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ESTATE PLANNING 101
"They’re trying to kill me"
Captain Yossarian in Catch-22
The words of Joseph Heller’s World War II aviator have been modified by time. Today the phrase is, "The federal government wants to take all of my money, now and after I die." Why has our protector become our predator? More importantly, what can we do about it?
Tax legislation is constantly in flux. Congress and any new administration, can change the estate tax again at any time.
A. Background
In today’s world, Federal tax policy favors the profligate over the saver. The family that borrows and buys and then borrows more and buys some more will savor life, though it may be a bankruptcy candidate in heaven. Dying with heavy debt will dramatically reduce or eliminate your estate tax burden. Of course, the debt might be rough on the survivors, but, with a little planning, even that can be softened.
Those who save for the rainy day, for retirement, for their dotage are in trouble unless they spend, gift or plan to get their estate below the current 2008 $2,000,000 exemption level. The very poor have no problem with estate taxes. The very rich have almost no problem. The wealthy can hire the best estate planners to avoid Uncle Sam’s bursar legally using a myriad of complex trusts (charitable remainder, grantor, generation skipping, irrevocable, dynasty, off shore and the like), family partnerships, foundations and other tax planning manipulations.
The axe falls on the "new" middle class, those with assets between $1,250,000 and $4,500,000. While this range may sound posh and not middle class, it is a common range of assets for many working families in many urban areas. Inflation (and hopefully appreciation) has taken the $30,000 home of the 1960’s to the $300,000 to $600,000 level. Both private and government retirement plans add value to the decedent’s estate as does life insurance owned by a decedent. Add individual savings, jointly owned properties and individual retirement programs and you soon are above the estate tax exemption level.* At this point the confiscatory estate tax rates kick in, going quickly from 15% to 45%.
To make matters worse, tax deferred retirement funds (e.g., 401(k); money purchase; profit sharing; IRAs) are also subject to income tax rates when withdrawn either before or after death. Most of us think we will have a lower tax rate when we are old enough to withdraw our retirement funds. We fantasize that the income tax burden will be minimal 15%. The reality is that most middle class couples pay income tax rates of 25% to 36% (i.e., with income between $63,700 and $349,700) even after retirement.1 Worse, if you die with substantial, tax deferred retirement funds, your estate might have to pay both the estate tax and the income tax combined. This combined tax could exceed 75% of the retirement funds. This heavy tax may be deferred if the retirement funds go to a surviving spouse but the federal tax vulture will merely circle the survivor and wait to pick up these large taxes after the second spouse dies.
B. The Tools of Estate Planning 1. Write your will. Without this control document, your assets will be distributed by local law, which is usually not what you want and often will cost more in taxes. 2
2. Execute a Durable Power of Attorney. This is invaluable for incompetency problems and may be used for estate planning purposes when gifting, planning and disclaimer powers are included.
3. Include a Bypass Trust (named because it bypasses the estate tax. It also may be called a Family Trust). The Bypass trust allows you to take the total amount of estate tax exemption available and separate it from your estate, usually for the benefit of your surviving spouse and then the children or grandchildren after the spouse’s death. The assets in the trust are exempt in your estate. If drafted correctly, the trust assets will not be included in your spouse’s estate (even though they can be used for the spouse’s benefit subject to the restrictions of distribution to an "ascertainable standard"). Thus the tax collectors will not hover over the surviving spouse for the amount in the Bypass Trust.
The Bypass Trust may be created by your will and become effective only at death, or the trust exemption carve out may go into a living trust (also called an inter vivos or a revocable trust) during a lifetime.
Caveat: Because of the higher federal tax exemptions ($3,500,000 in 2009) and the disparity in the many State estate tax exemptions, a problem may exist with the use of the Bypass Trust. To avoid placing too many or all assets of the estate into the trust (with its restrictive distribution rules) you may adjust the toal funding after death by the use of disclaimer powers or a Disclaimer Trust.
4. The Living, Revocable or Inter Vivos Trust may or may not be the solution. This trust is often created to avoid probate, to assure privacy and to coordinate the administration of assets during life and ater death. It also may be used as a substitute for a durable power of attorney. However, the revocable trust will be included in your taxable estate and does not avoid estate taxes if the value is over the current exemption. The trust is revocable in case the grantor wants to use the funds for another purpose. The maker (i.e., grantor) is usually the trustee. The maker’s property is transferred to the trust for administration and the trust may provide for distribution at the death of the maker (as a will would do). Since the individual does not own the property, there is no local probate administration. The trust may continue after death as an irrevocable trust, often used to administer the Bypas Trust and other trusts.
5. The Irrevocable Trust. If a trust can not be revoked or otherwise controlled by the grantor (the person who supplied the money) or is not for the grantor’s benefit, then it is not included in a decedent’s estate and so estate taxes will not be assessed against the decedent for the value of the irrevocable trust. This trust is usually used to own and hold life insurance policies on the life of the grantor. Often the life insurance proceeds are used to pay the taxes for the estate of the second spouse but the trust assets may be used for other purposes.
The Irrevocable Grantor Trust. [All trusts are funded by a "grantor" but there are unique IRS Code provisions (IRC 671, et seq) called grantor trusts.] The beneficiaries of an irrevocable trust must usually pay income taxes on their share of the trust, but it is possible to create a defect in the trust that would put the income tax burden back on the grantor (i.e., maker or donor). While the value of the trust assets would not be in the grantor’s estate at death, the grantor would pay the income tax liability of the trust. Often a grantor prefers to pay the income tax to get more money in the hands of the beneficiaries of the trust but does not want the trust assets to be in his estate. The income tax payments would also reduce the size of the grantor’s estate and would not be treated as a gift.
This trust could also be drafted to make the grantor liable for the income tax liability and have the assets included in the grantor’s estate. This would be done to get the ownership of assets out of the grantor’s and creditor’s or spouse’s reach during the grantor’s lifetime.
6. Gifting. People are often surprised that the gift giving person (the donor) may be taxed on the money he gives away. (If this were not the case, gifts would be taxable income to the recipient). The gifts accumulate over a lifetime and are added to the estate value to determine whether they have exceeded the estate tax exemption level. Even if a gift tax must be paid by the donor, the gift is out of the estate and may ultimately reduce the total tax paid by the estate.
Each year a person may give away up to $12,000 to each of as many persons as she/he would like without any gift tax effect and $24,000 per year if the spouse joins in the gift. The $12,000 annual gift is the easiest way of making tax-free gifts and reducing your estate for tax purposes. The problem is that it is very hard to give away a substantial sum of money at $12,000 a pop when you have only a few people to whom you wish to give gifts (e.g., your children). It sounds like the kind of problem everyone would like to have until it becomes real. With a substantial estate and an insufficient number of beneficiaries, the $12,000 annual gifts won’t make much of a dent in the total estate.
Any person may also make unlimited gifts by paying medical expenses and educational tuition. This works well for parents, grandparents and family friends. However, the payments must be paid directly to the educational institution or the medical service provider to qualify.
7. The Marital Deduction. Everything you pass to your spouse goes free of estate taxes. The IRS favors marriage and cuts married couples big tax breaks. Some examples are the joint income tax rates; the ability to roll a retirement plan to a spouse tax free; and the ability to pass any amount (e.g., 100 billion dollars) to your spouse, at your death, estate tax free. But the IRS does not starve, it just delays its meal. The vulture will now patiently hover over the surviving spouse and collect the estate tax when she/he dies.So the good news and the bad news is the first spouse’s estate tax free marital deduction. The trick is to keep the assets of the first spouse to die out of the estate of the surviving spouse but at the same time make funds available for the surviving spouse during the spouse’s lifetime.
One way to have it both ways is the Bypass Trust despite its restricted distribution requirements. But that is only good for the amount of the estate tax exemption (i.e., $2,000,000 in 2008 and $3,500,000 in 2009 and eventually taxable to the beneficiaries). What can you do if you have more assets? Remarriage of the surviving spouse is one answer. However, this is rarely very effective because: (1) many older people do not want another spouse despite any tax advantages; and, (2) the surviving spouse is not likely to be young and will probably pass on in a relatively short period of time. Perhaps each surviving spouse could marry only very young, long living spouses in seriatim to keep the funds away from the IRS, but this is a rather unlikely scenario.
8. QTIP. The tax code allows a limited transfer that works particularly well for second marriages when there are children from a first marriage. The Qualified Terminal Interest Property trust allows a spouse to provide any amount of value for the surviving spouse but still direct the trust funds away from the surviving spouse’s control at the second spouse’s death. If correctly drafted, the trust will be a tax-free marital deduction and the ultimate distribution could go to whomever you choose. The only catch is that the value of the trust must be included in the second spouse’s estate so that Uncle Sam can get his due.
9. Charitable Trust. Gifts to charities are income tax deductions; they reduce the value of the estate; and, the gifts are not taxable as income to a tax-exempt charity at the time of receipt or at the time of sale. This win/win scenario comes with additional perquisites. Many charities will provide a lifetime annuity to a donor in order to induce them to make their gifts. In addition to the annuity, the income tax deduction and the reduction of the estate for estate tax purposes, the estate is able to rid itself of appreciated assets that would incur heavy taxes if and when sold before death by the owners.
There are several different types of charitable trusts that can benefit you and the charity. Just call your favorite charity and there will be free legal advice at your doorstep within seconds.
10. Generation Skipping Trusts. A trust can be established to skip a generation (usually your children) and benefit the next generation (usually grandchildren). There is a history of social policy and laws that work against such trusts. Tax policy is aimed at collecting taxes and not allowing the postponement or avoidance of taxes for multiple generations. Complex and draconian tax penalties have created a minefield for those trying to pass on more than $2,000,000 (or as later increased) beyond the skipped generation.
The common law rule against perpetuities was also developed to prevent the passing on of wealth indefinitely. Recently a few states have passed new laws avoiding the rule against perpetuities. These states allow what is known as dynasty trusts that may go on indefinitely.
11. Asset Protection. Assets in Trusts for a beneficiary can be protected from the beneficiary’s creditors. A spendthrift clause will usually protect trust assets from the creditors of a profligate beneficiary. A trustee’s total discretionary power to distribute or not distribute assets may also work.The original owner of the assets may protect his/her assets from creditors by creating asset protection trusts. This may be in the form of an offshore trust in a country whose laws offer such protection. Recently a few states have created new laws that allow someone to create a trust that will be protected from personal creditors. However, this may not protect the transfers to the trust if the transfer is fraudulent. If the transfers are clean and/or a statute of limitations for fraudulent transfers or fraud has passed, however, the trust assets may be protected without sending assets to a foreign country.
12. Insurance. Insurance may be an integral part of an estate plan for several reasons. Insurance premiums purchase a very large potential benefit at a reasonable cost unless the insured lives forever. Insurance premiums may be treated as a gift for insurance held in a trust for other beneficiaries. Insurance not owned by a decedent will not be subject to an estate tax. The dividends, interest and cash surrender value earned by insurance policies are exempt from income tax even though the value may increase considerably. Insurance policy payouts are exempt from income tax to the recipients of the proceeds. However, insurance owned by a decedent will be included in his/her estate for federal and State estate taxes.Apart from the leveraging and income tax benefits, insurance may be used to address specific planning problems such as:
If a gift item has appreciated in value, the recipient (donee) takes the cost (basis) of the giver (donor). But if you receive something from a dead person’s estate, you take it at a basis equal to the value at death. Thus the sale of appreciated property received from a decedent would have less of a gain and less tax would be due than if the property were gifted. So it is often better to wait until death to pass on certain types of highly appreciated assets. Of course, this is true only if you and the beneficiary can afford to wait and the numbers work.
14. Spending. You need not save all your life. I hereby give you permission to be nice to yourself and your spouse. If you have the funds, enjoy them. Spending is good for the economy and a fun way to cut back on estate taxes.
C. What To Do The above material is just an outline of some of the basic elements of estate planning. There are many more techniques available for different levels of sophistication and complexity.
To start your estate planning, you should:
(b) Determine how they are titled, both joint and separate;
(c) Determine the current value of each asset;
(d) Determine the cost (basis) of the asset.
Make a plan of distribution after death. Determine the age you wish to distribute to minors.
Designate a guardian and trustee for minor children.
Designate a personal representative, trustee and attorney in fact for your will, trust and durable power of attorney.
Consult a lawyer to advise, formulate, draft and execute the plan.
Do not make the estate planning process any more complicated than it need be - but do not ignore it either. A few simple steps can save you and your spouse or partner many thousands of tax dollars and provide a good deal of comfort for you and your heirs.
Depending upon the complexity, this office will provide either a fixed fee or a fixed range of costs at the initial consultation. You are invited to call now to begin the process.
Paul D. Pearlstein
2928 Ellicott Street, N.W.
Washington, D.C. 20008
(202) 223-5848
202-223-5848 (voice)
202-223-8737 (fax)
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