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08 Apr

Do You Need a Living Trust or a Will?

In Trusts And Wills by admin / April 8, 2013 / 0 Comments

Estate Planner Jan-Feb 2000

Two types of documents can form the basis of your estate plan to transfer your assets to your family upon your death. A will is the traditional method for designating distribution of assets held in your name alone. A living trust acts as a substitute for a will and avoids probate. Both documents may minimize estate tax. Whether you should have a living trust or a will depends on many individual factors.

Weighing the Options

A will’s biggest disadvantage is that it must go through probate in a state court to establish its validity. The probate court supervises the administration of the estate and the distribution of assets. Recent changes in many states provide for minimum involvement by the court under most circumstances. Because the procedure varies from state to state, probate may be expensive and time consuming in some states but not in others. If you die owning real estate located in more than one state, a probate may be required in each state.

A living trust can avoid probate when you die because the trust’s successor trustee takes title to the trust assets and distributes them according to your wishes as expressed in the trust document. But probate will be avoided only for assets in the trust.

This means that to avoid probate, you must move assets in your name alone into the name of your trust. In addition, you are the grantor and may also be the trustee and beneficiary. A living trust is considered revocable — you can change or cancel it at any time.

The Specifics

You can keep modest and frequently accessed assets — such as checking accounts — in your own name or place them in the trust. Assets in your name alone that are not transferred to the trust will pass through a “pour-over” will into your trust when you die. This type of will is used to ensure that all of your property is distributed according to the terms of the trust.

Even if some assets pass through a pour-over will, you can still avoid probate in many states through the use of a procedure that applies to small estates. For example, the laws in some states may provide that assets valued at $50,000 or less may avoid probate by using an affidavit indicating to whom the assets should be delivered. When presented with such an affidavit, a bank would turn over the account that was held by the decedent to the person named in the affidavit.

Living Trust Advantages

A living trust has several advantages over a standard will:

  • A trust is usually easier to amend than a will because in most states no witnesses are required to execute a trust agreement.

  • A trust provides greater privacy because a will filed with the court after death becomes a public record available for inspection.

  • A living trust allows you to plan for your incompetence without court involvement. You name a successor trustee to act in your place if you become disabled and unable to manage your affairs. Without a trust, the court must appoint a conservator or guardian to administer your assets if you do not have a power of attorney. Guardianship requires court supervision and may require approval of all expenditures for you. Procedures for appointing a guardian vary from state to state. Powers of attorney do not require court involvement but often are suspect and if improperly drafted may not give your family needed flexibility.

  • In some states, revocable trust assets are not subject to the after-death claims of your creditors unless the transfer was in fraud of the creditor’s rights. Instead, probate assets must settle these claims. Because the power to revoke the trust is available only to you, the grantor, that power terminates on your death. This may leave creditors with little authority to assert claims against trust assets.

  • It is more difficult for heirs or beneficiaries to initiate and win a lawsuit against a living trust. Heirs or trust beneficiaries can contest a trust based on undue influence or lack of capacity. The longer the trust has been funded and in existence, the more difficult it is to contest. A will is more likely to be attacked successfully partly because it doesn’t take effect until your death. On the other hand, a living trust may provide less protection of the assets from the surviving spouse’s nursing home bills.

Seek Professional Advice

If you would like assistance in determining whether a living trust or will is right for you, please let us know. Our professionals can help answer any questions that may arise when deciding between these two important estate planning methods.

08 Apr

2001 Estate Tax Relief Act – Estate and Gift Tax Changes

In 2001 Tax Changes by admin / April 8, 2013 / 0 Comments

July 27, 2001

You may have heard that Congress has changed the rules of the estate and gift tax as part of the 2001 Tax Relief Act. In an effort to keep our clients well informed, this letter summarizes and sets forth a few general implications of the new law so that you can determine (with our help if you like) what effect, if any, the new tax law will have on your current estate plan.

I. Summary of the New Law

Congress tinkered with two basic elements of the estate tax: (1) the “free amount” and (2) the top estate tax rates. By “free amount” we mean the amount that can be transferred to someone other than your spouse without any estate tax having to be paid. The new law gradually increases the free amount and reduces the top estate tax rates over the next nine years, finally repealing the estate tax (but not gift tax!!) in the year 2010. Curiously, the estate tax repeal is only for one year. That is, the House, the Senate and the President need to agree in the year 2010 to extend the repeal, and if they are unable to do so, the estate tax is reinstated pursuant to the laws in effect as of 2001! In short, if you survive the next nine years, the free amount drops back to $1,000,000, and the maximum estate and gift tax rates return to 55%.

The increased free amounts and reduced top rates are phased in over the next nine years as follows:

Top Estate Tax Rate
Estate Tax “Free Amount”
Gift Tax “Free Amount”
50% $1,000,000 $1,000,000
49% $1,000,000 $1,000,000
48% $1,500,000 $1,000,000
46% $1,500,000 $1,000,000
45% $2,000,000 $1,000,000
45% $2,000,000 $1,000,000
45% $2,000,000 $1,000,000
45% $3,500,000 $1,000,000
Repeal Repeal $1,000,000
55% $1,000,000 $1,000,000

You will note that while the estate tax “free amount” increases beyond the $1,000,000 mark in 2004, the gift tax “free amount” stays at $1,000,000. Also, keep in mind that gift tax is not repealed in the year 2010 and at such time there will be a flat gift tax rate of 35%. Finally, the generation skipping transfer tax “free amount” increases in the same manner as the estate tax “free amount” and is repealed for one year only, along with the estate tax, in 2010.

The trade off for repeal of the estate tax was the loss of a step-up in income tax basis at death. Current law provides that capital gains tax is washed away upon death (i.e., in most instances your heirs do not have to pay capital gains tax on the pre-death appreciation of assets that are sold after your death). This changes for persons dying in the year 2010, when property acquired from a decedent will retain the decedent’s tax basis. This is known as “carryover” basis. When the recipient of the property eventually sells it, he or she will need to compute the gain using the decedent’s adjusted basis. The legislation contains two major exceptions to carryover basis. First, each estate receives a $1.3 million increase in basis. Second, an estate is entitled to an additional basis increase of up to $3.0 million for property passing to the surviving spouse.

II. Estate Planning Implications of New Law

  • Planning is difficult when the law is changing and its future is uncertain. There are more variables now. Not only is the law scheduled to change nearly every year between now and 2011, but there is additional uncertainty over whether and when Congress will make additional changes to the law. Remember, 2004 and 2008 are Presidential election years.

  • We recommend you continue lifetime giving programs (i.e., hedge your bets against the reinstatement of the estate tax in 2011). We do not, however, recommend you pay gift tax unless you are unlikely to live until 2010. Keep in mind that your gift tax free amount increases to $1,000,000 in 2002 but does not thereafter increase. I know some of you have given away your entire current $675,000 estate and gift tax free amount. Come January 1, 2002, you will be able to give another “big” gift of $325,000. If you are unlikely to need this amount, gifting it in 2002 will leverage the benefit of this increase, in that all appreciation on this amount will occur outside of your estate.

  • Lifetime charitable gift planning is unlikely to change, since much of it is income tax driven. Charitable remainder trusts will still be valuable tools for eliminating the tax on appreciated assets, while at the same time converting those assets into a lifetime income stream.

  • Detailed planning for carryover basis in 2010 is probably premature in most cases, but begin record keeping that will aid in the proof of basis (i.e., knowing the basis of your assets is going to be more important than ever).

  • Unrelated to the Tax Relief Act, the IRS changed the rules with respect to retirement plan beneficiary designations and minimum distribution elections (required when a person turns 70 ½) in early January of this year. Many of you will benefit from the new rules; therefore, reviewing the beneficiary designation on your IRAs and qualified retirement plans is particularly timely, especially for those of you with big retirement accounts (to the extent they may still be considered “big” after the stock market “correction” of 2000-?)

Generally, we recommend you come in for an estate plan review every 3-5 years or at any time there is a significant change to your family, health or finances. Given the sweeping new changes to the law, we recommend you visit us sooner rather than later so that we can ensure your estate plan is still appropriate for you and your family. While most of the plans we have created in the past ten plus years are appropriate for the next nine years, each case is different and warrants careful review. If you wish to schedule a visit, please call our Office Manager at (206) 583-0155 ext. 0.

08 Apr

How You Own Your Home Can Save You Taxes

In Home by admin / April 8, 2013 / 0 Comments

Estate Planner Nov-Dec 1998

Last year Congress changed the rules for taxing the gain resulting from the sale of a principal residence. These new tax rules may have a significant effect on the way you structure the ownership of your family residence for estate planning purposes.

The Changes

Under the Taxpayer Relief Act of 1997, eligible married taxpayers filing jointly may now exclude up to $500,000 ($250,000 for a single taxpayer or a married taxpayer filing separately) of such gain. This exclusion is available once every two years and replaces:

  • The one-time $125,000 exclusion from capital gain for a homeowner age 55 or older; and
  • The tax free rollover available to any homeowner who acquired a more expensive replacement home within two years of the sale of a principal residence. 

Step-Up in Basis

If you do not expect the appreciation in your family home to exceed $250,000, you will no longer need to put ownership in the name of the spouse who is most likely to die first. Why? Because you no longer need the step-up in basis available at death for assets included in the deceased’s gross estate to avoid capital gains tax when the home is sold.

If the appreciation in the family home will approach $500,000, consider joint ownership with your spouse, either through joint tenancy, community property (if available), tenancy by the entirety or tenancy in common. In such instances, one half the value of the residence will be included in the estate of the first spouse to die. It will receive a step up in basis, and the surviving spouse will have a $250,000 exclusion from gain on his or her one half interest in the residence. Therefore, you will eliminate or minimize capital gain on the sale.

Sale of Second Residence

The exclusion from capital gain only applies to the sale of a residence that has been your principal residence for at least two years. Accordingly, if you are considering selling your vacation home and it has appreciated substantially, deferring the sale for two years and taking steps to make the vacation home your principal residence may be tax advantageous.

Changing your principal residence is not necessarily easy or wise, however. Depending on a number of circumstances, you may need to completely change your domicile to a new state. Or you may need only to spend more time in the second home than in the first home for two years to make the vacation home your principal residence.

You may have intentionally changed your state of domicile to take advantage of favorable income tax treatment (Florida and Nevada, among others, have no state income tax) or to escape state imposed gift, inheritance or generation-skipping transfer taxes, but maintain a residence in your former state as well. Neither residence is considered a vacation home, but make an effort to show that the residence in the new domicile is the principal residence. When it comes time to sell the residence in the former state, however, you will owe capital gains tax on the appreciation.

The capital gain exclusions under the new tax law will not apply if you are not selling a principal residence. You may want to consider “moving” back to the old domicile for two years prior to a sale to re-establish that home as your principal residence. The benefit could be a savings of up to $100,000 ($500,000 gain exclusion times 20% tax rate). A disadvantage is that for two years you might be exposing yourself to the tax system you sought to escape. After the sale and tax savings, you can reestablish residency in the tax advantaged state. Keep in mind that after two years in the new principal residence, the exclusion from capital gain is again available.

The inconvenience and cost involved in changing a secondary residence to a principal residence may override the potential capital gains tax savings. Yet, if you are likely to sell or dispose of a residence in the near future, it may be worthwhile to consider the ramifications of a change.

Qualified Personal Residence Trusts

A gift of a remainder interest (effective after a term of years) in a vacation residence is a popular technique to leverage a gift to children for estate planning purposes. This type of gift uses a qualified personal residence trust (QPRT) or a residential grantor retained income trust (ResGRIT). You place the residence in trust and reserve the right to occupy it for a set period. At the end of the term, the residence is owned by the remainder beneficiaries (such as your children or a trust for their benefit) and you either become a rent-paying tenant or vacate the property.

One QPRT disadvantage is that the remainder beneficiaries inherit your basis in the property and will pay a capital gains tax on its subsequent sale. But if, prior to the sale, ownership of the residence vests in one (or more) of your children who is able to maintain the property for two years as a principal residence, then up to $100,000 in capital gains tax savings may be realized.

08 Apr

Use a QTIP Trust To Save Estate Taxes on Your Home

In Home,Marital Deduction by admin / April 8, 2013 / 0 Comments

Estate Planner Sept-Oct 1997

Because the marital residence often is one of the most valuable assets held between spouses, planning to reduce the impact of estate taxes on its transfer is critical for most couples. Many couples, however, are missing out on tax-savings opportunities, such as using qualified terminable interest property (QTIP) trusts to gain discounts and reduce estate taxes.

Case 1: Missed Opportunities

George and Martha owned a $1 million home. Because they held the property in joint tenancy, when George died, it was automatically transferred to Martha by operation of law. The transfer qualified for the unlimited marital deduction, so it didn’t trigger any estate tax.

However, when Martha died, the entire $1 million value of the property was includable in her estate, which triggered considerable estate tax. Although Martha’s $600,000 exemption equivalent was available, her estate was still left with an estate tax on $400,000, which, assuming an effective tax rate of just under 39% and no other assets, would equal $153,000.

George and Martha could have avoided this result if they had split their joint tenancy and used a QTIP trust to take advantage of minority discounts, like John and Abby in the following example.

Case 2: Maximum Tax Savings

John and Abby, who also owned a $1 million home, took advantage of the simple estate planning technique mentioned above and reaped significant tax saving. How? They took title to the marital residence as tenants in common, with John owning a 50% interest and Abby owning a 50% interest. (If, instead, John and Abby held the residence as community property and not also as joint tenancy property, each spouse would hold a 50% interest, which upon death, he or she could pass to anyone.)

Upon Abby’s death, Abby’s interest in the residence passed to a QTIP trust established under her estate plan. John had the right to receive all the income from the QTIP trust during his lifetime, but Abby chose who would benefit after his death. The transfer of Abby’s 50% interest in the residence into the QTIP trust qualified for the unlimited marital deduction, so no estate tax was owed.

When John died, his 50% interest in the residence plus the value of the interest held in the QTIP trust were includable in his estate. On John’s estate tax return, John’s executor took the position that John’s $500,000 (assuming there was no appreciation on the residence since Abby’s death), 50% interest in the residence could be discounted by 30% because John owned only an undivided fractional interest. The 50% held in the QTIP trust could likewise be discounted. This meant that estate tax would be due on only $700,000 (John’s discounted fractional interest of $350,000 + the discounted QTIP trust interest of $350,000).

Because John’s lifetime exemption equivalent was still available, estate tax was owed on only $100,000, which, assuming a 37% effective tax rate, would equal $37,000, leaving $116,000 more for John’s and Abby’s heirs than was available for George’s and Martha’s heirs. Even if John had owned 60% on his death (with the QTIP holding 40%), a discount might have been considered because the interest still would have been an undivided fractional interest and not readily marketable.

Weighing the Pros and Cons

When valuing property for estate tax purposes, the whole is often greater than the sum of its parts. Because fractional interests in property are not readily marketable, it is generally accepted that they can only be sold at a discount. However, as discussed at left, the approach outlined here may continue to be challenged by the IRS. If you are severing a tenancy by the entirety, this may result in some loss of protection from creditors. Carefully weigh the benefit of intentionally splitting joint tenancies to take advantage of valuation discounts against the possibility of a battle with the IRS. o

Risky Business?

The Internal Revenue Service (IRS) could claim that the interest owned by John and the interest held in the QTIP trust were merged, and deem that John owned the entire interest in the residence at the time of his death. This argument, however, has been rejected by various courts.

One theory for rejecting the argument is that the deceased spouse could determine who the ultimate beneficiaries of the QTIP trust would be, leaving the surviving spouse no control over the disposition of the QTIP trust assets. So, in John and Abby’s case, while the QTIP trust assets would be includable in John’s estate for estate tax purposes, this inclusion would not create a merger of interests.

08 Apr

Leveraging the GST Tax Exemption

In GSTT by admin / April 8, 2013 / 0 Comments

Estate Planner Sept-Oct 1998

The type of assets you transfer to your grandchildren and other heirs –and the means you use to transfer them — can make a difference in the amount of generation skipping transfer (GST) tax that will have to be paid. A 55% GST tax is imposed — in addition to the applicable estate tax — on transfers of property to people who are two or more generations below that of the property owner. Fortunately, an exemption from the GST tax exists. For 1998, this exemption is $1 million, but it will be indexed for inflation beginning in 1999.

Each individual’s exemption is allocated, either automatically or by specific allocation, to a particular transfer or transfers. How this allocation is made can greatly leverage the value of assets exempted from the tax. By allocating the GST exemption to a trust, you can ensure that the entire trust will never be subject to GST tax, even when assets pass out of the trust to multiple generations.

Leveraging With Discounts

Leveraging assets that would be exempt from the GST tax enables you to increase the value of these assets to your heirs. One form of leveraging is the transfer of discounted assets, such as stock in a closely held corporation where minority interest and lack of marketability discounts are available. Let’s look at an example. Sam gifts his 20% interest in ABC Corporation to his granddaughter. ABC is valued at $1 million, but the gift might be valued at $140,000 ($200,000 less 30% minority and lack of marketability discounts). Thus only $140,000 of GST exemption needs to be allocated. If the business is sold for $1 million, Sam’s granddaughter will receive $200,000. If the business appreciates to $2 million and is then sold, she will receive $400,000. Although, for GST purposes, Sam has only given her $140,000. The increased value in her hands occurs with no additional gift or GST tax, even though she now has an asset of much greater value.

Leveraging With Life Insurance

Another type of asset that allows for some of the greatest leverage is life insurance. You can create an irrevocable trust to hold an insurance policy on your life and make gifts to the trust to pay the premiums. The GST exemption can be allocated to the premiums and not to the death benefit. This offers great leverage. A late allocation of GST exemption based on the values of trust assets as of the date of allocation can result in less exemption being used. You must, though, adhere to complex rules ensuring proper allocation of the exemption.

Grandfathered Trusts

Trusts that were irrevocable on Sept. 25, 1985, are grandfathered from the GST tax unless additions were made to the trust after that date. With these trusts, you can obtain even more leverage by using trust assets to purchase a life insurance policy. For example, assume a grandfathered trust has $2 million in assets. The trustee, exercising the trustee’s power to invest in a variety of assets, purchases a policy on the life of the grantor, or perhaps even better, on the life of the spouse, child or grandchild of the grantor. When the insured dies, the insurance trust will collect proceeds which will remain exempt from GST tax. However, if additional contributions have been made to the grandfathered trust, it would lose its grandfathered status in whole or in part. The result is that a portion of the trust would be subject to GST tax upon distribution out of the trust to a skip-person. Again, be careful when purchasing life insurance to avoid adverse or undesirable estate or income tax consequences.

How Should You Leverage Your GST Tax Exemption?

Determining how to best leverage the GST exemption is complex. It requires the careful analysis of options. Please let us know if you have any questions about this or any other estate planning topics. We would be glad to help you maximize the value of your estate for your heirs.

The Return of Dynasty Trusts

Many states have repealed the rule against perpetuities, making it possible to extend the life of a trust indefinitely. Through the creation of such a trust that is exempt from GST tax, huge amounts of wealth can pass down through the generations free from transfer tax. Even if the rule against perpetuities has not been repealed in your state of residence or that of the trust beneficiaries, you may be able to establish nexus with another state and take advantage of the repeal. Nexus is the term used for the right that states have historically had to impose taxes on any company that’s had adequate contact with the state. You have to look into the tax codes of each state you deal with to stay on top of nexus.

08 Apr

A Simpler, More Flexible Approach to GST Planning

In GSTT by admin / April 8, 2013 / 0 Comments

Estate Planner Jan-Feb 1998

Many people understand the tax advantages of creating generation-skipping trusts that benefit grandchildren and make use of the $1 million exemption from generation-skipping transfer (GST) tax. Yet not everyone who would benefit from this type of planning is willing to undertake it. Why? Perhaps they:

  • Don’t have any grandchildren yet.
  • Have some children who have a more immediate need for the funds who would not benefit from having their inheritances tied up in generation-skipping trusts.
  • Think revising an existing estate plan would be too complex or expensive.

In planning to take advantage of the $1 million GST tax exemption, the goal is to have assets pass from grandparent to grandchild without being taxed in the child’s estate.

Generation-skipping trusts limit the children’s access to the funds to avoid taxation in the children’s estates. A simpler approach to GST planning, however, also allows more flexibility.

Back to Basics: A Case Study

Tom has an estate of $2 million that he plans to leave to his children, Susan and Sarah. Susan owns a successful business and has a large estate of her own. Sarah is a struggling actress and has few assets.

In his estate plan, Tom provides that his estate be divided equally between Susan and Sarah with their shares held in separate trusts for their benefit. Each child will have the right to receive all the income from her trust and as much trust principal as is necessary for her support. Knowing that Susan is financially secure and Sarah needs funds, Tom gives them each a general power of appointment: the right either to withdraw all funds from her trust or to direct the trustee to distribute the principal of the trust to any person, including herself. The general power of appointment, however, will cause the trust to be subject to tax in the child’s estate.

Because Susan has a substantial estate that will be subject to estate tax on her death, she wants to ensure that as much as possible passes to her children tax-free. To do this, on her father’s death she disclaims the general power of appointment while retaining the right to receive income and principal from her trust. By so doing,she converts her trust into a generation-skipping trust for the benefit of her children. At Susan’s death, her children will receive the proceeds of the trust tax-free.

Sarah is not concerned about GST tax because she has no children and her estate likely won’t be subject to estate tax. On her father’s death she exercises her general power of appointment to take the principal of her trust outright. At Sarah’s death, any portion of the trust estate that she did not use during her lifetime will be included in her estate and, if her estate is large enough, will be subject to estate tax.

Make GST Planning Easy

Generation-skipping trusts can offer additional advantages, but the disclaimer method allows you to provide for your children equally, leaving the decision to implement GST planning up to each child. This method also gives your children the option to disclaim their general powers of appointment over a portion of trust assets rather than over all trust assets. This provides your children with the flexibility to use part of their inheritances for GST planning and retain part for their own use. Consequently, your children may be more inclined to take advantage of GST planning.

We would be pleased to tell you more about these trusts and to help you make GST planning work for you and your heirs.

4 Disclaimer Method Pitfalls

Although the disclaimer approach simplifies GST planning, you need to consider additional issues, including the following four potential pitfalls:

1. Your child may not be able to deal emotionally with these complex decisions within nine months after your death, as is required for the disclaimer to be valid.

2. Your child may be incapacitated and unable to make a valid disclaimer.

3. Your child may have creditor problems and the state where the child resides may not allow him or her to disclaim assets that would otherwise be available for creditors.

4. Your executor or administrator may not be capable of handling the complexity the children’s disclaimers and GST allocations would add to administration of the estate.

08 Apr

5 Ways To Avoid the GST Tax

In GSTT by admin / April 8, 2013 / 0 Comments

Estate Planner Sept-Oct 1997

Did you know that as much as 79.7% of a transfer you make to your grandchild can end up going to the government? Transfers that skip a generation are subject not only to a gift or estate tax, but also to a generation-skipping transfer (GST) tax. While gift and estate taxes are based on a sliding scale at rates currently ranging from 37% to 55%, the GST tax is assessed at the highest currently applicable estate and gift tax rate — 55%. As a result, planning to reduce or minimize the GST tax is critical. Here are five ways you can avoid the GST tax.

1. Use Your GST Tax Exemption

The simplest way to reduce your GST tax burden is to use your GST tax exemption. Each person is allowed to make a total of $1 million of transfers to “skip persons” — persons who are more than one generation below you, such as grandchildren, great-grandchildren, grandnieces, grandnephews and unrelated people more than 37 years younger than you — without incurring the GST tax. Through smart allocation of your GST tax exemption, such as applying it to leveraged gifts like property that you expect to appreciate greatly or life insurance premiums, you can significantly increase its effectiveness. The GST tax exemption can be allocated either to outright gifts or to gifts made in trust.

2. Make Annual Exclusion Gifts

If you wish to give your grandchildren more than $1 million, you can make outright annual exclusion gifts of $10,000 ($20,000 if you and your spouse split gifts) to each of them. The gifts will not only qualify for the annual exclusion from gift tax, but also for annual exclusion from GST tax. This can be beneficial if you want to save your GST exemption or have already used it.

3. Make Gifts To Crummey Trusts

If your grandchildren are young or not financially responsible, you may prefer to make gifts to a trust, such as a Crummey trust. For gifts to the trust to qualify for the annual gift tax exclusion, the trust agreement must give the beneficiaries the right to withdraw all or a proportionate share of any gifts you make to the trust each year, and the trustee must notify all beneficiaries of the amount of these gifts and the amount that the beneficiaries may withdraw. For the gifts to also qualify for the annual GST tax exclusion, the trust must have only one beneficiary and must be taxed in his or her estate upon the beneficiary’s death.

4. Make Gifts To 2503(c) Minor’s Trusts

If your grandchildren are minors and you don’t mind if they have complete access to trust assets when they reach age 21, you can avoid the administrative burdens of a Crummey trust by making gifts to a 2503(c) minor’s trust. These gifts will qualify for the annual exclusion for gift tax and GST tax purposes if the trust agreement:

  • Allows trust income and principal to be distributed for the child’s benefit before he or she reaches age 21,
  • Allows the child to withdraw the entire trust corpus when he or she reaches age 21, and
  • Requires that, if the child dies before age 21, the trust corpus pass to the child’s estate or to the person the child has appointed.

5. Make Gifts From A Grandfathered Trust

Irrevocable trusts created before Sept. 25, 1985, are grandfathered from GST tax. Thus, if you created such a trust and have kept it grandfathered (by not adding new assets to the trust), distributions made from the trust to your grandchildren will not incur the GST tax. Distributions also can be made through the exercise of granted powers of appointment in favor of beneficiaries who otherwise would be considered skip persons.

Stretch Your GST Tax Exemption

Gifts made directly to grandchildren or other skip persons not only benefit them today, but avoid double exposure to transfer tax — once when you pass the property to your child and again when your child passes the property to your grandchild. The methods described above allow you to stretch your GST tax exemption for additional tax savings.

Predeceased Ancestor Rule Offers More GST Tax Protection

Gifts made to a grandchild will not trigger GST tax when the grandchild’s parent has died prior to the transfer to the grandchild. This special exception is referred to as the “predeceased ancestor rule.” Legislation has been introduced to extend the predeceased ancestor rule to include grandnieces and grandnephews, but Congress has not yet passed this legislation.

08 Apr

Roll with it – Keep wealth in the family using rolling GRATs

In GRAT by admin / April 8, 2013 / 0 Comments

Estate Planner May-June 2006

A grantor retained annuity trust (GRAT) can be a powerful tool for transferring wealth to family members with minimal gift and estate tax consequences. But GRATs also have some disadvantages.

Perhaps the most significant drawback is the “mortality risk.” Generally, the longer a GRAT’s term, the better it performs. But if you, as the grantor, fail to survive the term, the GRAT’s benefits are lost. Thus, designing a GRAT involves striking a balance between maximizing performance and minimizing mortality risk. One technique that may offer the best of both worlds (maximizing the GRAT’s term while minimizing the risk of dying during its term) is the use of rolling GRATs.

How a GRAT works

To take advantage of a GRAT’s benefits, you make a one-time contribution of assets to an irrevocable trust. In return for your contribution, the trust pays you an annuity for a specified term, and at the term’s end, any remaining assets are transferred tax-free to the trust’s beneficiaries. The annuity payments are either a fixed percentage of your initial contribution’s value or a fixed percentage of the trust’s assets recalculated on a periodic – generally annual – basis. A GRAT is considered a “grantor trust,” so you pay any income taxes on the trust’s earnings.

A GRAT can reduce your estate tax exposure because the assets you contribute are removed from your estate – as long as you outlive the trust’s term. When you create a GRAT, however, you make a taxable gift to the trust’s beneficiaries equal to the present value of their remainder interest. The amount of the gift is calculated by subtracting the present value of your annuity payments from the value of the assets you transfer to the trust.

Increasing the GRAT’s term and the size of the annual payments increases your annuity’s present value and, therefore, decreases the size of the taxable gift. If you set the term long enough and the annuity payments large enough, the gift disappears altogether (a so-called zeroed-out GRAT).

GRATifying results

Now here’s the secret to taking advantage of a GRAT: Your annuity’s present value for tax purposes is based on an assumed rate of return – the Section 7520 rate – published monthly by the IRS. The applicable rate is the Sec. 7520 rate in effect during the month you create your GRAT. If you design the GRAT so the present value of your annuity payments is equal to the value of the assets you contribute to the trust, the present value of the remainder interest is zero. Therefore, there’s no taxable gift, but any appreciation of the GRAT assets above the Sec. 7520 rate passes to your beneficiaries gift-tax free.

So, the key to a successful GRAT is for the trust assets to generate returns that exceed the assumed rate of return. The Sec. 7520 rate often is referred to as the “hurdle rate,” because your GRAT’s growth rate (appreciation and earnings) must top that rate to pay off. This is one reason longer-term GRATs tend to perform better. Historically, longer-term investments have yielded higher average returns: the longer your GRAT’s term, the greater your chances of clearing the hurdle rate. GRATs also typically do well in a low-interest-rate environment because you can lock in a low hurdle rate, increasing your chances of success.

GRATs on a roll

As interest rates continue to increase, GRATs become riskier. After dropping to a historical low of 3% in July 2003, the Sec. 7520 rate has inched back up to the 5% to 6% range. Although you can improve your chances of outperforming the hurdle rate by choosing a long trust term, this increases your mortality risk.

Rolling GRATs are an alternative to traditional GRATs that may allow you to enhance performance without increasing the mortality risk. The technique involves creating a series of short-term GRATs (typically two or three years) with each successive GRAT funded by annuity payments from the previous ones. By using short trust terms, you can minimize the mortality risk. But over the longer term, rolling GRATs stand a good chance of successfully transferring wealth, and in many cases outperform single, longer-term GRATs.

Improving your odds

With a single, longer-term GRAT, poor market performance in the early years can make it difficult for the trust to recover. Rolling GRATs, on the other hand, thrive on volatility. And unlike the success of a single, longer-term GRAT, which usually performs better when interest rates are low at inception, the success of a series of rolling GRATs is less dependent on a lower initial interest rate.

Rolling GRATs offer other advantages as well. They may allow you to transfer wealth to your beneficiaries sooner. And you can stop creating GRATs if your assets’ growth rates drop too low, you feel you’ve transferred enough wealth or you need the income from the trust assets.

Rolling out a strategy

Like most investments, rolling GRATs offer no guarantees of success. But under the right circumstances, they can greatly improve your chances. And remember, when a GRAT “fails” – either because you don’t outlive the trust or because the trust doesn’t outperform the hurdle rate – the money isn’t lost. It simply goes back into your estate and you’re no worse off than if you hadn’t created the GRAT in the first place.

Sidebar: Rolling GRATs in a volatile market
Rolling GRATs can be effective because of their ability to capture the upside of a volatile market. To illustrate this concept, consider the period from 1965 to 1974. The S&P 500’s compound return for that 10-year period was about 1.2%. And though the IRS didn’t establish the Sec. 7520 rate until 1989, analysts have estimated that the hurdle rate at the beginning of 1965, based on IRS methodology, would have been 5.2%.

According to a 2005 study by Bernstein Investment Research and Management, if you’d created a 10-year GRAT in 1965 funded with $5 million and invested in a diversified portfolio of U.S. equity securities, at the end of the term nothing would have been transferred to your beneficiaries.

If, on the other hand, you’d used that $5 million to create a series of two-year rolling GRATs, about $1.5 million would have been transferred to your beneficiaries gift-tax free. Why? Because, despite the stock market’s dismal overall performance between 1965 and 1974, there were a couple of very good years. Although most of the two-year GRATs would have failed – that is, not transferred wealth to your beneficiaries – strong performance by the GRATs established in 1967 and 1971 would have been enough to produce a windfall transfer.


08 Apr

From GRIT to GRAT to Great GRAT

In GRAT by admin / April 8, 2013 / 0 Comments

Estate Planner Mar-Apr 1997

Like most techniques used in shifting wealth from one generation to the next, the grantor retained annuity trust (GRAT) is a currently approved version of an old estate planning tool.

The GRAT is the successor to the grantor retained income trust (GRIT), in which the value of the gift to trust could be significantly reduced by the transferor’s retention of the right to receive income for a term of years. The GRIT was so successful in leveraging gifts that Congress changed the Internal Revenue Code to negate its effectiveness for making gifts to children.

But, Congress did permit the value of a gift to a trust to be reduced by the present value of the transferor’s retention of the right to receive an annuity amount for a term of years — the GRAT. In theory, the transferor will receive annuity payments from the trust equal to the value of the retained annuity interest. These payments will earn income or appreciate and be part of the transferor’s estate. The only gift is the current value of the remainder interest. If the transferor dies during the term, some portion will be included in the estate, but arguably not 100%.

How GRATs Work

The present value of the annuity rights is determined by Internal Revenue Service (IRS) valuation tables (Section 7520 rate), which can change monthly. If the GRAT assets only grow at the Section 7520 rate or less, then the gift has not been leveraged. Accordingly, the GRAT is best used when there is a basis for optimism that the growth of trust assets will markedly outperform the Section 7520 rate.

The value of the gift of the remainder interest in the GRAT is influenced by the amount of the annuity payment and the term over which payments will be made. Higher annuity payments and longer payout periods reduce the amount of the gift.

While the retained annuity interest cannot reach 100% (meaning the value of the gift is zero), it is possible to get the value of the gift close to zero — in fact, close enough to conclude that the only thing you have to lose by trying is the cost of the transaction.

How To Create a GreatGRAT

Accordingly, if we have a nothing-to-lose GRAT which can be funded with assets that have an enhanced ability to out-perform the market, there is the potential for a highly leveraged (low gift tax cost) transfer of wealth to the next generation — the GreatGRAT. Several types of assets can be considered for the GreatGRAT:

  • Stock in a closely held company that could be subject to an initial public offering in two or three years, or
  • Stock that could be valued using lack-of-marketability, lack-of-control or minority-interest discounts, such as:
  • S corporation shares that can generate cash flow to pay the annuity and are discountable, and
  • Minority limited partnership interests from a family limited partnership.

Can a GRAT Work for You?

GRATs can be a highly effective wealth transfer technique. All you have to do is to find the right asset, make projections and run the numbers. You will know right away whether this plan can work for your situation.

08 Apr

What Do You Mean It’s Defective? How You Can Benefit From Intentionally Defective Grantor Trusts

In Grantor Trusts by admin / April 8, 2013 / 0 Comments

Estate Planner Jan-Feb 2001

Would you use a product or service that is intentionally defective? Probably not, but an increasingly popular estate planning technique uses an intentionally defective grantor trust. This is an irrevocable trust that you purposely create to be complete for federal transfer tax purposes but incomplete for federal income tax purposes, thus the term “intentionally defective.” The IRS treats you, the grantor, as the owner of the trust’s assets only for income tax purposes.

Use this trust as an effective estate-freezing device by selling assets to the trust in exchange for the trust’s installment note with a reasonable market rate of interest — currently between 8% and 10%. Typically, the subject assets are stock, membership or partnership interests in a closely held business, real estate, or marketable securities. The assets generally have significant growth potential. Let’s take a closer look at how intentionally defective grantor trusts work and then examine how the estate-freeze technique might benefit you.

How These Trusts Work 

When you acquire or retain certain powers or interests in a trust you create, the Internal Revenue Code treats you as the owner of the trust’s assets for income tax purposes. For this type of trust — known as a grantor trust — the IRS will attribute the trust’s income, deductions and credits to you — as the trust owner — even though the trust instrument distributes or accumulates trust income in the trust for the benefit of another person. So you are liable for tax on both the trust’s ordinary income and capital gains. If the trust is properly drafted, trust assets will be excluded from your estate for estate tax purposes.

The IRS will consider you the owner of trust property for income tax purposes if you or your spouse:

  • Has a reversionary interest in trust income or principal exceeding 5% of trust value,
  • Retains certain prohibited powers exercisable by you or a nonadverse party (or both you and a nonadverse party) that can affect the beneficial enjoyment without an adverse party’s approval or consent. An adverse party in this context is any person with a substantial interest in the trust who would be adversely affected by the exercise or nonexercise of this power,
  • Retains certain prohibited administrative powers or the right to revoke the trust, or
  • Can benefit from trust income.

You can create a defective grantor trust if:

  • You have the power in a nonfiduciary capacity to reacquire trust corpus by substituting property of equal value,
  • You retain the right in a nonfiduciary capacity to sell trust assets or change the nature of trust assets,
  • You are related or subordinate to more than half the trustees, and they have power to distribute income or corpus among the beneficiaries,
  • A nonadverse party, such as the trustee, has the right to add beneficiaries other than children born after the creation of the trust to the trust,
  • You may use the trust’s income to pay your life insurance premiums provided the trust owns such insurance,
  • You can pay the trust’s income to your spouse, or
  • You retain the power to borrow trust assets without adequate security.

The Estate-Freeze Technique In Action

The objective of an estate freeze is to place a ceiling on the current value of an asset in your estate and to shift all future appreciation to family members while paying a minimum gift tax. How do you do this? If you sell an asset to the grantor trust at fair market value, there is no gift tax and all future growth in value belongs to the trust.

For example, suppose Steve owns all stock in a business worth $2.5 million with a positive growth outlook. Steve creates a trust for the benefit of his children and grandchildren that is defective for income tax but not for estate and gift tax purposes. How? By including the power to reacquire the trust property by substituting assets of equivalent value or to borrow trust assets without providing adequate security.

Steve initially funds the trust with a cash gift of $250,000. The gift equals about 10% of his business’s stock value — the assets that are to be sold to the trust — and many estate planners recommend providing liquidity to the trust apart from its interest in the purchased stock. The contributed cash represents a taxable gift to the trust’s beneficiaries — a gift that may or may not be within Steve’s gift and estate tax applicable exclusion amount. Steve then sells his stock to the trust for full and adequate consideration, receiving a 10-year installment note for $2.5 million from the trust with interest at the applicable federal rate.

The sale of the stock generates no taxable gain to the trust in the estate-freeze technique. The IRS doesn’t recognize any gain or loss in transactions between you and a defective grantor trust because the trust is not an entity separate from you. If the sales price is fair, the transfer of stock to the trust isn’t subject to gift tax because fair and adequate consideration will have been paid. When you die, only the value of the note should be included in your estate. Any increase in stock value held by the trust and the income generated by it will escape estate tax. You can further reduce the value of your estate by the amount of tax you pay on trust income. And the tax payment is effectively a tax-free gift to beneficiaries because they receive the trust income but you — as the grantor — pay the tax.

Is a Defective Grantor Trust Right for You?

Using a defective grantor trust offers you the opportunity to transfer substantial assets at a reduced tax cost compared to continuing to hold appreciating assets. Defective grantor trusts also allow you to transfer the future appreciation in assets to your children or grandchildren at minimal transfer tax cost. If you have questions about the use of defective grantor trusts, please give us a call. We’d be happy to explain how a “defective product” can work in your favor.

The objective of an estate freeze is to place a ceiling on the current value of an asset in your estate and to shift all future appreciation to family members while paying a minimum gift tax.