Advanced Estate Planning Going Beyond the Basics

Introduction to Tax Planning

Advanced estate planning focuses primarily on reducing transfer taxes and income taxes.  Under current federal law, there are three taxes that are imposed on the transfer of assets:  the gift tax, the estate tax, and the generation-skipping transfer tax ("GSTT"). In  addition to the transfer taxes that may apply, income tax can also reduce transfers. The gift tax applies to transfers made during life, the estate tax applies to transfers at death, and the generation-skipping transfer tax applies to transfers during life or at death that skip the children's generation and pass to "skip persons", who are generally grandchildren and those in lower generations.

• Gift Tax: A donor can give assets with unlimited values to spouses who are U.S. citizens and to qualified charities. In 2006 and 2007, gifts totaling up to $12,000 can be made to any number of individuals in each calendar year. "Taxable gifts" are all gifts other than those that qualify for the (a) marital deduction, (b) charitable deduction, or (c) $12,000 annual exclusion; however, no out-of-pocket gift tax has to be paid until a donor's cumulative lifetime gifts exceed the "applicable exclusion" (explained below) that is available for gift and estate tax purposes.  After the applicable exclusion amount has been exceeded, the federal gift tax rate is 45% (during 2006, 2007, and 2008). The gift tax is paid by the donor out of assets remaining after the gift, so the tax itself is not included in the computation of the tax.

• Estate Tax: Upon death, the decedent's gross estate includes the then current fair market value of all property interests held by the decedent at the time of his or her death, whether passing by operation of law (such as joint tenancy assets), by operation of contract (such as insurance proceeds), or by operation of probate laws.  There are deductions for debts, administrative expenses, qualified transfers to spouses, and transfers to qualified charities. The net amount is the taxable estate.  To the extent the applicable exclusion has not be utilized for lifetime gifts, it will be applied to the taxable estate. The estate tax is paid out of the taxable assets, so the amount of the estate tax itself is actually included in the computation of the tax.  

• Applicable Exclusion:  The "applicable exclusion" for the federal gift and estate taxes is scheduled to increase in steps as follows:

  Year	“Applicable Exclusion Amount”		Lowest Gift Tax Rate (after exclusion)	Lowest Estate Tax Rate (after exclusion)	Highest Tax Rate
  	Gift Tax	Estate Tax
  2001	$675,000	$675,000	39%	39%	55%
  2002	$1,000,000	$1,000,000	41%	41%	50%
  2003	$1,000,000	$1,000,000	41%	41%	49%
  2004	$1,000,000	$1,500,000	41%	45%	48%
  2005	$1,000,000	$1,500,000	41%	45%	47%
  2006	$1,000,000	$2,000,000	41%	45%	46%
  2007	$1,000,000	$2,000,000	41%	45%	45%
  2008	$1,000,000	$2,000,000	41%	45%	45%
  2009	$1,000,000	$3,500,000	41%	45%	45%
  2010	$1,000,000	41%	unlimited	0%	0%
  2011	$1,000,000	$1,000,000	41%	41%	55%

  
  NOTE: This table reflects the current law, but it is anticipated that this will change before it becomes fully effective. If not changed, the 2001 tax act is automatically repealed for 2011 and after.

• Generation-Skipping Transfer Tax: Congress enacted the generation-skipping transfer tax (GSTT) which applies to transfers to "skip persons", whether made during life or at death. "Skip persons" are grandchildren and lower generations. The GSTT is a one-rate tax equal to the highest applicable estate tax rate (shown in the table above this paragraph), and it applies in addition to any applicable gift or estate tax. Estate taxes paid are deducted before computing the GSTT, but combination of the estate tax and the GSTT can result in a combined rate of over 70%. Each donor or decedent has a $1,120,000 GST exemption (as of 2003), which can be used for transfers either during life or at death. The GST exemption applies to the transferor (donor or decedent) regardless of the number of skip persons to whom the transfers are made. In 2004 and later, the GST exemption will be the same as the "applicable exclusion" for estate tax purposes.

• Income Taxes: Income taxes further deplete transfers, especially with respect to assets that are all taxable income, such as retirement plan benefits. The combination of transfer taxes and income taxes can deplete some transfers by more than 85%.

Nontax Issues

• Nontax Goals: A will or a living trust can accomplish most of your nontax objectives. First, you want to make sure that your assets are administered and distributed as you desire. Second, you want to minimize the expenses and complications that can come with the administration of your estate. The primary tool for most clients with substantial estates is the revocable living trust. A properly drafted living trust can be used to:

  • Provide for your own care and benefit during any periods of incapacity without the need for guardianship proceedings;

  • Make sure that assets are transferred after your death to your intended beneficiaries;

  • Reduce or perhaps eliminate the need for probate proceedings at death, together with the fees, costs, and delays associate with probate;

  • Protect beneficiaries from mismanagement and from the claims of creditors and ex-spouses;

  • Discourage certain types of conduct; and/or

  • Give incentives to beneficiaries to be productive members of society.

Basic Transfer-Tax Planning

• Defer estate tax for married couples upon the death of the first spouse to die through the use of marital-deduction trust planning.

• Reduce or eliminate estate taxes for beneficiaries by establishing one or more "bypass trusts".
  • A bypass trust can be used as a "credit-shelter trust" to preserve a decedent's estate tax "unified credit" or "applicable exclusion", which is $1,000,000 in 2003. [For later years, see the applicable exclusion table, above.]

  • A bypass trust that maximizes the GST exemption can also serve as a "generation-skipping trust" to reduce or eliminate estate taxes for children and other descendants.

Bypass Trust

Permitted Benefits. The Internal Revenue Code permits a beneficiary to receive significant benefits from a trust without causing the trust or its assets to be considered part of the beneficiary's estate. Unless the assets were contributed by the beneficiary, the assets will not be considered part of the beneficiary's taxable estate if even the beneficiary has the right to:

• Receive all trust income
  
• Receive payments from trust principal for support, health, education, and maintenance
  
• Withdraw 5% of principal per year
  
• Direct distributions of the principal during life (to recipients other than the beneficiary and the beneficiary's creditors)
  
• Direct distributions of the principal after death (to recipients other than the beneficiary's estate or creditors)
  
• Act as a trustee.

Additional Restrictions. Not every bypass trust needs to be a maximum-benefit trust, and the settlor can restrict or eliminate any or all of the powers. It is common, for example, to eliminate the annual 5% withdrawal right and to limit the power to direct distributions so that the recipients must come from a particular group, such as the settlor's descendants.

Bypass Trusts for Spouses. For married couples, it is common to want to shelter the predeceased spouse's applicable exclusion1 while at the same time leaving the surviving spouse with broad benefits and control over the exempt amount. Perhaps the "Credit-Shelter Trust" is the most common form of the bypass trust, and it is discussed briefly below.

Bypass Trusts and the GSTT. Before the enactment of the generation-skipping transfer tax (GSTT), there was no restriction on the value of assets that could be allocated to a bypass trust. Under current law, only $1,120,000 can be allocated to a bypass trust without incurring the 49% GSTT at one time or another.

• For any person who names a grandchild as a beneficiary or as an alternate beneficiary, it is important to allocate as much as possible into a totally exempt trust so that all federal transfer taxes can be avoided.

• Although a bypass trust can always save the federal estate tax, it cannot save the GSTT unless the trust is totally exempt. Unlike the estate tax, the GSTT has no lower tax brackets, so it is usually unwise and unnecessary to incur a generation-skipping tax.

• A trust is made exempt from the GSTT by filing a federal gift tax return (IRS Form 709) each time transfers are made to it and by declaring on the return that the GST exemption equal to the value of the transfers is allocated to the trust. After death, the GST exemption is claimed on the federal estate tax return (IRS Form 706).

The A/B Trust and the A/B/C Trust

A/B Trust. Upon the death of the first settlor to die, an A/B Trust divides into Trust A and Trust B.

• "Trust A" or the "Survivor's Trust" remains revocable and contains the survivor's property interests, and the surviving settlor has total control. If the survivor is the deceased settlor's spouse, this trust usually receives all assets that exceed the applicable exclusion, and this qualifies for the marital deduction, thus deferring any estate tax until the surviving settlor's death. If the survivor and the deceased settlor are not married, the deceased settlor's assets are usually not added to the survivor's trust since there is no way the transfer can qualify for the marital deduction.

• Trust B or the "Credit-Shelter Trust" is irrevocable. It is designed as a bypass trust, which is discussed above. For a married couple, the Credit-Shelter Trust contains the deceased settlor's assets that can pass tax free, equal to the unused applicable exclusion. For a married couple, this trust contains the deceased settlor's assets, and the estate tax is imposed on the trust to the extent it exceeds the applicable exclusion. This trust is designed as a bypass trust so that it can pass to the next generation of beneficiaries without triggering a transfer tax.

• Trust A or the Survivor's Trust contains the surviving settlor's assets only.

• Trust B or the Credit-Shelter Trust contains the amount that can pass free, which is equal to the unused applicable exclusion.

• Trust C is a Marital Trust, which qualified for the marital deduction.
  • The most common type of marital trust is the "qualified terminable interest property trust", which is referred to as a QTIP Trust. In this type of trust:
    • the surviving spouse must be entitled to receive all of the trust's income during the survivor's lifetime;
      
    • the surviving spouse must be able to compel the trustee to make unproductive assets produce income; and
      
    • no one but the surviving spouse may be a beneficiary until after the surviving spouse's death.

  • Another type of marital trust is the "income-and-general power of appointment" trust. In this type of trust:
    • The surviving spouse must be entitled to all of the the trust's income during the survivor's lifetime;
      
    • the surviving spouse must be able to compel the trustee to make unproductive assets produce income; and
      
    • the surviving spouse must have a "general power of appointment" that permits the survivor to say where the trust goes upon the survivor's death. A "general power of appointment" is one that is exercisable in favor of the survivor, the survivor's estate, the survivor's creditors, and/or the creditors of the survivor's estate.

  • The QTIP is frequently used because:
    • This is considered a spendthrift trust in many jurisdictions, which means it is not subject to the creditor's of the surviving settlor.
      
    • The trust may restrict the surviving settlor from making changes, making it appropriate where each spouse has different beneficiaries, such as children from prior marriages.
      
    • A portion of the QTIP trust can be made exempt from the generation-skipping transfer tax (GSTT) using the GST exemption of the first spouse to die.

The Need to Go Beyond the Basics

• Saving Transfer Taxes: Revocable trusts cannot eliminate estate taxes for unmarried individuals with estates exceeding the applicable exclusion or for married couples with estates exceeding twice the applicable exclusion ($2,000,000 in 2003). In those cases, transfer taxes must be provided for in one way or another. Either the taxable estate must be reduced, or arrangements must be made to pay the tax. There are many estate planning "tools" that can use to supplement your basic will and/or revocable trust. The purpose of these materials is to briefly outline some of those tools.

• Personal Considerations: Most of the estate-tax savings techniques require you to give up at least some control over your own assets and to limit or eliminate the benefits you receive from them. Only you can decide how much benefit and control you are willing to give up in order to save someone else (your children or other beneficiaries) taxes and other expenses at a future date.

  • Some techniques -- like life insurance trusts -- probably will not have much impact on you or your lifestyle because you are giving up control over and benefits from an asset you probably would not tap into anyway. Of course, if your planning requires significant insurance, it will also require the payment of significant insurance premiums, making cash flow an important factor in your estate plan.

  • Some estate planning tools seem illogical and can simply make people uncomfortable. For example, irrevocable trusts can be designed so that the grantor*.does not receive trust income but pays income taxes on trust income in order to indirectly benefit trust beneficiaries without making  taxable gifts. It may be psychologically unpleasant to have to pay taxes on  someone else's income, but for persons trying to reduce their taxable estates, it can be an effective tool.

  • Other techniques -- such as a qualified personal residence trust -- require you to give away assets earlier than you normally would, assets that you may really want to keep and use for the rest of your life.

  • And some techniques -- such as charitable remainder trusts -- not only remove assets from your estate, but also keep those assets from your children or other beneficiaries.

  • Each person has to decide for himself or herself the combination of estate-planning techniques that balance the desire to save taxes and expenses with the desire to maintain control over and benefits from hard-earned assets.

These materials continue in the article entitled "Reducing the Taxable Estate".

*NOTE: "Grantor", "settlor", and "trustor" are used interchangeably to refer to the creator of a trust.

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Updated 30 December 2006.

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