Planning the Client’s Estate
Ted Kurlowicz

Individual Ownership of Property

Fee Simple Ownership. The most complete interest in property is a fee simple estate (outright ownership of property). The individual who holds such an unlimited interest in property owns all the rights associated with the property, including the current possessory rights and the ability to transfer the property at any point during his or her lifetime or at death. In planning the estate of a client a property held outright by the client is an obvious asset to be considered in the dispositive scheme. If the estate of a married couple is being planned, it is possible that either spouse might own substantial property individually.

Life Estates. The life estate is a common form of property ownership and provides the life tenant with the right to possess and enjoy the property for a time period measured by the life of an individual (typically the life tenant). The life estate gives the owner the absolute right to possess, enjoy, and receive current income from the property until the life interest terminates.

Term Interests. A term interest provides the current tenant with the right to possess, enjoy, and receive income from the property during a specified term. The interest of the current tenant terminates at the end of the specified term.

Future Interests. A future interest in property is the current right to future enjoyment of the property. A future interest in property could either be vested or contingent on the occurrence of some future event. The future interest holder has no immediate right to use and enjoy the property. One type of future interest is a remainder interest, which is an interest that takes effect immediately upon the expiration of another interest in the same property. For example, a remainder interest might take effect upon the termination of a life estate or a term of years. A remainder interest is often held by one individual, the remainderperson, on property contained in a trust that currently benefits another individual¾for example, a life income beneficiary.

Another type of future interest is a reversionary interest. The reversionary interest occurs when the current property owner transfers current possessory rights to another. The reversionary interest gives the transferor the right to the return of the property at the end of the possessory term of the transferee. For example, a parent could create a trust for a child for a term of years and retain a reversionary interest in the trust corpus following the child’s interest.

Joint Concurrent Ownership of Property

Current possessory rights to property may be held by more than one individual. Such a partial current interest in property is often generically referred to as joint ownership of property.

Tenancy in Common. Two or more individuals may hold current possessory rights to property without survivorship rights. Such individuals, known as tenants in common, each hold an undivided interest in the property and may transfer their interest during their lifetime or at their death. Both related and unrelated individuals may hold property by tenancy in common.

Joint Tenancy with Right of Survivorship. Two or more individuals may hold property jointly with their survivors ultimately receiving the entire interest in the property. Both related and unrelated individuals may hold property jointly with rights of survivorship. Since this property interest transfers automatically at the death of a joint tenant to his or her surviving tenants, the property is not subject to disposition by a decedent at his or her death. Usually a joint tenant may transfer his or her interest during life without consent of the other joint tenants. Such a transfer will generally sever the joint tenancy and destroy the survivorship rights of the joint tenants.

Tenancy by the Entireties. A tenancy by the entirety is a property interest restricted solely to spouses. It is joint ownership of the property by the spouses with rights of survivorship. A tenancy by the entirety creates a unique situation with respect to disposition of the property. Property is transferred automatically to the surviving spouse at the death of a joint tenant. Thus the property is not subject to disposition by will of a deceased spouse. In addition, the property cannot be transferred during the lifetime of the spouses unless both tenants consent. Tenancy by the entirety is severed automatically upon divorce. An estate planner must know the laws within his or her state jurisdiction with respect to joint property since property held jointly by spouses may or may not be presumed to be held with such rights of survivorship.

Community Property. Nine states¾Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington, and Wisconsin¾have some form of community-property laws with respect to spousal property. Property in such states is treated as either separate or community property. Generally speaking, property acquired during marriage is treated as community property and is equally owned by the spouses. Although community property is not technically jointly held, the law limits the ability of each spouse to transfer community property to individuals other than his or her spouse.

Other Property Rights

Other property interests may be held by a client and used as a vehicle for the transfer of a client’s wealth. These other rights generally provide varying restrictions on the ability of the holder to enjoy or transfer the property. These forms of property ownership should be used when the restrictions are appropriate for the objectives of the client.

Beneficial Interest in Property. Certain property interests may provide one individual with a beneficial interest in property, such as the right to current income or principal distributions. An example of a beneficial interest is the interest owned by the beneficiary of a trust. The trust is created by a grantor who transfers title to the trust property (corpus) to a trustee. The trustee’s function is to hold legal title to and administer the trust property for the benefit of the beneficiary. The trustee’s ability to make distributions to the beneficiary is determined by the terms of the trust. The trustee may be required to make specific distributions or may be given broad discretion as to the size or timing and to the identity of the beneficiaries. Thus the trustee could possibly be left with substantial dispositive decisions. Trust beneficiaries themselves are generally limited in their ability to transfer their interests until trust distributions are actually received.

Powers. Certain powers to make property decisions may be held by (or transferred by) the client. A power of appointment provides the holder of a power with the ability to transfer the property subject to the power. The holder may have a broad power to transfer the property to virtually any recipient. This is known as a general power. Or the holder may have a special power, which typically provides the holder with a limited class of potential recipients of the property. Any powers of appointment held by a client should be considered in his or her dispositive plans. In addition, a client may wish to grant a power of appointment to another to delegate the ability to transfer the client’s property.

Another power that can be held or granted by a client is a power of attorney. A power of attorney gives the holder of the power (the attorney-in-fact) the ability to stand in the place of or represent the grantor of the power (the principal) in various transactions. Among the possible transactions is the ability of the attorney-in-fact to transfer property for the principal. The advantages of using a power of attorney will be discussed below.

Despite the importance of the will in a client’s estate plan, it is estimated that seven out of ten Americans die without a valid will. Unfortunately these individuals have left the disposition of their estates to the provisions of state intestacy law. In addition, the estates of these individuals will be handled by a court-appointed administrator. In many cases the estate will be subject to unnecessary taxes and administration expenses. In any event, a valid will is necessary for the implementation of a cohesive estate plan.

Living (Inter Vivos) Trust

A trust can be created during the lifetime of a grantor. It could be created for several reasons. The trust could hold property and operate prior to the death of the grantor. Or a trust could be created during the lifetime of the grantor simply to receive assets at the grantor’s death. Such a trust is known as a pour-over trust.

A trust could be either revocable or irrevocable. A revocable trust is created when the grantor transfers trust property to the trust but reserves the power to alter or revoke the agreement. Since the revocable trust is an incomplete transfer, the creation of a revocable trust has no effect on the client’s income, estate, or gift tax situation. The revocable trust gives the grantor the ability to observe the management of the trust assets without relinquishing ultimate control of the assets. Thus the grantor can reclaim the trust assets at any time. The revocable trust becomes irrevocable only when the grantor modifies the trust to become irrevocable or dies and therefore is no longer able to modify the trust.

The revocable trust has gained popularity in recent times as an estate plan in itself. It is drafted to provide the dispositive directions normally contained in a client’s will. The client will then transfer all appropriate assets to the trustee to be retitled in the trustee’s name. At the grantor’s death the trust becomes irrevocable and all property contained in the trust is managed or disposed of under the terms of the trust. The revocable trust is popular as an estate plan since property disposed of by the revocable trust avoids the publicity, delay, and some expenses associated with the probate process.

A living trust can also be designated as irrevocable by the grantor. Since the irrevocable trust is a completed gift, it is effective for gift and estate tax purposes. A properly designed irrevocable trust can receive property from the grantor which, as a completed gift, will avoid the gross estate of the grantor at his or her death. In addition, funds placed in the irrevocable trust become the property of the trustee and are exempt from the claims of the grantor’s creditors. The irrevocable trust is an effective estate planning tool for older grantors who face substantial estate tax burdens.

Testamentary Trust

A testamentary trust is created under the will of the testator. Since the will can be changed as long as the testator retains legal capacity, the testamentary trust is never irrevocable until the client’s death (or permanent legal disability). A testamentary trust does not receive property until the client dies and the proceeds are transferred to the trust by the executor. Since the trust is contained in the client’s will, it is subject to probate. In a simple will testamentary trusts are often drafted to provide for the testator’s children should the spouses die in a common disaster. In a more complex estate plan testamentary trusts are often the vehicles for the marital and family trusts described earlier in this chapter.

A living will is a document indicating the client’s intentions should the client become disabled and lack the legal capacity to make decisions for himself or herself. Generally speaking, the living will deals with the health care measures that the client wants imposed should he or she become legally disabled. If a living will is desired, the document should carefully spell out whether or not the client desires that heroic measures be taken should he or she experience a life-threatening accident or illness. Living wills are not valid in all states, and local counsel should be obtained if the client wishes to state his or her intentions in this regard.

Transfers through Will Provisions

Many misconceptions exist with respect to the various terms associated with the estate planning process. Popular opinion of estate planning is that a primary goal is to reduce the size of the probate estate. The probate estate includes all assets passing by will or intestacy. Probate property is owned outright by the decedent and is not transferred by operation of law or contract, as discussed below. For married individuals probate property is generally limited to the individually owned property of a deceased spouse. Thus the probate estate is often minimized by the usual form of property ownership between spouses¾ tenancy by the entirety.

Probate (which technically means the process of proving the validity of the will) begins when the original will is deposited in the court with jurisdiction over the decedent’s estate. The probate court oversees matters involving the settlement of the estate, distribution of probate property, appointment and supervision of fiduciaries, and disputes concerning the decedent’s will. If a valid will exists, the probate court will ensure that the probate property is distributed according to the terms of the will after all estate settlement costs are paid. Although the court has jurisdiction solely over probate property, the state and federal taxing authorities may have the statutory authority to collect any unpaid taxes from nonprobate property if probate assets are insufficient.

Transfers by Intestacy

If a decedent dies without a valid will, all probate property passes under the laws of intestate succession of the jurisdiction state. The intestate laws are deemed to replace the intent of a decedent in the distribution of his or her probate property. The default mechanism provided by the intestacy laws may be of little significance since the probate assets are not substantial in the typical estate.

States vary with respect to intestate laws. Distribution under the intestate laws will depend upon the related individuals who survive the decedent. A decedent’s spouse receives primary consideration and will receive the decedent’s entire probate estate if the decedent is not also survived by children or parents. If the decedent is survived by children, the surviving spouse and children will generally receive 50 percent each of the estate. The parents of a married decedent will generally get a share only if the decedent is not also survived by children. If the decedent is not survived by any of these related individuals, the next closest related survivors will inherit.

State intestacy laws also apply to a transfer under a will or contract that is deemed invalid.

Transfers by Operation of Law

The nature of certain ownership interests in property causes the property to pass automatically at the death of a decedent. Such property is not subject to the laws of probate and does not pass under the will or intestacy rules. The most significant example of property that is transferred by operation of law is property held jointly with rights of survivorship. The survivorship provisions cause such property to automatically pass to the surviving joint tenant at the death of the joint tenant. As discussed earlier, property held as tenants by the entirety is also an example of an operation-of-law transfer. Many married individuals own property acquired during their marriage in this fashion. For example, the family home, automobile, and significant investments are often held jointly by spouses. At the death of one spouse the property passes automatically to the survivor outside the jurisdiction of the probate court.

As noted earlier, living trusts can be effective tools in estate planning. Recall that only irrevocable living trusts affect the grantor’s income, estate, and gift taxation. However, both revocable and irrevocable living trusts are methods of transferring property by operation of law, thus avoiding some of the expense, publicity, and delay of probate.

In addition, it is quite common for elderly parents to reduce their probate estate by creating operation-of-law transfers to their descendants. One such transfer is the establishment of joint bank or securities accounts with their children or grandchildren with survivorship rights. A similar vehicle for transfer by operation of law is the Totten trust. A Totten trust occurs when an individual (generally a parent or grandparent) opens up a bank account in trust for a named individual. At the death of the account holder this property passes automatically by operation of law to the named beneficiary. It should be noted that both such transactions are incomplete gifts and, while effective in reducing probate, have no impact on the taxable estate.

Transfers by Operation of Contract

Another form of nonprobate transfer is transfer by contract. The most common form of transfer by contract involves the transfer of life insurance or employment benefit proceeds to a named beneficiary. The policy proceeds of a life insurance policy will be distributed to the beneficiary designated by the owner of the policy. The same result occurs if an employee has named individuals as beneficiaries of various employment benefits, such as death benefits from retirement plans. These benefits will pass by operation of contract and will not become part of probate unless they are made payable to the executor (or the estate) in lieu of a named beneficiary.

The Federal Transfer Tax System

Federal Gift Taxes

Federal gift taxes will apply only if the following two elements are present:

• There is a completed transfer and acceptance of property.

• The transfer is for less than full and adequate consideration.

These two essential elements of a taxable gift reveal some noteworthy facts. First, only property transfers are subject to gift taxation. Thus the transfer of services by an individual is not a taxable gift. In addition, all completed transfers including direct and indirect gifts of property are taxable. Finally, the less than full and adequate consideration requirement does not contain an element of intent. Therefore it is not necessary that the grantor intends to make a gift. It is merely required that the transfer be for less than full consideration. Generally speaking, transfers between unrelated individuals in a business setting are treated as "bad bargains" and are not treated as taxable transfers.

Exempt Transfers. Certain transfers are exempt from the gift tax base by statute. First, a transfer of property pursuant to a divorce or property settlement agreement is deemed to be for full and adequate consideration under some circumstances. Second, transfers directly to the provider of education or medical services on behalf of an individual are not taxable gifts to the recipient of the services. Finally, gifts that are disclaimed by the donee in a qualified disclaimer are not treated as taxable gifts.

The Annual Exclusion. Much of the design and complexity involved in gift tax planning involves the annual exclusion. Qualifying gifts of $10,000 or less may be made annually by a donor to each of any number of donees without gift tax. The exempt amount can be increased to $20,000 if the donor is married and the donor’s spouse elects to join in making the gifts on a timely filed gift tax return.

To qualify for an annual exclusion the gift must provide the donee with a present interest. Outright interests or current income interests in a trust will provide the beneficiary with a present interest. Trust provisions giving the beneficiaries current withdrawal powers can be used to qualify gifts to a trust for an annual exclusion even if the trust provides for deferred benefits. Use of the annual exclusion in the estate planning process will be discussed below.

Deductions from the Gift Tax Base. Two types of gifts are fully deductible from the transfer tax base. First, the marital deduction provides that unlimited qualifying transfers made by a donor to his or her spouse are fully deductible from the gift tax base. The marital deduction will prove quite useful if it is necessary to rearrange ownership of marital assets in the implementation of the estate plan. This deduction is similar to the marital deduction against federal estate taxes discussed below.

The charitable deduction provides that qualifying transfers to a legitimate charity will be deductible against the gift tax base. Thus all qualifying transfers made to charity will avoid transfer tax.

The Unified Credit. A cumulative credit of $192,800 is currently available against federal gift tax due on taxable transfers. Under the unified nature of the federal estate and gift taxes this credit provides a dollar-for-dollar reduction of transfer tax otherwise payable against taxable transfers either during lifetime or at death or both. The credit of $192,800 can be used against each dollar of transfer tax until it is exhausted. The tax credit of $192,800 is equivalent to an exemption of $600,000 of taxable transfers from the federal estate or gift tax. Thus the credit is often referred to as the $600,000 unified credit equivalent. Since no taxes are due on transfers until aggregate transfers by the donor have exceeded $600,000, the first tax rate bracket applicable to a transfer actually subject to tax is 37 percent. The unified credit is discussed further below.

The Federal Estate Tax

Often the most difficult task in calculating the estate tax is determining the assets that are included in the decedent’s estate tax base. Some of the included assets are obvious, such as individually owned property. However, the estate tax rules often cause the inclusion of property in surprising circumstances. For example, property previously transferred by a decedent can be brought back to the estate tax base by provisions of the statute.

The Gross Estate. The starting point in the estate tax calculation is determining the property included in the gross estate for federal tax purposes. The gross estate includes the property included in the probate estate, but it also includes property transferable by the decedent at death by other means. The decedent’s gross estate includes

• property individually owned by the decedent at the time of death

• (some portion of) property held jointly by the decedent at the time of death

• insurance on the decedent’s life if either (1) incidents of ownership are held by the decedent within 3 years of death or (2) the proceeds are deemed payable to the estate

• pension or IRA payments left to survivors

• property subject to general powers of appointment held by the decedent at the time of death

• property transferred by the decedent during his or her lifetime if the decedent retained (1) a life interest in the property, (2) a reversionary interest valued greater than 5 percent of the property at the time of death, or (3) rights to revoke the transfer at the time of death

As the list above indicates, the gross estate of the decedent is defined much more broadly than the probate estate, and a reduction of the probate estate will often have little effect on the size of the federal estate tax paid.

Items Deductible from the Gross Estate. Analogous to the federal gift tax rules, certain items are deductible from the gross estate for estate tax calculation purposes. First, legitimate debts of the decedent are deductible from the gross estate if these debts are obligations of the gross estate. Second, reasonable funeral and other death costs of the decedent are deductible from the gross estate. Third, the costs of estate settlement, such as the executor’s commission and attorney fees, are deductible to the extent such fees are reasonable.

Marital Deduction. As with the gift tax, qualifying transfers to a surviving spouse are deductible under the marital-deduction rules. Since the marital deduction is unlimited, the usual dispositive scheme (100 percent to the surviving spouse) will result in no federal death taxes for a married couple until the death of the survivor of the two spouses. As a client’s wealth increases, sophisticated planning is needed to make optimal use of the marital deduction. Planning for the marital deduction will be discussed below.

Charitable Deduction. The federal estate tax charitable deduction provides that transfers at death to qualifying charities will be fully deductible from the estate tax base. The charitable deduction is an excellent device to reduce the gross estate of a wealthy individual. As we will discuss below, the transfer of a remainder of current term interest to charity can substantially reduce the estate tax burden of a wealthy client without significantly disrupting his or her dispositive goals.

Credits against the Estate Tax. The unified credit discussed above with respect to gift taxes is similarly applicable to transfers occurring at death. If the unified credit has not been exhausted by sheltering lifetime gifts, it is available against transfers made at the death of a decedent. The optimal use of a unified credit in conjunction with the marital deduction will be discussed below.

The state death tax credit provides a dollar-for-dollar reduction (within certain limits) against the federal estate tax due for any state death taxes paid by the estate. The state death tax credit is limited, and the maximum state death tax credit available to a particular estate is provided for by a progressive rate schedule in the federal tax code. The size of the credit against the federal estate tax is equal to the lesser of the state death tax actually paid or the maximum state death tax allowable under the progressive credit schedule. State death taxes are usually equal to at least the maximum state death tax allowable under the federal estate tax rules.

Generation-Skipping Transfer Tax (GSTT)

The GSTT was created by the Tax Reform Act of 1986 to prevent the federal government from losing transfer tax if a transferor attempts to skip one generation’s level of transfer tax by transferring property to a generation more than one generation below the level of the transferor (for example, when a grandparent makes a gift of property to a grandchild). Although the GSTT is designed to prevent a transferor from finding a transfer tax loophole in the federal estate/gift tax system, it is different from the unified estate and gift tax system in many ways. The GSTT is applied at a flat rate equal to the highest current estate or gift tax bracket on every taxable generation-skipping transfer. Thus any taxable transfers will be currently subject to a 55 percent rate if the GSTT applies. This GSTT is applicable in addition to any estate or gift tax that might otherwise be applicable to the transfer. Thus if the GSTT applies, a transfer could easily be subject to a tax rate in excess of 100 percent of the value of the asset transfer. Obviously, planning to avoid the GSTT is of paramount importance for wealthy individuals.

The GSTT applies to three different types of transfers. First, the GSTT applies to a direct skip, which is an outright transfer during life or at death to an individual who is more than one generation below the transferor. The direct skip gift tax applies only if the parents of the skip beneficiary are alive at the time of the direct skip.

The GSTT is also applicable to a taxable distribution. A taxable distribution is a distribution of either income or principal from a trust to a person more than one generation below the level of the trust grantor. The recipient of the taxable distribution is a skip beneficiary of the trust. Thus a taxable distribution can occur when a trustee makes a distribution to a skip beneficiary even if a nonskip beneficiary still holds a current beneficial interest in the trust.

Finally, a taxable termination is also subject to a GSTT. The taxable termination occurs when there is a termination of a property interest held in trust as a result of death, lapse of time, or otherwise and a skip beneficiary receives the remainder interest outright in the trust.

A $1 million exemption is available to each taxpayer to be applied against GSTT for all potential generation-skipping transfers. The exemption can be applied against transfers during life or at death. Thus a married couple can split gifts and make up to $2 million of generation-skipping transfers without incurring the GSTT. The exemption must be affirmatively allocated to specific transfers in the transferor’s appropriate tax return. If this GSTT exemption is not allocated on a gift tax return during the life of a transferor or in the transferor’s will, the taxing authorities will allocate the exemption by default. A client would be making a substantial mistake by failing to appropriately allocate the GSTT exemption.

Most material on estate planning minimizes the discussion of state death taxes. Although state death taxes are generally applied at a lower rate than the federal estate tax, these taxes should not be ignored for many reasons. First, the majority of estates will not be subject to federal death taxes due to the $600,000 unified credit equivalent. The average estate will, however, be subject to state death taxes. In large estates the federal estate death tax is admittedly the largest expense. However, the state death taxes will also be quite significant. Finally, the state death tax base is defined differently from the federal estate tax bases in many states. Planning for state death taxes should not be ignored since the taxable transfers for state purposes can often be avoided by simple planning that might otherwise be ineffective (and thus disregarded) for purposes of federal estate tax planning. For example, many states exempt life insurance benefits paid to a named beneficiary.

State Inheritance Taxes

Some states impose a tax on the right of a beneficiary to receive the property from the estate of the decedent. The tax rate is based on the amount of property received by each beneficiary and is often based on the relationship of the beneficiary to the decedent. An inheritance received by a close relative is generally subject to a lower rate than an inheritance received by a more distant relation. In many cases the inheritance tax on property received by relatives outside the decedent’s immediate family (surviving spouse or children) is subject to a tax that exceeds the federal state death tax credit. In many circumstances the state inheritance tax could be more significant than any federal estate tax due. Despite the fact that inheritance taxes are imposed on the right to receive property, payment of these inheritance taxes is usually the responsibility of the estate.

State Estate Tax

A state with an estate tax is similar to the federal system in that both taxes are imposed on the privilege of transferring property by the decedent. These taxes are generally imposed at progressive rates and apply to a tax base similar to the federal system.

Credit Estate Tax

All states currently impose a credit estate tax (also known as a sponge tax) to bring the total state death tax liability up to the maximum federal death tax credit. In many states this sponge tax is the sole form of state death tax. Thus the state death taxes paid will generally be at least as great as any federal death tax credit allowable.

Factors to Consider in Planning for State Death Taxes

A detailed analysis of each state’s inheritance or estate tax is beyond the scope of this discussion. However, there are some peculiarities in the state death tax base that an estate planner should be aware of in the state where his or her clients are located. First, it is important to note that some states will not tax property held jointly by a decedent at the time of his or her death. As we have discussed above, jointly held property is included in the federal estate tax base. Quite often a decedent can avoid state death taxes without affecting federal taxes by transferring property to joint ownership prior to his or her death.

In addition, some states provide for no marital deduction for individually owned property transferred to a surviving spouse. Therefore severing a joint ownership of property with a surviving spouse may create state death taxes even if that property is transferred to the surviving spouse in a transfer deductible from the federal estate tax base.

Finally, life insurance is often not taxable at the state level if payable to a named beneficiary. It is important to note that life insurance can often avoid state death taxes even if owned individually by an insured at the time of his or her death provided the estate is not the named beneficiary.

Nontax Advantages of Lifetime Gifts

Clients give away property during their lifetime for many reasons. The advantages of making lifetime gifts are as follows:

• The donor can provide for the support, education, and welfare of the donee.

• The donor gets the pleasure of seeing the donee enjoy the gift.

• The donor avoids the publicity and administrative costs associated with a probate transfer at death.

• The donated property is protected from the claims of the donor’s creditors.

Tax Advantages of Lifetime Gifts

Although the federal gift and estate taxes are unified for tax purposes, there are some distinctions that make lifetime gifts favorable from a tax standpoint. The tax advantages of lifetime gifts include these:

• The annual gift tax exclusion for gifts of $10,000 or less provides a complete loophole from federal gift and estate taxes. Each year any number of $10,000 gifts ($20,000 if the spouse joins in them) can be made to reduce the ultimate transfer tax base of a donor.

• The gift tax is imposed on the value of the gift at the time a completed transfer is made. Thus any posttransfer appreciation on the property avoids all transfer tax.

• The gift tax payable on gifts made more than 3 years prior to the donor’s death is excluded from the donor’s estate tax base.

• The income produced by gifted property is shifted to the donee for income tax purposes. Lifetime gifting may be used to move taxable income from a high-bracket donor to a lower-bracket donee. (This advantage is somewhat limited by special tax rules related to unearned income of children under age 14.)

• Unlimited qualifying transfers can be made between spouses without incurring gift taxes. Spouses can advantageously shift assets between themselves to meet the needs of the estate plan of each spouse.

The Opportunities Created by the $10,000 Annual Gift Tax Exclusion

As discussed above the annual exclusion allows the donor to make up to $10,000 worth of gifts tax free to any number of donees each year. If the donor’s spouse elects to split gifts with the donor for the tax year, the annual exclusion is increased to $20,000 per donee. If the client has a substantial estate and several individuals to benefit, the systematic use of annual exclusion gifts can cause the transfer of substantial wealth free of transfer tax.

Example: Tom Taxplanner, a 65-year-old widower, has two children and four grandchildren. Tom can make up to $60,000 of qualifying transfers annually to his heirs without ever subjecting the transfers to federal gift or estate taxes. If Tom lives an additional 16 years (his actual life expectancy), he can give away $960,000 and save up to $528,000 of estate tax (assuming a maximum 55 percent bracket). The actual tax savings are even greater since the appreciation on the property transferred also escapes gift and estate taxes.

The annual exclusion is available only for gifts that provide the donee with a present interest. For example, an outright transfer of property provides a present interest. Since the outright transfer is often unfavorable (for example, the donee is a minor), significant planning is often necessary to design gifts that restrict the donee’s current access to the funds while qualifying for the annual exclusion.

Gifts to Minors

Quite often annual exclusion gifts will be made to minor children or grandchildren as part of the estate plan of a wealthy client. This creates problems for the donor and donee. First, there are restrictions on a minor’s ability to hold or otherwise deal with property under state law. In addition, the donor will naturally be concerned about the safety of the funds if the minor has significant access rights. Fortunately there are several methods for making annual exclusion gifts to minors with restrictions on the minor’s access to the property.

Uniform Gifts to Minors Act (UGMA) or Uniform Transfers to Minors Act (UTMA). The UGMA and UTMA statutes are model laws that have been adopted in various forms in individual states. They permit the transfer of funds to a custodial account for the benefit of a minor. The custodian of the UGMA or UTMA account manages the property under the rules provided by state law. There are restrictions on the type of property permissible as an investment for these purposes. The original model act, UGMA, has been expanded in many states to increase the types of permissible investments. In a majority of states the newer model act, UTMA, has been adopted, and relatively few restrictions exist in these states on the permissible investments. A UGMA or UTMA transfer is particularly favorable for smaller gifts because it provides for the protection of the assets without the expense of the administration of the trust. The provisions for distribution from the UGMA are provided under the various state laws. Generally speaking, the UGMA funds can be accumulated during the minority of the donee, but the custodial assets must be distributed to the beneficiary upon majority.

Sec. 2503(b) Trust. A Sec. 2503(b) trust is an irrevocable trust created by a donor during his or her lifetime to receive annual exclusion gifts. The trust requires that income be distributed at least annually to (or for the benefit of) the minor donee. The minor would receive distribution of the trust principal whenever the trust agreement specifies. A distribution of principal does not have to be made at the majority of the donee. The annual gift tax exclusion is limited to the value of the income interest provided by the trust. The Sec. 2503(b) trust should be invested in income-producing property and is less favorable in some respects than the UGMA gift because income cannot be accumulated.

Sec. 2503(c) Trust. A Sec. 2503(c) trust is another type of irrevocable trust designed to receive annual exclusion gifts for a minor. This type of trust requires that income and principal be distributed to the minor at age 21. However, the trust is allowed to accumulate current income prior to the termination of the trust.

Irrevocable Trust with Current Withdrawal Powers. A client often wishes to make gifts to a trust with the purpose of accumulation. If the trust provides for accumulation and does not currently benefit the donee, the annual gift tax exclusion would normally be forfeited. Provisions of the law, however, permit the annual exclusion if current beneficial rights are given to the donee. An annual exclusion is permitted if the donee is granted at least temporary withdrawal rights to the deposits to the trust. Under these rules a gift to a trust will qualify for the annual exclusion if the donee has the noncumulative, temporary (for example, 30 days) right to demand the least of (1) the annual addition to the trust, (2) $5,000, and (3) 5 percent of the trust corpus. These provisions are frequently called Crummey powers, named after the taxpayer who litigated the landmark decision authorizing an annual gift tax exclusion for gifts and trusts subject to these powers.

Irrevocable trusts with withdrawal powers are often used for the purposes of holding life insurance on the life of the grantor. Since the life insurance will be paid with annual premium additions to the trust, it is intended that these premiums will accumulate in the policy and no distributions will be made until the death of the grantor. If each beneficiary is provided with the ability to withdraw a pro rata share of the annual premium addition to the trust, the annual premium will qualify as an annual exclusion gift to the beneficiaries. Thus a life insurance trust can be created without gift tax costs. The estate tax advantage of the life insurance trust will be discussed below.

Planning for the Marital Deduction

The marital deduction provides that certain transfers at death from a deceased spouse to a surviving spouse are fully deductible from the gross estate for estate tax purposes. This deduction is unlimited as long as the property is included in the gross estate of a deceased spouse and is transferred to a surviving spouse in a qualifying manner.

Through maximum use of the marital deduction a married couple can, at their option, eliminate all federal estate taxes due at the first death of the two spouses. The estate plan of a marital unit making full use of this marital deduction merely defers the estate taxes until the second spouse dies. The marital deduction will be available at the second death only if the surviving spouse remarries and transfers the property to his or her new spouse. Thus a decedent can avoid all federal estate taxes on his or her estate by making a qualifying transfer of all property included in his or her gross estate (both probate and nonprobate property) to the surviving spouse.

Simply answering the "who" question in favor of the surviving spouse will not necessarily qualify such transfers for the marital deduction. Tax laws provide that only qualifying transfers will be eligible for this deduction. Thus the "how" question must also be answered appropriately.

Outright Transfers. The simplest and most common method of transferring property to a surviving spouse¾the unrestricted transfer¾is eligible for an unlimited marital deduction. This includes all property included in the gross estate of the decedent that passes directly to the surviving spouse. Therefore outright transfers of probate assets by will or intestacy qualify for the marital deduction. In addition, transfers by operation of law or contract that pass outright to the surviving spouse at death similarly qualify. Thus life insurance proceeds payable to the surviving spouse or jointly held property received from survivorship by the deceased spouse qualify for the marital deduction.

Property transfers that place restrictions on the surviving spouse’s use or enjoyment of the property may or may not qualify for the marital deduction. The marital deduction was envisioned to prevent a substantial first-death tax to a married couple if the usual dispositive scheme (100 percent to the spouse) is followed. However, Congress intended that the estate taxes would be payable at the second death of the two spouses. Thus a general rule of thumb is that the marital deduction is available only for transfers to a surviving spouse that would cause the ultimate inclusion of the property in the surviving spouse’s gross estate. Property transferred to a surviving spouse will not qualify for the marital deduction if the interest is terminable at the death of the surviving spouse.

An interest in property left to a surviving spouse will be nondeductible if

• it terminates upon the occurrence of an event or a contingency, such as death, and

• a third party gains possession of the property after the surviving spouse’s interest terminates

A common example of a nondeductible terminable interest is the transfer of a life estate to the surviving spouse with the remainder interest being paid to the couple’s children under the terms of the deceased spouse’s will. Such a transfer would not create a second-death tax since the surviving spouse’s interest terminates and therefore would not be included in his or her estate. However, a first-death tax would be payable since the life estate transferred to the surviving spouse would not qualify for the marital deduction.

Congress recognized that many married individuals prefer leaving property in trust for the surviving spouse. The transferor may be concerned that the spouse may be unable to properly manage the trust property. Or the transferor-spouse might want to limit the invasion rights of the surviving spouse. In addition, it is generally the intent of individuals to ultimately leave their property to their children. The transferor-spouse may want to control the ultimate disposition of the property to preserve the rights of his or her children. This is particularly true if the transferor-spouse has children from a prior marriage. Fortunately the marital-deduction rules have created several opportunities that meet many of these objectives.

Estate Trust. A transfer to a surviving spouse through an estate trust qualifies for a marital deduction. Under this arrangement a deceased spouse leaves a life estate in trust to the surviving spouse. The surviving spouse’s estate is the remainderperson of this trust. Income from the estate trust can either accumulate or be paid to the surviving spouse at the discretion of the trustee. Since the remainder interest is transferred to the surviving spouse’s estate, the property will be included in his or her gross estate, and a second-death estate tax may be payable at that time.

Power-of-Appointment Trust. Another common marital-deduction trust is the power-of-appointment trust. This trust is designed to distribute income to the surviving spouse during his or her life and provides the surviving spouse with a general power of appointment over the trust property. The general power of appointment may be exercisable by the surviving spouse in all events, or may be exercisable only at the death of the surviving spouse. Since the surviving spouse has a general power of appointment over the trust principal, the principal is included in his or her gross estate for federal tax purposes.

QTIP Marital-Deduction Trust. A special provision of the tax law provides for a marital deduction if qualifying terminable interest property (QTIP) is left to a surviving spouse. Under these rules a terminable property interest can be transferred to a surviving spouse and such interest will qualify for the marital deduction. The QTIP deduction is available if the executor of the deceased spouse elects for QTIP treatment on the estate tax return. The QTIP trust can be funded by probate assets or other types of testamentary dispositions. The surviving spouse must have the right to all income annually from the QTIP for life. At the death of the surviving spouse the QTIP election provides that the property will be included in the surviving spouse’s gross estate.

The primary advantage of the QTIP is the ability of the transferor-spouse to control the transfer of his or her assets. The ultimate disposition of the QTIP property would be predetermined by the terms of the trust created by the original transferor-spouse. Thus the QTIP trust permits a transferor-spouse to provide for his or her surviving spouse but still preserve the ultimate interests of his or her children.

Planning for the Unified Credit

The unified credit against estate or gift tax is designed to prevent the imposition of these transfer taxes on moderate-sized estates. As noted earlier, the credit is currently $192,800 and is applied dollar-for-dollar against any estate or gift tax due. This credit provides a shelter against approximately $600,000 of taxable transfers during a transferor’s lifetime or at death, and it is often called the $600,000 unified credit equivalent.

For the unified credit to be applicable to a transfer, the transferor must first create estate or gift tax. Thus the unified credit is not applicable to a transfer that is exempt or deductible from the tax base as a result of other provisions of the federal transfer tax rules. For example, if a transfer is exempt from estate or gift tax as a result of the marital deduction or annual exclusion, the transferor’s unified credit will not be applicable.

Coordination of the Marital Deduction and Unified Credit

The maximum use of a marital deduction is the typical dispositive scheme for most married individuals. All property is generally left either outright to the surviving spouse or in other manners qualifying for the marital deduction at the first spouse’s death. Since no estate tax will be payable under these circumstances, the unified credit available at the death of the first spouse to die will be wasted.

With appropriate planning each spouse can make maximum use of the unified credit, and the marital unit as a whole can shelter up to $1.2 million in marital wealth from federal estate taxes. This shelter can only be accomplished if each spouse makes maximum use of the $600,000 unified credit equivalent. As discussed above the usual marital dispositive scheme does not take advantage of the $600,000 unified credit equivalent available to the first spouse at his or her death. Thus all assets transferred to the surviving spouse under the marital deduction will be sheltered by only one unified credit available at the second spouse’s death.

The usual dispositive scheme can be altered to make maximum use of each spouse’s unified credit and optimal use of the marital deduction. Again, this requires appropriate answers to the "who" and "how" questions. With some restrictions, all the objectives of the usual dispositive scheme can be accomplished without wasting the unified credit of either spouse. This maximum estate tax shelter is accomplished by designing each spouse’s estate plan to transfer property to both a marital and unified credit trust. This arrangement is commonly referred to as an AB trust arrangement. The AB trust arrangement is designed to operate as follows:

• The A trust is some form of marital-deduction trust. This trust receives assets in a manner qualifying for the marital deduction and provides for maximum use of these assets by the surviving spouse. The remainder of the assets transferred by the decedent are placed into the B trust.

• The B trust is designed not to qualify for the marital deduction. Instead the B trust, funded with approximately $600,000, will be part of the taxable estate since it will not be deductible under the marital deduction. However, the $600,000 transferred to the B trust qualifies for the $600,000 unified credit equivalent.

The "how" question must be answered by designing the transfer to the B trust in a nonqualifying manner for the marital deduction. Therefore the surviving spouse’s interest in the B trust must be limited to a life estate, perhaps with some limited invasion rights. Since the B trust is designed as a nonqualifying terminable interest, the assets in the B trust will not be included in the surviving spouse’s gross estate and the remainder interest can be reserved for the children.

The "who" question must be answered with respect to the B trust, often referred to either as the family trust or the credit-shelter-bypass trust. The B trust can be used to provide substantial rights to the surviving spouse but must fail to qualify for the marital deduction. If the client is extremely wealthy, the B trust could entirely avoid benefiting the surviving spouse, and is an excellent way to provide for other heirs at the first death.

The AB trust arrangement makes maximum use of each spouse’s unified credit, and since the A trust qualifies for the marital deduction and the B trust is sheltered by the unified credit, no estate tax will be paid at the first spouse’s death. Thus the AB trust arrangement does not change the usual first-death tax results. However, the second-death taxes are reduced since an additional $600,000 unified credit equivalent was used at the time of the first death. Thus the surviving spouse’s estate is reduced in size by the amount of property transferred to the B trust at the first death of the two spouses.

AB Trust Arrangement
Client creates two testamentary trusts
A Trust Spouse is beneficiary Receives assets not placed in B trust Qualifies for marital deduction Subject to estate taxation at death of spouse	B Trust Spouse receives no more than life income interest and limited invasion powers; children may receive current and/or remainder interest. Receives $600,000 of assets Does not qualify for marital deduction; makes use of unified credit Escapes estate taxation at death of spouse

Planning Charitable Contributions

Qualifying gifts of property to charities may generate deductions against federal income, gift, and estate taxes. Although some limitations exist for the charitable deduction for income tax purposes, qualifying gifts of property are deductible in full against either the federal gift or estate tax base.

Charitable contributions are deductible for federal income, estate, and gift tax purposes only if made to qualified organizations. Generally speaking, an organization is qualified if it is operated exclusively for religious, charitable, scientific, literary, or educational purposes. In addition, the charity must hold such qualified status under the rules of the Internal Revenue Service. A list of qualified charities is published by the IRS and may be inspected by any individuals interested in making a charitable contribution.

Advantages of Gifts to Charity. The value of property gifted to a qualified charity is fully deductible from the federal gift or estate tax base. In addition, the value of property gifted to charity will be deductible from the federal income tax base of the donor. (Some limitations exist on the size of the income tax deduction, but they are not discussed here.) Thus a donor can reduce current income taxes and the eventual size of his or her taxable estate. Quite simply, any property gifted to charity will remove the property (including any postcontribution appreciation) from the transfer-tax base of the donor. Since the charitable gift tax deduction is unlimited, charitable contributions can be even more effective than gifts to noncharitable donees in reducing the size of the gross estate of a wealthy client. The charitable deduction is similarly unlimited for testamentary bequests to charities. Through the techniques discussed below, charitable contributions can significantly reduce the decedent’s estate tax liability without completely divesting other heirs of the donated property.

Gifts of Remainder Interests to Charity. One disadvantage of an outright lifetime contribution of property to charity is that the donor loses the current enjoyment of the property. Fortunately there are methods to take advantage of the tax benefits provided to charitable contributions while retaining the donor’s use or enjoyment of the property. Certain types of trust arrangements, known as charitable remainder trusts, can be employed to retain the current enjoyment of the property for the life of the donor (or lives of the donor’s family members) while providing gift, estate, and income tax advantages. The charitable remainder trust can be established during the donor’s lifetime or at his or her death. The charitable remainder trust permits the donor to retain the current income for the donor or his or her family. The income from the trust corpus will be retained for a time period (usually measured by the life of the donor or lives of selected family members) with the charitable institution holding the remainder interest. The current tax deduction is measured by the present value of the remainder interest held by charity. Thus the donor (or possibly members of the donor’s family) receives current benefit of the trust property and current tax advantages, while the charity receives the benefit of the property outright when the remainder interest is distributed. To prevent abuses of the transfer tax system, tax rules carefully specify the types of charitable remainder trusts eligible for such tax benefits.

Donating Income Interests to Charity. Under some circumstances a client may donate a current income interest to charity as opposed to a remainder interest. Under this arrangement, known as a charitable lead trust, a trust is established to provide a charity with a current term income interest. The remainder interest in the trust is retained by the grantor (or for his or her family). The donor gets an upfront income and gift or estate tax deduction for the present value of the lead income interest donated to charity. However, the grantor remains taxable annually on the actual trust income.

The charitable lead trust is generally used for testamentary dispositions. If the current income interest bequested to the charity is substantial, the estate will receive a deduction in an amount equal to a large portion of the value of the property placed in the trust. Thus the taxable estate is significantly reduced while the family retains the ultimate control of the trust property through its remainder interest. The charitable lead trust is an excellent tool for extremely wealthy individuals who have other substantial assets to leave to their heirs currently, since the assets placed in the charitable lead trust may not be available for several years.

Life Insurance for Estate Enhancement

Life insurance is generally used for estate enhancement for (1) younger clients, (2) clients with dependent family members, and (3) clients with small to moderate-sized estates. Clients in these categories generally have protection as the primary need for their life insurance coverage. These individuals need to protect their families from the loss of future earnings with which to support the family members. These clients are either in or are headed toward their peak earning years, and their families rely on these future earnings for such things as the educational and medical needs of the children, the support needs of the client and his or her spouse, and the eventual retirement needs of the client and his or her spouse.

The death taxes facing a younger client with a small to moderate-sized estate are relatively minor. The unified credit and marital deduction will generally remove the danger of federal estate taxes for these individuals. Thus estate liquidity is not the primary concern. It is highly improbable, however, that these individuals have accumulated enough wealth to replace future income and support of a prematurely deceased breadwinner. Life insurance is the perfect estate enhancement tool to replace some or all of the financial loss created by the premature death.

Life Insurance for Estate Liquidity Purposes

For older clients with larger estates estate liquidity becomes a primary focus in the use of life insurance. Older clients have generally completed or nearly completed the heaviest support and educational expense years for dependent children. These individuals are usually well along in the funding of their retirement plans and have fewer years of employment ahead of them.

Since these clients may have accumulated substantial wealth, the protection offered by the marital deduction and unified credit may be inadequate to shelter their estates. Although the marital deduction will generally shelter all of the estate from tax at the death of the first spouse, the second death creates a substantial tax problem in the foreseeable future (if the spouse is of similar age). As noted earlier, with optimal planning the unified credit and marital deduction can shelter only $1.2 million of total family wealth from taxes.

In addition, an affluent client may have accumulated substantial wealth that is not liquid. For example, an interest in a closely held family business is often assigned a high value for the purposes of the federal estate tax. However, the business interest may be unmarketable to purchasers outside the family group. If the heirs are to remain in the business, they must discover a method to pay any estate taxes due.

Under the circumstances described above, life insurance is quite useful in providing for estate liquidity. Life insurance can be secured by a client to provide death proceeds equal to the size of the wealth lost in the form of the substantial state death taxes and federal estate tax. In addition, the life insurance proceeds provide cash, which, as opposed to illiquid estate assets, is more readily available to provide for the liquidity needs of settling the estate.

The estate tax treatment of the life insurance selected by these individuals is critical. Since affluent clients are hoping to solve liquidity problems rather than add to a tax burden, life insurance should be purchased and owned in a manner that keeps the death proceeds out of the gross estate if at all possible. Thus these individuals often have ownership arrangements for the life insurance that provide the insured with no incidents of ownership. This can be accomplished by having either the spouse or children of the insured apply for and own the life insurance policy. Or, as discussed below, a trust can be designed to own the life insurance policy. However, the estate or the executor should never be the beneficiary of the proceeds since this beneficiary designation would place the proceeds in the gross estate for tax purposes.

Life Insurance Trusts

Revocable Trusts. A revocable life insurance trust is designed to own and/or be the designated beneficiary of life insurance coverage on the grantor’s life. The revocable life insurance trust serves no estate tax planning purposes. Since the trust is revocable, the insured is treated as the owner of the policy and the death proceeds will be included in the insured’s gross estate. The revocable trust is ordinarily used when a specific, perhaps temporary, protection need exists.

The revocable trust is an excellent method for providing life insurance benefits for the protection of young children. If the insured dies, the trust becomes irrevocable and the children can be provided for by the beneficial terms of the trust. The revocable life insurance trust is also an excellent method of providing protection for children following a divorce.

Irrevocable Life Insurance Trusts. An irrevocable life insurance trust is generally used by older clients who have a more stable family and financial situation. The irrevocable trust can be designed to provide for heirs life insurance benefits that will be excluded from the client’s gross estate. In addition, contributions to the trust can be designed to avoid gift or generation-skipping taxes. Thus the irrevocable life insurance trust is a perfect tool for the estate liquidity needs of older wealthy clients without adding to the tax burden. Since the trust is irrevocable, the client should be certain of his or her beneficial intent at the time the trust is drafted.

Previous

Top

Next