The Continued Importance of Gift & Estate Tax Planning

Although the estate tax is repealed effective January 1, 2010, fiscal considerations may cause Congress to “repeal the repeal” allowing the estate tax to remain, albeit with a higher applicable exclusion amount, perhaps $3.5 million.  Time-tested estate tax planning techniques may not only reduce potential estate tax liability, but also assist in other important estate planning objectives, including asset protection.

Transferring future appreciation out of the gross estate is recurrent theme in estate and gift tax planning. Often, trusts can accomplish this goal with minimal gift tax cost. The transfer of assets to a trust with the retention of an annuity can shift future appreciation out of the grantor’s estate. The Grantor Retained Annuity Trust (GRAT), one such trust, works well in the present low-interest rate environment. At the end of the GRAT term, assets pass to beneficiaries free of estate and gift taxes. When the GRAT is created, the grantor is deemed to make a gift equal to the fair market value of the assets transferred to the trust reduced by the present value of the annuity. If the GRAT is “zeroed-out,” no initial gift is deemed made. After losing in court, the IRS has acquiesced in its longstanding objection to zeroed-out GRATs.

Life insurance can fund a future estate tax liability. If a life insurance policy is transferred to an irrevocable life insurance trust (ILIT), the life insurance proceeds may be entirely removed from the insured’s estate. For this to occur, the trust must provide that the insured possess no “incidents of ownership” over the trust assets.  The term is defined narrowly: for example, retaining the right to change beneficiaries is considered an incident of ownership.

Gift tax issues may arise when an ILIT is funded. However, the annual exclusion may be utilized to fund the annual insurance premiums if the trust instrument contains a “Crummey” withdrawal provision, and the trust contains a sufficient number of beneficiaries (including  contingent beneficiaries who may never actually take under the trust).

The ILIT may be required to file tax returns if the trust contains assets which generate taxable income. However, if the trust is not “funded” and annual premiums are paid for entirely by gifts, the ILIT will have no income and no tax return will be required. If the ILIT is “funded” and contains income-producing assets which will pay the annual premiums, the trust may still be able to avoid incurring taxable income, and the attendant obligation to file a tax return, provided the trust is a “grantor” trust. In that case, the insured would report all trust income on his own tax return. If a grantor trust were utilized, trust assets would also not be depleted to pay income taxes, thus permitting the trust assets to grow without the yearly imposition of income tax.

Despite some recent adverse case law, the family limited partnership (FLP) and the family limited liability company (FLLC) continue to permit parents to transfer assets to children at a greatly reduced gift tax cost, while still allowing the parents to retain a significant amount of control over the assets. In view of these recent adverse decisions, the operating agreement should be drafted so that the managing member has little or no discretionary authority to make decisions regarding distributions. Also, the FLP and FLLC should contain some assets transferred by children.

When funding an FLP, assets might be contributed to the FLP in exchange for perhaps both a 1% general partnership and a 99% limited partnership interest. The limited partnership interest would be gifted to the children or, more typically, to a family trust for their benefit. Since the gifted interests are entitled to both minority interest and lack of marketability interest discounts, the actual value for gift tax purposes is greatly reduced. If a family trust holds the gifted limited partnership interest, the trusts can be structured as “grantor” trusts for income tax purposes. This will enable to the trusts to grow unimpeded by the imposition of yearly in come taxes. Of course, the grantor will be required to pay income taxes attributable to trust assets.

If one’s entire gift tax exclusion amount of $1 million has been exhausted, gifts of limited partnership interests to the trust would generate present gift tax liability. Instead, the LP interests could be sold to a grantor trust in exchange for a promissory note. Since this would constitute a sale rather than a gift, no gift tax liability would arise. Payments due under the note would be satisfied by distributions made by the FLP to the trust (which owns the FLP interests). Ideally, the note should be guaranteed by trust beneficiaries, or alternatively, the trust beneficiaries should themselves transfer assets to the trust.

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