Although the estate tax may be repealed or significantly changed in the near future, don’t expect those changes to last forever.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.