Two things are certain: death and taxes. With smart planning, your wealthy clients can limit the latter when the former occurs. This article discusses a few basic estate tax planning techniques that should be in every estate planner’s toolkit.
On the most basic estate tax planning level, simply being married when you die is a way to defer the payment of estate tax. Consider a U.S. citizen husband and wife with a combined net worth of $12,000,000, each owning half of such property. Husband dies intestate. Husband’s $6,000,000 estate, assuming he has no children from a previous relationship, automatically passes to wife per intestate succession. (Utah Code Ann. § 75-2-102). No estate tax is due because of the “unlimited marital deduction.” (IRC §2056).
Lifetime Gift and Estate Tax Exemption
Assume the $12,000,000 estate in the previous scenario (now owned entirely by wife) appreciates to $15,000,000 before wife dies. Congress taxes estates at a flat 40 percent rate (IRC §2001), but it provides an exemption (currently $5,450,000) for assets gifted during life and at death (the “basic exclusion amount” or simply “lifetime exemption”) (IRC §2010). If wife did not use up any of her lifetime exemption through gifting during her life, her estate will pay estate taxes of $3,820,000 ($15,000,000 – $5,450,000)*0.4).
In the previous example, wife could have saved her estate over $2,000,000 had she timely filed an estate tax return (IRS Form 706) and elected to add (or “port”) husband’s unused lifetime exemption to her own exemption after husband’s death. (IRC $2010). Assuming husband died without using any of his lifetime exemption, wife’s estate, by electing portability, will pay only $1,640,000 in estate taxes ($15,000,000 less wife’s $5,450,000 exemption less husband’s $5,450,000 exemption)* 0.4).
A-B Credit Shelter Planning
If, in the previous scenario, husband executed a revocable living trust with an A-B framework, then, upon his death, the first $5,450,000 of his estate (representing his unused exemption amount) would be funded into a credit shelter (or “B”) trust, which would grow estate-tax free and be immune from wife’s creditors, yet could be used to benefit wife during her lifetime. The remaining $550,000 of husband’s estate would be funded into a marital (or “A”) trust, deemed to be owned by wife for estate-tax purposes
If all assets grew pro rata to $15,000,000 at the time of wife’s death, then total estate taxes to be paid would be only $1,095,000. Hence, in our scenario, the estate of husband and wife has saved $2,725,000 through some very basic and inexpensive planning.
Zero Tax, Balance to Charity
Some charitably minded clients are not so concerned that every last penny go to their own children, but they are adamant that the IRS receive none of their estate. This type of client can simply direct her assets, up to the exemption amount, to her heirs, and the balance to charity. Dispositions to charity are not subject to gift or estate taxes because of the “unlimited charitable deduction.” (IRC §2055). This desire may be expressed simply in a trust or other testamentary document and requires very little planning.
Annual gifts up to $14,000 per donee (adjusted for inflation) do not count toward the lifetime exemption (and direct payments of tuition and medical expenses have an unlimited exclusion)(IRC §2503). Gift amounts in excess of the $14,000 annual exclusion reduce the lifetime exemption, and gifts in excess of the lifetime exemption are subject to the payment of estate tax in the following tax year. However, taxable lifetime gifts are more efficient than taxable dispositions at death. Lifetime gifts are tax exclusive (donor pays taxes on the net gifted amount); death dispositions are tax inclusive (decedent’s estate pays tax on the net gifted amount and on the tax itself). (IRC §2502 vs. §2001).
Note, however, that the donee of a lifetime gift has the carryover basis of the donor in the asset; whereas, the heir of a disposition at death receives a “stepped up” basis (the asset’s value at death). (IRC §§ 1014 and 1015). Lifetime gift donees will therefore usually pay more in capital gains tax upon later sale of the asset than will death-time heirs. As a general rule, clients should gift high-basis assets before gifting low-basis assets.
If a client believes his business or investment interests will substantially appreciate prior to his death, he could consider selling them to an intentionally defective grantor trust (IDGT). IDGT assets appreciate outside the grantor’s estate but are considered owned by the grantor for income tax purposes.
Assume Joe has used his lifetime exemption. Joe creates an IDGT and “seeds” it with $100,000 and pays the IRS the corresponding $40,000 gift tax. Joe then sells to the IDGT his business interests with a FMV of $1,000,000 in exchange for a note (discounts may apply for lack of control and lack of marketability, resulting in additional savings). The interests appreciate to $10,000,000 at the time of Joe’s death. The IDGT repays the $1,000,000 note to Joe’s estate. IDGT beneficiaries are left with $9,000,000 in appreciated business interests, none of which is subject to estate tax. Joe’s estate pays $400,000 in estate taxes on the $1,000,000 note proceeds and then distributes the $600,000 note proceeds balance to his heirs.
Through this freeze transaction, Joe and his estate are able to pass $9,600,000 of assets while incurring a gift and estate tax of only $440,000. Without this transaction, Joe’s estate would have paid $4,000,000 in estate taxes to pass $6,000,000 of assets. Again, however, the estate tax savings will be partially offset by increased capital gains taxes on later sale of the assets due to the beneficiaries’ low cost basis in the assets. (IRC §1012).
Of course other tools, including charitable remainder trusts and irrevocable life insurance trusts, are utilized by wealthy families to keep assets from Uncle Sam and to preserve them for one’s beneficiaries. Hopefully this article shows that even the most basic strategies can result in substantial estate tax savings.