The goal of the estate planning attorney is to consider and to minimize each area of taxation to which the client may be susceptible; namely, income taxes, gift taxes, estate taxes, and generation-skipping transfer taxes. In short, to disinherit the Internal Revenue Service.
To accomplish the goals, the estate planner will take advantage of and make use of many tax planning tools available to accomplish the goal. This article will discuss some of the fundamental tools.
A will is important because if you do not designate who will inherit your property, a state statute will. And, very likely, the statutory distribution scheme (known as intestate distribution) will differ from your wishes.
Typically, intestate law divides the decedent's estate between the surviving spouse and children, one-third to the spouse and two-thirds to the children. Even if the decedent does not have children, the spouse generally will not inherit the entire estate. Moreover, because your children are minors, the court will require a fiduciary (e.g., a guardian or trustee) to be appointed to receive and manage the property the children inherit. This can be a cumbersome and expensive process, requiring court supervision throughout the children's minorities.
Perhaps most important, a will gives you the opportunity to designate a guardian for your children. You have better insight than a court into which of your relatives or friends will best be able to care for your children, both emotionally and financially. Your will can put the structure in place, designating the best person for each type of function.
A will also can simplify the probate process for your survivors. For example, you can designate a personal representative (also known as an executor) to handle your estate. You can direct how taxes and debts should be paid. You can waive state limitations on funeral expenses payable from your estate and enable your estate to take maximum advantage of estate tax savings.
One objective of the use of the "QTIP" (or qualified terminable interest property) trust is to enable the estate tax marital deduction to be available to your estate. This enables a postponement of the federal estate tax until your spouse's death. One reason that this postponement is permitted is that the property transfer to your spouse must be in a form that will result in the inclusion of the property in your spouse's gross estate. Although the property will be subsequently included in your spouse's estate, the tax funds attributable to this property will be sourced from the QTIP trust created under your will or within a trust created during your lifetime (an "ntervivos trust").
To assure that, during your spouse's life she or he will receive income from your properties but that, at his or her death, the property will be held in trust (or distributed) for the benefit of children from a current or first marriage. If it is your desire to provide for your spouse during his or her lifetime and that the property ultimately be for the benefit of another (child or other beneficiary) a QTIP might be the best mechanism to accomplish your goals.
A QTIP trust can provide that your spouse will receive all the trust income for life, but that, at his or her death, the property goes to your children (or grandchildren) as remaindermen. Your spouse must be entitled to receive the current income. However, to enable the marital deduction, your spouse need not have the right to dispose of the property at the time of his or her death.
The preparation of a will including this kind of trust provision is relatively common. Although this technique is complicated, and the trust provisions need to be carefully prepared, a will can be constructed to accomplish your objectives.
Designating a QTIP trust as the beneficiary of your individual retirement account (IRA) and your rollover IRA containing the distribution from your qualified retirement plan can also postpone the estate tax on your IRAs until your spouse's death. Because of the size of your IRAs, this technique can generate substantial estate tax advantages. Under this type of arrangement, your spouse will receive the greater of: (1) the minimum distribution from your IRAs required by the laws governing IRAs or (2) all the income the IRA earned that year. This distribution scheme will allow your family to continue to take advantage of income tax deferral under the laws governing IRAs without sacrificing estate tax deferral under the laws governing QTIP trusts. At the same time, you will be able to assure that after your spouse's death your children by your prior marriage will benefit from the IRAs.
Because the technical requirements of the income tax laws and the estate tax laws must be satisfied to achieve both income and estate tax deferral, careful attention must be paid to drafting the IRA beneficiary designation as well as the QTIP trust. The necessary modifications to your IRA beneficiary designations necessary provisions must be incorporated into your will or your intervivos trust.
Family limited partnerships are currently a popular topic in the estate planning field.
Family partnerships have long been used as a tax reduction device by astute tax planners. In the pre-Reagan era of high marginal income tax rates, family partnerships were often used to shift income from family members in a high tax bracket (i.e., the parents) to those in a lower bracket (the children). In a typical case, a parent who owned an income-generating business or piece of real estate would transfer it to a partnership and then make gifts of limited partnership interests to his children. A portion of the income from the business or real estate could then be directed to the children, who would usually be subject to a much lower tax rate than their parent.
The use of family partnerships tapered off after the 1986 Tax Reform Act for two reasons. First, the lowering of the top income tax rates reduced the incentive to shift income to family members in lower brackets. The second reason was the enactment of the "kiddie tax," which subjected passive income received by children to the same tax rate that was paid by their parents. As a result, there was no longer a strong income tax incentive to creating a family partnership.
In the early 1990s, however, family limited partnerships were revived as an estate tax planning tool. The critical stimulus was the IRS's 1993 publication of Revenue Ruling 93-12, in which it abandoned its discredited "family attribution" theory. Before this ruling, the IRS had taken the position that the interests of all family members must be considered when valuing a gift of an interest in a family-controlled entity. For example, if Father, who owned 100% of a family corporation, made a gift of 10% of the stock to each of his three children, it was the IRS position that none of the gifts qualified for a minority interest discount since the family still owned 100% of the corporation.
After consistently losing on this issue in court, the IRS reversed itself in Rev. Rul. 93-12 and said that it would no longer apply family attribution. As a result, in the example above Father was now allowed to discount the value of each of the gifts to his children, thereby reducing the gift tax that he paid on the transfers.
Smart tax practitioners soon realized that the family limited partnership was an ideal vehicle for taking advantage of the discounts that became available with Rev. Rul. 93-12. Unlike the pre-1986 family partnerships, these new partnerships were used to reduce transfer taxes, i.e., the gift, estate, and generation-skipping taxes, rather than income taxes. The new family partnerships were no longer funded solely with businesses and real estate. Since the income from the property was no longer relevant to the decision to create a partnership, the new type of family limited partnership could be funded with a variety of assets, including investment assets and assets that produced little or no income.
Under current practice, a parent (or grandparent) creates a family limited partnership, naming himself as the general partner. The parent will generally contribute most of the assets to the partnership. Typically, he will receive a 1% general partnership interest (to ensure his control) and the rest as a limited partnership interest. His children (or grandchildren) will make modest contributions to the partnership in return for relatively small limited partnership interests. The parent will then begin to make gifts of his limited partnership interests to the children. These gifts will be subject to large discounts, sometimes of up to 70%, depending upon the size of the transfer and the restrictive features of the partnership agreement.
An example is the best way of demonstrating the tax savings that are inherent in family limited partnerships. Assume that Father contributes $980,000 in stocks and bonds to a family limited partnership in return for a 1% general partnership interest and a 97% limited partnership interest. At the same time, his two children each contribute $10,000 in cash to the partnership in exchange for a 1% limited partnership interest. Several months later, Father decides to make a gift of a 10% limited partnership interest to each of the children. Each 10% interest represents $100,000 in partnership assets, but Father claims that the 10% partnership interest, because of restrictions imposed by the partnership agreement, is worth only $50,000. In addition, each gift qualifies for the $10,000 annual exclusion, reducing the taxable gift to only $40,000. By using the partnership, Father is able to transfer $100,000 of assets to each child, while treating it as a $40,000 gift for tax purposes. Over time, Father can transfer his entire 97% limited partnership interest to the children at a significantly reduced gift tax cost, while still maintaining control over the partnership through his 1% general partner interest. If the partnership works properly, only that 1% interest will be taxed in his estate at death.
Needless to say, the IRS has not been happy with the potential loss of tax revenue. As a result, it has instituted a number of audits of family limited partnerships. These audits, as well as related litigation, are still in a preliminary stage and it remains unclear whether the IRS will forced to allow significant discounts for gifts of family limited partnership interests. Before entering into any family limited partnership, you should be aware that there is an audit risk, especially if the partnership is funded with nonoperating assets.
Family limited partnerships remain a popular, albeit risky, tax planning device. You may wish to consider creating one as part of your estate plan. Your estate planning attorney should continue to monitor the IRS position in this area and prepare a plan that best meets your family's needs while still acknowledging the IRS' concerns.
If you plan to make gifts to your children you should seek advice concerning what types of property are best to be used for this purpose. Particularly, you will want to know whether appreciated property should be used for this purpose.
The best property to use for making gifts is cash. A donee takes as the tax basis for the gift property the basis for that property in the hands of the donor. Consequently, the usual advice is to transfer high basis assets by gift, unless the property will be sold soon, at which time the gain will be recognized to a donee who might be in a lower marginal income tax bracket. If lower basis property is retained until death, its basis will be stepped-up at that time, with the tax potential on the appreciation then disappearing from the income tax base.
If you do transfer appreciated property, the tax basis to the donee will be increased by that gift tax which is attributable to the appreciation component of the property. Consequently, some benefit will be available to the donee.
You should not, however, ordinarily transfer depreciated property by gift. If the donee subsequently sells the property, for purposes of determining loss, his basis will only be the fair market value of the property at the time of the gift, not the higher tax basis. The reason for this rule is to preclude the transfer of tax losses to a related taxpayer. The assumption is, of course, that losses will be transferred to those family members who can best use the loss, absent such a rule of limitation.
The better approach with loss property, therefore, is for the donor to sell the property, take the loss and then transfer the cash proceeds. Of course, this may not always be appropriate where a donor feels that the property will significantly appreciate, or should be kept in the family for sentimental reasons. In such a situation, if gift tax might be incurred, the objective would be to transfer the property by gift when it does have a low value.
Before 1998, you and your spouse together could transfer $1,200,000 free of estate tax to their children and, additionally, can entirely postpone the federal estate tax on the amount of your estate (and your spouse's estate) in excess of the $1,200,000 amount until the surviving spouse's death. In 1998 the amount you can transfer increased to $1,250,000. It will continue to increase in irregular increments for the next few years until the amount a married couple can pass tax free at the death of the surviving spouse is $2 million in 2006.
The "unified credit" is a tax credit that in 1998 offsets the estate tax on the first $625,000 of assets in each individual's estate which would otherwise be subject to estate tax. The amount protected by the unified credit is variously known as the applicable exclusion amount, the unified credit exemption equivalent, and the amount effectively exempted from transfer tax by the unified credit.
The estate planning objective is to place this amount in a trust (often called a family trust, a credit shelter trust, or a bypass trust) which provides benefits for your spouse and children, but is in a form which will not be included in your spouse's estate at his or her subsequent death. This can be accomplished by providing that the trustee can make discretionary distributions of income and principal to your spouse, children and/or grandchildren. If you wish your spouse to serve as the trustee of the family trust, the trust must be specifically drafted to limit the trustee's discretion. Even with this limitation, your souse, as trustee, will be able to make distributions to himself or herself to meet needs for health, education, support, and maintenance and the needs of those he or she is obligated to support. You also can give your spouse the power to withdraw the greater of $5,000 or 5% of the trust property annually without causing the trust property to be included in your spouse's estate.
Your spouse can make the same arrangement under his or her will (or trust) to protect the applicable exclusion amount, placing that value into a trust for you and your children but in a form that will not be included in your gross estate should your spouse die first.
The remaining estate assets can be transferred to the surviving spouse in a form eligible for the marital deduction. Each of your wills (or the intervivos trust) would provide that the remaining estate goes to the other spouse. A variety of arrangements exist for the form of this transfer, all of which can qualify for the marital deduction. These include outright transfers and certain transfers in trust where the surviving spouse has a right to income during life. These alternatives should be discusses with your estate planning attorney. If your spouse is not a U.S. citizen, even though your spouse has lived here for many years, special rules govern the transfer to your spouse. Therefore, it is vital that your estate planner confirm the citizenship status of your spouse.
As the amount that can be protected from estate tax by the unified credit increases through 2006, the amount of property that should be placed in the family trust will increase. Please note that there will be no need to update your will in response to each increase in the applicable exclusion amount because the division into the marital gift and the family trust may be made by a formula that automatically adjusts the division to achieve the desired results.
The economic value of using the marital deduction to the maximum extent (except for the portion excluded by use of the unified credit) is that the amount which otherwise would be used to pay federal estate tax can be retained and invested. Thus, the deferred tax will continue to produce income for the survivor's benefit. After several years this income effect may produce significant compounded income. This asset accumulation will further enhance the financial benefits for you and your family members which, after tax, can ultimately be passed to your children.
You have probably seen news reports discussing the significant changes made to the Internal Revenue Code by the Taxpayer Relief Act of 1997. Some reports may have led you to believe that planning for the estate tax is no longer important to you because the amount of property that an individual can give to his or her beneficiaries by lifetime gift or under his or her will has been increased from $600,000 to $1 million. Although it is true that each individual will eventually have an effective $1 million estate and gift tax exemption, that level will not be reached until the year 2006. In 1998, the effective exemption (also known as the applicable exclusion amount and the exemption equivalent) has increased only $25,000 to $625,000.
Therefore, it is important not to let the news reports lull you into a false belief that estate planning is no longer an important issue for you to consider. In fact, the tax law changes do not change the need to implement the basic estate tax strategies we have discussed in the past. For example, the basic advantages of the unlimited marital deduction coupled with the use of the effective estate tax exemption to create a "by-pass trust," to protect each spouse's applicable exclusion amount remain the same. However, it is important to review your financial situation to determine whether the increase in the applicable estate tax exclusion would make the need for a bypass trust less likely and whether the mandatory use of the bypass trust should be replaced with disclaimer provisions that would allow your spouse to place into the by-pass trust only the amount likely to ensure that there is no estate tax payable in either of your estates.
You also may have heard reports that the $10,000 you can give to an unlimited number of donees each year will be indexed for inflation starting in 1999. Although this statement also is true, it raises unrealistic expectations. Because the statute requires the inflation-adjusted amount to be rounded down to the nearest $1,000, it may be many years before the $10,000 amount is raised to $11,000. Other inflation-adjustments mandated by the Tax Act (e.g., an increase in the $1 million amount exempt from the generation-skipping transfer tax), however, will start in 1999 if inflation in 1998 is at least 1%, but the adjustments may not be as high as anticipated because of the rules for rounding the adjustments.
It is also important to review your gift-giving strategies because the amount of property you can keep without risking an estate tax liability will be higher. In addition, the new education incentives included in the Tax Act provide additional strategies for making gifts to your children and grandchildren that should be explored.
In addition, the new provision allowing homeowners to exclude up to $500,000 (for a married couple filing jointly) in gain from income taxation requires an examination of your housing needs and an appropriate plan for your highly appreciated home. You should consider the option of your retaining your home as part of your estate, rather than selling it or gifting it to your children, to avoid a large capital gain and obtain a stepped-up basis for the home after the deaths of you and your spouse. You now may find it preferable to take advantage of this exclusion, purchase a smaller home that better fits your needs, and use the remaining sale proceeds to make gifts to your children or purchase other assets.
Several of the more significant changes made by the Tax Act are intended to provide estate tax relief to family-owned businesses and farms. If you own such property, a thorough review of your estate plan is recommended at this time. If you are a beneficiary of an estate that elected to defer estate tax because the estate was composed of closely held business interests or a beneficiary of an estate that elected special-use valuation for farmland or property used in a business, additional decisions may have to be made because of Tax Act provisions concerning interest on the deferred amounts and cash-leasing of property. Again, a thorough review is recommended.