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Advanced estate planning focuses on reducing estate, gift, and income taxes.
See Estate Tax / Gift
Tax / Generation Skipping Tax Information for background
information. Based on the current and forecasted appreciation of your gross
estate, additional estate planning tools can be incorporated to your existing
estate plan to help minimize taxes, maximize the transfer of wealth and
provide increased asset protection. These tools may include the following:
| Irrevocable Life Insurance
Trust (ILIT) |
| Gifting through Spendthrift Trusts
/ Children's Trusts / Grandchildren's Trusts |
| Family Limited Partnership (FLP) |
| Limited Liability Company (LLC) |
| Qualified Personal Residence Trust (QPRT) |
| Sale to Intentionally Defective Grantor
Trust |
| Charitable Planning |
| Special Needs Trust |
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| Jack has a taxable estate above the federal exclusion (more than
$3.5 million in 2009) not including his life insurance. Jack
has a $2 million life insurance policy. The entire death benefit
of Jack’s policy ($2 million) will be taxable and Jack’s estate will
have to pay approximately $1,000,000 in estate taxes. If Jack’s
life insurance policy is transferred to an ILIT, the $2 million policy
can pass income and estate tax free to Jack’s wife and children. Jack
can provide his heirs with an additional $1,000,000. |
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If you currently have a taxable gross estate or are expected to in the future,
use of an ILIT can help to save your estate hundreds of thousands of dollars
in estate taxes. An Irrevocable Life Insurance Trust,
commonly referred to as an “ILIT” is an extremely effective estate planning
tool. When an insurance policy is owned in your name individually, or
through your living trust, you can revise the terms of the life insurance,
beneficiaries, etc. In this way, you, as the insured, are said to have
“incidences of ownership” and the full value of the proceeds from the life
insurance policy are included in your gross estate upon death (not just the
face value or cash value of the policy during your lifetime). Because
many individuals have life insurance policies valued at $1 million or more,
your gross estate can quickly reach a "taxable" level.
An ILIT is an irrevocable trust created for the principal purpose of
owning a life insurance policy (or policies). When properly structured
and maintained, the death benefits paid to the trust will be excluded from
the insured’s gross estate. Once drafted, ownership and beneficiary
designation under the policy must be in the name of the ILIT. It is preferred
that the insurance policy is applied for and purchased in the name of the ILIT
from inception. In this way, because the insured has no "incidences of
ownership" in the policy, it can pass income and estate tax free to the beneficiaries
upon death.
While it is possible to transfer existing life insurance policies to an ILIT,
it is important to note that the transfer of a policy to an ILIT is considered
a "gift" equal to the cash value of the policy at the time of the transfer
and is also subject to a "3 year look back period". Therefore,
if the insured dies within 3 years of the transfer of an existing policy to
an ILIT, the proceeds of the policy will be included in the insured’s gross
estate. This
3 year look back period can be avoided by structuring a "sale" of
the policy to the ILIT. By law, when the policy is sold (rather than
gifted), the 3 year look back period is ignored.
The ILIT must
apply for its own Federal Tax Identification Number and should also have a separate
bank account opened in the name of the ILIT. In addition, the premium payments
made are considered "gifts" to the beneficiaries of the ILIT. These
gifts must be considered in the context of your annual gift exclusions and lifetime
exemption. In order for the premium payments to be considered gifts, the
beneficiaries must have a "present interest" and immediate rights to
the gift. This "present interest" should be communicated to the beneficiaries
of the ILIT through what is commonly referred to as a "Crummey" letter,
named after a famous court case. The "Crummey" letter is a letter sent
every calendar year to each of the beneficiaries of the ILIT informing each beneficiary
of his / her right to withdraw the gift within a certain time period.
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| Jack and Diane made annual gifts to their children through
custodial accounts. When their daughter turned 18, she went
to the bank and withdrew a large portion of the money in her
custodial account. She used the money to buy clothes and a
motorcycle for her boyfriend. If Jack and Diane would have
instead gifted to their children through trusts, this never
would have happened. |
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As discussed under "Gift Tax", each calendar year you are allowed
to make gifts of the "annual gift tax exclusion amount" without incurring
any gift tax or using any of your lifetime applicable exclusion amount
against estate and gift taxes. In 2009, the annual gift tax exclusion
for an individual is $13,000 per recipient (or $26,000 for a married
couple). This means that a married couple with three children
can transfer $78,000 ($26,000 gifted to each child) outside of their
gross estate on an annual basis tax free.
Many clients have taken advantage of estate planning tools to leverage
gifting and also provide for increased asset protection for the recipients
of the gifts. If you intend to engage in a regular gifting
to a child or grandchild, it is preferable to gift through a trust
rather than individually or through a custodianship account. While
gifting to a child beneficiary through a custodian account or an UTMA
Account (account established under the Uniform Transfers to Minors
Act), can provide some level of control – it is important to note that
the child beneficiary will have full access to the account upon reaching
the age of majority. It is difficult to predict what an 18 year
old may elect to do with the money in the checking account that has
accumulated over the child’s lifetime.
Thus, many parents and grandparents elect to make gifts to children
/ grandchildren through what is commonly referred to as a "Spendthrift
Trus". A Spendthrift Trust is an irrevocable trust created
for the benefit of a person which gives an independent trustee full
authority to make decisions as to how the trust funds may be spent
for the benefit of the beneficiary. The funds are thus
held in trust for the child beneficiary and subject to the terms of
the trust, the trust assets may be used for the child’s health, maintenance,
education, or for a down payment on a new home. The decision
of how the funds will be used, however, will be subject to the trustee’s
discretion. Similarly, because the child beneficiary has no control
over the trust assets, creditors of the beneficiary (a car accident,
outstanding debt, or future spouses) cannot reach the assets in the
trust.
Similar to ILITs, gifts made to children through Spendthrift Trusts
must have corresponding Crummey Letters which provide the child with
notice of a present interest and immediate rights to the gift.
Lastly, there are also income tax benefits. The
trust can be structured such that taxable income or loss would flow
onto the beneficiary’s individual income tax return once the beneficiary
is old enough to become "separate taxpayers" and file their own tax
returns. This is beneficial as a child or grandchild would likely
be in a lower tax bracket than the donor.
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| Jack and Diane have a taxable gross estate. They set up a
Family Limited Partnership to hold their long-term investment portfolio. Jack
and Diane can gift portions of their limited partner interest to
their kids each year. By gifting through the partnership, in
2009, Jack and Diane gifted $39,000 in value to their kids (rather
than just $26,000). By taking a discount on the interest they
gifted, they were able to transfer $39,000 in value to each child
and stay within the annual gift exclusion. |
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A Family Limited Partnership (FLP) can provide many advantages, including
the following:
| Asset protection from creditors |
| Consolidation of family assets with centralized
management and control |
| Investment advantages where a larger pool
of assets are invested |
| Discounts based on lack of control and/or
lack of marketability |
A FLP is a partnership designed to hold family assets. By definition,
a limited partnership has two types of partners: (i) general partner;
and (ii) limited partners. The general partner has all control over
investment and management decisions and therefore bears 100% of the liability
associated with the FLP. The limited partners, however, cannot participate
in the management of the FLP and have limited liability. Because the
limited partners have no control over the management of the FLP, when properly
structured, the interest held by a limited partner may be eligible for valuation
discounts at the time of a transfer (either for gifting purposes during one’s
lifetime or transfers on death).
Not all FLP’s are created equally. Many FLPs which were established
years ago and have not been reviewed / closely monitored should be revised
to ensure discounts on limited partnership interests will be respected by
the IRS. Many
court cases brought by the IRS help to identify "good facts" and lay the framework
for how to properly establish and operate an FLP. Years ago, many FLPs
were established with an individual or his/her living trust as the general partner. Recent
court cases and IRS revenue rulings strongly suggest that the general partner
of the FLP should be a corporation or limited liability company and each individual
shall own a minority piece of the corporation. In this way, it helps
to support the business and any related gifting to be seen as an “arms length
transaction” and minimizes the issue of whether an individual has retained
meaningful economic benefits from the transferred assets.
Assume Jack and Diane decided to transfer long-term investments to a FLP. The
FLP would be owned 1% by the corporate general partner and 99% by the Limited
Partners. Initially, the 99% limited partner interest would be owned by
Jack and Diane. Jack and Diane could make annual exclusion gifts to their
children (or children’s trusts). Rather than simply write a check to their
children, Jack and Diane could make annual exclusion gifts of their limited partnership
interest. Furthermore, as limited partners with no control, the value
of the limited partner interest could be substantially reduced by using discounts
to reflect the lack of control and/or lack of marketability of the limited
partner interests. For example, by gifting through a limited partnership,
Jack and Diane can transfer $39,000 to each beneficiary on an annual basis rather
than $26,000. (Assuming a 33.3% discount, the fair market value of a $39,000
limited partner interest can be discounted to $26,000 and fit within the annual
gift tax exclusion). Jack and Diane would be transferring not
only the present value of the limited partner interest to their children but
also future appreciation. In this way, Jack and Diane can maximize wealth
transfer. Jack & Diane’s children now own a percentage of the FLP
and also share in any future growth of the partnership assets.
The FLP must file a tax return, however the entity itself is not taxable. Rather,
the owners of the partnership report their proportionate share of the partnership’s
income and deductions on their personal tax returns.
Based on an individual’s asset portfolio, perhaps a limited liability
company (LLC) or Series Limited Liability Company (Series LLC) may better suite
your asset portfolio than an FLP.
An LLC is an entity which combines features
of corporations and partnerships. The
owners of the LLC are called "members". Members have the liability
protection of a corporation and cannot be held personally liable for debts
of the LLC (unless the members have signed a personal guarantee). Profits
can be distributed in varying forms and all business losses, profits, and expenses
flow through to the individual members. Thus, there is no double taxation.
For
estate planning purposes and to maximize asset protection, the LLC should be
managed by a manager (instead of by “members”). The manager can be
an individual or another entity. Similar to an FLP, because the members
of the LLC have no control over the management, when properly structured, the
interest held by a member may be eligible for valuation discounts at the time
of a transfer (either for gifting purposes during one’s lifetime or transfers
on death).
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| Jack had a taxable gross estate and formed a Family Limited Partnership
to begin “gifting” limited partner interests to his children. Unfortunately,
Jack funded the FLP with long term investment accounts and a
commercial rental property. When a tenants slipped and fell
in the rental property, Jack discovered his umbrella policy for the
property was inadequate. Because the rental property and the
long term investments were in the same FLP, Jack’s long term investments
could be easily reached by the tenant. |
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The situation described above refers to the "overstuffed entity"
problem – where clients put too many assets into one entity. The
entity is intended to provide some level of asset protection, but when
one of the assets in the entity becomes tainted, all of the assets in the
entity are at risk.
In a perfect world, a separate LLC would be formed to hold each property
or business. In this way, only the assets owned by a specific LLC would
be subject to claims or lawsuits arising against that particular LLC. However,
the legal and administrative costs associated with properly forming, qualifying
and maintaining separate LLCs become prohibitive.
A Series Limited Liability Company ("Series LLC") is a special form
of LLC that provide liability protection across multiple “series”. Delaware
was the first state to recognize Series LLCs in 1996. Since that time,
several states, including Illinois, now recognize Series LLCs.
When properly
structured and maintained, each series is protected from liabilities arising
from the other series. Thus, if there was ever a liability
with respect to Series A, the assets of Series B and Series C would remain
protected. Each series holds title to distinct assets, incurs separate
liabilities, and may have different managers / members. However, a
Series LLC pays only one filing fee and files only one income tax return.
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| In 2000, Jack and Diane purchased a summer home in Michigan
for $900,000. They imagined their children and grandchildren
enjoying the summer home for decades to come. Each of Jack
and Diane established a QPRT for the ultimate benefit of their
3 children. The house was appraised for $900,000 but Jack
and Diane were only deemed to have made a gift of $300,000 to their
children. Upon termination of the QPRT term, the house was
appraised at $3.5 million. Jack and Diane were able to move
an asset that appreciated to $3.5 million in value and transferred
it to their children for just $300,000. |
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A Qualified Personal Residence Trust ("QPRT") is
an irrevocable trust designed to hold and own your primary or secondary residence. The
QPRT allows you to remove the value of your primary or secondary residence
from your estate at a reduced gift tax value.
For gift tax purposes, when your home is transferred to a QPRT, you are
deemed to have made a gift to the ultimate beneficiaries of the QPRT (your
children). However, you continue to retain the right to use the
residence for the retained income period. Thus, because the trust beneficiaries
cannot take ownership of the property for several years, the value of the
gift is calculated at a fraction of the fair market value of your home. The
calculation depends on many factors including your age at the time of the
gift, interest rates at the time of the transfer, and the number of years
you elect for the retained income period.
Upon the termination of the retained
income period, ownership of the property will be transferred to the final
beneficiaries you identify in the QPRT. Because
you no longer have own the property, the property is removed from your
estate for estate tax purposes. Furthermore, if you elect to continue
to live in the property, you can pay "rent" to the owners of the property. Rental
payments are not considered gifts to the beneficiaries, helps to further
reduce the value of your taxable estate, and maximize wealth transfer. There
often comes a point where simply leveraging gift exclusions and valuation discounts
to minimize estate and gift taxes are not enough. The
sale of an asset to an Intentionally Defective Grantor Trust ("IDGT") can
"freeze" the value of assets in your gross estate. All
appreciation in the asset would be moved from the Grantor’s gross estate
to the IDGT.
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| Jack and Diane owned non-voting stock in a closely held family
business. The stock was appraised at $1 million but was expected
to appreciate in value and be worth more than $5 million within
10 years. Jack and Diane sold their non-voting stock to an
intentionally defective grantor trust in exchange for a promissory
note. Now, for valuation purposes, the asset in their gross
estates was a $1 million promissory note. The stock and all
appreciation in value was outside of their estates. The transaction
helped to save Jack and Diane in excess of $2 million in potential
estate taxes. |
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An IDGT refers to a trust that is a complete transfer to a trust
for transfer tax purposes but an incomplete, or "defective", transfer
for income tax purposes. Grantor trust rules are different
for income tax and for gift and estate tax. For estate tax purposes,
transfers to IDGTs are considered completed gifts and outside the grantor’s
gross estate. However, for income tax purposes, the existence of
the trust is ignored ("defective") and the grantor is treated as the
owner of the trust. This creates a unique planning opportunities.
Sales
to IDGTs are often attractive vehicles for assets that are expected to
appreciate in value. The sale of an asset to an IDGT
can be both income and capital gains tax free. Under an
IDGT, the grantor retains certain powers. As a result, although the
grantor is not a beneficiary, the grantor is taxed on all of the trust's
income, even though the grantor is not entitled to any trust distributions. This
helps to further reduce the grantor’s gross estate. However, the
underlying assets in the IDGT appreciates outside the grantor’s estate. The
IDGT receives the gross income generated from the income producing assets,
which accrue to the benefit of the trust’s beneficiaries.
Charitable planning can
take a variety of forms. You can leave a bequest
in your estate plan to provide that a percentage of your estate, a certain
dollar amount, or a specific asset be donated to charity. A charitable
organization can also be named the residuary or ultimate beneficiary of all
or party of your estate in the event the other named beneficiaries fail to
survive you.
There are a myriad of charitable planning tools available. One
of the more popular estate planning tools is the Charitable Remainder Trust
("CRT") which can be established as a Charitable Remainder Annuity Trust ("CRAT")
or a Charitable Remainder Unitrust ("CRUT").
CRTs are flexible vehicles which
allow you to make charitable gifts but retain an income stream for yourself
(or others) for life or for a fixed number of years (not to exceed 20 years). CRTs
are well suited for gifts of appreciated assets which produce little or no
income at the time of the gift. Because
the CRT is tax-exempt, the CRT can sell the underlying asset without incurring
capital gains tax and reinvest the proceeds for a higher yield.
Benefits of CRTs include the following:
| Immediate income tax charitable
deduction in the year the gift is made |
| Steady income stream |
| Avoid capital gains when making a gift of
appreciated securites |
| Make a generous gift to a charitable organization |
| Reduce estate tax liability |
A Special Needs Trust (also known as a Supplemental Needs Trust) is a specialized
trust designed to benefit an individual who has a disability. The trust
enables a person under physical or mental disability, or an individual with
a chronic or acquired illness, to have assets held for the individual's benefit. When
properly drafted, the assets of a Special Needs Trust are not considered "countable
assets" for purposes of qualification for specific governmental benefits.
The
purpose of the trust is to provide "special" or "supplemental" care for the
beneficiary over and above that in which the government provides. A
supplemental needs trust is an irrevocable trust and is considered its own
entity with its own federal identification number issued by the IRS. Thus,
the trust is not registered under the Grantor's social security number nor
the beneficiary’s social security number.
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