TECHNIQUES IN ESTATE PLANNING
By: William H. Copperthwaite Jr., EsquireESTATE PLANNING
There are a variety of techniques that can be used in estate planning as a means of providing for a client and his or her family. They can be divided into a number of different categories, ranging from simple to complex. A general description of these techniques is described below.
Trusts
Trusts can either be revocable or irrevocable. A revocable trust is frequently referred to as a "living trust" because the individual creating the trust (the "Grantor" or "Donor") establishes the trust during his or her life and reserves the right to revoke or amend the trust during this time. Revocable trusts are typically used as a means of avoiding probate and serving as a will substitute. They do not save estate taxes because the Grantor is considered to be the owner of the assets in the trust because of the reserved right to revoke the trust. However, they are valuable in providing for the management of the grantor's assets in the event of incapacity and when the grantor dies they typically contain testamentary provisions to provide for surviving family members.
On the other hand, an irrevocable trust can save taxes because the grantor is not usually considered to be the owner of the trust's assets. These types of trusts are frequently used to own assets such as life insurance or to benefit another person or entity, such as a charity. If a grantor creates a revocable trust and then dies, the trust becomes irrevocable.
Use of Trusts in Estate Planning
Credit Shelter Trust (or By-Pass Trust or A-B Trust) - A trust that is established in a revocable trust or in someone's will (i.e., a testamentary trust) can be used to receive assets upon an individual's death. This trust protects or "shelters" the amount of property that you can own without paying federal estate tax. At the death of the first spouse, the trust is funded with the amount of the Applicable Exclusion Amount (also commonly known as the "unified credit"), which is $3,500,000 for 2009. This transfer into the trust should not cause an estate tax liability because each individual is permitted to have a taxable estate of $3,500,000 (Applicable Exclusion Amount) before estate taxes are due. This trust typically benefits the decedent's surviving spouse by including the surviving spouse as an income and principal beneficiary.
Since the size of the trust is limited to that amount of property that can be protected from estate taxes, no estate taxes are paid at the death of the first spouse. While you are allowed an unlimited marital deduction for transfers between spouses, saving estate taxes in the estate of the first spouse to die is not critical. However, the use of the trust will provide for savings in the estate tax at the death of the second spouse. The estate tax savings occur in the estate of the surviving spouse because the credit shelter trust is not included in the estate of the surviving spouse. The result of the trust is that the property that passes into a trust for the surviving spouse and your children will not be taxed in the estate of the surviving spouse, even if it later appreciates beyond $3,500,000.
Marital Deduction Trust - A marital deduction trust is a trust that receives assets on behalf of a surviving spouse in a manner that will qualify for the marital deduction. While use of the marital deduction does not save taxes, it does postpone taxes until the death of the surviving spouse. A marital deduction trust establishes an investment management structure, if one is needed, to assist the surviving spouse in the management of the estate of the deceased spouse and can also be written to assure the first spouse to die that the individuals of his or her choosing will receive the property in the trust upon the death of the surviving spouse (e.g., children from a first marriage).
Irrevocable Insurance Trust - An irrevocable insurance trust is used to own life insurance on the life of the grantor. The life insurance policies that you currently own in your own name or in the name of the revocable trust will be included in your estate upon your death. By owning the life insurance individually or through the revocable trust, you are unnecessarily increasing the potential for an estate tax liability.
However, if the life insurance is owned by an irrevocable trust, the insurance is not included in the estate of the insured. An irrevocable life insurance trust can be established to get the life insurance that you currently own out of your estate and enable you to remove that amount of life insurance from estate taxes. The use of an irrevocable life insurance trust would remove the insurance from your estates while allowing you to own more assets without inflating the size of your estate with insurance. Removing insurance from an individual's estate is a matter of paperwork and does not affect your lifestyle. The irrevocable life insurance trust would make the insurance proceeds available for the support of your family and for the payment of estate taxes without attracting additional estate tax.
Since the trust is irrevocable, transfer of insurance to the trust is considered a completed gift and if the insured survives the transfer by three or more years the insurance will not be included in his or her estate. If the irrevocable trust purchases the insurance, the three-year in contemplation of death rule will not apply and the insurance will not be included in the insured's estate. As with the credit-shelter trust, the non-insured spouse can be a beneficiary as well as a trustee of the trust without the insurance becoming an asset of his or her estate.
The trust should provide that each beneficiary of the insurance trust is permitted to make annual withdrawals from the trust. This is called a "Crummey" power and has the effect of qualifying the premium payments to the trust as gifts of a present interest that will be covered under the annual $13,000 gift tax exclusion. In this way the premium payments will be easily absorbed by the annual exclusion. Beneficiaries of the trust must be notified of this right of withdrawal on an annual basis.
The irrevocable life insurance trust will potentially save your estate the taxes due on the life insurance proceeds. Thus, the insurance proceeds can be made available to the family and ultimately pass to the next generation without estate tax.
The Retirement Plan Beneficiary Trust - Benefits received from a qualified retirement plan (401k or IRA) pose certain planning problems if you desire to receive payments over the beneficiary's life expectancy and if you want the payments to go into a trust, rather than directly to the beneficiary in order to minimize the potential estate tax in the estate of the surviving spouse. If a significant portion of your estate is in retirement plans, utilizing the trust as the beneficiary is the best way of coordinating the disposition of your retirement plans with the rest of your estate without accelerating the payout from the retirement plan (which would trigger an income tax liability).
Personal Residence Trust - A personal residence trust allows the owner of a personal residence to place ownership of his or her residence in a trust and to reserve the right to live in the home for a stipulated period of time, typically calculated not to exceed the owner's life expectancy. The right to live in one's own home has an actuarial value that is subtracted from the remainder interest, i.e., the right to receive title to the house at the end of the term of the trust.
For example, an individual 60 years old could create a personal residence trust to last for 15 years at the end of which time ownership would pass to the individual's children. The right to live in the home for 15 years is worth 77% of the value of the home and the gift of the remainder interest to the owner's children would be worth 23% of the value of the home. If the home was worth $500,000 it could effectively be "given" to the children at a value of $115,000. You would not lose the capital gain exclusion upon the eventual sale of your house (assuming it was sold while it was held in the trust) and you would continue to be able to deduct any real estate taxes on the residence. This represents an effective method of passing valuable property to the next generation at a reduced gift tax cost.
Please note that your heirs will not receive a stepped-up basis upon your death in the property. While this may create a capital gains tax for them upon the sale of the property, it is a better situation to pay the capital gains tax in the future on the appreciation, which is at 20%, than to pay the estate tax on the total value property, which is at 50%.
Charitable Remainder Trusts - A charitable remainder trust ("CRT") is an irrevocable trust or a trust that is created in a decedent's will (thereby becoming irrevocable). It enables the grantor to transfer certain assets into the trust for the present benefit of a non-charitable income recipient with the remainder passing as a gift to a charity. The non-charitable income recipient can be the grantor, members of his or her family, or anyone else of the grantor's choosing. The income recipient is entitled to receive the income (at least 5% annually) from the trust for his or her life or for a period of years not exceeding 20. The longer the trust pays income to non-charitable beneficiaries, the smaller the charitable deduction.
There are two types of CRT's, an annuity trust and a unitrust. With an annuity trust, the trust pays the income beneficiary a percentage of the initial value of the assets transferred into the trust (at least 5% per year). The income payout can be continued for the lives of successive individual beneficiaries. The other type of CRT is a unitrust. With a unitrust the payout to the non-charitable beneficiary is again a percentage of the assets in the trust. However, the value of the CRT and the payout is determined each year. If the value of the trust increases, the payout will reflect this increase. If the trust had been an annuity trust, the payout would remain the same. A unitrust provides a degree of protection against inflation.
Individuals establish CRT's for a number of reasons. Of course, one of the primary reasons is to benefit a charity while reserving an interest in the trust assets for themselves. Another reason for their popularity has very little to do with charitable inclinations. The grantor of the CRT can donate appreciated assets to the CRT and if the CRT then sells the assets, there is no immediate recognition of the capital gain because the CRT is a tax exempt entity. The proceeds from the sale of the assets can then be diversified and perhaps reinvested in higher income yielding investments, thereby improving the grantor's cash flow. In turn, the grantor can purchase life insurance through an irrevocable insurance trust replacing the value of the assets that had been placed in the CRT. This is frequently referred to as a wealth replacement CRT. The grantor's cash flow has improved and the family remains whole because the life insurance has taken the place of the appreciated assets.
Another use of CRT's is as the beneficiary of extremely large retirement plans (or IRA's). In those situations, when the combined federal income and estate taxes can easily exceed 80% of the value of the retirement plan, designating a CRT as the beneficiary of the retirement plan upon the death of the surviving spouse can save significant estate and income taxes. The children of the retirement plan owner can be the beneficiaries of the CRT which helps to ensure that the account owner's family will eventually receive the full value of the retirement account. Alternatively, if the account owner had planned to make a charitable bequest of part of the estate, using retirement plan dollars to satisfy this part of the estate plan while passing other assets to the family will enable the family to receive a larger inheritance.
Use of a Family Limited Partnerships in Estate Planning-
Family Limited Partnerships - Family limited partnerships ("FLP") are used as a method of owning either businesses or personal securities portfolios. The use of FLP's has spread because it enables the original owners of the property (typically the parents) to discount other value of the assets in the FLP, give minority interests away (typically to the children) at a discounted value without necessarily giving the income attributable to the property. Ultimately, estate taxes are reduced on the value of the assets in the partnership due to the gifts and discounts claimed, even if the assets are publicly traded securities. FLP's also offer unique protection from the potential claims of creditors who may be unable to reach the interest of the limited partners of the FLP.
A family limited partnership would continue to provide you with the same use and enjoyment that you now have, but potentially enables your estate to discount the value of the underlying securities by approximately 20%. There is no guarantee that a family limited partnership would accomplish such a dramatic savings, but there is no risk in establishing it. In addition, the potential estate tax discount would be available regardless of when you pass away. If it is established and if you own less than 50% of the partnership, then the discount in theory would be immediately available to your estate.
With respect to the family limited partnership, the partnership agreement is the governing document controlling the allocation of income and deductions, as well as imposing restrictions on the disposition of property from the partnership. You can transfer your investments to the family limited partnership, in which you will serve as a general partner and in which your children will become limited partners. The transfer of the property to the partnership will not have any adverse income tax consequences to you, but the effect of the limited partnership agreement should eventually save considerable estate taxes because a partner's ability to transfer his or her interest in the partnership will be restricted under the partnership agreement and, as a consequence, will be less valuable for estate tax purposes. Over time, interest in the limited partnership can be given to your children without giving them access to or control over the property in the partnership. However, by placing your investments into the partnership and entering into a partnership agreement, you will be able to discount the value of these investments for estate tax purposes. This arises from a partner's inability to freely dispose of his or her limited partnership interest. This impacts the children more than it does you, because as a general partner, you can easily waive the restrictions. However, since they are contained in the agreement, they do create an estate tax discount on the assets in the partnership. It would be reasonable to expect a discount of more than 20% on the value of the partnership assets.
Over time, as you transfer limited partnership interest to your children, they will share ownership interest in the enterprise with you. There is no precise formula for determining how much of a discount would be available when valuing a limited partnership interest in your estate. Some of the factors that come into play are the limitations that are imposed upon the transfer of a limited partnership interest to another, even someone that is already a limited partner (i.e., the consent of a general partner is needed for the transfer). Another element in determining the discount is that members of the family can eventually have a minority interest. A minority ownership of a partnership offers an additional discount.
Viewed in a different way, there is nothing to lose in using the Family Limited Partnership since you need not sacrifice any income or control over the assets. However, the Family Limited Partnership could provide you with significant estate tax savings.
Please note that the information contained in this summary is intended for informational purposes only and is not to be considered tax/legal advice. For specific advice, please contact the Law Offices of William H. Copperthwaite Jr., L.L.C.
