Ronald G. Coleman Attorney and CPA - Advanced Tax Planning

This memorandum sets forth some of the estate planning techniques currently available for individuals - married or single - who have larger estates. The estate of a single person whose net worth exceeds $2,000,000 at death may face estate tax, as may a married couple whose combined net worth exceeds $4 million (assuming they have established an A-B trust plan).

I. $12,000 Annual Gift Exclusion
The first $12,000 in gifts made in a qualified manner by a donor to any one donee during each calendar year is not taxable and a gift tax return is not required to be filed. Therefore, if you have two children, you can transfer $24,000 per year to your children. If you are married, the two of you could transfer $48,000 per year to your two children. With an ongoing gift program for 10 years, $480,000 in gifts could be passed tax-free to the children ($960,000, if each child has a spouse). That $480,000, plus future appreciation, will be removed from your taxable estates. Gifts need not be cash; anything of value can be given, including percentage or fractional interests in real estate, such as the family vacation home.

II. Lifetime Use of $1,000,000 Lifetime Gift Exemption
The federal estate tax applies to taxable estates exceeding $2,000,000 and the tax rate is 46 percent. There currently is no California estate or inheritance tax.

Note, however, that while the estate tax exemption is $2 million, only $1 million can be given while you are alive without incurring gift tax.

If the value of your taxable estate plus gifts during lifetime exceeding the $12,000 annual exclusion is less than $2,000,000 at the time of your death, there will be no estate tax liability. In the case of married person, the value of his or her estate includes all of his or her separate property and one-half of the couple's community property.

The gift and estate tax system in the United States is "unified," that is, you cannot escape estate taxation by giving all your property away during your lifetime. Lifetime gifts generally will reduce your $2,000,000 estate exemption dollar for dollar. A benefit of lifetime gifts, however, is that future appreciation after the date of the gift will also escape estate taxation

Example: Mother, age 55, gives her children $200,000 of securities. At her death at age 85, the securities are valued at $3,870,000 (assuming 10 percent compounded annual growth). The $200,000 gift during her lifetime reduces her $2,000,000 exemption to $1,800,000. However, the appreciated securities are not included in her estate. Net savings, assuming a 46 percent estate tax rate, is $1,688,200.

The disadvantage of lifetime gifts is that the beneficiary takes a so-called "carryover" income tax basis in the property, whereas property included in an estate receives a "stepped-up" income tax basis under current tax law.

Example: Parents give children their vacation home valued at $150,000, which they purchased for $30,000. Children's income tax basis in the property is $30,000, which results in $120,000 taxable gain if they sell the property. If parent dies and then the property passes to the children, the children's income tax basis is $150,000, which equals the date of death fair market value, and a subsequent sale at that price creates no income tax liability.

Therefore, lifetime gifting requires comparing probable estate tax and income tax rates, making assumptions concerning the growth of an asset and about whether an asset necessarily will be sold. Estate tax is a certainty if the estate exceeds a specified size; income tax need not be incurred if the property isn't sold.

III. Life Insurance Planning
Your gross estate will include the proceeds of any insurance on your life if you own the policy. While the unlimited marital deduction will remove those proceeds from your taxable estate if you are married, those proceeds will be included in your spouse's estate subject to tax unless spent or disposed of during his or her lifetime. A single person's life insurance will be taxable in his or her estate if the value of that estate exceeds $2,000,000. For example, $1 million policy proceeds subject to a 46 percent estate tax would leave net proceeds of only $540,000.

Therefore, primarily as a technique to avoid estate tax, you may want to consider establishing during your lifetime an irrevocable life insurance trust to own your policies. One or more of your adult beneficiaries typically are named as the trustee of the trust. For policies insuring the life of a spouse, e.g., the primary wage earner, the surviving spouse is entitled to all the income from the invested proceeds during his or her lifetime. At the death of the second spouse, the trust could continue for the benefit of minor children, or the trustee could use the proceeds to buy estate assets, loan money to the estate, or distribute trust assets to the beneficiaries to pay death taxes and other expenses.

Life insurance companies have developed a new type of policy that insures the married couple jointly and pays one death benefit at the second death. Known as "joint and survivor" or "second-to-die" policies, these are useful in providing estate liquidity for the payment of estate taxes, since generally estate taxes are payable only after the second spouse dies. These policies usually are less expensive than a policy that insures only one spouse. Cost of policies can vary considerably from one carrier to another, so shop around. A married couple both aged 62 will probably pay between 15 and 20 cents for a dollar of insurance coverage. The proceeds provide liquidity to pay the estate taxes without themselves being subject to estate taxes, eliminating the need to sell real estate or family business assets. In appropriate cases, a joint and survivor policy can be an excellent way to increase the after-tax estate passing to the children: the cash build-up in the policy is not subject to income tax, and the proceeds escape income and estate tax.

IV. Leveraging the $1,000,000 Gift Exemption
Would you rather receive a dollar today or a promise today to receive the dollar ten years from now? The common sense notion that a dollar is worth more today than in the future is the foundation for increasing the $1,000,000 gift exemption by placing property in a trust in which you retain an income interest for a specified period of years. There are two basic versions of this trust--one for your principal or second residence and the other for all other property.

A. Qualified Personal Residence Trust (QPRT)

B. Grantor Retained Annuity Trusts (GRATs) and Grantor Retained Unitrusts (GRUTs)

V. Charitable Remainder Trusts
Charitable contributions made during the donor's lifetime can be more advantageous than a testamentary contribution. A charitable contribution during your lifetime not only will keep the property out of your taxable estate, but also will provide a current income tax deduction.

The charitable remainder trust may be especially beneficial where there are highly appreciated but low income-producing assets, such as real estate (including a principal residence) or stocks. The transfer to the trust generally is not taxable; the trust may sell those assets without facing income tax, and then the trustee can invest the proceeds in higher-yielding assets, thus increasing the donor's income stream. For donors with children or other heirs, a portion of the increase in income and the tax benefit of the charitable deduction can be used to replace the asset value via life insurance.

Example: A couple aged 64 has an $800,000 home purchased several years ago for $50,000. The owners are approaching retirement, the children are grown, and the couple wants to move to a smaller, less expensive retirement home. If the couple sells their house outright, gain recognized will be $250,000, after taking advantage of the $500,000 exclusion on the sale of a principal residence. Assuming a combined Federal and California income tax rate of 23 percent, the tax will be $57,500.

Instead, they transfer one-third of the house to the charitable remainder trust, and they and the trust simultaneously sell their interests to a buyer. The couple's gain of $500,000 is sheltered by the $500,000 residential exclusion provisions. The trust's gain of $250,000 is exempt from income tax because it is a charitable trust. Therefore, net proceeds for investment are increased by $57,500. Assuming an 8 percent trust payout rate, the couple's annual income is increased by $4,600.

In addition, they take an income tax charitable deduction for the present value of the property that passes to the charity upon their deaths, based on their life expectancy and the trust payout rate chosen. In this case, the deduction would be about $47,000 (subject, however, to a limitation of 30 percent of adjusted gross income). A portion of that increased income and the tax benefit from the charitable deduction can purchase life insurance to replace the $267,000 of trust assets that will pass to charity. The charitable remainder trust can provide income to the donors either throughout their lifetimes or for a specified number of years (not to exceed 20 years), after which the trust terminates and its assets are paid to one or more designated charities.

VI. Charitable Lead Trusts
A charitable lead trust is the opposite of a charitable remainder trust. It is a charitable gift of an annuity or unitrust interest followed by a noncharitable remainder interest. Charitable lead trusts are a useful way to make a lifetime or testamentary gift at a reduced gift or estate tax cost.

Example: Parent wants to give Daughter $1 million when she attains sufficient age and maturity to manage it. Parent creates a trust, to pay a qualifying charity an 8 percent fixed annuity payable monthly for fifteen years. Assume the trust portfolio earns 12 percent per year. After the 15-year term the trust terminates and Daughter receives the principal outright.

The charitable portion of the gift is about $800,000, and therefore the taxable gift is only $200,000 (which reduces Parent's $2,000,000 estate and gift exemption by only that amount). At the end of 15 years, the trust assets, valued at $2.5 million, pass to Daughter without gift tax.

Unlike the GRAT or GRUT discussed above, the death of the donor during the term of a charitable lead trust does not cause the trust assets to be included in the donor's gross estate for federal estate tax purposes. The charity selected can be a private foundation established by the family to benefit selected charities.

VII. Private Foundations
A private foundation is usually formed as a nonprofit corporation with the family members as the officers and board of directors. Appreciated assets transferred to the family's private foundation can be sold by the foundation without incurring capital gain tax.

Generally the foundation must distribute at least 5 percent of its asset value annually. That 5 percent includes gifts to charities, travel, directors' fees and salaries and expense reimbursements to officers and other employees. And because the foundation is organized as a corporation, the foundation continues to be operated by succeeding generations of the family.

Publicly traded stock contributed to a private foundation gives rise to a federal charitable contribution deduction equal to 100% of the stock's current fair market value. The deduction for other assets contributed to a private foundation generally is limited to the asset's tax basis, except for contributions to operating foundations.

VIII. Generation Skipping Trusts
The value of assets in your estate in excess of $2,000,000 will be subject to estate tax, at a rate of 46%. After the payment of that tax, the net amount will be included in your child's taxable estate, again potentially subject to an estate tax of 46%. A 46% estate tax levied at both your and your child's deaths will result in your grandchildren receiving only 29% of the amount subject to tax in your estate.

To avoid such a result you can place assets in trust for your children, giving them an income interest in trust assets during their lifetime and access to trust principal as needed for health, maintenance, support, and education. A properly established "generation-skipping" trust will allow your children and grandchildren liberal use of the assets without those assets being included in their taxable estates. Because of the ability of a generation-skipping trust to avoid estate tax for several generations, the amount that you can place into a generation-skipping trust without adverse tax consequences is limited to $2 million per transferor.

Example: Fred and Wanda Rogers, aged 65, with two adult children, have a $2 million estate. They have established a revocable living trust that will divide into A-B trusts upon the death of the first spouse. Based on their life expectancies of 20 years and a 5% annual appreciation of their assets, their after-tax estates that will pass to their children will be about $4.7 million, or $2.35 million per child. Added to the children's own taxable estates, that $4.7 million might face up to 46% estate tax in the children's estates, or $2.2 million, leaving the grandchildren with $2.5 million. Instead, the Rogers amend their living trust to provide that upon the death of the first spouse, the surviving spouse will make a generation-skipping tax election with respect to $2 million of the pre-deceased spouse's property. Upon the death of the second spouse, that $2 million (and its appreciation between first death and second death) and $2 million of the surviving spouse's property will be placed in two separate generation-skipping trusts for the benefit of the Rogers' children during their lifetimes and, if desired, during the lifetimes of the grandchildren and great grandchildren as well. Any of the Rogers' trust assets in excess of the generation-skipping exempt amount will pass outright to the Rogers' children at the second death. The use of a generation-skipping trust does not reduce estate tax imposed on the estates of Fred and Wanda, but it does eliminate estate tax liability on the estates of the Rogers' children. The result is that $4 million (and its growth) passes from generation to generation without estate tax.

IX. Qualified Domestic Trust for Non-Citizen Spouses
If the surviving spouse is not a United States citizen, special requirements must be met in order for the unlimited marital deduction to be available, including that the property must be placed in a trust designating a U.S. citizen or a U.S. corporation as a co-trustee.

The first $2,000,000 given to the surviving spouse by the deceased spouse is exempt from estate tax, regardless of the citizenship of the survivor. However, amounts in excess of $2,000,000 left to the surviving spouse by the deceased spouse must be placed into a Qualified Domestic Trust in order to defer estate tax until the death of the second spouse.

A Qualified Domestic Trust is an irrevocable trust established for the benefit of the surviving spouse. The surviving spouse must receive all income of the trust. Distributions of principal from a Qualified Domestic Trust, both during the lifetime of the surviving spouse and at the spouse's death, are subject to estate tax, unless the distribution to the surviving spouse is on account of hardship.

X. Business Planning
Interests in family corporations or family partnerships often constitute a significant portion of a family's total wealth. Thus transferring a share of the family wealth necessarily involves a transfer of some type of interest in the family business. Such transfers usually raise very special considerations, such as the retention of control in a transferred interest, prevention of the further transfer of the interest outside the family, shifting of future appreciation, and retention of special tax status of an S corporation.

Business planning may include methods of transferring stock (and therefore future appreciation) while retaining voting control, retaining family ownership through buy-sell agreements, funding the buy-sell agreement with life insurance or through other means, splitting the business into operating and investment companies for children active in the business and other children who are not, gift-leaseback of business equipment to shift income to family members, and employing family members.

A family limited partnership or limited liability company may offer several benefits to the family, including asset protection, income shifting among family members, retention of operating control by the parents, involvement of the children in the family business, and possible reduction in value of assets for gift and estate tax purposes.

Example: Husband and wife own a commercial building worth $4 million that pays net rents of $250,000 per year (about 6%). The couple establishes a limited liability company (LLC) that names them as the managers and Class A "preferred" members who will receive an annual guaranteed payment of $250,000, and an irrevocable generation-skipping trust for the benefit of their children and grandchildren as Class B "common" members. The operating agreement restricts the ability of the members to sell their interests to outside parties. Because of the marketability restriction and the amount of rent, a valuation specialist appraises the LLC to be worth $2.4 million, a 40% adjustment to the value of the underlying property. Based on the $250,000 guaranteed payment, the Class A partnership interest is valued at $2.16 million and the Class B interest at $240,000. Husband and wife file gift tax returns, reporting combined gifts of $240,000 that reduce their lifetime $2 million exemption. In 20 years, when the couple dies, the building is worth $10 million. However, the couple's Class A interest is "frozen" at $2.16 million. All the property's appreciation has been shifted to the generation-skipping trust that owns the Class B LLC interest.

XI. Other Planning Techniques/Summary
Numerous other tax planning techniques are available to transfer family wealth from one generation to another or others: Installment sales, private annuities, transfers of joint interests, various forms of transfers with retained interests, special problems of transfers to minors, spousal gift-splitting, transfers by or to individuals in special circumstances, such as handicapped individuals, non-U.S. citizens, and those with creditor or marital problems. Often family wealth planning can serve the additional purpose of protecting assets from creditors of both the donors and the donees.

This memorandum outlines some of the techniques available under current tax law to transfer wealth among family members. Some of these techniques are, of course, not appropriate to all families. The goal in all cases is the same, however: selecting the type of transfer that will achieve the desired tax-saving objectives without interfering with the normal organization and operations of the family and its enterprises.

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