Estate planning can be viewed as 2 distinct but related disciplines: 1) estate distribution planning and 2) estate tax planning. Estate distribution planning–who gets what, how and when–pertains to every estate, while estate tax planning applies particularly to estates that exceed the applicable exemption amounts ($2 million per person or $4 million per married couple, 2007-2008).
As exemptions and exclusions increase and transfer tax rates decrease, fewer estates may be taxable, but those that are will be larger (over $4 million in 2007 and 2008; over $7 million in 2009). Also, the traditional planning techniques–gift and estate tax exemptions, credit shelter trust planning, annual exclusion gifts and irrevocable life insurance trusts–may not be sufficient to meet these estate owners’ planning objectives. To be sure, these clients may want to transfer more of their estates to their heirs tax-free but don’t know how.
Your wealthy clients, Mr. and Mrs. Diedrich (died o rich) have a taxable estate exceeding $4 million. Their estate plan already takes advantage of the gift and estate tax exemptions and annual exclusions, but the Diedrichs would like to transfer more to their heirs without incurring gift taxes.
A portion of their portfolio is invested in low-risk, “lazy” assets such as CDs, money market funds and municipal bonds. Although they don’t need the principal, which they have earmarked to go to their heirs at their deaths, they would like to retain the modest 4% interest they receive from these investments.
Mr. and Mrs. Diedrich (both age 65) create an irrevocable trust to hold assets for the benefit of their heirs and lend the trust $1 million worth of these “lazy” investments. Since these funds are loaned to the trust and not gifted, (1) the Diedrichs will incur no gift taxation on the transfer and (2) the trust will be required to pay annual interest to the Diedrichs on the note at the prevailing long term applicable federal rate (AFR). We’ll use a 5% rate and $50,000 interest payment ($1 million x .05) for our case study.
To meet the $50,000 annual obligation on the note, the trustee decides to purchase a joint, single premium immediate annuity with the $1 million loan. The annuity pays $70,000 annually, or $20,000 in excess of what the trust needs to make its interest payments to the grantors. Since the Diedrichs made clear they are interested in passing as much to their heirs as possible without incurring gift taxes, you show them how they can use the $20,000 “excess” annuity payout to purchase a $1,300,000 survivorship life insurance policy.