From the January 2003 issue of Investment Advisor • Subscribe!

January 1, 2003

A World of Taxes

The techniques to reduce U.S. taxes for the global

The U.S. tax system is extremely complex, and to an investor it can be very dangerous--much like traversing a minefield without the proper maps to help navigate it. Whether he is a U.S. resident or not, the widening scope of U.S. taxation can cost the global investor prohibitively high rates of income and transfer taxes.

With good planning, however, the global investor with holdings in the U.S. may be able to legally minimize tax costs and therefore achieve a better rate of return, or get to keep most of the assets that he has accumulated through years of work and savvy investing. This article presents a portfolio of tax planning techniques that work. They cover a spectrum of situations. Each is only briefly sketched, and the advisor will need to customize them to individual situations.

Family Limited Partnership (FLP)

What it does: An FLP allows a family to own and control investments (which can consist of a variety of assets, such as cash, stocks, or real estate) in a partnership form (such as an LLC--Limited Liability Company--vehicle). Typically the parents retain control, but are able to transfer much of the equity value to their children at deep discounts for gift and estate tax valuation purposes, and therefore significantly slash potential gift and estate taxes.

It works because . . . when done correctly, U.S. taxpayers have been winning in court against the IRS, getting what is known as the "minority" or "lack of marketability" discount when it comes to valuing gifts of FLP interests.

It works especially well for . . . assets that are difficult to transfer or divide, such as real estate.

It can be used by . . . U.S. residents and non-resident aliens, known as NRAs.

Asset Basis Refreshing

What it does: Allows a non-resident alien to bring the tax cost basis of certain assets up to the fair market value level, and avoid future U.S. income taxes should the NRA acquire U.S. residency status in the year of sale of the asset.

It works because . . . for an NRA who is not yet subject to U.S. income taxation, he can generate a transaction that for U.S. tax purposes would recognize a basis step-up of the asset to fair market value, and yet for their home country tax purposes, the transaction is not taxed.

Examples include . . . sale of U.S. situs assets to an offshore entity; use of a U.S. check-the-box election for a foreign entity to receive stepped-up basis assets; use of an intentionally failed Section 351 transaction.

It's particularly appropriate . . . as part of an NRA's pre-immigration planning, or before an NRA comes to the States for an extensive period.

Can be used by . . . NRAs only.

Lifetime Gifts

What it does: Allows individuals to transfer assets to beneficiaries, efficiently utilizing their annual gift tax exemptions or a portion of their lifetime gift/estate exemption. Gets the future value appreciation of assets out of the estate, and cuts future estate taxes.

It works because . . . simple and well- timed gifts during life can work elegantly to reduce gift and estate taxes by using the annual gift tax exemption ($11,000 per donee in 2002). Combined with other techniques, such as the FLP above, this can be a powerful tool.

Examples include . . . We transferred real estate owned by a couple worth $2 million into an LLC. The couple has four adult children, all married, each with two children of their own. With each child's household having four individuals, this means that each child's family can receive $88,000 worth of gifts simply by using the couple's annual gift tax exemption. Using a conservative 35% valuation discount on the LLC shares, an $88,000 gift to each child's family reflects a $135,384 underlying real estate market value. In four years' time, the couple can transfer substantially all the FLP's equity to their four children's families without touching their lifetime gift/estate tax exemption.

It's particularly appropriate . . . for assets with future appreciation potential.

Can be used by . . . U.S. residents and NRAs (with some modifications).

Irrevocable Life Insurance Trust

What it does: Removes the life insurance proceeds from a person's taxable estate, so the beneficiaries (spouse, children, etc.) get the insurance money free of estate or income taxes. A well-structured ILIT can also provide a way to "rescue" high-value assets in an Individual Retirement Account (IRA) that may get taxed at rates as high as 70% to 85% (estate and income tax rates combined).

It works because . . . by creating an irrevocable trust, a person can either transfer an insurance policy, or better yet, let the trust buy the insurance on her life. Since at the time of death, the trust owns the policy, none of the insurance proceeds are included in the taxable estate.

It's particularly appropriate . . . as soon as a person--or a person and spouse's--combined assets exceed the lifetime estate tax exemption amount. It may also never be too late. We recently arranged for life insurance on an 82-year-old who has substantial assets in an IRA account, reducing a significant amount of future estate taxes.

Use of Non-U.S. Entity

What it does: Allows a non-resident alien to avoid U.S. estate taxes on U.S. situs property.

It works because . . . the U.S. situs property owned by an NRA is subject to U.S. estate tax, such as shares in a U.S. corporation. By putting the U.S. shares (U.S. situs property) into a foreign entity (such as a British Virgin Islands-based company), and with the NRA owning the BVI company instead, the NRA will no longer own U.S. situs property at the time of his death.

It's particularly appropriate . . . for almost any type of property, including U.S. equities, valuable artwork, and U.S. real estate.

Can be used by . . . non-resident aliens only.

Grantor-Retained Annuity Trust

What it does: Transfers assets with future appreciation potential to beneficiaries by efficiently utilizing the grantor's gift tax exemption, and lets the grantor retain an income stream for a fixed term of years. The effect is to reduce gift and estate taxes significantly.

It works because . . . the grantor will voluntarily pay a gift tax on the "remainder value" of the GRAT, which is based on a present value calculation. Once the grantor survives the GRAT terms, having received the annuity payments, the remainder of the GRAT passes on to the beneficiaries free of gift tax.

Works particularly well with . . . assets with high appreciation potential, such as closely held companies about to be sold at a sizable gain to the owner, or companies about to go public. Assets such as LLC interests and real estate can also be placed inside a GRAT.

Can be used by . . . U.S. residents in relatively good health who are likely to outlive the GRAT term.

Intentionally Defective Grantor Trust

What it does: Shifts future appreciation of assets to beneficiaries without gift tax effect.

It works because . . . by customizing an irrevocable trust, so that for income tax purposes it is a "grantor trust," an individual can sell an asset with high appreciation potential to the IDGT, and yet because it is a grantor trust, the individual will not have taxable gain on that sale (for income tax purposes, it is like selling it to yourself; i.e., a non-event). The trust is intentionally made "defective" in the sense that we fail to make it a separate income tax entity from the grantor. As the sale to the IDGT was for full market value, there is no gift tax incidence at time of sale. Yet, for gift and estate tax purposes, the sale was a completed sale, so that the trust assets will not be included in the grantor's estate. By making the sale at today's relatively low value, the grantor gets the high future appreciation and gain potential out of his estate at virtually no estate tax cost.

Works particularly well with . . . assets with some appreciation today, but with much higher gain appreciation potential in the future.

Self-Cancellation Installment Note

What it does: Transfers extremely high value of assets to beneficiaries (such as children) at very low estate tax cost if the asset owner has very short life expectancy.

It works because . . . by selling assets at their fair market value today, and taking back a note which, based on actuarial assumptions, will pay the owner an annual amount for the duration of the owner's life, yet the note will self-cancel upon the owner's death, the cancelled portion of the note will not be included in the owner's estate and therefore not taxable.

Can be used by . . . asset owners in very poor health who are not expected to live much longer.

Dynasty Trust

What it does: Passes wealth to future generations while minimizing estate, gift and generation-skipping transfer (GST) taxes.

It works because . . . by allocating a sufficient GST exemption (for year 2002 it is $2.2 million combined for a grantor and spouse) to a trust that will distribute trust income and principal to beneficiaries at the trustee's discretion, all future GSTs from the trust to beneficiaries will be exempt from the GST tax. Typically, dynasty trusts are set up for the maximum term permitted by law (in states with the rule against perpetuity) or in perpetuity. This way, a vast amount of wealth can be given to multiple successive generations at no additional estate tax costs.

Works particularly well for . . . wealthy individuals who wish to provide for future generations.

Tax-Free Exchange

What it does: Defers the taxation for owners of highly appreciated business assets who wish to exchange those assets for like-kind assets.

It works because . . . by complying with the very precise technical requirements of Federal tax law section 1031, an owner of an appreciated asset (such as rental real estate) can do an exchange (multi-party exchange, deferred exchanges, or even reverse exchange) of the asset for like-kind property--essentially upgrading the asset owned--and yet be able to avoid paying taxes on the gain currently.

Works particularly well with . . . real estate businesses and investment property--although real estate is not the only kind of business property that may qualify.

The list presented above is by no means exhaustive; many others are available. The ones described here, however, can be very effective if properly used.

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