Estate Tax Saving Strategies

As one may surmise from the many alternatives reviewed briefly below, additional information, documentation, consultations with advisors or meetings may well be necessary before solutions can be recommended. Dependent upon the complexity, net worth and objectives of the estate, the Law Offices of Michael J. Wittick, P.L.C. may need to analyze, test and challenge combinations of planning theories and strategies for the optimal allocation, distribution and protection of your assets. The preliminary plan may also need to be enhanced by the contributions of your other advisors. In fact, it has been said that in an advanced estate plan, most of the work is in the design.

1) Unlimited Marital Deduction (UMD) Delays the Tax
An unlimited amount of assets transferred to a surviving spouse pass tax free at the time the first spouse dies, as long as the surviving spouse is a U.S. citizen. But this doesn’t solve your problem because it only delays the tax until the surviving spouse dies. In fact, the UMD is premised on the theory that the tax will be paid when the surviving spouse dies and the requirements to qualify for the UMD are designed to make sure that the property will later be included in the surviving spouse’s estate. One way to disqualify a transfer to a spouse from the UMD is if the interest transferred can terminate or lapse upon the passage of time or occurrence (or non occurrence) of an event. You therefore should seek advice of competent counsel to make sure your transfer qualifies for the UMD.

2) Doubling the Exemptions of a Married Couple Avoids the Tax
If the decedent’s assets pass to the surviving spouse in a manner that qualifies for the UMD but there is no further planning to preserve the decedent’s estate tax exemption, such exemption will not be utilized and will therefore be lost forever. However, a married couple can double their exemptions available at the second death in their living trust by including a Bypass Trust funded with the assets of the first spouse to die, up to his or her exemption amount. That trust then bypasses the second death tax free because, by its terms, the surviving spouse does not own any of the Bypass Trust assets. This bypass trust therefore avoids the tax because it preserves and utilizes the decedent’s exemption. The surviving spouse’s exemption also remains available at the second death.

3) Life Insurance
Within the estate planning process, life insurance should be purchased for two purposes: to create a part of your estate that does not exist or to protect an existing estate from losses that will be sustained through estate taxes and probate costs.

Life insurance purchased to create an estate should be looked upon as casualty insurance – insurance purchased to replace income loss resulting from the death of the family bread-earner and to maintain your heirs’ lifestyles in the event of that death. Life insurance purchased to protect an existing estate from estate tax and probate expenses is one of four generally utilized categories of advanced estate tax planning in excess of that available in a revocable living trust.

a) Leveraged Payment of Tax

For either of its estate planning purposes, life insurance represents leverage because what it buys in death benefits is much more than it costs in premiums. It may therefore be used to pay any estate tax with pennies on the dollar. It is also a low risk investment that can be favorably compared to a Roth IRA invested with after tax dollars into an investment that appreciates income tax free and pays off income tax free. There is only one hang up, which is that the insured must die before the beneficiary receives the pay off. However, estate planning is, in part, post death planning and therefore results in post death expenses that can be catastrophic. Furthermore, estate tax is due nine months after death in cash. The thought of selling significant business assets that may destroy ones business, just for the purpose of paying off estate tax after death, has been known to cause many a business owner to develop a twitch. Even if you don’t own a business, you may find that like many other estates, your estate is cash poor. If you are one of the many owners of a family business whose expertise is an absolute necessity to the proper operation of the business, proper business succession planning requires that your life be adequately insured.

Because a properly structured estate plan delays estate tax until the second death through the Unlimited Marital Deduction, many consider the benefits of Second to Die Life Insurance for the purpose of paying their estate tax bill in a leveraged manner. Such insurance insures both spouses but only pays off at the death of the surviving spouse. Thus otherwise uninsurable spouses may be covered and insurance premiums are lower than for single life insurance. Other spouses desire that the coverage be available to maintain the surviving spouse’s standard of living and purchase enough Single Life death benefit to anticipate that it will also be available to pay any estate tax at the second death. Yet other spouses exercise a combination of both strategies. This is a good example of how your estate planning attorney should work with a qualified life insurance specialist to explain the best option for you.

b) Ownership by Irrevocable Trust can Double the Death Benefit

If the insured owns life insurance on his or her life, all of the life insurance death benefit proceeds will be included in his or her estate for federal estate tax purposes. And ownership is not simply a manner of who is listed as the owner of the policy but is determined primarily by Treasury regulations setting forth “incidents of ownership” which, if possessed by a decedent, will mean that the insurance proceeds will be taxed in his or her estate. These “incidents of ownership” include but are not limited to who has the power to change the beneficiary, to assign the policy, to borrow on the policy, to surrender or cancel the policy, and other rights of control over the policy.

In choosing the best owner of your life insurance, you should consider the purpose of the insurance, such as to replace income, provide liquidity or transfer wealth to your heirs, and weigh those factors against the importance to you of avoiding estate tax on the death benefit. If you give up all “incidents of ownership” in a life insurance policy insuring your life, you may avoid having the death benefit proceeds taxed in your estate. In making this determination, you must first calculate if any part of the death benefit of your life insurance, when included in your net worth, is subject to estate tax by being in excess of your estate tax exemption if you are single or in excess of both exemptions of a married couple who have doubled their exemptions in their living trust as set forth above. For example if a single decedent in 2011 has a net worth without life insurance in the amount of $1,000,000 and his or her life is insured for another $1,000,000, then 55% of that life insurance policy will be subject to estate tax.

Those who have listed others as owners of life insurance on their lives are taking the risk that no “incident of ownership” will be found attributable to the insured, a substantial risk indeed, if the cost is that the insurance proceeds will be subject to a 50% tax bracket. Many other problems associated with nonowned life insurance are beyond the scope of this article. On the other hand, an Irrevocable Life Insurance Trust (ILIT) designed to own and be the beneficiary of life insurance is acknowledged in the industry as the best way to make the life insurance estate tax free upon your death and the death of your spouse. The terms of the ILIT controls how the death benefit will then be distributed to the beneficiaries and/or pay the death expenses including estate taxes. If the full amount of the life insurance would otherwise be subject to a 50% bracket as in the above example, the result of having utilized this strategy is that you would have doubled the death benefit of your life insurance, by removing it from that 50% tax bracket. That leverage combined with the leverage of your premiums costing far less than the death benefit substantially reduces the effective cost of the estate tax paid by your life insurance.

4) Discounting the Assets which reduces the Tax
Tax PlanningAs long as there are valid non tax business purposes for a Family Limited Partnership (FLP) or Limited Liability Company (LLC), certain assets transferred to those business entities would ordinarily be subject to valuation discounts. These discounts are the second generally utilized broad road to explore in advanced estate tax planning.

A lack of control or minority interest discount is applied when the owner of the interest does not have managerial control over the FLP or LLC policy and cannot force distributions or liquidation of the entity to get at the core assets, making the interest less attractive to investors.

A lack of marketability discount reflects the difficulties inherent in the sale of an interest in a non listed private business which lacks the inherent liquidity of an interest in a listed business, such that there is no ready market for the sale. Accordingly, the lack of marketability discount applies to both minority and majority interests in the same business. This could be due to restrictions imposed by the FLP or LLC or due to restrictions imposed by state or federal law.

FLP or LLC interests may also be gifted to children or other family members at valuation discounts, thereby not only lowering gift taxes but also eliminating the gift from the donor’s estate.

However, it is emphasized that these entities must be established with nontax business purposes before the courts will allow the discounts. Some nontax business purposes are asset protection, financial tutelage and incentives for children through the business structure, maintaining control and lifestyle while engaging in meaningful estate planning, spreading income generated by invested assets to more family members, consolidation of family assets to centralize management and reduce costs, control over ownership interests through private arbitration of disputes, efficient wealth transfer (gifting) opportunities, flexibility, and encouragement of family unity.

It is also important to consult with competent practitioners who are familiar with the cases of IRS opposition to discounts which provide a roadmap of how to draft and implement these business entities so that the discounts will be respected by the courts.

5) Gifting Assets to reduce the Tax
a) Annual Exclusion Gifts

There is an “Annual Gift Tax Exclusion” which provides that 2008 gifts to anyone of $12,000 or less per recipient and 2009 gifts to anyone of $13,000 or less per recipient are not subject to gift tax. Annual Exclusion gifts can reduce the size of your estate and thus reduce your estate tax. This exclusion is indexed for inflation and will therefore likely increase in the future. Gifting assets that are likely to appreciate is a way of leveraging these gifts. Married couples can combine their exclusions and give up to $24,000 in 2008 and $26,000 in 2009 to as many persons as they wish. Payments of any amount for school tuition and medical expenses that are made directly to the school or medical provider are tax free and are in addition to the annual exclusion.

b) The Gift Tax is Exclusive, an Advantage over the Inclusive Estate Tax

Although gift and estate taxes are applied at the same rate, they are calculated differently. The gift tax is “tax exclusive”, meaning the gift excludes the tax, whereas the estate tax is “tax inclusive”, meaning the bequest includes the tax. Example in a 50% bracket: Gift of $1,000,000 creates additional tax of $500,000. Total cost of gift: $1,500,000. Effective tax rate: 33 1/3 %. However, to leave a bequest of $1,000,000, the amount you leave is reduced by a 50% tax. Total cost of $1,000,000 bequest plus $1,000,000 tax: $2,000,000. Effective tax rate: 50%. Therefore, you pay less taxes on assets transferred before you die than on assets transferred after death.

c) Estate Freeze Strategies

Clients who can afford to take advantage of gifting their assets during life sometimes utilize a variety of irrevocable trusts to do so in which they retain an interest or income for a period of years after which the asset passes to the beneficiaries for a discounted or zeroed out remainder value subject to gift tax. This is the third generally utilized major road one investigates during advanced estate tax planning. The goal of this strategy is to remove an appreciating asset from one’s estate in this leveraged manner while retaining the income interest, which may be structured so that the grantor recovers the value of the original asset in income, and then take advantage of the gift tax exclusive rate. This can be a particularly attractive option in a bear market when values have been depressed and appreciation is anticipated to be greater in the future.

It is beyond the scope of this article to detail the myriad of irrevocable trusts which can remove appreciating assets from one’s estate. However, two commonly used tools for this purpose are Grantor Retained Annuity Trusts (GRATs) and Intentionally Defective Grantor Trusts (IDITs). Both are normally utilized by clients who can afford the gift of an income producing asset without affecting their lifestyle, want to pass significant wealth to children or heirs, need to minimize estate tax and their life expectancy is long enough to take advantage of the strategy. A GRAT allows a donor to transfer property to an irrevocable trust in the manner described in the paragraph immediately above. An IDIT is generally structured as a sale of certain assets to an irrevocable trust owned by the grantor in return for a note or an annuity which is a completed transfer for estate and gift tax purposes but incomplete or defective for income tax purposes. Therefore, advantages of an IDIT are that the grantor not only removes appreciation from his estate and pays no gift tax but there is no capital gain on the sale transaction because the sale is treated as being from the grantor to a trust owned by the grantor.

Please refer to Mr. Wittick’s presentation on Special Tax Savings Trusts for Spouses or Build Up Equity Retirement Trusts, for yet another estate freeze strategy, which allows spouses to gift to each other in ways that are exempt from gift and estate tax, allow the assets to grow income tax free for retirement and then pass the same assets to the children free of estate tax.

6) Estate Tax Charitable Deduction Gifts
Please reference Charitable Planning for the fourth generally utilized road to advanced estate tax planning, which qualifies for the estate tax charitable deduction, among other benefits.

7) Special Strategies
a) Second Marriages

Estate planning for the second marriage can be complicated and emotional, especially when children from a prior marriage are involved. Finding the right planning technique for your situation can not only ease family tensions but also help you avoid disputes between the surviving spouse and step children that often arise after the death of the biological parent.

A QTIP marital trust can maximize estate tax deferral while benefiting the surviving spouse for his or her lifetime and the children after the spouse's death. A common estate planning concern is that assets left to a spouse will eventually be distributed in a manner against the original owner's wishes. For instance, you may want stock in your business to pass only to the child active in the business, but your spouse may feel it should be distributed to all the children. Or you may want to ensure that after your spouse's death the assets will go to your children from a prior marriage. A QTIP will allow the decedent to control its beneficiaries. Combining a QTIP with life insurance benefiting the children in specific ways can further assist in accomplishing each spouse’s objectives. For example, if the husband’s net worth was higher upon entering a blended marriage and he wants to leave his assets to his children by prior marriage, he could purchase life insurance on the life of his wife and allow the beneficiaries to be her children by prior marriage.

A pre or postnuptial agreement can also help each spouse achieve their estate planning goals if they wish to divide community property from separate property so that each can be left to children by prior marriage. Such an agreement could then become an exhibit in standalone trusts for the community and separate property to clarify and achieve planning objectives.

It is very also important in second marriages with children by prior marriage to avoid conflicts of interest in the selection of trustees, for example, if there is any distrust of the step parent trustee by the step children.

b) Unmarried Couples

The California Domestic Partner Rights and Responsibilities Act of 2003 provided that most of the state law rights and responsibilities of married couples also applied to domestic partners but this is not automatically applied and unmarried couples must register as such with the Secretary of State and comply with the Act. There are also many unanswered questions as to how that law applies to federal law and until those questions are answered, it is our feeling that it is better to create separate estate plans for each partner.

The unlimited marital deduction does not apply to domestic partners which can create an overwhelming tax burden at the first death. One solution is to create a bypass trust for the surviving partner much like married couples utilize in their estate planning for the purpose of removing those assets from the estate of the surviving partner. Other alternatives are to create an Irrevocable Life Insurance Trust or Charitable Remainder Trust for the benefit of the other partner.

c) Noncitizen Spouses

The unlimited marital deduction also does not apply to noncitizen spouses unless the assets are transferred to a Qualified Domestic Trust (QDOT), which satisfies the government’s concern that the noncitizen spouse would inherit the assets tax free and then leave the country without paying tax, by imposing special requirements to insure that the tax will be paid. Additionally, there is a special increased annual gift tax exclusion for gifts to noncitizen spouses, indexed for inflation, which in 2008 is $128,000 and for 2009 will be $133,000.


Law Offices Of Michael J. Wittick, A Professional Law Corporation is located in Irvine, CA and serves clients with estate and wealth preservation matters throughout Irvine, Lake Forest, Laguna Woods, Laguna Hills, Foothill Ranch, Tustin, Aliso Viejo and the surrounding areas.

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