Estate Planning Techniques
That Preserve Your Wealth
state planning is a complex process requiring the services of an estate planning professional. The objective is to put in place a plan which, at your death, will result in the distribution of your assets as you intend with the least cost and taxes. Your most important part of the process is to decide how you want others to benefit from your assets after your death.
First, think of all the people whom you would like to benefit, as well as the charitable organizations you would like to support, and determine what you would like to provide to each person and organization. Then, when you visit a professional estate planner, he or she will help you accomplish your goals by employing the best strategy and techniques.
If you already have an estate plan in place, you should review your plan with your estate planning professional every two years to determine whether modification is needed to keep up with changes in your circumstances or changes in the law.
The following material briefly describes some of the techniques which are employed in estate planning, when appropriate to the circumstances of the estate.
Will and Revocable Trust
A will is a legal document that tells your executor how you want your estate to be divided at your death. Generally, a will must be probated by a court proceeding before the estate can be distributed.
However, the cost and delay of a court proceeding can be avoided by transferring your property to a revocable trust established during your lifetime. For married people, a revocable trust can also reduce estate taxes if it includes a basic estate planning technique: the bypass trust. A common mistake made by married couples who want to leave everything to each other is the failure to establish such a bypass trust.
Leaving everything to your spouse outright is not always a good idea, especially for those whose estates are large enough to be taxable. Because everyone each spouse is entitled to exempt a certain amount from estate tax, a person should establish a bypass trust to protect that amount. For the years 2002 and 2003, this exempt amount is $1,000,000, with gradual increases until it reaches $3,500,000 by the year 2009.
Example: A married couple has $5 million worth of assets. The wife dies first leaving everything to her husband and incurring no estate tax. At the husband's death (assuming no increase in value), his estate will pay around $2 million in estate tax, based on current exemptions and rates, leaving their children $3 million.
If, instead, the couple properly plans for the use of both spouses' estate tax exemptions using revocable trusts with provisions for bypass trusts, the estate tax will be $500,000 less, with the difference passing to the children.
Using the revocable trust, the wife effectively divides her estate into two parts: one consists of the assets in the bypass trust; the other consists of the remaining assets. Her husband will have access to the remaining assets and will also receive income from the bypass trust. (He also will have access to the bypass trust principal for his support and health.) Under this plan, the husband's taxable estate will not include his wife's bypass trust.
A proper estate plan must take into account the possibility that the other spouse may die first. The benefits in the example above are realized only if the wife predeceases her husband. If the husband dies first, the wife will still have all the assets in her estate which will be taxed without the benefit of her husband's exempt amount.
To ensure that taxes are not incurred unnecessarily, each spouse should own some of the couple's assets. Ideally, assets should be divided equally until the combined estate exceeds the combined exemptions. Spouses can effect an equalization through the use of unlimited tax-free gifts between them.
Irrevocable Life Insurance Trust
An irrevocable life insurance trust ("ILIT") lets you reduce estate taxes and have more control over the proceeds of your life insurance policies. If the ILIT (rather than you personally) owns your insurance policies, the proceeds will not be included in your estate at your death. However, the proceeds of the life insurance will be available to pay estate taxes and other expenses so that your other assets will not have to be liquidated. The trust agreement controls the management and distribution of the life insurance proceeds after your death. The life insurance proceeds will not be subject to probate and will generate income for your spouse for life, thereafter passing to your children free of estate and income taxes.
Qualified Personal Residence Trust
You can reduce your estate taxes by transferring your residence to a qualified personal residence trust ("QPRT"). A QPRT is recognized by the Internal Revenue Code as a trust which can hold title to a personal residence but no other property, except for immediate cash needs for taxes or maintenance. When you transfer your residence to a QPRT, the transfer is considered to be a gift to the person who will receive title to the property at the end of the trust's term (the "remainder interest") but you can continue to live in the residence at no charge until that time. The value of the gift depends on your age, the length of the term, and the IRS specified interest rate in effect when the transfer in trust is made. For example, assuming your residence is worth $400,000 and using a 7-year term, your residence could be transferred to a QPRT at a gift tax value of about $260,000, with estate tax savings of between $50,000 and $65,000 based on current tax law.
At the end of the term, your children (or other beneficiaries) would become the owners of the residence. If you wished to continue to use it, you would need to rent from them at a fair market value.
Limited Liability Company
A limited liability company ("LLC") is widely used by individuals in their estate plans to reduce estate and income taxes attributable to family assets, particularly family-owned businesses and real estate, and to protect those assets from claims of outside creditors.
An LLC combines the protection from liability offered by a corporation with the flexibility of operation and the tax benefits of a partnership.
Through the use of an LLC, the owners can take advantage of gift and estate tax valuation rules that allow discounts in value for "lack of control" and "lack of marketability." These discounts, when combined, range from 10% to 30%, depending on the structure of the LLC and the type of investments owned by the LLC.
LLCs can be especially beneficial to an individual who wants to transfer assets to other family members, yet retain control over those assets and protect them from claims of creditors of the members.
Many people have accumulated a great deal in retirement assets (IRAs, 401(k) plans, and other retirement plans) that have grown in value over the years. Careful planning is very important because retirement assets are often taxed twice: for estate taxes upon death of the individual, and for income taxes at the time distributions are made to the beneficiaries. The combined tax rates can be as much as 85%, meaning that for every $100.00 in a retirement account, the beneficiary receives $15.00
Various techniques are available to reduce these taxes. They range from extending the distribution period by utilizing stretch IRAs (IRAs with younger generation beneficiaries, such as grandchildren) to naming charities as beneficiaries, thereby eliminating estate and income taxes. One innovative technique we are using is to utilize an LLC to discount the value of IRAs.
Charitable Remainder Trust
A charitable remainder trust ("CRT") allows you to make a gift to charity without giving up your income on the transferred assets. A CRT makes distributions at least annually to the donor and/or others. At the end of the trust's term, often at the end of the income beneficiaries' lifetimes, assets remaining in the trust are transferred to one or more charitable organizations.
There are two types of CRTs: a charitable remainder unitrust (CRUT), and a charitable remainder annuity trust (CRAT). They differ mainly in the method for calculating the amount of the annual distributions. A CRUT distributes a fixed percentage of the trust assets, revalued annually, whereas a CRAT distributes a fixed dollar amount. Lifetime benefits include a substantial charitable income tax deduction, the avoidance of capital gains tax when the contributed asset is sold to produce income, and often, an increase in income from the asset. The benefit to the estate is the elimination of estate taxes on the assets ultimately transferred to the charitable organizations.
Example: A 65-year-old man establishes a CRUT that pays income for the rest of his life and that of his 63-year-old wife, if she lives longer. The trust is designed to provide an income of 5% of the amount of the assets as they are valued each year. (The income can rise or fall, depending on the trust's investment return.) This type of trust is chosen because, if prudently invested, it will generate income that over time can rise with inflation. Two people in their mid-60s have a life expectancy of approximately 30 years. A CRAT, which distributes a fixed-dollar amount each year, could be established instead, but such fixed income would lose its purchasing power over the years.
The donor transfers $100,000 of appreciated stock to the CRUT. The stock currently generates an annual dividend of 2%. The donor wants to create more income for his and his wife's retirement years, and also wants to make a substantial gift to a charitable organization someday. At the end of the trust term (when the second spouse dies), the asset is excluded from the donor's and spouse's taxable estate.
Amount to trust
Current income tax deduction
Income tax savings (31%)
Increase in income
Increase in income
* based on quarterly payments, 6% federal midterm rate
The estate tax savings are equal to the amount of taxes that would have been due on the value of the assets had they been retained by the donor.
The donor who establishes a CRT may wish to replace the donated asset with life insurance. The heirs who otherwise would have received the asset transferred to the CRT are normally the beneficiaries of the insurance policy. Money to pay all or part of the annual premium is generated by the savings from the income tax deduction, plus some or all of the increase in income created by the gift. Often, the life insurance policy is placed in an ILIT (see above) to avoid estate taxes on the proceeds of insurance.
Examine Your Options
These estate planning techniques can significantly reduce or eliminate death taxes on the transfer of wealth from one generation to the next. You should discuss these techniques with your estate planning professional to determine which of them are appropriate to your circumstances.
For more information on issues highlighted here, please contact one of the following Shaheen, Novoselsky, Staat & Filipowski professionals:
Henry N. Novoselsky
Lawrence G. Staat
Steven C. Filipowski
James J. Eccleston
William E. Hofmann
Jack L. Haan
Stephen S. Berkeley
Scott E. Galbreath
Mercy T. Tang-Tellez
Michael J. Vahey
Ronald M. Amato
April J. Lindauer
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