Effective estate planning actually encompasses many objectives, the most obvious of which is to implement a legally effective method of transferring wealth to loved ones. Estate planning should also reduce the incidence of gift and estate taxes, through full use of available tax credits and their leverage where possible. Estate planning should seek to maximize the value of the estate through use of tax-favored investment vehicles. Finally, estate planning should also seek to preserve and protect estate assets.
A well-drafted Will is perhaps the most important single step that can be taken to ensure that assets are distributed effectively at death. Sometimes it is useful to execute a “durable” power of attorney or a “springing” power of attorney when a Will is executed. The existence of these powers may avoid the necessity of court intervention in the event of the incapacity of the person granting these powers. Although these powers are inherently less flexible than similar provisions which could be found in a revocable living trust, in most instances they are acceptable substitutes. The revocable living trust is now also an attractive Will substitute, although avoidance of probate alone is for most persons probably not a sufficient reason to forego the use of a Will.
A Will may also contain testamentary trust provisions within it. These trust provisions greatly enhance the effectiveness and versatility of the Will by enabling the testator to ensure that (1) full use is made of the unified credit; (2) assets are not squandered by trust beneficiaries or seized by creditors; and (3) the surviving spouse is provided with yearly income.
The unified credit will currently shield $600,000, but will eventually shield $1 million by 2006. A “credit shelter” trust which typically resides in the Will makes full use of the unified credit by ensuring that at least $600,000 is transferred to persons other than the testator’s spouse. (A transfer in trust to the testator’s spouse may qualify for the unlimited marital deduction; therefore the unified credit must be applied elsewhere.) However, the credit shelter trust may provide the surviving spouse with a limited income interest without risking inclusion in her estate.
The general power of appointment marital trust and the QTIP trust are both effective in providing an income interest to the surviving spouse while providing the estate with a full marital deduction. Both trusts must provide that all income be distributed to the surviving spouse. A general power of appointment marital trust must provide that the surviving spouse has the right to dispose of trust assets either during life or at death. A QTIP trust, by contrast, may provide the surviving spouse with a very limited power of appointment. The QTIP trust may be preferable where the testator wishes to provide for his first or second spouse, but also wants to insure that assets will ultimately pass to children from a prior marriage. A QTIP election must be made by the executor of the testator’s Will. Failure to elect will result in forfeiture of the marital deduction to the estate.
Often a testator does not know exactly how much his spouse will require when the Will is drafted, or at the time of his death. Including a “qualified disclaimer” provision in the Will permits the surviving spouse to disclaim to residuary legatees, e.g., children, that portion of her legacy which she does not want. This “post mortem” estate planning can be effective in making maximum use of the unified credit, as well as in minimizing the estate taxes.
The incidence of estate and gift taxes can be minimized by leveraging the available tax credits. Effective techniques exist which can leverage both the unified credit and the $10,000 annual exclusion. A simple method of leveraging the annual exclusion is for a married couple to split a gift to a relative. This permits $20,000 to be transferred yearly to that person.
The $10,000 annual exclusion can be further leveraged by other techniques. A common technique is to use “Crummey” powers in conjunction with a life insurance trust. A life insurance trust is an excellent estate planning vehicle, since the proceeds can be used to pay estate taxes. Funding the trust with gifts that qualify for the annual exclusion through the use of “Crummey” powers further enhances the attractiveness of this vehicle. If properly set up, the entire proceeds of the policy will be excluded from the decedent’s estate. In addition, no income tax is imposed on the appreciation of investment within the insurance policy.
Another extremely effective method of leveraging the unified credit and the annual exclusion is by using LLCs or family limited partnerships. These vehicles are also imbued with formidable asset protection features. They may also be effective in shifting income tax liability to lower bracket family members.
The IRS recognizes three types of “discounts” applicable to the transfer of an LLC interest. The discounts are recognized based upon the lack of marketability of the LLC interest, the minority interest discount, and the discount for illiquidity. Each of these discounts, if present, may be taken. They typically may result in a valuation discount of up to 30% or 40%. The types of assets that may be transferred to an LLC for which a discount may be claimed include an interest in a closely held business or income-producing real property. Marketable securities may also qualify for a discount.
The asset protection features of the LLC are also attractive. Creditors attempting to reach LLC assets will at best obtain a “charging order” against the member’s interest. The creditor “stands in the shoes” of the LLC member against whose interest he holds a charging order. Since the operating agreement will provide that the managing member has the power to determine when and how much to distribute from the LLC, a creditor holding a charging order will be faced with the possibility of receiving “phantom” income. That is, although the creditor will not receive any distributions from the LLC, he will be forced to report income based on his distributive share of the income earned by the LLC.
Typically, the managing member, who initially owns the asset or business transferred to the LLC, makes yearly gifts of a portion of his interest to family members. If the gift qualifies for a 40% discount, then the amount qualifying for the annual exclusion is effectively raised from $10,000 to $16,666.
With the recent reduction in capital gains tax rates, intrafamily sales are more attractive. Assume, for example, that an unmarried testator with two children owns a house worth $500,000, with an adjusted basis of $100,000, and also has $1 million in liquid assets. Upon death, the estate tax liability would be $363,000 at current rates. If the testator were instead to sell the house to a child, taking back a mortgage, then $200,000 of the capital gain will be excluded (assuming the testator lived in the house for 2 of the past 5 years) and $200,000 would be taxed at 20%, for a total income tax liability of $40,000.
The parent could even continue to live in the house, making rental payments pursuant to a lease. Those payments could enable the child to pay the mortgage and real estate taxes. Note, however, that if the home were nominally “sold” but the parent continued to pay real estate taxes and neither received mortgage payments nor paid rent, the IRS would seek to include the value of the home in his estate on the theory that he had retained a life estate.
Split-interest trusts, which were developed for estate planning, also have significant asset protection value. In these trusts, the grantor transfers property in trust with a remainder interest passing to beneficiaries. The remainder interest is asset protected. Moreover, since the gift is composed only of the remainder interest, the value of the gift for gift tax purposes is reduced, thereby leveraging the unified credit. One essential requirement of split-interest trusts is that the grantor outlive the trust term; if not, the transaction will be estate tax neutral. Typically, the trust provides that the grantor receives yearly income, based upon an interest rate percentage provided for in the trust instrument. If a high interest rate is used, then the value of the remainder interest is lower, and the amount of the gift is reduced.
There are four types of split-interest trusts: (1) Grantor Retained Annuity Trusts (GRAT); (2) Grantor Retained Uni-Trust (GRUT); (3) Grantor Retained Income Trusts (GRIT); and (4) Qualified Personal Residence Trusts (QPRT). GRATs and GRUTS are useful for income-producing property. In both, the grantor’s interest is in the form of an annuity for a term of years. While GRUTs require revaluation each year, GRATs do not. GRITs are useful for nonincome-producing property, such as works of art or raw land, in which the grantor retains use. Where the grantor’s interest is in a personal residence or vacation home, a QPRT is effective.