Securing Your Family’s Future: Perspectives on Estate Planning

Perhaps the most frequently asked question of Smith, Gambrell & Russell, LLP's Estate Planning and Wealth Protection Group is -- "Will the federal estate, gift and generation-skipping taxes be repealed during my lifetime?" Our short answer is -- "Don't count on it. Permanent repeal is highly unlikely."

Perhaps the most frequently asked question of Smith, Gambrell & Russell, LLP’s Estate Planning and Wealth Protection Group is — “Will the federal estate, gift and generation-skipping taxes be repealed during my lifetime?” Our short answer is — “Don’t count on it. Permanent repeal is highly unlikely.”

The Status of the Death Tax

Permanent repeal has been championed by the present administration and has passed the House of Representatives. In this election year, however, many believe several pieces would need to fall into place for permanent repeal to become a reality. The present administration would need to retain power, and the Republican Party would need to retain control of the House of Representatives. In addition, since 60 votes are required for the passage of permanent repeal in the Senate, at least 60 senators who would vote in favor of repeal would need to remain in power or be elected. Most current estimates indicate that only 57 senators would vote in favor of permanent repeal, and it appears highly unlikely that any of the current senators will change his or her mind on this issue. Current budget deficits could increase opposition to any further tax cuts or repeals. Thus, permanent repeal of the “death tax” appears to be only a remote possibility.

Even if permanent repeal of the death tax becomes a reality, it will likely come with strings attached. Under the legislative proposal favored by the administration and most supporting members of Congress, permanent repeal of the death tax is coupled with the continuation of federal gift tax laws and the repeal of income tax laws which grant a new income tax basis for most property that is subject to federal estate taxation (the so-called “stepped-up basis” rule).

The retention of federal gift taxation is perceived to be necessary to avoid the erosion of income tax revenues. Without gift taxation, taxpayers could simply shift assets that produce taxable income from a family member in a high income tax bracket to a family member in a lower income tax bracket. For example, if the federal gift tax laws were repealed, a parent in a high federal income tax bracket who owns income-producing property, such as rental real estate, could transfer that property to a child who is in a lower income tax bracket, thereby reducing the income tax collected by the Internal Revenue Service from the rental income. Retention of the federal gift tax provisions would force the parent to incur gift tax consequences, thereby discouraging such a transfer.

The allowance of a step-up in basis for property subject to estate tax has been considered appropriate to avoid both estate taxation and income taxation on the same appreciation that may be inherent in an asset that passes through an estate. Any permanent repeal of the death tax will also repeal the rules granting a stepped-up basis to property passing through an estate, thereby subjecting the beneficiaries to increased capital gains tax when the inherited assets are sold. The present proposal contains some relief provisions, such as authorizing an executor to assign a limited amount of stepped-up basis to certain assets, but a full stepped-up basis would no longer be available for larger estates. In addition to the adverse income tax consequences of this proposal, the documentation required to establish the basis of inherited assets will likely prove to be difficult, particularly for those assets owned for many years before inheritance.

There is a reasonable probability that limited relief from the arduous burden of death taxation will occur with the increase of the Applicable Exclusion Amount, rather than a permanent repeal of the death tax. The Applicable Exclusion Amount is the amount of one’s property that is, in effect, exempt from federal estate taxation. Currently, the Applicable Exclusion Amount is $1,500,000 for persons dying in 2004 or 2005, $2,000,000 for persons dying after 2005 but before 2009, and $3,500,000 for persons dying in 2009. The estate tax is scheduled to be temporarily repealed for people dying in 2010 but reinstated for people dying in 2011 or later with an Applicable Exclusion Amount of $1,000,000 (under the same statutory provisions that existed in 2001). This “repeal and reinstatement” of the estate tax has been roundly criticized as absurd from a policy standpoint and makes planning very difficult for taxpayers and their advisors.

Based on these assumptions, we are advising our clients that death taxation is likely here to stay and is an important part of one’s overall financial planning.

Customizing an Estate Plan

For an unmarried taxpayer, the Applicable Exclusion Amount is available, as are deductions for charitable bequests, administrative expenses and certain other items. However, if the assets owned by an unmarried taxpayer exceed the Applicable Exclusion Amount and allowable deductions, estate taxation normally follows.

For married taxpayers, the judicious use of the Applicable Exclusion Amounts of both spouses is important. This is generally achieved by each spouse owning assets in his or her individual name in an amount at least equal to the Applicable Exclusion Amount and fashioning the wills of both spouses to create a trust, usually known as a Credit Shelter Trust, for the benefit of the surviving spouse and other family members. By funding the Credit Shelter Trust with an amount designed to use the Applicable Exclusion Amount of the first spouse to die, the exemption of the first spouse would be used to avoid estate taxation on the value of the property transferred to the Credit Shelter Trust. At the death of the surviving spouse, there would be no estate taxation on the property in the Credit Shelter Trust, without regard to the value of the assets in the Credit Shelter Trust, because the Applicable Exclusion Amount of the first spouse to die was used to protect the assets held in the Credit Shelter Trust from estate taxation at both deaths.

Obviously, Credit Shelter Trusts can be very effective estate planning tool, but using Credit Shelter Trusts requires the realignment of family assets to dovetail with the provisions of the wills. For example, if assets are owned by a husband and a wife jointly with rights of survivorship and if life insurance, 401(k) plan benefits, individual retirement accounts and other assets passing by beneficiary designation are all payable to the surviving spouse, the first spouse to die may not have enough assets available to fund his or her Credit Shelter Trust.

To the extent that the taxable estate of a married person exceeds his or her Applicable Exclusion Amount, estate taxes can be avoided at the death of the first spouse to die by leaving that excess amount directly to a surviving spouse or in a special trust for his or her benefit. By using a Credit Shelter Trust and the Marital Deduction in this manner, estate taxes can be avoided in their entirety upon the death of the first spouse. At the death of the second spouse, the property in the Credit Shelter Trust will not be subject to estate taxation, and whatever property is subject to estate taxation at the death of the second spouse will be reduced by the application of his or her Applicable Exclusion Amount.

For many of our married clients, simply having a proper will and arranging the family assets to allow for the utilization of the Applicable Exclusion Amounts of both spouses is sufficient estate tax planning. Currently, these basic steps will shield at least $3,000,000 from federal estate taxation (and even more if one or both spouses live until 2006). If Congress increases the Applicable Exclusion Amount, many married people will be able to avoid estate taxation simply by arranging their assets correctly and having wills with Credit Shelter Trusts.

If family assets exceed the available Applicable Exclusion Amounts of both spouses, some estate taxation still may be incurred. However, a will that provides for a Credit Shelter Trust and a Marital Deduction bequest will postpone all estate taxation until the death of the surviving spouse.

Transactions Designed to Reduce Estate Tax

After the basic estate planning documents have been completed, many of our clients wish to reduce estate taxation further by engaging in a transaction or series of transactions designed, in part, to reduce estate tax. Many of our clients find that a simple but well-constructed gifting program will achieve a substantial reduction in estate taxation. Anyone can make Annual Exclusion gifts of up to $11,000 each calendar year to as many persons as he or she may desire, and married couples can double-up by giving $22,000 to each donee. For example, a married couple with three children and seven grandchildren can gift up to $220,000 per calendar year to those family members, without transfer tax consequences. Such a program, carried out over a number of years, can reduce estate taxes quite substantially.

A gifting program can be combined with other estate planning ideas to achieve even greater results. For example, if the younger generation uses some or all of the gifted property to purchase a life insurance policy on one or both of their parents, the value of the property passing to the children or younger generations often can be substantially increased while avoiding transfer tax on both the annual gifts (because of the Annual Exclusion) and on the receipt of the death proceeds (because it is the children, not the parents, who own the insurance policy and receive the death proceeds).

A variation of this plan to gift cash to individuals to buy life insurance involves the creation of an irrevocable life insurance trust. If a properly prepared irrevocable trust is established, a person can gift property to the trust (usually free from all gift taxation) in an amount sufficient to allow the trust to purchase one or more life insurance policies on the life of the donor. The insurance policy would be owned by the trust, and the death proceeds would be payable to the trust. Under this arrangement, the proceeds of the insurance would not be subject to estate taxation on the death of the donor. The surviving spouse and other family members are usually the beneficiaries of the trust, and the trust often emphasizes supporting the surviving spouse during his or her lifetime and making the remaining assets in the trust available to the children at the death of the surviving spouse to help defray the estate tax obligation that may arise upon the death of the surviving spouse.

Many of our clients wish to make charitable gifts. Sometimes a simple bequest in a will fulfills this desire. Such a bequest creates a charitable deduction that reduces estate taxation. However, if the client has sufficient assets to do so, we often suggest making a lifetime charitable gift in lieu of a testamentary charitable bequest. A lifetime charitable gift creates the equivalent of an estate tax charitable deduction (because the asset is removed from the taxable estate of the donor) and usually creates an income tax deduction. This “double deduction” can also be obtained by the use of a lifetime Charitable Remainder Trust or Charitable Lead Trust.

Much has been written about the use of a Family Limited Partnership (FLP) in estate planning. When correctly utilized, an FLP can be an effective device to achieve business goals for a family and reduce estate taxation. Usually, the FLP is created with business assets, such as real estate, stocks and bonds. Then, some or all of the partnership interests are gifted or sold to family members or to one or more trusts designed to provide benefits for family members. The FLP facilitates a gifting program and can reduce estate taxation, but its primary purpose is to achieve business goals for a family.

A Grantor Retained Annuity Trust (GRAT) is also an effective estate planning device. A GRAT is a trust in which the grantor retains an annuity for life or for a certain number of years. When the GRAT terminates, the assets remaining in the GRAT usually are distributed to the grantor’s children. If the assets transferred to the GRAT appreciate at a rate higher than the interest rate used to calculate the annuity, a shifting of value to members of a younger generation can occur without transfer taxation. We have found GRATs to be a very effective estate planning idea for many clients, especially in today’s low interest rate environment.

Careful Consideration of a Family’s Goals is Vital

The estate planning process can be quite simple or quite complex, depending upon the desired results of the overall estate plan. For many of our clients, basic wills using Credit Shelter Trusts and the Marital Deduction, and disability planning documents are the only necessary steps to be taken. Other clients also use annual gifting programs, lifetime or testamentary charitable gifting, generation-skipping transfers and irrevocable life insurance trusts. And some clients, after they have taken these steps, desire to use FLPs, GRATs and other transactions which have the potential of substantially reducing the estate taxation their family will likely face. While these transactions can become complex, they often result in significant shifts of wealth from an older generation to a younger generation with minimal or no transfer taxation. Regardless of the complexity of the estate plan, however, it is vital to consider what is important to you and plan accordingly.

The Estate Planning Process- Basic Tax Principles

Estate planning usually takes place in two phases. First, everyone should carefully consider having basic estate planning documents, such as wills, trust agreements, living wills and powers of attorney for health care and financial matters. Second, many people should also consider entering into a transaction or series of transactions designed to reduce estate tax.

The estate planning process starts with the careful consideration of a family’s goals. Family goals, after they have been articulated, often are implemented in wills and other estate planning documents by the application of the following five basic tax principles:

  1. For federal estate and gift tax purposes, all U.S. citizens are entitled to an Applicable Exclusion Amount, the exact amount of which will depend on the year in which he or she dies.

  2. There is no gift or estate taxation on property passing from one spouse to another spouse (who is a U.S. citizen) outright or in certain types of trusts. This is called the Marital Deduction.

  3. For federal generation-skipping transfer tax purposes, all U.S. citizens are entitled to an exemption, generally in the same amount as the Applicable Exclusion Amount.

  4. Lifetime gifts are exempt from federal gift and estate taxation as long as the value of the gifts does not exceed $11,000 per year per donee (the so-called “Annual Exclusion”). In addition, payments to certain educational institutions for educational purposes or to certain medical providers for medical purposes are exempt from gift taxation. Gifts protected by the Annual Exclusion may be made to an unlimited number of donees each year and will not be taken into consideration for federal estate tax purposes, even if made shortly before death. The Annual Exclusion obviously allows a married couple to gift up to $22,000 per year to each descendent (or other person) without transfer tax consequences. Because of a special tax provision applicable to a married couple, gifts made by one spouse may be treated as though each spouse had made one-half of the gift, simply by filing a Gift Tax Return and making the appropriate elections, thus allowing the Annual Exclusions of both spouses to be applied to a transfer made by only one spouse.

  5. A charitable deduction is available for federal gift and estate tax purposes in the full amount of any direct gift to a charity and in a partial amount for gifts to trusts that have both charitable and non-charitable beneficiaries, such as a Charitable Remainder Trust or a Charitable Lead Trust.

Normally, we are able to achieve the estate planning goals of our clients by the careful application of one or more of these principles.

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