requisite term of years, your children will have received the full value of the property, while you pay the gift tax only on a discounted remainder value. 

4. Irrevocable Life Insurance Trust

An insurance policy usually has three parties involved.  The insured, who is the life insured by the policy, the owner, who is the person who purchased and owns all incidents of ownership in the policy, and the beneficiary, who is the person who receives the proceeds upon death of the insured.  If you purchase a life insurance policy on your life and you are the owner, at the time of your death the proceeds of the policy are taxable in your estate for federal estate tax purposes.  This is so even though they would not generally be subject to income tax. 

In many instances, particularly where insurance is purchased to pay federal estate taxes, you would like to be certain that the insurance proceeds are available to your family, but are not subject to a federal estate tax.  This can be accomplished by transferring ownership of the policy either to third parties, such as your children, or into an irrevocable life insurance trust for the benefit of your children or other designated beneficiary.  Properly structured, such a trust can assure that the life insurance proceeds are not themselves subject to a federal estate tax.

5. Charitable Gifts.

Gifts to qualified charitable organizations are exempt from the federal estate tax and often provide an income tax deduction.  There are many mechanisms and devices to accomplish direct gifts, in trust or gifts in trust with retained benefits (such as qualified remainder trusts of many sizes and shapes).  The basic premise, however, requires that you have an interest in the charitable organization.  Despite some statistical information that I find dubious, I believe that there is no effective method to give property away to charity and have your family ultimately receive more property than if you had not made the gift.  If you do have charitable goals, however, a wide array of structures exist which can reduce tremendously the after tax costs to you of making charitable gifts.  Planning for charitable gifts should be done with the cooperation of both your attorney and accountant to assure the impact of the proposed transfers.

6. Grantor Retained Annuity Trust

The grantor retained annuity trust ("GRAT") is an irrevocable trust in which the grantor retains the right to an annuity for a specific term of years.  A GRAT is a gift of a remainder interest in a trust, which, because the grantor retains an annuity interest for a term of years, has a reduced value for gift tax purposes.  Thus, the grantor can give away the remainder interest with a significantly reduced gift tax.

The GRAT offers a method of shifting future income and appreciation to another person with little initial tax cost while at the same time limiting the amount of gift tax payable in the event of a valuation dispute with the IRS.  Currently, with interest rates at relatively low levels, it is possible to pass "excess" growth to beneficiaries without incurring additional gift tax if the assets funding the GRAT are likely to outperform the current IRS stated interest rate.  In other words, future income and appreciation can be shifted to beneficiaries with relatively little gift tax.
There is no additional gift tax at the point in time when the grantor’s interest terminates.  The gift is complete at the time the trust is funded and there is no post-transfer adjustment mechanism in the law.  To the extent that the assets have outperformed the IRS table rate at the time the trust was funded, there will be extra value in the trust that will pass to the beneficiaries without additional tax.


7. The Advantages to this Vehicle Are as Follows:

First, the grantor retains for a fixed term of years the right to receive a specific amount from the property given away. 
Second, the GRAT arrangement takes advantage of the fact that the IRS’s actuarial tables may result in the undervaluation of a remainder interest after a qualified annuity interest terminates.  The tables assume that a specified annuity will be paid during a designated term.  A GRAT must actually pay out that annuity amount.  If the actual yield (including any appreciation in value) of the GRAT exceeds the amount assumed in the tables, the excess will inure to the benefit of the remainder beneficiaries, without added gift taxes. 
Third, S corporation stock may be transferred to a GRAT.

8. Planning with Intentionally Defective Irrevocable Trusts

An irrevocable living trust may be used as an effective vehicle for making gifts to an individual, particularly in those instances where the individual has not yet reached an age of maturity and financial responsibility.  Instead of making the gift directly to the individual, however, the gift is made to the trustee of an irrevocable trust established for the benefit of the individual.  The trust may provide that it terminates at a later, more mature age.  In the meantime, if desired, the trust assets may be used for the benefit of the individual.

An aggressive offshoot of this mainstream planning is creation of an intentionally defective irrevocable trust ("IDIT").  This is an irrevocable living trust that is funded with transfers that are completed gifts for gift and estate tax purposes, but is still a grantor trust for income tax purposes --that is, the grantor pays the income taxes on any gains or earnings of the trust that are actually distributed to or applied to benefit the beneficiaries.  The trust is called "defective" because you retain selected administrative powers or rights so that the trust income is taxable to you, but the trust assets are not included in your gross estate for transfer tax purposes.  The trust assets grow at a pretax rate as you report and pay tax on the trust income on your personal income tax return.
The primary reasons for intentionally violating the grantor trust rules are twofold:

First, to enable you to augment the value of the trust on a tax-free basis, by paying the income taxes on the trust’s income.  Many grantors, trusts and beneficiaries are in marginal income tax brackets of 45 percent (federal and state combined).  Your payment of the beneficiary’s income taxes effectively increases the size of tax-free gifts by up to 45% of future trust income and gains.

Second, to enable you to engage in tax-free transactions with the trust.  For example, a sale transaction by you with the trust is treated as a sale to yourself without current income tax consequences.

9. Other Structures.

There are many other very effective structures utilized in more complex estate planning, such as the use of an Employee Stock Option Plan ("ESOP"), charitable lead trusts, and various estate freeze techniques and similar devices.  Utilizing structures of this nature generally requires that you be extremely cautious in dealing with your personal planning advisors, including your accountant, your financial planner and your estate planning attorney.  While these types of vehicles, and the potential risk inherent in their use, make economic sense in very large estates, you also want to offset the tax planning benefits by the personal aggravation that use of these types of devices require.  You need to be extremely careful not to have the enthusiasm of your tax planner outweigh your common sense in getting involved in complex structures.  This is particularly the case where the planning reaches areas which may require you to defend the structure or strategy from challenge by the Internal Revenue Service.  I do not mean by these warnings to indicate that these devices are not effective, and quite desirable, in many planning circumstances.  It is important in making the decision to proceed, however, to assure that you understand the risks and are willing to endure the aggravation if the Service disagrees with the evaluation and recommendations of your professional advisors.