Top 10 estate planning strategies.

• Author: Capassakis, Evelyn M.
• Position: Part 1

Every estate planner has an arsenal of favorite techniques to offer clients. Part I of this two-part article presents five methods: use of lifetime gifts, insurance trusts, dynasty trusts, qualified personal residence trusts and grantor retained annuity trusts. The article discusses how each works, the types of clients for which each is suitable and technical and planning considerations.

When meeting with clients to discuss estate planning, tax advisers generally have an assortment of ideas they consider, discuss and present. This article discusses 10 estate planning techniques. It 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 (or troubling) technical considerations, discusses the type of client suitable for the concept and addresses some of the planning considerations involved.

One: Lifetime Gifts

Most taxpayers can accomplish significant estate planning objectives simply by taking advantage of lifetime giving. This includes making (1) maximum use of the annual exclusion, (2) lifetime use of the applicable exclusion amount and (3) lifetime taxable gifts.

How They Work

Annual Exclusion Gifts

Under Sec. 2503(b), every taxpayer can transfer up to $10,000 each year to any donee, free of estate, gift and generation-skipping transfer (GST) taxes.(1) There is no limit on the number of permissible donees. Annual exclusion gifts can be made to minors by using a Uniform Transfers to Minors Act account under applicable state law or a minor's trust that meets the requirements of Sec. 2503(c). If a client has a large family, significant wealth can be transferred and escape estate taxes, by making annual exclusion gifts.

Example 1: X, an individual, has three married children and five grandchildren. Giving $10,000 to each of these 11 donees, for a total of $110,000, saves X $60,500 in estate taxes if he is in the 55% estate tax bracket. If annual exclusion gifts are made in each of two calendar years, X can transfer $220,000, for a $121,000 tax savings.

The growth in value of the asset after the transfer date also comes out of the estate. If both X and his spouse are U.S. citizens or residents, X can double the gifts (to $440,000 over two years); his spouse can elect on a timely filed gift tax return to treat the gifts as made one-half by her (Sec. 2513), thereby doubling the benefit.

If other large gifts have been made or are contemplated for the same year, the gift-splitting election forces the spouses to consent to split all gifts made by both during the year to third parties. The spouses may not pick and choose which gifts to split; thus, they cannot decide to split only the annual exclusion gifts and no others.

Planning Considerations

Valuation discounts: If the annual exclusion is used to make gifts of property other than cash (such as real estate, an interest in a closely held business or units in a family limited partnership (FLP)), minority interest and lack of marketability discounts could be available. A client would be able to transfer a greater interest as a result.(2) If, for example, there were a 30% combined lack of marketability and minority interest discount,(3) in one year a client and spouse would be able to transfer $314,286 in value of a business, using the same $220,000 annual exclusions. Over five years, the client could transfer over $1.5 million in business interests, using just the annual exclusions.

One drawback, however, is that if the valuation used for gift tax purposes is found to be incorrect, the gift would use part of (and reduce) the applicable exclusion amount (or would be taxable). Given the change in the gift tax statute of limitations(4) (SOL), however, there may now be greater certainty as to valuations. However, for the SOL to begin to run, the transaction must be adequately disclosed on a gift tax return. Adequate disclosure may require substantial information under Regs. Sec. 301.6501(c)-1 (f).

Annual revaluations: A revaluation, with the attendant expense, would be required annually. However, if a taxpayer is making other gifts of these interests during the year, he would already have obtained a valuation. If the valuation is close to year-end, presumably the client would incur minimal additional expense to obtain valuations for both the year-end gifts and those at the beginning of the following year.

Medical and Tuition Payments

A client can also make unlimited tuition and medical payments to an unlimited number of beneficiaries under Sec. 2503(e). To qualify for this exemption, the transfers must be made directly to the educational institution or the medical care provider. If the client has grandchildren attending private school or beneficiaries with large medical expenses, transfers using this technique can add up quickly. At a 55% maximum estate tax rate, such transfers can also produce significant estate and gift tax savings.

Applicable Exclusion Amount

Similarly, a client can achieve a substantial benefit from using the applicable exclusion amount to make gifts during life. Under Sec. 2010(c), each U.S. citizen or resident can transfer up to $675,000 of property in 2001 without the imposition of estate or gift tax. The applicable exclusion amount (formerly the unified credit equivalent amount) increases incrementally from the original $600,000 for decedents dying in 1997 and earlier, to $1 million by 2006.

Outright Taxable Gifts

There are significant estate tax savings to be achieved from making lifetime taxable gifts.(5) If a donor survives the gift date by three years, the gift tax paid will not be included in his estate under Sec. 2035. Under that provision, the gift tax paid is included in the estate for estate tax purposes only if the donor dies within three years of the gift date. The result is to treat gifts made within three years of death the same as bequests for transfer tax purposes.

Example 2: H and W, a married couple, are in the 55% effective rate bracket for both gift and estate tax purposes. H's will leaves a $1 million interest in a business to D, his child. H needs $2,222,222 of assets to fund this bequest. The $2,222,222 will be included and taxed in H's estate, resulting in $1,222,222 of estate tax, leaving the desired $1 million for D. The estate tax is imposed on a "tax inclusive" basis (i.e., the amount used to pay the tax is included in the tax base).

If, instead, H gives D $1 million as a gift during life, he pays $550,000 in gift tax, for a total cost of $1,550,000 if H lives for three years from the gift date, a $672,222 savings. The gift tax is imposed on a "tax exclusive" basis (i.e., the amount used to pay the tax is excluded from the tax base). If the gift is a direct skip for GST tax purposes, the GST tax is not added back to the gross estate for estate tax purposes, effectively removing it from the gross estate.

Suitable Clients

General Application

Lifetime giving techniques work for all taxpayers, but work best for those with smaller estates. These taxpayers are less likely to be willing to incur the costs associated with some of the more sophisticated planning. They can have significant benefits for high-net-worth clients as well, particularly if used in combination with other techniques. As with all gifts, lifetime transfer techniques work best for property with significant appreciation potential.

Three-Year Rule

Because of the risk of inclusion of the gift tax paid under Sec. 2035, outright taxable gifts work best for clients likely to outlive a transfer by at least three years. As a corollary, if the client lives for too long beyond the three-year period, the lost opportunity cost attributable to the gift tax paid must be considered.

Planning Considerations

Carryover Basis

Because the income tax basis of the property transferred will carry over from the grantor, the income tax cost must be weighed, particularly if the gift is made outright to family members, rather than transferred to a grantor trust of which the client is the grantor for income tax purposes.

Two: Insurance Trusts

The creation of a life insurance trust is viewed by many as one of the main building blocks of an estate plan.

How They Work

Either the insured (i.e., the person on whose life the policy is held) or another party creates an irrevocable trust; the trust then purchases insurance on the insured's life. Occasionally, an existing policy is transferred to a trust. When the insured dies, the trust owns the policy; the policy proceeds are generally not included in the insured's estate for estate tax purposes.

Technical Considerations

Estate Tax

Under Secs. 2042, 2035 and Regs. Sec. 20.2042-1(b)(1), insurance proceeds payable on the life of the insured are included in his estate if (1) the insured retains "incidents of ownership" in the policy at death or relinquishes such rights within three years of death; (2) the insurance is payable to the insured's estate; or (3) the insurance is available for the payment of the taxes, debts or other expenses or charges of the insured's estate.

"Incidents of ownership" are defined by Regs. Sec. 20.2042-1(c) to include the right to designate the policy beneficiary; the power to cancel, surrender, pledge or borrow against the policy; the right to the cash surrender, value; a reversionary interest in the policy worth more than 5%; or any other right that gives the insured or his estate the economic benefits of a policy.

Thus, the insured must not have (either directly or indirectly) any policy rights or interests. In addition, if the insured relinquishes such rights (e.g., transfers policy ownership to a trust) within three years of death, the policy proceeds are included in his estate under Sec. 2035(a). It is thus preferable for the insurance trust to purchase the policy directly. If this is not possible and the insured...