Practice Areas • Estate Planning • Advanced
Advanced Estate Planning Tools
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
Irrevocable Life Insurance Trust (ILIT)
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.
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.
Gifting through Spendthrift Trusts / Children’s Trusts / Grandchildren’s Trusts
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.
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.
Family Limited Partnership (FLP)
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.
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.
Limited Liability Company (LLC) or Series Limited Liability Company (Series LLC)
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).
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.
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.
Qualified Personal Residence Trust (QPRT)
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.
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.
Sale to Intentionally Defective Grantor Trust
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.
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.
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
Special Needs Trust
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.