6 Estate Planning Techniques and the Presentation Learning Objectives An understanding of the material in this chapter should enable the student to 6-1. Discuss the marital deduction and how it is used in estate planning. 6-2. Explain how overqualification or underqualification of the marital deduction may affect federal estate tax liability. 6-3. Discuss the requirements that must be met before property qualifies for the marital deduction. 6-4. Discuss the terminable interest rule and the exceptions to it. 6-5. Explain the marital trust and its uses in estate planning. 6-6. Describe the bypass (credit shelter) trust and how it is used in estate planning. 6-7. Explain the QTIP trust and its uses in estate planning. 6-8. Explain the A/B trust and A/B/Q trust strategies to coordinate the marital deduction and the applicable credit amount. 6-9. Discuss the legal documents used to protect a client s interest in the event of incapacity, old age, and disability. 6-1. Discuss techniques that can be used to reduce the taxable estate. 6-11. Discuss the key elements in the organization and presentation of recommendations to the client. 6.1
6.2 Foundations of Estate Planning Chapter Outline ESTATE PLANNING TECHNIQUES FOR THE MARITAL DEDUCTION 6.2 Improper Use of the Marital Deduction 6.2 Qualifying for the Marital Deduction 6.3 FOUR WAYS TO QUALIFY FOR THE MARITAL DEDUCTION 6.4 By Will, Contract, or Operation of Law 6.4 Power of Appointment Trust 6.5 Estate Trust 6.5 QTIP Trust 6.7 COORDINATING THE MARITAL DEDUCTION AND THE APPLICABLE CREDIT AMOUNT 6.9 A/B Trusts 6.1 Bypass Trust Case Narratives 6.12 A/B/Q Trusts 6.13 HEALTH CARE PLANNING 6.13 General Power of Attorney 6.13 Durable Power of Attorney 6.14 Advance Medical Directives 6.14 Long-Term Care 6.15 ESTATE REDUCTION TECHNIQUES 6.16 Create Tax-Exempt Wealth 6.17 Divide the Estate via Gifting 6.18 Discount the Estate Tax Obligation 6.19 Eliminate the Estate 6.19 Freeze the Estate 6.21 Which Technique to Use? 6.22 THE PRESENTATION 6.23 Organizing the Presentation 6.23 Delivering the Presentation 6.25 Presentation Skills 6.28 SAMPLE PRESENTATION 6.3 Sample Presentation Script John and Patsy Wilson 6.31 CHAPTER SIX REVIEW 6.42 ESTATE PLANNING TECHNIQUES FOR THE MARITAL DEDUCTION Improper Use of the Marital Deduction The problem of excessive estate costs and taxes is often related to the improper use of the marital deduction. Many people are so busy building an estate that they seldom take time to plan for its conservation and distribution.
Chapter 6 Estate Planning Techniques and the Presentation 6.3 While it may not be bad planning to have some property exposed to taxation at the first death, it should not happen unexpectedly. overqualification underqualification Frequently, the estate owner has only a simple will, leaving everything outright to his or her spouse either by survivorship or through the beneficiary designation of life insurance and other contracts. Estate planning may rely too heavily on the unlimited marital deduction, when in fact the marital deduction may not be available at all. A spouse may die before the spouse who owns the bulk of the estate. One way to risk losing part of the marital deduction is to die intestate. If there are children, intestacy laws generally provide that only one-half of the decedent s separate property goes to the surviving spouse and the other half to the surviving children. If the children s share exceeds the amount covered by the applicable exclusion amount, it is subject to taxation. When a person disqualifies property so that it does not pass to the surviving spouse, part of the marital deduction is lost. If this property does not exceed the applicable credit amount, it will not be taxed at the first death. While it may not be bad planning to have some property exposed to taxation at the first death, it should not happen unexpectedly. Including less property for the marital deduction raises the costs and taxes in the first estate, but lowers costs and taxes at the second death. This discussion centers on overqualifying and underqualifying the unlimited marital deduction. These concepts coordinate the marital deduction and the applicable credit amount to minimize estate taxes at the death of each spouse. Overqualification occurs when there is underutilization, or not using the estate owner s entire applicable credit amount at the death of the first spouse. The result is that more property goes to the surviving spouse through the marital deduction than is necessary to reduce the estate owner s federal estate tax to zero. Thus, at the surviving spouse s death, more property than necessary is exposed to tax. Proper planning is important to ensure efficient use of both spouses applicable credit amounts and prevent unnecessary stacking of taxable assets in the surviving spouse s estate. Underqualification of the marital deduction means that less property passed tax free to the surviving spouse in a qualifying manner than should have. For example, assume that this year a wife had a $3 million adjusted gross estate, but left only $1, to her spouse through the marital deduction in a qualifying manner. There is a $9, underqualification $2 million (26 28) goes to the credit shelter or bypass trust (discussed below) and no tax is payable; that leaves $1 million that could qualify for the unlimited marital deduction. In other words, the marital deduction is underutilized by $9,. Qualifying for the Marital Deduction As discussed in chapter 3 regarding gifting, an individual can transfer an unlimited amount of property to his or her spouse during lifetime or at death free of federal gift and estate tax. To review, there are a number of requirements and limitations that must be met for property to qualify for the marital deduction:
6.4 Foundations of Estate Planning The surviving spouse must be a U.S. citizen. The property must be included in the decedent s estate. The property must pass or have passed to the surviving spouse. The decedent must have been married at the date of death to the spouse receiving the property. The property must not be of a terminable interest. FOUR WAYS TO QUALIFY FOR THE MARITAL DEDUCTION There are four ways that property can qualify for the marital deduction, three of them being trusts. In general, the marital deduction can be obtained for property passing outright to a surviving spouse, or in a qualifying trust for the spouse. The following discussion covers these methods. By Will, Contract, or Operation of Law One method of qualifying for the marital deduction is the outright transfer of property to the surviving spouse by will, through a contract such as life insurance death proceeds, or through an operation of law such as joint tenancy with rights of survivorship. Often people falsely assume that special language is required to obtain the benefits of the marital deduction. The requirements, however, are quite simple. No Special Language Required Often people falsely assume that special language is required to obtain the benefits of the marital deduction. The requirements, however, are quite simple. If all the family s assets are in the decedent s name alone, and there is a simple will leaving everything to the spouse, the decedent s estate will be allowed the maximum marital deduction. Also, if everything is held in joint names with right of survivorship between spouses, those assets will qualify for the marital deduction to the extent they are includible in the decedent s gross estate. Whether property passes outright to the spouse by means of the decedent s will or by right of survivorship, the marital deduction is obtained at the decedent s death to the extent the property is includible in the decedent s gross estate and passes to the spouse in a manner that permits inclusion in the surviving spouse s gross estate at death. Advantages of a Marital Trust If it is not necessary to use a trust to pass property to a spouse, why use a trust at all? There are several advantages to using a marital trust: The surviving spouse may be unwilling or unable to invest and manage the responsibility of a large amount of money, an investment portfolio, or a family business.
Chapter 6 Estate Planning Techniques and the Presentation 6.5 A trust avoids probate and therefore provides privacy in the estate of both spouses. Should the surviving spouse become physically, mentally or emotionally incapacitated, the trustee can invest and manage the property. If a grantor spouse wants to qualify property for the marital deduction, but wishes the ultimate beneficiaries to be someone other than the spouse, a QTIP marital deduction trust can provide this solution. If a spouse does not want to overqualify the marital deduction and leave too much in assets to the surviving spouse, a bypass trust can be used in conjunction with the martial trust to minimize taxes in both estates. power-of-appointment trust general power of appointment estate trust Power of Appointment Trust A second method of leaving property to a spouse that qualifies for the marital deduction is to establish a power-of-appointment trust. Typically, the power-of-appointment trust gives the surviving spouse a lifetime interest in the trust income and property with the right to name a beneficiary during lifetime or in his or her will. It usually also provides that if the surviving spouse fails to name the beneficiaries of trust assets, the trust property will go to a beneficiary named by the grantor of the trust. The trustee, as well as the surviving spouse, is often given the right to use trust principal for emergencies or to make gifts to children and grandchildren. Essentially, the trust gives the surviving spouse the power to consume, use, give, or leave trust property to anyone. This trust is also known as a marital or A trust. The power-of-appointment trust is the most widely used method of qualifying property for the marital deduction. Essentially, the power-of-appointment trust is, as its name implies, a trust designed to hold assets for the surviving spouse and to qualify for the marital deduction by providing the surviving spouse with a general power of appointment over the principal (see figure 6-1). A general power of appointment is a power over the disposition of property that can name any person the holder of the power elects, including oneself, one s estate, one s creditors, or the creditors of one s estate. Because the surviving spouse has a general power of appointment over trust property, it is included in his or her gross estate for federal estate tax purposes. Estate Trust The third form of marital bequest under a will is known as an estate trust. An estate trust gives the surviving spouse an interest for life (life estate), with the remainder payable to his or her estate. This gives the surviving spouse the equivalent of a general power of appointment by will, since that spouse can transfer property subject to the power to anyone he or she chooses (see figure 6-2). For this reason, the trust is taxed in the survivor s estate. The estate
6.6 Foundations of Estate Planning FIGURE 6-1 Power-of-Appointment Trust Transferor-Spouse Property TRUST Surviving spouse has general power of appointment Income Corpus Surviving Spouse Beneficiaries (including surviving spouse, surviving spouse s creditors, surviving spouse s estate, and surviving spouse s estate creditors) FIGURE 6-2 Estate Trust Transferor-Spouse Property TRUST Income Remainder Surviving Spouse Surviving Spouse s Estate Estate Beneficiaries
Chapter 6 Estate Planning Techniques and the Presentation 6.7 trust does not violate the terminable-interest rule because the property is in the surviving spouse s estate, and no interest passes to anyone other than the surviving spouse or to the surviving spouse s estate. The objective of the estate trust is to achieve a balance between attaining the marital deduction and restricting the surviving spouse s ability to access trust property during his or her lifetime. This type of trust is not required to give the surviving spouse all the income during his or her lifetime, but pays all the accumulated income and the principal to the surviving spouse s estate when he or she dies. During lifetime, the surviving spouse can be given income or principal at the trustee s discretion, but the surviving spouse personally has no lifetime right to demand either income or principal. An estate trust is a useful alternative to the power-of-appointment trust for two reasons. First, the trustee of an estate trust can accumulate income within the trust instead of paying it out. If the trust is in a lower income tax bracket than that of the surviving spouse, the power to accumulate can result in income tax savings. Second, because the spouse does not have to receive all of the income annually, a trustee can either invest in non-incomeproducing property or retain nonproductive assets, such as non-dividendpaying stock in a family-owned corporation. These advantages must be weighed, however, against the certainty that any income accumulations (together with the original principal) will be includible in the surviving spouse s estate. QTIP Trust The fourth method of qualifying for the marital deduction is through the QTIP trust. The QTIP trust gives the spouse a lifetime interest in the income of the trust property but no general power of appointment either during lifetime or at death. At death, assets in the trust pass to the beneficiary or beneficiaries named by the original donor spouse. The Terminable Interest Rule The requirements for qualifying property for the marital deduction were discussed in chapter 3 regarding spousal gifts. The terminable interest rule is discussed here in more depth. Property transferred to a spouse will not qualify for the marital deduction unless certain conditions are met. Property transfers do not qualify for the marital deduction if an interest in that property will terminate upon the lapse of time or upon the occurrence or non-occurrence of some event. Examples of a terminable interest would be an estate for a term of years, such as to my wife for 1 years, or to my wife, until she remarries. Because in both
6.8 Foundations of Estate Planning cases the property interest would end (in the first after a lapse of time and in the second on the occurrence of an event), the property interest is terminable (capable of being terminated). It is not necessary that the event or contingency actually occur or fail to occur, but merely that the interest could terminate. The terminable interest will also occur if any interest in the property passes to another person as a remainder interest when the surviving spouse dies and that property is not included in the surviving spouse s estate. Exceptions to Terminable Interest That Qualify for the Marital Deduction The terminable interest transfer will qualify for the marital deduction under certain conditions. If the condition is that the spouse must survive for a period up to 6 months after the donor s death. If the property is placed in a marital trust the surviving spouse is entitled to all income the income is paid at least annually the survivor has power to appoint interest to himself or herself or to his or her estate the appointment power can be exercised during life or at death no other person has the power to appoint Finding the correct balance of property to pass to the surviving spouse is one of the functions of estate planning. The intent of these requirements is to ensure that property qualifying for the marital deduction but not consumed during the surviving spouse s life will be taxed in the surviving spouse s estate. If the conditions to qualify for the marital deduction are not met, more property will remain in the estate of the first spouse to die, possibly creating an unexpected tax liability. If less property is passed than is allowed, the full value of the marital deduction for the first spouse is lost or wasted. If too much property is passed to the surviving spouse, more than is necessary will be taxed at the second death. Finding the correct balance is one of the functions of estate planning. Qualified Terminable-Interest Property (QTIP). The exceptions to the terminable interest rule allow terminable interest property to qualify for the marital deduction. A person can provide that his or her spouse will receive only the income from property and, at the death of the surviving spouse, that property must pass to the person or persons specified in the will of the original donor spouse. This terminable interest qualifies for the marital deduction hence the name qualifying terminable-interest property (QTIP) if certain requirements are met. This provision permits a spouse to provide for the
Chapter 6 Estate Planning Techniques and the Presentation 6.9 surviving spouse through a transfer sheltered by the marital deduction and still retain control over the ultimate disposition of the assets. The QTIP allows a donor spouse to protect the interests of other heirs (perhaps children from a prior marriage) while also providing for the surviving spouse. Thus, with a QTIP trust, the first spouse to die can control where the property goes at the surviving spouse s death. The first donor spouse s executor must make an irrevocable election on the decedent s federal estate tax return. The election provides that, to the extent the QTIP property has not been consumed or given away during the surviving spouse s lifetime, its value at the surviving spouse s death will be included in his or her estate. In the case of a lifetime gift of QTIP property, the donor spouse must file an election on the gift tax return that the QTIP property will be in the estate of the donee spouse unless disposed of during the donee spouse s lifetime. The QTIP trust is particularly useful in second marriages, where there are children from a first marriage that the spouse wishes to provide for, or in any marriage where the property owner may be concerned that at his or her death, the surviving spouse may remarry or leave the property owner s assets to someone whom the owner would not have chosen. A QTIP may be a good choice for anyone worried that his or her assets may end up in the hands of a surviving spouse s future spouse, children of a future marriage, the spouse s favorite charity, or squandered or totally consumed by the surviving spouse. COORDINATING THE MARITAL DEDUCTION AND THE APPLICABLE CREDIT AMOUNT A or marital trust B or family trust The typical estate plan for many married couples is to make maximum use of the unlimited marital deduction and give everything in their estate to their spouse. Because no estate tax is payable under these circumstances, the applicable credit amount that is available at the first spouse s death is wasted. With proper planning, each spouse can make optimum use of both the applicable credit and the marital deduction and accomplish their estate goals without wasting either spouse s applicable credit amount. This maximum estate tax shelter is accomplished by designing each spouse s estate to transfer property to separate trusts, an A or marital trust, and a B or family trust. These trusts used in combination can accomplish the client s goals and wishes, include minimizing estate transfer and administrative expenses, maximizing income to a surviving spouse, passing assets to children (from both current and previous marriages), and fulfilling charitable wishes. Both A/B trust and A/B/Q trust estate plans have estate tax savings as one of their primary objectives. The focus in both instances is preservation of the credit shelter equivalent available to the first spouse to die, as well as using the
6.1 Foundations of Estate Planning marital deduction to defer taxation. This is accomplished by placing assets outside the full control of the surviving spouse. The following planning strategies, A/B trusts and A/B/Q trusts, are commonly used to accomplish the above goals. A/B trust credit shelter or bypass trust Perhaps the most common application of trusts in estate planning is the use of the credit shelter or bypass trust to maximize the value of the applicable credit amount. A/B Trusts The marital/nonmarital A/B trust, also called the marital/bypass or credit shelter trust, is an arrangement designed to give the surviving spouse full use of the family s economic wealth, while at the same time minimizing to the extent possible the total federal estate tax payable at the deaths of both spouses. Generally, the estate owner will set up two trusts: a marital or spouse s trust (often referred to as the A trust) and a nonmarital or family trust (called the B trust). The marital or A trust is designed to hold assets that qualify for the marital deduction. There will be no estate tax due on this portion at the first death. The nonmarital or B trust is not designed to qualify for the marital deduction. Instead, the B trust is intended to provide management for assets that are taxable at the first spouse s death and are valued at approximately the applicable exclusion amount. These assets are exposed to estate tax, but the tax obligation is covered by the applicable credit amount and thus no taxes are due. The surviving spouse has no control over the eventual disposition of family trust property. Assets in the B trust are not part of the survivor s estate and are thus not subject to taxation at the second death. The B trust provides the spouse with additional income and even limited amounts of principal without causing an inclusion of principal in the survivor s gross estate. This trust provides security for the spouse but bypasses taxation in the surviving spouse s estate when that spouse dies. The B trust is often called a credit shelter or bypass trust because it should be funded with assets equivalent to the decedent s applicable exclusion amount (credit equivalent bypass trust). These assets are taxed at the first spouse s death, but are equivalent to the applicable credit amount, so there is no actual expense to the estate. Thus the A/B trust arrangement does not alter the usual first death results, but the second death taxes are reduced because the applicable credit amount is used at the time of the first death. Example of Credit Shelter or Bypass Trust Perhaps the most common application of trusts in estate planning is the use of the credit shelter or bypass trust to maximize the value of the applicable credit amount. The best way to see how this works is to consider the distribution of an estate two ways: one with a credit shelter trust and one without. Figure 6-3 shows what occurs with no credit shelter or bypass trust.
Chapter 6 Estate Planning Techniques and the Presentation 6.11 FIGURE 6-3 Sample Will: 22/211 Rates No Credit Shelter Year First spouse dies with an adjusted gross estate of 22 $3,8, and transfers the entire estate to the second spouse under the unlimited marital deduction $3,8, which, ignoring inflation and growth, will be valued at the second spouse s death at 211 $3,8, which is subject to administrative costs and taxes estimated to be $1,47,35 leaving $2,329,65 for the heirs Figure 6-4 shows what occurs using a bypass trust. FIGURE 6-4 Bypass Trust Arrangement: 22/211 Rates First spouse dies with an adjusted gross estate of $3,8, and transfers as a gift an amount and transfers the balance of the equal to the credit amount to a estate to the second spouse under bypass (credit shelter) trust the unlimited marital deduction $1,, $2,8, which, ignoring inflation and growth, will be valued at the second spouse s death at $1,, $2,8, which is subject to administrative costs and taxes estimated to be $94,53 leaving $1,859,47 which, when combined with the value of the bypass trust, transfers to a total of $2,859,47 to the heirs, an increase of $529,82 over the simple will arrangement
6.12 Foundations of Estate Planning Bypass Trust Case Narratives Joe and Joan Joe has an adjusted gross estate of $3.8 million. Without the use of a credit shelter trust, Joe s entire estate passes to his wife Joan under his will. Because of the unlimited marital deduction, there is no federal estate tax due. However, Joan s estate is now valued at $3.8 million and, at her death, the full amount will be subject to estate tax. The estate has not benefited from Joe s applicable credit amount to reduce the ultimate estate tax. By placing assets equal in value to the applicable credit amount in a trust for their children at Joe s death, the property does not pass to Joan and, therefore, is not taxable in her estate when she dies. The ultimate taxable estate at Joan s death has been reduced by the amount of the applicable credit amount, saving a significant amount of estate tax. Of course, a trust does not have to be used to accomplish this. Joe s could have transferred property equal to the applicable credit directly to his children through his will. The advantage of using the trust is that the income from the assets can be arranged to be paid to Joan during her life. To employ this technique, estates need to be divided between both spouses, at least to the extent of the applicable credit amount for each. If one member of the couple owns all or a majority of the assets and the other partner dies first, the credit would be lost. One way to ensure that the assets of the estate are distributed in a way that maximizes the applicable credit amount is to divide them in advance using trusts. Using the unlimited marital deduction for lifetime spousal gifts, the estates of a husband and wife can be equalized. Mr. and Mrs. Duran Using the unlimited marital deduction for lifetime spousal gifts, the estates of a husband and wife can be equalized. For example, Mr. and Mrs. Duran have an estate valued at $4 million. Mr. Duran s estate, including his share of their jointly owned property, is $85,. The jointly held property with survivorship rights makes up $52, of his estate. Mrs. Duran s estate is $3.15 million. If Mr. Duran dies first, the $52, value that is jointly held transfers by operation of law to Mrs. Duran. Only $33, remains for disposition, far short of the $1 million that could be transferred under the applicable credit. To correct this situation, Mrs. Duran could transfer some of her property to her husband. By equalizing their estates, they can maximize the use of applicable credit regardless of which partner dies first. The same problem exists when most of the property held by a couple is owned jointly with rights of survivorship. Under these conditions, the property passes directly to the surviving spouse. To make full use of the applicable credit, ownership of the property needs to be rearranged while both spouses are still living.
Chapter 6 Estate Planning Techniques and the Presentation 6.13 A/B/Q trust A/B/Q Trusts The A/B/Q trust plan is used when it is desirable to use a QTIP trust for some or all of the estate to ensure that at least some of the marital deduction property passes to the grantor spouse s chosen beneficiaries at the death of the surviving spouse. The A or marital trust would be controllable by the surviving spouse as to its disposition. The QTIP trust assets are marital deduction assets that are designated for the next generation under a QTIP trust, allowing the grantor to control the eventual disposition of the property. We could have the following three trusts in this arrangement: 1. A Trust A marital trust permits the spouse to control income and principal and invade principal during lifetime. The surviving spouse has the power to appoint the property to anyone he or she wishes. This property qualifies for the marital deduction and is includible in the surviving spouse s estate. A = Appointment Trust 2. B Trust A family trust that receives property equal in value to the applicable credit amount; it is a credit shelter or bypass trust. This trust can provide income to the surviving spouse, but will not be includible in his or her estate. B= Bypass Trust 3. Q Trust A QTIP trust will yield income and possibly limited amounts of principal to the spouse. This property will qualify for the marital deduction and is includible in the surviving spouse s estate. The first spouse to die can control where the property goes at the death of the surviving spouse. Q = QTIP Trust The client s needs and objectives dictate the best estate plan. The order of these is not important, but there can be flexibility in design. As in all other planning, the client s needs and objectives dictate the best plan. As in all estate planning matters, the creation of wills and trusts requires the expertise of a qualified attorney. Your role is to uncover needs and to help prospects understand the various ways they can accomplish their goals. The difficult part is in getting them to explore the sensitive issues involved and helping them reach a consensus on a plan that satisfies their mutual interests. HEALTH CARE PLANNING power of attorney General Power of Attorney A power of attorney is a written legal document by which an individual (principal) authorizes another person (agent) to act on the principal s behalf. The document spells out the scope of the power, which may be extremely narrow or very broad. The agent has a fiduciary responsibility to use the power in the grantor s best interest. For example, it may apply to only one transaction, such as a house closing when the principal cannot be present. On the other hand, it may authorize a daughter to help a senior manage his or her day-to-day affairs.
6.14 Foundations of Estate Planning There are two types of powers of attorney a general power and a durable power. A general power is effective as long as the person granting the power remains in good health. Failing health is often a reason for using powers of attorney, but a general power becomes legally ineffective in the case of mental incompetence or medical incapacity. Durable powers of attorney solve this problem by allowing designated family members or advisors to step in and manage financial affairs. durable power of attorney Preparing an advance directive relieves family and friends of the responsibility of making decisions regarding lifeprolonging actions. Durable Power of Attorney A durable power of attorney is designed to continue should the grantor become incapacitated so that the attorney-in-fact can make appropriate decisions about the grantor s health care, custody, and financial concerns. Without an executed durable power of attorney, the family or friends of an incapacitated person must petition the court to be made that person s guardian. The process of determining that a person is incapacitated can be difficult and time consuming and often comes at a time when family members need to make difficult decisions quickly. Prior planning in the form of a durable power of attorney can avoid the difficulties, allowing the person named as attorney-infact to step in and assume the responsibility when it is most needed. A revocable trust can also protect the estate in the event of severe physical incapacity or mental incompetence, A durable power of attorney would empower the trustee to deal with non-trust assets and complement the revocable living trust. Planning the durable power of attorney also provides another advantage for all parties involved. It provides the opportunity the forum for family members to discuss their wishes for their own care should they be unable to make decisions for themselves. Advance Medical Directives Individuals by law have a right to make their own medical choices based on their own values, beliefs, and wishes. However, what happens if a person has an accident or suffers a stroke and can no longer make decisions? Would the person want to have his or her life prolonged by any means necessary, or would he or she want to have some treatments withheld to allow a natural death? Usually, directives will go into effect only in the event that the person cannot make and communicate his or her own health care decisions. Preparing an advance directive lets the physician and other health care providers know the kind of medical care the individual wants (or does not want) if he or she becomes incapacitated. It also relieves family and friends of the responsibility of making decisions regarding life-prolonging actions. There are two kinds of advance directives.
Chapter 6 Estate Planning Techniques and the Presentation 6.15 living will health care proxy Living Will A living will is a legal document that addresses a person s desires for medical treatment if he or she is unable to provide instructions. It typically describes the types of medical treatment an individual wishes to receive and chooses not to receive. The purpose of a living will is to let others know of a person s medical wishes should he or she become terminally ill or go into a vegetative state and be unable to communicate. A living will authorizes a doctor to withhold or withdraw life support under certain conditions. Because it is a legal document, it must meet the requirements of the jurisdiction in which it is applicable. A living will is important because it permits a person to make his or her wishes known. Encourage your prospects and clients to consider the importance of making these decisions for themselves in advance to spare their children and other family members the agony of having to make such critical decisions for them. By the same token, you should encourage your prospects to talk to their parents about the parents wishes. Health Care Proxy or Health Care Power of Attorney Although a living will makes a person s medical treatment wishes known, it does not guarantee that these wishes will be followed. Someone still has to make the necessary decisions about whether or not to continue treatment a difficult, emotional decision. Sometimes close relatives are reluctant to let their loved one die. A health care proxy is a signed and witnessed legal document that names the person the individual wishes to make medical decisions about his or her care. As with a living will, the health care proxy goes into effect when the person is no longer able to make health care decisions. Sometimes the proxy is incorporated in a durable power of attorney. Depending on state law, which varies widely in directives officially recognized, it may have to be drafted as a separate document. It is also a component of a well-drafted living trust. Long-Term Care Disposition of property during life and at death is a key issue in estate planning. Estate concerns are inextricably intertwined with long-term care (LTC) because both are concerned with the preservation of assets. Everything a person owns may be depleted by the enormous potential costs of LTC. The ultimate goal of estate planning is to fulfill the wishes of the individual at death regarding the disposition of his or her property. LTC planning can protect assets that may otherwise be used to pay for LTC. You should discuss LTC planning with all of your prospects. If prospects have elderly parents, this offers the possibility of additional cases and sales.
6.16 Foundations of Estate Planning You also need to help clients plan for the eventuality that their parents may outlive them. Will their parents need financial support in the future? If Spouse A dies, will Spouse B provide the financial support needed for Spouse A s parents? Do Spouse A and Spouse B need to structure their estates in a way that ensures their parents needs will be met? Anticipating parents needs is similar in some respects to planning for dependent children. These can be difficult decisions, but should not be left to chance. Parents with limited assets, for example, may qualify for services under Medicaid provisions, which can provide nursing home care. Leaving assets to parents to cover their care can disqualify them for government support. Provisions can be made using informal, restricted, or discretionary trusts, all of which can be funded from existing assets or with additional life insurance. ESTATE REDUCTION TECHNIQUES As mentioned repeatedly throughout this text, the major goal of estate planning is to ensure that a property s owner s property is distributed according to its owner s wishes. This typically means that the assets that have been accumulated will be distributed to the desired beneficiaries without significant reduction for expenses and taxes. Traditionally this has meant that a major part of estate planning was dedicated to arranging the estate s assets in ways that would avoid or reduce federal estate taxation. As discussed previously, EGTRRA 21 has changed the landscape of estate planning by offering increasingly higher exemption amounts and the possibility that federal estate taxes will be repealed. EGTRRA has reduced the already small number of Americans who are subject to paying a federal estate tax. In 26, this number is estimated to be less than 1 percent of all estates. Because of the sun-setting provision of EGTRRA, estate tax planners and estate owners are left in something of a quandary as to how to plan. The fact remains, however, that an estate can suffer significant reduction even without federal estate taxes. As we have seen, probate and administrative fees can significantly reduce an estate, and state death taxes can also take a toll on the amount of an estate that actually reaches its intended beneficiaries. These facts, combined with the possibility of federal estate taxation in the future, or of a carryover basis and capital gains taxation of estate assets, support a conservative approach to planning. There are five common techniques that have been used (alone or in combination) to reduce estate taxation, and we will look at each of these to determine their effectiveness in reducing estate expenses and taxation in today s planning environment. The techniques are to create tax-exempt wealth divide the estate
Chapter 6 Estate Planning Techniques and the Presentation 6.17 discount the estate tax obligation eliminate the estate freeze the estate All of these techniques involve working with tax concepts and laws that are currently in place and which may or may not remain viable after 21. Each should be evaluated based on its effect under both tax scenarios. In other words, will it meet the estate owner s basic goals if there is no estate tax as it does when there is estate tax exposure? Because these techniques are based on complex tax concepts and laws, they should be accomplished only with the guidance and assistance of a qualified attorney. Your role is to introduce the concepts to your prospects where appropriate, showing them the advantages and disadvantages of the different strategies and giving them a general understanding of the tax implications and other estate shrinkage issues. It is important for you to develop good working relationships with attorneys who are familiar with estate planning because you cannot give legal advice it is both illegal and unethical. Second, by developing relationships with estate planning attorneys, you open the opportunity to become the insurance and financial expert whom they turn to for help. Cultivate these relationships, learning with which attorneys you have the best rapport and with whom you share planning philosophies. With these thoughts in mind, let s examine the five methods briefly in summary fashion. A more in-depth look at these techniques is covered in other chapters. The words create wealth should immediately trigger the idea of life insurance. Create Tax-Exempt Wealth The words create wealth should immediately trigger the idea of life insurance. Life insurance is the one product that creates a financial resource as the result of death. This concept of tax-exempt wealth needs clarifying because the value of life insurance proceeds may be included in the decedent s estate, but life insurance can be arranged so that its proceeds will pass to heirs without estate inclusion. This combination of benefits for the estate planning client and heirs can be a powerful motivation. Life insurance owned by the deceased is included in his or her estate. If the policy insured the estate owner s life and if the insured held any incidents of ownership in the policy, the amount of the proceeds is included in his or her estate, even if they are paid to a named beneficiary. (Incidents of ownership are discussed in the next chapter.) If, however, the insured does not hold incidents of ownership, the proceeds are not included in the estate. For example, if Martha s son owns and pays the premium on a policy insuring Martha s life and names himself beneficiary, neither the value of that policy nor the proceeds it pays at her death will be part of her estate. The proceeds will be paid directly to the named beneficiary and will not be taxed in the estate.
6.18 Foundations of Estate Planning The same situation can be created using an irrevocable life insurance trust (ILIT), also called a life insurance trust. The trust applies for, owns, and is the beneficiary of a policy (or policies) on the estate owner s life. The estate owner has no incidents of ownership and, because the trust is irrevocable, no control over the trust. The proceeds of the policy are received by the trust at the estate owner s death and are distributed, free of income or estate taxation, to the beneficiaries of the trust. Because the policy was owned by the trust, not the insured estate owner, its proceeds or value are not included in the estate. Remember that to qualify as a tax-exempt gift, a gift must be of present interest. If the life insurance trust is used, special steps must be taken to make sure gifts to the trust (premium payments) qualify as present interest gifts. This can be accomplished through what are called the Crummey provisions. These concepts will be discussed in the next chapter. For a credit shelter trust to be used effectively, it is important to make sure that each spouse owns enough property to transfer an amount equal to the applicable exclusion amount. Divide the Estate via Gifting There are two common ways of dividing an estate to reduce estate taxes. One method uses lifetime gifts to divide the estate between its original owners and future heirs. The other method creates a testamentary credit shelter trust. Lifetime gifts reduce the size of the estate. By using lifetime (inter vivos) gifts, an estate owner can distribute the estate property prior to his or her death, dividing the estate in advance. These transfers, however, may be subject to taxation. Consequently, the decision to make lifetime gifts must be viewed in light of the prospect s goals as well as for its tax implications. When all factors are measured, even taxable gifts may serve the prospect s planning objectives. Remember that the gift tax law still allows an unlimited amount to be transferred tax free between spouses during life or at death. Taxable gifts would be eligible for the annual gift tax exclusion, set at $12, in 26 and indexed for inflation, rounded down to the next lowest multiple of $1,. The second approach for reducing the size of an estate involves the creation of a credit shelter or bypass trust at the death of an estate holder, as discussed earlier in this chapter. For a credit shelter trust to be used effectively, it is important to make sure that each spouse owns enough property to transfer an amount equal to the applicable exclusion amount. If one spouse owns most of the estate assets, the other may not own enough to benefit fully from the exclusion. If, for example, everything is titled in the husband s name or is jointly titled with survivorship rights and the wife dies, there is no way for her estate to benefit from the full value of the applicable exclusion; the benefit is lost. Couples in this situation may want to retitle their property, dividing it equally between the two using the gift unlimited marital deduction, which maximizes the applicable exclusion.
Chapter 6 Estate Planning Techniques and the Presentation 6.19 Where do discounted dollars come from? They come from life insurance. Discount the Estate Tax Obligation Even with careful planning, some estates, especially large ones, will be faced with significant reductions for administrative expenses and might be liable for estate taxes as well. A sound plan will identify the potential estate tax and settlement obligations and meet the expenses with discounted dollars. If the discounted dollars are not needed for estate taxes and expenses, they, like the other estate assets, will pass to the estate s beneficiaries. Where do discounted dollars come from? They come from life insurance. The premiums paid for life insurance are only a fraction of the death proceeds that are paid. The premium cost of a dollar used to settle estate taxes and administrative costs is less than a dollar. Eliminate the Estate Charitable giving can reduce the size of an estate or eliminate it completely. Lifetime charitable gifts can be made in a way that allows the donor to continue to benefit from the use of the asset for the remainder of his or her life while removing its value from the estate. For example, a gift can be made to a charity that uses it to purchase an annuity with itself as the owner and ultimate beneficiary. The annuity can provide ongoing lifetime income for the donor without being included in his or her estate. Charitable Giving In addition to safeguarding family security, many people want to leave something behind to benefit others. Many have been deeply involved as volunteers to bring about social change. Others want to provide help to a social agency, educational institution, religious organization, or other charitable cause. Donations to Charitable Organizations. Those organized and approved under Sec. 51(c)(3) of the Internal Revenue Code churches, schools, hospitals and medical research organizations, certain private foundations, and federal, state, and local governments receive favorable federal income and estate tax treatment. This is true of gifts made during the donor s lifetime or at death. Unlike other gift transfers, there is no limit to the amount that can be given or left to a charity. The full amount of the gift, regardless of its size, passes free of gift tax or directly reduces the size of the donor s taxable estate. In addition, gifts made during life also provide income tax deductions for the donor, although these gifts have limitations relating to income tax deductions. All of these factors, combined with the donor s desire to share the success of his or her life with others, makes charitable giving attractive for many.
6.2 Foundations of Estate Planning Partial Transfers and Future Interest To qualify for the tax advantages, the charitable contribution does not have to be complete or of present interest. It is possible to create the gift and still maintain an interest in the property. This can be done using powers of appointment partial interest charitable remainder trusts guaranteed annuity interest split gifts Powers of Appointment. A charitable deduction is allowed for property that is included in the donor s estate because he or she holds a general power of appointment. Remember that property over which a person holds a general power of appointment is included in that person s gross estate. If the property passes to a qualified charity as the result of the exercise of the power (or its lapse or release), it is considered to be a deductible gift. Partial Interest. A charitable deduction is allowed for at least four types of charitable contributions of less than the entire interest in the property being donated. These four are a testamentary gift of the decedent s entire undivided portion of his or her interest in the property (mentioned above) a remainder interest in a personal residence a remainder interest in a farm transferred by the decedent at death a remainder interest to a charitable remainder trust or pooled income fund charitable remainder trust Charitable Remainder Trusts. Charitable remainder trusts allow the donor to receive the tax benefits of making a gift to a qualified charitable organization while providing income to a noncharitable beneficiary. The noncharitable beneficiary receives income from the trust until the donor s death, at which time the property held in trust goes to the qualified charity. To receive the tax benefits, the trust must be one of the following: annuity trust charitable remainder unitrust pooled-income fund Annuity Trust. A charitable remainder annuity trust provides to a noncharitable income beneficiary a fixed annuity that is worth not less than 5 percent of the initial net fair market value of the property paid in trust. This amount must
Chapter 6 Estate Planning Techniques and the Presentation 6.21 be paid at least annually to one or more noncharitable beneficiaries who are alive when the trust is created. Upon the death of the last income beneficiary or at the end of a term of years not greater than 2, the remainder interest must be held for or paid to a qualified charitable organization. Charitable Remainder Unitrust. A charitable remainder unitrust differs from an annuity trust in that a fixed percentage (not less than 5 percent of the net fair market value of the trust assets as annually revalued) is paid at least annually to one or more noncharitable income beneficiaries. Again, as with the annuity trust, the remainder interest will be paid to or held for the benefit of a qualified charitable organization, either at the death of the last income beneficiary or after a term of years not greater than 2 years. Pooled-Income Fund. A pooled-income fund is an investment fund maintained by a qualified charity to collect donations from different sources. A donation to the fund purchases units that are similar to mutual fund shares, and the income attributed to those shares is payable to the noncharitable beneficiary. The remainder interest must be irrevocably earmarked for the charitable organization. charitable lead trust You can transfer an entire estate through a charitable remainder trust and avoid estate taxation on both the charitable gift and the transfer to the noncharitable beneficiary. Guaranteed Annuity Interest (Lead Trust). Commonly known as a charitable lead trust, a guaranteed annuity interest is the reverse of a charitable remainder trust. The income interest is transferred to the qualified charity, with the remainder going to the noncharitable beneficiary. In order to qualify for the charitable deduction, the income interest must be in the form of an annuity interest or unitrust. Further, the guaranteed annuity must be provided by an insurance company or similar entity engaged in the business of issuing annuity contracts. Split Gifts. It is possible to transfer an entire estate through a charitable remainder trust and avoid estate taxation on both the charitable gift and the transfer to the noncharitable beneficiary. However, the only noncharitable beneficiary of the income must be the donor s surviving spouse. In this case, the estate receives a charitable deduction for the remainder interest of the trust and uses the marital deduction for the interest transferred to the surviving spouse. Freeze the Estate Freezing the estate refers to any planning technique where the owner of property tries to freeze the present value of his estate by removing appreciating assets and shifting the future growth to successors, generally the next generation. One way to do this is by making allowable gifts of the assets thought to be most likely to appreciate.