Memorandum TO FROM FILE Naim D. Bulbulia, Esq. DATE May 5, 2005 RE Estate Planning Primer The following memorandum has been prepared in order to provide you with an overview of estate and gift tax law and to demonstrate to you some of the techniques that can be used to reduce or avoid estate and gift tax: I. Federal Estate and Gift Tax Law. Taxable transfers at death and during life are currently subject to federal estate and gift tax at a top marginal rate of 47% on taxable transfers in excess of $2 million. Each individual has a tax-exempt amount, an applicable exclusion amount, that can pass free from federal estate and gift tax. Due to recent changes in the federal estate and gift tax laws, this amount is presently $1 million for gift tax purposes, and $1.5 million for estate tax purposes. For federal estate tax purposes (but not for federal gift tax purposes), it is rising, in phases, to $3.5 million by 2009 (it is $2 million for the years 2006-2008). The applicable exclusion amount is allocable to both lifetime gifts and testamentary transfers. To the extent that it has not been used to shelter lifetime gifts from gift tax, it is available to shelter testamentary transfers from estate tax. In addition, there is no estate or gift tax due on property passing between spouses. Nevertheless, even when a Will leaves most property to a surviving spouse, it is still important to carve out the applicable exclusion amount and hold it in trust (a credit shelter trust ). By creating a credit shelter trust for the benefit of the surviving spouse, and perhaps also for the benefit of descendants, the spouse still has access to the property, but upon the spouse s death, the property will not be included in his or her estate, and it will pass tax-free to the couple s descendants or to the other beneficiaries of the trust. Of course, this same result can be achieved by leaving the applicable exclusion amount directly to descendants or other beneficiaries (who are not the spouse). [It should be noted that due to the decoupling of federal and state estate taxes the funding of the credit shelter trust has become more complicated. It is generally advisable to mandate the funding of the credit shelter trust with the amount that generates no state or federal estate tax and give the surviving spouse the option to disclaim a larger amount into such trust. This permits the calculation of whether to pay any state tax upon the first death to
be deferred until said death, thereby preserving the maximum flexibility in the estate plan]. Simple Plan - Outright to Survivor: Plan with Credit Shelter Trust: Husband s Assets Wife s Assets Husband s Assets Wife s Assets Taxes $0 To Wife At Husband s Death Taxes $0 Credit Shelter Trust Taxes $705,000 To Children $2,295,000 At Wife s Death Taxes $0 To Children $3,000,000 Forming a credit shelter trust permits the surviving spouse to allocate his or her own applicable exclusion amount to other property. If no trust were set up and all property passed to the surviving spouse, then only the surviving spouse s applicable exclusion amount could ultimately pass tax-free to descendants (or other beneficiaries), and the first spouse s applicable exclusion amount would be wasted. In order to maximize the tax savings to be achieved when the first spouse dies, each spouse should have sufficient assets in his or her own individual name to fund a credit shelter trust. Jointly owned property, for example, will not pass by Will, but will pass by operation of law directly to the surviving spouse when the first spouse dies. Therefore, adjustments with respect to how property is held may be appropriate. Further, by reason of the gift tax annual exclusion, each person is permitted to make annual gifts of $11,000 ($22,000 if the gift is split with a spouse) per donee, without such gifts being subject to gift tax. Also, tuition payments made directly to an educational institution and medical expenses paid directly to the health care provider can be paid in an unlimited amount for the benefit of donees (e.g. children and grandchildren) free from gift tax. The $11,000 annual exclusion gifts and the tuition and medical expenditures are in addition to, and not in reduction of, the applicable exclusion amount. Lastly, there is a generation-skipping transfer tax ( GST tax ) that is imposed on transfers of property to persons more than one generation below the transferor s generation (such as grandchildren). The tax is in addition to the estate tax and the gift tax and currently is imposed at a flat rate of 47%. -2-
Each person is entitled to an exemption from GST tax. This amount (the GST exemption ) is rising from $1.5 million to $3.5 million by 2009 (on the same schedule as the exemption from federal estate tax). Because of this exemption, certain types of generation-skipping trusts can be created which will permit assets to be available to children and other descendants without being included in the child s estate for estate tax purposes. This substantially reduces transfer taxes over time. The alternative generally would be to transfer assets directly to children, who would then eventually pass the assets to grandchildren. In the process, the property would be subject to estate tax twice: once when it passes to children, and again when it passes to grandchildren. * * * In addition to structuring Wills in a tax-efficient manner, there are a variety of techniques that can often be employed during an individual s lifetime that can provide valuable gift and estate tax savings. Inasmuch as each family has different needs and goals, many of the following strategies are valuable for certain individuals and not applicable to others. II. Insurance Trusts. If a client owns any life insurance policies on his or her own life, or if a client decides to acquire any such policies in the future, we recommend that the policies be held by someone other than the insured (or the insured s spouse) in order to insulate the insurance proceeds from estate tax upon his or her death. By transferring the ownership of the policy or policies to an insurance trust, clients effectively remove the value of the life insurance proceeds from his or her estate and enable a spouse and descendants to share in the full value of the property upon the insured s death. These trusts can be structured such that the value of the insurance proceeds can bypass the surviving spouse s estate as well, thereby effectively transferring insurance proceeds to the children s generation free from estate and gift tax. This is a simple change in the form of ownership that can result in large estate tax savings in the future. III. Qualified Personal Residence Trusts ( QPRTs ). A qualified personal residence trust is a special type of irrevocable trust sanctioned by specific IRS regulations that allows a grantor to gift a residence (whether a principal residence or a summer or other vacation residence) while retaining the right to live in the residence for a term of years. By making a gift now of the right to own the residence in the future (after the grantor s right to live in the residence expires), the grantor can remove the value of the residence (and all future appreciation on the residence) from his or her estate at a reduced gift tax cost. Utilizing a QPRT to gift a residence to children can be a valuable tool for passing a residence to the next generation in a tax-efficient manner. Furthermore, if the grantor -3-
wishes to continue to use the residence after the term expires, the grantor can do so by paying fair market rent to the children. -4-
IV. Tax-Free Lifetime Gifts. (a) Annual Exclusion Gifts and Other Tax-Free Expenditures. As discussed above, each individual may gift up to $11,000 per calendar year ($22,000 if the gift is split between spouses ) to an unlimited number of recipients, free of gift tax. This amount is known as the gift tax annual exclusion. Such gifts are in addition to the $1 million an individual may currently gift free of tax by using his or her applicable exclusion amount. All gifts made to a donee during the calendar year count toward the amount the donor may gift to that person during such year using his or her annual exclusion. To the extent economically feasible, we recommend making annual exclusion gifts to children and grandchildren (or to trusts for their benefit) each year. In this way, the gifted property and all of the appreciation on the gifted property will be removed from the donor s estate and grows for the benefit of the recipient. In addition, as discussed briefly above, the payment of another person s tuition for education is not a taxable gift, regardless of amount, so long as the payment is made directly to the school. Such payments may even be made on behalf of an individual the donor is not legally obligated to support. The payments may be made for public or private elementary or secondary school, as well as college, graduate or professional school. However, this exclusion does not cover payment for books, supplies, room and board, and other education-related expenses only tuition. Further, the payment of another person s medical and associated expenses (including medical equipment and pharmaceuticals) is not a taxable gift, regardless of amount, so long as the payment is made directly to the health care provider. Such payments may even be made on behalf of an individual the donor is not legally obligated to support. (b) Applicable Exclusion Amount/ Leveraging. As discussed above, each individual has a tax-exempt amount, an applicable exclusion amount, that can pass free from federal estate and gift tax. To the extent it is affordable, one or both spouses can simply gift their remaining amount (or a portion thereof) to descendants (or to trusts for their benefit). In that way, the property, as well as all future growth on the property, will be outside of the donor s estate. However, a more efficient use of the applicable exclusion amount is to leverage the gift so that using the remaining exemption amount transfers property having a value considerably greater than the exemption amount to descendants without gift tax. Various leveraging techniques are discussed below in the sections relating to Limited Liability Companies and Grantor Retained Annuity Trusts (items V through VII of this memo). -5-
(c) Making Gifts to a Dynasty Trust. In making lifetime gifts, consideration should be given to making the gifts to a trust for the benefit of children and also more remote descendants (a Dynasty Trust ). Such a trust can be structured so that it is not only exempt from estate and gift tax, but is also exempt from the generation-skipping transfer tax (discussed above). As a result, the trust property (and all appreciation in its value) can be made available to children, grandchildren, and more remote descendants, in a manner that permits the assets to be transferred from one generation to future generations without being taxed at any generation level. In addition, the trust can be structured so that the grantor pays the tax on the income of the Dynasty Trust, thereby enabling the trust s investments to grow income tax-free and permitting greater wealth to accumulate outside of the grantor s estate. Paying the income tax on the trust constitutes an additional benefit to the beneficiaries of the trust which is not subject to gift tax. Thus, with a $1 million gift, assuming a growth rate of 8% per year, if left to grow for 30 years, the trust property would be worth more than $10 million - all gift tax, estate tax and GST tax exempt. Please note that the remainder of this memorandum discusses more sophisticated techniques that generally are not employed unless assets held (excluding insurance and pension plans) are in excess of $5 million. V. A Family Limited Liability Company (an LLC ). An LLC is an entity composed of members. Like partners of a partnership, all members share in the LLC s profits and losses in proportion to their ownership interests. However, the Managing Member is solely responsible for managing the LLC s investments and determining the timing and amount of distributions to the members; the other members are passive participants. An LLC is an ideal vehicle for passing wealth to future generations, while retaining a large degree of control over the property. An individual can transfer marketable securities as well as more illiquid assets and closely-held or restricted securities, to an LLC, and then, in turn, gift interests in the LLC to children and other descendants (or to a Dynasty Trust or separate trusts for their respective benefit). Discount on Gifted LLC Interests. LLC interests transferred to descendants (or to trusts for their benefit) are entitled to valuation discounts for gift tax purposes due to the restrictions in the LLC operating documents and the application of minority interest and lack of marketability discounts acknowledged under current tax law. The combined discount applicable to LLC interests for tax purposes generally ranges from 20% to 60%, as determined by a qualified appraiser (but generally one can reasonably expect a range of 25%-35% to be an appropriate discount). As a result of the discounts, an individual can make transfers of the assets that are held in the LLC which are worth more than the -6-
gift tax value of the LLC interests being transferred (e.g., assuming a 33% discount, $1.5 million worth of LLC interests could be valued at $1 million for gift tax purposes when held in LLC form, enabling an individual and his or her spouse to use their $1 million exemption amount to effectively transfer greater than $1 million). The amount of the discount is, in effect, a tax-free gift. Furthermore, any post-gift appreciation in the value of the transferred property will pass to descendants estate tax-free. In addition to using applicable exclusion amounts to make larger gifts to children, an individual can continue gifting small amounts of LLC interests to descendants on an annual basis, by reason of the gift tax annual exclusion. Discount on LLC Interests Owned At Death. Any LLC interests owned at death can also receive valuation discounts for estate tax purposes in order to reflect the lack of marketability of the LLC interests and, if at death the decedent is no longer the Managing Member (or otherwise lacks control over the LLC), to reflect such lack of control. The amount of the discount is, in effect, an estate tax-free transfer to descendants. VI. Installment Sale to Defective Grantor Trust. If assets are transferred to an LLC, consideration should also be given to an installment sale of such LLC interests to a defective grantor trust. In a typical transaction, after transferring assets to the LLC, an individual can sell his or her interests in the LLC, on a discounted basis, to a trust in return for a balloon note. The note can be structured so that it matures at a fixed time in the future (which the individual would determine), and interest can be payable on the note at the lowest permissible rate (currently 3%-4% as determined by applicable IRS tables). To legitimize the sale, the trust should have some equity (the $1 million or $2 million applicable exclusion gifts discussed above could be used for this purpose). The transaction can be structured such that no capital gain is recognized on the sale and no gift tax is due upon any equity transfer to the trust. As a result of the transaction, the value of the assets transferred to the trust can be effectively frozen (with regard to the individual making the sale) at an amount equal to the note balance due, but the interests in the LLC, and all appreciation in their value, will be transferred to children (or to a trust for their benefit) at a discount. The note is then repaid (with interest) at the specified future date, and all additional growth on the assets is kept by the trust, gift tax free. In addition, the trust can be structured so that the grantor pays the tax on the income of the trust, thereby enabling the trust s investments to grow income tax-free and permitting greater wealth to accumulate outside of the grantor s estate. As mentioned previously, -7-
paying the income tax on the trust constitutes an additional benefit to the beneficiaries of the trust which is not subject to gift tax. VII. Grantor Retained Annuity Trusts ( GRATs ). GRATs are excellent vehicles for transferring assets which are likely to appreciate in value or which otherwise produce high investment returns. Closely held investments may be appropriate for a GRAT. A GRAT is a trust in which the grantor retains the right to receive fixed annuity payments, payable at least annually, for a term of years. At the end of the term, the remaining trust principal is distributed to the remainder beneficiaries (e.g. descendants) or held in further trust for their benefit. If the grantor fails to survive the term, the GRAT property is included in the grantor s estate for estate tax purposes. In general, the gift made to the remaindermen upon the creation of the GRAT is equal to the value of the property that the IRS predicts will be left to pass to the remaindermen at the conclusion of the GRAT term. In order to compute this amount, the IRS uses actuarial tables that assume a certain investment return (the Section 7520 rate ) and further assumes that paying an annuity in excess of the table rate requires depletion of principal. However, if the GRAT actually produces an investment return (income plus appreciation) greater than the IRC Section 7520 rate, the value of the property reflecting such excess investment return passes to the remaindermen free of gift or estate tax. In the past, GRATs involved the risk that gift tax would be paid but the assets would underperform the Section 7520 rate, resulting in little or no property passing to the remaindermen. A recent Tax Court case (the Walton case), however, has changed that. GRATs can now be structured so that the present value of the annuity payments, using the Section 7520 rate, is exactly equal to the value of the assets transferred to the GRAT, and thus the remainder is zero for gift tax purposes a zeroed-out GRAT. Therefore, if the GRAT has an investment return greater than the Section 7520 rate, all the remaining trust property passes to the remaindermen at the end of the GRAT term, free from gift and estate tax. With the Section 7520 rate currently being around 4%, now is an excellent time to employ one or more zeroed-out GRATs. For example, if a client transfers property (in any amount) to a GRAT and retains a total return annuity (through income and/or appreciation) equal to 10% of the initial value of the gifted property each year, then the trust would only have to last 13 years in order for the gift of the remainder interest to have a value of zero for gift tax purposes. Although any type of property may be transferred to a GRAT, it is often desirable to transfer interests in a family LLC or other restricted family business entity into a -8-
GRAT because the investment return derived from the restricted interest is calculated on the basis of the discounted value of the interest, rather than the actual value of the underlying property held in the entity. For example, LLC interests valued at $1 million for gift tax purposes may actually hold assets having an underlying value of $1.5 million (based on a 33% discount). Therefore, if we assume a 13-year zeroed GRAT paying a 10% annual annuity (as described above), the $1.5 million of assets would only have to produce a total return of $100,000 (6.7%) in order for the entire $1.5 million of assets (plus any appreciation thereon) to pass to the remaindermen of the GRAT at the end of the term, free from gift tax. Even if the assets only return 4% during the trust term, or if the grantor dies during the GRAT term and all of the GRAT property is included in his or her estate, nothing is lost by attempting a zeroed-out strategy, since no gift tax has been paid. Furthermore, an argument can be made that only the remaining annuity payments, and not all of the property, is included in the grantor s estate. This would create a potentially large estate tax savings even in the case of the grantor s premature death. VIII. Charitable Strategies. There are several charitable strategies that can be used to benefit a grantor s descendants as well as charitable organizations. For example: 1. Charitable Lead Annuity Trust. A charitable lead annuity trust ( CLAT ) is an irrevocable trust that pays a fixed annuity to one or more charities for a specified term of years, and disposes of the remaining trust property to or in trust for the benefit of the remaindermen (e.g. descendants) at the expiration of the term. The present value of a descendant s right to receive the remaining trust property at the termination of the CLAT is subject to gift tax; however, if structured properly, this value (and the gift tax) will be zero. Any appreciation in the trust property in excess of the discount rate used to value the remaindermen s interest will pass to descendants free of transfer tax. Thus, if investments perform well, descendants will receive a windfall, free from estate and gift tax, at the conclusion of the term. There are also a variety of other charitable strategies that can fulfill charitable goals while benefiting family members. 2. Private Foundations. A private foundation is a tax-exempt organization established to receive charitable contributions and provide funds for charitable purposes. The money that is earned by the foundation increases the asset value of the foundation and can be (i) disbursed as grants to charities and/or (ii) reinvested to generate additional funds. A private foundation can serve as the recipient of a client s charitable contributions, as well as the distributions from the charitable lead annuity trust (CLAT) -9-
described above, thereby allowing a family to play a continuing role in the use of the donated funds. Of course, contributions to a private foundation are tax-deductible, subject to certain limitations. In addition, a private foundation offers an array of intangible benefits: - Designating Areas of Concern or Interest. The organizational documents for a foundation allow an individual or family (if desired) to establish general or specific guidelines for granting funds. While foundations generally allow for distributions to any qualifying charitable organizations, an individual can (for example) provide for a foundation to support only certain types of charities or only specifically designated charities. - Desire for Recognition or Anonymity. A foundation can perpetuate a name or a family s name so that an individual and a family can be recognized and appreciated for its generosity or, if preferred, can act as a buffer thereby enabling a family to avoid publicity and distance itself from requests for funding. - Access to Resources. The legitimacy associated with recognized foundations results in an access to information that is not as readily offered to individuals. This enables the foundation to learn more about substantive areas of interest and provides a means to increase the foundation s involvement. - Family Tradition and Personal Fulfillment. A foundation can be used as a means to develop and reinforce family unity through regular meetings, informal discussions and decision-making processes. Family members who are involved can take pride and derive personal satisfaction in seeing the results of their work and generosity. * * * The above is simply an introduction to federal estate and gift tax law and some of the many sophisticated estate planning techniques that are available. Please do not hesitate to contact me if you wish to discuss any of the above information in more detail. Naim Bulbulia Skoloff & Wolfe, P.C. 293 Eisenhower Parkway Livingston, NJ 07039 (973) 992-0900 -10-