Back in the old days--say, prior to mid-December of 2000--estate planning was a rather straightforward, albeit increasingly complex, endeavor. The planner pulled from his bag of tricks a number of tried-and-true strategies, such as charitable remainder and lead annuity trusts, life insurance in a trust, sales to defective trusts, annual gifts, and, of course, transfer of the applicable exclusion amount. These and others were mulled over while weighing the pros and cons of integrating any of the more radical approaches du jour into a plan so cleverly conceived as to force Uncle Sam to panhandle someplace else.
Last April in this space we noted that many taxpayers, especially the newly minted rich who hit pay dirt with company stock options and supercharged portfolios, were embracing the estate planning process at a much earlier age than their parents had--a good trend for planners, indeed. We extolled the virtues of the family limited partnership (FLP)--"Everything is off a partnership wrapper right now," one attorney enthused--and explained such things as the "char FLP," the family limited partnership's spunky offspring merging FLP discounts with charitable giving. We looked at guaranteed GRATs (grantor-attained annuity trusts), last year's new estate-planning kid on the block. And we examined trusts in general, which after somewhat of a hiatus came back with a vengeance that has yet to abate.
Hold That Thought
You'd think that with such a panoply of powerful estate planning tools, advisors and clients would be off and running toward the dotted line. Most are not. Instead, what we have today is the estate planners' version of the 1950s movie "The Day the Earth Stood Still." In effect, advisors are doing their darnedest to not do anything, adopting a wait-and-see approach and implementing strategies that sometimes contradict others that for years have been set in stone.
"People right now are probably going to slow down on any aggressive estate planning until they see what the new tax laws look like," says Judith McGee, a branch manager with Raymond James Financial and the principal of McGee Financial Strategies, both in Portland, Oregon. And that could take some time. That the President has made rapid strides in his efforts to cut taxes was evidenced by a March 9 nod from the House approving an across-the-board reduction in rates. Still, a split Senate, the bill's next stop, might prove a tougher sell. (See News & Comment, page 20, for more on the legislation's prospects.) And while President Bush has vowed to reduce the marriage penalty tax, phase out the estate tax, and reduce the gift tax rate, it remains uncertain how far Congress will go in meeting this part of his agenda and when changes in law will actually occur, especially in regard to estate and gift taxes. McGee guesses that due to intense lobbying, "we're a year out," and that the timing really depends upon the mood of this Congress. "I think they're wrestling with serious economic problems and pressures; they've come hard and fast and nobody's seen this before, so that's the major concentration right now."
Not everyone agrees with the wait-and-see approach, especially if the wait becomes protracted. "I think the biggest downside with this uncertainty is that we may be caught napping and not taking action, delaying the planning activity," says Jeff Hatchman, vice president at New York Life's Advanced Planning Group in New York City. "My gut is that it will probably be decided in the last hours of the Congressional session, where some sort of compromise will be hammered out that is more reform than repeal." It's possible, he adds, that the present uncertainty may lead to a legislative gridlock, and that nothing will be decided regarding the estate tax in the year 2001. "If that happens and we have clients and advisors who are waiting, that might create a very big problem for some."
Another reason for taking action sooner than later, Hatchman points out, is that any change in estate tax law is a legislative issue, as opposed to a Constitutional issue; hence, should one administration repeal the estate tax, or delay or defer the repeal, another administration could do the opposite.
Charles Lieberman, former chief economist at Chase Manhattan and managing partner of the investment advisory firm Advisors Financial Center in Suffern, New York, is confident that Bush's proposals will reach fruition, allowing for some "give and take on revisions." (Visit www.investmentadvisor.com for an exclusive interview with Dr. Lieberman.) "I have no doubt that a tax cut is coming," he says. "And it's very likely that Bush will succeed in getting an enormous deduction in the estate tax." That being the case, Lieberman agrees with advisors who feel that it is very difficult to do good estate planning at this point in time. His advice for those who already have some sort of estate plan in place, is simply to wait. For those who don't have an estate plan in place, he cautions them to "think carefully about how [tax] changes are likely to affect them."
These changes will affect more than individual clients, however. They'll turn on its head a cornerstone of estate planning itself--at least the variety of planning that has as its objective not charity but, in the words of Encyclopedia of Estate Planning author Robert Holzman, "the transmission of as much of one's wealth as possible to chosen parties [read: heirs] in the most appropriate manner." That cornerstone is the estate gift tax (the estate tax and gift tax were unified in 1976), which previously was commonly employed to remove the assets, and the appreciation of those assets, from an estate.
Consider the Implications
For years, planners encouraged their clients to "gift" by exceeding the so-called applicable exclusion amount of $675,000 (tentatively to reach $1 million by 2006), as well as the tax-free annual exclusion of $10,000 per person, per donee, and paying gift tax on the overage, since it has always been more advantageous to pay gift taxes than estate taxes. "Even under the current uncertainty, you still want to use up your applicable exclusion amount because that's free," says Gail Cohen, senior vice president and chief trust counsel at Fiduciary Trust Company International, headquartered in New York City. "But in the old days, we would say go beyond it; if you can afford it, do it, because it's cheaper."
Cohen offers this example: If you would like to pass to your heir $1 million (after reaching the applicable exclusion amount and using the tax-free annual exclusion), make it a gift and pay the gift tax. Assuming a gift tax rate of 50% (the rate is 37% up to $750,000), it would cost the taxpayer $1 million in gift money and $500,000 in gift tax, for a total of $1.5 million, to ensure that the heir gets his or her $1 million. However, if the person were to die, and wanted the same heir to get his $1 million, that person has to die with $2 million. That's because the 50% estate tax would be imposed on the full $2 million, leaving $1 million to the heir. In effect, there would be a tax on the tax itself, since while there is no tax on the gift tax there is a tax on the estate tax. Today, if you gift and it turns out there's no gift tax, "you may have shot yourself in the foot," says Hatchman.
It also remains uncertain whether, in the absence of an estate tax, there will be a stepped-up basis for appreciated assets for capital gains tax purposes. "There are a lot of ways to skin a cat," says Lieberman--meaning that one way or another, the government will get its money from the wealthiest segment of the nation's population.
An estate tax repeal could spell a reduction in the use of charitable remainder trusts, though in the event of increased capital gains taxes, CRTs would likely still be viable. In addition, repeal would probably have a large, negative financial effect on non-profit organizations and charities. According to the San Clemente, California-based Surfrider Foundation, "Many large charitable donations are made by wealthy individuals who receive significant tax breaks for donating part or all of their estates to charities. The repeal of the estate tax would eliminate the existing financial incentives to donate estate assets to charities." This bears watching.
Of concern, also, says McGee, are the new IRA rules (see "Bipartisan Medley," February 2001 issue). At issue today is second-generation stretch-out planning with IRAs and the use of trusts. "If you're going to use a trust, be sure that it's IRA-qualified so that you don't lose the stretch-out," she cautions, adding, "It means getting up to speed on all those IRA rule changes."
Often criticized for their steep fees, variable annuities, which offer income tax deferral, guaranteed rates, lock-in step-up protection, and avoidance of probate, are not particularly effective estate planning tools, says New York Life's Hatchman. "If I owned an annuity on my life, I put $100,000 in, and now it's up to $300,000, that $200,000 gain will be subject to regular ordinary income tax rates--either to me, if I take the money out while I'm alive, or to my beneficiary at ordinary income tax rates at the bracket they're in," he explains. He notes that one of various life insurance policies, such as universal life, might be a better bet. One thing that will make the annuity more attractive, he says, would be if the government were to wipe out the step up in basis.
"Right now, the most important, cutting-edge approach is finding ways of getting assets down to the next generation without paying any gift tax," says Cohen. She says, too, that if your clients are in good health and the prospect of their living six years is likely and you think the estate tax is going away entirely, "Why should they pay any gift tax now whatsoever?"
Better Than Peanut Butter
What are the best alternatives? Planner Judith McGee describes the so-called 529 plans as the "hottest thing since peanut butter." Officially known as Qualified State Tuition Programs, enacted into the tax code in 1996 under Section 529, these 529s are "just starting to be promoted by a lot of financial advisors, including ourselves," says McGee. Previous college plans, known as prepaid plans, were only available to residents of a given state, she explains. Now states compete for 529 money, which makes the plans more innovative and competitive.
According to McGee, the 529s have far-reaching benefits, including federal and state tax deferral, no income limits, and generous contribution maximums, which translates to an opportunity for aggressive gifting. For example, a gift of up to $50,000 (or $100,000 for a married couple) won't trigger federal tax consequences, as long as one doesn't make additional gifts to the beneficiary for five years. Earnings grow tax-free, taxes are paid when the beneficiary pulls the money out, and gifts are excluded from an estate for estate tax purposes. The owner has the ability to remove assets from the estate while retaining discretion over their use.
The 529 plans also satisfy some of the control issues surrounding Uniform Gift to Minors Accounts (known as an UGMA or an UTMA). The 529 plans allow transfers of existing UGMA/UTMA accounts but do not allow a change of the original beneficiary. Under a 529 plan, beneficiaries do not gain control of the assets at their age of majority as they would with an UGMA/UTMA. McGee offers this strategy: Transfer an existing UGMA/UTMA account to a 529 and keep the same beneficiary, but do not give up control of the assets until you decide on a school. Since money in a 529 plan remains under the parent's ownership, it is not counted as a student asset and will not interfere with the student's ability to obtain other financial aid. The downside? As an investment vehicle, 529s aren't as liberal as other kinds of trusts, but they are getting better. McGee speaks highly of the Rhode Island plan, which is sponsored by Alliance Capital.
For estate-tax fence-straddlers who want nonetheless to be covered in the event of an outright repeal, try the family split-dollar arrangement, suggests Hatchman. He explains that what some people do is to create an irrevocable trust, and use the trust to purchase a life insurance policy on either the husband or the wife, with one spouse advancing the funds under a split-dollar arrangement to the trust to pay those premiums. The advantage is that should something unfortunate happen today, or if the estate tax is not repealed down the road, the death benefit that flows into the irrevocable trust is outside of the estate tax structure. And the spouse who has advanced the money gets back his or her premium advances.
"Let's say for the sake of discussion that the estate tax is repealed two years from now," says Hatchman. "If you want to say, 'Gee, we wish to kind of dismantle this trust,' the spouse who advanced the money could take the money back, and that way you've got it without having given it away permanently. So you kind of get it outside the estate but still retain some of the control."
A variation on this theme is the spousal lifetime access trust, wherein the grantor gifts the money to the trust, but gives his or her spouse access as a beneficiary to take the cash out or to take the policy.
Sales to defective trusts, notes Hatchman, have become a popular strategy in the past three or four years as a technique to transfer assets for estate tax purposes while not having to pay capital gains in an income tax basis. It is an approach that, like charitable remainder trusts, could become even more effective if there is significant estate tax reform. Life insurance in qualified plans would become increasingly effective for the same reason.
Cohen finds that grantor-retained annuity trusts are a good estate planning structure to be utilized during this "wait-and-see" period. GRATs are a tool which enable a person to gift money or assets into a trust, but retain the right to receive back an annuity from that property. The GRAT can be structured in such as way that for tax purposes, the value of what the person has given away is zero. "The beauty is that with a GRAT there is no gift tax. That's why we do it, instead of making a gift that would incur a gift tax," she explains.
Cohen gives this example: "Let's say you give away a million dollars' worth of value. You create a trust that lasts for two years, and you retain the right to receive an annuity; in this case, $547,000 a year from that trust for two years--a figure I reached using the IRS's current [March] growth rate of 6.2%. You can see that what you've retained is greater than the original million. But if you structure it that way, you have no gift tax to report, since there's no taxable gift. You might say, 'Why would you do that, since it seems like you haven't given anything away?' But the idea here is that what you give away is something that's going to appreciate significantly. If you can grow something in excess of that 6.2%, you've gotten something down to the next generation with zero gift. If the assets don't grow in value, and they decline, you really haven't lost anything for trying."
Sales of assets are also popular during this time of uncertainty, Cohen says. These work in different ways. One could be an installment sale: The grantor takes something--real estate, a business, virtually anything that might offer favorable valuation--and sells it at fair market value to his children. They, in turn, pay for it with a note at some appropriate rate of interest as determined by the IRS. The grantor can take the property and put it into one of the limited partnership structures, such as the family limited partnership, and sell units of the partnership at a low cost, due to a deep discount on the valuation. The strategy can be used with a GRAT as well, Cohen adds, by putting in units of family partnership instead of straight securities, with the same valuation benefit. The children or a trust for the next generation might buy it and pay off the seller in installments, and the seller can realize the gain in installments.
There's also a private annuity type of sale. Here, you come up with a price, and structure the payments out over someone's lifetime expectancy based on the mortality tables; the gamble is that if the person doesn't live out his expectancy, he or she gets less for the property than its fair market value. This is a good thing, in that the older generation will take in less money, while passing more money down to the next generation. If the person outlives his life expectancy, then he will pay a lot more than the property was worth.
Don't Forget the Obvious
While Cohen stresses the importance of properly structuring these estate planning "alternatives," and enhancing their value by using them in conjunction with the family limited partnership, there are other options planners often overlook due to their simplicity. First, make sure to use the full unified credit amount or applicable credit amount, along with the annual $10,000-per-person exclusion. "It's amazing how often it gets forgotten," says Cohen. The classic example is that of the grandparents with seven grandchildren. "That's $140,000 a year they can give to their grandchildren free of any transfer tax."
Direct payment of tuition is another example. Tuition can be paid directly to the school, whether college, private secondary school, or nursery school, in any amount, and in addition to the annual exclusion, without incurring a transfer tax. The same holds true for the direct payment of medical expenses. "This is underutilized as well," says Cohen.
One of the major pitfalls for planners today is the improper use of trusts--they are not drafted with enough technical precision, and often fail to give the trustee enough flexibility, says Cohen. She points out that trusts have always been in existence and have always been used, though at times more enthusiastically than others. For a while they fell out of favor because people felt that trustees had to be more conservative in the way they invested assets, which nudged people towards the partnership as a protection vehicle. But laws governing trusts have changed, enabling trustees to invest money more the way individual investors would. 'People really should consider long-term trusts in their estate plans because they offer asset protection for their beneficiaries as well as certain tax advantages that you can't get with an outright disposition."
Estate planning in these fence-straddling days before the estate tax verdict is about more than products and strategies. "Obviously we can't implement them all," says Cohen. "And since most people have a variety of interests, I need to know what's most important for the client. Maybe their non-tax issues are paramount, and we start there. I've also met with clients for whom the most important question is who's going to continue to manage a particular asset--maybe it's a business, maybe it's a piece of real estate that's been in the family forever. Hopefully, you end up with a recommendation that will solve a lot of needs. Communication is key."