Estate planning often appears to be a highly complex science, drawing upon an intricate array of trusts, transfers, financial facts and legal fictions.
Yet the best estate planning is also practiced as an art, and the key to creating an estate masterpiece is keeping a clear perspective on two basic concepts: the value of property, and who owns it.
The more property you own, the more you are taxed. The more valuable the property is, the higher the tax. All the rest are details.
What does that mean in the real world?
Fundamentally, you and your estate attorney should make every effort to remove property and value from the tax collector's radar. That doesn't mean that you should become a pauper to spite the government. Rather, you'll want to become savvy about avoiding estate tax traps and benefiting from every opportunity Congress has made available to you in current tax law.
In practice, that means taking full advantage of the estate tax "exclusion" and the Unlimited Marital Deduction. The exclusion is the amount the IRS will allow you to pass to heirs tax-free. This year, the exclusion is set at $675,000, but it will gradually rise to $1 million by the year 2006.
Marital tax benefit: Here today, gone tomorrow
The Unlimited Marital Deduction is a great benefit, but sometimes also a tempting trap. The IRS will allow your estate of any size to pass tax-free to your spouse. As a result, many individuals opt for an estate plan that provides for property to pass directly to a spouse upon death.
The problem with this strategy occurs later, when the surviving spouse passes away and leaves the remaining estate to children or other heirs. They'll likely pay extra tax because the first parent's estate tax exclusion was never used to shelter assets. Remember, the federal government allows each individual to pass $675,000 to heirs free of estate tax. For a couple, that sheltered amount would be $1.35 million if each spouse's exclusion is fully utilized. Because transfers between spouses are tax-free anyway, the first parent's (husband's) $675,000 exclusion died with him.
Assuming the wife owned $675,000 worth of property, and the husband bequeathed an additional $675,000, her estate is now worth $1.35 million. When it passes to children or other heirs upon her death, only half of that will be exempt from estate tax.
The solution
This is where the key estate planning concept of ownership management enters the picture. Instead of leaving the $675,000 to the wife outright, the husband could have left it to a Credit Shelter Trust created for the wife's benefit. Instead of relying on the Unlimited Marital Deduction to pass property, he would use his $675,000 estate tax exclusion.
With proper planning, the wife will not only reap the benefits of the Credit Shelter Trust, but can act as trustee as well. The money is available for the wife's economic benefit, but not considered to be part of her estate. Meanwhile, the assets grow estate tax-free during the life of the surviving spouse.
A similar ownership management tool is the Generation Skipping Trust. Federal law allows each spouse to leave $1 million to such a trust and protect it for generations.
One of the most popular ownership management strategies is to take maximum advantage of the $10,000 annual gift tax exclusions. Every individual may give $10,000 gifts annually to an unlimited number of recipients completely tax-free. You and your spouse could give $20,000 to each of your children each year, slowly transferring ownership of estate assets, thereby lowering the tax profile.
Split Interest Gift Planning
Because current control and use of property is so important to many people, a strategy called Split Interest Gift Planning was devised. Under this technique, one piece of property is divided into a current use share and a remainder use share. The individual retains the current use share and gives away the remainder use share as a gift. The effect is to have only the value of the remainder treated as a gift, rather than the entire value.
Examples of this Split Interest planning include Grantor Retained Annuity Trusts (GRATs), Grantor Retained Unitrusts (GRUTs), and Qualified Personal Residence Trusts (QPRTs). Each of these tools requires that the owner transfer money or property (a personal residence in the case of the QPRT) to a trust in return for income (or use of the residence) for a defined period of time. At the end of that time, the trust property either passes outright to children, or is held in trust for their benefit.
Value management
Despite the many prudent ways to transfer assets out of your estate, remember that ownership is only half the estate planning equation. Your heirs will also reap substantial benefit if you can lower the value of property-on paper, that is.
The definition used by the IRS for determining value for estate tax purposes is the price at which the property would change hands between a willing buyer and a willing seller. Neither must be under any compulsion to buy or sell, and both must have reasonable knowledge of all relevant facts.
The "willing buyer, willing seller" definition of value gives estate planners plenty of leeway to take certain actions that will make the property less valuable to the "willing buyer" while preserving its worth to you.
Factors affecting value include income produced, ability to control and ability to resell.
If ownership of the property includes little or no control over it, its value is reduced. If it's difficult to resell the property, or if it can only be sold to a limited number of persons, the value is likewise lowered. An asset that can't be easily sold is not as valuable as one that is readily marketable.
Sometimes you can alter the value of an asset by transferring it to an entity, such as a corporation, partnership or Limited Liability Company (LLC), in return for interests in the entity. The original "property" is now a piece of paper rather than the property itself. The question becomes: "Is the piece of paper worth as much as the property?"
A prime example of this concept at work is the Family Limited Partnership (FLP). Owners are able to transfer assets into this entity in exchange for both general and limited partnership interests. The general partnership interest allows them total control over all partnership decisions. The limited partnership interests give them a passive investment share of the entity.
In the partnership agreement that controls operation of the entity, they may insert a number of restrictions that will lower the value of the FLP property. For example, the agreement could specify that no partner may sell his or her interest without either the unanimous approval of all partners, or offering it first to the partnership.
When it comes time for the government to apply estate tax to property in the FLP, the IRS rules allow a discount on the value of these assets, although the amount of the discount is sometimes a matter of dispute.
In this case and others, you can see the fundamental estate planning interplay at work. By deftly combining the broad brush strokes of ownership and value management, the inspired attorney is able to create an estate masterpiece-one that will be passed down and treasured for generations.
Mr. David A. Ison is a member of the American Academy of Estate Planning Attorneys and has been engaged in the practice of law for the last 17 years. For more information, visit his web site at www.daveison.com, call (614) 336-3083, or email at dave@daveison.com