Estate Planning is management of you assets during and after your lifetime for the benefit of your self and your family.  It's having concern about the tax implications, it's having concerns about lifetime gifts to children, it's having concerns about your pension benefits and how they should be handled, family business and what is going to happen to it, and many other factors.

 

Determine the Planning Objectives.

        While specific planning objectives will vary from one client to another, the general objectives of the planner and the client are to design an estate plan that features the following six factors:

1.                 Control

2.                 Management

3.                 Tax & Saving

4.                 Flexibility

5.                 Asset Protection

6.                 Leveraging the available tax – Planning opportunities

7.                 Federal Estate and Gift Taxes – Imposition and Unified Tax Rates

 

Federal Estate and Gift Taxes ‑ Imposition and Unified Tax Rates.

 

The federal government imposes a tax on the transfer of assets wherever located by a person who is a United States citizen or resident. The tax is applicable to transfers made during a person's lifetime (the gift tax) and to transfers made or taking effect at death (the estate tax). Transfers are taxed *in accordance with a Unified Tax Rate Table, as set forth below.

All property owned at death is subject to the estate tax. The gift tax applies to any direct or indirect lifetime transfer of property, including outright gifts or gifts in trust.

Tax Inclusive vs. Tax Exclusive Aspects of Lifetime and Death Transfers.

Although the same tax rates apply to transfers subject to the gift tax and to the estate tax,, the method of calculating the two taxes is substantially different. This difference results in the effective tax rate applicable to transfers at death being more than twice as high as the effective tax rate applicable to lifetime gifts.

The reason for this significant difference in effective rates is the fact that the estate tax is "tax inclusive" (that is, the entire estate owned at death is taxed, including the funds that are used to pay the estate tax) while the gift tax is "tax exclusive" (that is, only the actual gift itself is taxed). The net result is that substantially more valuable property can be transferred by making lifetime gifts, rather than by awaiting a decedent's death.

To illustrate this point, consider this Example:

Assume a Taxpayer (T) has used up all of his unified credit, has $2 million of assets remaining, and the transfer tax rate is 50%.

   Alternative 1: T makes a $1 million lifetime gift to daughter (D). D receives $1 million, there is $500,000 of transfer tax due from T, which T pays, and T still has $500,000 left.

   Alternative 2: T makes no lifetime gift, and dies with the $2 million. His will leaves his property to D. T's estate tax liability is $1 million, leaving $1 million for D.

In Alternative 1, D got $1 million, the taxes were paid, and $500,000 remained available to T possibly for further gifting to D.

In Alternative 2, D got $ 1 million, the taxes were paid, and nothing was left. Even if we assume that the $500,000 remaining available in Alternative I will be taxed at T's death (not a necessary assumption given annual gift tax exclusions and other tax‑free transfer opportunities) D will receive $250,000 of that property and at the very least be better off by that amount when Alternatives I and 2 are compared.

The tax exclusive calculation used for gift transfers will always be more favorable than the tax inclusive estate tax calculation, except if a donor dies within three years of the date of the gift, since the gift tax paid within three years of death is included in the estate as an includable transfer made within three years of death.

 

Transfers Made Within Three Years of Death.

As a general rule, gifts made within three years of death (so-called "gifts in contemplation of death') are not included in the decedent's estate at their date of death value. The operation of the unified transfer tax system and the cumulative method of taxing transfers makes this rule unnecessary in most cases.

There are several situations, however, where transfers made within three years of death are brought into the estate at their date of death value. Where these rules apply, the motive of the transferor is irrelevant. The three year rule is applied mechanically.

The most notable exception to the general rule here involves the transfer of life insurance policies on a decedent's life. Such a transfer within three years of the decedent's death results in the full amount of the policy proceeds being included in the decedent's estate. Code Section 2035. As indicated in the previous section, payments of gift tax within three years of death are brought back into a decedent's date of death calculations. Where a decedent has transferred property while retaining some rights to control or enjoy the transferred property and then releases those retained rights or interests within three years of death, the value of the retained interests is included in the decedent's taxable estate.

 

Income Tax Basis Rules - Lifetime Gifts.

When a donor makes a gift during lifetime to a donee, the donee takes an income tax basis in the gifted property equal to the donor's basis in that property, increased by the amount of any gift tax that was actually paid. This is called a "carryover basis" Code Section 1015.

 

Income Tax Basis Rules - Property Received from a Decedent.

When a person receives property from a decedent, the recipient's basis in the property received is equal to the fair market value of the property as reported by the decedent's estate (either the date of death value of such property, or the alternate valuation date value, if the alternate date is properly elected on the decedent's federal estate tax return (Form 706)). This is called a "stepped-up" or "stepped-down" basis. Code Section 1014. Where this rule applies, the decedent's own cost basis in the property becomes irrelevant.

No stepped-up basis is available for property which was transferred to the decedent within one year of the decedent's death and returned to the transferor as the result of the decedent's death. Code Section 1014(e).

No stepped-up basis is available for items which are classified as items of "income in respect of a decedent" (see the discussion below).

 

Income in Respect of a Decedent.

Income in respect of a decedent (IRD) refers to those items of income that a decedent earned, but did not receive prior to his or her death. Examples include accumulated retirement plan benefits, IRAs, accrued salary, balances due of installment payments, and certain interest and dividend payments. Since a decedent had a claim of right to these items at the time of death, IRD items are included in the decedent's estate at their present value at the time of the decedent's death.

IRD items do not receive a stepped-up basis, despite their inclusion in a decedent's estate. However, the beneficiary of an IRD item is allowed to claim an income tax deduction for any estate tax paid on. such item by the decedent's estate.

 

Taxation of Jointly-Held Property.

The value of a decedent's interest in jointly-held property or property held as a tenant by the entirety is taxable at the decedent's death.

Where the joint owners of the property are husband and wife, one-half of the value of the jointly held property is included in the estate of the first joint tenant to die, regardless of which of them actually furnished the consideration. Code Section 2040(b).

Where the joint owners of the property are other than husband and wife, there is a rebuttable presumption that the entire value of the joint property is included in the estate of the first joint tenant to die, subject to the ability of the surviving joint tenant to prove his or her contribution to the cost of the property. Code Section 2040(a).

Since only one-half of the value of jointly held property is included in the estate of a decedent spouse, the surviving spouse receives a stepped-up basis in only one-half of such property.

 

Taxation of Powers of Appointment.

The value of property subject to a general power of appointment is taxable in the estate of the holder of the power. If the power was created on or before October 21, 1942, it must be exercised by the decedent to be included in the decedent's estate. If the power was created after October 21, 1942, it need only be possessed by the decedent at death, or exercised or released in a testamentary manner to require the property subject to the power to be included in the decedent's estate. Code Section 2041 (a).

The term "general power of appointment" refers to a power which is exercisable in favor of the decedent, his estate, his creditors and the creditors of his estate. Code Section 2041 (b)(1). This may be contrasted with a "limited" or "special" power of appointment which may be exercised in favor of any one else without being included in the decedent's estate.

A power to consume, invade or appropriate property for the benefit of a decedent which is limited by an "ascertainable standard" relating to the health, education, support, or maintenance of the decedent is not deemed to be a general power of appointment. Code Section 204 1 (b)(1)(A). The technique of limiting a transfer by an ascertainable standard is often used in estate planning documents to give a trust beneficiary a generous benefit in the trust property, while not requiring the inclusion of the value of such property in the beneficiary's estate

 

Taxation of Life Insurance Proceeds

The proceeds of a policy of life insurance that insures the decedent's life is included in the decedent's estate in two circumstances.

    a. The policy is payable to the decedent's estate, or otherwise to the decedent's executor for use in connection with the decedent's estate. Code Section 2042(a).

    b. The decedent retained an "incident of ownership" in the life insurance policy, i.e. a right to designate a beneficiary, borrow against the cash value of the policy, pledge the policy as collateral for a loan, etc. Code Section 2042(b).

The transfer of ownership of a life insurance policy to another person, or to an irrevocable trust in which the transferor‑decedent held no incidents of ownership removes the life insurance proceeds from a decedent's estate, even if the decedent continued to pay the life insurance premiums prior to death; provided, however, that such a transfer was made at least three years prior to the death of the decedent. (See the discussion in "Transfers Made w/in 3 yrs.", above).

If a life insurance policy is taken out on the life of the decedent by another party, including the trustee of an irrevocable trust, and if the decedent never possessed any incident of ownership in the policy, the proceeds of the policy are excluded from the decedent's estate even if the decedent dies within three years of the inception of the policy.

As a general rule, death benefits under a life insurance policy are received free of federal income tax. Code Section 101. However, there is an important exception to this rule known as the "transfer for value" rule. If a life insurance policy is transferred for valuable consideration, the excess of the amount of policy proceeds received by the new policy owner over the amount paid to acquire the policy is taxable income to the new owner.

Several important exceptions apply to this rule. If a transfer is within one of the exceptions, it is exempt from the transfer for value rule. The exempt transfers include: transfers to the insured; to a partner of the insured; to a partnership in which the insured is a partner; to a corporation in which the insured is a stockholder or officer. Note that a transfer between stockholders is not an exempt transfer. Accordingly, Us rule may be a problem in dealing with transfers of life insurance policies which are held to Rind buy‑sell agreements among corporate shareholders.

 

Taxation of Retirement Plan Benefits, IRAs and Annuities.

As a general rule, the value of all qualified retirement plan benefits, IRA accounts (including traditional IRAs and Roth IRAs) and annuities in which a decedent had an interest at death, and which are payable to a surviving beneficiary, are included in the decedent's estate. Code Section 2039.

In addition to the federal estate tax consequences of these assets, they are (with the important exception of the Roth IRA) also subject to income taxation in the hands of the recipient, since they constitute income in respect of a decedent. See paragraph 15, above. As such, they may also be eligible for a deduction on the recipient's income tax return based on the estate tax paid as the result of the inclusion of such items in the decedent's estate.

It may be said that these items, at the highest tax brackets (and ignoring the impact of state death taxes and state income taxes) are taxable at the net tax rate of approximately 73%. (Assume a 55% death tax rate and a 40% income tax rate (95%) offset by an IRD income tax deduction of 40% of the 55% tax paid, or 22%, leading to the net effective tax rate of 73% (95% minus 22% equals 73%)).

 

Community Property.

Community property is property acquired by married individuals who reside in a community property state. Each spouse is deemed to own an undivided one-half interest 'in the community property, regardless of who earned it or provided the consideration for it. Where a spouse acquires property during the marriage by gift or inheritance from a third party, such property is not deemed community property.

The income tax basis rules applicable to community property acquired from a decedent are more generous than the rules relating to jointly held property (See paragraph 16, above). At the death of the first spouse to die, the income tax basis stepped-up for both halves of community property. Accordingly, the surviving spouse receives a new cost basis for his or her own half of the community property (as well as for the half acquired from the decedent) when the other spouse dies. Code Section 1014(b)(6).

At the present time, there are nine community property states, namely: Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington and Wisconsin. There are very substantial differences among these states with respect to the technical aspects of each of their community property laws.

 

Taxation of Lifetime Transfers.

Certain transfers made by the decedent during lifetime are considered "testamentary" in nature, and are brought back into the decedent's federal estate tax calculation at their date of death (rather than date of transfer) values. These transfers typically, but not necessarily, involve transfers to trusts. The lifetime transfers subject to this rule include the following:

    a. Certain transfers made by the decedent within three years of death. Code Section 2035. See the discussion in paragraph 12, above.

    b. Transfers made whereby the decedent retained the right to income from the transferred property, or the right to possess or enjoy such property until the time of the decedent's death. Code Section 2036.

    c. Transfers made which take effect at the time of the donor's death in which the donor retained a reversionary interest. Code Section 2037.

    d. Transfers made whereby the donor retained the right to alter, amend, revoke or terminate the transfer. Code Section 2038.

The Qualified Family-Owned Business Interest Deduction.

A decedent's interest in a family-owned business may qualify for the Qualified Family-Owned Business Interest Deduction (QFOBI) of $675,000 and an applicable exclusion amount of $625,000, regardless of the year in which the decedent dies. If the estate includes less than $675,000 of QFOBI's, the applicable exclusion amount is increased on a dollar for dollar basis, but only up to the applicable exclusion amount available for the year of death. Code Section 2057(a).

Accordingly, the maximum combined effect of the QFOBI deduction and the applicable exclusion is $1.3 million in any given year. Since the applicable exclusion is being phased in through 2006 (when it reaches $1 million) the use of the QFOBI deduction has diminished utility in the coming years when considered in combination with the applicable exclusion. While the QFOBI deduction will be fixed at $675,000, the percentage of the applicable exclusion amount utilized by a decedent's estate taking full advantage of the QFOBI deduction may actually decline.

There are many technical requirements to be satisfied to qualify for this deduction. The major requirements include the following:

    a. The business interest must be transferred at death by a decedent who was a United States citizen or resident at death.

    b. The value of the decedent's interest in the family‑owned business must exceed 50% of the value of the decedent's adjusted gross estate (this figure may be adjusted by including gifts made by the decedent to family members other than the surviving spouse).

    c. The business interest must pass to one or more "qualified heirs" (i.e. family members of the decedent or an employee of the business for at least ten years).

    d. The decedent and/or family members must have "materially participated" in the operation of the business for a period aggregating five of the eight years prior to the decedent's death. In addition, the qualified heirs and/or the qualified heir's family must own and manage the business for ten years subsequent to the decedent's death.

      e. If the business is disposed of within ten years of the decedent's death,, other than to a family member of a qualified heir, the tax savings are recaptured. When recapture applies, the amount is 100% if the recapture event occurs within six years of the decedent's death, which percentage is reduced by 20% each year thereafter, until after the tenth year, when there is no recapture. Code Section 2057(f)(2)(B). Interest incurred on recapture is payable from the date of death.

 

The Charitable Deduction.

A decedent's transfer tax liability may be reduced by making transfers to qualified charitable organizations. The transfer tax deduction for charitable transfers is unlimited. Code Sections 2055 and 2522.

Gifts to charity may be made as outright transfers. They may also take the form of a Charitable Remainder Trust whereby a transfer is made to a trust that reserves a payout (in the form of an annuity trust or a unitrust) to the trust grantor, the grantor's spouse, or some other individual beneficiary for the lifetime of the beneficiary or for a fixed term not in excess of twenty years. At the expiration of the designated term, the trust property passes to one or more charitable beneficiaries designated by the trust grantor or selected by the trustees. A charitable deduction is available for the value of the property transferred to the trust, less the actuarially calculated value of the reserved payout interest.

Charitable gifts may also be made in the form of a charitable lead trust. In such a trust, payments are made to one or more charitable beneficiaries for a designated term of years, or for the life or lives of designated individuals, with the trust property being distributed to one or more individuals (usually family members of the trust grantor) after the expiration of the charitable term. If created by the will of a decedent, such a trust generates an estate tax deduction based on the value of the interest passing to charity, and enables the balance of the trust property to pass to selected heirs in the future.

 

The Generation-Skipping Transfer Tax.

The Generation-Skipping Transfer tax ("GST tax') is imposed on all transfers made either during lifetime or at death that are made either in trust or outright, to a person two or more generations younger than the transferor. Such a person is referred to as a "skip person". Code Sections 2601, 2611, 2613. The GST tax is imposed at the highest rate of transfer tax, currently 55%, and is imposed in addition to the regular gift tax or estate tax that may be due on a given transfer of property. Code Section 2641.

The GST tax is imposed upon the occurrence of one of three possible generation-skipping events.

    a. Direct skip. This refers to a transfer subject to estate or gift tax of an interest in property to a skip person or a transfer to a trust whose only beneficiaries are skip persons. Code Section 2612(c). The GST tax is paid by the transferor or the estate. The taxable amount does not include the amount of the GST tax.

Example: A transfer of property directly from a grandparent to a grandchild or the creation of an irrevocable trust by a grandparent solely for the benefit of the grandchild.

    b. Taxable Distribution. This refers to a distribution of income or principal to a skip person from a trust which distribution is not otherwise subject to estate or gift tax. Code Section 2612(b). Here, the GST tax is an obligation of the transferee. If the GST tax is paid by the trust, the payment is treated as an additional taxable distribution.

Example: A grantor establishes a trust permitting the " sprinkling" of income and/or principal to a child and a grandchild. From the grantor's perspective, the transfer to the trust is a potential gift tax event, depending on the available of annual and lifetime applicable exclusions to the grantor. Subsequently, the trustee makes a distribution of income to the grandchild. Although this distribution is not subject to estate or gift tax, the distribution is subject to the GST tax.

    c. Taxable Termination. This refers to a termination of a beneficiary's interest in a trust which results in all of the interests in the trust being held by beneficiaries two or more generations younger than the transferor of property to the trust. Code Section 2612(a). So long as one non-skip person holds an interest in the property, a taxable termination cannot occur. Here, the GST tax is paid by the trust.

Example: A trust is established by a grantor providing income for the life of a child remainder to a grandchild. Upon the child's death, there is a taxable termination if the grandchild is living and there are no other trust beneficiaries with a present interest in the trust who belong to a generation older than that of the grandchild.

The Code provides two areas of exemption from the GST tax.

    a. Transfers exempt from gift tax under the $ 10,000 annual exclusion of Code Section 2503 are also exempt from the GST tax. Code Section 2642(c)(1).

        (i) Outright transfers under this exemption are exempt from the GST tax.

        (ii) Transfers to trusts must satisfy additional requirements to qualify under this exemption. The trust must provide that during the lifetime of its beneficiary, no part of the trust income or principal may be distributed to or for the benefit of any person other than the beneficiary, and if the beneficiary dies before the trust is terminated, the trust assets must be includible in the beneficiary's estate. Code Section 2642(c)(2).

        (iii) In addition, the GST tax does not apply to any inter vivos transfer which would not be treated as a taxable gift ‑under Code Section 2503(e), relating to payments of tuition or medical expenses. Code Section 2611 (b).

   b. Every individual is allowed a GST tax exemption of $1 million (as adjusted annually for inflation - the exemption is $1,030,000 for 2000) which may be allocated irrevocably by such individual or his or her executor to any property with respect to which such individual is the transferor. Code Section 263 1. It is very important to actually allocate the generation‑skipping transfer tax exemption to the particular transfer of property for which the GST tax exemption is desired.

        (i) The "inclusion ratio" of a trust is the percentage of a trust that potentially is subject to GST tax, The ratio is equal to the excess of I over the "Applicable Fraction". The numerator of the fraction is the amount of the GST exemption being allocated to a particular transfer. The denominator is the value of the property transferred (less the sum of Federal or state death taxes recovered from the trust attributable to such property (if any) plus any Federal gift or estate tax charitable deduction allowed). Code Section 2642.

        (ii) A trust with an inclusion ratio of zero is completely exempt from GST tax.

        (iii) A trust with an inclusion ratio of one is completely subject to GST tax if a generation-skipping transfer occurs with regard to the trust.

 

 

PART TWO: THE TOOLS OF ESTATE PLANNING

 

The Unified Credit Shelter By-Pass Trust.

As indicated in "The Applicable Exclusion and Unified Credit" of Part One, every person has available the unified credit against transfer tax. In 2000 and 2001, the unified credit of $220,550 shelters $675,000 of property from transfer taxation. However, to benefit from this credit, it must actually be used, and using it requires some affirmative planning.

If all of a decedent's property passes to a surviving spouse, there will not be any death tax as the result of the unlimited marital deduction, but the opportunity to use the unified credit at the first death of the spouses will be lost. The credit will only be used at the second death, resulting in property valued at $675,000 passing tax free to heirs - while that number could have been $1,350,000 with better planning.

For an individual to fully utilize the unified credit, the individual must generally have property equal to the annual exclusion amount (currently $675,000) titled in his or her own name. Jointly-held property, as well as life insurance proceeds and retirement plan benefits payable to a surviving spouse, pass directly to such spouse, resulting in the unified credit not being used. A will leaving everything to the surviving spouse has the same result.

Properly utilizing the unified credit requires a two-step process. First, title property in the separate names of the spouses. If necessary, remove a residence from joint ownership and place it in a tenancy in common (A good feature of community property states is that the automatic division of property into undivided equal shares for each spouse solves this problem). Second, create an arrangement as part of the estate plan that deals with the unified credit portion of the decedent's property.

The plan most commonly used is the unified credit shelter trust. At the decedent's death, the assets are divided into two portions: (a) An amount equal to what can be protected by the unified credit is used to fund a unified credit shelter trust, and (b) The balance of the decedent's assets are used to fund the marital deduction for the surviving spouse.

The unified credit shelter trust typically provided that all income from the trust will be paid to the surviving spouse, along with such principal as the trustee may determine, using discretion pursuant to an ascertainable standard. At the surviving spouse's death, the trust property is typically paid to the children of the couple. Thus the amount used to fund the credit shelter trust can benefit the surviving spouse while living, but is not included in such spouse's estate at death thereby bypassing the estate of the second spouse to die. That spouse's estate uses his or her own unified credit at death, resulting in the optimal use of the unified credit by each spouse over two deaths.

The "typical" trust method of distribution is not the only possible plan here. A "sprinkling" trust could be used, where the spouse along with other beneficiaries could all be named as permissible beneficiaries, and be paid the income and/or principal of the trust. Another alternative could exclude the spouse as a beneficiary of a trust completely, and leave the trust property available only for children or others. Still another variation would be to leave the unified credit amount outright to beneficiaries other than the spouse. The point is that using the unified credit at the first death, however it is actually allocated, is a positive estate planning tool, allowing more property to pass transfer tax free to one's ultimate heirs.

The unified credit may be used prior to one's death by making outright lifetime gifts to non-spousal beneficiaries, or by setting up an inter vivos trust to benefit the spouse as the (or a) life beneficiary as described above. An advantage of this technique is that not only will the unified credit be used, but post‑transfer appreciation on the gifted property will not be subject to transfer tax when the donor dies.

 

Retain Post-Death Control Over Property with a Marital Deduction OTIP Trust.

As indicated in "The Marital Deduction" of Part One, there are several different ways to leave assets to a surviving spouse that qualify for the marital deduction. All of these techniques will obtain the desired tax result, namely no tax on the property qualifying for the marital deduction at the death of the first decedent, and deferral of transfer tax on such property until the death of the second decedent.

However, planning sometimes reveals that one spouse has concerns about other's ability to manage property, and may further be concerned that the survivor will leave the property ultimately in a manner that the first spouse would not have desired (such as disproportionately among children, to a new spouse or other third party, etc). Of the available marital deduction techniques, the outright gift assumes that the survivor is able to deal appropriately with both management and control. I this is the case, then the outright gift is certainly the simplest construction.

If management is a concern, but ultimate control is not, the general power o appointment trust may serve the client's needs. The trust format will deal with th issues of management of property, while giving the surviving spouse unlimited discretion to leave the property as the survivor desires will place ultimate control in the hands of the survivor.

If both management and control are concerns, the QTIP trust becomes the preferred solution. While providing the lifetime benefit of all the trust income (and possibly trust principal, if desired) for the surviving spouse, the trust format deals with management issues, and the QTIP rules deal with control. Under these rules, it is the will (or trust directions) of the first spouse to die that controls the ultimate disposition of the trust property. Accordingly, the surviving spouse, while entitled t the lifetime enjoyment of the property, is not permitted to defeat the dispositive plan of the first decedent. Code Section 2056(b)(7).

 

Living Trusts.

A living trust is typically created as a lifetime transfer of property by the grantor to a trustee (often the grantor acting as trustee, sometimes to the grantor and another person acting as a co‑trustee, or to a third party acting as the sole trustee). The primary beneficiary of the trust is the grantor. There may or may not be other permissible beneficiaries while the grantor is living. The grantor generally reserves the right to revoke the trust. Upon the grantor's death, the trust becomes irrevocable, and typically contains the grantor's entire estate plan, creating interests for spouse and children, incorporating unified credit and marital deduction dispositions, etc.

A living trust may be considered a good idea in all cases where continuity of property management is an issue. The grantor creates this structure to manage his or property while able, and then has a successor in place (or a concurrently named co-trustee, if necessary) to handle management issues.

The greatest limitation of the living trust is the careful attention that must be paid to making certain that all of the decedent's assets are properly titled as owned within the living trust. Any asset in the decedent's own name will be a probate asset. Careful planning suggests having a will that "picks up" any property that was not titled in the name of the living trust, and "pours it over" into the trust.

Bear in mind that the living trust is not a income tax-saving vehicle and sometimes does not save State estate taxes. All of the trust income is taxed to the trust grantor, just as it would be absent the living trust, and all of the trust assets are included in the taxable estate of the grantor at death - just as they would be if no trust had been created. Since the trust is revocable, the grantor does not make a gift when assets are transferred to the trust.

Are living trusts preferable to the probate of assets under court supervision?  It may be and it may not be.  Consultation with your attorney is necessary.  Probate is often misunderstood and clients need to know the costs and benefits and should ask about them.  Courts are often not as bad as many believe and avoiding probate does solve the concerns of he trustee who has the duty to make distribution of the trust in some point of time.  If not done correctly - beneficiaries complain and litigation results.

 

Gift-Giving and the Crummey Power

As indicated above in paragraph 7 of Part One, annual gifts of up to $10,000 per donee may be excluded from transfer tax so long as the gift constitutes the transfer of a present interest in property. However, when a gift is determined to be of a future interest, the annual exclusion is not available, and the gift is entirely taxable. To circumvent this problem in appropriate cases, the technique of the Crummey power was developed, based on the case of Crummey v. Commissioner, 397 F. 2d 82 (9th Cir. 1968); Rev. Rul. 73-405, 1973-2 CB 32 1.

The Crummey power refers to a currently available right of withdrawal that is included in a trust. Permitting a trust beneficiary to exercise this right of withdrawal creates the required present interest in the trust, permitting transfers to the trust which are subject to this right of withdrawal to be qualified for the present interest gift tax exclusion. The use of a Crummey power of withdrawal is central to trust planning for minor beneficiaries and for irrevocable life insurance trust planning, as discussed below.

 

Gift Planning for Children.

Parents and grandparents often desire to transfer property to their children and grandchildren. Transfers of assets to minor beneficiaries utilizing either the Uniform Gifts to Minors Act (UGMA) or the Uniform Transfers to Minors Act (UTMA) are the simplest method to accomplish such gifts. These transfers qualify for the present interest gift tax exclusion since the custodial property is vested in the minor and must be distributed to the minor by age 21 (or by age 18 in some jurisdictions). The UGMA/UTMA custodianship does contain certain restrictions on the property that can be transferred into, or the investments that may be held by such an arrangement. Greater investment and management flexibility exists if a trust is used.

One such specially approved trust is the Code Section 2503(c) trust. This trust provides that if all of its requirements are satisfied, transfers to it will qualify for the present interest gift tax annual exclusion, notwithstanding the fact that property is transferred to the trust and held in it until the trust beneficiary attains age 21. The core requirements of this trust are: (a) principal and income must be available for distribution to a single beneficiary while the donee is under age 2 1; (b) if the donee survives to age 21, all accumulated income and principal must be distributed to the donee upon attaining age 21, and (c) if the donee dies before age 21, all income and principal must be paid either to the donee's estate or to the donee's appointees pursuant to a general power of appointment.

The most significant drawback to the Section 2503(c) trust is the requirement that the property must be distributed at age 21. The IRS has ruled that if the beneficiary is given the right to withdraw the property from the trust upon attaining age 21, and declines to do so, the property can remain in the trust without forfeiting its status as a trust qualified for the annual exclusion. Rev. Rul. 74-43, 1974-1 CB 285.

However,, since there is always the chance that the beneficiary will decide to withdraw the trust funds, the Section 2503(c) trust remains less than the ideal solution for many prospective donors, particularly those that wish to make rather significant gifts over a number of years.

Here, the Crummey Trust becomes a viable solution. The present interest in this trust exists by virtue of the annual right of withdrawal, not a required distribution at any particular age. A Crummey Trust could continue for the lifetime of a beneficiary. So long as annual additions were not being withdrawn, such additions would continue to be made. If the beneficiary exercised a right to withdraw an annual gift against the wishes of the donor, further gifts could be suspended. During the years that the beneficiary is a minor, the annual Crummey notice of contribution and right of withdrawal would be given to his or her guardians, presumably the parents of the donee.

Where a grandparent wishes to create a trust for a grandchild and make gifts to that trust, the generation-skipping transfer tax rules for annual exclusion gifts must be taken into account along with the gift tax annual exclusion rules. See the discussion in paragraph 24 of Part One. For annual exclusion gifts in trust to be exempt from the GST tax, the trust must be created for the benefit of a single skip person and must be vested in that single beneficiary for estate tax purposes. Code Section 2642(c)(2).

 

Life Insurance Planning Strategies.

As indicated in "Taxation of Life Insurance Proceeds" of Part One, the ownership of a life insurance policy by an insured will cause the proceeds of that policy to be included in the insured's estate. Accordingly, if husband owns a policy on his life, names wife the beneficiary and dies, the proceeds are in the husband's estate, but exempted from estate tax by the marital deduction. As a result, when the wife dies, any remaining portion of the insurance proceeds is part of the wife's estate. Having the wife own the policy does not solve this problem, since the wife's receipt of the proceeds at the husband's death would still result in the unexpended portion of the proceeds being subjected to death tax when the wife dies.

This problem may be solved by the use of an irrevocable life insurance trust (ILIT). Here, the life insurance policy is owned by the trust, not by either of the spouses. The insured may continue to pay the premiums on the policy, which premium payments are deemed gifts of future interests to the trust beneficiaries. The Crummey power should be used here to address and resolve this issue. Allowing the trust beneficiaries to withdraw the annual additions to the trust per the Crummey right of withdrawal creates the present interest in the trust, and allows the premium payments by the trust grantor to be viewed as gifts of present interests covered by the gift tax annual exclusion. The terms of the ILIT typically provide that when the insured dies, the policy proceeds are held by the trustee for the benefit of the surviving spouse, who is paid the trust income and who may be given trust principal in the discretion of the trustee pursuant to an ascertainable standard. The 'insured should not be a trustee of this trust.

When the surviving spouse dies, the trust proceeds are paid to children or other beneficiaries as determined by the dispositive provisions contained in die trust as decreed by the originally insured spouse who created the trust. Assuming there is no problem with the transfer within three years of death rule, the ILIT as described herein results in the policy proceeds being excluded from the insured's estate (at the time of death, the insured did not possess any incidents of ownership in the policy or rights in the trust) and also from the estate of the surviving spouse (who had only a life estate in the trust, did not have a general power of appointment, and no marital deduction election was required to exclude the property from estate taxation at the death of the first spouse to die).

The ILIT may be used for whole life and term insurance, for policies that were owned by the insured and transferred to the ILIT, or policies that were owned from inception by the trustee of the ILIT It may be used for group policies where the employer pays the premium.

The ILIT may provide an important source of liquidity when the surviving spouse dies. The technique to employ here is to have the trustee of the ILIT use the life insurance proceeds to purchase assets from the decedent's estate. This will place cash into the estate for payment of taxes and other debts and will move the family assets into die ILIT from which they can be distributed. This is a far more preferable procedure than having the proceeds of the policy coming into the MIT be made directly available to the estate. This could cause the IRS to conclude that the policy proceeds were payable to the decedent's estate, and cause an inclusion in that estate,, thus defeating the tax planning the MIT was designed to achieve.

Some taxpayers have sufficient wealth so as to not require life insurance proceeds to support or sustain a surviving spouse at the first spouse's death. However, such taxpayers may still have a need for substantial liquidity at the second death, if for no other reason than to pay the large death taxes that fall due at that time. Here, a second to die life insurance policy may be acquired to only pay off at the time of the second death. Such a policy should be held in an irrevocable trust of which neither spouse acts as the trustee. At the second death, the policy proceeds are collected and should pass free of any death tax to the trust beneficiaries.

Irrevocable trusts holding second to die life insurance policies are sometimes combined in an estate plan with significant gifts to charity. This arrangement is sometimes referred to as a "Wealth Replacement Trust". Here, the taxpayers leave a substantial portion of their estates (usually at the time of the second death) to a charitable beneficiary (either outright, or to a charitable remainder trust naming their children as the lifetime beneficiaries of such trust or to a charitable lead trust, naming their children as beneficiaries after the charitable interest expires). The effect of this charitable gift is to dramatically reduce the amount of tax due from the estate of the second spouse to die. However, since a substantial amount of property is passing to charity, this gift also reduces the inheritance available for children. To the extent that this causes the taxpayers concern, they use the proceeds of the second to die policy passing free of transfer tax to children as the means to "replace" the wealth that went to charity and not to the family. Keep in mind that if such a policy is large, the premiums will be costly, and there not may not be enough Crummey beneficiaries to treat all premium payments as tax-exempt gifts, resulting in taxable gifts that must be reported.

Life insurance also plays an important role in a number of other estate planning situations. It provides the currency to enable a business buy‑out to be handled smoothly. Funding an entity buy‑out or a cross purchase agreement among business owners with life insurance policies relieves some of the strain on business succession issues when one of the owners dies. Having life insurance proceeds available at the death of a person who had significant interests in IRA benefits allows the insurance proceeds to be used to pay the death tax on the value of the IRA, and allows the IRA beneficiaries to receive the MA interest intact (not reduced by death taxes) so that such beneficiaries can withdraw a far greater volume of funds from the IRA over their actuarial life expectancies (the so-called "Stretch

 

Planning with Disclaimers.

Some people die without having undertaken proper estate planning. Others are unable) despite their best efforts, to organize the ownership of their assets to achieve the optimal unified credit trust funding described in "The Unified Credit Shelter By-Pass Trust" of Part Two. Others find that despite their best efforts in planning, changed circumstances result in the plan not satisfying all of the needs and issues at the time of someone's death. A possible solution to all of these problems is the technique of the qualified disclaimer.

A qualified disclaimer permits a donee to in effect turn his or her back on a purported transfer of property, and instead allow it to pass to the next heir in the line of succession. If all of the necessary requirements for a proper disclaimer are observed, the disclaiming individual is never treated as having owned the disclaimed property and is not deemed to have made a gift to the ultimate recipient of the property.

An important consideration in deciding whether a disclaimer is appropriate is an analysis of the disclaimer "path". That is, where will the property go if a disclaimer is exercised. Without advance planning, a person may be faced with the decision of whether to accept property knowing it will generate a high tax liability, or disclaim it, knowing that it will pass outright to someone young and irresponsible. Alternatively, if the possibility of a disclaimer in the future is built into the estate plan when it is written, and a "disclaimer path" created that is sensible (such as having disclaimed property pass to a discretionary trust for the benefit of children which refrains from required outright distributions until an age of (supposed) maturity is reached) then the disclaimer alternative may be viewed more favorably.

In order to have a "qualified" disclaimer, it must be in writing and effected within nine months after the later of the creation of the interest to be disclaimed or the date that the disclaimant attains age 21. Note that an interest created by a will is created on the date of the decedent's death. The disclaimant may not direct where the disclaimed property goes. It must pass to the next beneficiary 'in line under the decedent's will or under the laws of intestacy. In order for the disclaimer to be effective, the disclaimant must not have accepted an interest in the disclaimed property or any of its benefits (i.e. no withdrawal of income, use of the property, etc.). Code Section 2518.

A disclaimer may be used to create a unified credit transfer when "too much" property passes outright to a surviving spouse, or protect an estate from taxation when the value of property passing to non-spousal beneficiaries exceeds the amount of the applicable exclusion, and the disclaimer results in the increase of the marital deduction. Disclaimers can be made of fractional interests in property or 'in specific items of property. A joint tenant in property may disclaim his or her survivorship interest in the joint property within nine months of the death of the deceased joint tenant. Reg. 25.2518-2(c)(3)-(5).

Valuation Discounts.

Recognizing and using valuation discounts is a key element in effective estate planning. Where family businesses and other closely-held business and investment enterprises are involved, valuation discounts are used to reduce the cost of transferring these assets.

Valuation begins with the general proposition that assets are to be valued at their "fair market value", typically a willing buyer/willing seller analysis. Reg. 20.203 1 - I (b). But it becomes quickly evident that aside from securities regularly traded on an established stock exchange, many assets are not easily valued (See the valuation criteria contained in Rev. Rul. 59-60, 1959-1, CB 237), thus opening the door for a valuation discount analysis.

Among the most important valuation discounts are those available for: a) minority interest, addressing the issue of lack of control over the business enterprise; b) lack of marketability, reflecting the fact that there is no ready market for shares 'in the business; c) key person, referring to the possible loss of a key element in the success of the enterprise; and d) built‑in capital gains discount, recognizing the existence of a capital gains tax liability.

The Internal Revenue Service has acknowledged that in determining the value of shares in a family-held business, family control would be disregarded, and each piece of the business interest would be viewed separately and distinctly, allowing a discount for minority interest and lack of marketability to be applicable. Rev. Rul. 93-12, 1993-1 CB 202. Recent case law has supported discounts in the range of 40% to 50% for minority interest and lack of marketability. Furman v. Commissioner,, 75 TCM 2206 (1998); Davis v. Commissioner, 110 TC 550 (1998); Simplot Estate v. Commissioner,, 112 TC 130 (1999).

 

Planning with Family Limited Partnerships.

A family limited partnership is an entity designed to allow a person to transfer valuable assets from his or her estate while at the same time maintaining control over those assets. There must be at least two partners in every partnership arrangement. In a limited partnership, there must be at least one general partner, and one or more limited partners. The general partner manages the partnership, is responsible for all partnership decisions, and is personally liable for all partnership debts and obligations. The limited partners share in the income, profits and losses of the partnership, without any right to participate in the management of the partnership, and without any personal responsibility for partnership debts. An Agreement of Limited Partnership memorializes these relationships and undertakings.

In the typical limited partnership case, both spouses create the limited partnership, naming themselves as both the general and limited partners. Each spouse may have a general partnership interest of 5% and a limited partnership interest of 45%. The spouses then obtain an accurate appraisal or evaluation of the property they desire to transfer to the partnership, and then proceed with that transfer. As a general rule, a transfer of property to a partnership in exchange for a partnership interest does not result in the recognition of gain or loss. Code Section 721 (a). The transferor's basis in the transferred property carries over to the partnership interest.

Caution: If marketable securities are transferred to the partnership resulting in the diversification of the transferor's portfolio, the transferor will be required to recognize gain or loss. Code Section 721 (b). Avoid this problem by having the transferors contribute an identical portfolio of securities to eliminate the diversification issue, or have one partner contribute marketable securities, while others either a) transfer assets (cash, real estate, etc.) which do not constitute marketable securities or b) receive a nominal interest (i.e. less than I %) in the partnership. PLR 9012024.

Once the partnership has been formed, the parents then begin giving away limited partnership interests to their children, using their available annual exclusion and/or unified credit gifting exemptions. In doing so, they should take advantage of the minority interest and lack of marketability discounts to leverage the amount of their gifting exclusions and increase the amount of the property actually transferred each year. See the discussion in paragraph 8 of Part Two, above. Over time, a substantial percentage interest of the partnership value will be transferred to the limited partners, with the parents retaining a decreasing amount of such interest and value, yet still remaining in control as long as they remain the general partners. If the family limited partnership is utilized in this manner, parents will be able to make substantial transfers of property to their children at discounted values with little or no actual tax cost, thereby removing not only the property itself, but also the future appreciation on such transferred property from their estates.

 

Planning with Limited Liability Companies.

A limited liability company (LLC) is an organization designed to offer the limited liability generally available through a corporation, with the pass through tax characteristics of a partnership. All 50 states have enacted laws authorizing LLC's, but the laws of these states are not uniform Planners must pay particular attention to how a state treats an LLC under its income tax laws, how states characterize a single owner LLC, as well as what would happen if an LLC does business in multiple jurisdictions, i.e. would different rules apply to the LLC in different states?

If these problems can be overcome, or if the LLC is able to operate exclusively within a single state the rules of which do not create any problems, then the LLC becomes another good planning vehicle. As in the case of the family limited partnership, control can be maintained, if desired, through management of the LLC exclusively by the parents, while percentage interests can be gifted to children using the same valuation discount opportunities discussed above in connection with the family limited partnership. Since the LLC is not required to have a general partner, no one has any personal liability for the debts of the LLC, unless a person agrees to assume responsibility for the LLC's obligations.

The members of the LLC will typically enter into an Operating Agreement to define their relationship and governing rules. The LLC may be managed by its members or by specially selected managers who are not necessarily members.

 

Estate Freezing Transactions: Installment Sales

The concept of a "freeze" transaction involves a transfer of property intended to remove an appreciating asset from a person's estate and replace it with an asset that will not appreciate further in value, thereby locking in or "freezing" the value f the transferred property.

An installment sale may be used to accomplish this result. A senior family member sells an asset to a junior family member presumably for fair market value to eliminate any gift tax issues) in exchange for a note to be paid over some period of time which bears a market rate of interest (the interest rate is needed to avoid a gift tax issue with respect to interest-free loans). The future appreciation of the transferred asset inures to the benefit of its new owner. If the transferor dies before the note is paid in full, the balance due on the note is an asset of the decedent estate. The seller thus retains the cash flow from the transferred asset no gift has been made, and the death tax value of the transferred property is "frozen" at the balance due on the note.

As installment payments are received, the seller will report ordinary income tax on the interest portion of each payment, and may have either basis recovery, capital gain or ordinary income on the balance of the payments, depending on the nature of the asset and its holding period. Rules relating to the recapture of depreciation (Code Section 1245) or to the sale of depreciable property between related taxpayers (Code Section 1239) may come into play to require characterization of sale proceeds as ordinary income.

The seller may elect to forgive the installment payments as they come due, utilizing the seller's gift tax exclusions in the process. The issue then becomes: was forgiveness of the debt the seller's intention from the outset of the transaction, in which case the IRS may attempt to recharacterize the transaction as a gift from its inception, and require a gift tax return reporting the entire value of the transfer‑red property. Rev. Rul 77-299. To avoid this result, there should not be a commitment to forgive the debt at the outset of the transaction, nor should there be a regular, predictable pattern of annual debt forgiveness. Have the debtor actually make some payments. If the seller wishes to make gifts, tie them to milestone events such as birthdays, anniversaries, etc.

 

Estate Freezes: The Self-Canceling Installment Note (SCIN).

The SCIN transaction takes the installment freeze a step further The SCIN involves the sale of property in exchange for an installment note calling for a specified number of fixed payments at a specified interest rate over a set period of time, but also provides that the payments terminate upon the death of the seller. The term of the note may not extend beyond the seller's actuarial life expectancy. Since death terminates the seller's right to receive payments, there is nothing of value to include in the seller‑decedent's estate. Clearly, this can be a significant estate tax benefit.

The presence of this termination feature of the SCIN raises gift tax concerns, as it appears that the value of the note may be less than the value of the transferred property. The gift tax issue is avoided by reflecting the self‑canceling feature as part of the bargained for consideration for the sale, by either placing a premium on the price to be paid for the property or by stating an interest rate substantially above the market rate.

The Tax Court has held that since the note, by its terms, is canceled by the noteholder's death, the value of the note is excluded from the decedent's estate. Estate of Moss v. Commissioner, 74 TC 1239 (1980); acq. 1981-1 CB 2; Cain v. Commissioner, 37 TC 185 (1961). If the buyer is a related person to the seller, the buyer should be cautioned against selling the property within two years of its purchase, since the amount realized by the related person on the second disposition is treated as a payment received at that time by the original seller, thus accelerating the gain to the original seller, and defeating the purpose of the SCIN. Code Section 453(e).

The termination of a SCIN does have potentially adverse income tax consequences. The unrealized or unreported installment sale gain (if there is any, depending upon the seller's tax basis in the property) must be reported in the year of death. The Tax Court held that the unrealized gain should be reported on the decedent's final federal income tax return, on the grounds that the installment obligation was canceled in the nature of a disposition of the obligation. The Eighth Circuit reversed the Tax Court and held that the gain should be reported on the fiduciary income tax return for die decedent's estate on the basis that the deferred gain was income in respect of a decedent transferred by the decedent's estate. Frane v. Commissioner, 98 TC 341 (1992); reversed 998 F. 2d 567 (8th Cir. 1993).

When considering the use of a SCIN, keep in mind that the use of a premium price or interest rate suggests that the seller should not be alive to actually receive the bargained for premium. In fact, the SCIN works best if the seller does not survive the term of the note. The sooner the seller dies after the property is transferred, the less the buyer must pay, and the greater the tax benefit realized. Accordingly, SCIN transactions are most often used for those persons whose actual life expectancy is expected to fall short of their actuarial life expectancy. Where death is imminent, the SCIN will not work,‑ as the IRS is allowed to disregard the actuarial tables is such circumstances. The actuarial tables must be used provided it can be shown that the seller has at least a 50% probability of surviving for more than one year from the date of the sale. Reg. 20.7520-3(b), even if the seller has a medical condition suggesting a true life expectancy less than the IRS tables.

 

Estate Freezes: The Private Annuity.

This is another planning transaction that works best where a transferor of property has an actual life expectancy shorter than his or her actuarially calculated life expectancy.

In the private annuity transaction, the transferor transfers ownership of property to a family member (the transferee) in exchange for the transferee's promise to make regular payments to the transferor for life. If the annual payments to the transferor are based exactly on the value of the transferred property and the transferor's actuarially determined life expectancy, no gift tax results from the transfer. Rev. Rul. 69‑74, 1969-1 CB 43. When the transferor dies, the value of the annuity is not included in the transferor's estate, since no payments continue to anyone after the annuitant's death. Code Section 2039. There is no note or other obligation to include in the transferor's estate.

If the annual annuity payments to the transferor are too low, the transferor will be deemed to have made a gift to the transferee, since the transferor will not be able to recover the full value of the transferred property, plus a required interest factor, within the transferor's actuarially calculated lifetime. The annuity payments to the transferor should not be derived directly from the transferred property. If they are, the IRS may recharacterize the transaction as a transfer with a retained life estate, and include the value of the business interest in the transferor's estate. Code Section 2036.

As the transferor receives payments during the annuity term, such payments are allocated among return of capital (basis recovery), capital gain and ordinary income (the interest element of the annuity payment) for federal income tax purposes. Code Section 72. The transferee does not receive an interest deduction for the interest portion of each payment. The transferee's basis in the transferred property is equal to the present value of the annuity, with each payment increasing the transferee's basis in the property. Rev. Rul. 55-119, 1955-1 CB 352.

Just as was the case with the SCIN, the shorter the life of the transferor, the greater the tax benefit to the transferor's estate. In the case of the SCIN, the buyer obtains a cost basis for the property immediately, while the transferee's basis in the private annuity awaits actual payments. However, the SCIN requires potential capital gain tax to be paid on the unrealized gain on the installment sale, while no income tax consequences are imposed on the termination of the private annuity arrangement.

 

Leveraging Transfer Tax Exemptions with Grantor Retained Interest Trusts.

The SCIN and private annuity transactions discussed above may not be appropriate for all taxpayers. Some may actually be healthy - and not prepared to bet on dying well before the expiration of their actuarially determined life expectancy. Others may be willing to transfer property, but still require an income stream from that property, or are unwilling to give up the opportunity for further control and the chance to grow the property value further. An ideal planning solution for persons fitting this profile is the creation of a grantor retained annuity trust (GRAT) or a grantor retained unitrust (GRUT).

The GRAT and GRUT are irrevocable trusts to which the trust grantor transfers property (a portfolio of stocks and bonds, investment real estate, or an interest in a closely‑held family business, including an S corporation, or a family limited partnership) while retaining the right to receive an annuity or unitrust interest, i.e. a fixed percentage return from the transferred property for a fixed term of years (a "qualified interest" within the meaning of Code Section 2702). When the term of years expires, the property passes to the designated remainder beneficiaries of the trust (presumably the children of the grantor).

A "qualified interest" includes any interest which consists of the right to receive either fixed amounts payable at least annually (the GRAT) or the right to receive annual payments of a fixed percentage of the fair market value of the trust property as determined annually (the GRUT). Code Section 2702(b).

The transfer tax advantage of GRATs and GRUTs lies in the ability of the grantor to transfer property to the remainder beneficiaries at a significantly reduced gift tax cost, since the actuarial value of the grantor's retained interest is subtracted from the value of the property placed in trust in order to determine the value of the transfer for gift tax purposes. The larger the retained interest (a function of the grantor's age, the duration of the trust, prevailing interest rates, and the selected fixed percentage retained payment) the smaller the taxable gift of the remainder interest.

GRATs and GRUTs are only effective to accomplish their intended transfer tax savings if the grantor survives the term of the trust. If the grantor fails to survive the term, then the grantor has retained an interest in the trust property at the time of the grantor's death, and the value of the trust property as of the date of the grantor's death is included in the grantor's estate. Code Sections 2036 and 2039. This suggests that the grantor should be conservative in evaluating his or her life expectancy, or "hedge" by using a series of trusts of differing terms (such as 3, 5, 7,10, 12 and 15 years, if appropriate) so that at least some of the trusts so created are likely to achieve the desired results. Otherwise, the outcome of a failed GRAT or GRUT is to leave the grantor in the position as if no planning had been done.

If the grantor does survive the end of the trust term, the property has been removed from the grantor's estate at a reduced transfer tax cost (note that a transfer to a GRAT or GRUT is the gift of a future interest, ineligible for the present interest annual gift tax exclusion), and all of the post‑date of gift appreciation inures to the benefit of the trust beneficiaries (note that if a GRAT or GRUT "works", the grantor's tax basis carries over to the trust beneficiaries, while if the GRAT or GRUT is unsuccessful, and the property is included in the grantor's taxable estate, the trust beneficiaries receive a stepped‑up basis to date of death value). Code Sections 1014, 1015.

 

Leveraging the Transfer of a Personal Residence by Using a Qualified Personal Residence Trust.

Similar to the GRAT and GRUT transfers discussed above, a grantor's transfer of a property which has been used by the grantor as a personal residence (it need not be the grantor's principal residence) to a trust in which the grantor retains the right to use and occupy such residence for a fixed number of years, with the remainder interest to pass to children or other beneficiaries, offers significant gift tax and estate tax planning opportunities.

Where the grantor satisfies the criteria for the creation of a qualified personal residence trust (a "QPRT") as set forth in Reg. 25.2702-5(c), the grantor is able to transfer the full value of the residence, valued at the date of transfer, but only bears a transfer tax cost equal to the present value of the remainder interest. The present interest gift tax exclusion is not available for this transfer. The grantor is able to maintain control over the residence during the retained interest term, and is permitted to use and enjoy the residence during such time. Assuming that the grantor outlives the term of the trust, and the residence remains in the trust, the residence is removed from the grantor's estate, and all post‑transfer appreciation inures to the benefit of the remainder beneficiaries (who then take the grantor's basis in the residence). If the, trust grantor should die before the end of the trust term, the residence is included the grantor's estate at its fair market value at death, and the trust beneficiaries receive a stepped‑up income tax basis.

The QPRT may be written to provide the grantor with the opportunity to lease the residence from the remainder beneficiaries after the expiration of the trust term by paying a fair market value rental.

The governing instrument of a QPRT must prohibit commutation (prepayment) of the term holder's interest. Reg. 25.2702-5(c)(6).The governing instrument must further prohibit the trust from selling or transferring die residence, directly or indirectly, to the grantor, the grantor's spouse, or an entity controlled by the grantor or the grantor's spouse during the retained term interest of the trust, or at any time after the retained term interest that the trust is a grantor trust. Reg. 25.2702-5(c)(9). If possible, any outstanding mortgages on a personal residence should be paid off before transferring an ecumbered personal residence to a QPRT to avoid having a portion of each mortgage payment by the grantor be treated as an additional gift of a future interest to the remainder beneficiaries.

 

Planning-With Buy-Sell Agreements.

Business owners not planning to leave their business interests to their children or other heirs at death should give serious consideration to the creation and implementation of a buy-sell agreement. This is an agreement among the owners of a business (a cross-purchase agreement) or between the owners and the business entity itself ( a redemption or entity purchase agreement) to sell and purchase business interests at a price set by the agreement upon the occurrence of certain future events, such as death, disability or retirement.

The objectives of a buy-sell agreement include: a) restricting the sale or transfer of the ownership interest to undesired third parties; b) providing a readily available source of liquidity for the owner's family of an otherwise unmarketable asset; c) avoiding ownership disputes and encouraging a smooth transition in ownership and control; d) establishing the value of the business interest for federal estate tax purposes.

A number of important considerations arise in deciding what to say in a buysell agreement. Among the most important are: a) What event(s) will trigger the buysell agreement (death, disability, retirement, sale to a third party, walk out, divorce, insolvency)?; b) What. approach will the agreement take to determining value (periodic professional appraisals, an agreed upon value, a mechanical formula, book value or adjusted book value to account for fixed assets and off balance sheet items)?; c) How will the purchase price be paid (cash, installments, borrowed funds, life insurance or disability buy‑out insurance proceeds, etc.)?

Certain troublesome tax considerations may arise in the context of a buy-sell agreement, depending on the nature of the corporation 0 corporation or S corporation). If a C corporation entity buy-sell agreement is funded by life insurance proceeds, the receipt by the corporation of the life insurance proceeds may trigger a corporate alternative minimum tax liability. Code Section 56(g)(1)(A). An S corporation's agreement similarly funded by life insurance or a cross-purchase agreement among the S corporation owners would not give rise to this problem. Where an entity buy-out agreement is used, the surviving or remaining shareholders do not receive a basis step-up for the purchase price that is paid. Such a step-up is available when a cross purchase agreement is used. However, a cross purchase agreement involving multiple shareholders funded by life insurance may give rise to problems under the transfer for value rule if life insurance policies are transferred among the shareholders. Here, a partnership to hold and transfer the life insurance policies may be used to come within an exception to the transfer for value rule.

 

Planning in the Absence of a Buy-Sell Agreement - Code Section 303.

Where an interest in a business will be left to heirs, a buy-sell agreement may not be in place. When this is the case, the issue to be confronted is the question of liquidity. How will death taxes be paid if the business interest is not available to be sold as a way to fund the tax payment?

Congress enacted Code Section 303 as a relief provision to pen-nit the use of the decedent's interest in the stock of the closely held corporation to pay estate taxes. Code Section 303 treats as an exchange (and not as a dividend) a redemption of the decedent's stock so long as more than 35% of the decedent's adjusted gross estate consists of the stock of the closely-held corporation. The stock to be redeemed may be common or preferred, voting or non-voting Reg. 1.303-2(c)(1). Code Section 303 is available for both C and S corporations. Code Sections 1368(e); 1371(a)(1). If necessary, interests in several closely‑held businesses can be aggregated to meet the 35% test, so long as the decedent owned at least 20% or more of the value of the stock of each corporation for which aggregation is sought. Code Section 303(b)(2)(B). By treating this redemption as a sale, no capital gain or loss should be realized, since the seller's basis will be equal to the date of death value of the decedent's shares, the same price at which the stock will be purchased by the redeeming corporation.

If the threshold requirements of Section 303 are met, the redemption is treated as a distribution in full payment in exchange for the stock redeemed to the extent of a) The estate, inheritance, legacy and succession taxes (including interest thereon) imposed because of the decedent's death, and b) The amount of funeral and administration expenses allowable as deductions to the estate. Code Section 303(a)(1).

For Section 303 to apply, the interest of the shareholder whose stock is being redeemed must be reduced directly by payment of death taxes imposed because of the decedent's death, or by the funderal and administration expenses of the decedent. Code Section 303(b)(3). For example, a marital deduction gift will generally not be eligible for a Section 303 redemption, since the surviving spouse will generally not bear the burden of taxes or expenses.

If the need to effect a Section 303 redemption can be anticipated prior to the death of a business owner, consider combining several smaller enterprises with which the decedent may be involved to reach the required 35% threshold. Be careful of valuation discounts in these circumstances. Claiming aggressive discounts may lower the value of the business interest below the 35% threshold. Consider giving away non‑business interests before the decedent's death to increase the percentage representation of the business interests in the estate.

Planners desiring to use Section 303 must also be wary of an unintended dilution of the family business interest. Where a single family controls 100% of a business interest, this will not be a problem. However, if two families each own 50% of the stock of a business, any redemption of the voting stock will create a loss of control situation for the redeeming family. This result should be prevented before any deaths necessitate resort to Section 303. The families should agree to create nonvoting stock through a simple tax-free reorganization. Both C and S corporations can create such stock. When a death occurs, the non‑voting stock should be tendered to accomplish the redemption. This will allow the decedent's family to receive the required Section 303 funds from the corporation without disturbing the balance of voting control.

 

Planning in the Absence of a Buy‑Sell Agreement: Code Section 6166.

Another relief provision enacted to help families owning closely-held businesses satisfy their estate tax liabilities without being forced to sell the business is Code Section 6166. Section 6166 is available if the decedent was a United States citizen or resident at the time of his or her death, and the value of the decedent's interest in a closely-held business exceeds 35% of the value of the decedent's adjusted gross estate. Code Section 6166(a)(1).

Where the threshold requirements of Section 6166 are met, the executor of the decedent's estate can elect to defer completely for five years the payment of the portion of the estate taxes attributable to the closely-held business interest, and thereafter pay the deferred portion of the estate taxes in up to ten annual installments. The estate tax attributable to the rest of the assets in the decedent's estate is due at the regular time, i.e. nine months from the decedent's date of death.

The election must be made no later than the time for filing the federal estate tax return, including extensions. It is generally in the form of a letter including appropriate tax calculations, and is attached to the federal estate tax return (Form 706) filed on behalf of the decedent. Reg. 20.6166-1(a). The Section 6166 election results in an extension of the statute of limitations on the assessment of deficiencies for the period of the extension of time granted for the payment of the tax. Code Section 6503(d). A special lien agreement may be signed by the executor of the estate designating a responsible person to deal with the IRS during the pendency of the installment payments. Such an agreement will generally persuade the IRS to forego requiring the filing of a surety bond. Code Sections 6165 and 6324A.

The benefits of Section 6166 are not limited to corporate interests. A proprietorship, a partnership (provided 20% or more of its capital is in the decedent's gross estate or if the partnership had fewer than 15 partners) and a corporation (if 20% or more of the value of its voting stock is in the decedent's gross estate or if the corporation had fewer than 15 shareholders) may each qualify as a closely‑held business interest. Code Section 6166(b)(1)(A) through (C). Passive business interests and passive business assets are not counted. Code Section 6166(b)(9). Multiple business interests in which the decedent had an interest may be aggregated to meet the 35% test, provided that 20% or more of each is included in the decedent's gross estate.

Interest is charged on the unpaid balance of the installments of tax that remain outstanding. The rate is 2% on the deferred tax attributable to the first $1 million in taxable value of a closely‑held business. The 2% and $1 million figures are to be indexed annually. For 2000, the 2% remains in place, with the $1 million now $1,030,000. Interest on the deferred tax in excess of the 2% portion is payable at a rate equal to 45% of the annual underpayment rate established under Code Section 662 1. Code Section 61660). The tax can be prepaid at any time without penalty. The interest payments made by the estate are not deductible as an estate administration expense for estate tax purposes, nor are they deductible for income tax purposes. Code Sections 2053(c)(1)(D); 163(k).

If certain prohibited events take place, the installment payments will be accelerated, causing the extension of time to pay the tax to be terminated, and all remaining payments to become due. Acceleration events include the failure to make a timely payment of a required installment (a payment is delinquent and acceleration imposed if it is more than 6 months late - a 5% per month (of the amount of the payment due) late payment penalty applies from the first month a payment is late). Another acceleration event is a distribution, sale, exchange or other disposition or a withdrawal of capital from an interest in a closely-held business that exceeds 50% of the value of that interest. Transfers to the beneficiaries of the decedent under wills and trusts are not prohibited by this rule. Code Sections 6166(g)(1)(A) and 6166(g)(1)(D). An exchange of like kind property is not an accelerating disposition. PLR 8304033.

Similar anticipatory planning applies in the context of Section 6166 just as it did with regard to Section 303, i.e. combine enterprises to reach the 35% threshold, be careful of aggressive valuation discounts, and make gifts of non-business property prior to the decedent's death. Once the election has been successfully made, be wary of an acceleration event. If the business interest is sold, it is likely that the buyer acquired more than 50% of the business, resulting in an acceleration event. If the buyer is paying on the installment basis, did the seller receive a sufficient down payment to cover the entire balance of the Section 6166 installment debt owed to the Internal Revenue Service? Hopefully so. If not, there is a serious problem for all involved with the estate, particularly the signatory of the special lien agreement.

 

 

Gene E. Schaefer