Living trusts continue to enjoy unprecedented popularity for a variety of reasons, particularly probate avoidance and increased control during incapacity and death. Many people fail to appreciate, however, that for those with taxable estates (over $2,000,000 this year for Washington state, dropping to $1,000,000 in 2013 for the Federal Exemption) estate planning should not end with the garden variety living trust.
This article reviews advanced estate planning techniques which take you beyond the living trust.
Qualified Personal Residence Trusts (QPRT)
A QPRT is an irrevocable trust that may hold only a personal residence (either a primary residence or a vacation home). The QPRT lasts for a terms of years that the Grantor selects. During the trust term, the Grantor has the right to continue to use the property. Because the value of this retained right is subtracted from the value of the gift to the QPRT, and because the value of the gift (the remainder interest) is frozen at current values and does not included future appreciation, substantial estate and gift tax savings are possible. At times when the real estate market is depressed, this technique can be especially powerful.
Life Insurance Trusts (ILIT)
A life insurance trust is an irrevocable trust designed to own a policy of life insurance on the individual or couple creating the trust. The policy could be either an existing policy or a new policy purchased by the trust with cash gifts made by the Grantor(s). The policy might be a single life or so-called “second-to-die” policy on a husband and wife. Life insurance owned individually is subject to estate and income taxes. Life insurance owned by a properly structured ILIT can be excluded from the taxable estate, passes free of estate and income taxes, and creates flexibility and liquidity for paying death and administration expenses.
Your current plan may provide for distribution of your estate outright to your children if they are adults, or in trusts to be distributed when they attain adulthood. If so, consider modifying your current plan to retain your children’s shares in trust for life with the trust passing to your grandchildren at the death of your children. Reasons for creating “generation-skipping trusts” include:
1. Assets in the trust, including appreciation on trust assets during your children’s lifetimes, will not be included in the taxable estates of your children, thus saving estate taxes;
2. The trust is protected from attack by a spouse if your child gets divorced; and
3. The trust’s assets will be protected from a child’s creditors in the event of a lawsuit, bankruptcy, failed business, or other financial difficulties your child might encounter. (Statistically, our children run a 50/50 chance of either experiencing a divorce or bankruptcy in their lifetime!)
Taking the concept of a generation-skipping trust one step further into the advanced planning realm, you might even consider forming the trust under the laws of a state (eg, Alaska, Delaware, Idaho, South Dakota, among others) that has abolished the antiquated “Rule Against Perpetuities” (in Washington a trust can last only for 150 years) so that the trust can run for generations without ever being subjected to estate taxes. This is sometimes referred to as a “Dynasty Trust.”
Family Limited Partnerships/Family Limited Liability Companies (FLP/FLLC)
FLPs and FLLCs enable you to make lifetime gifts of fractional interests in assets on a discounted basis. For example, if you own a business, vineyard, rental or investment real estate, stocks and bonds, etc, you can transfer those assets to a limited partnership (or the newer limited liability company), and you and your family members become limited partners. By making gifts of limited partnership interests to your children, grandchildren or to irrevocable trusts for their benefit, you can transfer the value of the assets at a fraction of their underlying value, thereby leveraging your annual exclusion ($13,000/person/year) and estate tax exemption amounts. The valuation adjustments are based on concepts of minority interest discount and lack of marketability and are a function of the restrictions placed in the partnership agreement. However, if you are considering this technique be forwarded that future discounts could be unavailable to changes in the estate tax law. During the Clinton administration and even now during the Obama administration bills have been offered in congress which would curtail the discounting. However, the FLP/FLLC is many benefits beyond discounting such as asset protection, consolidated management, and financial training for future generations which will always make it a valuable planning tool.
Charitable Trust Planning
Whether or not you are charitably inclined, if you own highly appreciated assets (such as real estate or stock) which produce a small return relative to fair market value, the charitable remainder trust (CRT) can be an attractive planning technique. Here’s how it works: you transfer assets to a trust, reserving the income stream defined either as fixed annual amount or a as a percentage of the value of the trust assets determined annually. At your death, whatever is left in the CRT passes to a charity or charities of your choice.
Not only do you receive an income tax deduction upon creating the CRT, but the CRT can sell the assets transferred by you free of capital gains tax. As a result, the full value of the assets, without reduction for capital gains taxes, is invested, producing a larger income stream than would have been possible if you had sold the assets, paid the tax, and invested the difference. Of course, by transferring assets to the CRT, the principal will not pass to your heirs. Therefore, CRTs are often paired with an irrevocable life insurance trust (the ILIT), with the insurance policy replacing the asset transferred to the CRT. (That’s why ILITs are often referred to as “wealth replacement trusts.”)
Other charitable planning techniques include outright gifts to charities, charitable lead trusts, supporting organizations, donor advised funds and the creation of private charitable foundations. For high-asset clients who are charitably motivated, the private foundation, supporting organization or donor-advised fund can be personally rewarding as well as economically rewarding from a tax planning point of view.
One of the simplest and most often overlooked ways to reduce a taxable estate is to take advantage of the annual gift tax exclusion. An individual may make as many gifts as he or she likes, up to $10,000 per donee per year, without paying a gift tax and without consuming any of his or her estate and gift tax exemption amount. Such gifts do not have to be in cash, but could include securities, mutual funds, partial interests in land, shares of stock in a family business, or interests in a family limited partnership. Gifts to minor children or grandchildren can include custodial accounts under the Uniform Transfer to Minors Act, an irrevocable trust, or perhaps the best option, contributions to a Section 529 College Savings Plan. In addition, few people know that a special gift tax provision makes it possible to give unlimited gifts to individuals for education or medical needs by making the payment directly to the school or medical provider!
Asset Protection Trusts
Many high-net worth clients with potential liability exposure (like doctors and lawyers) can combine family limited partnerships, irrevocable trusts and tax-neutral offshore trusts (eg. Cook Islands) or on-shore trusts (eg. Alaska, Delaware) to set aside a “nest egg” in case of a catastrophic lawsuit. To be done legally, such planning must be accomplished before you have knowledge of a claim.
Business Succession Planning
Statistics show that only a small percentage of family businesses pass successfully from one generation to the next. Estate taxes and the failure to plan for the transfer of control are the major culprits. Business succession planning often involves a combination of several techniques discussed above, as well as use of the Family Business Exclusion, buy-sell agreements, split-dollar life insurance, deferred comp plans, stock recapitalizations, qualified and non-qualified stock option plans, Employee Stock Ownership Plans (ESOPs), and re-structuring the form of entity, such as changing from a sole proprietorship or general partnership to a Limited Liability Company (LLC), limited partnership or corporation.
Even if you already have a basic estate plan, you should consider updating and reviewing your plan to see if some of these techniques are appropriate for you and your family. If you have not completed your estate plan, the foregoing techniques are important adjuncts to a basic plan consisting of a living trust or will, health care directive and power of attorney.