The basic goals of estate planning are to dispose of your property in accordance with your wishes and to avoid unnecessary taxes and expenses. This article has been prepared to help our clients understand the many different elements of estate planning. It is an introduction to a complex subject. It is not intended to be an exhaustive treatment of state and federal tax laws nor of the fiduciary law of any jurisdiction. It should not be used in lieu of consultation with counsel. We hope this information will help you gain a basic understanding of an increasingly complicated field, and we will be pleased to provide any assistance you may request.
The first step in estate planning is to prepare a list of assets held in your sole name, in your spouse’s sole name and in joint names. You should include property that would pass outside your Will, such as company benefits, IRAs, jointly owned property (including your residence) and proceeds of life insurance on your life. Interests in existing trusts and their nature (i.e., income or remainder) should be listed separately.
Values on this list may be approximate. The value of your residence or other real estate need only be estimated. It is not necessary to know the exact value of each security that you own, but it is useful to know the approximate value of all securities to the nearest $10,000 or even $25,000, and the approximate value of all bank accounts. Estimate the replacement value of household furnishings and personal effects and divide by three or four because their death tax value is what they would sell for at auction. Values always fluctuate, but the goal is to get an idea of the total value of your gross estate for death tax estimates and family financial planning. Included with this article as Appendix A is a brief estate planning form to help you formulate a more detailed picture of your gross estate.
Your list should include gifts over $3,000 made from 1976 through 1981, gifts over $10,000 made from 1982 through 2001, gifts over $11,000 made from 2002 through 2005, gifts over $12,000 made from 2006 through 2008, gifts over $13,000 made from 2009 through 2012, and gifts over $14,000 made after 2012, and the date of each gift. It is also essential to have available all gift tax returns filed by you or your spouse.
Another useful preliminary step, if possible, is to prepare a post-death budget, including all potential sources of income, such as Social Security, survivor annuities, the income from all your property and insurance remaining after payment of death taxes, debts and administration expenses. This will enable you to determine whether you need additional life insurance, either to protect your family or to pay death taxes and expenses.
Death Taxes and Estate Planning
The Federal Estate Tax
The federal estate tax will be the focus of most planning to minimize death taxes. Every individual is entitled to an applicable exclusion amount against the federal estate tax. In 2013, the applicable exclusion amount excludes from estate tax the first $5.25 million of taxable transfers at death. The applicable exclusion amount is adjusted for inflation. The effective estate tax rate in 2013 (that is, the tax rate on taxable estates after taking into account the applicable exclusion amount) is 40 percent on that portion of the taxable estate in excess of $5.25 million.
Since 1976, the federal estate tax has been combined with the federal gift tax so that all taxable transfers, whether lifetime or at death, are considered together when computing the estate tax. Thus, the tax imposed on your estate at death will be determined after adding the value of all post-1976 taxable lifetime transfers to your taxable estate.
Your gross estate includes all property (including life insurance) owned by you, certain company benefits, one-half of property owned jointly by you and your spouse, and all property held jointly with any other person to the extent your Executor cannot provide evidence that the other person contributed to its purchase price.
Funeral expenses, debts and administration expenses, and charitable gifts are deductible from your gross estate in computing your taxable estate. However, the most important deduction in many estates is the marital deduction for property passing to a surviving spouse. The estate of the first spouse to die is entitled to an unlimited marital deduction. To obtain the marital deduction, property must pass outright to the surviving spouse by Will or otherwise, or in the form of a qualifying trust. Unless disposed of by the surviving spouse during his or her lifetime, the marital gift will be subject to federal estate tax at the surviving spouse’s later death. Thus, full use of the unlimited marital deduction will defer all federal estate tax until the death of the surviving spouse, but could increase the tax at the death of the survivor.
The marital deduction is not available if the surviving spouse is not a U.S. citizen, unless the property passing to the spouse is placed in a trust meeting certain requirements. Estate planning in the case of a family in which a spouse is not a U.S. citizen requires special attention.
Types of Marital Deduction Transfers
Outright transfers to your surviving spouse, whether by joint ownership, beneficiary designation or bequests under your Will, all qualify for the marital deduction. In addition, a joint and survivor annuity qualifies for the marital deduction as long as only the surviving spouse has the right to receive payments during his or her lifetime.
There are two types of trusts commonly used that will qualify for the marital deduction: a general power marital deduction trust and a qualified terminable interest property (QTIP) trust. Both have specific requirements in order to qualify for the marital deduction. These trusts may be created at your death or may be established during your lifetime.
In a general power marital deduction trust, your spouse must receive all of the trust’s income for life and must either have a power to appoint the property in his or her Will to his or her estate or creditors (i.e., a general power of appointment) or unlimited right to withdraw the principal during his or her lifetime.
Like the general power marital deduction trust, your spouse must receive all of the income for life from a QTIP trust. However, unlike the general power marital deduction trust, you do not have to give your spouse a power to appoint the principal by Will or an unlimited right to withdraw the principal during his or her lifetime. Thus, you may obtain the marital deduction while retaining the right to control the ultimate disposition of your property. A QTIP trust may be especially valuable if you have children from a prior marriage.
In both trusts, the Trustee may invade principal for your spouse’s maintenance, health and support or for any other reason you may decide to specify. However, only the spouse may receive the principal during his or her lifetime.
Minimizing Total Federal Estate Taxes on the Estates of You and Your Spouse
Thanks to the unlimited marital deduction, you may give your entire estate to your surviving spouse without paying any federal estate tax. However, at your spouse’s death what remains of your estate will be subject to federal estate tax as a part of your spouse’s estate with the benefit of only the spouse’s applicable exclusion amount. The tax at your spouse’s later death may be reduced (or even eliminated) if you place in a separate non-marital trust that portion of your estate equal to the amount shielded from tax by the applicable exclusion amount. In this manner, both spouses’ exclusions are used.
Your spouse may receive all income for life from this non-marital trust and the Trustee may distribute principal for his or her and your children’s (or any other person’s) maintenance, health, education and support. You may also give your spouse the right to withdraw the greater of $5,000 or 5 percent of the principal of the trust each year on a noncumulative basis without the Trustee’s consent. If your spouse has such a power to withdraw principal, only the amount he or she may withdraw on the date of his or her death will be included in his or her estate for federal estate tax purposes. Amounts not withdrawn in prior years will escape taxation. In addition, you may give your spouse the power to give the principal by Will to anyone other than his or her own estate or creditors. Principal subject to such a limited power of appointment is not subject to federal estate tax at the death of the person holding the power.
To summarize, you may establish a tax-saving estate plan under which your surviving spouse may have: (1) at least all of the income from and up to full control over the marital deduction portion of your estate; (2) all income from the non-marital trust for life; (3) the right to withdraw the greater of $5,000 or 5 percent per year from the non-marital trust; (4) the right to have your Trustee invade the non-marital trust for maintenance, health and support; and (5) the limited power to appoint the non-marital trust by Will. In addition, your Trustee may have the power to invade the non-marital trust for the maintenance, education, health and support of your descendants.
By setting aside a portion of your estate in a non-marital trust to take advantage of the applicable exclusion amount, you will reduce the amount of the property qualifying for the marital deduction. Your spouse may then use the applicable exclusion amount at his or her death to shield an additional portion of the marital property from tax in his or her estate. Thus, up to $10.5 million may be sheltered between both estates in 2013. Using a non-marital trust will insure that both your and your spouse’s applicable exclusion amounts are utilized to the extent possible.
Recent tax law changes made permanent the concept of “portability,” which permits a surviving spouse to use the unused federal estate tax exemption of the first spouse to die, but only if the estate of the first to die files a federal estate tax return. However, portability has drawbacks, and the use of a non-marital trust remains a more tax-efficient method of using the applicable exclusion amount of the first spouse to die.
Trust Protection for Your Spouse and Children
Trusts also have a useful non-tax purpose — protection. Your spouse may not be experienced in the investment of significant sums of money. Even if completely capable now, he or she might become less capable in old age. In addition, your children might be too immature to handle large sums of money at age 18, which is now the age of majority in most states. To protect children, many people place a child’s share in trust, giving them, for example, one-half of the share at age 25 and the balance at age 30. Others establish a so-called “spray trust” under which the Trustee decides who will receive income and how much. A spray trust may also be used to spread income of the non-marital trust among several beneficiaries during your spouse’s lifetime.
Generation-Skipping Transfer Tax
The Generation-Skipping Transfer Tax (GSTT) is imposed independently of the estate and gift tax at the time property is received by persons who are two or more generations younger than the transferor. The tax is imposed at the highest federal estate tax bracket, currently 40 percent. Direct transfers to grandchildren (or in trust for them) are subject to GSTT at the time of transfer. Transfers in trust for a child with remainder to a grandchild are subject to GSTT at the death of the child. An additional GSTT will be due each time the trust passes to a still younger generation (great-grandchildren, etc.).
Each transferor has a GSTT exemption equal to the estate tax exemption.
The exemption applies to transfers during life and by Will. The exemption permits a person to create a trust for a child for life with principal payable to the child’s children free of both GSTT and federal estate tax. The exemption applies to the entire trust at the time of funding, regardless of how much the principal appreciates. Thus, a GSTT-exempt transfer (whether by gift or by Will) might result in a grandchild receiving two to three times that amount free of GSTT or federal estate tax at the death of his or her parent.
A GSTT trust can be extremely flexible. The child can be given a power to appoint the principal by Will to anyone except his or her estate or creditors. In Pennsylvania, the trust can be extended for future generations indefinitely, while other jurisdictions limit the term of the trust with the rule against perpetuities (21 years after the death of all trust beneficiaries living at the time of the transfer). Provision can also be made for income interests to spouses of descendants.
There is also a special provision under which the transferor may make use of his or her spouse’s GSTT exemption to the extent that the spouse does not otherwise make use of it.
Selecting an Executor, Trustee and Guardian
An Executor’s duties include: the collection of all assets in your sole name; payment of debts, funeral expenses and administration expenses; valuation of all assets subject to death taxes; filing an inventory and state and federal death tax returns, final income tax and personal property tax returns; electing to qualify certain trust income interests for the marital deduction; maintenance of records and preparation of an account in proper form for filing with the court; and distribution of your estate in accordance with the terms of your Will. Depending on circumstances, the Executor may also be involved in the division of personal and household effects, the sale of real estate not passing by joint ownership, or the management of a business.
Since an estate is a separate taxpayer for income tax purposes, an Executor may have the opportunity to plan for income tax savings during the course of administration. If distribution is outright, the investment role of the Executor may be limited, and many assets may be converted into cash. However, if distribution is to be made into a trust, the Executor may become involved with long-range investment policy, possibly in consultation with the Trustee (who may be the same person).
The Trustee’s duties have a somewhat different emphasis. A long-range investment plan tailored to the needs of the beneficiaries is essential. In addition, the Trustee may be involved with discretionary duties, such as applying income for a minor or incapacitated person, or invading principal for support or education.
An Executor or Trustee is entitled to reasonable compensation for his or her services. Banks ordinarily charge on the basis of a set fee schedule. In many cases, individual family members waive commissions. More than one Executor or Trustee may be chosen, and a trust company may serve with one or more individuals. The ultimate selection will be personal to you.
Another important choice you may make is selection of a Guardian of the person of minor children. Such a guardian does not have responsibility for your children’s money (except as distributed by your Trustee), but does assume personal responsibility for your minor children.
Joint Ownership with Your Spouse
Property owned jointly by spouses with a right of survivorship passes automatically to the surviving spouse on the death of the first spouse, without delay and without regard for the provisions of any will or trust. It also may avoid some (but not all) of the expenses of estate administration. A jointly owned bank account may be used by the surviving spouse immediately after the death of the first spouse.
One-half of the value of property you own jointly with your spouse will be included in your gross estate for federal estate tax purposes. This half, however, will qualify for the marital deduction provided your spouse is a U.S. citizen. While this may reduce the total federal estate tax due, your surviving spouse will receive an increase in the basis of the property for capital gain tax purposes only with respect to the one-half included in your estate. This makes record keeping on jointly held property very important.
Property included in a decedent’s gross estate receives a stepped-up basis equal to the value used on the estate tax return. This avoids the need to determine the basis of each and every asset a decedent owned.
If you have a non-marital trust to preserve the applicable exclusion amount in your estate, you must be careful not to place so much property in joint names with your spouse that there are insufficient assets in your sole name to fund the non-marital trust. Too much jointly held property may result in unnecessary tax in the estate of the second spouse. However, property owned jointly by a husband and wife has, in some jurisdictions, special protection under state law from attachment by the creditors of each spouse. Hence, the decision to divide entireties’ property must be considered carefully.
It is important that the ownership of assets be carefully scrutinized to obtain the maximum tax and family planning benefits.
Qualified Pension Assets and IRAs
There are special estate planning considerations that arise with respect to pension assets, IRAs and similar tax-deferred investments. These assets are generally payable in accordance with a beneficiary designation, and therefore are not governed by the Will. Under federal law, certain pension assets must be payable at the employee’s death to his or her spouse unless the spouse has signed a written waiver. This is not the case with respect to IRAs. Ordinarily, the deferred income tax on these assets is payable at death. The income tax deferral can be continued, however, if certain requirements are satisfied.
The Federal Gift Tax
The federal gift tax is a “building block” tax. Every individual is entitled to an applicable exclusion amount, which excludes from gift tax the first $5.25 million of taxable gifts made during his or her lifetime. The tax in any year is determined by subtracting the tax on all taxable gifts made before that year (including those after 1976) from the tax on all taxable gifts including those made in that year There is a $14,000 annual exclusion for outright gifts to each donee. The annual exclusion is indexed for inflation, but it can increase in $1,000 increments only. Gifts of property in trust may or may not qualify for the annual exclusion depending on the terms of the trust. Gifts covered by the exclusion do not generate a federal gift tax and, therefore, do not reduce the applicable exclusion amount. (See Federal Estate Tax discussion under Part 2, Death Taxes and Estate Planning.) In addition to this $14,000 exclusion, amounts paid on behalf of someone else directly to an educational organization as tuition or to any person who, or institution which, provides medical care (or medical insurance) are not considered as gifts for gift tax purposes.
Your spouse may join in your gift to a third party by filing a federal gift tax return and may add his or her annual exclusion (and applicable exclusion amount) to yours without actually transferring any of his or her own property. In this way, $28,000 per donee per year may be covered by annual exclusions. The federal gift tax is computed upon the date of gift value. Consequently, lifetime giving can avoid tax on appreciation between the date of gift and the date of death. In addition, if you survive the gift by three years, there will be no federal estate tax on the assets used to pay the federal gift tax in excess of the applicable exclusion amount. Lifetime giving is particularly applicable to life insurance on your life. The federal gift tax value of life insurance is roughly its cash surrender value, whereas its federal estate tax value is the amount of proceeds payable. However, you must survive the transfer of life insurance by three years in order to have the proceeds excluded from your estate. The purchase of a policy by a trustee or family member may avoid this three-year limitation.
The donee’s basis for income tax purposes in property given after 1976 generally is the donor’s basis, plus the federal gift tax on the excess of the date of gift value over the donor’s basis.
Gifts to Spouse
All gifts between husband and wife escape federal gift tax because of the unlimited marital deduction, provided the spouse is a U.S. citizen. If your spouse has little or no property and predeceases you, he or she will have lost an opportunity to pass a portion of your combined estates tax free by using the applicable exclusion amount. To ensure the use of the exclusion, you may wish to consider making gifts to your spouse sufficient to utilize his or her applicable exclusion amount. The gift may be outright or in the form of a lifetime QTIP trust. Your spouse may either pass the gifted property directly to your descendants or may put the property in a non-marital trust for your benefit. Property in such a trust would not be included in your estate at your subsequent death, thereby escaping tax in both your and your spouse’s estates.
Gifts to Minors Under Age 21
Gifts to a minor under age 21 may be made to a trust and still qualify for the $14,000 annual exclusion if: (i) all income and principal is payable to the minor or for his or her benefit no later than age 21; and (ii) if the minor dies before age 21, any unexpended principal or income must be paid to the minor’s estate or as he or she appoints by Will. Qualifying gifts also may be made to a custodian under the Uniform Transfers to Minors Act, in some jurisdictions. A gift to a minor under the Act must be distributed to him or her at age 21. Some jurisdictions (including Pennsylvania) allow the custodian to delay distribution until age 25 if the donor of the gift so directs at the time the gift is made. The income, including capital gains, will not be taxed to you for income tax purposes unless used to relieve your obligation to support your child. However, if you are trustee or custodian as well as the donor, the principal could be included in your estate for death tax purposes. Also, unearned income of a minor under 14 is taxed at the parent’s tax rate and is reported on the minor’s own income tax return or, in certain cases, on your own return.
Gifts of Life Insurance in Trust
Life insurance may be an ideal candidate for a gift in some circumstances. Term insurance, including group insurance, has minimal value for federal gift tax purposes; whereas the value of whole or ordinary life insurance for federal gift tax purposes is approximately its cash surrender value (plus prorated interest). If you continue to pay premiums after the gift, or your employer pays them for you, each premium payment is a separate gift.
You may give life insurance outright to your spouse. If he or she dies before you and gives the policy by Will to your children rather than to you, the only federal estate tax at the parent level (assuming you survive the gift to your spouse by three years) will be the tax on the cash surrender value, if any.
Alternatively, you may transfer complete ownership of the insurance to an irrevocable trust or the trustee may independently purchase a policy on your life. As with the non-marital trust discussed above, your spouse may receive the income and have certain other limited rights in trust principal, with your children ultimately receiving the remaining trust principal. If you survive the transfer by three years, the insurance proceeds will escape federal estate tax in your estate, whether or not your spouse survives you.
Consideration should be given to your estate’s liquidity; that is, your Executor’s ability to pay debts and death taxes without being forced to sell estate assets at a sacrifice. The insurance trust can be designed to buy assets from and lend assets to your Executors, thereby providing cash for your estate when needed.
Qualified Personal Residence Trust
A technique that presents an opportunity for achieving a transfer tax savings is the Qualified Personal Residence Trust. Under current law, a taxpayer may transfer his or her principal residence (or one other residence) to a trust that permits the donor the right to reside in the residence for a fixed term of years. At the conclusion of the term, the property passes to family members. A taxable gift to the family occurs at the time the trust is created, but the value of the gift is discounted to account for the delay arising from the retained interest of the donor. If the discounted value of the gift is less than the applicable exclusion amount, no current tax is due. So long as the donor lives through the trust term, no further tax is due at the time the trust terminates. As a result, if the donor survives the term, it is possible to pass a residence to children in five to ten years (or any other number of years) at a deeply discounted tax cost compared to the cost of having the residence pass through the donor’s estate at death and be subject to federal estate tax at its date-of-death value. If the donor dies during the term, an adjustment is made in the federal estate tax calculation so that the tax result is equivalent to what would have been the case had the transfer to the trust never been made.
Charitable Remainder Trusts
You may obtain a present income tax deduction for property transferred to an irrevocable trust, from which you retain the lifetime benefit, with a charity receiving the principal on your death. Furthermore, the trust may be funded with low-cost-basis assets, the sale of which by the trustee will produce no capital gain because it is for the benefit of charity.
In addition, although the trust principal would be included in your estate at death, because of your retained life interest, you will receive an offsetting federal estate tax charitable deduction for the entire principal.
Only trusts drawn in strict compliance with the Internal Revenue Code and its regulations will qualify for these charitable deductions. The two types of trusts most often used are a trust from which you receive an amount equal to a stated percentage (at least 5 percent and no more than 50 percent) of principal revalued annually (a “unitrust”), or a trust from which you receive a stated amount equal to a stated percentage (at least 5 percent and no more than 50 percent) of the initial value of trust principal (an “annuity trust”).
A unitrust or annuity trust may be established for one or more living individuals, so that you could give life benefits to your spouse or other relatives in addition to yourself. Charitable trusts may also be established by Will. In order to qualify as a charitable remainder trust, the actuarial value of the charity’s interest must be at least 10 percent of the value of the principal passing to the trust.
Charitable Lead Trusts
Another charitable planning technique, the charitable lead trust, provides an attractive opportunity to pass assets to one’s children or grandchildren at a reduced transfer tax cost. Charitable lead trusts provide for a specified annuity to be paid to the charity of your choice for a term of years, with the remaining principal payable to the trust’s remainder beneficiaries (children, grandchildren, etc.) at the termination of the trust. The present value of the gift of the remainder interest to the family members is calculated at the time of the transfer to the trust based on IRS tables. The present value of the gift of the annuity interest to the charity is a charitable gift, deductible for income and gift tax purposes. The larger the annuity payment and the longer the trust term, the smaller the taxable gift and the larger the charitable deduction. The value of the remainder interest is generally a fraction of the amount that actually passes to the beneficiaries. Thus, the tax cost of the transfer is significantly less than it would have been if the property were retained and passed under the Will of the donor.
Business Succession Planning
The owner of a closely held business is confronted with a host of unique issues separate from those already discussed. Given the high federal estate and gift tax rates, and the liquidity constraints common to owners of closely held businesses, one of the most difficult issues facing the owner of any successful business is how the business, or the personal wealth that it represents, can be preserved for the benefit of one’s family after death. While it is natural for business owners to concentrate their energy and resources on developing strategies for current business growth and profitability, a lifetime’s work can quickly dissolve if insufficient attention is paid in advance to planning for the continuity of the business and the stream of income it produces.
A successful business succession plan is based on a careful analysis of the family and business considerations particular to each situation. Provisions must be made for surviving family members who are both active and inactive in the business. In addition, the corporate balance sheet must be analyzed to determine if there is an opportunity to reduce the taxable value of the entity.
Normally, a long-term gift program will be a major component of the plan. To avoid loss of control, a corporation’s stock can be divided into voting and non-voting shares. A family limited partnership might also be a component of a business succession plan, leaving control in specified general partners. Planning for the owner of an S corporation involves special considerations, and offers unique opportunities to pass wealth to the next generation in a tax-efficient fashion. In addition, the business succession plan will usually involve the creation of a shareholder’s agreement to ensure that the business assets remain under family control. With proper planning, significant tax savings can be achieved, enabling the surviving family members to continue a successful enterprise with a minimum of disruption.
Planning for Incapacity
In addition to making provisions to protect your family in the event of your death, a proper estate plan should take into account the possibility that your mental or physical condition may render you unable to handle your financial and personal affairs. Normally, it would be necessary to seek a court-appointed guardian to handle your affairs, a procedure that is costly and time-consuming. There are, however, a number of steps that can be taken to ease the burden of this circumstance on family members.
A “Durable Power of Attorney” will permit your designated “Agent” to handle your property for your benefit, including full access to your assets, whether in bank accounts, securities or real estate. Such a document may also permit the Agent to handle your tax affairs, including the authority to undertake tax planning steps in order to reduce the estate tax burden at your death. The document may also include a provision to authorize medical and surgical procedures and make decisions with respect to custodial care. The powers may be effective either immediately upon execution of the document or not until your subsequent incapacity.
Another method of planning for disability is the “Living Trust.” This is a fully revocable trust that holds your investments or other assets. Although the Living Trust does not reduce the overall death tax burden, it does provide a mechanism for a trustee to step in and manage your assets in the event of incapacity with little interruption and without the need for court interference. A Living Trust can be funded fully at its inception, or funded in stages, as you become more willing to allow another to undertake the responsibility for your financial affairs.
Finally, you may be interested in providing comfort for family members should a circumstance arise in which there is no useful purpose in administering “heroic” medical procedures to sustain your life. Under current law, an individual has the right to refuse such procedures or have such procedures withdrawn if death is imminent or he or she is in a permanently unconscious state. Because the individual is unable to communicate his or her wishes, it is necessary to have a “Living Will” or “Medical Declaration” in place stating your desires with respect to this issue. The document may also appoint a surrogate to make the actual medical decisions that would be required.