Planning Without Estate Taxes Concerns
Today a couple can transfer up to $4 million without having to worry about their estate paying any estate taxes on the death the surviving spouse. When I have this discussion with my clients, I mention that planning will still continue in order to protect their assets and shift income to heirs. $4 million is still a lot of money today even in this highly appreciated real estate market.
The first topic deals with the fact that in order to transfer the $4 million to their children they will have to establish the typical family trust that provides for the first $2 million to be transferred into a decedent’s trust. I recommend that the decedent’s portion of their estate should allow the flexibility to have the surviving spouse to be able to change how the distributions to their children will be if there is a change in circumstances after the death of the first spouse. Unfortunately, this type of planning is not provided for in some family trust documents that I have reviewed.
What else should you be thinking about, if you have substantial assets that will not be subject to estate tax either because of total repeal of the death tax (good luck) or more than likely your estate may be under the exemption amount? What are the various planning tools to use in this environment?
If wealth preservation is a key motivator for you and protecting them at the same time, using a limited partnership or limited liability company will certainly be one tool. This is particularly true where real estate is a major asset. Various types of trusts will also be something to explore.
In a recent article by : JOHN J. SCROGGIN entitled “Income Tax Planning Now That Estate Taxes Are Less Significant” he discusses the various planning tools to think about both now and in the future.
Income tax planning
Many planning opportunities have been limited by concerns over the avoidance of federal estate tax. When estate tax rates reached as high as 60%, while federal income rates topped out at 39.6%, this concern was certainly valid. But these estate tax restrictions will disappear for the vast majority of Americans, whose tax planning strategies will shift from federal estate tax avoidance to state and federal income tax reduction. Here are some of the possible opportunities.
Income shifting. A client who is funding benefits or obligations (e.g., college tuition or support costs) for someone (e.g., a college age child or a parent in a nursing home) who is in a lower income tax bracket should consider adopting approaches by which the ordinary income or capital gains of the client are shifted to the lower tax rate taxpayer. There are a number of methods for accomplishing this task, including the following:
1. Trusts can be created to hold income-producing assets; the trust income is allocated among the beneficiaries based on the trustees’ discretion. These “spray trusts” are discussed in more detail later.
2. The transfer of noncontrolling interests in flow-through entities (e.g., limited liability companies (“LLCs”), partnerships, and S corporations) may be used to shift income to lower-bracket family members without giving up control over the underlying asset or the family business. The recent IRS assaults on family limited partnerships (“FLPs”) have focused primarily on the estate tax aspects of FLPs. However, for most clients, the federal estate tax issues surrounding FLPs will become moot. FLPs remain an excellent tool for maintaining control of an asset, while income earned from the asset is allocated to lower-bracket family members.
3. A business could hire family members to work in the business. However, if the business owner has earned income over $90,000 (in 2005), then this approach could create Social Security taxes which the business owner would not have incurred.
Planning example. Assume a client has a rental property that produces ordinary taxable income of $200,000 per year. The client is in the 35% federal income tax bracket, but his five children and ten adult grandchildren are all in an effective tax bracket of 15%. The client places the rental property in an FLP and retains a 2% general partnership interest. Over two years, he transfers the FLP interests to a spray trust for his descendants using Crummey withdrawal rights to preserve his state and federal estate tax exemptions. The trust has the right to spray income among his descendants. Using the income tax brackets of the 15 trust beneficiaries, the overall federal income tax on his rental property would drop by up to $39,200.
Income shifting can also result in changes in the character of shifted income. For example, suppose that a client is a real estate developer. Because the developer is considered a “dealer” in real estate, income from the developer’s development of real property will generally be treated as ordinary income. If property were initially acquired by, or transferred to, family members who were not developers, sale of the real estate could be treated as a capital gain transaction.
Income shifting may also be used to reduce the phase-out of tax benefits that apply to many higher income taxpayers. For example, the ability to fund a Roth IRA is phased out for married taxpayers with a modified adjusted gross income of over $150,000. If the shifting of income took the taxpayer below the limits for any applicable deductions or tax benefits, it could provide an additional advantage to the donor.
Income shifting does carry some risks. For example:
Clients who adopt income shifting strategies should make sure the transactions have economic substance, do not run afoul of the “assignment of income doctrine,” and do not result in the IRS’ reconfiguring the transaction to avoid the evasion of taxes or to clearly reflect the taxpayer’s income. If these doctrines and rules are violated, the client may remain taxable on the income that was supposedly shifted to lower-bracket taxpayers.
In creating such structures, planners should keep in mind the state income tax ramifications of shifting income. Many states have begun taxing nonresidents on the income distributed from local flow-through business entities. For example, Georgia requires that nonresident owners pay income taxes on the income distributed from some S corporations, partnerships, and LLCs. While forum shopping for estate tax and asset protection purposes has been in vogue for some time, clients may also use forum shopping to minimize any state and local income tax liability.
Payments of unearned income to beneficiaries who are under age 14 can result in the income taxes being calculated using the parent’s income tax bracket, not the child’s bracket.
The client must give up the income. In most cases, income shifting makes sense only if the client is willing to forgo future income and/or if the client is already funding a need of a lower-bracket taxpayer (e.g., nursing care costs).
The increased focus on basis. The cost basis of assets generally is stepped up to their fair market value (FMV) at the time of death. The new higher estate tax exemptions frequently mean that less of an estate is subject to federal estate tax. As a result, a quantum shift in tax planning may occur. Instead of lowering the value of assets to reduce transfer taxes, clients may actually want to increase the value of assets to obtain a higher basis step-up. The higher basis will reduce the income taxes paid by heirs on the sale of inherited assets and will create new depreciable values for depreciable assets.
Planning example. A chronically ill father owns 40% of a family business worth $3 million. Assume the available estate tax exemption is $2 million and a 40% discount would apply to the father’s ownership interest. Also assume there is a 10% control premium. His wife and heirs own the remaining 60% of the business. Wife transfers 11% of the business ownership to the husband as a marital gift. The husband’s will provides that the amount of his estate tax exemption equivalent is placed in a spray trust for the benefit of the wife and descendants. If the father dies before the transfer, the value of his interest in the family business would be $720,000 (i.e., $3 million times 40% times 60%). If the 11% interest is transferred, the effective value of the 40% stock interest would be $1,320,000. The creation of a controlling interest creates an additional $500,000 of basis.
It will be a crazy world in which the IRS and tax practitioners will be swapping asset valuation arguments. Moreover, techniques such as intentionally defective grantor trusts will be turned on their heads to become Estate Defective Trusts (discussed later).
Charitable bequests and IRD. When clients want to make a charitable bequest, they should consider funding that bequest with qualified retirement plan assets or other assets that would have created “income in respect of a decedent” (“IRD”). Because of the current rules on naming beneficiaries of retirement accounts, the client is best advised to bifurcate any IRA into an account that names a charity as beneficiary and one or more other accounts that name noncharitable beneficiaries. If the client either does not want retirement assets to go to charity or does not have retirement assets, the will or living trust could provide that any charitable bequest first be funded from IRD assets to the extent the estate or trust held or receives such assets.
Planning example. A client wants to pass $30,000 to a charity at his death. He holds an IRA worth $25,000. The client could name the charity as beneficiary of his IRA and provide in his will that the estate pay to the charity the difference between $30,000 and the IRA value at his death. Assume the IRA was worth $20,000 at death and the client’s only heir is in a 40% state and federal income tax bracket. The passage of the $20,000 in IRA funds to charity would save the heir up to $8,000.
Investment decisions. Investments in trusts and estates may be changed to investments that are more tax-effective. Net after-tax returns will become a critical part of investment evaluations. For example, fiduciaries will be more prone to use tax-efficient mutual funds and capital gain investments rather than those that may be taxed at higher ordinary income rates, particularly when trusts and estates will be accumulating income.
This trend is already evident in the growth of total return trusts. One motivation for total return trusts is the desire to move away from strict definitions of income and principal that tend to distort fiduciary investment decisions. When fiduciaries are free to make the best economic decisions to produce the highest after-tax return, the net return to all beneficiaries should increase. (Total return trusts are discussed more later.)
Not only the form of the investment (e.g., stocks or bonds), but also the tax vehicle that holds the investment may be important. In an appropriate situation, Roth IRAs, charitable remainder trusts, health savings accounts, Coverdell savings accounts, and Section 529 plans can offer tremendous tax savings.
The impact on the use of trusts
This new tax environment is also changing how clients and planners approach the use and creation of trusts. Trusts remain one of the most adaptable planning tools available. As a result, clients will continue to use trusts to accomplish both tax and nontax estate planning goals. Income tax planning opportunities using trusts will increasingly become part of the estate planning process. Among the expectations are the following:
`Spray trusts.’ As discussed earlier, the new tax environment will encourage the allocation of income to lower-bracket taxpayers. The use of a trust spray power to allocate income among various family members (particularly those in lower tax brackets) will be an increasing part of the planning process. Accordingly, a college student who is in a 10% income tax bracket may be sprayed income from a trust, resulting in more after-tax dollars to fund the child’s college education.
Planning example. A client intends to create a trust, contributing an asset that has a value of $500,000 and a basis of zero. The trust will sell the asset for an installment note payable annually over ten years at 8% interest. The trust is intended to provide for the college education of grandchildren who will not begin college for 11 years. Assume that the grantor’s state of domicile will impose an 8% tax on the income and capital gains retained in the trust. The grantor is considering establishing the trust in Delaware—a state that does not impose taxes on trusts that accumulate income for nonresident beneficiaries. If the trust is set up in the donor’s state, the state income taxes over the next ten years will be almost $60,000. If the trust were formed in a nontaxable state, such as Alaska, Delaware or Florida, there might be no income tax liability.
Fiduciary income tax issues. Income tax planning will become a higher priority for the majority of estates and trusts. For example, advisors will also need to examine estate and trust investments based on the relative after-tax returns.
Planning example. A trustee intends to accumulate trust income for ten years until grandchildren of the grantor reach college age. The trustee has two investment choices: an ordinary income investment that generates an 8% return and a capital gain investment that generates a 6.5% annual return. The trust is in an ordinary income tax bracket of 35%, while the capital gain rate is 15%. Ignoring any other investment or tax issues (e.g., trust deductions, investment risk, diversification, etc.), which is the better investment? The net after-tax yield on the ordinary income investment is 5.2%, while the net after-tax yield on the capital gain investment is 5.5%.
Estate Defective Trusts. For years, clients and planners have used intentionally defective grantor trusts, which cause the trust’s income to be taxable to the grantor while the transfer of assets to the trust is complete for estate tax purposes. The objective of such trusts, which I will refer to as “Income Defective Trusts,” is to reduce a client’s federal estate taxes. An Income Defective Trust uses the differences in the income tax and estate tax rules to create a trust that remains taxable to the grantor for income tax purposes (pursuant to Sections 671-678), while the trust assets are removed from the grantor’s taxable estate.
However, with the recent increases in the applicable exemption amount (and with more increases still to come), the gap between the income tax and transfer tax rules may create planning opportunities for “Estate Defective Trusts” (“EDT”). Such trusts are intentionally created to have the trust income taxable to the trust or its beneficiaries, but to have the trust assets remain in the grantor’s taxable estate.
An EDT has two major income-tax-related benefits. First, the tax on the income of an EDT is allocated to either the trust or its beneficiaries. Unlike an Income Defective Trust, the EDT can effectively permit a grantor to use the lower income tax brackets of the trust beneficiaries to reduce the overall taxes of the family.
Planning example. A client has a grandchild in college, and the client owns an asset that generates an annual income stream of $40,000. The client is in an effective income tax bracket of 40%, while the grandchild is in an effective income tax bracket of 15%. Using an EDT, the family saves $10,000 in annual income taxes. If the grantor were paying Social Security or self-employment taxes (e.g., by being the manager of an LLC), the savings would be even more significant.
Not only are income taxes reduced, but the after-tax proceeds from the income are not includable in the grantor’s estate, reducing the possibility that the grantor may be subject to either state or federal transfer taxes.
Planning example. Assume in the above example that the client dies in 20 years, but retained the asset that generated $40,000 in annual income until his death. Assuming an annual 6% return, the annual after-tax income (even at a 40% income tax rate) from the asset could create an additional estate value of over $685,000 at the grantor’s death.
Second, many clients hold low-basis assets (e.g., a family farm or business). The client may desire to gift the asset to family members, but does not want to lose the benefit of the step-up in basis which occurs at death. The client can place the asset in an EDT. Beneficiaries will receive the current benefit of the asset, but the asset will remain part of the grantor’s taxable estate, permitting a step-up in basis.
Planning example. A client owns a business that has a zero basis, but is worth $500,000. The business is growing at an annual rate of 5%. The client’s son is taking over the business. If the father gifted the asset to his son, the son would take over the father’s zero basis. Assume the father dies in five years, when the business is worth $640,000. By placing the business in an EDT, if the son sold the business when he was in a 20% effective tax bracket, he would save $128,000 because of the EDT.
Conclusion. Benjamin Franklin said that only taxes and death are inevitable. As long as we have taxes, tax avoidance will remain an important motivation for many people. This does not mean that planning does not continue on in preserving and protecting your assets.