Preserve your wealth for family members
You’ve spent a lifetime building your wealth, and you’d like to provide for your family and perhaps even future generations after you’re gone. With proper planning, you can do just that — regardless of what happens to the estate and gift taxes in the future.
There are three main transfer taxes: the gift tax, estate tax and generation-skipping transfer (GST) tax. Estate taxes are levied on a taxpayer’s estate at the time of death, while gift taxes are applied on gifts made during a taxpayer’s lifetime. The GST tax is an additional tax applied to transfers of assets to grandchildren or other family members that skip a generation (including non-relatives 37½ years younger than the donor). Each transfer tax has its own rates and exemption amounts, which are scheduled to change drastically in the coming years. (See chart 10.)
The estate tax and GST tax are scheduled for full repeal in 2010, before coming back in 2011 with higher rates and lower exemptions. This may be unlikely to occur. As this guide went to print, Congress was scheduled to begin considering estate tax reform options before the year’s end. You always want to keep your estate planning strategies up to date for both changes in law and your personal situation. (See Tax planning opportunity 17.)
Check with Grant Thornton for an update on the progress of legislation, and keep in mind that a full repeal of the estate tax is unlikely any time in the foreseeable future.
Planning for transfer taxes in uncertain times
Taking steps to minimize transfer taxes is as important as ever. Regardless of where exactly the exemption amounts and rates end up in the future, there are strategies that can help you minimize your transfer tax burden. First you want to make sure you maximize the exemptions, deductions and exclusions available for each transfer tax.
The estate and gift tax have unlimited marital deductions for transfers between spouses. Your estate can generally deduct the value of all assets passed to your spouse at death if your spouse is a U.S. citizen, and no gift tax is due if you passed the assets while alive. There is also no limit on the estate and gift tax charitable deductions. If you bequeath your entire estate to charity or give it all away while alive, no estate or gift tax will be due.
The GST includes a lifetime exemption. Your estate may benefit in the long run if you use up this exemption while you’re alive. But remember, you’ll also need to use your gift and estate tax exemptions to make these transfers completely tax-free.
The gift tax also offers both a lifetime exemption and a yearly exclusion. Gifting remains one of the best estate planning strategies. You definitely need to consider using part or all of your lifetime exemption. (See Tax planning opportunity 18 for more information.) But first, formulate a gifting plan to take advantage of the annual gift tax exclusion. The annual exclusion is indexed for inflation in $1,000 increments and reached $13,000 per beneficiary in 2009.
You can double this generous exclusion by electing to split a gift with your spouse. So, even if you want to give to just four beneficiaries, you and your spouse could gift a total of $104,000 this year with no gift tax consequences. If you have more beneficiaries you’d like to include, you can remove even more from your estate every year.
You can also avoid gift taxes by paying tuition and medical expenses for a loved one. As long as you make payments directly to the provider, you can pay these expenses gift-tax free without using up your annual exemption.
When deciding what assets to gift, keep in mind the step-up in basis at death. If it’s likely that the loved ones you give property to won’t sell it before you die, think twice about giving it to them. If it stays in your estate, the property gets an automatic step-up in basis to fair market value at the time of your death. This could result in significant income tax savings for your heirs upon later sale. Keep in mind that the rules regarding the step-up in basis could be more complex in 2010 if the temporary repeal of the estate tax is not amended.
Using business interests in gifting
Interests in a business can save you in transfer taxes, whether it is a business you own or a limited partnership you set up. There is a pair of special breaks for business owners:
- Section 303 redemptions. Your company can buy back stock from your estate without the risk of the payment to the estate being treated as a dividend for income tax purposes. Such a distribution generally must not exceed the tax, funeral and administration expenses of the estate, and the value of your business must exceed 35 percent of the value of your adjusted gross estate. But be careful. If there isn’t a non-tax reason for setting up this structure, the IRS can challenge its validity.
- Estate tax deferral. Normally, estate taxes are due within nine months of death. But if closely held business interests exceed 35 percent of your adjusted gross estate, the estate may qualify for a deferral. No payment (other than interest) for taxes owed on the value of the business is due until five years after the normal due date. The tax then can be paid over as many as 10 equal annual installments. Thus, a portion of your tax can be deferred for as long as 14 years from the original due date.
If you’re a business owner, you may be able leverage your gift tax exclusions by gifting ownership interests that are eligible for valuation discounts. So, for example, if the discounts total 30 percent, you can gift an ownership interest equal to as much as $18,571 tax-free because the discounted value doesn’t exceed the $13,000 annual exclusion. But the IRS may challenge the value, and an independent and professional appraisal is highly recommended to substantiate it.
Whether or not you own a business, there are many reasons to consider a family limited partnership (FLP) or limited liability company, including the ability to consolidate and protect assets, increase investment opportunities and provide business education to your family. Another major benefit of these structures is the potential for valuation discounts when interests are transferred. For example, you can transfer assets, such as rental property or investments, to an FLP, and then gift FLP interests to family members. The valuation discount, combined with careful timing of the gifts, may enable you to transfer substantial value free from gift tax. An FLP can work especially well for transfers of rapidly appreciating property.
But be careful because the IRS is scrutinizing FLPs. The IRS has had some success challenging FLPs in which the donor retains the actual or implied right to enjoy the FLP assets, or when the donor retains the right to manage the FLP. You shouldn’t transfer personal-use assets to an FLP, transfer so much of your assets as to leave insufficient means to pay for living expenses or have unfettered access to FLP assets for your own use. If you wish to create an FLP, you should discuss the risks with Grant Thornton and determine the best way to proceed.
Leverage life insurance
Life insurance can replace income, provide cash to pay estate taxes, offer a way to equalize assets among children active and inactive in a family business, or be a vehicle for passing leveraged funds free of estate tax.
Life insurance proceeds generally aren’t subject to income tax, but if you own the policy, the proceeds will be included in your estate. Ownership is determined by several factors, including who has the right to name the beneficiaries of the proceeds.
To reap maximum tax benefits you generally must sacrifice some control and flexibility as well as some ease and cost of administration. Determining who should own insurance on your life is a complex task because there are many possible owners, including you or your spouse, your children, your business and an irrevocable life insurance trust (ILIT).
To choose the best owner, consider why you want the insurance — to replace income, to provide liquidity or to transfer wealth to your heirs. You must also consider tax implications, control, flexibility, and ease and cost of administration. You also may want to consider a second-to-die policy. (See Tax planning opportunity 19.)
Trusts offer versatile planning tools
Trusts are often part of an estate plan because they can be versatile and binding. Used correctly, they can provide significant tax savings while preserving some control over what happens to the transferred assets. There are many different types of trusts you may want to consider:
- Marital trust. This trust is created to benefit the surviving spouse and is often funded with just enough assets to ensure that no estate tax will be due upon the first spouse’s death. The remainder of the estate, which would equal the estate tax exemption amount, is used to fund a credit shelter trust.
- Credit shelter trust. This trust is funded at the first spouse’s death to take advantage of his or her full estate tax exemption. The trust primarily benefits the children, but the surviving spouse can receive income, and perhaps a portion of principal, during the spouse’s lifetime.
- Qualified domestic trust (QDOT). This marital trust can allow you and your non-U.S.-citizen spouse to take advantage of the unlimited marital deduction.
- Qualified terminable interest property (QTIP) trust. This type of trust passes trust income to your spouse for life with the remainder of the trust assets passing as you’ve designated. A QTIP trust gives you (not your surviving spouse) control over the final disposition of your property and is often used to protect the interests of children from a previous marriage.
- Irrevocable life insurance trust (ILIT). The ILIT owns one or more insurance policies on your life, and it manages and distributes policy proceeds according to your wishes. An ILIT keeps insurance proceeds, which would otherwise be subject to estate tax, out of your estate (and possibly your spouse’s). You aren’t allowed to retain any powers over the policy, such as the right to change the beneficiary. The trust can be designed so that it can make a loan to your estate or buy assets from your estate for liquidity needs, such as paying estate tax.
- Crummey trust. This trust allows you to enjoy both the control of a trust that will transfer assets at a later date and the tax-savings of an outright gift. ILITs are often structured as Crummey trusts so annual exclusion gifts can fund the ILIT’s payment of insurance premiums.
- Grantor-retained trusts. Both grantor retained annuity trusts (GRATs) and grantor-retained unitrusts (GRUTs) allow you to give assets to your children today — removing them from your taxable estate at a reduced value for gift tax purposes (provided you survive the trust’s term) — while you receive payments from the trust for a specified term. At the end of the term, the principal may pass to the beneficiaries or remain in the trust. It’s possible to plan the trust term and payouts to minimize — or even avoid — a taxable gift. (See Tax planning opportunity 20 for more on the benefits of zeroing out a GRAT.)
- Qualified personal residence trust (QPRT). This trust is similar to a GRAT except that instead of holding assets, the trust holds your home — and instead of receiving annuity payments, you enjoy the right to live in your home for a set number of years. At the end of the term, your beneficiaries own the home. You may continue to live there if the trustees or owners agree and you pay fair market rent.
- Dynasty trust. The dynasty trust allows assets to skip several generations of taxation. You can fund the trust either during your lifetime by making gifts or at death in the form of bequests. The trust remains in existence from generation to generation. Because the heirs have restrictions on their access to the trust funds, the trust is excluded from their estates. If any of the heirs have a real need for funds, the trust can make distributions to them. Special planning is required if you live in a state that hasn’t abolished the rule against perpetuities.
