Death and taxes are a pairing we often hear featured together due to Ben Franklin’s famous quote “In this world nothing can be said to be certain, except death and taxes.” Death will take us all, but we can have some control over taxes, especially Transfer Taxes.
First, let’s start by understanding that Transfer Tax (Gift Tax, Estate Tax, and Generation Skipping Transfer Tax) affect less than one fifth of one percent of the population, about 17 in 10,000 people in the USA. The current threshold is over $5,000,000 and increases each year as it is indexed for inflation. This amount ($5,430,000 for 2015) is for each person, thus couples, with proper planning, can pass over $10,000,000 Estate Tax free. If your net worth is under $5,000,000 under current law, transfer tax is not much of a concern; between $5-10 million for a couple make sure a plan is in place to utilize both exemptions; and above $5 million for individuals and $10 million for couples, more complex planning is available to help reduce or eliminate the tax. So two factors drive the need for planning: a high net worth, or fear of exemption being reduced in the future.
Second, realize that WHO your beneficiary is makes a difference as well. Transfers to charity are transfer tax free, so if you leave any or all of your estate to charity, there is no transfer tax regardless of value, so we will skip charitable giving in this article. Transfers to your spouse, if they are a U.S. citizen, delay the tax until the surviving spouse transfers the property. Finally, a transfer to anyone else is subject to transfer tax above the tax free amount previously discussed. Thus the intended beneficiaries are the driving force in all planning.
Third, assuming we are dealing with a potentially taxable estate, we can look at techniques during life (Gifts), at death (Estate), and to protect future generations from the same problems (Generation Skipping).
Annual Exclusion. Giving away up to the Annual Exclusion each year to any or all of your intended beneficiaries is the first and simplest technique. Annually you can give up to $14,000 per person, per year with no transfer tax effect. Generally this has to be an outright gift or a gift using certain special trusts that qualify for the exclusion. This requires either liquidity or an entity that you can give away a portion of, like a corporation or partnership, which can make giving illiquid assets easier and in most cases can also discount the value of the underlying assets, since you are giving a minority interest in the entity.
Tuition and Medical Exclusion. Wealthy individuals should also consider paying the tuition and medical expenses of their intended beneficiaries since these gifts are transfer tax free when paid directly to the service provider. This exclusion is unlimited in amount and in addition to the annual exclusion, yet it does require liquidity.
Irrevocable Trusts. There are a wide variety of techniques which range from simple to complex which involve the use of Irrevocable Trusts. Gifting of life insurance policies can be done with Irrevocable Life Insurance Trusts. Additional leverage can be provided through complex techniques like Grantor Retained Annuity Trusts and Sales to Intentionally Defective Grantor Trusts, both of which perform well in low interest rate environments and can often be additionally leveraged with the use of Family Limited Partnership interests as the funding method. These techniques are used by those well over the estate tax free amount to reduce the additional growth of their estates, shifting future income and appreciation of their assets out of their estates.
What is left at death is then distributed at its fair market value and receives a change in cost basis to the date of death value. Again, entities like Family Limited Partnerships may provide discounting, but this can be a disadvantage to estates on the borderline of taxation, reducing the basis step up for capital gain tax purposes. In some cases, unwinding the partnership, or altering it so that it does not discount the underlying property may be preferable when the partnership was created when estate tax exemptions were much lower.
Portability or A-B Trust. For married couples “portability” is the new factor in the transfer tax equation. Portability refers to the ability to leave one’s unused exemption at death to one’s surviving spouse. This has provided an option to the traditional A-B Trust structure usually used which utilizes a separate trust to take advantage of the exemption of the first spouse to die. The traditional method is still preferable in estates expected to continue growing, planning to pass multiple generations, where controls on the use or future beneficiaries are appropriate, and where the traditional tax and asset protection is desired.
Generation skipping is not necessarily what it sounds like in that you do not have to skip a generation in order to “generation skip.” The name is a reference to an additional layer of tax imposed upon transfers that pass multiple generations avoiding the estate tax at each generation.
Dynasty Trust. You can create a Dynasty Trust up to the exemption amount that can benefit spouse, children, grandchildren, and provide the tax and asset protection features of irrevocable trusts for as long as money remains in the trust regardless of how much the assets grow in value. For wealthy families, this is like giving your children an extra estate tax exemption. The same applies to every future generation that the trust serves. Dynasty trusts have a separate exemption applied that protects the undistributed funds from estate tax in the estates of the beneficiaries.
Clearly the area of estate planning and transfer tax techniques does not have one simple solution. The best solution is based upon the objectives, wealth, and willingness to make permanent decisions in order to save taxes.
Engaging with knowledgeable, experienced professionals is essential to choosing the right path for you, and staying engaged with those professionals so that plans can be changed as laws change, wealth changes, and objectives change.
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