MEMORANDUM
FROM: Andrew H. Dohan, Esquire
RE: Death Tax Savings Ideas
DATE: August 6, 2004
Once an estate plan includes the proper utilization of each spouse’s tax-free unified credit amount (currently $1,500,000 each) as well as irrevocable life insurance trusts to own any life insurance policies, there is nothing further which we can do without you giving something up. In other words, it is simply now a question of how much you feel comfortable giving away and choosing the optimum gift vehicle to accomplish that. For death taxes, this amount is currently $1,500,000 and is on the slow track to increase to $3,500,000 before reverting back to $1,000,000 in 2011.
The simplest thing which you can do is for each of you to make gifts of $11,000 per year per recipient. You can do this with your children and anybody else for that matter. As you know, $11,000 per year per recipient is the amount which you can give away completely gift tax free. This amount is a calendar year limitation, and thus is renews every January 1. I would certainly recommend that you both make at least $11,000 per year gifts to each child.
An unlimited amount can be expended for the medical expenses or education expenses of the gift recipient provided that the payments are made directly to the medical or education provider. In addition, such payments do not count towards the $11,000 per year limitation so that other gifts can be made directly to the child. Tuition payments can also be paid in advance directly to the educational institution. This theory could also be extended to the creation of a trust to pay children and grandchildren education expenses provided that the purposes of the trust were limited solely to making qualifying medical or tuition payments directly to the service providers.
After the $11,000 per year per donee limit, there is a cumulative lifetime amount which each of you can give away. The lifetime gift limit is $1,000,000 even though the death limit is higher. Each of you could give away this amount now without incurring any gift tax. I would certainly recommend that you consider doing this. Even though there is an exemption available to your estate when you die if you have not used it up during your lifetime, it is more advisable to make gifts during your lifetime than it is to do them through your Will when utilizing this exemption amount. The reason for this is that the sooner you give away the cumulative exemption amount, the more income and appreciation will be earned on that property which will also be out of your estate. For example, if three years ago you had given away $1,000,000 each to the children, then with appreciation even more would be out of your estate. In this way, for the price of $1 million per child, you would have effectively reduced your balance sheet by considerably more than if you had made no gift.
These first two ideas are relatively simple and straightforward, and once we get beyond those, we start increasing in complexity. We could, for example, create a family limited partnership with the two of you as the partners and you could gift property into the partnership (such as your real estate or stocks and mutual funds). (Although the transfer of Pennsylvania real estate to such a partnership would incur realty transfer taxes.) The partnership agreement would contain resale-type restrictions on it which would have the effect of reducing the saleability of any partnership interest which you may give away. Usually, we can take a 30% reduction for the lack of marketability and the minority interest involved. Thus, we could give away $1,428,571 for each of you which after the 30% discount, would effectively equal the amount of your $1,000,000 exemption amount and thus would incur no gift tax. The two of you should not be in control of the partnership.
With a charitable remainder trust, property is transferred to a trust and you may reserve a specific dollar or percentage annuity for either or both of you for the balance of your lifetimes. When both of you have passed away, the remaining trust corpus will be paid over to charities which you may specify in the trust document. It qualifies you for a charitable contribution deduction on your income tax return for the year in which property is transferred to the trust. Any property sold by the trust does not incur any capital gain taxes. This is the major advantage of this type of trust. It allows nonproductive or underproductive property to be transferred to the trust, have the trustee sell that property, and reinvest it in higher yielding investments with that enhanced income stream being payable to the two of you for the balance of your lifetimes without the value of the underlying principal being diminished by capital gain taxes. Any distributions from the trust, generally, will be taxable income to you. A family member can be a Trustee and receive reasonable management fees for his services. The obvious disadvantage of this type of trust is that when both of you have passed away, the remaining property is paid to charities and not to the children. However, what is often done is to utilize the enhanced cash flow from the reinvested sale proceeds in part to purchase a life insurance policy. This policy is designed to replace, at least in part, some of the principal value which will be paid to charity. The policy would be owned by either the children or an irrevocable life insurance trust and in either event, the children would receive the economic advantage of it. The life insurance, if owned by the children or an irrevocable trust, would not become an additional taxable asset in your estate.
Another gift giving concept is known as a grantor retained annuity trust (or GRAT for short). Under this type of trust, property is transferred to a trust and the right to receive a specific dollar amount or a specific percentage each year for a limited and specified number of years for either or both of you can be reserved. If you die before that specified term is up, essentially the trust corpus will be a taxable asset in your estate (or at least a major portion of it). If you die after the term is over, then all of the trust corpus is out of your estate, but you also are not receiving the annual income. For example, you could set up a trust and fund it with $1 million in cash and securities and reserve the right to receive $50,000 a year for 10 years. This 10-year annuity has a value which is subtracted from the $1 million to come up with the value of the taxable gift being made to the trust. If you died before the 10 years were up, the trust would, to a large extent, be taxable in your estate. If you live beyond the 10 years, then the trust would not be taxable in your estate. GRATs work well in low interest rate environments.
Another type of trust involves the same general concept as a GRAT except that you place your personal residence into the trust reserving the right to live there for a specified number of years. If you die before that term has expired, then the trust corpus will be taxable in your estate; and if you live beyond the trust term, then it is completely out of your estate. The trust can be drafted so that you have the right to lease it after the term has expired at a full fair market rental. In this type of trust as well as in the GRAT, the trust beneficiary after the two of you can be the children or anyone else for that matter.
Another concept to consider is making a gift which exceeds both your annual $11,000 exemption amount as well as your $1,000,000 lifetime gift exemption amount so that you end up in a taxable gift situation. The reason why this is advantageous is that the gift tax which is imposed on that taxable excess must be paid by you rather than the gift recipient. This tax payment reduces your taxable balance sheet over and above the amount of the gift. Thus, there is even less left for the government to tax when you pass away.
If you are inclined to leave money to a charity and you also have an IRA or other qualified plan such as a profit sharing plan, then it is better to name the charity as a direct beneficiary of those qualified plan funds. The reason for this is that normally, these funds are subject to both death taxes in your estate as well as income taxes on the recipient when paid out. Thus, if you were to pass away and a beneficiary received a distribution from an IRA, then that distribution would be taxable income to the recipient beneficiary. In addition, the beneficiary would have had to have come up with the death tax payment from other funds. Often times, the net after all of the taxes is anywhere from 15¢ to 25¢ on the dollar. By making a charity the beneficiary of these plans, all of these taxes are avoided. It is as if the government were subsidizing a large percentage of your charitable gift.
Alternatively, an IRA could have as its beneficiary a charitable remainder trust. This trust could provide an income benefit to either a spouse or to children for their respective lifetimes. When the income beneficiaries were deceased, then the remaining trust corpus is paid to one or more charities. The advantages of such a trust are that the payment from the IRA to the trust does not incur any income tax, and therefore, the entire principal amount can be reinvested for enhanced income to pay an annuity to spouse or children. One disadvantage is that the remaining trust corpus must be paid to a charity when everyone is deceased. A second disadvantage is that the actuarial value of any annuity payment to a child will be taxable from a death tax standpoint, but at a lesser amount based upon the actuarial value of the life annuity to the child rather than the full value of the IRA.
In addition to gifting, there are a number of “sale of assets” strategies which can be used not so much for the elimination of taxable value, but for freezing the taxable value at current levels. One such vehicle is a SCIN. A SCIN is a self-canceling installment note. With this strategy, assets are sold to children, a partnership, or a trust. Installment payments are made for the a term certain except that, upon the seller’s death, no further installments will be owed. Because of the benefit factor of a premature death, an enhanced principal amount or an enhanced interest rate is necessary to compensate for the financial advantage to the buyer from an early termination of the installments.
A concept designed to freeze the value of an asset in the taxable estate is to sell assets to a “grantor trust”. Grantor trusts are designed to escape taxation in the estate but to have any current taxable income of the trust taxed to the grantor/seller. Since the sale is essentially a sale to one’s self, any gain is not recognized. It is, in essence, a substitution of a note for an asset, but with nobody being required to pay the capital gains tax. The interest rate on the note must be at least the applicable federal rate (and not the 120% of the applicable midterm rate). The one disadvantage is that, if the grantor trust status terminates while the note still has an outstanding balance, then the gain will be recognized at that time. The law is currently unclear as to whether or not the death of the grantor/seller causes such a termination thus resulting in accelerated capital gain on the grantor/seller’s final income tax return.
Once you have had the opportunity to ponder these general comments, please let me know which ones you would like to explore in greater detail. We should set up a meeting to flesh them out further if you have any interest.
