How to Make Tax-Saving Gifts

Transcription

1 How to Make Tax-Saving Gifts By William S. Moore ECONOMIC EDUCATION BULLETIN Published by AMERICAN INSTITUTE for ECONOMIC RESEARCH Great Barrington, Massachusetts

2 About A.I.E.R. AMERICAN Institute for Economic Research, founded in 1933, is an independent scientific and educational organization. The Institute's research is planned to help individuals protect their personal interests and those of the Nation. The industrious and thrifty, those who pay most of the Nation's taxes, must be the principal guardians of American civilization. By publishing the results of scientific inquiry, carried on with diligence, independence, and integrity, American Institute for Economic Research hopes to help those citizens preserve the best of the Nation's heritage and choose wisely the policies that will determine the Nation's future. The Institute represents no fund, concentration of wealth, or other special interests. Advertising is not accepted in its publications. Financial support for the Institute is provided primarily by the small annual fees from several thousand sustaining members, by receipts from sales of its publications, by tax-deductible contributions, and by the earnings of its wholly owned investment advisory organization, American Investment Services, Inc. Experience suggests that information and advice on economic subjects are most useful when they come from a source that is independent of special interests, either commercial or political. The provisions of the charter and bylaws ensure that neither the Institute itself nor members of its staff may derive profit from organizations or businesses that happen to benefit from the results of Institute research. Institute financial accounts are available for public inspection during normal working hours of the Institute. ECONOMIC EDUCATION BULLETIN Vol. XXXIX No. 7 July 1999 ISBN Economic Education Bulletin (ISSN ) (USPS ) is published once a month at Great Barrington, Massachusetts, by American Institute for Economic Research, a scientific and educational organization with no stockholders, chartered under Chapter 180 of the General Laws of Massachusetts. Periodical postage paid at Great Barrington, Massachusetts. Printed in the United States of America. Subscription: $25 per year. POSTMASTER: Send address changes to Economic Education Bulletin, American Institute for Economic Research, Great Barrington, Massachusetts

3 CONTENTS Introduction 1 I. Tax Consequences of Lifetime Gifts 3 Gift and Estate Tax Exclusions 3 The Generation-Skipping Transfer Tax and the "GST Exemption" 5 Income Tax Considerations 5 The Most Useful Lifetime Gifts 7 II. Gifts for College and Other Expenses 11 "Sprinkle" Trusts 11 Savings-Type Qualified State Tuition Plans 14 The Advantages and Disadvantages of Savings-Type Qualified State Tuition Plans 15 Sprinkle Trusts and Tuition Plans Compared 18 Summary 20 III. Gifts of Residences or Other Real Estate 21 The Basic Structure of QPRTs and the Transfer Tax Savings They Produce 22 Other Important Aspects of QPRTs 24 QPRTs for Married Couples 26 The Advantages of Making QPRT Income Taxable to the Donor 27 Use of Annual Exclusion Gifts To Give Away Real Estate IV. "Small IRS Remainder" GRATs 33 V. Life Insurance Trusts 37 Use of a Life Insurance Trust to Reduce the Taxable Estate "Second to Die" Life Insurance 39 Life Insurance Trusts and Charitable Gifts 40 Conclusion 43

4 INTRODUCTION 1 IN AIER's The Estate Plan Book, originally published by AIER in 1994,1 briefly discussed how lifetime gifts can produce valuable tax savings. At this time more can be said, and more needs to be said, about using such gifts to produce tax savings. Changes in the tax laws have created new opportunities to save taxes through lifetime gifts. For example, federal legislation since The Estate Plan Book was originally published has authorized states to establish plans through which people can save for the college education of children, grandchildren, and others and these provide significant tax benefits that simply did not exist before. Moreover, a number of recent IRS cases, regulations and rulings, and other authorities have shown how to tailor previously existing tax-saving techniques so that they can be used more effectively. Gifts such as "qualified personal residence trusts," or "QPRTs," and "grantor retained annuity trusts," or "GRATs," had become available through legislation only shortly before The Estate Plan Book was published, and, at that time, few rulings could provide direction for how they might best be used. Since then, pertinent rulings as well as other literature have become available. Beyond this, the widening distribution of wealth over the past decade has prompted demand for information and instruction on how to save taxes through lifetime gifts. As the economy and stock market have continued to do well, most people's wealth has grown. Even if there is gift and estate tax relief in the future, the likelihood is that many people will owe substantial estate taxes upon their deaths unless they take appropriate steps during their lifetime. Some estate taxes can be reduced by will. In particular, if a married couple provides for a so-called "bypass trust" to be fully funded at the death of one spouse, substantial tax savings on the couple's estates can be achieved. Generally, however, people with estates large enough that estate taxes would be due on their deaths will have to make lifetime gifts to reduce those estate taxes. The purpose of this booklet is to describe the most advantageous techniques for doing so. 2 William S. Moore, Esq. 1 This booklet is intended to provide accurate and timely information to readers. The contents do not constitute legal, accounting or other professional service. If legal advice or other professional assistance is required, the services of a competent professional should be sought. 2 Readers should not attempt to use the estate planning techniques I discuss without the 1

5 assistance of a qualified estate planning lawyer familiar with their circumstances and the laws of their state. This is particularly important for readers who live in community property states, because in such states the laws may significantly affect the advisability or implementation of certain estate planning measures discussed in this booklet.

6 I. TAX CONSEQUENCES OF LIFETIME GIFTS ALL types of transfer taxes gift, estate, and generation-skipping transfer taxes have important exclusions and exemptions that can save you tax dollars. There can also be income tax advantages to lifetime gifts, especially if the pertinent rules inform your decisions about which property is to be so used. Gift and Estate Tax Exclusions All gifts by a United States citizen or resident during lifetime or at death are subject to (sometimes very burdensome) gift or estate tax unless they are shielded by an exemption or exclusion. For most people all lifetime gifts will be shielded by one exclusion or another, and the tax on them deferred until they (or their surviving spouse) dies. Then, however, if taxable lifetime gifts and the estate exceed the applicable "exemption equivalent," the rates on the taxable estate begin at roughly 40% and can go as high as 55% (and in very large estates can go even higher). Obviously, it is important to use gift and estate tax exclusions and exemptions to shield as much property as possible from these high rates. 3 The most important of the gift tax exclusions is the so-called "annual exclusion." Under the annual exclusion, each U.S. citizen or resident can make gifts not exceeding $10,000 per donee to as many different donees as the donor wants in a year and all those gifts will be completely tax-free. 4 A gift tax return does not even have to be filed. Likewise, a married couple can make tax-free "annual exclusion" gifts of $20,000 per donee per year, even if only one spouse provides all the property for the gifts (when this is done, a gift tax return in which the other spouse consents to the gift must be filed). Gifts made under these exclusions do not reduce the donor's "exemption equivalent," which remains available to shield lifetime taxable gifts and gifts at death. Such gifts are completely tax-free. 5 Two further gift tax exclusions may apply in particular situations. One 3 The gift and estate tax rates are supposedly unified so that a gift is taxed at the same rate whether it is made during lifetime or at death. Because of a fundamental difference in the way the rates are applied, however, gift tax rates in practice are much lower than estate tax rates. This difference is only relevant for persons with very large estates who during their lifetimes make gifts in excess of the "exemption equivalent" so that tax has to be paid on the gifts when made. For such persons, however, such gifts can produce very large savings. 4 Beginning in 1999, the $10,000 will be indexed for inflation. 5 It is important to note that for a technical reason, special steps have to be taken to qualify gifts made to a trust for the annual exclusion. This matter is discussed below.

7 excludes from any tax liability payments for private school or college tuition made directly to the educational institution. The other excludes from any tax liability payments for medical care made directly to the provider of such care. These exclusions are in addition to the annual exclusion. Thus, if a grandparent makes a $10,000 "annual exclusion" gift to a grandchild in a given year, he still could then pay for the grandchild's college tuition and medical care. As with "annual exclusion" gifts, no gift tax return need be filed unless the donor also makes one or more gifts in the same year that do not qualify for any gift tax exclusion. No gift tax will be due unless and until the total of all lifetime taxable gifts (which do not include gifts qualifying for the gift tax exclusions) exceeds the "exemption equivalent." This means that a person can make very substantial lifetime gifts without having to pay any gift tax. If a gift does not qualify for an exclusion, it will be a taxable gift for which a return must be filed and will reduce the donor's "exemption equivalent" available to shield lifetime taxable gifts or gifts at death. Under the 1997 tax act, the "exemption equivalent" will increase in stages to $1 million in 2006 and thereafter. The "exemption equivalents" during the "phase-in" period are as follows: Year Exemption Equivalent Amount $ 625,000 $ 650,000 $ 675,000 $ 675,000 $ 700,000 $ 700,000 $ 850,000 $ 950,000 $1,000,000 Although a lifetime taxable gift reduces the donor's "exemption equivalent," such gifts can still have valuable tax benefits. While the value of a lifetime gift will be taxed upon the donor's death if the donor has a taxable estate an estate which, when lifetime gifts are added to it, exceeds the amount of "exemption equivalent" at the time it will only be taxed on its value when made. Thus, all appreciation in value and income from the gift property, which may even exceed the value of the gift when made, will escape transfer tax. Assuming the donor has not made lifetime taxable gifts in excess of the "exemption equivalent," any tax on the gift is effectively deferred until the donor's death. Consider the possible tax savings in the following example. Assume that a person makes a lifetime taxable gift of $100,000, the gift property appreciates to $200,000 in value at his death, and the marginal estate tax

8 rate on his or her estate is 50%. 6 Since the $200,000 value of the gift has been removed from the donor's estate, only $50,000 in tax is payable at his or her death. The effective transfer tax rate on the property given away thus is only 25%. If the donor had continued to own the gift property, an estate tax of $100,000 would have been incurred on the $200,000 in value of the property, at the 50% applicable rate. By making the lifetime gift, the donor halved the effective tax rate to the property and saved $50, The Generation-Skipping Transfer Tax and the "GST Exemption" The generation-skipping transfer tax ("GST tax") is a complicated tax that for most persons probably will have little effect on their estate planning. For those with large estates, however, lifetime gifts can usefully take advantage of the so-called "GST exemption" and save GST tax. The GST tax is a tax imposed when a person makes gifts that "skip" a generation. The simplest example is an outright gift from a grandparent to a grandchild. Such a gift skips the parent's generation, and thus is subject to the GST tax at the time it is made. Another example of a generation-skipping gift is one which a donor makes to a trust for a child with any remainder upon the child's death to go to that child's children, (i.e., grandchildren of the donor). In this circumstance, it is only the amount that will eventually go to the grandchildren that skips a generation, and therefore only that amount will be subject to GST tax upon the child's death. What is most notable about this tax is the magnitude of the GST exemption. Each person has a $1 million exemption that can be applied against the GST tax. 8 To any extent that people do leave property outright or in trust for grandchildren, the one million dollar GST exemption generally will be sufficient to shield such property from tax and is obviously valuable even for people with quite large estates. 6 There is no estate tax rate of 50%, but there are estate tax rates very close to this percentage. We have used it for the ease of example. 7 For persons with quite large estates, lifetime taxable gifts even in excess of the "exemption equivalent," so that gift tax has to be paid on the gifts when made, can also produce savings. Not only do such gifts remove future appreciation from the donor's estate, but they are also taxed at relatively low rates because gift rates are as a practical matter much lower than estate tax rates. However, during the phase in of the increased "exemption equivalent" through 2006, it is questionable whether gifts in excess of the "exemption equivalent" should be made as that will result in some tax being paid that would not have to be paid in 2006 or thereafter. The donor's estate at death would get a credit for the gift tax paid, but the donor would have lost the use of the funds used to pay the gift tax until his or her death. Accordingly, in many cases people with large estates should wait until 2006 or thereafter to make gifts in excess of the applicable "exemption equivalent." 8 Beginning in 1999, the GST exemption will be indexed for inflation.

9 Income Tax Considerations In the past, substantial income tax savings could be obtained by making lifetime gifts to trusts, young children, grandchildren, or custodianships under a State's Uniform Gifts to Minors or Uniform Transfers to Minors statute. The reason was that, inasmuch as a child's income was markedly less than that of the parent or grandparent making the gifts, the gift property would be taxed at lower marginal rates than if the donor continued to own it. However, through two actions, Congress reduced the extent to which gifts of this kind can produce tax savings. First, it substantially raised the income tax rates applicable to trusts, so that high marginal rates are applicable even when there is only a relatively small amount of income taxable to a trust. Second, it enacted the so-called "kiddie tax," which provides that the investment income of a child under age 14 will be taxed to the child's parents at their top marginal rate when it exceeds a certain amount adjusted for inflation (about $1,400 in 1999). Such gifts can, however, still produce valuable tax savings. In particular, after a child has attained age 14, over $25,000 in income can be taxed to the child at a 15% rate. Moreover, before that much of the trust property can be invested in growth stock, and when the child reaches 14, this stock can, if desired, be sold and the capital gains taxed at 15% or at most at the standard 20% capital gains rate. Another income tax consideration is even more important in planning lifetime gifts. Property included in a person's gross estate gets a "step up" in its basis for capital gains tax purposes to its value at death. For example, if a person bought stock (or real estate or any other asset) for $100,000 and by the time of death it had appreciated to $200,000, the beneficiaries could sell the property for $200,000 immediately without recognizing any gain. By contrast, when a person makes lifetime gifts, the donee takes the donor's capital gains tax basis in the gift property. Thus, if the stock in the preceding example were given away during lifetime and not at death, the donees would take the donor's basis in the property. Accordingly, if they sold it immediately after the donor's death, they would have to recognize $100,000 in capital gains. This possible capital gains tax disadvantage to lifetime gifts can be avoided or greatly reduced by judicious selection of the property to be given away. For example, suppose that a person owns stock of one company bought for $100,000 that has a present value of $200,000 and owns stock of another company bought for $ 190,000 that is now worth $200,000. If the person intends to make $200,000 in "annual exclusion" gifts over a period of years, making such gifts with the latter stock, rather than the

10 former, would greatly reduce any capital gains tax disadvantage to the donees. By using money or property that has not appreciated to any extent rather than highly appreciated property to make lifetime gifts, the possible capital gains tax disadvantage can be avoided or minimized. There are also other ways to minimize the possible capital gains tax disadvantage of lifetime gifts. For example, suppose that the person who owns the $400,000 in stock described in the above paragraph wants to give all of that stock away over a period of years in "annual exclusion" gifts to children and grandchildren. Suppose further that the stock that was bought for $100,000 and is worth $200,000 is a blue chip stock that is likely to be held by whoever it is given to for a considerable period. Making gifts of that stock to the children, and using the other stock with a basis quite close to its present value to make gifts to grandchildren, probably would be advisable. That is so because the children have much shorter life expectancies than the grandchildren, and if the children hold the blue chip stock given them until their deaths, then it will get a "step up" in its basis that will shield from capital gains tax both the appreciation during the children's lifetime and the earlier appreciation while it was held by the donor. Even where appreciated property is used to make a lifetime gift and the possible capital gains tax disadvantage cannot be eliminated or minimized, that disadvantage generally will be greatly outweighed by the transfer tax savings. Consider again the stock purchase that has a basis of $100,000 and a present value of $200,000. If that property were given away during lifetime and then sold, the capital gains tax would be $20,000 the usual 20% capital gains rate times $100,000. However, if the person retained the stock so that it were included in his or her gross estate at death and that person had a taxable estate, the entire value of the property would be taxed at estate tax rates that would be in the range of 40% to 55%. Assuming the estate tax rate was 50%, the estate tax would be $100,000. If the stock had instead been given away during lifetime in such a way that no gift or estate tax liability were incurred, such as by using it to make "annual exclusion" gifts, the estate tax savings would be $100,000. Even subtracting the capital gains tax liability of $20,000 if the stock were sold would yield a net tax savings of $80, The Most Useful Lifetime Gifts While virtually all lifetime gifts will produce some tax savings, some types of gifts maximize the tax savings possible. In some cases, these are 9 Another income tax consideration is relevant only in connection with a particular type of lifetime gift gifts to "qualified personal residence trusts," or "QPRTs" and is discussed below in connection with such gifts.

11 gifts that produce virtually "pure" tax savings with no offset. Other types of gifts are very advantageous because they allow the donor to leverage the gift, letting the donor remove substantial property from his or her estate while paying tax on only a small percentage of the property. Yet others provide income tax savings as well as transfer tax savings in specific circumstances, such as in saving for the college education of children or grandchildren. These are the gifts that provide the "biggest bang for the buck," and are detailed at some length in subsequent chapters. Several of the gifts discussed in following chapters are designed to take advantage of the annual exclusion, and because this exclusion is so valuable,and is not used as much as it should be because of unwarranted concerns, it is important to say a few more words about it before turning to more specific techniques. "Annual exclusion" gifts produce "pure" or virtually "pure" tax savings, 10 and over a period of years can be used to produce hundreds of thousands of dollars in transfer tax savings. Many people are aware of this exclusion and use it, but often they do not make as much use of it as they should. For example, some people do not make gifts to minor children or grandchildren or to spouses of children or grandchildren because they are concerned that the gift property may not be used as they want. In many such cases, however, making the gift to a trust rather than directly will eliminate this concern. 11 Other people limit their annual exclusion gifts because they want to treat their children's families equally, making sure the gifts to each child and his family do not exceed the gifts to another child and his family. This is certainly a legitimate objective, but it can be achieved more advantageously. For example, if one child of a couple with a quite large estate is married and has no children while the only other child of the couple is married and has two children, the couple might limit their annual gifts to both children's families to a total of $40,000 per family, the maximum amount that can be given under the annual exclusion to the child and spouse without children. In such a case, however, it would generally be better for the couple to make gifts of $80,000 per year per child's family. The reason is that then $40,000 more could be given away tax-free and the $40,000 in annual gifts that did not qualify for the annual exclusion would produce substantial transfer tax savings (i.e., it would remove all future income appreciation on the gift property from the couple's estate). 10 The only possible offset to the savings through "annual exclusion" gifts would result if greatly appreciated property had to be used to make the gifts and the possible capital gains tax disadvantage of such gifts could not be minimized. 11 It must be remembered, however, that special steps must be taken when gifts to a trust are made to qualify the gifts for the annual exclusion. See the discussion of this point below. 8

12 "Annual exclusion" gifts can be particularly valuable in a "second marriage" situation, where spouses can help each other make full $20,000 per donee per year gifts without having to contribute to the other spouse's gifts. A husband and wife can "split" the gifts that each of them makes in a year, even though each contributes the full amount of all the gifts to his or her donees. To do so, the couple must file a gift tax return whereby each spouse agrees to such "split gifts." Thus, each spouse can join in $20,000 gifts that the other spouse makes to his or her children or grandchildren without contributing at all to those gifts. An even more advantageous arrangement if husband and wife are willing to commingle assets is for the spouses first to deploy the funds into a joint account, with each spouse contributing $20,000 times the number of donees he or she plans to make gifts to in the year. Then the spouses can make $20,000 gifts to their children and grandchildren from the joint account without the need to file a gift tax return, since each gift will then be considered made one-half by each spouse.

13 II. GIFTS FOR COLLEGE AND RELATED EXPENSES FOR many parents and grandparents, a principal goal is to provide funds for the education of children and grandchildren. The costs of college education have continued to rise. As a result, saving to meet these costs probably is of greater concern to parents and grandparents than ever. The annual exclusion and the special gift tax exclusion for gifts directly to an educational institution can be used to pay college expenses as they are incurred. For example, under these exclusions a grandparent can pay a grandchild's college tuition each year and pay the grandchild $10,000 for room and board at college. However, this approach does not allow a parent or grandparent to save for future college education in a tax advantageous way. In response to rising tuition, Congress has authorized so-called "qualified state tuition plans." There are three types of these plans, but the best in most situations is the type under which people can invest in tax-advantaged funds that can be used for tuition and other college expenses at any accredited college, university, professional, or graduate school in the United States and also at certain post-secondary vocational schools. 12 Some states have set up such programs, and while they have some uncertainties, they can provide valuable benefits. These new plans have not, however, displaced the traditional "sprinkle" trust. But their advent does require some comparison of these two methods of saving for the college education of children and grandchildren. It should be emphasized that the following discussion assumes that the donor wishes the gifted funds to be usedfor educational purposes. In some circumstances, it may not be advisable to set aside funds for such a limited purpose. "Sprinkle" Trusts In my view, the clear "winner" as the most advisable of the traditional methods of saving for the college education of children and grandchildren is a so-called "sprinkle" trust for a group of beneficiaries. In some cases, depending upon such factors as the number of children or grandchildren 12 The other types of qualified state tuition plans are (1) prepaid tuition plans that provide credits toward tuition for contributions, and (2) prepaid tuition plans whereby a contributor enters into a contract to pay set amounts at regular intervals toward tuition. Among other drawbacks, these plans generally provide for payments toward tuition only at a school or schools in the state establishing the plan. 11

14 involved, the size of the donor's estate, and the amount of gifts likely to be made, another method, such as the establishment of separate trusts for children or grandchildren or separate custodial accounts for them under a state's Uniform Transfers to Minors Act, might be advisable. 13 Generally, however, a "sprinkle" trust for the group of beneficiaries is the best approach. Here is how such a trust would work: The original donor and possibly others make contributions to the trust, usually contributions that qualified for the annual exclusion from the gift tax. 14 The trustee or trustees (the donor should not be a trustee but one or more close family members or friends can and generally should be) would have discretion to make distributions from the trust for the higher education of the children or grandchildren, or, if authorized, for other purposes to their benefit. No one knows the future, and events might require, say, medical care not covered by insurance, for which trust funds could make provision. Moreover, some of the beneficiaries may prefer to pursue alternatives that the donor would consider acceptable and that would also require use of funds from the trust. Granting the trustee discretion to make payments other than for college expenses may also be helpful in allowing beneficiaries to qualify for scholarships or financial aid, as the trust would not be dedicated only for education. If one or more beneficiaries qualified for scholarships or other aid, the trust funds might not be exhausted and would be available for other purposes. The "sprinkle" trust should terminate no earlier than the date on which the last beneficiary could reasonably be expected to have completed his or her college education, with some "cushion" built in. Sometimes it is advisable to provide that the trust can continue as long as any of the group of beneficiaries is alive, subject to the trustee's discretion to terminate the trust earlier. The reason is that if the trust is to terminate at a specified time (such as when the youngest of the group of beneficiaries has attained age 27) and at that time the trust assets are to be distributed in equal shares, some beneficiaries might decide to forego their education in the expectation that they will get a larger distribution when the trust terminates. Whatever the attitudes of the beneficiaries, there are many advantages of a "sprinkle" trust such as this: Flexibility. Distributions can be made both for different children and for 13 In particular, if a grandparent's estate is quite large and he or she plans to make substantial gift during lifetime and at death that will be subject to GST tax, the grandparent might well want to make gifts to separate trusts for grandchildren 1 written in such a way that the gifts will qualify for a special exclusion from the GST tax similar to the annual exclusion from the gift tax. 14 Again, special steps must be taken to qualify gifts to trusts for the annual exclusion from the gift tax. See the discussion below. 12

15 purposes other than education. Having multiple beneficiaries rather than a single one is very advantageous. If two beneficiaries are in college at the same time, the trust funds can be used as needed for both. Moreover, if one child goes to college only for a year or two while another gets a full undergraduate education and also a graduate or professional school degree, the trust funds can be devoted primarily to the child receiving an extensive education. By contrast, if separate trusts or custodial accounts had been set up for these two children, the funds set aside for one child might have been insufficient to pay for the full education he or she wanted while the funds set aside for the other child might have been only partially used for his or her college education. Allowing payments for purposes other than college education is also desirable because a beneficiary may develop other compelling needs or, as a result of scholarships or for other reasons, the trust funds may be more than necessary to provide for the beneficiaries' educations. Few Disincentives to the Beneficiaries. Because the trustee has discretion over how to allocate trust funds among the beneficiaries, no beneficiary can count on receiving trust funds if he or she does not go to college or leaves early. As indicated above, that is particularly the case if the trustee has discretion to keep the trust in effect as long as any beneficiary is alive. By contrast, under a custodianship established under a Uniform Transfers to Minors Act, the custodial funds must be turned over to the beneficiary at 21 at the latest, 15 so the beneficiary might decide to forego a college education and receive substantially more funds. Likewise, if a separate trust for a beneficiary provides that the beneficiary would receive the remaining trust funds at a certain age, such as 25, the beneficiary might forego some education to receive more funds then. Even if a separate trust did not require that the trust funds be distributed to the beneficiary at a certain age, the beneficiary might well believe that more funds would be distributed to him if he did not get a full education because the trust funds could not be used for any other beneficiaries. Less Likelihood that Beneficiaries will be Disqualified for Financial Aid. The types of financial aid colleges and universities and federal and state governments provide, ranging from scholarships to low interest loans, usually depend on the resources of both the applicant and parents. The rules vary widely from state to state and change frequently. Logically, however, a "sprinkle" trust for several children that allows the trustee to distribute funds for other than education should be less likely to disqualify beneficiaries for financial aid than custodial accounts or separate trusts for 15 Under the Uniform Transfers to Minors Acts in some states, it may be that the funds must even be turned over at

16 beneficiaries. 16 Income Tax Savings. The income taxation of trusts for children is somewhat complicated. Depending on the trust provisions and the circumstances, the trust income can be taxed to the trust or to individuals a child beneficiary, the donor, a parent and so taxed at different rates. Because a "sprinkle" trust has different beneficiaries with different ages, it generally can be used to produce greater income tax savings than custodial accounts and trusts for separate beneficiaries. By investing in growth stock when children are young and then taking steps so that income of the trust is taxed to children (without being distributed outright to them) after they are 14, considerable income can be taxed to them at a 15% rate. It should be possible to have most income of a "sprinkle" trust taxed at 15% or 20% rates. In many respects, then, a "sprinkle trust" for children and grandchildren is preferable to other traditional means of saving for the education of children and grandchildren. The only disadvantage of "sprinkle" trusts as compared to other traditional alternatives is that they are somewhat more complicated than options such as separate custodial accounts or trusts for children or grandchildren. In most circumstances, however, the advantages of a sprinkle trust outweigh this disadvantage. Savings-Type Qualified State Tuition Plans Savings-type qualified state tuition plans offer a new means of saving for the college education of children and grandchildren as well as providing significant tax benefits. How to Participate. In a savings-type qualified state tuition plan, a donor* s initial cash contribution to a plan account establishes participation in that plan. 17 The donor chooses the owner of the account and names a "designated beneficiary." 18 Contributions can be made to the account without any limitation based on the donor's income or the designated beneficiary's resources. The only limitation is that the contributions for a particular designated beneficiary cannot exceed roughly $100,000 but this amount will increase as the costs of college educations rise. Investment of a Donor's Account. By law a donor cannot control the 16 In some cases, it may be possible and practical to add certain provisions to a "sprinkle" trust for children or grandchildren that will make it more likely that the trust will not disqualify the beneficiaries from receiving financial aid. Interested readers should ask their estate planning attorneys about this. 17 "How to Ace Saving for College," Kiplinger's Personal Finance Magazine, February 1999, provides a useful report on existing savings-type qualified state tuition plans. 18 Someone other than the donor can be the account owner under some plans. However, it generally is advisable for the donor to be the account owner, as discussed below. 14

17 investment of the funds in an account. The plan specifies how accounts are to be invested, and generally deploys assets according to the age of the designated beneficiary. The account portfolios of younger beneficiaries usually hold more equities and those of older children contain more money market funds and short-term bonds. Distributions. Under most if not all savings-type qualified state tuition plans, an account can be used to pay college education expenses of the designated beneficiary at any accredited college, university, graduate or professional school in the United States and at certain post-secondary vocational schools. These expenses can include tuition and fees for undergraduate, graduate, and professional education and, while the designated beneficiary is attending school at least half time, the costs of room and board. When distributions are made for a designated beneficiary's college education, the income portions of the distributions will be taxed to the designated beneficiary, not the donor. A donor can also without incurring any tax liability change the designated beneficiary of an account by naming a relatively close family member of the original designated beneficiary as the new designated beneficiary. Likewise, the donor can roll the account of a designated beneficiary over to an existing account of another designated beneficiary who is a relatively close family member of the original designated beneficiary of the rolled-over account. When there is such a change in the designated beneficiary or rollover, the account can thereafter be used to pay for the college education of the new designated beneficiary, and the income portions of distributions for this purpose will be taxed to him or her. An account can also be used for other purposes for the designated beneficiary as decided upon by the donor, or even withdrawn by the donor for his or her own benefit or transferred to someone else the donor chooses. However, when the account is used for purposes other than the college education of the person named as designated beneficiary of the account at the time, the distribution generally will be taxed at relatively high rates and a tax penalty will be imposed. The Advantages and Disadvantages of Savings-Type Qualified State Tuition Plans The principal advantage of a gift to a savings-type qualified state tuition plan is that taxes on the income of a donor's account are deferred until distributions are made, as with a 401(k) plan or traditional IRA. Moreover, to the extent an account is used to pay college education expenses of the designated beneficiary, the distributions are included in the beneficiary's income and taxed at his or her marginal rates, which generally will be lower than the donor's rates. This combination can be quite valuable. There can also be state income tax advantages to savings-type qualified 15

18 state tuition programs. For example, states such as New York and Iowa exempt the earnings on accounts in the plans from state income tax and also give a deduction against state income tax, to a certain maximum, for contributions made by residents to the plan in a particular year. Gifts made to savings-type qualified state tuition plans also can have gift, estate, and GST tax benefits. Such gifts qualify for the annual exclusion from the gift tax, and for the similar exclusion from the GST tax. Moreover, a donor can make an annual contribution to an account for a single designated beneficiary of up to $50,000 ($100,000 for a couple) and elect to have that gift applied ratably against the donor's gift and GST tax annual exclusions for the five years beginning that year. 19 In addition, although a donor as owner of an account for a designated beneficiary will have powers over the account that normally would subject it to estate tax if the donor died, qualified state tuition plan accounts are exempt from such estate tax. Another advantage to a gift to a savings-type qualified state tuition plan is that the donor as account owner retains overall control over distribution of the account. In particular, a donor can without adverse tax consequences change the designated beneficiary of an account or have the account rolled over to an account of another designated beneficiary, as long as in each instance the "new" designated beneficiary is a close family member of the original designated beneficiary. For example, if a particular child did not go to college, any remaining funds in his account could be used for another child. However, an account cannot be used simultaneously for different beneficiaries, which is a disadvantage. Moreover, a grandparent donor could not convert an account for one grandchild to benefit another grandchild unless they were siblings. A cousin of a designated beneficiary of an account is not deemed a sufficiently close relation to the original designated beneficiary to be a "new" designated beneficiary of the account. As indicated above, a donor as account owner can also cause distributions to be made for the designated beneficiary that are not related to college education, can cause distributions to be made to persons other than the designated beneficiary, and can even withdraw the funds in the account for his or her own use. Whenever such distributions or such a withdrawal is made, the income portion of the distribution or withdrawal will then be 19 If the donor made another gift to the designated beneficiary in any of those five years, that gift would not be shielded by the donor's annual exclusion for that year unless it qualified for a gift tax exclusion other than the annual exclusion. In addition, if the donor died before the expiration of the five years, the portion of the gift to which the annual exclusion for future years had not yet been applied would be included in the donor's estate and subject to estate tax. 16

19 taxable, apparently to the donor at his or her rates even if the distribution is made to someone else. Except in a few special circumstances, a tax penalty that under most plans is roughly ten percent of the earnings will also be imposed. 20 However, the donor's right to withdraw the account for his or her own use is a valuable benefit. This in effect allows the donor to revoke a gift made to a savings-type qualified state tuition plan, if an emergency or unexpected hardship arises. It is sometimes said that it is an advantage that qualified state tuition plans are professionally managed. However, this management is done strictly in terms of the plan involved and donors have no control over plan investments. Under other college saving options, professional management can be obtained with overall supervision by a trustee or custodian selected by the donor. The principal disadvantage to savings-type qualified state tuition plans is that if a distribution is made to the designated beneficiary for purposes other than paying college education expenses or is made to other family members, the earnings portion of the distribution will not only be taxed to the donor but a penalty of roughly ten percent generally will be imposed. If the donor wants to withdraw the account funds for his or her own benefit and thus effectively rescind the gift this tax cost is, in effect, incurred at the discretion of the donor. However, these costs may be more burdensome if the account funds must be used for the designated beneficiary for purposes other than college expenses or for other family members. A "sprinkle" trust could authorize such distributions and there would be no tax penalty when the trust made them. There are also questions concerning possible gift and GST liability to the designated beneficiary in certain circumstances. In most cases, however, these issues probably will not be sufficiently major to deter people from making contributions to savings-type qualified state tuition plans where that otherwise appears advisable. In addition to these possible tax disadvantages, gifts to an account for a designated beneficiary or a savings-type qualified state tuition plan could prevent the beneficiary from obtaining financial aid. Last year Money magazine reported that while such contributions might not be a significant problem under federal and state aid programs, they might well be under financial aid programs offered by private schools The special circumstances when a penalty will not be imposed are when a distribution is (i) made because of the designated beneficiary's death or disability, (ii) made because the designated beneficiary received a scholarship greater than the amount of the distribution, or (iii) rolled over within sixty days to an account of a close family member of the beneficiary. 21 See the article "New College Savings Plans," in the December 1998 issue of Money. 17

20 Sprinkle Trusts and Tuition Plans Compared The advantages and disadvantages of "sprinkle" trusts vs. savings-type qualified state tuition plan may be summarized as follows: Income Tax Benefits. If, under a gift to a savings-type qualified state tuition plan, most or all of the account for a child or grandchild of the donor is used to pay that child or grandchild's college education expenses, or through a redesignation or rollover is used to pay the college education expenses of another child or grandchild, the account will produce considerable income tax benefits. Income tax on all account earnings will be deferred until the college education expenses are paid, and then those earnings will be taxed to a child or grandchild at rates presumably much lower than if taxed to the parent or grandparent who established the account. However, if matters do not work out as intended if the parent or grandparent establishing the account needs to use it for another purpose, or if neither the child or grandchild who is the designated beneficiary or any other child or grandchild who can without tax penalty be substituted as designated beneficiary attends college sufficiently to use up the account then the earnings will be taxed to the parent or grandparent at his or her rates and a penalty of roughly 10% will be imposed. This possibility is by no means an insignificant one, because many minors who their parents or grandparents anticipate will go to college either do not do so or do not complete their undergraduate studies. Sometimes this is because they choose what the parents or grandparents consider acceptable alternatives. However, even if such alternatives are chosen, income tax liability and a penalty would have to be incurred to use the account to pay for them. Under a "sprinkle" trust, on the other hand, no penalties would be incurred in paying for such alternatives or in using the trust funds for other purposes if the trust authorized payments for those other purposes. A "sprinkle" trust does not allow tax deferral. As indicated above, however, through proper planning it should be possible to have much of the trust income taxed at rates of 15% or 20%. In sum, if everything goes according to plan and the children or grandchildren involved go to college and use up the funds set aside for them, contributions to a savings-type qualified state tuition plan would be the "winner" over a "sprinkle" trust from an income tax standpoint. If however, considerable earnings of the contributions to the plan would be subject to relatively high income tax rates and a penalty, the "sprinkle" trust would probably be the "winner" from this standpoint. Gift and Estate Tax Benefits. Both would take advantage of the annual exclusion and remove the gift property from the taxable estate. There is no 18

21 significant difference between the two in terms of their gift and estate tax consequences. Flexibility. A "sprinkle" trust can make payments for the college expenses of different beneficiaries at the same time, while a savings-type qualified state tuition plan account can do so only for one beneficiary at a time. Moreover, funds in a "sprinkle" trust can be used to pay other than college expenses, while funds in a savings-type qualified state tuition plan generally can do so only by incurring higher income taxes and penalties. On the other hand, savings-type qualified state tuition plans allow the donor to withdraw funds for his or her own use, albeit with tax liability on the income portion of the amount withdrawn and a penalty, while under a "sprinkle" trust the donor cannot withdraw the trust funds under any circumstances. While people should not make gifts unless they are sure they will not need the assets given away, this opportunity to retrieve the gift property in the event of an emergency or unexpected hardship is an important benefit. In my view, the two types of gifts are equally flexible. Disincentive to Seek College Education. Neither of these types of gifts provides a child or grandchild a disincentive to obtain a college education. Effect on Financial Aid. This factor is particularly difficult to evaluate in current circumstances. A "sprinkle" trust theoretically would seem less likely to affect eligibility for financial aid adversely. However, that savings-type qualified state tuition plans are the creation of Government may mean that considerable pressure will be brought to prevent colleges from "discriminating" against students who may benefit from gifts to such programs. Uncertainties and Costs. The tax implications of a "sprinkle" trust are generally clear whereas those of savings-type qualified state tuition plan accounts are somewhat clouded. In terms of cost, there probably will not be much difference between the two types of gifts. There will be a relatively small initial cost to setting up a "sprinkle" trust and annual income tax returns will have to be filed for the trust. On the other hand, the costs charged by the sponsor state and the administrator of a savings-type qualified state tuition plan may make the investment expenses of a gift to it somewhat greater than for a "sprinkle" trust, at least when a family member or friend is trustee of the "sprinkle" trust and charges only a nominal fee, if any. However, competition between the different savings-type qualified state tuition plans presumably will tend to keep their charges reasonable. Individual "Tailoring." The "sprinkle" trust is the big winner here. With respect to investments, for example, the donor of a "sprinkle" trust 19

22 can choose his or her own trustee to decide on investments and, if he desires, also set out in the trust instrument guidelines concerning investments or make suggestions concerning investments to the trustee. By contrast, the donor can have no voice in the investments in a savings-type qualified state tuition plan account. 22 While such an account will be professionally managed, such management could also be obtained for a "sprinkle" trust if desired and the trustee would still be in overall charge. For some people, lack of control of investments under a savings-type qualified state tuition plan will disqualify it as a type of gift to use. Under a "sprinkle" trust, the donor can also specify that trust funds be used for purposes other than college expenses, when the trust will terminate, and how it will be distributed upon termination. Summary Even though there are some disadvantages and uncertainties, in circumstances where gifts to more than one child are being contemplated and the children are young, the long period of tax deferral, the lower tax rates applicable when the funds are used for college education, and the donor's power of withdrawal generally make savings-type qualified state tuition plans more advisable than "sprinkle" trusts. However, even in these circumstances and certainly in other circumstances all the relevant facts should be considered in deciding which type of gift would be best. For many people today, it may be advisable to defer decisions about gifts for college costs for a period. Advantageous changes concerning savings-type qualified state tuition plans may occur soon. Bills already before Congress would provide that no federal income tax ever be charged on the savings of accounts in these plans if the funds are used to pay college expenses. This and other possible changes would make such contributions to such plans more advantageous and warrant their use in more circumstances. 22 The donor does have "all or nothing" control over the account's investments through the power to withdraw the funds in the account. Moreover, if the account has not earned much, there might not be much cost to exercising this power. 20

23 III. GIFTS OF RESIDENCES OR OTHER REAL ESTATE THE tax cost of continuing to own a residence until death can be great, because a residence is often one of the largest assets in an estate. I have administered several estates with substantial estate tax liability in which there would have been very little if any tax liability if the residence had been removed from the estate before death. If one could live in a residence after making a gift that would remove it from the taxable estate, one could continue to enjoy the advantages of ownership but avoid the related tax costs. Since a residence does not produce income (assuming no part of the residence is rented), such a gift would not reduce the funds that the donor uses to pay living expenses. For some time, the IRS took the position that if a person gave away a residence but continued to live in it, it would still be included in the taxable estate, even if the donor paid fair market rental for its use. The IRS presumed that since the recipients of such gifts usually children of the donor had allowed the donor lifetime use of the residence, there must have been an implied agreement between the parties to that effect. Under the Internal Revenue Code, when a person retains the lifetime right to use property he or she has given away, that property remains in the taxable estate. Thus, the IRS's presumption of an implied agreement to allow the donor to continue to use the residence resulted in its inclusion in the estate. In the early nineties, however, Congress authorized "qualified personal residence trusts," or "QPRTs," whereby a donor could transfer his or her residence to a trust and retain the right to live rent-free in that residence for a specified period of years. If the donor outlived that period of years, the residence would be removed from his or her estate. Moreover, IRS rulings have confirmed that under this a QPRT, if the donor outlives such a period, will not be included in the estate even if thereafter the donor rents the residence from the QPRT. Under a QPRT, therefore, a donor can continue to live in his or her residence until death and yet remove it from his or her estate. Moreover, the IRS rulings concerning QPRTs have also made other types of gifts of a residence or interests in a residence more feasible. A particularly advantageous type of gift is a QPRT structured so that any income generated by the residence while in the trust will continue to be taxable to the donor. As discussed below, this maximizes the benefits of the QPRT, adding options not otherwise available. Also useful are "annual exclusion" gifts over a period of years that give away a vacation home, which can also be used to give away real estate not used as a residence, 21

24 such as rental property. Gifts of this kind can be used to remove the real estate involved from the donor's estate at no transfer tax cost whatsoever. The Basic Structure ofqprts and the Transfer Tax Savings They Produce As indicated above, under a QPRT the donor retains the right to live in the residence transferred to the QPRT for a period of years that the donor chooses. Upon the expiration of this period of years, the property either passes outright to the donor's designated beneficiaries or is held in trust for those beneficiaries for the remainder of the donor's lifetime. Generally the latter approach is preferable because then the donor can rent the residence back from the trust after expiration of the specified rent-free period. Moreover, when married couples establish QPRTs and they generally are even more advisable for couples than single persons the residence can be retained in trust for as long as either spouse is living. A QPRT produces tax savings because the donor makes a taxable gift only of the remainder interest in the residence that will pass to designated beneficiaries outright or in trust at the end of the period for which the donor has retained the right to live in the residence rent-free. The value of the remainder interest is measured according to IRS tables and will differ depending upon the donor's age, but generally it will be only a relatively small percentage of the entire value of the residence. If the donor survives the retained period of years, the entire residence will be removed from the donor's estate at a cost of tax on only this small percentage of its value as of the date the gift was made. The rest of the value of the residence at that time, plus all appreciation in its value until the donor's death, will pass taxfree. Moreover, assuming the donor does not use up his or her entire "exemption equivalent" on other lifetime gifts, the gift tax liability will effectively become due only on the donor's death. 1 Thus, the donor generally does not have to pay any tax when the gift is made or at any time before death. If the donor dies during the period of years for which he or she has retained the right to live in the residence rent-free, the residence will be included in the donor's taxable estate and the tax savings sought through the QPRT will be lost. The reason is that property that a donor retains the right to use until his or her death is included in his or her estate. However, the possibility that the donor will die during the retained period of years can be minimized by selecting a period that is at least a few years shorter than the donor's life expectancy. Moreover, if the donor should die during 1 For a technical reason, gifts to a QPRT do not qualify for the annual exclusion from the gift tax. 22

25 the retained period, the tax liability caused by the earlier gift of the remainder in the residence will effectively be eliminated so nothing is "lost." Thus, the possibility that a donor might die during the retained period is not a reason to forego establishing a QPRT it is simply a factor to take into account in structuring the QPRT to maximize the possibility that it will produce the transfer tax savings sought. The following table shows the transfer tax savings possible under five hypothetical QPRTs that are assumed to have been established in May 1999 and involve a residence worth $500,000: 2 Savings Possible from QPRTs Donor's Age Retained Period 23 Years 15 Years 8 Years 9 Years 6 Years 4 Years Transfer Tax Savings $228,547 $199,323 $153,280 $187,622 $164,194 $146,663 For three of the QPRTs in the table where the donors are 50,60 and 70 respectively a period five years less than the donor's life expectancy was chosen as the rent-free period, so there would be this cushion to protect against the possibility of the donor dying earlier than predicted. For the remaining three QPRTs, where the donors are 75, 80 and 85 respectively, the period chosen was two years less than the donor's life expectancy. As the table shows, the estate tax savings produced on the QPRTs would range from almost $150,000 to almost $230,000. These figures actually understate the savings because they do not take into account the likelihood that a residence added to a QPRT would appreciate in value thereafter, which would increase the savings because that appreciation would also be removed from the estate. In some cases, there will be an offset to these savings. A capital gains tax disadvantage incurs if appreciated property is given away during the donor's lifetime, since then the donee takes the donor's basis in the property rather than the "stepped up" basis that would result if it were held until the donor's death. Thus, if a residence has appreciated, this capital gains tax disadvantage can result from transferring it to a QPRT. As discussed below, this tax liability sometimes can be eliminated or greatly minimized. However, even when a capital gains liability incurs, it will almost always be outweighed by the transfer tax savings. For example, assume that in each of the hypothetical QPRTs in the table above, the donor's basis in the 2 It was assumed that the QPRTs were established in a particular month because the value of the remainder interest in a QPRT is determined using a formula based on an IRS presumed rate of return on investments that changes each month. This rate has not changed dramatically for some time and is not likely to do so in the next year or so, so the savings shown in the table in the test are likely to be representative of the savings obtained on similar QPRTs established at least in the next year or so. 23

26 $500,000 residence was $300,000. Then $200,000 in capital gains would be realized if it were sold following the donor's death, when it would no longer be needed by the family. The capital gains tax due would be $40,000 and the net savings produced by each of the QPRTs would be as follows: Savings Possible from QPRTs even with Capital Gains Tax Disadvantage Donor's Age Retained Period 23 Years 15 Years 8 Years 9 Years 6 Years 4 Years Net Tax Savings $188,547 $159,323 $113,280 $147,622 $124,194 $106,663 The net savings still range from $106,000 to almost $190,000. Again, these figures understate the actual savings because they ignore the appreciation in the value of the residence likely to occur between the date of its transfer to the QPRT and the donor's death. Other Important Aspects of QPRTs A donor is not "locked in" to living in the residence transferred to the QPRT for the rest of his or her life. The donor can and generally should be trustee of the QPRT during the retained rent-free period, and after its expiration, one or more close family members or friends should become the trustee or trustees. Thus, there should at all times be a trustee or trustees who can sell the original residence and purchase a new one if that is desired by or advisable for the donor. This can be particularly important if a donor wants to move into a facility where assisted care is available. In many such facilities, the residents buy the real estate in which they live, be it a condominium or cooperative or townhouse. Thus, the trustee of the QPRT could sell the original residence and purchase the real estate involved. If the residence involved is a principal residence and the QPRT is structured so that any income it generates will be taxable to the donor, the donor's $250,000 capital gains tax exemption on sale of a principal residence ($500,000 in the case of a couple) will be available to shield the proceeds from capital gains tax. A residence added to a QPRT can also be sold without the purchase of a new residence. If the sale occurs during the period for which the donor has retained the right to live in the residence rent-free, the statute authorizing QPRTs requires that the donor be paid an annuity for the remainder of the term. This can be advantageous if the donor wants to move into a facility providing assisted care in which the residents do not purchase real estate. Then the original residence can be sold and the annuity payments to the donor can be used to pay the rent and costs of care at the facility. As noted, a donor who desires to live in the residence after the expiration of the rent-free period must pay fair market rent to do so which some 24

27 may consider a detriment to QPRT arrangements. They may also be dismayed that a fair market rent on their residence could be substantial. If there is any possibility that available funds will be insufficient to pay such rent, a QPRT should not even be considered. Beyond that, however, the need to pay rent should not be considered a disadvantage, or at least not one that deters people from establishing QPRTs. Any inconvenience or emotional distress involved in the payment of rent to live in what many donors no doubt continue to consider "their own homes" is outweighed by the tax savings obtainable through QPRTs. Moreover, from a transfer tax standpoint, the need to pay such rent is actually advantageous. This rent will be paid either to a trust for the donor's designated beneficiary or to the designated beneficiaries themselves. Thus, the rent will generally stay in the family and increase what will pass to the intended beneficiaries. Moreover, the rental payments will further reduce the donor's taxable estate, saving additional estate tax. In addition, because the income of the QPRT should be taxable to the donor, no income tax should be due on the rental payments. In sum, the rental payments following the retained period of a QPRT are to a large extent another type of lifetime gift and have the transfer tax advantages of lifetime gifts. Another possible QPRT disadvantage is that part of the payment of any mortgage on a residence transferred to a QPRT, and the cost of any capital improvements to the residence, must be treated as additional gifts to the extent that they increase the value of the remainder interest. This means that a new determination of the value of this gift must be made and a new tax return filed. However, most owners generally make capital improvements to a residence infrequently, so these additional steps will probably seldom be necessary. In the case of a mortgage, however, a new gift will be made each time a monthly mortgage payment is made. For most donors, this will not be a problem because they no longer have a mortgage on their residences. For example, the May 6,1997 issue of USA Today reported that 67% of home owners over 50 own their residences mortgage-free. Of course, for people who do have mortgages, the easiest way to eliminate the disadvantages that mortgage payments after a QPRT create is to pay off the mortgage. When the mortgage has already been paid down to a small amount, this should be done. This leaves situations in which there is a not insignificant mortgage and it is difficult to pay it off or inadvisable to do so because of the deduction available for the interest portion of the mortgage payments or for other reasons. In such situations, it may be inconvenient to deal with the additional gifts made each time mortgage payments are made, but this inconvenience should not dissuade people from establishing QPRTs. 25

28 QPRTsfor Married Couples QPRTs are generally more advantageous for married couples than single individuals. However, there are specific steps that they should take to maximize QPRT tax savings. Most married couples own their residences in a form of ownership called "tenancy by the entirety" which has a certain advantage compared to other forms of ownership. 3 Tenancy by the entirety ownership is a form of joint ownership with right of survival that is available only between married couples. The unusual and advantageous characteristic of tenancy by the entirety ownership is that a person who has received a court judgment against only one of the spouses referred to as a "judgment creditor" of that spouse cannot reach property held in such ownership to pay the amount due. For example, if one spouse is in an automobile accident and a judgment is entered against him or her in excess of the available insurance coverage, or if one spouse is in a high risk profession such as medicine and is faced with a judgment in excess of the available insurance coverage, the judgment creditor cannot reach the married couple's tenancy by the entirety property to recover the amount due. Instead, the judgment creditor is limited to recovering against property that the spouse who is the judgment debtor owns individually, or property that is owned jointly or as tenants in common by the married couple. Some married couples consider their residence the most important asset to be held in tenancy by the entirety ownership because it is the last thing they want to lose in the event of a large claim against one spouse. Under a QPRT, a judgment creditor logically should be barred from reaching only the value of the remainder interest that has been given away, and perhaps a judgment creditor could even reach this interest. Thus, married couples who transfer residences to QPRTs will give up some protection against creditors. However, this generally should not deter couples from taking this step. The creditor protection advantage of tenancy by the entirety ownership should not be overrated. A judgment creditor of both spouses and banks and others loaning money to one spouse for use in a trade or business generally will require the other spouse to sign the financing documents can reach tenancy by the entirety property. Moreover, when property is in joint tenancy ownership or tenancy in common ownership (or a residence is divided into two separate QPRTs established by a husband and wife, which is how married couples desiring to set up QPRTs 3 Here it should be noted that I do not practice in community property states and do not know all the ramifications of transferring a residence in a community property state to a QPRT or the steps that should be taken in doing so. Residents of such states should consult qualified estate planning attorneys in their home states concerning these matters. 26

29 should establish them), a judgment creditor of only one spouse can reach only half of the total property. The other half, that owned by the spouse against whom the judgment creditor has no claim, cannot be reached. 4 Accordingly, for most married couples the additional creditor protection advantage of tenancy by the entirety ownership does not justify their foregoing the substantial tax savings of QPRTs. The issue then becomes how married couples who want to establish QPRTs for their residences should do so. IRS regulations authorize the transfer of a residence held in tenancy by entirety ownership to a single QPRT for the two spouses, but the regulations impose requirements on such a QPRT that make it inadvisable. Instead, the married couple should transfer their residence to tenancy in common ownership in which each owns one half interest in the residence, then each should transfer the onehalf interest to a separate QPRT. Usually, each spouse should be the trustee of his or her QPRT during the period for which the spouse retains the right to live in the residence, just as generally the donor of a QPRT should be the trustee during the retained period. However, immediately upon the expiration of the retained period, a successor trustee or trustees should begin to serve, as in the usual case. Generally the same successor trustee or trustees should serve for each spouse's QPRT so that the residence will be administered uniformly. 5 In valuing the two QPRTs, a discount can be taken in determining the value of each half interest transferred to one of the QPRTs, which will reduce the value of the remainder interest that constitutes the taxable gift, because of the multiple ownership of the spouses. Such a discount is warranted because neither spouse can require that the whole residence be sold, and therefore no purchaser would be likely to pay half the total value of the residence for a onehalf interest in it. With such a discount, the transfer tax cost of removing the residence from the estate can be reduced even further. Cases and rulings vary significantly on the percentage discount appropriate in such circumstances, and an estate planning attorney should be consulted at the time the QPRTs are established to determine what discount should be taken. The Advantages of Making QPRT Income Taxable to the Donor The donor's retention of the right to live in the residence transferred to a 4 There can be situations in which, based on a claim of fraud or some other ground, a judgment creditor of one spouse may be able to reach property of the other spouse. It would be impossible to discuss all the rights of debtors and creditors in all circumstances. 5 It would be possible to have different retained terms and this could be advisable when there is a significant disparity in ages. Another step that might be advisable where there is a significant disparity in the spouses' ages would be to transfer the residence to the younger spouse and have only that spouse establish a QPRT, one for the entire residence. 27

30 QPRT for a period of years will cause the residence to be considered owned by the donor during that period for estate tax purposes. The retention of that right, and the fact that the residence will revert to the donor's estate if he or she dies during the retained period, will also cause the residence to be still treated as owned by the donor during the retained term for all income tax purposes, including capital gains tax purposes. 6 Having the QPRT treated as owned by the donor for income tax purposes has several advantages. Indeed, having the QPRT treated as income taxable to the donor is so desirable that special steps should be taken so that the income of the QPRT including capital gains income, remains income taxable to the donor even after the expiration of the trust term. This is a delicate matter, because after expiration of the trust term, a QPRT should only be treated as taxable to the donor for income tax purposes, and not for estate tax purposes. Otherwise the transfer tax savings sought through the QPRT will be lost. Nonetheless, a qualified estate planning attorney can include in a QPRT provisions that will safely make it income taxable to the QPRT without causing it to be included in the donor's estate. And, to repeat, this should be done because it will produce advantageous income tax treatment in several respects. For some it will even make it advisable to initiate transactions to obtain income tax savings. The major advantages of having a QPRT income taxable to the donor are: If the residence in the QPRT is sold, the capital gains exclusion of $250,000 ($500,000 for a married couple) will be available to shield gain on the sale from tax. During the retained period, mortgage payments and real estate taxes paid by the donor will be deductible by the donor. After expiration of the retained term, rental payments made by the donor should not be taxable as income to the trust. The first of these advantages will in many cases be the most important. For example, assume that a married couple decide that they would like to have their residence, which they purchased for $400,000 and is now worth $900,000, sold by the QPRT. When the trustee makes the sale, no capital gains tax will be due because all the gain will be shielded by the couple's $500,000 exclusion. The savings will be $100,000 ($500,000 times the 20% capital gains tax rate). 6 A slight qualification here is that in rare cases, the value of the reversionary interest the value of the right the donor retains to have the residence go to the donor's estate if he or she dies during the retained period Will not be high enough to cause capital gains income of the QPRT to be taxed to the donor. An estate planning lawyer should check into this very technical matter when establishing a QPRT. 28

31 Indeed, in some cases it will be advisable to sell of a residence in a QPRT in order to completely or largely eliminate the capital gains tax disadvantage of having an appreciated residence held in a QPRT. A residence transferred to a QPRT will not get a "step up" in its basis if the donor outlives the retained period of years because then the residence will not be included in the donor's estate. Moreover, in most cases, children or other family members who receive the residence from the QPRT after the donor's death will not be able to make use of the capital gains tax exclusion because they will not use the property as a residence themselves. However, if they buy the residence from the QPRT during the donor's lifetime for its fair market value, the donor's capital gains tax exclusion will be available to shield the proceeds from capital gains tax. Thus, upon the donor's death, the donor's children or other beneficiaries would own the residence with a basis of its market value when they bought it and they would receive the sale proceeds from the QPRT either completely unreduced by or with a very large savings in capital gains taxes. For example, suppose that the couple in the second paragraph above wanted to continue to live in their residence as long as either of them was alive, but would like to avoid the capital gains tax disadvantage that would occur if the residence continued to be held in the QPRT until the survivor's death (the children, who are be the beneficiaries after their deaths, would then have to take their parents' $400,000 basis in the residence). If their children bought the residence from the QPRT either before or after the expiration of the trust term assuming the QPRT contained provisions making it income taxable to the donor at all times the entire gain on the sale would be shielded by the $500,000 capital gains tax exclusion and following the donors' deaths the children would have the residence and the full $900,000 in proceeds. The savings would again be $100,000. Moreover, the donors could over a period of years make annual exclusion gifts to their children to give them funds to make a "fair market" downpayment on the residence, with the QPRT taking back a fair market mortgage for the balance. The children could then rent the residence to their parents so the donors could continue to live in it as long as either was alive. And the rental payments to the children could be used by them to make the payments on the mortgage to the QPRT. In sum, by structuring QPRTs so that they will be income taxable to the donor even after expiration of the retained term, donors of QPRTs can give themselves opportunities for substantial income tax savings as well as the basic transfer tax savings derived from establishing QPRTs. 29

32 Use of Annual Exclusion Gifts To Give Away Real Estate QPRTs are available only for residences, but another technique is often a useful means of making lifetime gifts of vacation property, a second home, or other real estate. This technique is to make "annual exclusion" gifts of interests in the property. A taxable estate may often contain real estate that could be used to make "annual exclusion" gifts, but is overlooked either because the owner believes that property cannot be divided up to make gifts or for some other reason. In many cases, however, the real estate is well suited to use in "annual exclusion" gifts. Real estate can easily be divided for purposes of gifts by deeding interests in the property to donees each year. A few examples support the usefulness of such gifts. Consider a vacation home owned by an individual or a married couple. Often this home and the principal residence will constitute a substantial portion of the estate. In such a case, the individual or couple might have a taxable estate, possibly quite large, and yet need the income from their income-producing assets, so that it is not advisable to use those assets for annual exclusion gifts. In such circumstances, giving the vacation home to children and grandchildren, or to trusts for them, in annual exclusion gifts over a period of years could produce substantial transfer tax savings. Such gifts work best where the children and grandchildren use the vacation home as well as the donor. Common use of the vacation home reduces the chance that the IRS might attempt to claim that it should be included in the donor's estate, even though ownership has been transferred, on the ground that the donor continued to retain use of the property. While the IRS has not tried to do so when QPRTs are involved, it may do so in other circumstances. Nonetheless, when the subject of gifts is a vacation home that the donor uses only infrequently, the IRS should have no such claim, and that should be particularly the case when the donees of the gift use the vacation home to much the same extent as the donor. When a vacation home has been given away, it may also be advisable for the donor to pay the donees rent for use of the vacation home. This would make the situation more analogous to that under a QPRT when the period for which the donor has retained the right to live rent-free in the residence expires and the donor rents the residence back from the QPRT. 7 7 There is a possible rationale that the IRS could use to try to distinguish the situation where the donor has given away a vacation home but continues to use it to an extent, from the situation where the donor of a QPRT has outlived the period for which he retained the right to live rent-free in the residence and then rents the residence back from the QPRT. In the latter case, years would have passed since the time the QPRT was established, and the IRS may believe that this passage of considerable time makes it more difficult than in the former case to presume that there was an implied agreement to continue to allow the donor use of 30

33 "Annual exclusion" gifts of real estate also can be useful when a person has built a substantial estate by buying and renting real estate. The person may have more rental revenue than needed, but the excess is not sufficient to fund the "annual exclusion" gifts it otherwise would be advisable to make to children or grandchildren and an outright gift of rental income would have to be made with after-tax dollars. In such circumstances, it might well be advantageous for the donor to give children and grandchildren (or trusts for them) interests in one or more rental properties. The donor could retain enough of the rental properties to provide sufficient income to meet his or her needs. The gifts generally could be structured so that much if not all of the rental income that the donor does not need would be taxed at lower rates, than if it continued to be paid to the donor. Over a period of years, the donor could completely give away one rental property in this way. Alternatively, if the donor wanted to retain majority control over each rental property, minority interests in two or three could be gifted. In deciding which rental real estate to use to make gifts, the donor should consider the difference between the fair market value of particular rental real estate and its basis for capital gains tax purposes, to try to minimize any capital gains tax disadvantage to the donees resulting from the gifts. Also, if valuable income tax deductions are available from some rental properties but not others, the donor should retain those properties. In some cases, a person owning real estate may be concerned about possible future disagreements with the recipients of such gifts. If strong disagreements developed, the donees could bring a partition action, which is an action to force the sale of real estate and division of the proceeds among the owners, or cause other problems. In most families, serious friction of this kind will not develop. Moreover, the donees have a disincentive to create problems, because that would endanger future gifts from the donor. Making the gifts to trusts with reliable trustees rather than directly to individuals would further reduce the likelihood of such problems, at least as they affect the administration of the rental property. Or the donor could establish a limited partnership or a limited liability corporathe residence after his right to use it rent-free expired. I do not consider this possible ground for distinction convincing. However, I am concerned that at least where a principal residence is given away and the donor retains full use of it while the donees retain no use of it, the IRS might well continue to presume an agreement between the donor and the donees that the donor could continue to use the residence. I consider it less likely that the IRS will make this argument where the donor uses the vacation property only a relatively small amount of the year, particularly where the donees also use it. Moreover, if the donor would not make annual exclusion gifts unless he or she made gifts of the vacation home, there is no downside to making gifts of it. 31

34 tion and be the general partner or the holder of a majority of the voting stock. Then the donor could give away limited partnership interests or minority stock interests and retain control. Because the donees will have even fewer rights than if they received interests in the real estate directly, use of a limited partnership or limited liability corporation should also allow the donor to discount the value of the property used for the gifts. 8 "Annual exclusion" gifts of real estate can be made quite easily. The first step is to determine what percentage of the real estate can be given to each proposed donee each year within the available annual exclusion (again, $10,000 per donee from an individual and $20,000 per donee from a married couple). The simplest approach would be to ascertain what percentage the applicable annual exclusion constitutes of the total value of the property to be gifted. However, other considerations need to be taken into account. If a married couple is making the gift, a multiple owner discount can be taken in valuing the property as a whole, which will allow a larger percentage of the property to be given away within the applicable annual exclusions. On the other hand, if the donor plans to make the mortgage and utility and real estate tax payments due on the entire property following these gifts, these payments need to be taken into account in determining the percentage interests to be given away. The reason is that they will constitute additional gifts to the donees, counting against the annual exclusion to the extent of their percentage interests in the property at the time the payments are made. For example, if the mortgage and utility payments and real estate taxes on the property are $2,000 and the donor has at the date of a payment of real estate taxes given away 50% of the property to a single donee, the donor's payment of the $2,000 would constitute an additional gift to the donee of $1,000 in the year the payment is made. Accordingly, a percentage gift of an interest in the residence made to the donee at the end of that year should be no more than this fraction: available annual exclusion gift - $1.000 total value of the property It should also be kept in mind that the value of the property may change over the period in which the "annual exclusion" gifts of interest in it are made. The procedures for making the gifts are quite simple. Each year the donor executes a deed to each donee giving the donee the proper percentage interest in the property. These deeds are essentially "cookie cutter" documents that vary only slightly and can be prepared easily and cheaply. The deeds must be recorded. In many states, no transfer or recordation tax However, the IRS sometimes challenges such discounts. 32

35 is due on deeds making gifts to relatively close family members, but in each case the law of the applicable state should be checked. For a married couple, if the real estate to be given away is owned solely by one spouse but the couple plan to use their full $20,000 per donee annual exclusion, it generally is advisable for the spouse who owns the property to deed it to both spouses as tenants in common before embarking on the gift-giving program. The reason is that although the spouse who does not own the property can join in gifts of it made solely by the other spouse (so that the spouses can use the full $20,000 per donee exemption) that approach requires the filing of a gift tax return each year such a gift is made. On the other hand, if the property is first transferred to both spouses, then each gift of a $20,000 interest in the property will constitute a gift of $10,000 by each spouse, and no gift tax return will be required. Avoiding this reporting requirement generally will justify taking this additional step. In short, annual exclusion gifts of real estate are often very advantageous because they allow use of the annual exclusion even when there are insufficient liquid assets available to make "annual exclusion" gifts. 33

36 IV. "SMALL IRS REMAINDER" GRATS GRANTOR Retained Annuity Trusts (GRATs) function much like QPRTs except they hold property other than a residence. 9 The donor transfers property to the GRAT and retains the right to receive annuity payments for a period of years, then the GRAT property goes to designated beneficiaries or is held in further trust for them. If the donor outlives that period of years, only the remainder interest is subject to transfer tax, and generally no tax is due until the survivor's death. If the donor dies during that period, the property is included in the donor's estate. As in the case of a QPRT, however, the donor generally can avoid this possibility by choosing to receive annuity payments from the GRAT for a period shorter than his or her life expectancy. Moreover, even if the donor should die during the retained interest period, nothing will have been lost, because in that event the tax liability caused by the gift of the remainder interest in the GRAT will effectively be eliminated. GRATs have more flexibility than QPRTs because the donor can select not only the retained period of years but also the amount of the annuity that he or she will receive each year. This flexibility allows donors to structure GRATs that have very small remainder interests as measured by IRS, and thus very small taxable gifts. Such GRATs can produce very substantial savings and yet are virtually risk-free. GRATs are very likely to produce tax savings because of the way the remainder interest, and thus the taxable gift, is valued. The remainder interest is valued according to IRS tables that presume a certain rate of return on property. This rate varies from month to month and the applicable rate for valuing the remainder interest in a GRAT is the rate for the month in which it is established. Since inflation has been low and is predicted to continue to be low for some time, this presumed rate of return on property has likewise been low and probably will continue to be low. In May 1999 this rate was only 6.2%. A percentage annuity payment larger than the applicable rate of return should be selected because then the IRS method of valuing the gift of the remainder interest will presume that the property in the GRAT will decrease over time. In fact, a percentage annuity payment and payment period should be selected that will result in the value of the remainder interest, and thus of the taxable gift, being very small a few thousand dollars or even less as 9 As in the case of a QPRT, gifts to a GRAT do not qualify for the annual exclusion from the gift tax for a technical reason. 34

37 measured by the IRS tables. In such circumstances, the IRS tables will presume that only a few thousand dollars will pass to the designated beneficiaries or a trust for them at the end of the term for which the donor retained an annuity interest, and only that few thousand dollars will be subject to gift tax, usually not until the donor's death. However, if instead of the IRS's conservative presumed rate of return the GRAT property produces a return of twelve or fifteen percent per year, which is possible, then at the end of the period of years for which an annuity interest was retained, much more property than presumed by IRS will pass to the designated beneficiaries of the remainder at a cost of tax on only a few thousand dollars. Thus, a GRAT with a small remainder interest and small gift, as measured by the IRS tables, can in fact produce a very large remainder interest, virtually all of which will pass free of transfer tax. Accordingly, such a "small IRS remainder" GRAT can produce significant tax savings. A "small IRS remainder" GRAT is also virtually risk-free. Assume that the GRAT property produces even less than the conservative IRS presumed rate of return on property. Nothing will really be lost from a tax standpoint, because only a very small tax liability of a thousand dollars or so resulted from the gift, and if the donor outlives the period for which the donor receives the right to receive annuity payments, this will be the total transfer tax ever imposed on the property transferred to the GRAT. It is questionable whether this should be considered a loss at all, and even if it is, the loss is a very small one. Thus, "small IRS remainder" GRATs provide an opportunity to obtain large tax savings at virtually no risk. Yet another advantage of "small IRS remainder" GRATs is that the donor continues to receive substantial benefit from the property added to the GRAT because he or she retains the right to receive a number of annuity payments based on the value of the property. Indeed, according to the IRS tables, these payments will have a value virtually equal to the full value of the property given away. In essence, "small IRS remainder" GRATs provide an opportunity for people to have any return on property in excess of the IRS's conservative return rate pass tax-free to children or other designated beneficiaries. Essentially the only risk a person has to take to obtain this opportunity is the risk that is taken whenever an investment is made that the return on the investment may not be as great as anticipated or hoped. And if the return on the investment meets or exceeds expectations, the tax savings can be great. The following table shows the tax savings that can be obtained, and the additional amounts that can be passed to beneficiaries, through the use of "small IRS remainder" GRATs. The table hypothesizes four "small IRS remainder" GRATs, each of $250,000, established by donors ages 60, 65, 35

38 70, and 75, respectively. In the case of the hypothesized GRATs for donors 60 and 65,1 chose a period for which an annuity interest was retained that was five years shorter than the donor's life expectancy. For the other two GRATs when the donors are 70 and 75, the period chosen was three years shorter than the donor's life expectancy. For each GRAT, the table compares the results the GRAT is likely to produce to the likely results if the $250,000 had been retained in the donor's estate. Certain assumptions were made in the calculations, principally (1) that the donor's death would occur as predicted by the donor's life expectancy, (2) that all property involved would produce an after-tax return of 10% a year, and (3) that the top marginal estate tax rate of 55% would be applicable to the donor's estate. Savings Possible from "Small IRS Remainder" GRATS Scenario 1 Property Transferred to GRAT Age of Donor at Nearest Birthday Term of Years of Retained Annuity Payments Value of Property Transferred to GRAT (Initial Amount) $250,000 $250,000 $250,000 $250,000 Net Amount to Beneficiaries $926,740 $674,688 $485,115 $369,323 Scenario 2 Property Remains in Estate Initial Value of Property Invested $250,000 $250,000 $250,000 $250,000 Term of Years of Investment Net Amount to Beneficiaries $758,357 $543,298 $400,809 $374,972 Additional Amount to Beneficiaries through use of GRAT $168,382 $131,389 $84,306 $62,937 The comparisons show that the $250,000 GRATs would produce from over $60,000 to almost $170,000 more for beneficiaries than the alternative of retaining the $250,000 in the estate. These are very significant additional amounts for beneficiaries considering that only $250,000 would be added to each GRAT. They would be somewhat less if the property produced an after-tax return lower than 10% or if an estate tax marginal rate of lower than 55% were assumed applicable. On the other hand, the additional amounts for beneficiaries would be greater if more than $250,000 in property were transferred to "small IRS remainder" GRATs or if the GRAT property produced an annual after-tax return greater than 10%. In short, "small IRS remainder" GRATs are simple to establish and provide the opportunity for large tax savings at virtually no risk. Accordingly, people who make the maximum "annual exclusion" gifts they can to children and grandchildren and possibly spouses of children and grandchildren (or to trusts for some of these beneficiaries) and yet still are likely to have taxable estates should consider establishing GRATs. 36

39 V. LIFE INSURANCE TRUSTS TRUSTS to hold life insurance can be used either to save taxes or provide tax-free funds to meet transfer tax liabilities. Considered here are three common situations where a life insurance trust, sometimes with related arrangements, would produce substantial tax savings or provide substantial tax-free funds. Use of a Life Insurance Trust to Reduce the Taxable Estate A large life insurance policy can be a particularly advisable asset to remove from the estate through lifetime gifts. Insurance generally does not produce any income that can be used to meet living expenses, and in many cases the cash value of insurance is small and the insured has no intention of converting the insurance to cash to meet living expenses in any event. In other words, for the great majority of people, their insurance is not intended to meet expenses during lifetime and could not do so to any extent anyway. They have the insurance only so that the proceeds will be available after their deaths. However, if they continue to own the life insurance until death and they have a taxable estate, the life insurance proceeds generally will be reduced by 40% to 55% because the marginal rates applicable to the estate will be in this range. Thus, if people with taxable estates give away life insurance during their lifetimes while still providing that it will pass as they want following their deaths, they will obtain substantial estate tax savings without altering the disposition of their life insurance. A life insurance trust allows a person to do just this. First the person sets up the trust, including in it provisions setting forth how the life insurance is to be used following his or her death. Then the person transfers his or her life insurance to it. If in the future the person decides to replace the insurance in the trust, the person should transfer the initial cost of the replacement insurance to the trustee so that the trustee, not the insured, will be the initial owner of the replacement insurance. Care should also be taken so that the application for the insurance and all related documents show the trustee or applicant and initial owners. These steps are advisable because there is a special "three year rule" for gifts of life insurance which provides that if life insurance is given away within three years of the insured's death, the insurance proceeds will be included in the insured's estate. 10 If 10 The "three year rule" bringing a gift of life insurance back into the estate for tax purposes if the gift occurred within three years of death does not apply with respect to virtually all other kinds of lifetime gifts. In other words, other gifts made within three years of a person's death will not be brought back into the estate for tax purposes. 37

40 the money to buy new insurance is first given to the trustee, and he owns the insurance from the outset, this "three year rule" can be avoided. 11 To maximize the tax savings that the insurance trust will produce, funds necessary to pay future premiums on the life insurance in the trust should be transferred to the trust a short period, such as thirty days, before a premium is due, and one or more beneficiaries should be given the power to withdraw the funds during this period. This is necessary to qualify the premium payments for the annual exclusion from the gift tax and keep them from reducing the donor's "exemption equivalent." 12 If they are not withdrawn, they can be used to keep the life insurance in effect, and since the insurance proceeds will produce a bigger eventual return than withdrawing the premium payments, it is in the interest of the beneficiary given withdrawal powers not to withdraw the funds. Moreover, if any beneficiary should withdraw funds, the donor can decide not to give that beneficiary the right to withdraw future funds. 13 Generally the only disadvantage to a life insurance trust is that the trust must be irrevocable to obtain the savings desired. 14 This can be a concern if, for example, the insured has a problematic marriage or children who are experiencing difficulties, because then the insured may want to retain the flexibility to change the disposition of the insurance proceeds if the marriage fails or the children's difficulties worsen. Often such problems can 11 Likewise, when a person intends to fund an insurance trust with completely new insurance, not existing insurance, he should, to avoid the "three year rule," pay the funds to purchase the insurance to the trustee so that the trustee will be the owner of the insurance from the outset. 12 A beneficiary or beneficiaries should also be given the power for a limited period to withdraw the life insurance transferred to the trust, and any funds transferred to the trustee to purchase new insurance, to qualify these gifts for the annual exclusion. Such withdrawal powers should also be given in connection with gifts to other types of trusts discussed herein, such as "sprinkle" trusts for children or grandchildren, to qualify the gifts for the annual exclusion. Withdrawal powers are discussed here because (1) they are particularly needed in the case of an insurance trust since the original life insurance and all payments to be used to pay premiums need to be qualified for the annual exclusion, and (2) in the case of an insurance trust special arrangements sometimes need to be taken with respect to these powers. 13 In the case of group life insurance, the funds to pay premiums are generally paid directly to the insurance company by the insured's employer. Even when this is the case, however, there is authority that the premium payments can be qualified for the annual exclusion by keeping an amount comparable to each annual premium payment in the trust and giving a beneficiary or beneficiaries the power to withdraw that amount when a premium payment is made. 14 Some people consider insurance trusts revocable as a practical matter because the donor can, so they say, cancel his existing life insurance and obtain new insurance. However, the donor may have become uninsurable or the costs of new insurance may be too high for its purchase to make sense. For these reasons, it should not be assumed that insurance trusts can as a practical matter be revoked. 38

41 be dealt with by including flexible provisions in the trust. For example, if an insured is concerned that one of the children may waste assets he or she received outright, then the insured could provide that payments for the child could be applied for the support or care of that child rather than paid directly to the child. The insurance could also provide that the insurance proceeds could at the discretion of the trustee be held in trust as long as any of the children were living and used as the trustee decides for any of the children. However, before establishing an insurance trust, an insured should be convinced the trust provisions deal satisfactorily with problems that could arise concerning the beneficiaries. If it is intended that an insurance trust will to a large extent benefit the insured's grandchildren, it probably will be advisable to apply part of the donor's $1 million exemption from the GST tax to gifts to the trusts. Only a relatively small amount of that exemption should be needed to shield the gifts to the trust to pay premiums, yet when the insured dies, the substantial insurance proceeds will be exempted from GST taxes. Thus, where a person has a taxable estate and a large insurance policy, establishing an irrevocable trust and transferring the insurance to it is often advisable because this can produce substantial savings generally in the range of 40% to 55% of the life insurance proceeds without depriving the donor of an income-producing asset and without altering the way the insured wants the insurance proceeds used after his or her death. "Second to Die" Life Insurance It sometimes will not be possible for people with taxable estates to reduce their estates sufficiently through lifetime gifts to avoid substantial taxes. In other cases, people will be reluctant to make lifetime gifts that could bring their estates to the level that can be shielded from transfer tax by the "exemption equivalent," or even close to that level, because, understandably, they want to enjoy their property while they are alive and also want to protect against the possibility that they will need expensive medical care or other care as they grow older. For many such people, there is an alternative to lifetime gifts that allows them to retain most or all of their property until death without having it then be reduced significantly by estate taxes. That alternative is to purchase life insurance roughly equivalent to the estate taxes that will be due at death and have that insurance held in an irrevocable trust that will not be included in the insured's estate at death. Then the tax-free proceeds can be used to pay the estate taxes A cautionary note here is that the provisions of the insurance trust authorizing use of the insurance proceeds to pay estate taxes must be drafted carefully to keep the proceeds from being included in the estate. 39

42 Many readers will object that this scenario presumes that people can buy insurance inexpensively, while for many people, particularly older people, insurance cannot be obtained at all or only at high rates. Thus, the first reaction of these readers will be that the above scenario will work only for relatively young people who can buy insurance at low rates. However, there is another class of people who often can buy a type of insurance, one specifically designed to pay estate taxes, at quite low rates. This class consists of married couples, and the type of insurance involved is so-called "second to die" insurance, which is payable only upon the death of the survivor of a couple. For most couples, this is when all of the estate taxes on their property will be payable, because the estate of the first to die can be completely shielded from tax by the "exemption equivalent" and the marital deduction, which is unlimited in amount. Since "second to die" insurance is payable only when two lives have ended and not just one, it is much cheaper than single life insurance. Often it will be available at low rates even to married couples who are relatively old. Thus, by purchasing such insurance and having it held in an insurance trust, many married couples can cheaply provide funds to meet the estate tax burden on their property. Accordingly, through the use of such a "second to die" insurance trust, couples can pass on significantly more property to their children or other beneficiaries than would otherwise be the case. 16 Life Insurance Trusts and Charitable Gifts Many people would like to make gifts to charities at their deaths but are concerned that if they do so there may not be as much property as they would like to go to children or others who they consider their primary beneficiaries. This is certainly a legitimate concern, because many variables can affect the size of a person's estate at death, such as future medical needs. Because of disability or for other reasons, a person may not be able to revise his or her will to take into account these changes. However, by establishing a "charitable remainder unitrust," or "CRU," or a "pooled income fund" and at the same time establishing a separate life insurance trust (in which the charity has no interest), many people can have considerable assurance that charitable gifts to be made at their deaths will not significantly reduce, and may in fact enhance, their estates. CRUs and pooled income funds are considered at some length in AIER's 16 Once again, to maximize the savings, withdrawal powers should be made to qualify for the annual exclusion payments made to the trust to produce the insurance initially and then pay the premiums on it. Also remember that the trustee should be the applicant for purchase of the insurance and should pay the initial cost of purchasing it as well as all subsequent premiums to avoid the "three year rule" applicable to transfers of insurance. 40

43 The Estate Plan Book and will be summarized only briefly here. Both are types of so-called split interest gifts gifts made partially to or for an individual beneficiary or beneficiaries and partially to a charity in which the charitable gift qualifies for a charitable deduction for income tax purposes. 17 A CRU is a trust under which the donor or another individual beneficiary or beneficiaries receive each year for a specified period a fixed percentage (which must be at least 5%) of the assets added to the CRU, then at the expiration of the donor's retained period to receive unitrust payments the remainder of those assets is paid to charity. A pooled income fund is an investment fund operated by a charitable entity for its donors. Donors are assigned units of participation according to the value of their gifts and the value of each unit at the time of the gift. The income received by the fund (dividends, interest, etc.) is "pooled" and distributed to the income beneficiaries according to the number of units so assigned. Then when the interest of a particular individual beneficiary terminates, the remaining value of the particular donor's units go to charity. Under both a charitable remainder unitrust and a pooled income fund, the donor can be a beneficiary, if the gift is made during lifetime, and there can be concurrent, consecutive, and contingent individual beneficiaries. An individual beneficiary's interest can terminate at death, upon the expiration of a period of years, or upon the occurrence of a certain contingency, such as a remarriage. The only restriction on the naming of individuals as beneficiaries is that they be living at the time the gift is made. 18 CRUs and pooled income funds have several tax and non-tax advantages in addition to the charitable deduction against the income tax for the value of the remainder interest going to charity. As indicated above, the donor can retain the right to receive annual payments for his life or for another period and can also name other beneficiaries to receive payments either instead of himself or herself or after the period for which he or she retained the right to receive such payments expires. Moreover, if the donor 17 Only certain specific types of split interest gifts that meet strict requirements of the Internal Revenue Code will qualify for a charitable deduction as a partial gift to charity. 18 AIER enters into and administers CRUs. It has a standard form of CRU agreement that it provides donors who wish to establish a charitable remainder unitrust. Each CRU has a separate portfolio and is individually managed by AIER as trustee. AIER also has two pooled income funds open for new donations, which it calls "Reserved Life Income Funds," or "RLIs": the RLI Stock Fund II and the Current Income Fund. With respect to each RLI contribution, AIER provides the donor a standard instrument of transfer form. The income beneficiaries of RLI contributions are assigned a number of "units of participation" determined by dividing the fair market value of the gift giving rise to the income beneficiaries' interest by the fair market value of a unit in the RLI at the time of the donor's gift. The net income of the RLI is distributed quarterly among income beneficiaries according to their respective units of participation. 41

44 names someone other than himself or herself to receive the unitrust or income payments, the annual exclusion can be used to reduce the amount of the taxable gift. 19 Gifts to CRUs and pooled income funds also have valuable capital gains tax benefits. If appreciated property is added to a CRU or pooled income fund, no capital gains tax will be due on its sale by the charity, so the unitrust or income payments to be made to the individual beneficiary will be based on the full value of the property without reduction for capital gains tax. Likewise, to the extent that property held by the charity appreciates, there will be no capital gains tax, and no adverse effect on the unitrust or income payments, when it is sold. Because of these different advantages, a CRU or pooled income fund frequently is the best way for a person to make a gift to charity. Moreover, by combining a CRU or pooled income fund with a life insurance trust, a person can make gifts to charity that do not reduce his or her estate to any extent and sometimes will even enlarge it. Under such an arrangement, a donor sets up a CRU or contributes to a pooled income fund retaining an interest for the donor's lifetime. The donor also establishes an irrevocable trust and uses part of the unitrust or income payments from the CRU or pooled income fund to fund the trust so that the trustee can buy insurance and pay the premiums on it. In many cases, only a relatively small portion of the unitrust or income payments from the CRU or pooled income fund will be sufficient to buy insurance equal to the estimated value of the property that will pass to charity upon the donor's death less the value of the estate tax that would be due on that property if it were included in the donor's estate. In such a case, the only cost that the gift to charity would have to the donor or to the children or other individuals who are the principal objects of his or her bounty would be the portion of the unitrust or income payments used to buy the insurance and pay premiums on it. If more insurance is obtained, even this cost can be eliminated and the donor's estate can even be enhanced. In particular, if a married person sets up a CRU or contributes to a pooled income fund and provides that payments are to continue as long as either spouse is alive, the couple might well be able to obtain substantial "second to die" insurance using only a small portion of the unitrust or income payments from the CRU or pooled income fund. In sum, combining an insurance trust with a CRU or pooled income fund can remove much and sometimes all of the cost, and thus much of the concern about the possible adverse consequences to a person's primary beneficiaries, of a gift to charity. 19 If a donor names one or more beneficiaries to receive payments following his death, the gifts of these interests will not qualify for the annual exclusion. 42

45 Conclusion These, then, are the best lifetime gifts to save taxes, and they can produce substantial savings, as examples given in the booklet show. Accordingly, people with taxable estates should consult an experienced estate planning attorney to determine which of these gifts they should consider in their particular circumstances. 43

46 Publications and Sustaining Memberships You can receive our twice monthly Research Reports and monthly Economic Education Bulletin by entering a Sustaining Membership for only $16 quarterly or $59 annually. If you wish to receive only the Economic Education Bulletin, you may enter an Education Membership for $25 annually. INVESTMENT GUIDE At your request, AIER will forward your payment for a subscription to the INVESTMENT GUIDE published by American Investment Services, Inc. (AIS). The GUIDE is issued once a month at a price of $49 per year (add $8 for foreign airmail). It provides guidance to investors, both working and retired, of modest and large means, to help them preserve the real value of their wealth during these difficult financial times. AIS is wholly owned by ADER and is the only investment advisory endorsed by AIER.

47 AIER PUBLICATIONS CURRENTLY AVAILABLE Personal Finance Prices THE A-Z VOCABULARY FOR INVESTORS (ISBN X) $ 7.00 COIN BUYER'S GUIDE COPING WITH COLLEGE COSTS 6.00 THE ESTATE PLAN BOOK and THE TAXPAYER RELIEF ACT OF 1997 (ISBN ) HOMEOWNER OR TENANT? How To Make A Wise Choice (ISBN ) 6.00 HOW SAFE IS YOUR BANK? 8.00 HOW TO AVOID FINANCIAL FRAUD 3.00 HOW TO AVOID FINANCIAL TANGLES 8.00 HOW TO BUILD WEALTH WITH TAX-SHELTERED INVESTMENTS 6.00 HOW TO COVER THE GAPS IN MEDICARE Health Insurance and Long-Term Care Options for the Retired (ISBN ) 5.00 HOW TO INVEST WISELY with TOWARD AN OPTIMAL STOCK SELECTION STRATEGY (ISBN ) 9.00 HOW TO AVOID FINANCIAL FRAUD 3.00 HOW TO MAKE TAX-SAVING GIFTS (ISBN ) 3.00 HOW TO PRODUCE SAVINGS IN THE ADMINISTRATION OF AN ESTATE 3.00 HOW TO READ A FINANCIAL STATEMENT 9.00 HOW TO USE CREDIT WISELY 6.00 INFLATION OR DEFLATION: What Is Coming? 6.00 INTERNATIONAL INVESTING: Theory, Practice, and Results 5.00 LIFE INSURANCE FROM THE BUYER'S POINT OF VIEW 8.00 SENSIBLE BUDGETING WITH THE RUBBER BUDGET ACCOUNT BOOK 5.00 WHAT WILL THE NEXT RECESSION MEAN TO YOU? (ISBN ) 6.00 WHAT YOU NEED TO KNOW ABOUT MUTUAL FUNDS 6.00 WHAT YOUR CAR REALLY COSTS: How to Keep a Financially Safe Driving Record 6.00 Economic Fundamentals THE AIER CHART BOOK 3.00 BREAKING THE BANKS: Central Banking Problems and Free Banking Solutions CAUSE AND CONTROL OF THE BUSINESS CYCLE 6.00 THE COLLAPSE OF DEPOSIT INSURANCE 4.00 FORECASTING BUSINESS TRENDS 6.00 GOLD AND LIBERTY 8.00 KEYNES vs. HARWOOD A CONTRIBUTION TO CURRENT DEBATE 6.00 THE POCKET MONEY BOOK A Monetary Chronology of the United States 2.00 RECONSTRUCTION OF ECONOMICS 6.00 USEFUL ECONOMICS 6.00 General Interest AMERICA'S UNKNOWN ENEMY: BEYOND CONSPIRACY 9.00 CAN OUR REPUBLIC SURVIVE? Twentieth Century Common Sense and the American Crisis 6.00 Behavioral Research Council Division of AIER THE BEHAVIORAL SCIENCES: ESSAYS IN HONOR OF GEORGE A. LUNDBERG* 8.00 A CURRENT APPRAISAL OF THE BEHAVIORAL SCIENCES* USEFUL PROCEDURES OF INQUIRY Note: Educational discounts for classroom use are available for all of the above publications. * Hardbound.