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Taxable Estates
 
Taxable Estates

If the decedent’s estate is large enough to have a substantial estate tax liability, there are a number of estate planning techniques that can be utilized to reduce the tax burden.

Some of the more commonly used methods are as follows:

  1. Irrevocable Life Insurance Trust. Contrary to popular belief, life insurance proceeds are generally subject to estate tax. However, if you create an irrevocable life insurance trust and transfer money to it each year for the trustee to pay the premiums on a policy on your life, and if certain other requirements are met, the life insurance proceeds payable to the trust are not subject to estate tax. This has two significant impacts: First, the value of the taxable estate is reduced by the amount of the insurance proceeds that are no longer subject to estate tax. Second, sometimes the estate’s assets are illiquid, meaning that they are not readily convertible to cash. Common examples of illiquid assets include real estate and closely held business interests. Yet, the estate tax on these assets is due nine months following the date of death. Without a ready source of cash, the trustee would have to either sell assets (potentially at distress prices, depending on market conditions at the time of the decedent’s death) or refinance them so as to generate the cash needed to pay the tax. The life insurance proceeds payable to the life insurance trust provide a pool of cash that may be used to pay the tax, thereby avoiding the need to sell or refinance assets.

  2. Grantor Retained Income Trusts. There are two types of grantor retained income trusts: One is called a Grantor Retained Annuity Trust (“GRAT”), while the other is referred to as a Grantor Retained Unitrust Trust (“GRUT”). Both are irrevocable trusts. In each case, during lifetime, you transfer assets to the trust while retaining the Annuity or Unitrust interest for your own benefit. The Annuity interest in a GRAT is a fixed percentage of the initial fair market value of the assets transferred to the trust. The Unitrust interest in a GRUT is a fixed percentage of the fair market value of the trust assets, redetermined annually. While the transfer to the trust is subject to gift tax, the value is reduced by the actuarial value of the retained Annuity or Unitrust interest. Because of this retained interest, the gift tax value is “discounted. This means that a smaller part of the tax exemption available for lifetime gifts is used, leaving more available to transfer assets at death. With the trust assets now outside the taxable estate, the estate tax obligation is reduced.

  3. Charitable Remainder Trusts. There are two types of charitable remainder trusts: One is called a Charitable Remainder Annuity Trust (“CRAT”), while the other is referred to as a Charitable Remained Unitrust (“CRUT”). Both are irrevocable trusts. In each case, during lifetime, you transfer the assets to the trust while retaining the Annuity or Unitrust interest for your own benefit. The Annuity interest in a CRAT is a fixed percentage of the initial fair market value of the assets transferred to the trust. The Unitrust interest in a CRUT is a fixed percentage of the fair market value of the trust assets, redetermined annually. When you die, the trust estate passes to the charity you designate in the trust. In addition to meeting your philanthropic goals, the charitable remained trust provides tax benefits as well. The actuarial value of the charitable remainder interest qualifies for a charitable donation deduction on your income tax returns. The trust is a tax-exempt entity, meaning the trust can sell appreciated property without having to pay an immediate capital gains tax. When you die, the actuarial value of the charitable remainder interest qualifies for the estate tax charitable deduction.

  4. Family Limited Partnerships. The estate tax applies to the value of all assets owned by the decedent at the time of his or her death. Use of a family limited partnership can reduce the value of assets for tax purposes. A lower value means a lower tax. Suppose, for example, during his or her lifetime, the decedent transfers his or her real estate to a limited partnership in which he or she is a 1% general partner and a 98% limited partner, with the children serving as 1% limited partners. For tax purposes, the value of a 98% limited partnership interest is less than 98% of the underlying real estate transferred to the partnership. Sometimes this “discount” may be substantial, resulting in a significant reduction of the estate tax liability.

  5. Qualified Personal Residence Trust. As the name implied, this technique may only be used with an individual’s personal residence (or vacation home). In this plan, you transfer your personal residence to an irrevocable trust, but retain the right to live there for a specific number of years (not for your lifetime). The actuarial value of the retained term of years reduces the value for gift tax purposes. If you outlive the retained term of years, the value of the residence is outside your estate and not subject to estate tax when you die. If you die during the retained term of years, then the plan fails and the residence is included in your taxable estate. If you outlive the retained term, you either have to move to a new residence or rent the residence from the trust or beneficiaries of the trust.

 
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