Estate Planning Techniques

1. Reducing the Value of the Taxable Gross Estate
    a. The Gift Tax versus the Estate Tax
    b. The Basics of Tax Basis
    c. General Rules About Gifts
2. Maximizing Estate Tax Deductions and Credits
    a. Balancing the Exemption Equivalent Amount vs. the Marital Deduction


Estate planning techniques generally fall into one of three types. One type reduces the value of the taxable gross estate. Another type maximizes the value of estate tax deductions and credits. The final type defers the value of estate tax liability.

1. Reducing the Value of the Taxable Gross Estate

There are a number of strategies one can employ to reduce the value of the taxable gross estate.

First, you should take advantage of the annual exclusion and maximize the lifetime transfers eligible for it. The annual gift tax exclusion currently permits you to give up to $13,000 of gifts per year per individual that are excluded from gift tax (See 26 U.S.C. § 2503(b) which indexes the exclusion amount for inflation with the adjustment amount rounded to the next lowest multiple of $1000). For example, you could give in a single year an $13,000 gift to each of three children and each of seven grandchildren (totaling $130,000 in gifts) that would be excluded from gift tax. And you could repeat that again and again each year without incurring any gift tax and without using any of the unified credit.

Moreover, if you are married, you and your spouse can currently give $26,000 a year to each recipient without incurring any gift tax treatment by making the gift-splitting election.

Relatively recent programs permit you to contribute money to what in essence is a savings account for future educational expenses of minor children. Earnings in the account are exempt from income tax and distributions from the account are not taxable if used for qualifying educational expenses. Gifts to these educational IRAs or qualified state tuition programs qualify for the annual exclusion. (See Regs § 530 & 529).

If your assets consist of nonliquid investments such as real estate or stock in a closely held business, you can take advantage of the annual exclusion by giving fractional shares over time. For example, you could create a family limited partnership or a family limited liability company and transfer fractional interests each year. Because these fractional interests are not marketable and lack having any control over the business, they typically warrant substantial discounts in value in relation to the value of the underlying property. Thus, you can effectively give more than the annual exclusion amount.

You may also want to consider transferring assets in excess of the annual exclusion. These transfers initially use up a portion of the unified credit and do not result in any tax until it is fully used up. By giving property that you expect to appreciate as gifts, you avoid having not only the property given, but also the appreciation in you taxable estate when you pass on. And if you have had to pay gift tax on the transfer because you used up the unified credit, that amount paid in gift tax will not be part of your estate provided that you live three years beyond the gift.

You can also consider a life insurance trust. If you transfer ownership of a life insurance policy to someone other than yourself, if you retain no incidents of ownership, and if the beneficiary of the policy is someone other than your estate, then when you die the proceeds of the life insurance policy are not included in your gross estate. You can also transfer your life insurance policy over which you retain no incidents of ownership to an irrevocable trust that terminates on your death with someone other than yourself as trustee to accomplish this result. Although this transfer of your life insurance policy is considered a gift, the gift is valued as the cost of obtaining a comparable policy at the time of your gift. Hence, it is a gift of well less than what the policy will pay when you pass on.

In order to make an intelligent decision about what property you should transfer by gift, you need to have at least a basic understanding of the differences in the gift and estate taxes.

1a. The Gift Tax versus the Estate Tax

There are two primary differences between estate tax and gift tax. First, the gift tax taxes the actual transfer to the recipient or donee, while the estate tax taxes what the decedent owns at his death. The estate tax doesn't care what the beneficiary gets.

If you make a gift and live 3 years, not only is the gift amount and any increase since the gift not included in your estate, but also the amount you paid in gift tax is not included. If you die before the three years is up, the amount paid in gift tax is included in your estate. With the estate tax, if you die, all of your assets are included in your gross estate.

Second, the gift tax generally has a carryover basis while the estate tax has a step up in basis (except in 2010). If the recipient or heir intends to sell the property they receive, this difference in basis can make a significant difference if the property has a low basis and a high fair market value. This is because the recipient of a gift upon sale of the property will pay significantly more in income tax than the heir who receives the property under a will because the basis is used to determine the amount of gain upon sale and thus the amount upon which tax will be paid. Therefore, you need to know the basis in property to know whether making a gift makes sense.

While it is true that there is an annual exclusion, that exclusion applies only to gifts of a present interest in property, not to gifts of a future interest. Gifts of a remainder interest do not qualify for the annual exclusion. But the transfer is still considered a gift and is subject to tax at the date of transfer.

The gift tax form, Form 709, must be filed for any year in which gifts made exceed the annual exclusion amount. In addition, a gift tax return is required for gifts of a future interest and to elect gift splitting.

1b. The Basics of Tax Basis

If property is inherited upon the death of the transferor (in any year other than 2010), the recipient's tax basis equals the fair market value of the property included in the transferor's gross estate.

The tax basis of property acquired by gift is complicated and depends on whether the property's value is more or less than the donor's tax basis on the date of the gift.

If the fair market value of the asset exceeds the donor's tax basis on the date of the gift, a carryover basis rule applies (i.e., donor's tax basis = recipient's tax basis).

If the fair market value is less than the donor's basis on the date of the gift, a split basis rule applies. And the recipient's tax basis depends upon whether he sells the property at a gain or loss. The tax basis for determining a gain on the disposition of the property is equal to the owner's tax basis on the date of the gift. The tax basis for determining a loss on the disposition of the property is the lower fair market value of the asset on the date of the gift.

Tax basis rules have important implications when selecting assets to be given away during the donor’s lifetime versus assets to be held until the donor’s death.

In choosing assets to give, the potential donor should consider whether the property’s fair market value is more or less than the donor’s tax basis at the time of the potential gift. And if the property is income producing, the potential donor should consider the relative marginal tax rates of the donor and the potential donee, remembering that the kiddie tax (unearned income of a child under 14) is taxed at the parents’ highest marginal tax rate.

1c. General Rules About Gifts

As a general rule, business and investment assets that have declined in value should neither be gifted nor held until death since the unrealized loss inherent in these assets will be lost when the recipient's tax basis is set at their fair market value. These assets should be sold prior to death to recognize the tax loss. Otherwise, the value decline will never be deductible for income tax purposes.

As a general rule, when assets have appreciated in value, the step up to fair market value allowed at death, without subjecting the appreciation to income tax by either the decedent or the heir, creates an incentive to hold appreciated assets until death. Otherwise, the donee will be subjected to income tax when they are sold.

However, as the length of time between a proposed transfer by gift and expected transfer at death increases, the incentive to gift property that might increase in value substantially prior to death exists.

Remember that if the donor lives for three years after the gift, not only is the gift tax only paid on what is actually received by the donee but also the gift tax decreases the value of the donor's future estate. Unlike the gift tax, if the property is held until death of the owner, the estate tax is paid on the amount of property owned by the decedent on his death. Thus, tax is paid on sums used to pay estate taxes.

2. Maximizing Estate Tax Deductions and Credits

The marital deduction permits you to leave everything to your spouse without incurring any estate tax. There are at least two primary reasons why you might not want to leave everything to your spouse. The first deals with the possibility of having to pay tax rather than leaving assets to your children free of tax. The second deals with the situation that occurs when there are multiple marriages.

If the combined gross estates of you and your spouse are more than the exemption equivalent amount and you leave everything to your spouse at your death, what you are likely doing is simply deferring the estate tax until the death of your spouse, rather than passing property to your children free of tax.

If the surviving spouse’s taxable gross estate is more than the exemption equivalent amount when the spouse dies, than upon the surviving spouse’s death the sums greater than the exemption amount which are being passed on to your children or others will be taxed (unless the surviving spouse died in 2010 when there was scheduled to be no estate tax).

2a. Balancing the Exemption Equivalent Amount vs. the Marital Deduction

To avoid paying estate taxes when the surviving spouse dies, you want to take advantage of the exemption equivalent amount. One typical way of doing that is to leave the exempt equivalent amount to someone other than your spouse, for example, your children. This amount can be left outright or by way of a trust that may or may not provide that either your children or your spouse gets the income of the trust during their lives. Indeed, the trust may even permit your spouse to invade the principal of the trust under a certain ascertainable standard.

What happens to the estate tax in the future depends upon politics. So keep turned.

This makes drafting a will more complicated than it used to be. The increases in the applicable exemption equivalent amount may create a serious problem if the credit shelter trust share does not permit the trust to be invaded for the needs of the surviving spouse.

You may need to consider a cap on the amount of the credit shelter trust to prevent that share from growing to the full size of the applicable exclusion amount. The amount of this cap will depend upon your goals, the needs of the surviving spouse, and whether the surviving spouse is to receive any of the income and can invade the principal (under an ascertainable standard) of the credit shelter trust.

The cap on the credit shelter trust can be drafted as a fractional share of the total residuary estate, or as a specific dollar amount. An arbitrary cap on the credit shelter trust share, of course, may increase the surviving spouse's taxable estate depending upon what the exemption amount is the year the surviving spouse dies. This increase could cause the surviving spouse's estate to be subject to estate taxes, if the combination of the surviving spouse's separate assets and the enlarged marital share exceed the surviving spouse's applicable exclusion equivalent amount.

Or the credit shelter trust could include as a beneficiary the surviving spouse and allow her to take out the income or invade the principal for her own benefit under an ascertainable standard, i.e., for the health, education, maintenance, and support of the surviving spouse.

The remainder of your estate in excess of the exemption equivalent amount was typically left to the surviving spouse either outright or in a trust that qualifies for the marital deduction but leaves the remainder interest to your children or another. Whether the remainder is left outright or in a trust typically depends on the amount of control (or protection) you desire to have over the property you leave to your spouse.

Trusts can provide control and protection: (1) where there is likely to be a second marriage and you want to ensure that your spouse is not taken advantage of by a new spouse; (2) where you are in a second marriage and want to ensure that your children from the first marriage are not ignored by your second spouse; (3) where your spouse is infirm; or (4) where your spouse due to having lived a sheltered life, age, or potential infirmity might be easy prey for hucksters or other confidence people.

To qualify for the marital deduction, a trust must either qualify as qualified terminable interest property (QTIP) and the QTIP election be made or provide the surviving spouse with a general power of appointment over the trust assets. A QTIP trust requires that (1) the surviving spouse be entitled to income from the trust for life at least annually and (2) no portion of the trust assets can be appointed to anyone other than the surviving spouse during his or her lifetime.

The estate tax was scheduled to be fully repealed for one year, 2010.  But the Tax Relief Unemployment Insurance Reauthorization and Job Creation Act of 2010 (“TRUIRJCA”) went into effect and set the federal estate tax exemption at $5,000,000 and the estate tax rate was 35% for 2010 and 2011.

For 2012, the federal estate tax exemption increased to $5,120,000.

But on December 31, 2012, as part of the settlement of the fiscal cliff, the federal estate tax exemption was maded to be $5,000,000, instead of the $1,000,000 it was to revert back to. 

Because Congress can change the law at any time, we have no idea about what will be the law in 2014 and beyond.

This means you must pay attention to the news, be familiar with how your estate plan (will and/or revocable living trust) are structured, and keep in touch with your estate planner.

This article is not provided for use or reliance by you or any third parties and does not purport to be exhaustive or to render legal advice for your particular situation or any other specific case. It is meant merely to assist you in sharpening the questions you might ask of your legal advisor in your particular case. Please give me a call should you have any questions. (See: Disclaimer)