Strategies for Reducing Estate Taxes
The key to keeping your estate intact for your beneficiaries is to reduce your estate tax liability through estate planning. There are many strategies available, and what is right
for your unique situation depends largely on your total net worth and how you want to distribute your assets. This page provides an overview of some of the most common tactics
used to reduce your estate's tax liability. These approaches fall into four categories: a gift-giving program while you are alive, the use of both lifetime exemptions if you are
married, the removal of assets from your estate by setting up trusts, and the use of life insurance to pay part of your estate tax liability.
Use Your Annual Gift Exclusions
The least complicated way to pass assets on to your beneficiaries is to use the annual gift exclusion and give them each annual gifts of up to $13,000 (or $26,000 from a couple) while you are alive. For instance, you and your spouse could give your two married children, their spouses, and your three unmarried grandchildren a cumulative total of $182,000 each year. When such gifts are given annually to several recipients, the annual gift exclusion can be an effective way to reduce the value of your estate and thus its estate tax liability. Additionally, you get to see your loved ones enjoy and use your gifts. To qualify for the annual exclusion, a recipient must have a "present interest" in the gift, which means that the recipient must legally be able to use the gift immediately.
If you want to use the annual gift exclusion but do not want to give control of the gifted assets to younger recipients, you can put the gift into a Crummey Trust. This is a special
type of trust that allows donors to meet the present-interest requirement and take advantage of the federal annual gift exclusion even though a transfer to a trust is usually considered
transfer of a future interest. A Crummey Trust satisfies the present-interest requirement by providing a 30-day window during which beneficiaries have the legal right to withdraw
all or a portion of the gifted assets. If a contribution is not withdrawn, the trust's terms specify when and how the assets can be used after that window expires.
Use Both Lifetime Exemptions
Many married couples assume that estate planning is unnecessary because the unlimited marital deduction allows the surviving spouse to receive all of the couple's assets without paying estate taxes. The result is that the lifetime exemption ($1.1 million as of 2010) of the first spouse to die is often unused. When the surviving spouse dies, the estate pays taxes on the full amount, which could be as high as 55%. To prevent this and take advantage of both exemptions, you can create a Family Trust, which is also called a Credit Shelter Trust, a Bypass Trust, or an Exemption Trust. At the first death, the estate can be split into a Family Trust for an amount up to the value of the lifetime exemption and these assets can be kept outside of the surviving spouse's taxable estate, even though the survivor has the lifetime use of those assets. When the first spouse dies, the trust uses the first exemption; the second exemption is used upon the death of the surviving spouse for the assets remaining in his or her estate. This type of trust is the most common way for families to reduce estate taxes.
Remove Assets from Your Estate
The most effective way to reduce the taxes to be paid by your estate is to make your estate smaller. Some ways to accomplish this are:
Limited Partnership (FLP): An FLP is a business
organization owned by family members, usually with
the parents as general partners with full control
and risk, and the children as limited partners with
no control and limited risk. The general partners
control the FLP's assets--which might include a family-owned
business, real estate, or stocks--including distribution
and investment decisions. Partners are entitled to
income from the partnership in porportion to their
ownership interest. By giving the shares of limited
partnership to your children, you can remove up to
99% of the asset's value from your estate. Additionally,
the limited partnership shares' value is highly discounted
because there is no market for them, so general partners
can transfer limited shares to family members at
a reduced gift-tax cost. The FLP must be conducted
like a business in order to withstand the formalities
of an IRS audit or legal challenge verifying that
the assets within the partnership are indeed business
related. FLPs should also be funded for likely debts
of the partnership. Personal assets shouldn't be
placed in the partnership.
Life Insurance to Pay Estate Taxes
Grantor Retained Annuity Trust (GRAT): GRATs
are irrevocable trusts that let you transfer income-producing
or highly appreciating assets to the trust, yet enjoy
an annuity from the assets for the fixed term of
the trust. At least once a year, you, as the grantor,
receive a fixed dollar amount. After the trust ends,
any assets remaining in the trust after payment of
your annuity go to the beneficiary. The gift tax
is paid based on the asset's original value reduced
by the present value of your retained annuity and
can be substantially less than corresponding estate
taxes, if the asset appreciates significantly.
Charitable Remainder Trust (CRT): A CRT allows
you to act on your charitable intentions while reducing
your estate taxes. This reduces your estate taxes
by removing a highly appreciated asset, such as stock
or real estate, from your estate. With this type
of trust, you as the grantor make a charitable gift
of a highly appreciated asset to the CRT's trustee
(who can be you), and the trustee sells the asset
(without paying capital gains taxes because the trust
is a charitable entity) and reinvests the proceeds.
Funds in the CRT are split between an income beneficiary
(typically you) and the remainder beneficiary (your
favorite charity or family foundation). At least
once each year for the term of the trust you receive
a fixed dollar amount or a fixed percentage of the
asset's value, revalued each year. After the term
expires, the balance goes to the charity. Because
you are able to sell an appreciated asset inside
the CRT without paying capital gains taxes, you are
able to enjoy a higher income stream for life from
the earnings of the CRT assets, which are undiminished
by income taxes while invested inside the trust.
Charitable Lead Trust (CLT): A CLT is functionally
the opposite of a CRT. In a CLT, the charity receives
the income from the trust and the remainder reverts
back to the donor's family (usually children) after
the trust ends. As with a CRT, a CLT reduces the
size of your estate. The value of your gift to your
children is discounted because the total value of
the property contributed to the CLT is reduced by
present value of the income stream to be paid to
the charity. If you have an asset that you think
will appreciate at a rate in excess of the IRS's
conservative rate assumptions, the excess appreciation
may be transferable to your beneficiaries with little
or no gift tax cost. A CLT is appropriate if you
are very charitably motivated.
Dynasty Trust:A Dynasty Trust uses the $2,000,000 (indexed for inflation) per donor exemption or $4,000,000 per a couple to transfer assets in trust for future generations, typically your grandchildren or great-grandchildren. This is a complex planning tool intended to protect as much as you can for as long as you can. By skipping one or more generations, your family can avoid the estate tax burden that would otherwise be levied at each generation. A Dynasty Trust can provide for your children (although it need not, if they are well off), but it is structured in a way that your children benefit from the assets without having the assets included in your children's estates.
Qualified Personal Residence Trust (QPRT): The
QPRT removes your home from your estate at a discounted
value. With a QPRT, your residence is transferred
into a trust for the ultimate benefit of your beneficiaries
(usually your children) after a specified time. Prior
to the end of the trust term, you can continue living
in your home. When the trust ends, the house becomes
the property of the beneficiary, and you must either
move or pay rent to continue living there. The QPRT
is most appropriate if your net worth is between
$2 million and $10 million and your house accounts
for a substantial portion of your assets. Because
using a QPRT involves giving up your home, this type
of trust works best for a vacation home.
Unlike a traditional insurance policy that is part of your estate, you can set
up an Irrevocable Life Insurance Trust (ILIT) as an entity separate from your
estate. The benefits paid to the trust are not subject to estate taxes and can
be earmarked to pay all or part of the estate's tax liability following your
death. The result is that your estate does not have to produce the cash to pay
the estate taxes.
To set up an ILIT, you have two choices: transfer an existing life insurance
policy to an ILIT, or purchase a new policy through an ILIT. Transferring an
existing policy removes that asset from your estate, but the process of changing
the policy ownership to the trust can involve many complexities. Also, there
is a tax rule that includes the proceeds of any life insurance policy transferred
by the insured within three years of death in the insured's estate. For this
reason, an ILIT is best funded with cash, and the trustee then acquires a new
policy for the benefit of the trust. Married couples can consider buying a survivorship
life, or second-to-die, insurance policy, which insures both spouses but pays
benefits only when the second spouse dies, which is when the insurance benefits
will be needed to pay estate taxes. Typically this type of insurance is less
expensive than insuring either spouse individually.
Using Strategy to Design Your Estate Plan
A comprehensive estate plan is likely to include a combination of several strategies
like those introduced in this article. Each has its advantages and disadvantages
and should be selected to suit your specific assets and goals. Talk to an estate
planning professional about your unique situation before making any decisions
about which strategies you want to use to reduce your estate tax liability.
Shoreline's Competitive Edge
Whatever your estate planning need, Shoreline Wealth and Investment Management can assist you in obtaining the best in tax planning advice.
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Charles M. Bloom, Registered Principal offers securities
and advisory services through Centaurus Financial, Inc. - Member FINRA and SIPC - 775 Avenida Pequena, CA, 93111 (mailing address: 3905 State Street Suite 7173, Santa Barbara, CA, 93105) - CA Life Insurance License No. 0A52786 - Centaurus Financial, Inc. and Shoreline Wealth & Investment Management are not affiliated companies.
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