Estate and Gift Tax Planning
 
November 29, 2005
 
Todd Schneider - Chicago

With the year drawing to a close, now is a good time to revisit your estate plan. This newsletter is intended to serve as a guide to acquaint you with the ever-changing landscape of the tax laws that may affect your estate plan, as well as a review of traditional year-end tax planning strategies.

Looming Changes in the Federal Estate Tax

Several pending changes in the federal estate tax laws will come as a pleasant surprise to many taxpayers. Perhaps the most important change is the scheduled increase in the federal estate tax exemption. On January 1, 2006, the exemption amount increases from $1.5 million per person to $2 million. Also, the top estate tax rate will fall from 47 percent to 46 percent. These changes will reduce the total amount of estate tax paid by most wealthy families, and will enable many families to avoid paying federal estate tax entirely. If your assets currently place you in this category, merely surviving until the end of the year could save your family over $470,000 in federal estate tax.

Need to Plan

Taxpayers who hope that these changes will simplify or even eliminate the need for estate and tax planning may be in for an unpleasant (and expensive) surprise: estate and generation-skipping transfer (GST) taxes are only reduced, not eliminated, for the next four years, and are actually eliminated for only one year – 2010 (see chart below). In addition, the gift tax exemption will remain at $1 million. Further complicating matters is the reinstatement of the so called carry-over basis rule, which is also scheduled to go into effect in 2010. Finally, unless Congress changes the law in the next five years, the estate tax exemption is scheduled to revert to $1 million in 2011 – meaning estate taxes may never really go away at all.

Year	Estate and GST Tax Exemption	Highest Estate, GST and Gift Tax Rate
2006	$2 million	46%
2007	$2 million	45%
2008	$2 million	45%
2009	$3.5 million	45%
2010	Repealed	35% (gift tax only)
2011 and later	$1 million	55%

Carry-Over Basis

As mentioned above, if the federal estate tax is repealed, the income tax basis of property received from a deceased person will carry over from the previous owner. Some assets will be allowed a $1.3 million increase in basis, and an additional $3 million of basis will be added to those assets left to a spouse. Even with these exemptions, however, many people will be better off with the current estate tax than with capital gains tax. For example, the heirs of a single person with assets worth $4 million that have a zero cost basis (before the $1.3 million adjustment) will pay approximately $315,000 less if he dies prior to the repeal of the estate tax (assuming a 20 percent capital gains tax rate):

Year of Death	Federal Estate Tax	Capital Gains Tax
2009	$225,000	0
2010	0	$540,000

As a result of these pending changes in the tax laws, proper planning and good record keeping will be essential.

Other Taxes

It is important to keep in mind that whatever changes occur in the future, many other taxes will continue to affect estate planning. For example, resident aliens are subject to various rules and regulations that do not apply to U.S. citizens. In addition, 18 states and the District of Columbia have enacted separate estate tax laws that may increase your overall estate tax liability. Many states also impose a separate tax on real estate and intangible assets (such as stocks and bonds) located within their borders. Retirement benefits continue to be subject to deferred income tax. And finally, federal gift tax will continue to apply to lifetime transfers.

Fewer Estates Subject to Tax

The good news is that although the federal estate tax system has made the headlines over the past few years, and is a regular target of the U.S. Congress and the White House, the percentage of estates actually subject to estate tax is very small. According to IRS statistics as reported in a recent New York Times article, only 65,039 estate-tax returns were filed in 2004. This represents less than 2.5 percent of all adult deaths in the United States. In addition, many of the estates that filed returns did not have to pay a federal estate tax. Of the 2004 total, only 31,329 – or less than half of the returns that were filed – were taxable, the New York Times reported.

Furthermore, most of these taxable estates would not have been subject to estate tax if death occurred after 2008. In 2004, for example, less than 30 percent of all taxable estates were valued at more than $2.5 million, and less than 5 percent were valued at $10 million or more. As a result, in the future, we expect that more individuals will focus on the non-tax aspects of estate planning, such as asset protection and spendthrift trusts.

Year End Gift Planning

If your estate is large enough to be subject to estate tax, you should consider making gifts that qualify for the various federal gift tax exclusions.

Annual Exclusion Gifts

In 2005, you can transfer assets worth as much as $11,000 to any individual (other than a spouse), without federal gift tax consequences. If you are married, you can give each person $22,000 without incurring gift tax. The exclusion amount is indexed for inflation. In 2006, the annual exclusion amount will rise to $12,000 per donee, or $24,000 per married couple. When used as part of a comprehensive estate plan, annual exclusion gifts can substantially reduce your potential estate tax liability. For example, each $22,000 gift that you make before the end of the year may eventually save your family over $10,000 in estate tax.

Education/Medical Exclusion

In addition to the annual gift tax exclusion, each person has an unlimited exclusion for direct payments of tuition or medical expenses. The only caveat is that the payments must be made directly to the provider of the medical care or the student’s school. They cannot be given to the person who incurred the expenses.

Lifetime Exclusion Gifts

Each person is also entitled to transfer assets worth as much as $1 million to any individual during the transferor’s lifetime without incurring any gift tax liability. This amount is effectively doubled for married couples. Since most people are uncomfortable transferring such a large amount without any restrictions, many people utilize dynasty trusts to hold the property for the benefit of their descendants. For high net worth individuals, this can be a very effective technique to reduce their overall income tax and estate tax liability, while preserving their wealth for generations to come.

College Savings Plans

If you are fortunate enough to have a child, grandchild, or other family member who expects to attend college in the future, you should consider making a contribution to a state-sponsored college savings plan (commonly known as a 529 Plan) or a Coverdell Education Savings Account (Coverdell ESA) prior to the end of the year.

529 Plans

Under present law, distributions from 529 Plans are completely free from federal income tax if they are used to pay for qualified college expenses, such as tuition, books, room and board. These plans allow a taxpayer, regardless of income, to contribute up to $55,000 (or $110,000 for a consenting married couple) to a student’s account in 2005, free of gift tax as long as the donor does not make any other gifts to the same beneficiary for the next five years. This allows parents, grandparents and others to “front-load” a child’s college savings account, greatly enhancing the effects of tax-free growth.

Many states offer income tax benefits to residents who participate in the in-state plan. For example, most states exclude distributions from state income tax. Several states also offer a state income tax deduction for contributions to the in-state plan. And finally, a few states permit the account owner to claim a state income tax deduction for distributions from a plan.

Coverdell ESAs

Although not as popular as 529 Plans, Coverdell ESAs (named after former Georgia Senator Paul Coverdell) can be an effective strategy as well. Like 529 Plans, contributions to Coverdell ESAs grow income tax free if used for qualified education expenses. They can also be used for a wider variety of educational expenses, such as primary and secondary school tuition, computer equipment and educational software. On the downside, contributions to Coverdell ESAs are limited to $2,000 a year. As a result, they probably will not cover all anticipated expenses. In addition, when the account is established, the designated beneficiary must be under age 18 or a special needs beneficiary. Finally, the amount that can be contributed phases out for taxpayers that have adjusted gross incomes between $95,000 and $110,000 ($190,000 to $220,000 for married couples).

Leveraged Wealth Transfers

Even with the anticipated changes in federal estate tax rates, it is still difficult for many wealthy families to transfer property to younger generations without incurring substantial tax liability. Fortunately, there are several estate planning strategies that allow families to retain more wealth and lessen their overall estate tax burden. The end of the year is a perfect time to consider implementing one or more of these strategies.

Family Limited Partnerships

One such technique is a family limited partnership (FLP). For many years, FLPs have been used as vehicles to own and manage family property and businesses. Recently, they have become a very effective technique to pass property interests (while retaining some influence over the underlying assets) to other family members at a substantial transfer tax discount. The discounts are often available even if control of the entity remains within the family unit both before and after the transfers.

In a typical family partnership, the senior family members create a company consisting of a 1 percent general partnership interest and a 99 percent limited partnership interest. Initially, the senior family members may own all of the interests. Over time, however, they give away some or all of the partnership interests to younger generations or to a trust for their benefit. The senior family members may retain some influence over the partnership assets, but the value of the interests that they give away should not be subject to estate tax.

The primary benefits of an FLP are as follows:

• future appreciation on transferred assets grows estate-tax free

• senior family members may retain influence over family wealth during their lifetimes

• younger generations learn how to effectively manage and accumulate wealth

• senior members pass on wealth at a discount for estate tax purposes

• assets are protected from creditors and other non-family members

• family assets are consolidated

• smooth transition of control to younger family members is facilitated

Although this is a highly effective technique when it is structured properly, FLPs have come under increased IRS strutiny in recent years. That is exactly what happened in a case decided this past summer in favor of the IRS, known as the Estate of Strangi. In this case, a federal appeals court held that there was an implied agreement between Mr. Strangi and his relatives for him to retain the use of the underlying partnership assets. The Strangi case demonstrates that in order to achieve the desired result, the person who funds the FLP must give up control of the transferred assets, or the property could be brought back into his or her estate under a complex statutory provision.

Sale to an Irrevocable Grantor Trust

As an alternative to giving away partnership interests, senior family members may want to sell their interests to an irrevocable grantor trust (IGT). This technique involves the creation of a trust that will purchase the senior family members’ assets in exchange for a promissory note that will pay them a stream of income each year. The trust will be designed so that the senior family members will not incur any capital gains upon the sale. Ideally, the assets held by the trust will appreciate and produce income at a rate greater than the minimum interest rate set by the IRS (which varies from month to month). This enables the senior family members to prevent future appreciation from building up
in their estates, without making an outright gift of the underlying assets.

Grantor Retained Annuity Trust

A similar technique is a grantor retained annuity trust (GRAT). It also involves the creation of an irrevocable trust to which senior family members transfer property and reserve a right to receive an annuity for a certain period of time. These payments can be modified to fit their cash flow needs and the income projections of the underlying assets. In addition, the trust can be structured to avoid the use of the grantor’s gift tax exemption. At the end of the annuity term, the trust terminates and the remaining assets will be distributed to the younger generation.

Although GRATs are specifically sanctioned by the Internal Revenue Service, they have several drawbacks compared to a sale to an IGT. For instance, if the senior family members die during the term of the trust, the full value of the trust assets would be taxed in their estates. Also, in order for the technique to be successful, the assets have to outperform the minimum interest rate set by the IRS for GRATs, which is about 20 percent higher than the minimum interest rate for IGTs.

Private Annuity

This strategy involves a sale of assets (or family limited partnership interests) in exchange for an unsecured series of payments that continue for the lifetime of a senior family member. The benefit of this technique is that unlike an IGT there is no gift tax incurred at the time of sale. The annuity payments are based on a variety of factors, including the actuarial life expectancy of the senior family member, the fair market value of the assets, and the IRS minimum interest rate at the time the sale.

Caveats

These wealth conservation strategies can potentially save a family millions of dollars in estate taxes while preserving the family’s wealth for many generations to come. However, because they are cutting edge techniques, they carry some risk of an IRS challenge. As a result, careful planning and attention to detail must be observed to achieve the desired results.

Asset Protection Planning

As estate taxes become less of a burden on most people, various non-tax issues, such as asset protection, can be the primary focus of the estate planning process. In an increasingly litigious culture, many individuals are anxious to find some means to protect their assets from claims of creditors that might arise in the future.

Perhaps the most effective mechanism an individual can employ to protect his or her assets from future creditors is an Asset Protection Trust. Such trusts can be established either in a foreign jurisdiction or in one of seven states in the U.S. that now permit an individual to create a self-settled asset protection trust. The primary benefit of such trusts is that the donor may retain a beneficial interest in his or her property while removing it from the reach of future creditors. Because the creation and funding of such trusts is complicated and carries some risk, it is best to consult with your attorney prior to entering into any asset protection strategy.

Advanced Directives for Health Care

The heavily publicized case of Terry Schiavo demonstrated the importance of disability planning, another non-tax aspect of estate planning. Terry Schiavo died at age 41, shortly after her feeding tube was removed some 15 years after she had lapsed into a permanent vegetative state. Like most Americans, Mrs. Schiavo did not have a living will or any other written statement that advised her family members and friends what type of treatment she would want if ever in a vegetative state. She also did not authorize anyone to make medical treatment decisions on her behalf. As a result, her husband and parents spent many years fighting over the right to direct her care. Had she signed an advanced directive prior to suffering the cardiac arrest that led to her medical condition, she may have spared her family years of agony and financial distress.

Most states allow individuals to direct their health care providers to withhold life-sustaining treatment under certain conditions. In many states, individuals may also designate an agent to make health care decisions on their behalf and to obtain access to their health care records. There are generally two types of advance directives: living wills and powers of attorney.

Living Will

A living will is a written declaration of an individual’s desires concerning death-delaying procedures. Most states have procedures that, if followed, will permit a physician to withhold life-support from an individual who has a terminal condition and is unable to verbally communicate his or her wishes concerning his or her treatment, without risk of civil or criminal liability.

Even if an individual has signed a living will, health care providers are generally required to provide the patient with treatment for the alleviation of pain. Also, health care providers might not be permitted to withdraw or withhold nutrition and hydration if death would result from dehydration or starvation.

Health Care Powers of Attorney

Powers of attorney for health care (sometimes known as health care proxies) enable an agent to deal with the subject of life-sustaining procedures on behalf of the person who appointed the agent. Agents are generally permitted to make decisions concerning the course and extent of treatment, hospitalization and organ donation. Agents may also have the power to review medical records.

By signing a health care power of attorney and providing detailed instructions to your agent, you will hopefully keep the courts and the legislature from intervening in your medical care. If you do not have a current advance directive, it is best to meet with your attorney and sign one as soon as possible.

Life Insurance Financing Opportunity

Many families will no longer have the need for life insurance if estate taxes are repealed. This will leave many people with an asset that they didn’t know they had: their unused insurability. This development has led to a recent phenomenon in the life insurance industry that may not be around much longer: the combination of third-party financing of life insurance, and the ability to sell life insurance policies on the secondary market. If you fit the appropriate profile, you may be able to obtain substantial life insurance coverage at no out-of-pocket cost. In addition, you might receive a substantial up-front payment equal to a portion of the death benefit. You will probably fit the profile if you are between 75 and 85, are in reasonable health, and have a net worth of at least $5 million.

These relatively new programs generally work as follows: an individual who fits the profile (the insured) will apply for a life insurance policy on his or her life. An institutional investor will finance the premium payments on the life insurance policy for two years. The policy will be owned by a trust created for the benefit of the insured’s family, or charity. The institutional investor will often make an upfront payment to the beneficiaries of the trust equal to 3 to 5 percent of the death benefit.

If the insured dies during the first two years of the policy, the institutional investor will recover the premium payments that it advanced, plus interest, and the beneficiaries of the trust will keep the balance of the insurance proceeds. If the insured survives for at least two years after the policy is issued, he or she can elect to either keep the policy by repaying the institutional investor, or transfer the policy to the investor and keep the 3 to 5 percent cash advance.

These programs may sound too good to be true, but if structured properly, they do have the potential of providing a substantial return to the insured’s family or favorite charity. If you are approached by an individual who is promoting such an arrangement, you should consult with your attorney and tax advisors immediately. There are many income and estate tax issues that should be considered prior to entering into one of these transactions.

Conclusion

As this newsletter indicates, there are many reasons – both tax and non-tax – to update your estate plan. We will continue to monitor changes in the federal estate tax system and will keep you apprised of developments through our quarterly newsletters. If you have not recently reviewed your estate plan with your attorney, it might be in your best interests to do so prior to the end of this year.

For more information, e-mail Todd J. Schneider at todd.schneider@hklaw.com or call toll free, 1-888-688-8500.