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- Estate Planning Basics
- Fundamental questions
- Will or living trust?
- Other facts about estate settlement
- Determining potential estate taxes
- Estate Tax Saving Strategies
- The marital deduction
- Life Insurance
- Annual gifting
- Charitable contributions
- Strategies for family-owned businesses
- Special strategies for special situations
- Community property issues
- Implementing and Updating Your Plan
- Where do you go from here?
- Estate planning worksheet
- Planning Levels Fee Schedule
Even with exemptions and insurance proceeds out of your estate, you still can have considerable estate tax exposure. One effective way to reduce it is to remove items from your estate before you die. Even with the pending estate tax repeal in 2010, this strategy makes sense — as long as you can make the gifts without incurring gift tax — because the estate tax might not actually be repealed, and even if it is, the tax will return in 2011 if there’s no further legislation.
Taking advantage of the annual gift tax exclusion is a great way to reduce your estate taxes while keeping your assets within your family. Each individual is entitled to give as much as $12,000 per year per recipient without any gift tax consequences or using any of his or her gift, estate or GST tax exemption amount. The exclusion will increase only in $1,000 increments, when warranted by inflation (and it just increased from $11,000 in 2005), so it will probably not increase again for a few more years. Case study III shows the dramatic impact of an annual gifting program.
- Case Study III
- The Early Bird Catches The Tax Savings
Five years ago, Mr. and Mrs. Brown had a combined estate of $5 million, which in 2006 would give them a federal estate tax exposure of $460,000, even if they took advantage of each of their $2 million exemptions. But Mr. and Mrs. Brown began a gift program, giving their combined annual exclusion amount ($22,000 in 2002, 2003, 2004, 2005 and $24,000 in 2006) to each of their two sons, two daughters-in-law and four grandchildren annually. This reduced their combined estates by $896,000 in five years, resulting in a combined estate tax exposure of $47,840 in 2006. That’s an estate tax savings of $412,160.
The savings may actually be even greater. If Mr. and Mrs. Brown had not made the annual gifts, those assets might have generated income or appreciated in value each year. This additional income and appreciation would have been includible in their estate. By making the gifts to their children and grandchildren, they passed on not only the $896,000 of assets free of tax, but also the future income and appreciation of those assets.
Make gifts without giving up control
To take advantage of the annual exclusion, the law requires that the donor give a present interest in the property to the recipient. This usually means the recipient must have complete access to the funds. But a parent or grandparent might find the prospect of giving complete control of a large sum to the average 15-year-old a little unsettling. Here are a few ways around that concern:
Take advantage of Crummey trusts.
Years ago, the Crummey family wanted to create trusts for their family members that would provide restrictions on access to the funds but still qualify for the annual gift tax exclusion. Language was inserted in the trust that allowed the beneficiaries a limited period of time in which to withdraw the funds that had been gifted into the trust. If they did not withdraw the funds during this period, the funds would remain tied up in the trust. This became known as a“Crummey” withdrawal power.
The court ruled that because the beneficiaries had a present ability to withdraw the funds, the gifts qualified for the annual gift tax exclusion. Because the funds weren’t actually withdrawn, the family accomplished its goal of restricting access to them.
The obvious risk: The beneficiary can withdraw the funds against the donor’s wishes. To protect against this, the donor may want to explain to the beneficiaries that they’re better off not withdrawing the funds, so the proceeds can pass tax free at his or her death. Your tax or legal advisor can counsel you about other ways of drafting the document to protect against withdrawals.
Establish trusts for minors. An excellent way to provide future benefits (such as college education funding) for a minor is to create a trust which provides that:
- The income and the principal of the trust be used for the benefit of the minor until the age of 21, and
- Any income and principal not used passes to the minor at 21 years of age.
A trust of this type qualifies for the annual gift tax exclusion even though the child has no current access to the funds. Therefore, a parent can make annual gifts into the trust while the child is a minor. The funds accumulate for the future benefit of the child, and the child doesn’t even have to be told about the trust. But one disadvantage is that the child must have access to the trust assets once he or she reaches age 21.
Leverage the annual exclusion by giving appreciating assets
Gifts don’t have to be in cash. Any asset qualifies. In fact, you will save the most in estate taxes by giving assets with the highest probability of future appreciation. Take a look at Chart 3. Cathy gave her daughter a municipal bond worth $12,000. During the next five years, the bond generated $550* of income annually but did not appreciate in value. After five years, Cathy had passed $14,750 of assets that would otherwise have been includible in her estate.
* This amount is hypothetical and is used for example only.
The power of giving away appreciating assets
|Municipal bond||Appreciating stock|
|Value of gift||$ 12,000||$ 12,000|
|Income and appreciation
|$ 2,750*||$ 7,000*|
|Total excluded from estate||$ 14,750||$ 19,000|
|By giving an appreciating asset, Cathy removes an extra $4,250 from her estate.|
|* These amounts are hypothetical and are used for example only.
Source: U.S. Internal Revenue Code
Suppose Cathy gave her daughter $12,000 in stock. If the stock generated no dividends during the next five years but appreciated in value by $7,000, Cathy would have given her daughter $19,000 of assets — and taken them out of her estate.
- Planning note
- Save The Most
You will save the most in estate taxes by giving assets with the highest probability of future appreciation.
Remember that a recipient usually takes over the donor’s basis in the property gifted. If a $12,000 gift cost the donor $8,000, the recipient takes over an $8,000 basis for income tax purposes. Therefore, if the asset is then sold by the recipient for $12,000, he or she has a $4,000 gain for capital gains tax purposes.
Consider whether “taxable” gifts make sense
The estate and gift tax system is a combined one. Taxable gifts are subject to the same progressive tax rate schedule as taxable estates, with one important exception: Under the 2001 tax act, the gift tax is never repealed — though in the year of the estate tax repeal (2010), the top gift tax rate will decrease another 10 percentage points to 35%. Taxable gifts equal to or less than the gift tax exemption amount made by an individual create no gift tax, just as assets in an estate equal to or less than the estate tax exemption amount create no estate tax.
But note that this is on a combined basis. In other words, if you make $200,000 of taxable gifts during your life, the amount of assets in your estate that will avoid estate taxes will be reduced by $200,000. You can use the exemption during life or at death, but not both.
When the estate and gift tax exemption increased to $1 million in 2002, those who had already used up their exemptions in earlier years had additional amounts to work with. The estate tax exemption then increased to $1.5 million for 2004 and 2005, and starting in 2006 it has increased to $2 million. In 2009, it's scheduled to go up again to $3.5 million, but the gift tax exemption will still remain at $1 million.
Because many assets appreciate in value and there is no guarantee the estate tax repeal will last beyond 2010 (or even that Congress won’t pass further legislation repealing the repeal or reducing the exemption increases), it may make sense to gift up to the exemption amount in 2006 if you haven’t already. (See Case study IV.)
Remember, each spouse is entitled to his or her own exemption. If a couple uses up their gift tax exemptions by making $2 million in taxable gifts in 2006 and after five years the assets have increased in value by 50%, they will have removed an additional $1 million from their taxable estates without having to use an additional portion of their exemptions.
Before the 2001 tax act, making taxable gifts even beyond the exemption made sense, but this is no longer the case in most situations. What did the benefit used to be? First, as with the gift in the previous scenario, future appreciation is removed from the estate. Second, gift tax is less expensive than estate tax. Gift tax is paid only on the amount of the transfer itself, while estate tax is paid on the amount of the transfer plus the amount of tax paid on the transfer. But now it doesn’t make sense to pay gift tax when the assets may be able to be transferred tax free at death.
- Case Study IV
- When “Taxable” Gifts Save Taxes
Let’s say John has an estate of $3 million (and thus has substantial estate tax exposure). In 2006 he has already given $12,000 for the year to each of his chosen beneficiaries and then gives away an additional $1 million of assets. Assume that, in the next five years, those assets will increase in value by 50%. John uses his $1 million gift tax exemption by making the taxable gift. Therefore, his estate can’t use that amount as an exemption. But by making the taxable gift, he also removes $500,000 of future appreciation from his estate within five years. This amount escapes the estate tax.
Leverage your tax-free gifts with an FLP
Family limited partnerships (FLPs) can be excellent tools for long-term estate planning, even in light of the 2001 tax act, because they can allow you to increase the amount of gifts you make. But they are controversial, so caution is needed when implementing them. (For more details, see below.) This type of partnership converts an estate plan into a family endeavor, allowing you to remain actively involved throughout your lifetime. FLPs are special because they may allow you to give assets to your children (and grandchildren) — at discounted values for gift tax purposes.
Here’s how it works: First you select the type of assets (such as cash, stocks, real estate) and the amount (based on the gift tax rules discussed earlier) and place them into the FLP. Next you give some or all of the limited partnership interests to your children and grandchildren.
The limited partnership interests give your family members ownership interests in the partnership, but no right to control its activities. Control remains with the small percentage (at least 1%) of partnership interests known as general partnership interests, of which you (and possibly others) retain ownership. The result is that you can reduce your taxable estate by giving away assets (the partnership interests), without giving up total control of the underlying assets and the income they produce.
Because the limited partners lack any control, these interests can often be valued at a discount. Recent court cases have given the IRS more ammunition to attack FLPs. Please seek professional advice about how this or any other legislation might affect the outcome when you create an FLP or make a gift of FLP interests. In any case, when making a gift of an FLP interest, obtaining a formal valuation by a professional business appraiser is essential to establish the value of the underlying assets and the amount of the discount, if any is permitted.