Advanced Estate Planning Tools
Once you have laid the proper foundation of an estate plan by reviewing and executing your wills, living wills and powers of attorney, some families will still have a federal estate tax
that will be applied when both spouses have passed away. Many clients will, once again, delay the implementation of advanced strategies due to lack of time or the belief that they do not
have to worry about it until one spouse dies. This can be a dangerous plan in that if both spouses die in a common accident, within a short period of each other, or if the surviving spouse
is not able to plan due to incapacity, a severe estate tax can be imposed at the surviving spouse’s death.
For those who wish to currently plan for the estate tax, several vehicles are often used, depending on the client’s objectives. Below is a summary of some options available to you if your
estate is or may be subject to the federal tax.
I. Family Limited Partnership
In General
The family limited partnership (“FLP”) is a limited partnership, L.L.C. or corporation where the ownership interests are typically held by members of the same family. It works by funding
the partnership with assets and then making gifts of non-voting ownership interests to the children, grandchildren or trusts for their benefits. This is a good vehicle for transferring
assets while still maintaining control because the parents can retain all voting power of the company while the children retain non-voting interests. Additionally, a family can leverage
its gifts by as much as 60%.
Additional Benefits
The following is a list of additional benefits associated with establishing a FLP:
- The transfer of interests in the company qualify for valuation discounts for gift tax purposes, which allows a greater value to be passed to the children, grandchildren or trusts for
their benefit. Further, all appreciation on the transferred assets is removed from transfer taxes;
- Retention of voting rights allows the parents to maintain control of the company and its assets;
- There is a centralization of family accounts, one tax return, centralized record keeping, increased educational opportunities for the family to learn about wealth management and asset
protection;
- Assets transferred to the FLP can be protected from the children’s creditors; and
- The assets transferred to the children pass free of probate upon the parents’ death.
Considerations
FLP’s are complex and careful consideration must be given to the establishment and operation of such entities. The FLP must follow all annual record keeping regulations governing the FLP,
and we must obtain valuations of the underlying assets of the company as well s a valuation of the non-voting interests in the company. This can be expensive but the tax savings are even
more substantial. In addition to the substantial tax savings, you can also achieve a greater degree of asset protection, consolidation of management of your assets and impart knowledge to
your children on the management of your assets.
If the FLP is used to discount the non-voting interests that are gifted in order to reduce estate taxes, the non-voting interests must be valued by a qualified appraiser. Treasury
Regulation § 20.2031-1(B) provides the test for determining the value of a limited partnership interest. The test is the amount a willing buyer would pay to a willing seller for the
non-voting interest (not an interest in the underlying asset), where neither the buyer nor the seller is under a compulsion to buy or to sell and both the buyer and the seller have
reasonable knowledge of the relevant facts of such transfer. Without such an appraisal, the discounting is unlikely to survive IRS scrutiny.
Care should be taken when transferring assets into a FLP. Funding the FLP with assets such as real estate holdings, commercial boats, and other closely-held business interests which are
generating income is ideal. However, personal residences, pension plans, and IRAs should not or cannot be transferred to FLPs.
Additionally, normal family expenses, such as utilities, clothing, and educational expenses, should not be paid from the FLP. Doing so may result in the FLP being disregarded for tax and
asset protection purposes.
Grantor Trusts
In General
The grantor trust rules, contained in IRC §§ 671-679, are a legislative response to the desire to shift income from high-bracket taxpayers (the grantor) to low-bracket taxpayers (the trust
and its beneficiaries), while still enabling the grantor to retain significant control over the trust.
When the grantor of a trust is treated as the owner of that trust for income tax purposes, the items of income, deduction, and credit that are attributable to the trust are included in the
grantor’s taxable income. These items are treated as if they were received or paid directly to the grantor and cause the grantor to pay income tax on income generated by the trust even
though the grantor no longer owns the assets held by the trust. If structured properly, this can save the family substantial amounts of transfer taxes.
An Intentionally Defective Irrevocable Trust (herein “IDIT”) is an irrevocable trust designed to secure certain tax benefits due to the fact that the grantor trust income tax rules (IRC §§
671-679) differ from the estate tax inclusion rules of IRC §§ 2036-2038. The discrepancy between these rules allows a trust to be drafted in a manner that will cause the grantor to be
taxed as the owner of the trust for income tax purposes while excluding the trust’s property from the grantor’s gross estate for estate tax purposes. The use of an IDIT thus obtains the
following benefits:
- Removal of the assets from estate taxation;
- Elimination of estate taxation on the appreciation of those assets; and
- By the Grantor continuing to pay the income taxes on the trust assets, the beneficiaries of the trust realize an after tax rate of return without additional gift taxes.
Drafting Safe Grantor Trust Rights & Powers
Great care must be taken in determining which rights and powers should be retained by the grantor or given to a beneficiary. Reversionary interests, transfers with retained life interests,
and revocable transfers must be avoided in order to exclude the trust property from the estate of the power holder. However, the use of other powers may be desirable in allowing the
grantor or beneficiary to exercise some control over the assets without causing them to be included in their estates.
The Use of GRATs and GRUTs
Grantor Retained Annuity Trusts (herein “GRATS”) and Grantor Retained Unitrusts (herein “GRUTS”) are tools available for leveraging gifts to the grantor’s family at a reduced transfer
cost.
A GRAT or GRUT is created by transferring property to a trust while retaining an annuity or unitrust interest in the trust property for a limited period of time. The trust term should be
one that the grantor is expected to outlive. At the end of the specified period, the trust property passes to the trust beneficiaries to the extent that the appreciation if the assets
exceed the interest rate set by the IRS when the trust was created. If the assets have grown at a rate greater than the IRS rate, the excess passes to the children free of gift tax. If the
assets decrease in value over the term of the trust, then the trust simply returns all of the assets to the grantor without owing the grantor anything else.
If the grantor dies during the term of the trust, part or all of the trust property will be includable in the grantor’s gross estate. However, the grantor will be in no worse position than
he was prior to the creation of the trust. Thus, if the assets appreciate in value, the client wins by transferring assets free of gift tax. If the assets don’t appreciate, then the client
is in the same economic position as they were prior to the GRAT other than the costs to establish the trust.
The determination of whether to use a GRAT or a GRUT should be based on the likely performance of the property over the term of the trust. A GRAT should be used when the trust assets
should produce earnings exceeding the IRC § 7520 interest rate in effect for the month in which the trust is created, which has recently hovered around 4%.
Charitable Remainder Trusts
Properly drafted Charitable Remainder Trusts (herein “CRTs”) can reduce your estate taxes, eliminate capital gains taxes, provide a guaranteed income stream for life, yield a substantial
income tax deduction and provide your favorite charities with a substantial donation at your death.
Clients have the opportunity to increase their return on investment since low-yielding appreciated assets can be sold without any tax on the appreciation and the proceeds can then be used
to purchase higher-yielding assets or assets that produce tax-exempt income to further reduce the income tax consequences to the client.
If a CRT plan is implemented, the client must decided whether to use a Charitable Remainder Unitrust (herein “CRUT”) or a Charitable Remainder Annuity Trust (herein “CRAT”). Numerous
differences exist between a CRUT and a CRAT, which are detailed below.
CRUTs
Generally, a CRUT must provide for an annual payout to the client of an amount equal to a fixed percentage of the trust assets valued annually. This percentage must be at least 5% and no
more than 50% of the value of the trust assets. It is important to note that this payment must be made annually to the client and is based upon the principal of the trust on the valuation
date, and not the investment performance of the assets. Consequently, this can act as an inflation hedge if the assets produce more than the required payout as set forth by the trust. The
trust may provide that income payouts be limited to the amount of actual trust income in any given year with the difference between the actual income and the required unitrust amount being
made up in future years.
In this manner, a CRUT can be used as a retirement plan by investing the trust assets in a way that does not yield income. This is commonly referred to as a net income makeup CRUT.
NIMCRUTS’s are generally simpler than retirement plans in the sense that there are no rules regarding highly compensated employees, the amount that can be contributed to the CRT, and
various other requirements under ERISA.
Beyond the requirements that the income payment must be at least 5% and no greater than 50%, Internal Revenue Code §§ 664(d)(2)(D) requires with respect to each transfer to the trust that
at least 10% of the net fair market value of the property transferred to trust will eventually be paid to the charity.
Finally, only a CRUT can be used if the client wishes to transfer additional assets to the trust at a future date. This is in distinction to a CRAT which, once it is created, cannot be
funded in later years.
CRATs
A CRAT is similar to a CRUT except that the annual payout is a specified sum which may be expressed as a stated dollar amount or a fraction of percentage of the initial net fair market
value of the assets placed in trust. Later additions may not be made to a CRAT and it offers the estate owner no protection against inflation since the annual payout is a specified sum
fixed at the inception of the trust. The advantage of the CRAT is that annual valuations of the assets are not required which may provide more flexibility in funding with assets that are
not easily valued.
For both CRUTs and CRATs, the term of the trust can be either less than or equal to 20 years or the life/lives of the individuals to whom the assets of the trust are to be annually paid. |
