Level 5 Planning - The Zero Estate Tax Plan
Situation
Desire to disinherit the IRS, and to choose children and charity over Congress.
Objectives
- Avoid being an involuntary philanthropist (i.e., paying estate taxes and letting Congress control those funds), and instead become a voluntary philanthropist (i.e., not paying estate taxes and letting the heirs control those funds).
- Make entire estate available to surviving spouse during his or her lifetime.
- Provide the children and grandchildren with a desired minimum inheritance.
Tools & Techniques
- Use Crummey/Dynasty Trust funded with a second-to-die life insurance policy to provide children and grandchildren with desired inheritance - generally, federal income and estate tax free. Sometimes called a Wealth Replacement Trust.
- Use Living Trust (with QTIP provisions) to provide for surviving spouse.
- Upon death of surviving spouse, that portion of the estate over the $2,000,000 exemption passes to a private (family) foundation - estate tax free! The grantor's heirs will manage the foundation, and can receive reasonable compensation from the foundation.
Disadvantages
- Grantor-insured cannot act as the trustee of an irrevocable trust.
- Crummey/Dynasty Trust is irrevocable and, therefore, cannot be amended or revoked.
- Grantor cannot directly reach trust property (i.e., cash values) during lifetime. However, the trustee can use cash values for the benefit of the grantor's descendants during grantor's lifetime. Moreover, grantor can give certain individuals (i.e., oldest living child, brother, sister, etc.) the power to appoint trust property back to grantor.
The Zero Estate Tax Plan
The Zero Estate Tax Plan was first made popular by Boston attorney Gregory J. Englund in his book Beyond Death and Taxes. It is an approach to estate planning which results in no Federal or State death taxes being paid. The concept is best understood by way of example. The diagrams that appear on pages 15 through 17 were derived from an article that appeared in the September, 1994 edition of Life Association News written by Thomas F. Commito. For simplicity's sake, assume a married couple, both age 60, with a $5 Million estate, a 50% estate tax bracket, and no growth or depletion of their estate.
Diagram I illustrates the standard Marital-Family Trust described on pages two, three and four of this brochure. Diagram II illustrates how the children can receive the same $3.5 Million they inherit in Diagram I, but with no estate taxes being paid. By gifting $300,000 ($25,000 per year for 12 years) to a Crummey/Dynasty Trust (described on pages 5 through 7 of this brochure) funded with a $1.5 Million second-to-die life insurance policy, it is possible to leave the children $3.5 Million while leaving charity $2.7 Million. The unlimited estate tax deduction for charitable bequests leaves the IRS out of the picture.
In Diagram III, by increasing the gift to the Crummey/Dynasty Trust to $600,000 ($50,000 per year for 12 years), the entire $5 Million passes to the children, while $2.4 Million goes to charity and, most importantly, no estate taxes are due.
In summary, by implementing the Zero Estate Tax Plan (Diagram III versus Diagram I), the children receive $5 Million instead of $3.5 Million; charity receives $2.4 Million instead of nothing; and the IRS receives nothing instead of $1.5 Million! Moreover, the $3.5 Million the children receive in Diagram I will be taxed again at their deaths, while the $3 Million in the Crummey/Dynasty Trust illustrated in Diagram III, will not be taxed in the estates of the children and possibly even the grandchildren!
The Charity of Choice:
Private Family Foundations
While the Zero Estate Tax Plan works with any qualified charity, the charity of choice is the donor's own private family foundation. In the context of the Zero Estate Tax Plan, upon the death of the surviving spouse, the private family foundation would receive that portion of the estate in excess of the $2 Million exemption. The foundation would carry the name of the donors and would be managed (in perpetuity) by the donor's descendants. The private family foundation is only required to make minimum disbursements (i.e., 5% of its value) each year to qualified charities. As such, the foundation will likely grow in value over the years. As directors of the foundation, the donor's descendants will learn to be altruistic and philanthropic, and will enjoy the self esteem and public notoriety that comes from benefiting charity. Finally, the directors are entitled to reasonable and customary salaries for carrying out the administrative duties of the foundation.
Click on the image below for a larger view of Diagram 1: Marital - Family Trust $5 Million Gross Estate (2011).
Click on the image below for a larger view of Diagram 2: Zero Estate Tax Plan $5 Million Gross Estate (2011).
Click on the image below for a larger view of Diagram 3: Zero Estate Tax Plan $5 Million Gross Estate (2011).
Special Section
Charitable Lead Annuity Trusts
A Charitable Lead Annuity Trust ("CLAT") is somewhat the opposite of the Charitable Remainder Trust discussed on page 11. While a CLAT can be established during lifetime, it is more often established upon death through a Will or Living Trust. Deferring the contribution to death eliminates potential income tax consequences to the donor and allows for a stepup in basis for the trust remainder beneficiaries. A CLAT pays a fixed dollar amount to the grantor's private family foundation or to one or more public charities for a set term of years. When the term of the CLAT ends, the remaining assets (i.e., the remainder interest) are then distributed to members of the grantor's family (usually the grantor's children).
Since the charity receives an income stream, only the value of the remainder interest is included in the grantor's gross estate. The value of the remainder interest is based upon the term of the CLAT, the amount payable each year to charity, and the monthly IRS prescribed interest rate. For example, assume a married couple with a $5,000,000 estate leave their children the $2,000,000 exemption, and leave the remaining $3,000,000 to a CLAT. If the CLAT pays the couple's favorite charity (or private family foundation) a 8% annuity (i.e., $240,000 per year) for 24 years, and assuming the IRS' prescribed interest rate is 6.0%, the taxable estate, after their estate tax exemption, would only be $10,200! This technique gained prominence when used by Jacqueline Onassis in her Last Will and Testament.
Since the grantor's assets receive a stepped-up basis on the grantor's death (except in 2010), there is no capital gain to the CLAT upon the sale of the assets. Moreover, if the CLAT earns more than it pays out to the charitable beneficiary, the future growth in the value of the CLAT passes to the grantor's family without further estate or gift taxes. Therefore, a CLAT works particularly well for assets expected to appreciate significantly.
A testamentary CLAT can be used to achieve a zero estate tax. However, the drawback to using a CLAT to obtain a zero estate tax is that the grantor's children may have to wait over 20 years after their parents' deaths to receive their inheritance. One solution is for the parents to make lifetime gifts of cash to an Irrevocable Life Insurance Trust funded with a secondto-die life insurance policy. Upon the death of the surviving parent, the trust can then provide the children with income and principal to maintain their standard of living until the term of the CLAT ends.
It should be noted that if the grantor's grandchildren are the beneficiaries when the term of the CLAT ends, the transfer will be subject to the generation skipping tax discussed on page 7. Nonetheless, a CLAT should always be considered by charitably inclined persons looking to reduce or even eliminate estate taxes.
Estate Planning Techniques That Still Make Sense Even If The Estate Tax Remains Repealed
The Economic Growth and Tax Relief Reconciliation Act of 2001 (the "Act") has a substantial impact on transfer taxes. However, unless re-enacted by a future Congress, these changes are merely temporary. These new laws "sunset" on December 31, 2010, and the transfer tax rules in effect in 2001 will be reinstated in 2011.
Accordingly, persons likely to have estates in excess of $1 Million at the time of their deaths should not postpone conventional estate planning. However, estate planning should proceed with an eye towards the possibility that estate taxes may eventually be repealed or that the exemption may be significantly increased in the future. Following is a discussion of ten techniques that will not result in any adverse tax consequences to the donor (or the donor's spouse) even if transfer taxes are eventually eliminated or substantially reduced.
- Use The Gift Tax &. Gifts of $11,000 ($22,000 for married couples) can be made annually to as many donees as the donor desires. These gifts not only reduce the donor's estate by the amount of the gift, but also by the future appreciation on the gifted property.
- Gift The Exemption Amount. Beyond the $12,000/$22,000 annual exclusion, donors can also give away their gift tax exemption of $1,000,000 in 2002. The advantage to using one's exemption to make lifetime gifts is that the future appreciation and income from the gifted property is shifted out of the donor's estate. If married, this planning opportunity doubles to $2,000,000 in 2002.
- Leverage the Generation Skipping Tax Exemption. The $1,000,000 GST exemption (indexed for inflation and doubled for married couples) can be "leveraged" by allocating it to lifetime gifts. In other words, use a "dynasty trust" in conjunction with the gifts referred to in paragraphs 1 and 2 above.
- Leverage Lifetime Gifts with Life Insurance. Consider using lifetime gifts to purchase a life insurance policy on the donor's life, or a survivorship policy on the life of the donor and the donor's spouse. Typically, an irrevocable life insurance trust ("ILIT") will be used to own the policy. In many instances, an ILIT will provide an excellent way to "leverage" the grantor's gift tax annual exclusion, gift tax exemption and GST exemption.
- Use CRTs While Income Tax Rates Are Higher. CRTs are widely used to avoid paying capital gains taxes when selling highly appreciated assets. If the grantor and the grantor's spouse are the only noncharitable beneficiaries, a CRT does not create any gift tax. In addition, a current income tax deduction is available equal to the present value of the remainder interest passing to charity. Since the Act also gradually reduces Federal income tax rates through 2006, the value of this charitable income tax deduction will decrease.
- Use a Private Foundation to Front-End Load Charitable Gifts. With a private foundation, donors can donate now and decide later which charities to benefit. Since the Act also gradually reduces Federal income tax rates through the year 2006, by donating sooner than later, the donor's charitable income tax deduction will be more valuable.
- Use a CLAT with the Remainder at the Exemption Amount. A charitable lead annuity trust is an excellent way to make a deferred gift to one's heirs at a deep valuation discount. The present value of the remainder interest passing to the donor's heirs is based on the value of the assets contributed to the CLAT, and the amount and term of the payout to the charity. By keeping the remainder valued at or below the exemption amount, no gift tax will be due. Therefore, if transfer taxes are repealed or reduced, the donor will not be disadvantaged.
- Use a GRAT with the Remainder at the Exemption Amount. A grantor retained annuity trust ("GRAT") is another way to gift income producing assets (e.g., Subchapter S stock and family limited liability company interests) to one's heirs with valuation discounts. It is similar to the CLAT, but with the annuity paid to the donor for the set term, rather than to a charity. Again, as long as the remainder interest is valued at or below the exemption, the grantor will not be disadvantaged if transfer taxes are subsequently repealed or reduced.
- Make Sales to Intentionally Defective Grantor Trusts ("IDGT"). In lieu of a GRAT, consider selling income producing assets to a "grantor trust" on an installment basis. Since the property is "sold" to the IDGT, there are no gift tax consequences as such. Moreover, under Rev. Rule. 85-13, a sale of property by the grantor to a grantor trust results in no capital gains tax. However, for estate tax purposes, it is recommended that some "seed" money be gifted to the IDGT prior to the sale. Usually, 10% of the value of the property sold is recommended. Therefore, a $1,000,000 gift (using the gift tax exemption) will support a $10,000,000 sale (after valuation discounts). Note, however, that the IRS has not directly ruled on the validity of this transaction.
- Use a QPRT with the Remainder at the Exemption Amount. A qualified personal residence trust is similar to the GRAT, but the trust is funded with a principle residence and/or vacation home. By retaining the right to occupy the residence for a term of years, the value of the remainder interest (and the taxable gift) is reduced. By keeping the remainder valued at or below the exemption amount, no gift tax will be due.
Conclusion
The Act offers little benefit to taxpayers because of the sunset provision. The noted exception for those persons who actually die in 2010. Nevertheless, estate planning documents should be drafted with flexibility that if the estate tax is eventually repealed or substantially reduced, irrevocable transfers can be "undone".
Perhaps the most effective estate planning tool to accomplish flexibility is a "limited power appointment". For example, the grantor of an irrevocable trust can provide in the trust agreement for a person (i.e., a family member, friend or trusted individual) to have the power to appoint trust property to the grantor, the grantor's spouse and/or the grantor's descendants (i.e., property can go to anyone other than the powerholder himself or herself). As such, if a future Congress reenacts estate tax repeal, the powerholder could transfer the trust property back to the grantor. If properly structured, there are no tax consequences to either the powerholder or the grantor upon exercise of the power.
In summary, even for those persons who believe that estate taxes will some day be eliminated or significantly reduced, use of any one or more of the aforementioned techniques, as well as limited powers of appointment when applicable, is not only safe, but a prudent course of action.