Tenth Floor Columbia Center 101 West Big Beaver Road Troy, Michigan 48084-5280 (248) 457-7000 Fax (248) 457-7219 SPECIAL REPORT www.disinherit-irs.com For persons with taxable estates, there is an assortment of advanced estate planning techniques to consider. This Special Report discusses the six advanced estate planning techniques that estate planners most frequently utilize. This Special Report is not intended to be an in-depth analysis of each topic. Rather, it merely provides an overview of each concept, presents some of the more pressing technical considerations, and addresses some of the planning considerations involved. I. IRREVOCABLE LIFE INSURANCE TRUSTS An irrevocable life insurance trust ( ILIT ) generally provides for the trustee to own life insurance in a manner that avoids the federal estate tax on life insurance proceeds. The trust agreement provides for the trustee to receive or acquire ownership of one or more life insurance policies, usually on the life of the person who sets up the trust (the grantor ). The grantor or others can then gift money to the trust to pay premiums on the insurance policies. When the insured dies, the trustee can hold the death proceeds for the benefit of family members. An ILIT accomplishes a number of objectives. Most often it is used as an economical way to provide funds for estate taxes. There are basically two ways an ILIT can use the death proceeds to pay estate taxes. The ILIT can either make loans to the estate, or the estate can sell assets to the ILIT. An ILIT is also an excellent vehicle for leveraging the grantor s $14,000 gift tax annual exclusion ($28,000 for married couples) and $5.34 million gift tax exemption ($10.68 million for married couples) in 2014. To help assure that life insurance proceeds are not included in the insured s estate for federal estate tax purposes, the insured should not serve as trustee. However, the insured s spouse and/or children can serve as trustee. Upon the insured s death, the surviving spouse can continue to serve as trustee or co-trustee of the life insurance trust and receive all of the income from the trust, plus monies needed for health, education, maintenance and support, based upon the standard of living to which the couple was THE ESTATE PLANNER S SIX PACK By Julius Giarmarco, J.D., LL.M. PAGE 1 accustomed. On the surviving spouse s death, assets in the trust escape estate taxation. The trustee s job is relatively simple during the life of the grantor. Upon receipt of gifts to the trust, the trustee can make the premium payments after proper notice has been given to each beneficiary (see below). Filing annual tax returns for the trust is usually not required under federal tax law because the trust does not have any income. The surviving spouse can also have a power of appointment, enabling the surviving spouse to specify how trust assets would be payable in the event of his/her death. This power can be restricted to the children and grandchildren of the marriage and must be specially worded to avoid estate tax at the time of the surviving spouse s death. The trust can also provide who will receive the assets if the power of appointment is not exercised. A second-to-die ILIT is designed to hold a life insurance policy that only pays benefits upon the death of both spouses. This is generally intended to create a fund to pay the estate taxes when they become due upon the second death. Normally, neither spouse should serve as trustee or have the right to benefit from the trust. ILITs are often designed to be generation-skipping trusts - the children of the grantors can become trustees or co-trustees of their own separate trusts and can receive income and principal for health, education, maintenance and support, during their lifetime without having the trust assets taxed in their estates. Special language must be used in the trust to facilitate generation skipping, and IRS Form 709 (gift tax return) must be filed to use the grantor s generation-skipping tax exemption. Each person is able to gift, tax free, up to $14,000 ($28,000 for married couples) per year to each beneficiary of the trust. Normally, gifts to an irrevocable trust do not qualify for this exclusion. An exception exists if children, grandchildren, or other potential beneficiaries of the trust are given a temporary withdrawal power, known as a Crummey Power (named after the court case that validated COPYRIGHT 2014 JULIUS GIARMARCO, J.D., LL.M.
this technique). As an example, a child of the grantor is given notice that a contribution has been made to the trust and such notice gives the child 30 days or more to withdraw his/her share of the amount placed in the trust. If the child does not promptly make the withdrawal, the withdrawal right lapses and the amount remains in the trust. Those amounts are then used by the trustee to pay insurance premiums. This technical withdrawal right qualifies contributions to the trust for the annual gift tax exclusion. Most of the time, transferring existing life insurance policies to a new life insurance trust is not a problem, but there are some factors to be considered. First, the transfer of an insurance policy to an irrevocable life insurance trust is a taxable gift. As long as the value of the policy does not exceed the gift tax exemption amount and otherwise qualifies for the gift tax annual exclusion, no gift tax will be due. Second, there is a three-year rule which states that a policy s death proceeds will be taxable in the owner-insured s estate for federal estate tax purposes unless the owner relinquished all incidents of ownership of that policy at least three years before his/her death. It is, therefore, often recommended that the trust be established before a new policy is purchased and that the policy be purchased by the trustee to avoid the three-year rule. Third, there are also complicated rules known as transfer-for-value rules that could cause a life insurance policy to be subject to income tax on all policy proceeds. This can occur if someone other then the insured owns the policy and transfers it to the trust. Finally, the irrevocable life insurance trust must be designed so that the grantor-insured has no power to revoke or amend the trust or have any control over the trust assets. However, with careful planning, the trust can be drafted to give the grantor (or members of his/her family) some flexibility to react to changes in the tax laws and/or to changes in family circumstances. II. FAMILY LIMITED LIABILITY COMPANIES Family limited liability companies ( FLLCs ) provide substantial leverage when making gifts for estate planning purposes. The reason is that gifts of limited liability company membership units are worth a good deal less than the underlying assets owned by the FLLC. How much less? Often between 20% - 40%, sometimes even higher, depending on the underlying assets and the client s risk tolerance to a gift tax audit. Discounts are set by an appraisal of the value of the FLLC units themselves, which is in addition to the required valuation or appraisal of the underlying FLLC assets. PAGE 2 In Michigan, we prefer to use limited liability companies over limited partnerships since the Michigan Limited Liability Company Act has been amended to make FLLC estate planning more advantageous. A major advantage of using an FLLC for gifting is that the donor can retain control of the FLLC s assets by acting as its manager. Moreover, the manager is entitled to reasonable compensation for managing the FLLC. To use an FLLC for estate planning purposes, the donor would transfer assets (i.e., cash securities, commercial real estate and/or unimproved property) to a newly-formed FLLC. The donor would receive voting and non-voting membership interests in the FLLC (similar to general and limited partnership interests). Appraisals and/or valuations of the assets of the FLLC would be obtained from a qualified appraiser. Thereafter, appraisals of the non-voting membership interests to be gifted would be obtained from a qualified business appraiser or an accounting firm. The appraisals are essential in substantiating the value of the gifts. Proper FLLC planning cannot be done without such appraisals, and failure to obtain proper appraisals could subject the donor to IRS penalties. The donor would then make gifts (either outright or in trust) of the non-manager FLLC interests to his/ her intended donees (i.e., children, grandchildren, etc.) using the $14,000 ($28,000 for married couples) gift tax annual exclusion, and some or all of the donor s $5.34 million ($10.68 million for married couples) gift tax exemption in 2014. Gifts are made by a relatively simple document assigning the FLLC membership interests to the donee or to a trust for the benefit of the donee. The FLLC interests themselves are similar to shares of stock in a corporation. They represent a right to share in the income, losses, and capital of the FLLC. The donor uses the voting membership interests to name himself/herself as the manager of the FLLC. The donor, as the manager of the FLLC, would control the FLLC s assets and the flow of income to the members. Although non-voting FLLC members are entitled to a proportionate share of distributed FLLC income, the manager decides how much of the FLLC s cash or property is distributed each year. Moreover, if the non-managing members are in a lower income tax bracket than the donor-manager, income taxes are reduced for the family. To preserve ownership of the FLLC within the family, the sale or transfer of membership interests can be restricted so that no one can transfer their membership interests without giving the other members a right of first refusal. Restrictions such as these, along with restrictions granted under state law, can provide significant creditor protection. In
addition, unlike a limited partnership, in which all liability for partnership debts is placed upon the general partner personally, all members of an LLC, including the manager, have limited liability for the debts of the LLC. Unlike a corporation, in which a creditor can seize a debtor s stock, a creditor (including a divorced spouse) cannot seize the membership interests in an LLC. Creditors seeking to satisfy a judgment against a member of an LLC for a debt unrelated to the LLC (e.g., a personal injury or a medical malpractice judgment) are limited to a charging order against the debtor-member s interest. The charging order provides that any LLC property which becomes distributable to the debtor member must be paid instead to the creditor to the extent of the unsatisfied judgment. Remember, however, that the non-voting members are not in control of how much LLC cash or property is distributed. The creditor will have to wait until the donor-manager decides to make a distribution to the members. In the meantime, the creditor may have to pay income taxes on his/her share of the LLC s profits. This can provide significant leverage for settlement. In summary, the FLLC is a valuable estate planning technique offering numerous advantages to persons with taxable estates. The donor leverages his/her gift tax annual exclusion and/or gift tax exemption because of the valuation discounts; the FLLC s income can be shifted to lower income tax brackets; the future appreciation on the FLLC s assets are removed from the donor s gross estate; the FLLC s assets are protected from creditors; and all the while the donor (as manager) has complete control over the FLLC s operations. III. QUALIFIED PERSONAL RESIDENCE TRUSTS The personal residence trust provides a unique opportunity to minimize gift and estate taxes by transferring a residence or vacation home at a fraction of its actual value. The trust is referred to as a qualified personal residence trust, or QPRT. To create a QPRT, the grantor transfers his/her residence or vacation home to an irrevocable trust (of which the grantor is the trustee and beneficiary) for a fixed term, such as 5 to 20 years. As the trustee, the grantor has full control over the property transferred to the trust. As the beneficiary, the grantor is entitled to use the property rent free and is responsible for maintaining the property and paying the property taxes and other expenses associated with the property. At the end of the term, the property passes outright (or in further trust) to the remainder beneficiaries named in the trust instrument (usually the grantor s children) free of estate tax and additional gift tax. For Michigan real property tax purposes, there is no reassessment under Proposal A upon transfer of a residence to a QPRT. However, at the end of the term when the property passes to the remainder beneficiaries, a change of ownership occurs and the property will be reassessed. At the time the grantor transfers the property to the QPRT, the grantor is deemed to have made a gift to the remainder beneficiaries. The tax advantage arises because the value of the gift is based on the discounted present value of the remainder beneficiaries right to acquire the property in the future. The amount of the discount varies, depending on the grantor s age, the term of the QPRT and the IRS s published interest rates at the time of the gift. The grantor s gift tax is, thus, based on a steep discount from the property s current value. Gifts to a QPRT do not qualify for the $14,000 ($28,000 for married couples) gift tax annual exclusion and, therefore, will use up some of the grantor s $5.34 million ($10.68 million for married couples) gift tax exemption in 2014. Assuming the grantor survives the term of the trust, upon the grantor s death, the property, including the property s appreciation in value, is not included in the grantor s estate and, therefore, escapes estate tax. If death occurs before the expiration of the QPRT s term, the property held in the trust is included in the grantor s estate for estate tax purposes. In this event, the QPRT s effect is tax neutral; there is neither an advantage nor disadvantage from a tax perspective. Any gift tax exemption used by the donor is restored. The only real costs to the grantor are the transaction costs of creating the QPRT. However, by having the grantor establish an irrevocable life insurance trust (see Section I above), the death proceeds can provide a hedge against the grantor s premature death. If the grantor survives the term of the trust, the property passes to the remainder beneficiaries and is, from that point on, owned by them. Therefore, the trust agreement should give the grantor the option to lease the residence at fair market rent. The grantor may then continue to live in the residence by paying rent to the remainder beneficiaries. Such rent payments further reduce the grantor s estate. Moreover, if the QPRT is designed as a grantor trust (see Section V below), the rent payments will not be taxable to the remainder beneficiaries. The grantor may not purchase the property from the QPRT prior to the QPRT s termination. PAGE 3 COPYRIGHT 2014 JULIUS GIARMARCO, ESQ.
If the residence is subject to a mortgage, the principal portion of each mortgage payment is considered an additional taxable gift. Therefore, it is generally preferable to pay off the debt prior to the transfer to the QPRT. Payments to improve the property (other than payments for normal maintenance) are similarly treated. Finally, a married couple can establish up to 3 QPRTs. IV. GRANTOR RETAINED ANNUITY TRUSTS A grantor retained annuity trust ( GRAT ) is an effective means for a large net worth individual to transfer high-yielding and/or rapidly-appreciating property (e.g., Subchapter S stock or membership interests in a family LLC) to a child with minimal or no gift tax, while retaining all or most of the income from the property for a term of years. The grantor provides in the trust agreement (which is irrevocable) that he/she retains the right to receive a fixed dollar amount (the annuity) which will be distributed to the grantor each year from the trust assets for a stated number of years (the annuity period). If the income of the GRAT is insufficient in any year to pay the annuity, trust principal must be used to fully satisfy the annual annuity payment. The grantor states in the GRAT that certain individuals are to be the trust remaindermen (usually the grantor s children) and, at the end of the annuity period, all trust assets remaining in the GRAT are to be distributed to those remaindermen either outright or in further trust. For tax purposes, a GRAT is considered to have two parts: (1) the annuity interest retained by the grantor; and (2) the remainder interest that is given to the designated remaindermen. The IRS Regulations provide the method for computing the relative percentage of the value of the trust assets represented by each part. This computation is based upon the length of the annuity period, the IRS s interest rate at the time the GRAT is established, and the dollar amount of the annual annuity at the time the GRAT is established. Generally, a longer term, a lower interest rate, and a larger annuity results in a smaller gift. The gift to the remaindermen will use part or all of the grantor s $5.34 million ($10.68 million for married couples) gift tax exemption in 2014. It will not qualify for the $14,000 annual gift exclusion. Because the value of the gift is much less than the total value of trust assets, the result is a leveraged use of the grantor s $5.34 million gift tax exemption. The use of a GRAT freezes the value of an asset for tax purposes in an individual s estate and shifts all appreciation to the remaindermen. By way of example, assume the grantor (age 60) transfers to a GRAT $1.5 million of Subchapter S stock that, after taking discounts for lack of control and marketability, is valued at $1 million. Also, assume the grantor retains the right to receive from the GRAT $112,495 per year for ten years. Assume further that the IRS published interest rate for the month the GRAT is established is 2.2%. Based upon IRS tables, the grantor s retained annuity interest is worth $937,429 and, therefore, the remainder interest is worth only $62,571. The grantor s taxable gift to the remaindermen is $62,571 and uses only that amount of the grantor s $5.34 million gift tax exemption. If the grantor survives the ten-year period and the trust property appreciates 10% annually, at the end of the term, $2,097,739 passes to the beneficiaries gift tax free. Thus, for the cost of paying gift tax on a transfer of $62,571, the grantor has excluded $2,097,736 from his/her taxable estate, although the grantor has received $112,495 in annuity payments each year during the GRAT term. If the property transferred to the trust appreciates (in income and principal) while it is held by the GRAT, the entire appreciated value is excluded from the grantor s estate. This is because the amount of the donor s gift to the remaindermen is based only on the values at the date of the transfer to the trust and is not later adjusted. If the grantor dies during the GRAT term, the IRS s position is that a portion of the GRAT assets are included in the grantor s estate. The portion so included is the amount necessary to produce the retained annuity in perpetuity (as if the annuity amount were the annual income of the GRAT s assets) using the IRS s assumed interest rate in effect on the date of death. Generally, if a GRAT s assets have substantially appreciated, there will be a significant tax-free transfer of wealth even if the grantor dies during the term. V. GRANTOR TRUSTS A common technique that has gained in popularity in recent years is the sale of an asset to a grantor trust created by the seller. The trust is generally known as an intentionally defective irrevocable trust, or IDIT. The installment sale of property to an IDIT is an estate freezing technique, similar to a GRAT, but one which takes advantage of the differences between the estate tax rules and the income tax rules governing ownership of property. The trust is intentionally drafted so that the grantor is treated as the owner for income tax purposes. Because of the PAGE 4
grantor trust status, the trust is treated as the alter ego of the grantor, and the sale of assets to the trust does not trigger recognition of gain. The grantor then sells assets (typically Subchapter S stock or membership interests in a family LLC) to the trust in exchange for an interest-bearing note. Because the transaction is structured as a sale, the note bears interest at the lowest rate permitted by the IRS for the month of sale. The face amount of the note is the fair market value of the assets sold, and takes into account any discounts for lack of marketability and lack of control. The primary benefit of making an installment sale to the IDIT is that, to the extent the assets generate more than the IRS s interest rate in income and appreciation combined, such excess will pass to the trust beneficiaries free of transfer taxes. An added benefit, as discussed in greater detail below, is that the grantor s payment of income taxes on income earned by the IDIT is the functional equivalent of a tax-free gift to the IDIT s beneficiaries. The IDIT works best for a person with assets expected to appreciate significantly (similar to a GRAT), so that appreciation can shift to the grantor s heirs without gift tax. As mentioned above, ideally the yield on the property sold to the trust should exceed the interest rate of the note. In addition, for the client interested in generation skipping, the IDIT is a good vehicle (as opposed to a GRAT), because the grantor s generation-skipping tax exemption may be allocated to the IDIT. As mentioned above, for income tax purposes only, the trust is treated as nonexistent if the grantor is considered to have certain interests or powers that cause the trust to be treated as a grantor trust. Of course, care must be taken to ensure that the powers chosen for insertion in the trust have the desired income tax effect on the one hand, and do not cause inclusion in the grantor s estate for estate tax purposes on the other. Because the trust is disregarded for income tax purposes, the trust will inherit the grantor s basis while the grantor is alive, and the grantor will continue to be taxed individually on the income and gains generated by the IDIT. By paying the income tax on trust income the grantor effectively makes additional gift-tax-free transfers to the beneficiaries of the IDIT. Key to the treatment of the IDIT strategy as a sale rather than a gift is that the transaction be structured as a bona fide sale. Accordingly, the fair market value of the property must be accurately determined. If the sale is at fair market value, no gift occurs. Therefore, it is advisable to obtain an appraisal for purposes of substantiating fair market value. If no assets are available to finance the interest payments on the note other than income from the assets sold, it is easier for the IRS to make the argument that the grantor transferred assets to the trust and indirectly retained the right to the income from them, causing inclusion of the trust property in the grantor s estate. Accordingly, it is advisable to either use an existing grantor trust that has other assets as the purchaser, or to transfer other assets to the trust. Of course, the transfer of other assets is subject to the normal gift tax rules. Generally, as a rule of thumb, the trust should be capitalized with assets having a value of at least 10% of the face amount of the note. Otherwise, the IRS has a better argument that the note is not true debt, but rather equity contributed by the grantor with a retained interest in income. Nevertheless, since only 10% of the purchase price must be gifted to the IDIT, this technique has the advantage of using less of the grantor s $5.34 million ($10.68 million for married couples) gift tax exemption (for 2014), or of minimizing the gift taxes due for grantors who have already exhausted their gift tax exemption. One of the most uncertain areas involving IDITs is the income tax consequences at the death of the grantor while the note is outstanding. Even though no gain is triggered upon the sale or as a result of any other transaction between the grantor and the trust during the life of the grantor, the IRS may argue that the death of the grantor, which causes the grantor trust status to cease, results in a deemed sale, triggering income equal to the fair market value of the amount unpaid under the note. A simple way around this problem is for the note to be paid (when possible) before the grantor dies. There are several methods of satisfying the note, including the following: (1) The trust can borrow from another source; (2) all or a portion of the purchased trust property (including income earned on the trust property) can be returned to the seller in satisfaction of the note (although an independent appraisal will most likely be necessary if the property is not publicly traded); (3) the remainder of the note can be discharged in the form of a gift; and (4) the trustee can sell the trust property to a third party and the proceeds, up to the unpaid balance of the note, can be distributed to the grantor. In summary, the sale to an IDIT technique combines the leveraging benefits of valuation discounts and deferred payment sales with the advantages inherent in being able to sell assets to one s heirs without income tax ramifications. While the typical sale to an IDIT will be structured as an interest-only sale with a balloon payment, it is possible to use a private annuity sale or a self-canceling installment note sale in appropriate circumstances. Because of the ability to PAGE 5 COPYRIGHT 2014 JULIUS GIARMARCO, ESQ.
generation skip an IDIT and because of the limited gift tax consequences to capitalizing the IDIT, a sale to an IDIT has surpassed the GRAT as the vehicle of choice to transfer substantial wealth to children and grandchildren. VI. CHARITABLE REMAINDER TRUSTS A charitable remainder trust ( CRT ) can be a useful tool for an individual who wants to dispose of all or part of appreciated property (e.g., securities, real estate, closely-held stock, etc.) during life. By using this form of trust, the donor can dispose of the property without paying capital gains tax, gift tax or estate tax, while still receiving income from the trust for the rest of his/her life (or both lives for couples). There are two forms of charitable remainder trusts. A charitable remainder annuity trust ( CRAT ) distributes a percentage of the initial value of the property transferred to the CRAT as income to the donor(s). Thus, the income payout does not change over the trust s term. A charitable remainder unitrust ( CRUT ) distributes a percentage of the value of the trust property recomputed annually. Thus, the income payout varies yearly with the value of the trust property. Consider the following example. A married couple owns securities worth $450,000 which has a tax basis of $50,000. If they sold the stock, they would have to pay income tax on a $400,000 capital gain. Instead, the couple transfers the stock to a CRT. The couple has a lifetime income from the CRT and a qualified charity receives the remainder. Due to the gift tax charitable deduction, there are no gift tax consequences resulting from the transfer as there would be if the couple, for example, gave the securities to a child. Note that the child (or any other donee) would acquire the couple s low basis in the stock if he/she received it as a gift. Additionally, giving stock valued at $450,000 to one individual would represent a taxable gift of $422,000 (i.e., $450,000 - $28,000 annual gift tax exclusion). Under the terms of the CRT, the couple receives a specified yearly percentage of the CRT s value as income (paid, for example, quarterly or monthly) for up to twenty years or the rest of their lives. The CRT can sell the stock with no capital gains tax consequences and invest the sale proceeds to generate the couple s life income. Since the CRT does not pay any income taxes, the entire sale proceeds can be invested to produce a greater income. The couple receives a current income tax deduction for the remainder value of the gift which can provide substantial income tax savings for up to six years. At the second spouse s death, the remaining trust principal passes to the charity estate tax free! Giving assets to a CRT makes it impossible for the couple s death beneficiaries (for example, the children) to inherit those assets. The death beneficiaries, however, can be benefited in other ways. For example, the couple could purchase a life insurance policy and place it in an irrevocable life insurance trust, of which the children would be beneficiaries. The insurance proceeds would not be subject to estate tax or income tax. The premiums to be gifted to the trust could come from the income tax savings from using a CRT. This is commonly referred to as a wealth replacement trust. It may be possible for the CRT s remainder beneficiary to be a private foundation the couple themselves create for a cause they consider worthy. The couple s children could be the directors of the private foundation and receive reasonable salaries from it for services rendered. This special report is designed to provide accurate (at the time of printing) and authoritative information with regard to the subject matter covered. It must not be used as the basis for legal or tax advice. In specific cases, the parties involved must always seek out and rely on the counsel of their own advisors. Thus, responsibility for modifying and guiding any party s action with respect to legal and tax matters is placed where it belongs with his or her own advisors. TO THE EXTENT THIS ARTICLE CONTAINS TAX MATTERS, IT IS NOT INTENDED NOR WRITTEN TO BE USED AND CANNOT BE USED BY A TAXPAYER FOR THE PURPOSE OF AVOIDING PENALTIES THAT MAY BE IMPOSED ON THE TAXPAYER, ACCORDING TO CIRCULAR 230. PAGE 6