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Is your estate over $5 million? Planning tips and traps



In 2015, the lifetime gift and estate tax exemption will exceed $5.4 million per individual (over $10.8 million for a married couple). The effective estate and gift tax rate is currently 40 percent. Transfers to grandchildren and subsequent generations are also subject to the generation-skipping transfer tax (GSTT). The GSTT exemption and rate track the gift and estate tax exemption and rate. For individuals residing in one of the approximately 20 states that have "decoupled" from the federal estate tax and established distinct exemption amounts, planning presents additional challenges (and options) due to the divergent exemption amounts. For example, the exemption amount is $1 million in Massachusetts, Minnesota, Oregon and Maryland. In addition, a handful of states adhere to the federal exclusion amounts but pull gifts made within three years of death back into the taxable estate.

While the "permanency" of current exemption amounts and tax rates is subject to the vagaries of the political process, strategies exist to minimize future estate and gift taxes that can be deployed now by investors and business owners who have estates in excess of the threshold. This article explores tips and traps associated with ten estate planning strategies you may want to consider.

Strategy 1: Annual gifts

Tip: An individual may give $14,000 per donee each year without gift tax. Known as the "annual exclusion," the donor and his or her spouse can opt to "split gifts," which allows for gifts of $28,000 per donee, regardless of which spouse actually transfers the property. Gifts to trusts, including gifts of interests in closely held businesses, can qualify for the annual exclusion, but the transfers must be gifts of a "present interest." To ensure that the gifts qualify as present interests, gift trust documents require careful drafting. Gifts of business interests, especially if donors seek to take advantage of valuation discounts based on the lack of marketability and the illiquidity of the transferred asset, require a valuation in order to comply with the Internal Revenue Code's adequate disclosure rules.

Gifting can have the added benefit of avoiding state estate taxes since no state taxes gifts that qualify under the federal annual exclusion rules. Lifetime gifts remove the future income and appreciation on the gifted assets from the donor's estate.

Trap: Very few gifts to trusts qualify for the annual exemption from GSTT, and individuals frequently forget to account for this aspect of gift making. Typically, lifetime GSTT exemption amounts will be allocated to gifts to trusts on a gift tax return. Gifts to insurance trusts to be used to pay insurance premiums count toward the annual exclusion amount.

Strategy 2: Direct payment of tuition and medical expenses

Tip: Section 2503(e) allows donors to make unlimited payments for tuition and medical expenses on behalf of another person without being subject to gift tax on those payments, provided those payments are made directly to an education organization described in section 170(b)(1)(A)(ii) or paid for medical care as defined in section 213(d). The school may provide instruction at any level, allowing payments to primary schools through graduate schools to qualify. Pre-school tuition counts in certain circumstances and depends on the school and its curriculum. Expenses for books, room and board, and supplies do not qualify for this gift tax exemption, but payments for medical insurance do. Payments for dental care and psychiatric treatment qualify as well, although cosmetic dental procedures are excluded.

Trap: Gifts to section 529(b) plans do not qualify under section 2503(e) because the gift is not made directly to a provider. However, the rules do allow donors to section 529(b) plans to make a front-loaded gift, up to a five-year outlay, in one calendar year, thus affording the ability to make a $70,000 gift.

Strategy 3: Using a revocable trust

Tip: Many tax professionals recommend using revocable trusts as the centerpieces of well-conceived estate plans. Assets transferred to a revocable trust during life avoid probate at death. This has several advantages, including privacy and cost savings. In addition, the successor trustee, the person or entity named in the trust agreement to succeed the original trustee, is able to step in and maintain investment goals and comply with the trust's distribution provisions. Upon the settlor's death (the death of the person who created the trust), surviving beneficiaries – through the successor trustee – have immediate access to funds and are not limited by probate rules requiring claims periods and creditor notifications. The dispositive provisions of a trust provide instructions to the trustee on how trust assets should or should not be distributed to the beneficiaries. Provisions can be inserted to minimize income taxes and obtain valuation discounts on business interests. Equalization provisions can be inserted to balance trust shares distributed to descendants who may have different economic circumstances and goals, such as a child who is managing a family business and a child who prefers to inherit real estate or personal property. Trusts can permit certain beneficiaries to have current interests in the trust, and other beneficiaries to have future interests in the trust.

Trap: In order to avoid probate, the trust must be funded during the settlor's lifetime.

Strategy 4: Incapacity planning

Tip: While working on funding and designing your revocable trust, be sure to plan for incapacity. If a revocable trust holds business assets and the settlor of the revocable trust becomes disabled, the successor trustee could then step in, manage the business assets, and use the trust funds to pay for the settlor's care as well as the maintenance and support of any dependents.

Trap: If business assets are held outside of a trust, a power of attorney for property should be executed that makes specific provision for the management of business assets by empowering an agent to run your business if you become incapacitated.

Strategy 5: Marital planning with trusts, portability and disclaimers

Tip: Estate planning documents drafted prior to 2011 should be reworked to account for "portability" as well as the higher exemption amounts. Portability is the ability of the first deceased spouse to transfer his or her unused exemption amount (DSUE) to his or her surviving spouse. One complexity of estate planning in 2014 is deciding how to make optimal use of portability. The primary advantages of portability are simplicity and the ability of the surviving spouse's estate to get a second basis step-up on estate assets. In considering how and whether to use portability, there are a number of factors to consider, including the surviving spouse's age and life expectancy, the classes and location of assets, whether assets will likely be sold by the surviving spouse or held long-term, state estate taxes, the family's comfort with trust planning, and the income tax brackets of the spouse's heirs. Another approach involves blending trust planning with outright spousal bequests. One such example is planning that transfers all assets to the surviving spouse but then has the survivor use some or all of the DSUE to make gifts to children and grandchildren, typically in trust.

Trap: Married couples residing in a state with a separate estate tax should consider using a by-pass trust or a disclaimer trust to create a trust at the first death, using the amount that can be excluded from state estate taxes to fund the trust, thereby ensuring that the state exemption amount of the first spouse to die is not lost. Other married couples may prefer a structure where outright transfers of the personal residence and retirement plan assets are made to the survivor in combination with a two-trust plan that (1) funds a by-pass trust with the amount necessary to eliminate all estate taxes on the first death, and (2) funds a marital trust with the balance of assets.

Strategy 6: Grantor retained annuity trust (GRAT)

Tip: A GRAT is an effective planning option for "freezing" the value of an estate asset at its current present value, while ensuring that further appreciation of the asset inures to the benefit of one's heirs. With a GRAT, the grantor (i.e., the donor) transfers property to a trust in exchange for a specified annuity payment back to the grantor for a specified term of years. Under Reg. section 25.2702-3, the annuity amount can be a stated dollar amount or a fixed fractional percentage of the initial fair market value of the trust. The annuity can be increased year to year (up to 20 percent over the prior year), which can permit the GRAT to have a longer term. At the end of the term, the remaining trust balance flows to stated beneficiaries (or into a trust for their benefit). The grantor allocates a portion of his or her lifetime exclusion amount to cover the actuarial remainder value of the gift. (A transfer to a GRAT does not qualify as an annual exclusion gift.) The lengths of the trust term, the size of the annuity, and treasury rates in the month of transfer coalesce to determine the value of the gift. The trust can be structured to almost zero out the value of the gift. (Many practitioners recommend preparing a Form 709 and reporting a small remainder gift to start the statute of limitations running on the valuation of the trust assets.) Provided the trust investments perform at a rate in excess of the Treasury rate (the October 2014 rate is only 2.2 percent) and the grantor survives the annuity term, the beneficiaries can ultimately receive a benefit for which only a nominal amount of lifetime exclusion amount is used.

Trap: One important caveat – the Obama administration has GRATs on their list of disfavored planning strategies. The administration has proposed that all GRATs have a 10-year minimum term. To avoid missing the opportunity to create a short term GRAT, set up and fund your GRAT in 2014.

Strategy 7: Qualified personal residence trust (QPRT)

Tip: QPRTs allow taxpayers to transfer ultimate ownership of a residence to their heirs (or into a trust for their heirs) at a discounted gift tax value. Under this strategy, the taxpayer(s) contribute their residence to a trust for a term of years (typically seven to 15) and pay gift tax (or apply their applicable exclusion amount) only on the value of the remainder interest. The value of the remainder is based on the taxpayer's age and the interest rate used by the IRS to calculate present value. During the term, the residence is administered as usual. The taxpayer pays the property taxes and maintenance expenses and continues to reside in the residence. If the taxpayer dies during the term of the QPRT, the residence reverts to the taxpayer's estate.

Trap: If the taxpayer survives the term, he or she must pay fair market value rent to either the remainder trust or directly to the heirs, depending on how the QPRT was designed. The best-constructed QPRT documents include a sample lease to ensure this significant QPRT feature is not overlooked or forgotten.

Strategy 8: Life insurance trusts

Tip: Insurance policy payouts can be excluded from an individual's taxable estate if the life insurance is owned by the trustee of an irrevocable life insurance trust (ILIT). Under the typical structure, the trustee of the ILIT is the policy owner, the trust is the beneficiary of the policy proceeds, and the settlor of the trust is the insured. The beneficiaries of the trust are usually the insured/settlor's spouse, children and grandchildren. ILITs are often GSTT-exempt trusts with discretionary distribution standards and spendthrift provisions.

Trap: If the policy is owned by the insured and transferred to the trust, the insured/settlor must survive for three years from the date of transfer in order for the policy proceeds to be excluded from his or her taxable estate. Where properly conceived, structured and implemented, ILITs can provide significant liquidity for an estate consisting primarily of closely held business assets, while also providing a ready source of funds for family members' support needs.

Strategy 9: Special needs trusts

Tip: A special needs trust is a discretionary trust that shelters assets and provides for the distribution of the trust assets and income for a person with a defined disability. These trusts are designed to sustain the beneficiary's eligibility for government benefits and services but also to enhance the beneficiary's quality of life beyond what is available from the government.

Trap: Careful drafting of the trust agreement is required to ensure the beneficiary is able to continue to receive federal and state benefits that are means-tested.

Strategy 10: Planning for estate taxes

Tip: Estate taxes are due nine months from date of death, and the best estate plans have built-in payment strategies. Two options allow for financing estate taxes. The first is a so-called "Graegin loan" arrangement. A Graegin loan provides an opportunity to use an outside lender instead of the IRS to fund the estate tax loan. The lender can be an external bank or a related party (family limited partnership or irrevocable gift trust) as long as the loan is bona fide. A Graegin loan has three requirements: (1) the estate must be illiquid, (2) the loan must be at a fixed rate, and (3) the loan must prohibit prepayment. Because the terms of the loan are fixed, the amount of the interest to be paid on the loan is ascertainable from the date of death, allowing the full amount of the interest to be paid to be permitted as a deduction rather than the discounted present value. This can create a sizeable favorable deduction for the estate. Section 6166 provides a second option for financing estate taxes. The section 6166 election is restricted to an estate with so-called "qualified business interests." Essentially, the deceased taxpayer must have been an active business owner with a business interest that accounts for at least 35 percent of his or her gross estate. The election allows the deferral of the first payment  of estate tax for five years and nine months from the decedent's date of death. Thereafter, each successive payment is made annually for the next 10 years until the debt has been paid off. This election is essentially a loan from the IRS at favorable low interest rates. The deferral can be lost if the estate is delinquent in making its installment payments or the business is sold during the installment term.

Trap: Although the filing date for the estate tax return can be extended for an additional six months, the obligation to pay the estate taxes cannot be extended. If illiquidity is an issue for your estate, make sure that you have a financing plan in place. We recommend specifically authorizing your executor to enter into a Graegin loan arrangement or to make a section 6166 election.


Your tax advisors can provide further insight on these strategies and assist you in developing a unique estate plan tailored to your assets and your goals. If your estate is close to, or exceeds, the taxable threshold, you should meet regularly with your tax advisor to ensure that your planning is updated and that your documents are current.

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