From the May 2005 issue of Investment Advisor • Subscribe!

Preserving the Legacy

Forget the political uncertainty over the estate tax--every planner should know these 12 top tools of estate planning

Although the estate tax may be repealed or significantly changed in the near future, don't expect those changes to last forever. Rising government deficits and the concentration of wealth in a small percentage of the population will probably bolster support for an estate tax. Perhaps the greatest problem with the estate tax debate is that it may cause people to delay using techniques that could save them millions of dollars if they acted now. Consequently, every planner should know the primary means of reducing transfer, that is, estate and gift taxes.

The most popular planning techniques are listed below in the approximate order in which they are most commonly employed. Because many of these techniques may be combined in creative ways, exclusive classifications are difficult. Many factors will affect the extent to which a client utilizes them, including the size of the estate, types of assets, and client's age, health, and disposition desires.

Tool #1: AB Trusts

Wills with "AB" trust provisions are designed to minimize the estate tax at the death of the first spouse while permitting the surviving spouse significant access to the wealth left by the deceased spouse. Usually the "B" trust is first funded with assets of the deceased spouse (to the extent practicable) equal to the "unified credit exclusion equivalent." The unified credit exclusion equivalent is $1.5 million for 2005. The surviving spouse usually receives rights to the income and possibly the principal of the B trust, but a B trust's assets will not be included in the surviving spouse's estate.

The remainder of the deceased spouse's estate is then left to an "A" or "marital deduction" trust which qualifies for the unlimited marital estate tax deduction.

The optimum use of the marital deduction (A share) and the unified credit (B share) usually means no estate taxes are paid upon the death of the first spouse. Simply by using the AB trust, a husband and wife can transfer to their heirs an amount equal to the sum of two "unified credit exclusion equivalents." For 2005, that sum would be $3 million.

One problem for AB trust planning is the changing unified credit. For 2006 through 2008, the unified credit exclusion equivalent is $2 million. For 2009, it is $3.5 million. In 2010, the estate tax will be abolished for one year. In 2011, the estate tax will supposedly be in place, and the unified credit exclusion equivalent will drop back down to $1 million.

Tool #2: Lifetime Gifts

For individuals with estates in excess of the unified credit exclusion equivalent (see above), future increases of estate values will be subject to high estate tax rates, generally in excess of 45%. By gifting assets now instead of transferring those assets at death, an estate owner can essentially "freeze" values at their current levels for transfer tax purposes.

The income and appreciation of a gifted asset accrues to the benefit of the donee, and will not be included in the estate of the donor. In addition to fully using the $11,000 annual gift tax exclusion it may be advisable to use some or all of the unified credit to transfer assets that are likely to highly appreciate in the future.

Tool #3: ILITs

The irrevocable life insurance trust, or ILIT, is usually funded by the estate owner with cash that the trustee uses to purchase a survivorship ("second-to-die") life insurance policy on the lives of the estate owner and his or her spouse.

The face amount of the life insurance policy, usually equal to the projected estate tax liability, will pass to the heirs free of all income, estate, and gift taxes.

The ILIT is one of the few ways to pass significant assets to heirs free of all three primary federal taxes on individuals; that is, income, estate, and gift taxes. Consequently, the ILIT can be the most effective and tax-efficient method of paying federal estate taxes. However, the effectiveness of this technique largely depends on insurability of the estate owner.

Tool #4: Family LPs

The family limited partnership (FLP), the fourth most popular technique, seeks to reduce transfer taxes by reducing the valuation of the assets transferred to heirs. "Valuation discounts" on assets owned by the FLP are used to reduce the valuation of assets for purposes of transfer taxes. Here's how most FLPs work:

First, the estate owner exchanges property for shares in a FLP. Usually, at least 95% or more of the FLP's value is assigned to the limited partnership shares and less than 5% is assigned to the general shares.

Second, the estate owner makes a gift of the limited partnership shares to children or other prospective heirs. Third, the estate owner files a gift tax return and claims "minority interest" and "lack-of-marketability" valuation discounts, generally up to 50% for the value of the shares transferred. These discounts are available when the transferred shares are not a majority interest and are not readily marketable.

The FLP accomplishes at least two objectives. First, total transfer taxes are reduced through lifetime gifts and valuation discounts. Second, the estate owner maintains control of estate assets and essentially transfers assets to family members without actually dividing specific assets.

Tool #5: GRATS

The fifth technique, the grantor retained annuity trust (GRAT), uses a timing division of property between "income" and "remainder" interests to lower estate or gift taxes. An income or present interest is the right to receive the current benefits of property for a specified term or for the life of the holder. When an estate owner transfers property to a GRAT that he or she creates, the estate owner normally retains this income interest. A remainder interest is the right to receive the benefits of property after the income interest has expired. This remainder interest normally is gifted by the estate owner/grantor to the prospective heirs (remaindermen) through the grantor's creation of the GRAT. The objective usually is to minimize the size of the remainder interest because this decreases the taxable value of the gift when the GRAT is established. At the end of the GRAT term or upon the death of the grantor, the property of the trust fund passes to the remaindermen.

For example, assume a parent/grantor creates a $1 million GRAT, and reserves a 5% annuity, or $50,000, for a period of 20 years. The grantor's retained annuity interest would be worth $563,165, assuming an IRC Section 7520 rate of 4.2%. The taxable gift of the remainder interest received by the children would equal $436,835, significantly less than the unified credit exclusion equivalent of $1 million. If the underlying GRAT property appreciates at a 4% annual rate (in excess of the annuity paid to the grantor), the property transferred to the children at the end of 20 years would be worth $2,199,019.

The GRAT is especially useful with property that produces significant income or property that is likely to appreciate substantially within a short period of time. However, if the grantor dies during the annuity term, the value of all the property in the trust would be includable in his or her gross estate in the view of the IRS. Term life insurance is normally purchased to cover the estate tax costs if the grantor were to die during this term.

One disadvantage is that property sold to the trust does not receive a stepped-up basis to the fair market value at the estate owner's death.

Tool #6: CRTS

In addition to providing a gift to charity, the charitable remainder trust (CRT) can be an effective way to transfer assets to heirs free of estate taxes. Normally, the estate owner's attorney will draft a CRT, which provides for income payments to the estate owner based upon an interest rate (a minimum of 5%, but it may be higher) and a time duration (usually life) that the estate owner selects. The estate owner then transfers property to the CRT. At the end of the income period, the trust assets are transferred to the charitable/tax-exempt organizations chosen by the estate owner in the CRT document.

A CRT may provide numerous benefits. First, capital gains and alternative minimum taxes that would normally be paid upon the sale of highly appreciated assets can be eliminated if those assets are contributed to the CRT. Second, the donor can receive significant charitable income tax deductions (generally ranging between 30% and 70% of the value of the property contributed to the CRT, depending on the amount and duration of income payments, age of the donor, and other factors). Third, the donor may possibly increase his or her after-tax income from an asset, particularly if the asset is highly appreciated and currently has low cash flow or low income. The CRT trustee can sell the contributed asset and allocate the sale proceeds to investments that better meet the income and risk objectives under the terms of the CRT. Fourth, federal estate and gift taxes on contributed assets will be eliminated. Fifth, the donor may provide an enhanced endowment for selected charitable organization(s). Sixth, the donor can use tax savings and/or CRT income to help replace the value of the donated asset for heirs by contributing the tax savings or income to an ILIT.

Tool #7: IDGTs

The intentionally defective grantor trust (IDGT) may have an odd name, but it is quite effective in removing the future appreciation and earnings of a specific asset from the estate owner's estate. First, the estate owner (grantor) creates an irrevocable trust that is structured to exclude trust assets from the grantor's estate for estate tax purposes but to treat those same assets as owned by the grantor for income tax purposes. Second, the grantor transfers some property to the trust. Third, the trust purchases assets from the grantor, generally on an installment basis with a balloon payment at the end. Interest is paid from assets gifted to the trust.

Because the grantor is the owner of the property for income tax purposes, gain or loss is not recognized on the sale of the property to the trust, and income taxes are not paid on the installment interest. The grantor also pays the income taxes on the earnings of the trust, the payment of which essentially represents tax-free gifts to the trust's beneficiaries.

The net effect is that all appreciation and earnings on the assets sold to the trust, in excess of the prescribed interest rate on the installment notes, will pass to the beneficiaries entirely free of estate and gift taxes.

One disadvantage is that property sold to the trust does not receive a stepped-up basis to the fair market value at the estate owner's death. This easily overlooked disadvantage may be significant, especially if capital gain taxes increase in the future.

Tool #8: IRC ? 303 Stock Redemptions

The ?303 stock redemption, the eighth technique, is used normally with a family-owned corporation. Redemptions in family corporations are normally treated as dividends because of the partial redemption and family attribution rules. Therefore, ?303 was passed by Congress to prevent the forced sale of small businesses because of the combined impact of estate and income taxes.

Under ?303 of the Internal Revenue Code, part of a principal shareholder's stock may be redeemed at death without any fear of dividend-tax treatment. To qualify for a ?303 redemption, the stock must constitute more than 35% of the value of the decedent's adjusted gross estate.

In addition, the amount of the redemption may not exceed the sum of (1) the estate, inheritance, legacy, and succession taxes imposed because of the decedent's death, and (2) the amount of funeral and administration expenses. Life insurance is frequently sold to the corporation to provide the cash necessary to redeem the stock when the estate owner dies.

Tool #9: QPRTs

The ninth technique, a QPRT, is similar to a GRAT, but the QPRT's only asset must be a personal residence and the QPRT is valued differently than a GRAT. With a QPRT, the grantor places his or her personal residence into an irrevocable trust. The grantor retains the right and obligation to treat this personal residence as his or her residence for a fixed period of years. The income interest is essentially the right to live in the residence without paying rent. At the end of the specified period, the residence will pass to a non-charitable beneficiary, such as a child of the grantor. Like the GRAT example above, the gift of the remainder interest to the heirs lowers the transfer tax costs by lowering the value of the gift and removing future appreciation of the residence from the grantor's estate.

Tool #10: Installment Sales

The installment sale directly to heirs is the tenth method of estate tax reduction. The installment sale is a device for the spreading out of the taxable gain and thereby deferring the income tax on the gain from the sale of property.

Although installment sales are frequently used in conjunction with IDGTs and other techniques, direct sales to heirs are frequently used, especially if issues of equal distribution among heirs are present or the estate owner desires more income than a sale to an IDGT would provide. By itself, the installment sale may actually be used less than the private annuity. The self-canceling installment note, or SCIN, is a variation of the installment sale. When it is used, the note contains a provision under which the balance of any payments due at the date of death are automatically canceled.

These techniques may have drawbacks. The assets sold on installment will receive no stepped-up basis at the estate owner's death. The income taxes on the capital gains recognized upon later disposition of assets by the heirs can offset some of the estate tax savings. The heirs must also have assets sufficient to make the installment payments to the estate owner.

Tool #11: Private Annuities

The private annuity is similar to the installment sale. The transferor/estate owner transfers complete ownership of property to a transferee (usually the children). The transferee promises to make periodic payments (annuity payments) to the transferor/estate owner for life.

However, the private annuity does not allow the buyer to depreciate assets based on the purchase price paid, nor allow the buyer to deduct interest expense. These advantages may be available in an installment sale. Also, no stepped-up basis of private annuity assets at the death of the estate owner is available. However, given the right type of asset and right interest rate environment, the private annuity can be an effective tool.

Tool #12: GSTs

Owners with estates in excess of $4 million who have children that also have substantial estates may find GST techniques to be highly effective. The GST is at the bottom of our list only because fewer people fit into this category. For this same reason we do not discuss the Private Foundation here.

The GST has traditionally been used as a device to save federal gift and estate taxes by keeping property out of the taxable estates of the members of the intermediate generation (i.e., the estate owner's children). Consequently, GST transfers generally are made to grandchildren or great-grandchildren (called the skip generation). The tax rules provide an exemption of a specified amount that can be transferred to the "skip generation" without imposition of the GST tax. Currently, that exemption is equal to the unified credit exclusion equivalent. That is equal to $1,500,000 for 2005. GST planning can be quite complex, and a discussion is beyond the purview of this article.

Conclusion

If the estate tax is changed significantly or abolished, it will be interesting to see how these techniques will be transformed by these new laws. First, if abolition of the stepped-up basis rules is part of the estate tax reform, then a greater tax burden will be shifted to middle class persons while the estate tax burden on the wealthiest 2% estate owners in the nation will be eased. Second, wealth may become more concentrated into the hands of fewer persons and families. Third, charities claim they will be hurt significantly because estate owners would have less incentive to leave large amounts to charities instead of their heirs. Fourth, estate owners would have less incentive to give assets during their lifetimes to their heirs and more incentive to wait until death to pass their assets to their heirs. Fifth, since massive amounts of wealth will be passed by the wealthiest 2% over the next 30 years, revenue loss to the government would be significant.

However, the ILIT may still be a useful wealth transfer device since it avoids the loss of stepped-up basis problem with tax-free death proceeds under IRC Section 101. FLPs, GRATs, CRUTs, IDGTs, ?303 stock redemptions, QPRTs, installment sales, and private annuities would seem to be in less demand.

Gary Underwood, JD, CLU, ChFC, an attorney with the advanced marketing department at Genworth Financial, can be reached at gary.underwood@genworth.com.

Reprints Discuss this story
This is where the comments go.