Areas of Practice - Estate Planning
Estate Planning Practice Group
Federal Transfer Tax System | Federal Unified Credit | New York's Limitation
Unlimited Marital Deduction | Generation Skipping Transfer Tax | Transfer Tax Summary
Probate and Non-Probate Property | Revocable Trusts | Transfers in Trust
Choice of Fiduciaries | Gifting Program | Qualified Personal Residence Trust
Grantor Retained Annuity Trust | Charitable Giving | Conclusion
An Introduction to Estate Planning
This memorandum is designed as a preliminary introduction to a number of important concepts and terms involved in the estate planning process. It is our hope that this memorandum will provide you with an insight into the estate planning techniques that may be utilized in developing an overall estate plan for you and your family. This memorandum is not, however, intended to be a substitute for specific legal advice which takes into account your unique financial and personal situation.
Federal Transfer Tax System
We currently have a unified (estate and gift) transfer tax system. As the name implies, it is the transfer of property that is taxed, not the property itself. The system is unified in that the value of transfers made by gift during your lifetime and transfers made through your estate at your death, are combined and taxed under a single schedule. At your death, the gift tax value of certain lifetime gifts is added to the value of your estate, a transfer tax is computed on the entire amount and you are then given credit for any previously paid gift taxes. The gift and estate tax is imposed at graduated rates that reach 45% for taxable transfers in excess of $3,500,000.
Federal Unified Credit
The federal tax law provides for a transfer tax credit which is applied against the estate or gift tax. Currently, the effect of this credit is to allow property worth $3,500,000 to be transferred free of tax as part of your estate. Note that only $1,000,000 of this amount can be transferred during your lifetime without paying any gift tax. This figure is referred to as the “unified credit” or the “applicable exclusion amount”. Each person is entitled to this exclusion. Therefore, in the case of a husband and wife, with proper planning and asset ownership property valued at $7,000,000 can be transferred free of federal transfer taxation. However, the use of the applicable exclusion amount is limited to the value of the assets owned by each spouse. If a decedent’s taxable estate is less than $3,500,000, part of the applicable exclusion amount will be lost.
The Economic Growth and Tax Relief Reconciliation Act of 2001 altered the applicable exclusion between 2001 and 2011. The federal applicable exclusion amount for estates was $1,500,000 for years 2004 and 2005. It increased to $2,000,000 for the years 2006, 2007 and 2008 and then to $3,500,000 for the year 2009. In the year 2010 the estate tax is scheduled to be eliminated. However, it is important to note that the tax act of 2001 also provides that after December 31, 2010, if the act is not re-approved by Congress prior to that time, these beneficial provisions will disappear and the estate tax will revert back to the system which was in place as of 2001 with an applicable exclusion amount of approximately $1,000,000.
New York's Limitation
Effective January 1, 2004, New York state limits the unified credit to $1,000,000. Therefore, the federal unified credit and New York state unified credit no longer coincide. Thus, if one has an estate value of $3,500,000 there will not be a federal estate tax, but there will be a New York state estate tax in the amount of $229,200.
For married couples, special planning considerations can be discussed to either provide for no estate taxes to be due upon the first spouse's death or to force a small New York state estate tax in order to shelter more assets from federal estate tax upon the surviving spouse's subsequent death.
Unlimited Marital Deduction
In addition to the unified credit, an estate or gift tax deduction is allowed for qualified transfers to a spouse. This is known as the “marital deduction”. The effect of the marital deduction is to postpone rather than reduce transfer taxes because property which passes to a spouse that qualifies for the marital deduction will be taxed in the spouse’s estate upon his or her subsequent death to the extent of its then value. The marital deduction is available for both lifetime gifts to a spouse as well as testamentary transfers at death, both in any amount.
Essentially, the unlimited marital deduction allows a spouse to transfer to his or her spouse any portion, including all, of his or her entire estate free of tax at the first death. From a purely tax motivated standpoint, the transfer of the entire estate, however, is generally not the most advantageous method of transfer. In doing so, the availability of the transferring spouse’s applicable exclusion amount would be lost and a larger estate tax would be generated in the surviving spouse’s estate. In a situation where the combined assets of the husband and wife are not likely to exceed the applicable exclusion amount for either spouse an estate plan anticipating that everything will be left to the surviving spouse may be appropriate. However, in order to retain flexibility under such an estate plan in the event asset values increase significantly, the Wills should contain specific language authorizing the survivor to direct the creation of a trust designed to utilize the first spouse’s unified credit. This is often referred to as a “disclaimer” or “renunciation” plan.
Currently, if the unified credit and the unlimited marital deduction are properly incorporated in both estates, property worth $7,000,000 can ultimately be transferred free of federal estate tax.
Generation Skipping Transfer Tax
Operating in conjunction with the estate and gift transfer tax system is a second tier of tax called the generation-skipping transfer tax (“GST”). As the name implies, this system imposes a tax on transfers that “skip” generations. Unlike the gift and estate tax that is imposed on a graduated scale, the GST is imposed at a flat rate equal to the highest federal estate tax rate -- currently 45%.
The GST system was enacted in 1986 and is designed to plug perceived “loopholes” in the estate and gift transfer tax system. It is the intent of Congress that transfers of property be taxed once at each generational level. To illustrate, if a parent makes a transfer to a child, that transfer is subject to estate or gift taxation at the parent’s level. If the child subsequently makes a transfer to a grandchild, the transfer is again subject to estate or gift taxation at the child’s level. If, however, the parent decided to make a transfer directly to a grandchild (thereby skipping the child) the transfer would, prior to enactment of the GST system, be subject to tax only at the parent’s level. As a result of the enactment of the GST, if the parent makes a gift to a grandchild, both an estate or gift tax and a GST tax would apply at the parent’s level.
In an attempt to “soften the blow” of the generation-skipping tax for less wealthy individuals the GST system is designed with several exceptions, the most important of which is the $3,500,000 Generation-Skipping Transfer Tax exemption. Using the GST exemption, an individual can make generation-skipping transfers of assets worth up to $3,500,000 to grandchildren or lower generation individuals (or to trusts for the benefit of such individuals) without incurring the GST. Due to the Economic Growth and Tax Relief Reconciliation Act of 2001, the GST exemption is now equals the Applicable Exclusion Amount but will go back to $1,000,000 in 2010, if not reenacted by Congress.
Transfer Tax Summary
As you can see, the transfer tax burden can be onerous, particularly if both an estate or gift tax and the GST tax apply to the same transfer. The applicable exclusion amount, marital deduction and annual exclusion (described below) are all applied to the gift and estate transfer tax system, but not the GST tax system (with the exception of certain annual exclusion gifts made directly to grandchildren).
Probate and Non-Probate Property
It is important to note that your Will can control only the disposition of your probate property. Certain types of assets (“non-probate property”) pass outside of your Will. The disposition of these types of assets is controlled by documents other than your Will. One example of non-probate property is a life insurance policy on your life, the proceeds of which pass at your death to whomever you have named in the policy beneficiary designation. Another example is property owned jointly, with rights of survivorship, which upon your death will pass to the surviving joint owner. A third type of common, non-probate property includes retirement benefits such as an IRA or pension, which upon your death passes to whomever has been named in the beneficiary designation, or if none, according to the plan document. Another increasingly common type of non-probate asset is property held in a Revocable Trust. Proper estate planning requires a complete knowledge of all of an individual’s assets, including both probate and non-probate assets.
Revocable Trusts
The revocable trust (sometimes referred to as a “living trust”) is a useful tool for avoiding probate, and for the management of property if the person who created the trust (the "Settlor") becomes incapacitated. By avoiding the probate process, revocable trusts also offer a level of privacy which Wills do not. When a person dies, the Will is submitted to the Court for probate at which point it becomes a public document that anyone may read at any time. A revocable trust, since it never goes to court, does not become a public document and therefore keeps many personal matters private. It is important to note that a revocable trust offers no tax advantages over a Will, and a revocable trust must be funded during the person's lifetime in order to avoid probate. However, with proper planning and funding, a revocable trust is a convenient tool for managing property, especially in the cases of incapacity or a long illness.
Revocable Trusts are typically designed for the sole benefit of the Settlor during his or her lifetime. In addition, as the name implies, the Settlor may modify, amend or revoke the revocable trust during his or her lifetime. Thus, a revocable trust is an extremely flexible instrument. However, because of the flexibility of a revocable trust, it does not provide the Settlor with any protection from creditors nor does it shelter assets beyond the reach of Medicaid in order to determine eligibility.
In conjunction with a revocable trust, a “pour-over” Will is also recommended. A pour-over Will is the common term for a simple Will which, upon death, disposes of a person’s probate property by directing such property be given to the trustees of the person’s revocable trust, and disposed in accordance with the provisions of such revocable trust. The pour-over Will is a necessary tool in order to “catch” any assets which may not have been titled in the revocable trust and place such assets in the trust upon death.
Transfers in Trust
There are substantial tax and non-tax benefits to having your beneficiaries receive all or a substantial portion of their inheritances in trust. To briefly note the major items, consider the following:
Non-Tax Advantages of an Inheritance in Trust:
1. The assets in a trust are not subject to the claims of the creditors of the beneficiary.
2. The assets in a trust are not subject to marital division in the event of divorce, separation or other financial settlement between beneficiaries and their spouses.
3. In the event the trust beneficiary dies, you can ensure that the assets that you have generated will pass according to your wishes. For example, if a beneficiary dies, you could provide that the trust fund would continue for the benefit of that beneficiary’s children, etc. and the assets would not be diverted to a spouse of a beneficiary who may subsequently remarry and/or provide for other children, etc.
4. The assets in a trust provide a financial security net for the beneficiaries. Thus, even though a beneficiary may have invested his or her own assets imprudently or have poor experience in business, the assets in the trust would continue to be available to him or her to provide for basic needs such as food, clothing and shelter.
Tax Benefits of an Inheritance in Trust:
1. A trust can be designed so that no estate tax is imposed upon the assets in a trust at your death or your beneficiary’s death.
2. Distributions from a trust can be made directly among several generations of beneficiaries such as to a child or grandchild whereas if the assets were given outright to the child, later transfers to the grandchild could constitute taxable gifts from the child to the grandchild.
Choice of Fiduciaries
The development of an estate plan not only involves an analysis of your assets and family situation, but also the identification of individuals or institutions capable of seeing to it that your wishes are observed. Typically, an individual will name one or more Executors to handle estate administration as well as one or more Trustees to handle the administration of any ongoing trusts. In addition, if you have minor children the appointment of Guardians is typically handled through your Will.
Executor. The job of an Executor is to “settle” your estate. The job of Executor includes collecting the decedent’s assets, paying outstanding debts, filing any necessary tax returns (including income, estate and gift tax returns) paying any tax due and, upon termination of the estate, distributing the assets of the estate as directed under the decedent’s Will.
Generally, individuals name as Executors close family members (such as a surviving spouse or child), close friends, business associates, professional advisors and/or financial institutions. As a general rule it is not necessary to appoint as Executor an individual who possesses all of the technical expertise needed to settle an estate. The named executor may hire the professional advice needed to guide him or her with respect to the requirements of appropriate estate administration.
We recommend that you name a successor Executor in addition to the primary Executor in order to avoid the necessity of a court proceeding in the event the first named Executor is unable to serve.
Trustee. The job of a Trustee is to “administer” a trust in accordance with its terms. Usually, the Trustee is responsible for the investment of trust assets as well as for decisions regarding the distribution of trust income and principal to or for the benefit of the trust’s beneficiaries.
Often Trustees are given a significant amount of discretion in deciding how, when and in what amounts distributions will be made from a trust. Accordingly, it is important to name as Trustees individuals in whose judgment you have a great deal of confidence. We recommend that you also provide a mechanism for the removal and replacement of Trustees in the event a trustee becomes disabled or becomes unresponsive to the needs of the trust’s beneficiaries. Moreover, since many trusts are designed to last for a period that may extend well beyond any one trustee’s lifetime, a mechanism to provide for long-term trustee succession is important.
With a revocable trust, often the creator (or “Settlor”) is the sole trustee during his or her lifetime. However, it is very important, at the time of creation of the revocable trust, to appoint a “successor trustee” to administer the trust assets upon the death or incapacity of the Settlor. Many times, the person who is named Executor of an individual’s Will is the same person who will be named as successor trustee.
Trust Protector. Typically, a Trust Protector is named as a way of providing for Trustee succession without the necessity of an extended Court proceeding. A Trust Protector may be granted the authority to remove a trustee, to designate an additional or successor trustee or to fill a vacancy in the office of trustee if one arises. In most circumstances, the Trust Protector has no responsibilities unless and until there is a problem with one of the trustees, between the trustees or between the trustee(s) and a beneficiary.
For example, if a disagreement arises between a beneficiary and the Independent Trustee over access to trust funds, without a Trust Protector the beneficiary's only recourse might be to seek judicial intervention and the removal of the Independent Trustee. This can be very costly, time consuming, public, and the results may not be to the beneficiary's liking. For a court to remove a trustee is very unusual unless the trustee has acted dishonestly or in bad faith. If a Trust Protector is appointed, however, he or she could remove the Independent Trustee or intercede as a moderator between the beneficiary and trustee.
We recommend that a successor Trust Protector be named and/or that a procedure be put in place whereby someone or some group of people are authorized to name a successor in the event of a vacancy in the Trust Protector's office.
Gifting Program
A significant method of reducing the amount of estate tax imposed is by the use of lifetime gifts.
Annual Exclusion Gifts. Under current gift tax law, a $13,000 per donee annual exclusion is available to every person. This exclusion allows you to make annual gifts of up to $13,000 per person to as many people as you desire. Married persons are entitled to take advantage of a special provision in the gift tax law and “split” a gift made by one of them, thus doubling the annual exclusion amount for the propertied spouse in those situations where the other spouse does not have sufficient assets of his or her own to make annual exclusion gifts. Whether through direct or “split” gifts, a husband and wife may give in the aggregate up to $26,000 a year to each of their children and grandchildren or to anyone else to whom they wish to make gifts. A regular program of gifting over a period of years can significantly reduce your taxable estate. These gifts can be made outright or to a special type of trust for the benefit of one or more donees.
Annual exclusion gifts are entirely outside of the estate and gift tax system. Thus, through the use of lifetime annual exclusion gifts, you can reduce your taxable estate without using your $3,500,000 applicable exclusion amount, thereby ultimately passing on significantly more assets to your beneficiaries tax-free. Moreover, by gifting assets that you expect will appreciate, you have also removed the appreciation from your estate and will not subject it to estate taxation upon your death.
Inter Vivos Insurance Trust. Another gifting method used to increase the amount of property available to your beneficiaries while increasing the liquidity of your estate is to create an insurance trust. Significant estate tax savings can result by removing some or all of the insurance on your life from your taxable estate by transferring the policies to a separate trust during your lifetime. If the trust is properly planned and you survive the transfer by at least three years, the insurance proceeds will escape taxation at the insured’s death as well as at the death of his or her spouse or other beneficiaries. For example, if you create an insurance trust to own insurance on your life, then upon your death, the trustee will collect the proceeds of the policies free of tax. Thereafter, the trustee will distribute the income earned by the trust and the principal of the trust as you have directed in the trust agreement. Thus, all of the insurance proceeds are removed from taxation while remaining available to your beneficiaries.
In order to remove existing policies from your estate you must survive the transfer of the policies to the insurance trust by three years, however, once the three year period has elapsed, none of the insurance proceeds will be subject to tax in your estate and, if so designed, in the estates of your beneficiaries. In contrast, if the insurance is owned by you at your death, the full amount of the proceeds are subject to estate tax. It is important to note that if an insurance policy is acquired directly by the trust (so that it is never owned by the insured) there is no three year waiting period and the insurance proceeds are immediately excluded from the insured’s estate.
Qualified Personal Residence Trust
Another estate planning technique which permits you to transfer assets at less than their fair market value is a Qualified Personal Residence Trust (“QPRT”). With a QPRT, you can transfer a residence into a trust and retain the right to reside in the residence for a term of years (typically the term of years would be set at a period of time which you would be reasonably anticipated to survive). Provided that the trust meets technical IRS rules and regulations, the gift tax value of the property transferred to the trust (and effectively being given to the beneficiaries of the trust) would be equal to the fair market value of the property, less the fair market value of your retained right to live in the property for the term of years. Typically, this results in a discount in the value of the gift of between 20% - 40%. Under the proper circumstances (typically where the family is interested in retaining the residence beyond an individual’s lifetime), the use of a QPRT can be very useful in reducing gift and estate taxes. In the event you do not survive the term of the QPRT, the entire value of the property will be included in your estate, although if this happens, your estate is no worse off from a tax standpoint than if you did not transfer the property to the QPRT at all. Perhaps the best residence to transfer to a QPRT is a vacation home that the transferor’s family wishes to continue to own.
Grantor Retained Annuity Trust
Another gift and estate planning technique is the creation of a Grantor Retained Annuity Trust (“GRAT”). GRATs are similar to QPRTs since the value of the assets given to the trust is reduced by the value of your retained interest in the property. For example, under a GRAT you could transfer corporate stock to a trust and have the trust pay a stated annuity to you for a term of years. The value of the gift would be equal to the value of the stock transferred to the trust, less the value of your annuity interest. The benefit of using a GRAT is that you can transfer a portion of a company to your family at a reduced tax cost while retaining for a term of years an annuity interest in the stock given away. If the stock is capable of generating sufficient income to pay the annuity, a GRAT may make a great deal of sense.
Charitable Giving
Outright Gifts. Perhaps the simplest form of charitable giving is an outright transfer of assets to a charitable organization. Such gifts can be made during lifetime or upon death and can be made in cash or of particular assets. Perhaps the best assets to donate to a charity are those that have income tax consequences that are not eliminated by the owner’s death such as Individual Retirement Accounts. Unlike the income tax charitable deduction which may be limited depending on the donor’s other income, the gift and estate tax charitable deductions are unlimited in nature.
Charitable Remainder Trust. Another form of charitable giving involves the use of a Charitable Remainder Trust (“CRT”). A CRT is an irrevocable, tax exempt trust that requires annual or more frequent payments to an individual or individuals for a term of years (not to exceed 20) or for such individuals’ lifetimes. The payments must be of a specific dollar amount or percentage of the value of the trust, provided that the initial payment must be equal to at least 5% of the value of the trust. Upon the termination of the interests of the individual beneficiaries the balance of the trust is to be paid to one or more designated charities or other types of qualified tax exempt entities.
A CRT is a very useful estate planning tool and can be created to be effective during lifetime or at death. In the event of a testamentary transfer to a CRT, the income beneficiary would be an heir and the estate would be allowed a charitable deduction. As noted above, a CRT is tax exempt. The Settlor of a lifetime CRT is entitled to an income tax charitable deduction (subject to certain limitations) in an amount equal to the present value of the eventual gift to the charity. Therefore, the Settlor will have an income tax savings resulting from the deduction which will be available for reinvestment.
The value of the assets in a lifetime CRT that terminates at the Settlor’s death are removed from the Settlor’s estate, thereby reducing estate taxes. A CRT can also be designed to suit a Settlor’s particular needs and purposes. Although nearly any assets can be transferred to a CRT, the transfer of highly appreciated assets may be most beneficial since the sale of the assets within the CRT will not be subject to an immediate capital gains tax, thus leaving the entire value of the transferred assets available to generate income and capital appreciation for the benefit of the individual beneficiaries.
A family foundation can be the charitable remainderman of a CRT. Thus, the family could have some continued involvement in how the charitable dollars would be applied within the community.
Frequently, an irrevocable life insurance trust is used in concert with the CRT in an effort to replace for the individual’s family the value of the assets eventually passing to charity. In effect, an individual would create both a CRT and an irrevocable insurance trust with the CRT generating income during the individual’s lifetime (usually in amounts greater than were being generated outside of the CRT). A portion of the income would be used by the individual to fund the insurance trust. At the individual’s death (or perhaps at the death of his or her spouse) the assets in the CRT would pass to charity while the assets in the insurance trust would continue for the benefit of the individual’s family.
Conclusion
We hope this memorandum has provided a useful introduction to the estate planning process. The Tax, Business, Estate and Trust departments of the Scolaro Law Firm constitute one of the largest groups of attorneys in Central New York focusing on the development and implementation of estate and business succession plans. We welcome the opportunity to work with you and your other professional advisors in developing the estate plan that best fits the needs of you and your family.
Unless expressly stated otherwise above, (1) nothing contained in this correspondence was intended or written to be used, can be used by any taxpayer, or may be relied upon or used by any taxpayer for the purposes of avoiding penalties that may be imposed on the taxpayer under the Internal Revenue Code of 1986, as amended; (2) any written statement contained in this correspondence relating to any federal tax transaction or matter may not be used by any person to support the promotion or marketing or to recommend any federal tax transaction or matter addressed in this message; and (3) any taxpayer should seek advice based on the taxpayer's particular circumstances from an independent tax advisor with respect to any federal tax transaction or matter contained in this message. No one, without our express written permission, may use any part of this correspondence in promoting, marketing or recommending an arrangement relating to any federal tax matter to one or more taxpayers.
Scolaro, Shulman, Cohen, Fetter & Burstein, P.C.
315-471-8111
