Written by P. Mark Accettura

The topics discussed in Chapter Nine apply to anyone considering an estate plan. The topics discussed in this Chapter Ten apply predominantly to individuals with a gross estate in excess of the Applicable Exclusion Amount (see “Planning to Avoid Estate Tax” in Chapter Nine).

Even with the changes brought by the Economic Growth and Tax Reconciliation Act of 2001, the techniques discussed in this chapter are still useful. The changes in the estate tax law have a sunset provision. They will expire on December 31, 2010, unless reenacted by Congress and signed by the President before that date.

Who knows what the politics will be in the future, especially if economic conditions worsen. There are also non-tax reasons for using these techniques such as transferring control of assets or family businesses to the next generation in an orderly manner, or tying up assets to prevent frivolous spending.

As noted in Chapter Nine, the face amount of life insurance is included in your estate. Irrevocable life insurance trusts are used to exclude the value of life insurance assets from the estate of the insured. If simply removing the life insurance from your estate will lower the value of your estate to be below the Applicable Exclusion Amount no further estate planning may be necessary.

If, after excluding life insurance, you still have a taxable estate, consider implementing a family limited liability company to make structured gifts to family members and loved ones. Finally, irrespective of the size of your estate, consider making charitable transfers to fulfill your social contract.

Life insurance provides liquidity to larger estates. At death, life insurance proceeds are available to satisfy the immediate needs of your family, as well as any estate tax (due within nine months of the decedent’s death) that may be due. Unfortunately, the face value of life insurance is included in your gross estate, exposing the proceeds to estate tax. The solution is to create an irrevocable trust to be both the owner and beneficiary of the policy.

Irrevocable trusts are a valuable estate planning tool for larger estates. They are used to remove assets like life insurance from estates that would otherwise be taxable. Unlike revocable trusts, which may be amended or revoked at any time during the grantor’s lifetime, irrevocable trusts may not be amended or revoked. Also, unlike revocable trusts, the grantor of an irrevocable trust may never act as trustee. Thus, once established, the grantor of an irrevocable trust relinquishes complete benefit and control of the trust.

As noted in Chapter Nine, your taxable estate consists of assets over which you exercise control at the time of your death. By relinquishing all such control in an irrevocable trust, you are able to exclude handpicked assets from federal estate tax. To avoid having the irrevocable trust assets leech back into your estate, you must also permanently forego the benefit or use of irrevocable trust assets.

Accordingly, when selecting assets to contribute to an irrevocable trust, you must select assets over which you are willing to permanently relinquish all control or enjoyment. Life insurance makes an attractive irrevocable trust asset, since the true value of life insurance is not realized until your death. Consequently, the fact that the policy is outside your control has little economic impact on you during your life.

To avoid adverse gift tax consequences, strict procedures must be followed when making life insurance premium payments. Since the irrevocable trust is the owner of the policy, premium payments are no longer your responsibility.

They become the responsibility of the trustee. Gifts of cash must be made to the irrevocable trust to allow the trustee to make premium payments. Transfers to the irrevocable trust are considered gifts to others since by definition you cannot be a beneficiary.

As noted in Chapter Nine, you may make gifts of $10,000 per beneficiary per year without incurring gift tax. However, in order to qualify for the gift tax exclusion, gifts must be of a “present interest.” For a gift to be of a present interest, the beneficiary must be able to enjoy the gift currently.

A transfer of life insurance premium payments to an Irrevocable Life Insurance Trust (“ILIT”) is not by itself a gift of a present interest, since the beneficiaries of a typical ILIT don’t receive a right to trust assets until the death of the grantor. However, gifts in trust are converted from future to present interest transfers by a device known as a “Crummey Notice.”

A Crummey Notice is given to all ILIT beneficiaries contemporaneously with each contribution to the ILIT. The Crummey Notice notifies each beneficiary of his or her right to withdraw his or her prorata share of the contribution. Under the terms of the ILIT and the Crummey Notice, if such right of withdrawal is not exercised within thirty days, it lapses. Despite numerous attacks by the IRS, the courts have consistently upheld the Crummey Notice as a valid means of qualifying gifts to an irrevocable trust as present interest gifts.

The following is a sample Crummey Notice:

It is the responsibility of the ILIT trustee to make annual life insurance premium payments. The insured/grantor should not make premium payments directly to the insurance company (bypassing the ILIT), as this could cause inclusion of the proceeds of the policy in the insured/grantor’s estate at death.

Instead, once the 30 day Crummey Notice period has lapsed (presumably no beneficiary has elected to withdraw their share of the annual contribution), the ILIT trustee may then make the annual premium payment to the insurance company.

Note that it is inadvisable to name either the grantor or the grantor’s spouse as trustee of the ILIT. As trustees, the grantor or grantor’s spouse would have powers considered to be “incidents of ownership,” causing the life insurance proceeds to be included in their estates. Accordingly, it is common practice to appoint other ILIT beneficiaries (such as grantor’s children) as Trustee.

The complex operation of an ILIT, and the flow of premium payments is summarized by the following illustration:

Whether through outright gift, transfers in trust, or charitable transfers, reducing estate tax liability involves some sort of gifting. The $10,000 dollar, per beneficiary, annual gift tax exclusion allows for substantial annual gifts. Assuming you begin a systematic gifting program early enough in life, significant estate tax reduction can be achieved over time. Not only are the gifted assets removed from your estate, but the future appreciation of the gifted assets is removed as well.

Having lost a spouse and experiencing your economic future as somewhat uncertain, you may be hesitant to make large gifts. You may not want to part with cash you believe you may need for a rainy day. You may be concerned that outright gifts to your children or other beneficiaries will negatively affect their work ethic. Or, you may simply not have sufficient liquid assets to make substantial cash gifts each year.

Most, if not all, of your gifting concerns can be addressed by using a Limited Liability Company (“LLC”) as a gifting vehicle. Limited Liability Companies are relatively new. They offer the liability protection of a corporation but are taxed as a partnership. LLC owners are called “members,” and their ownership is expressed as a percentage.

Like shareholders in a corporations, members’ liability is limited to the extent of their investment in the LLC. Members share in LLC profits and loss in direct proportion to their ownership.

Limited liability companies created for gifting purposes are often called “family” LLCs. Most family LLCs provide for the appointment of a manager who controls the day-to-day operation of the LLC. Naturally, you would appoint yourself as the manager to allow you to control investment of LLC assets as well as disbursement of LLC income and principal. Exclusive management authority allows you to make gifts without relinquishing control of the gifted assets.

To create an LLC, Articles of Organization must be filed with your state’s Corporations and Securities Bureau. The initial LLC members then execute an Operating Agreement that sets forth the names and ownership interests of all members, appoints a manager, and establishes the rules of operation for the LLC.

Once these steps have been completed, you can begin to transfer selected assets to the LLC. During your life, you act as manager, retaining full control of company stock, real estate, or other assets transferred to the LLC. After death, the successor manager appointed by you in the Operating Agreement implements the terms of the LLC to provide structure among the competing interests of your beneficiaries.

Tension, and even outright conflict often manifest after the death of the family patriarch or matriarch. Such family disputes can be minimized by clearly defining ownership and authority succession in your LLC.

LLCs are the preferred vehicle for gifting business, investment and real estate assets. It is difficult if not impossible to divide a shopping mall, family farm, or apartment building in precise fractional shares. However, if such hard to divide assets are first transferred to an LLC, precise membership interests can be calculated and easily gifted.

Once transferred, the LLC provides for the orderly management of the property by its appointed manager (you). As an added bonus, substantial gift tax “discounts” (discussed below) are available when LLC interests are gifted.

LLC interests, once gifted, are insulated from the claims of outside creditors. Unlike outright gifts, LLC gifts are relatively secure from the claims of your children’s spouses and creditors. The LLC Operating Agreement prohibits members from making voluntary transfers and severely limits involuntary transfers due to the bankruptcy, divorce or insolvency of a member.

Such events trigger an automatic “buy back” under the Agreement for a nominal price. Buyback may not even be necessary. The inherent lack of marketability of LLC interests make them unattractive to outside creditors. Even if a creditor were able to acquire a member’s share, the creditor would only be an assignee, and as such would not eligible to participate in LLC activity or management.

As a “pass through” entity, LLCs pay no tax. Instead, items of income and loss pass through to the members in proportion to their ownership interest, and are taxed at the member’s marginal tax rate.

As a separate entity, the LLC must file annual income tax returns (IRS Form 1065). Each member’s share of income and loss is calculated on Schedule K1 of Form 1065, which must be given to members by January 31 of the following year. As a practical matter, members cannot file their personal income tax returns until they have received a copy of their K1.

LLCs are the preferred gifting vehicle for all gifts except gifts of life insurance (which should be made to an ILIT). While the manager of an LLC may both manage and enjoy LLC assets, the grantor of an irrevocable trust may neither retain an interest in the trust nor act as Trustee. While an irrevocable trust cannot be amended, modified or revoked, an LLC may be amended as circumstances change.

Valuation is a critical issue in gift and estate tax. In fact, the majority of gift and estate tax audits involve valuation issues. To avoid IRS problems, all gifts must be valued. For gifts of cash and publicly traded securities, the value of the gift can easily be determined. However, gifts of real estate and business interests require that you obtain a written appraisal from a licensed appraiser.

If the gift is an interest in an LLC, determining value is a two-part analysis. First, the LLC’s assets must be valued, and then the membership interests must be valued. Interestingly, the member’s pro rata share of LLC assets is only the starting point in determining the value of the member’s interest.

A discount must then be applied to account for the member’s lack of participation in management (“minority discount”), and the restrictions on transferability imposed by the operating agreement (“marketability discount”).

The courts have reasoned that an outside purchaser would pay less to acquire the membership interest than to acquire the underlying LLC assets directly.

Valuation discounts allow you to make larger annual gifts. For example, a thirty five percent (35%) discount allows you to make a 35% larger gift within the annual gift tax exclusion. In the long run, the ability to make larger annual gifts can dramatically reduce your estate tax liability.

The earlier gifts are made the better, since future appreciation of LLC assets will be owned by your beneficiaries instead of by you. The following example illustrates the operation of LLCs and the benefit of valuation discounts:

EXAMPLE: Mary wishes to give her four children an interest in her waterfront vacation home worth $1,000,000. Mary creates a limited liability company to which she transfers the vacation home. Mary appoints herself as manager. Without a valuation discount, Mary could transfer a 1% LLC interest to each of her children, representing a gift of $10,000 (1% x $1,000,000), all of which is sheltered from tax by Mary’s annual gift tax exclusion. Since Mary’s children are acquiring minority interests, and are subject to the transfer restrictions imposed by Mary in the LLC Operating Agreement, Mary is eligible for a valuation discount on the gifted interests.

A 35% valuation discount (readily acceptable by the IRS in such circumstances) allows Mary to gift $15,385 ($10,000 gift exclusion ¸ (1 -.35)) annually to each child. Accordingly, Mary could make larger tax-free gifts of 1.55 % to each child, retaining a 93.8 % interest in the LLC after the gift. Using the LLC, Mary is able to gift precise fractional interests in the vacation home annually. She also retains full control of the vacation home after the transfer, which would not have been the case if Mary had simply added her children to the deed as joint owners.

Mary would be advised to annually gift LLC membership interests until she gave away all but one (1%) percent of her interest in the LLC. Since in our example it would take Mary 16 years to gift 99% of her interest, she should consider gifts to grandchildren and other family members as well as making taxable gifts.

CHARITABLE TRANSFERS

Charitable transfers generate an income tax deduction if made during life (inter vivos gifts), and are deductible for estate tax purposes when made at death (testamentary transfers). The advantage of inter vivos gifts over testamentary transfers is that they are tax deductible for income tax purposes, and also remove the gifted asset from your estate.

Lifetime gifts can substantially reduce the tax bite of high-income taxpayers with large estates. Apart from the obvious tax benefits associated with charitable giving, charitable transfers also fulfill your “social contract” by subsidizing programs, scholarships and other charitable endeavors that advance the charitable causes you support.

There are as many reasons for making charitable gifts, as there are charitable givers. Whether you want to give to charity in order to give something back to your community, for religious reasons, to better society, to repay an institution or cause that made a difference in your life, or just because you were brought up that way, why not give in a way that allows both the charity and you to benefit?

There are a myriad of options and gifting vehicles available to anyone with a charitable bent. Naturally, gifts can be made in cash. You may also gift personal property, appreciated stock, and real estate. The federal tax code also permits, and even promotes, a wide variety of gifting vehicles discussed below.

A charitable deduction is available for contributions to “501(c)(3)” organizations; which include churches, educational institutions, foundations and other organizations promoting charitable works. The philosophy behind the deduction is that taxpayers should be encouraged to support organizations engaged in charitable works that the government would otherwise be forced to provide.

To promote gifting, a number of “split interest” trust options are available. All split interests involve the division of the gifted assets into two component parts: income and principal.

The most common split interest gifts allow you to retain the income from the gifted asset for a period of years or your lifetime with the charity receiving the remaining principal at your death. “Charitable remainder trusts,” “pooled income funds” and “charitable gift annuities” fall into this category. “Charitable lead trusts,” by contrast, reverse the sharing of income and principal, allowing the charity to enjoy the income from the gifted asset for your life, with your family owning the gifted asset outright at your death.

You will need the assistance of an estate planning attorney to help choose the appropriate gifting vehicle for you. Most established charities have a planned giving professional on staff who can also provide valuable information.

Split interest gifts allow you a current income tax charitable deduction without requiring you to forfeit the entire enjoyment of the gifted asset. You give the charity future ownership and retain the income for a period of years (not exceeding 20) or life.

Your charitable deduction is less than the fair market value of the gift since the charity cannot immediately enjoy the gift. A somewhat complicated calculation of the present value of the gift must be made to determine your income tax deduction (see below).

CHARITABLE REMAINDER TRUSTS

Charitable remainder trusts (“CRT”) are the most common gift splitting vehicle. Highly appreciated assets that have been transferred to a CRT can be sold tax-free, solving the problem faced by older taxpayers who are often saddled with highly appreciated assets that cannot be sold without substantial capital gains.

Without a CRT, the standard of living of such individuals can suffer if the highly appreciated assets are not income generating. Despite their high net worth, people in this predicament have no spend able income.

The CRT itself is exempt from income tax, and therefore can sell highly appreciated property tax-free. After the transfer to the CRT, and the subsequent sale, the entire proceeds of the sale (undiminished by income tax) are available to pay an annual income.

You are entitled to a percentage (which must be at least 5%) of the value of the trust assets as valued on the first day of the year. Since the value of trust assts fluctuate, your income interest will change from year to year.

CRT distributions are taxable to you to the extent that the CRT has income. The character of the income is the same as in the hands of the CRT. Distributions are first considered ordinary income, then capital gains, then tax-exempt income, and finally tax-free return of principal.

The following example illustrates the use and operation of a CRT:

EXAMPLE: Assume that Mary (70 years old) has a substantial estate. She owns highly appreciated non-income producing stock worth $100,000 for which she only paid $5,000. If Mary were to sell the stock she would have a $95,000 capital gain. Hearing of the benefits of CRTs, Mary contributes the stock to a CRT. She elects to retain an 8% annual income interest for the balance of her lifetime. Based on tables provided by the IRS, Mary is entitled to a whopping $39,845 charitable income tax deduction (see chart) in the year the CRT is created.

In the first year, Mary will receive a distribution of approximately $8,000 (8% of $100,000) prorated to the extent the first year is not a full twelve-months. Mary, as Trustee of the CRT, will sell portions of the CRT stock as needed to pay herself her annual 8% amount. The sale of the appreciated stock by the CRT is not taxable to the CRT since it is tax exempt. The $8,000 received by Mary will be taxable to her as a capital gain since the trust had only capital gains. Note that if the CRT had ordinary income, the distribution to Mary would first be treated as ordinary income to the extent of the CRT’s ordinary income, with the excess treated as capital gains.

The actual dollar figure distributed to Mary will change from year to year depending on the fair market value of the CRT on January 1 of each year.

The table below illustrates the income tax deduction available to an individual creating a CRT. The calculation assumes a $100K contribution. The deduction depends on the age of the donor and the income interest retained.

POOLED INCOME FUND

Pooled income funds are another type of split-interest gift. Unlike CRT’s that are established by the donor, pooled income funds are created and operated by charities. Gifts to a pooled income fund are merged with the gifts of other donors, and, in that respect, closely resemble a mutual fund.

As with CRTs, you are entitled to a deduction in the year of contribution. The charitable deduction is based on your age and the funds highest rate of earnings in the previous three years. You give money or property to the fund in exchange for fund units, which entitle you to a pro rata share of the fund’s actual income each year for the remainder of your life. At your death, your share of the fund passes outright to the charity.

GIFT ANNUITY

In a charitable gift annuity, you make a gift to charity in exchange for a guaranteed income for life. A charitable gift annuity is very much like buying an annuity in the commercial marketplace, except that you get an immediate charitable deduction equal to the excess of the contribution over what the annuity is worth, based on IRS tables.

Unlike the pooled income fund or CRT, income from the charitable gift annuity is an obligation of the charity that does not depend on investment results. The rate of return on the gift annuity is not variable, as in a pooled income fund, or negotiable, as in a CRT.

As with any annuity, a portion of each year’s annuity payment is tax-free allowing you to recover your “investment in the contract” over your life expectancy. The simplicity of charitable gift annuities allows for much lower contribution limits, typically in increments of five thousand ($5,000) dollars (depending on the charity). You may recognize capital gain if appreciated assets are transferred to the charity to purchase the annuity.

CHARITABLE LEAD TRUST

A charitable lead trust is a CRT in reverse: the charitable beneficiary is entitled to the current income with the non-charitable beneficiary entitled to the remainder. The general rules of CRT’s apply to charitable lead trusts with the exception that there is no requirement that the payout rate be a minimum of 5%.

Charitable lead trusts are primarily used to save estate and gift taxes, and do not provide the same income tax saving opportunities as CRT’s. To accomplish this result, you must postpone the receipt of the trust assets by your family until the charitable lead interest of the charity has expired.

WEALTH REPLACEMENT TRUST

If you fear that making substantial gifts will deprive your children of their inheritance, you should consider a “wealth replacement trust.” Notwithstanding the bumper sticker credo, “I’m spending my children’s inheritance,” most parents want their children to be properly remembered. Fortunately, the needs of the family can be accomplished by creating a “wealth replacement trust” concurrently with the split interest trust.

A wealth replacement trust allows you to leave a substantially larger tax free inheritance to children. Here’s how it works: basically, a portion of the income distributed to you from your CRT is used to purchase a life insurance policy inside a wealth replacement trust (which is simply an irrevocable trust). At your death, the charity receives the assets remaining in the CRT, and your family receives the life insurance proceeds from the wealth replacement trust.

The net effect of this arrangement is as follows: 1. You get a substantial income tax deduction in the year you create the CRT. 2. Your taxable estate is reduced by the gift. 3. The charities of your choosing receive bequests at your death. 4. Your children receive tax-free life insurance proceeds.

The following diagram illustrates the use of a CRT in combination with a wealth replacement trust: