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Q-TIP TRUSTS - PROVIDE FOR SPOUSE AND CHILDREN

If you're married, you should consider a Q-TIP trust. The more assets you have, the more these trusts make sense. At some major law firms that cater to the wealthy, over 90% of married clients have Q-TIPs.

Q-TIPs are especially suitable for second marriages, where each spouse already has children. Why? Because a Q-TIP lets you provide for your spouse, defer taxes and dictate where your money will eventually wind up.

Before explaining the Q-TIP acronym, let's look at a typical remarriage scenario. Jim is a divorcee with two children. He marries Sue, who also has children from a previous marriage. When Jim plans his estate, should he leave his money to his kids or to Sue, his wife? If he leaves his money to his children, Sue won't be provided for and estate taxes will be due upon Jim's death. But if he leaves his money to Sue, Jim's money may ultimately wind up with her children, not his.

HAVE IT AND USE IT

The answer, as the Jims of this world are discovering, is to designate his assets as Q-TIP property. The "Q" stands for "qualified," meaning that the assets will qualify for the marital deduction from estate taxes. Q-TIP property is taxed after both spouses die, which can defer estate tax for many years. The "TIP" stands for terminable interest property," meaning that Sue's interest in that property ends at her death. She has no say as to where those assets wind up.

In practice, Q-TIP property usually goes into a trust. The income from the trust must go to the surviving spouse, for life. (Otherwise, there would be no marital deduction, and estate tax would be due at the first death.) At Sue's death, the estate tax will be due and the Q-TIP assets will go to whomever Him has designated. Most likely, his money will go to his own children and grandchildren.

Not just for second marriages. Q-TIPs, though, are by no means limited to second marriages. They are well suited to many situations.

For example:

* First marriages. You may have a perfectly happy marriage with children that you both adore. But you could die tomorrow. If your assets go directly to your spouse, what happens if he or she remarries? The wealth you earned, or the wealth you inherited from your own family, may wind up commingled with the assets of the new spouse. Those assets may buy a new house for children you've never seen or pay for their tuition at an Ivy League college.

That needn't happen if you have a Q-TIP. Your assets could go into a trust, with all income payable to your spouse. When your spouse dies, estate tax will be paid and the remainder will go to your own children.

* Protection of surviving spouses. Your spouse may not be comfortable handling large sums of cash if you're the one who has always handled the family's financial decisions. There are lots of hustlers out there, from religious frauds to churning stockbrokers, and they're all looking for prey. If you leave your money in a Q-TIP with a competent trustee, your surviving spouse will always have enough to live on, and your children can be sure they'll come into their legacy.

* Relief of intra-family stress. A Q-TIP can take the pressure off of your surviving spouse. Children or stepchildren, new lovers or swindlers: They can all be put off, with no hard feelings, if your widow or widower explains that the money is locked into a Q-TIP. Q-TIPs can head off some potential family troubles, too. Suppose your spouse favors one child over the other. After you've gone, he or she has a club to hold over the one who always comes in second. "You haven't called me since last money, your brother called me last week, so I'm going to leave everything to him."

Unfortunately, such situations arise more often than people want to admit, especially when the surviving spouse falls victim to Alzheimer's disease or some other form of senile dementia. You can't prevent disease or hard feelings, but you can at least rest easy, sure that each child will get a fair share.

EMERGENCY CARE

What happens if an emergency arises and the surviving spouse needs more money? That depends on how the Q-TIP is designed. Generally, the trustee can have the power to "invade the principal" in case of emergency and the trust will still qualify for the marital deduction. However, if anyone but the surviving spouse has the power to receive part of the principal, the marital deduction will be lost.

Observation: In a recent Tax Court case, the Q-TIP deferral was lost because the trustee was allowed to use principal to benefit the surviving spouse's daughter, with the surviving spouse's consent. The Tax Court found this violated the letter of the law.

So be very careful here, because the IRS will go after faulty Q-TIPs.

As a practical matter, the intent of the Q-TIP is to provide assets for the trust's beneficiaries (for example, your children and grandchildren), so you don't want your surviving spouse to invade the principal too freely. A typical solution is to give the trustee or co-trustees the discretion to invade the trust, if necessary.

Recommendation: If it's feasible, try to enlist a family member with good business sense as a co-trustee. You may have a brother or sister or an in-law who's suitable, for example. The other trustee might be a local bank. If there's no family member who's suitable, the bank might be the sole trustee, but in many cases your widow will feel uncomfortable going to a strange banker, whom she might not know, and asking for money.

Invading the principal. What kinds of situations might arise that might merit an invasion of principal?

* Medical and education expenses usually are permitted by the trustee. Example: One widow's older child left a junior college to attend Harvard the same year the younger child entered Stanford. Total college costs: over $50,000 a year. The widow showed the college bills to her trustee, a banker, and received the money.

* New Home. Suppose the surviving spouse remarries someone who has five kids. The new couple want a bigger house. Does the trustee tap the principal to provide a down payment or money for home remodeling? That's a tough call. A trustee's prime role is to protect trust assets for the beneficiaries. But those beneficiaries--the children of the spouse who died--may be better off if they can live in a bigger house. However, a bunch of strangers will be living in a house provided by the decedent.

There are no easy answers to such questions. Nevertheless, you can help by making sure that all the family members understand the Q-TIP provisions. They should know which assets are to go into the Q-TIP, what kind of income can be expected and the provisions for invading the principal.

THE RULES

If the idea of a Q-TIP appeals to you, what do you need to make it work? An experienced attorney, a savvy executor and appropriate assets.

Assets. To establish a valid Q-TIP, the assets must produce income, because the surviving spouse must have an income interest. The attorney drawing up your trust should know which assets make sense for Q-TIPs. Some of the following qualify:

* Residences raise questions, so a personal residence generally is left outright to the surviving spouse, rather than placed in a Q-TIP.

* Interests in closely held business can go into Q-TIPs. The profits from the business (possibly in the form of dividends to stockholders) can be distributed, according to the amount of the company held on the Q-TIP. A possible catch is the trust's structure.

There is no problem placing "C corp" interests in a Q-TIP. However, if the business is an "S corp," the Q-TIP trust must be structured so that it can be an S corp shareholder. Only certain kinds of trusts are allowed to own shares in an S corp, so your attorney must set up a Q-TIP trust that is eligible. (See Chapter 11.)

* Income-producing securities make excellent assets for Q-TIPs. No-dividend growth stocks do not.

* Unproductive assets, such as raw land and collectibles, generally won't work, unless the trustee is directed to sell them and raise cash.

Caution: Don't put a family heirloom into a Q-TIP with a provision against selling it. Some states allow the surviving spouse to force the trustee to liquidate unproductive property to preserve Q-TIP status. But don't count on state law to bail out an improperly drafted Q-TIP trust.

Post-mortem tax planning. Q-TIPs are usually testamentary trusts, established through your will or living trust. Therefore, in addition to a good lawyer and proper asset selection, you need a savvy executor. The reason: The Q-TIP election is made after your death. Your executor should elect Q-TIP status for income-producing property and avoid the election for assets that don't generate income. An improper election can jeopardize Q-TIP status and lead to immediate estate-tax liability.

To qualify for the marital deduction, your executor must make an irrevocable election on the estate-tax return, generally within nine months of your death. In some cases, your executor may decide not to make a Q-TIP election, or to make a partial election, putting only some of the assets into the trust.

Why would such a decision be made? Generally, to reduce estate taxes. One advantage of a Q-TIP is that estate taxes can be deferred from the first death to the second. That can be a great help if your surviving spouse is relatively young and in good health, with a long life expectancy. It's better to pay taxes later than sooner.

But if your surviving spouse is old or frail, the second death may seem imminent and the value of estate-tax deferral scant. In that case, your executor may try to balance the estates and reduce the overall tax bill.

Example: A taxable estate of $4 million would owe nearly $1.6 million in federal estate taxes while two $2 million estates would owe a total of less than $1.2 million, because larger estates face higher marginal tax rates. Using a partial Q-TIP election to equalize estates, in this case, would save over $400,000. So the Q-TIP rules give the executor a chance to do some post-mortem tax planning. Be sure your executor is familiar with these options. The surviving spouse also may have a "limited power of appointment" over the Q-TIP assets. Example: Suppose the money in the trust is to go to your three children, after your surviving spouse dies.

Your surviving spouse may be able to allocate the inheritance, within a given range. The child who has done very well financially may get a minimum share while the child who really needs the money may get more.

While Q-TIPs allow for post-mortem planning, they don't have to involve "mortem" at all. You can set up an "inter vivos" (living) Q-TIP. Example: Joanne recently sold her business and decided to go into a very speculative venture with the money she received. She put her other assets into an irrevocable Q-TIP trust, where they won't be vulnerable in case the venture falls through. Whatever happens, she knows that the trust will provide income to her husband and, ultimately, wealth to her children.

WHEN THE SECOND SPOUSE DIES

A technical problem arises in most Q-TIPs. Income may be paid annually, semi-annually, quarterly or more frequently. Typically, when the second spouse dies, there is money in the trust that hasn't yet been paid out. Who gets that money? The heirs of the surviving spouse or the trust beneficiaries, who may not be one and the same?

The IRS formerly said, in proposed regulations and letter rulings, that it was permissible to allow the trust beneficiaries (specifically, those named by the first-to-die) to collect this accrued income. But, in the case of the Estate of Rose D. Howard, decided in 1988, the Tax Court ruled that the money must go to the estate of the second-to-die spouse. If not, that spouse doesn't have the requisite income interest, and the unlimited marital deduction may be stripped away retroactively.

Observation: Having the marital deduction stripped away could be disastrous. Your estate might face a huge bill for back taxes and interest. Therefore, make sure that your trust specifies that the unpaid income goes to the estate of the surviving spouse, which will not necessarily benefit the Q-TIP trust beneficiaries.

THE WAITING GAME

Is there a drawback to a Q-TIP? One possible hitch is that your surviving spouse must get all the trust income for the rest of his or her life, in order to qualify for the estate-tax deferral. In a second marriage, you may have a considerably younger spouse, who may live for many years after your death. For all those years, your children won't get anything.

So you may not want to put all of your assets in a Q-TIP. You might want to leave some money outright to your children. You can leave up to $600,000 total to beneficiaries other than your spouse without incurring an estate-tax obligation. Alternatively, you could give each child up to $10,000, each year, without incurring any gift tax. Or, you could carry life insurance payable to your children at your death. These strategies will give your children some money while they can still enjoy it.

AGGRESSIVE APPROACHES

Two pro-IRS rulings in Tax Court were recently overturned by federal Circuit Courts, indicating that Q-TIPs may become even more flexible. These decisions refer to post-mortem estate planning: deciding which assets will qualify for Q-TIP treatment must be elected by the estate's executor. In some situations, it makes sense to make a partial election or to skip the Q-TIP election altogether. If the age and health of the surviving spouse indicates that the estate tax deferral won't be very long, you may want to take the full tax hit right away.

Example: You're the executor of an estate in which shares in a closely held business are temporarily depressed. You may want to pay estate tax now, while the value is down.

Example: Balancing the spouses' estates may be desired. If you pay tax on two $1.5 million estates, the estate tax rate won't exceed 43%. If you wait and pay all the estate tax later, you're moving assets into higher brackets, up to 55% on amounts over $3 million.

POTENTIAL

The typical strategy is to set up a trust that's eligible for a Q-TIP election: the surviving spouse is entitled to all the income from the trust assets, for some or all of the assets, if it's deemed appropriate. The disclaimed assets may directed elsewhere, if a specific provision has been included in the trust creator's will.

But what if the surviving spouse is not capable of making a tax-saving disclaimer or not willing to give up access to the trust assets? Then, it would be better if the executor had this discretion.

Consider the case of Willard Robertson. Robertson set up several trusts, including two that could be Q-TIPed and a family trust for his descendants. According to his will, any assets not covered by a Q-TIP election were to be redirected to the family trust.

The Tax Court ruled this approach gave the executor too much power. The amount passing to the surviving spouse could not be determined, at Robertson's death, because the executor had the power to shift assets from the marital trusts to the family trust. Thus, the spouse was not entitled to all the income from the Q-TIP assets during her lifetime, as required--the executor could strip her of those assets. With Q-TIP treatment denied, the estate tax was due immediately. (Estate of Willard Robertson, 98 TC 678)

TAXPAYERS SAFETY

But the Tax Court's verdict in the Robertson case was overshadowed by the Fifth Circuit Court of Appeals, which reversed the Tax Court in the Clayton case, where the executor had similar powers. (Estate of Arthur M. Clayton, Jr., 976 F2d 1486) The appeals court upheld a Q-TIP election for certain assets, chosen by the executor, even though the non-elected assets passed under the will to other trusts where the surviving spouse did not receive all the income.

The Fifth Circuit noted that Congress left the Q-TIP election up to the executor, not the surviving spouse. The court held that the executor was acting on Clayton's behalf, carrying out his wishes by making this partial Q-TIP election.

In essence, the Fifth Circuit focused on the underlying economic reality. The assets not chosen for Q-TIP status would be subject to estate tax right away while the Q-TIP assets would be taxed at the death of the surviving spouse. That's what Congress intended, when it passed Q-TIP legislation, so the Court upheld the taxpayer's strategy.

Observation: If the Fifth Circuit's opinion in the Clayton case is followed by other courts, it can provide much greater flexibility in the use of partial Q-TIP elections. Assets not elected to be in a Q-TIP can be moved to other trusts with other beneficiaries, besides the surviving spouse, and where the trustee has more discretion over the distribution or accumulation of trust income.

Caution: The IRS may find a case to test this issue, in another appeals court, rather than acquiesce with the Clayton decision.

SOLUTION

In another recent Q-TIP case (Estate of George D. Ellingson, 964 F2d 959), it was the Ninth Circuit that overturned the Tax Court. Here, the trustees of the marital trust were directed to distribute the "entire net income" to the surviving spouse yet they were also authorized to accumulate income in the survivor's "best interests and welfare."

Faced with this contradiction, the appeals court determined that Ellingson desired to set up a Q-Tip, which would require a full payout of income, but hedged his bets by permitting accumulation if Q-TIP status were not elected. Further, if Q-TIP status were elected, it would be in the survivor's "best interest and welfare" to distribute all the income, because this would preserve the estate tax deferral.

Observation: If the marital deduction had been denied in this case, a family farm might have had to be sold in order to pay the estate tax. This particular judge likely did not want to do this.

However, you can't always count on a court being so concerned with a taxpayer's well being, so trust documents should be screened for poor wording.

In both taxpayer victories (Clayton and Ellingson), the appeals courts found a difference between the requirements for trust distributions, in case of a Q-TIP election, and the way assets may be distributed if there is no election. Therefore, there is solid precedent for estate plans in which increased Q-TIP discretion is given to executors. Nevertheless, such matters are complex so you should work with an attorney who specializes in estate planning.

CAUTION

If you're a business owner, your primary asset will be the shares of your corporation. You can leave them to a Q-TIP trust, but you need to be careful how you do it. In IRS Ltr. Ruling 9139001, the Service gave a vivid example of how not to mix a Q-TIP with a closely held business.

Dave was the sole owner of ABC Co. At his death, all shares of ABC went into a Q-TIP trust; his widow Emily was to get all the trust income. At Emily's death, Dave's son Fred would inherit.

According to Dave's will, the Q-TIP trust could sell the ABC shares only to Fred. What's more, Dave's will stated that the sale would be at book value, which was effectively 20% below the stock's fair market value.

In the meantime, Fred had the right to vote all the ABC stock. ABC, though profitable, had not paid any dividends for several years.

You can see where this left Emily. The only way she could get income was through ABC dividends, yet the company was not paying any and was not likely to. Fred, who controlled the company, had an interest in not paying dividends: the retained earnings or reinvested capital would boost the value of ABC, which he would ultimately inherit.

Emily could not force the trustee to sell the ABC stock and reinvest in income-producing assets. Any sale had to have Fred's approval, and he was entitled to buy the shares at a 20% discount. So the IRS disallowed the Q-TIP claim. Emily, it ruled, really had no income interest in the trust. What's more, Fred had a significant interest in the trust assets, even during Emily's lifetime.

What was the consequence of the Q-TIP denial? Estate tax was due immediately, upon Dave's death. In such situations, the estate may be forced to sell all or part of the ABC shares, to raise the necessary cash.

Observation: Although the circumstances cited by the IRS may be rare, many Q-TIP trusts include closely held stock subject to a buy-sell agreement, often at a bargain price. With this letter ruling, the IRS is saying that the buyout price must be at fair market value. If not, the Q-TIP will be denied.

Recommendation: If Dave is concerned that Fred will not be able to pay the full market price for ABC Co., he could purchase a second-to-die life insurance policy, payable to Fred after Dave and Emily die. This can provide the necessary cash. To ensure the policy is fully funded, Dave could bequeath a separate amount (not Q-TIP property) to a life insurance trust, which would maintain the policy.

In addition to a valid buy-sell agreement, a Q-TIP involving a closely held company must make some income provision for the surviving spouse. She must receive dividends or the trust must be able to sell shares and reinvest in cash-flow vehicles. Appointing an independent trustee or co-trustee will strengthen the surviving spouse's position.

IN BRIEF:

* Leaving property to your spouse will defer federal estate tax. However, you'll lose ultimate power over the distribution of your assets.

* Q-TIP trusts retain your marital deduction from estate tax and provide your surviving spouse with a lifetime income, yet they allow you to say where your wealth will wind up.

* Q-TIPs are most commonly used in second marriages, where you want your assets to wind up with your own children.

* Q-TIPs also are worthwhile in first marriages, to guard against problems that may arise if you die and your spouse remarries.

* A Q-TIP trust also can protect your widow or widower from con artists and relieve the pressures of intra-family disputes after your death.

* Q-TIP property should be income-producing. If ineligible assets wind up in a Q-TIP, you could lose the marital deduction, forcing your estate to pay taxes immediately.

* When setting up a Q-TIP, work with your executor and your trustee as well as your attorney.

* Pick at least one trustee with whom your spouse will feel comfortable, in case principal has to be tapped for extraordinary expenses.

* Sophisticated wealth transfer planning can provide for your children while your widow is still alive.

* Recent court decisions indicate that you may be able to set up a Q-TIP trust so that the executor can decide, after your death, which assets will get Q-TIP treatment and where the other assets will wind up.

* Be very careful when putting closely held stock into a Q-TIP trust; there may be a conflict between the surviving spouse, who wants current income, and your chosen successor, who may want to reinvest profits in the company.

CREDIT SHELTER TRUSTS

How to pass on up to $1.2 million (and more) with no estate tax. The 1981 tax act established an estate-tax system that still exists today. With lawmakers, as always, anxious to find sources of additional tax revenue, it's likely that estate taxes will go up sometime in the near future. For now, though, savvy use of trusts can shelter up to $1.2 million from estate tax.

Here's how:

Everyone is entitled to a $192,800 estate-tax credit--enough to exempt $600,000 in assets from estate tax. Thus, if you die with less than $600,000 in assets, no estate tax will be due. That doesn't mean $600,000 in cash. After your death, your executor must add up all of your assets and file a tax return. Those assets include the value of your house, your life insurance proceeds (if you own the policy), your retirement plan, your investments, your business interests, your collectibles, etc. Everything you own must be counted, whether you leave it via a will, a living trust, through joint tenancy or by other means.

Assets over $600,000 are steeply taxed. The tax kicks in at 37%--if you have A $700,000 estate, you'll owe $37,000 on the excess $100,000. From there, the tax escalates to 55%, with a special 5% surcharge on the tax due from estates valued at $10 million to $21 million (see Table 1, page 102).

In most cases, that tax is payable in full within nine months of your death. If cash isn't readily available, your executor may have to sell real estate, stocks or other assets in a hurry to raise the money. The rules and amounts are changing. Check for current laws and rules.

SPOUSAL SHELTER

One way to avoid this estate-tax bite is to leave assets to your spouse. No matter how large, such bequests aren't taxed if your spouse is a U.S. citizen, thanks to an "unlimited marital deduction" from estate tax. You can have a $1 million estate, even a $100 million estate: If you leave everything to your spouse at your death, no estate tax will be due. However, when your spouse dies, everything over $600,000 will be subject to estate tax.

Example: Robert and Linda have a total estate of $1 million. This includes $500,000 in jointly owned assets, $300,000 in Robert's name and $200,000 in Linda's name. Robert dies first. At his death, the jointly owned property passes to Linda automatically. Robert's will calls for his entire estate, all $300,000 worth, to go to Linda. No estate tax is due.

Now Linda has $1 million worth of assets. She lives modestly and her assets appreciate in value until her death, some years later. Her estate, which is left to her children from her marriage to Robert, totals $1.2 million. Now, her children will owe around $235,000 in federal estate tax. If you add state death taxes, probate fees, funeral costs and so on, the total might be close to $300,000.

TAX BREAKS

Robert and Linda could leave everything to their children with little or no estate tax, and you can do the same, if you follow this strategy:

* Make sure that you and your spouse have roughly equal assets, up to the point where each has at least $600,000. These assets should be held outright, not jointly. If one spouse has significantly greater assets than the other, tax-free spousal gifts can be used to make sure each spouse has at least $600,000.

Observation: Jointly held property makes estate-tax avoidance difficult. As you can see in the above example, either Robert or Linda would have $500,000 in assets, whichever one survives, plus his or her own assets. Therefore, an estate tax on the second death will be hard to avoid.

* Each spouse should have a will or a living trust stating that their estates, up to $600,000 worth of assets, should pass to children or grandchildren at their death. No matter which spouse dies first up to $600,000 will go to future generations, sheltered by the estate-tax exemption. The rest can be left to the other spouse, sheltered by the unlimited marital deduction. Therefore, no estate tax will be due at the first death.

* At the second death, when all the remaining assets are passed down, another $600,000 will be sheltered. Thus, $1.2 million will escape estate tax, in addition to any assets given away through gifts.

Some problems with this approach are obvious. If you and your spouse have $800,000 worth of assets, for example, and $400,000 passes to the children at the first death, the surviving spouse is left with only $400,000 worth of assets. If you assume this includes the couple's principal residence, there may relatively little in liquid assets to provide income. The surviving spouse may become dependent on the generosity of the children, who inherited $400,000, tax free.

To solve this problem, each spouse can provide for the creation of a trust, to be established upon the death of the first spouse to die. Into this trust might go all of the deceased's assets, except for the personal residence, up to a maximum of $600,000. This trust is known by many names: a family trust, non-marital trust, bypass trust, credit shelter trust and so on. Whatever the name, the basic idea is that this trust will not qualify for the unlimited marital deduction. It will be exposed to estate tax but, because the amount doesn't exceed $600,000, no estate tax will be due.

Terms of this trust can vary, according to each family's circumstance. But a "vanilla" approach would be to give the income to the surviving spouse, during his or her lifetime, and the assets to the children after the second death. Thus, the surviving spouse will have income from the full estate, until death.

Example: Robert and Linda have restructured their assets so that each has $400,000 in his or her own name, with only their $200,000 personal residence held jointly. Each one has a will calling for the creation of a trust, to which his or her individually owned assets will be held.

Now, when Robert dies, $400,000 goes into a credit shelter trust, paying lifetime income to Linda. Thus, Linda will be able to live off $800,000 worth of assets while she owns a $200,000 house. So she'll be well provided for. At her death, the trust assets will go to the children, estate-tax-free. Linda will leave her original $400,000 in assets, plus the $200,000 house, again free of estate tax.

Observation: It's possible that Linda's $600,000 estate will grow before her death, leading to an estate-tax obligation. But, even if her estate grown to $700,000, the estate-tax bill will be a modest $37,000. If she is well advised she can make lifetime gifts to her children or grandchildren, up to $10,000 per recipient per year. This will avoid gift tax and reduce her exposure to estate tax.

The importance of being equal. Why does this strategy call for tax-free gifts between spouses to equalize estates, at least partially? The spouse with fewer assets may die first.

Example: Bert and Lydia have $900,000 in assets, $800,000 in Bert's name and $100,000 in Lydia's. Lydia dies first, leaving her $100,000 to a credit shelter trust. No estate tax is due. Robert dies a few years later, leaving an $800,000 estate. Federal estate tax owed: $75,000. If Robert had given $200,000 to Linda, each could have had a credit shelter trust that would have escaped estate tax.

Observation: Of course, this strategy will work only if the wealthy spouse feels comfortable making large, no-strings gifts to his or her spouse.

LARGE ESTATES

With this basic strategy, couples with estates up to $1.2 million can pass their assets to their children with little or no estate tax. But what about estates larger than $1.2 million?

Assuming that your marriage is solid, you should use tax-free gifts to make sure that each spouse has at least $600,000 worth of assets. Then, no matter which spouse dies first, $600,000 can be left to your children, in trust or outright, to take full advantage of the estate-tax exemption. Thus, you'll be able to pass tax free $600,000 at each death.

Beyond that, planning for large estates involves some judgment. Suppose a couple has a total of $4 million. If the first spouse to die leaves $600,000 to a credit shelter trust, leaving everything else to the other spouse, the surviving spouse may leave a $3.4 million estate and a federal estate-tax bill of over $1.298 million.

Now, suppose, they had equalized their estates at $2 million apiece and each died with those assets. The total estate tax would be $1.176 million. The estate-tax saving would be $122,000.

However, this equalization plan (each has $2 million) means that half of the taxes are paid now, rather than all of the taxes paid later. What's better--paying $588,000 now and $588,000 later, or paying $1.298 million later? There's no simple answer.

If the surviving spouse lives for a long time and invests well, the $588,000 not paid up front may increase by more than enough to make up for extra estate tax. Or a series of gifts may reduce the estate, and the ultimate estate-tax bill.

Naturally, you shouldn't make such decisions by yourself, especially if you expect to have a multi-million-dollar estate. Consult with a full range of advisors: attorney, accountant and investment analyst. As these examples illustrate, successful estate-tax planning can wind up saving your family hundreds of thousands of dollars.

ACT NOW

It's likely that someday--may be someday soon--the estate-tax exemption may be reduced from $600,000 to a lower amount, and the top estate tax rate may be increased from 55% to 60% or higher. However the numbers change, the above strategy will work. The idea is to take full advantage of the estate-tax exemption, whatever it may be, at each death.

Observation: The sooner you act, the greater the chance your estate plan will be "grandfathered" if tax laws change. You should consult with an estate planning attorney as soon as possible after any change in tax law.

REMOVING ASSETS PERMANENTLY

One estate planning goal is to keep assets out of your taxable estate or the taxable estate of a family member. One wrong word, though, can ruin all your estate planning and expense.

Suppose, for example, you create a trust to provide lifetime income for your spouse, who's younger than you and probably will be the survivor. You want to keep the trust assets out of your spouse's estate. At her death, the assets will pass to your children or will stay in trust for the benefit of your children and grandchildren.

Your spouse is worried that the trust income won't provide enough for her to live on comfortably. She wants to be able to get to the principal if she needs more money. Therefore, some provision is made for her to have access to the trust assets.

Caution: If the survivor's access to trust principal is made too broad, the IRS will consider the assets under her control and thus part of her taxable estate.

The tax court's decision in the Estate of Norman Vissering case (96 TC 749, 1991) illustrates what can happen. Vissering's mother set up a trust to pay lifetime income to herself. After her death, the trust was to pay lifetime to her son, Norman Vissering. Other family members were also named as beneficiaries, eligible to receive trust distributions. Norman Vissering was co-trustee, along with a bank.

Many years after his mother's death, Norman Vissering developed Alzheimer's disease and was declared incapacitated. He died a few months later. The IRS asserted that the trust assets were part of his taxable estate.

The case went to tax court, where the IRS pointed to the trust provision giving the trustee the authority to use the principal for the "continued comfort, support, maintenance or education" of the beneficiaries. This provision, it contended, gave co-trustee Vissering a "general power of appointment," meaning control over the assets. If this general power of appointment did indeed exist, the trust assets would be includible in his taxable estate.

HEALTH, EDUCATION, SUPPORT, & MAINTENANCE

Vissering's estate argued that the power of appointment was limited, not general. The tax code specifically states that the power to invade the trust for a beneficiary's "health, education, support or maintenance" is a limited rather than a general power and thus does not result in inclusion.

Result: Vissering's estate lost solely because the word "comfort" was included in the trust. "Comfort" goes beyond "health, education, support or maintenance." In fact, the IRS has specifically stated that the words "comfort," "welfare" and "Happiness" result in broader powers and may result in inclusion.

Essentially, the IRS has blessed four words--health, education, support and maintenance--for situations where the trust may need to be invaded. Those words are safe harbors. Any other words are invitations to disaster. In this case, one word, "comfort," resulted in inclusion and cost the estate $700,000 in estate tax that needn't have been paid.

Observation: In one recent letter ruling, the IRS added the word "care" to the terms conveying broader powers than permitted. Such words as "catastrophe" and "emergency" also should be avoided. In truth, none of these words adds very much to the powers implied by the acceptable health-education-support-maintenance.

Because of the trust wording in this case, co-trustee Vissering could distribute the trust assets however he wanted for the comfort of beneficiaries. Therefore, said the tax court, the assets were under his control and includible in his taxable estate.

Observation: Vissering was officially incapacitated and could make no distributions at the time of his death. The court included the assets anyway because Vissering had not been removed as trustee and technically still retained the trustee's powers.

Similarly, the fact that Vissering was co-trustee with a bank did not sway the court. The bank was not an "adverse" party, with an interest in the trust assets opposed to Vissering's.

Whenever a trust beneficiary is also a trustee, the danger of inclusion is present. It may help to name a co-trustee with an adverse interest, such as another trust beneficiary.

Even if a trust beneficiary is not a trustee, assets may be includible if the beneficiary can dismiss the trustee and name a replacement. Ever since 1979 (revenue Ruling 79-353), the IRS has taken the position that broad discretionary powers will result in a general power of appointment when beneficiaries can unilaterally remove and substitute trustees. (Irrevocable trusts in place before October 29, 1979, are grandfathered.) That is, the beneficiary has control over the assets because he or she can appoint a friendly trustee.

Often, the beneficiaries' ability to remove trustees may be their sole leverage in assuring that they receive quality service. Therefore, if your estate planning calls for giving trust beneficiaries this leverage, you need to be sure the power of appointment is limited rather than broad. Check the wording in existing trust documents and your will if any call for a testamentary trust to be created.

BEYOND THE $10,000 LIMIT

To save estate tax, you can give away assets before you die.

Everybody is allowed to give away $10,000 worth of assets per year, per recipient, while married couples can give away $20,000. Larger gifts are subject to a gift tax.

Maria Cristofani, though, found a way to shift $70,000 per year to her two children, free of gift tax, a tactic the tax court upheld. Maria, a widow with two children, Frank and Lillian, established a trust. At her death, the assets were to be split between the two children, who were twins. At the time she created the trust, Frank and Lillian were 35 years old and in good health.

Frank and Lillian's five children (Maria's grandchildren), aged 2 through 11, were named secondary beneficiaries. If either Frank or Lillian failed to outlive Maria by 120 days, that child's children would split his or her share.

After setting up the trust, Maria transferred real estate valued at $70,000 to the trust in 1984, and again in 1985. She did not file any gift tax returns.

When Maria died, the IRS charged that $20,000 of the annual gifts could be excluded but the other $50,000 per year was subject to gift tax.

According to the Cristofani estate, there were seven trust beneficiaries: Frank and Lillian and the five grandchildren. With seven beneficiaries, the $70,000 gifts incurred no gift tax.

Under the terms of the trust, each beneficiary had a Crummey power. After each contribution, the trustees (Frank and Lillian) were required to provide written notice to all seven beneficiaries. Each beneficiary then had the right to withdraw up to $10,000 within 15 days.

The IRS said that the grandchildren were not bona fide gift recipients because their right to the trust fund was too contingent to be recognized. The tax court, though, held for the taxpayer because the children had the legal right to withdraw assets from the trust during the 15-day period.

Observation: While Frank and Lillian, the primary beneficiaries, were also the trustees, the secondary beneficiaries were all minors. In order to exercise their withdrawal rights, the children could do so only through their guardians--their parents, including Frank and Lillian.

Frank and Lillian therefore effectively controlled all the trust assets. Maria was able to shift $140,000 worth of assets to her two children in two years, without owing gift tax.

Multiple-beneficiary trusts can thus be used to expand the gift tax exclusion. Make sure that all the formalities are observed, in terms of the withdrawal power, and that there is no prior agreement not to use the withdrawal power.

Observation: Cristofani trusts may be ideal for holding life insurance. If you're buying a large insurance policy to cover your estate tax bill, the premiums may exceed the $10,000 or $20,000 annual gift-tax exclusion. With multiple beneficiaries, you may be entitled to multiple $10,000 exclusions.

Moreover, Cristofani trust beneficiaries must have a real interest in the trust. There must be at least a slight chance that the secondary beneficiaries could inherit the entire trust proceeds, giving them a reason not to exercise their Crummey withdrawal power. The limits are changing. Check current amounts.

IN BRIEF:

* Under current law, federal estate tax is levied on all the assets you own at your death, even those that bypass probate.

* Everyone can transfer up to $600,000 worth of assets, free of federal estate tax.

On estates over $600,000, federal tax rates are 37% to 55%. States may impose additional taxes.

* You can avoid federal estate tax by leaving all of your assets to your spouse. Eventually, though, those assets will be subject to estate tax.

* A better approach is for the first spouse to die to leave up to $600,000 to the children, taking advantage of the estate-tax exemption.

* To provide for the surviving spouse, this bequest can be made to a trust that provides lifetime income to the survivor. At the survivor's death, the assets pass to other beneficiaries, probably your children or grandchildren.

* To keep trust assets out of a beneficiary's estate, the beneficiary should not be given access to trust funds except for what's necessary for "maintenance, education, support and health."

* If you name secondary trust beneficiaries, and they have genuine access to trust funds, you may be able to increase tax-free transfers to trusts.

RETAINED INTEREST TRUSTS

Reduce your taxable estate with deferred gifts.

If you're concerned about estate tax, you may want to make large gifts now to take full advantage of the $600,000 estate-tax exemption ($1.2 million for a married couple) while it still exists. Otherwise, you run the risk that the exemption will be trimmed to $400,000, $300,000 or less.

However, you may not want to part with $600,000 or $1.2 million worth of assets. If that's the case, consider a split-interest gift: You make a gift with strings attached.

Typically, you'll make a gift to a trust with a fixed term. The trust pays you income during the trust term. After the trust ends, the principal goes to the beneficiaries. Because the gift is deferred, you get a gift-tax discount.

Example: You hold a securities portfolio of $1 million, which you transfer to a trust. The present value of the income stream you retain is $350,000. Thus, you're making a $650,000 gift to the trust beneficiaries.

That's true even if the securities in the portfolio increase to $2 million or more, at the time of the transfer.

GRATS AND GRUTS

Setting up a retained interest trust involves choices. The first decision you must make concerns the term of the trust. The longer the term of the trust, the smaller the gift, for tax purposes. However, you must outlive the trust to get the estate tax benefits. Ten-year trusts are common. If you have doubts about your health, shorter trusts are preferable.

After choosing a trust term, you must decide whether to use a grantor retained annuity trust (GRAT) or a grantor retained unitrust (GRUT). With a GRAT, you'll receive a fixed amount each year. With a GRUT, you'll receive a fixed percentage of the trust assets each year. Thus, GRUT payouts fluctuate with the potential of increasing or decreasing from year to year.

* If you want to receive, say, $50,000 a year, use a GRAT.

* If you prefer, say, 5% of the trust value very year, go with a GRUT.

Next, you have to choose the level of income you want to receive. The more you keep for yourself, the lower the gift, for tax purposes. Gift taxes are set by the IRS interest rates in effect at the time of the transfer. These rates change monthly to reflect current interest levels.

Example: You transfer $100,000 to a 10-year GRAT, retaining a $10,000 annual income interest. The IRS Section 7520 interest rate at that time is 7%. The value of your gift is under $30,000.

However, if you were to retain an income interest of only $6,000 per year, the value of the gift would be nearly $60,000.

Observation: GRATs provide stable income while GRUTs can offer inflation protection, if you're willing to bear some risk. You should select the type of income you'd prefer.

GRATs usually are more advantageous than, GRUTs as long as the annuity rate is higher than the IRS interest rate. That will give you a high, fixed stream of income and a low gift tax bill.

If you select a payout below the IRS interest rate, choose a GRUT, because your income likely will grow as the trust principal increases. Again, your gift tax obligation will be reduced.

Caution: The major drawback to GRATs and GRUTs is that trust assets need to be income-producing. Shares in a closely held business may not work unless the business throws off sufficient cash flow.

INTEREST RATES AND EFFECTS

Low interest rates increase the appeal of GRATs and GRUTs. Interest rates play a key role in determining the present value of your retained interest. The IRS publishes a Section 7520 rate each month, roughly equal to 120% of the yield on intermediate-term Treasury securities. This interest rate, in conjunction with the term of the income stream, is used to calculate the present value of the income stream you'll receive.

If treasuries pay more than 10%, as they did a few years ago, receiving $70,000 a year from a $1 million GRAT would be no big deal. The principal likely would grow, and the trust beneficiaries can expect to receive a healthy sum down the line. Thus you'd incur a hefty gift tax.

Today, with Treasuries paying closer to 5%, receiving that $70,000 a year is much more meaningful. That $1 million fund likely will shrink, or the trustee will have to take risks to make it grow. So the present value of the income stream is greater, the value of the remainder interest is small and gift tax is lower.

There are thus sizable gift tax advantages to transferring assets in a 5% climate, rather than in a 10% climate.

Today, you could transfer a $1 million portfolio, lock in a $70,000 annual income and owe gift tax on less than half of that amount. In a 10% world, your gift tax on an identical trust would be nearly 60% of the assets transferred.

Observation: The calculation is a bit different but the principle is the same for a GRUT. The more income you'll receive, the longer the time frame and the lower the interest-rate climate, the lower the value of the taxable gift.

What happens if you die before the trust term expires? All of the trust assets will be included in your taxable estate.

Recommendation: For the best results, avoid long-term trusts. Choose a time period you're likely to outlive.

IN BRIEF:

* You may want to reduce your taxable estate by making gifts to family members, but you also may not want to give up assets right away. If so, you can give assets to a trust and retain the right to receive income from the trust, for a given time period.

* Such a deferred gift gives you an income stream as well as a smaller gift tax obligation.

* The longer the deferral and the more income you'll receive, the lower the gift tax obligation.

* Grantor retained annuity trusts (GRATs) pay a fixed amount of income while grantor retained unitrusts (GRUTs) pay a fixed percentage of trust assets.

* In a low-interest rate environment, transfers to retained interest trusts generate lower gift tax consequences.

* If you die before the trust term expires, the assets will be included in your taxable estate, so you should pick a trust term you're likely to outlive.

PERSONAL RESIDENCE TRUSTS

Cut estate taxes by giving away your house.

Qualified personal residence trusts (QPRTs) allow you to remove your house from your taxable estate with little gift tax obligation. Plus, a properly structured QPRT can reduce income tax as well.

Observation: If you own a valuable home, you can wind up ahead by hundreds of thousands of dollars.

With a QPRT, you create a trust and transfer a house to it, naming yourself as trustee. The house can be your primary residence or a vacation home. In fact, you can have two QPRTs, as long as one is for your principal residence. During the trust term, the trust can hold only the one residence, plus some cash needed for house-related purposes.

Just as in a GRAT or a GRUT, you, as grantor, retain an interest after the transfer to the trust. Usually that interest is the ability to live in or use the house for a certain time period. Common trust terms are 10 and 15 years.

Observation: QPRTs, unlike GRATs and GRUTs, don't generate a stream of income during the trust term.

At the end of the trust term, the house passes to the trust beneficiaries, usually your children, so you're making a gift. Because it's a deferred gift, the taxable gift may be a fraction of current value.

RETURNING OWNERSHIP

QPRTs frequently contain a contingent reversionary interest: If you die before the trust term ends, the house returns to your estate. This increases the value of your retained interest and thus reduces the amount of the taxable gift to the trust beneficiaries.

Example: George, aged 50, sets up a QPRT when the interest rate used to value such gifts is 7%. (This rate is published monthly by the IRS, based on current interest rates.) He retains a 10-year interest in the house plus a reversionary interest.

If the house is worth $400,000, the taxable gift would be only $186,000.

Observation: If a QPRT holds a house subject to a mortgage, each subsequent payment builds equity in the house and thus will be deemed a taxable gift. Thus, debt-free houses are best for QPRTs.

After making this transfer, George gets to live in the house for 10 years. When the term ends, the house will pass to his children. He has moved a $400,000 asset (which may then be worth $500,000 or $600,000 or more) out of his estate, at a $186,000 gift-tax cost.

The term of the trust should be selected with care. A relatively young person can choose a long term and substantially reduce the gift tax while sheltering many years of potential appreciation. On the other hand, a 80-year old can include a reversionary interest, which reduces the gift, even with a three year trust, as long as he outlives the term. IRS regulations dictate that the trust remains in effect, even if the grantor moves into a nursing home.

Thus, you should choose the longest term you reasonably can expect to outlive. The longer the term, the smaller the taxable gift. However, if you don't outlive the trust, and there's a reversion, the house goes back to the estate and the gift-tax savings is lost. You haven't gained anything but you haven't lost anything, either.

Observation: You can offset this risk by purchasing an insurance policy on your own life. This policy might be for the term of the trust, with the death benefit equal to the anticipated tax savings.

SPLIT OWNERSHIP

Another way to reduce the risk is for you and your spouse to each set up a OPRT with part of the house. Or, you each could create a QPRT with a different house. Chances are, at least one of you will outlive the trust term and at least some tax benefits will be enjoyed.

What if your property is owned jointly? You might transfer it to the younger, healthier spouse, who can transfer the house to a QPRT. Yet another option is to have the remainder interest go to the grantor's spouse if the grantor dies during the term of the trust. Again, this reduces the value of the taxable gift.

If you want to sell the house, a QPRT can make the sale and buy another as long as the replacement is acquired within two years.

Caution: A house in a QPRT can't be mortgaged to raise can in case of an emergency.

When the trust term ends, you may be reluctant to move out of your home. If that's the case, you can stay there, paying rent to the new owners (probably your children). The rental payments will get more money out of your estate.

Observation: The IRS has approved prior arrangements to lease the house to the grantor, after the term ends, as long as a fair market rent will be paid. However, QPRTs should be considered only if you're on good terms with your beneficiaries, so you'll be able to rent the house, if desired.

If you don't want to pay rent, you can give the house to the trust yet give your spouse a life estate (the right to stay in the house), after the trust term. That will your spouse (and, presumably, you) lifetime use of the house with no rent and no loss of control.

Recommendation: Vacation homes often work better than principal residences in QPRTs, because you won't be as concerned over the long-term fate of the house. Often, you might be happy with a deal that allows you to use a vacation house for another 10 or 15 years, then give the house to your children.

CAPITAL GAINS

Capital gains can be a problem with a QPRT. Suppose, when George transfers his $400,000 house to a QPRT, he has a basis of $100,000. At the end of the trust term, when it passes to his children, its value is $600,000.

George stays in the house, paying rent, until his death. At that point, the house is valued at $800,000, and his children sell the house for that price.

Thus, George has transferred an $800,000 asset to the next generation while incurring a gift tax of $186,000. This knocks more than $600,000 from his client's taxable estate and saves over $300,000, in a 50% estate tax bracket.

However, George's $100,000 tax basis in the house is passed on to the trust beneficiaries. When his children sell the house for $800,000, they'll have a $700,000 taxable gain. Assuming a 28% tax rate on long-term capital gains, the kids will owe almost $200,000. Thus, the total tax savings is reduced to just over $100,000.

Recommendation: Just before the trust term ends, George could buy the house back for fair market value, then $600,000. As long as George buys back the house for fair market value, no income tax will be due.

Observation: George now has a $600,000 house back in his estate but he has moved out the $600,000 purchase price, so it's a wash. What's the advantage? George has regained ownership of the house. If he holds onto the house until his death, his heirs will inherit with a step-up in basis. They can sell the house and owe no capital gains tax. This strategy reduces income tax as well as estate tax.

Suppose George doesn't have $600,000 to buy back the house. He can buy the house with an installment sale, paying with a note. To avoid an IRS challenge, he must show that it's a real note, backed by real assets, and that all payments are made on schedule.

Recommendation: QPRTs are such a great tax shelter they may be outlawed by Washington, but trusts created before legislation is proposed will likely be grandfathered. So act soon if a QPRT is appropriate for you. Moreover, the sooner you set up the trust and start the clock ticking, the better your chance of outliving the trust.

IN BRIEF:

* A qualified personal residence trust allows you to remove a home from your taxable estate with relatively slight gift tax consequences.

* QPRTs can be used for principal residences or for vacation homes.

* To use a QPRT, you transfer a house to a trust for a certain time period, retaining the right to live there.

* At the end of the trust term, the house reverts to your beneficiaries, typically your children.

* The longer the trust term, the lower the gift tax you'll incur, as a percentage of the house's value.

* At the end of the trust term, if you want to stay in the house, you can pay rent to the new owners.

* Another option is to buy back the house from the trust, paying a fair price.

* If you buy back the trust and hold in until your death, all the housing appreciation will escape capital gains tax.

S CORPORATION TRUSTS

If you own a small business, you may have elected S corporation status. S corporations avoid the corporate income tax; they also avoid such tax problems as unreasonable compensation and excess accumulative earnings.

To qualify for S. corporation status, you must meet and maintain certain standards. For example, an S corporation can have no more than 35 shareholders, all of whom are citizens or residents of the U.S. S. corporation shareholders must be individuals, estates or certain qualifying trusts. If a corporation fails to meet any of these conditions, it will lose its S status and owe corporate income tax.

Some of these conditions are not hard to comply with. However, if your S corporation is your family's major asset--which usually is the case--you may want some of your shares held in trust. Then, you need to be certain you use the "right" kind of trust.

Here are the only trusts that are eligible to be S corporation shareholders: 1. Grantor trusts. The person who creates a trust is known as the grantor; if the grantor retains control over a revocable trust, and retains the income, the trust is known as a grantor trust. Such trusts have no tax liability. Instead, all the taxes are the responsibility of the grantor. Such trusts are eligible to own S corporation shares, so you can transfer S corporation stock to a revocable living trust.

Observation: To retain S corporation eligibility, you, as grantor, must control all the income from all the assets in the trust.

Grantor retained annuity trusts (GRATs) and grantor retained unitrusts (GRUTs) are eligible S corporation shareholders because the grantor retains a right to all of the trust's income.

However, GRATs and GRUTs aren't always appropriate S corporation shareholders: * If the grantor dies before the trust terminates, the shares are thrown back into his or her taxable estate.

* GRATs and GRUTs have a commitment to distribute a certain amount of income each year, which places an obligation on the S corporation to distribute cash.

* Distributions made to the GRAT grantor must be matched for each one of the S corporation shareholders, which may be a financial strain on the company.

2. "Section 678" trusts. Section 678 of the Internal Revenue Code permits trust income to be shifted to another person. That other person, the "income beneficiary," owes all the tax on trust income so the trust is merely a pass-through vehicle, just like a grantor trust.

Section 678 trusts may be used by a parent who wants to pass income to a child, while the grantor retains control of the trust assets. Another common application: these trusts often are used to pass assets to a surviving spouse, giving the survivor income as well as the right to direct the ultimate disposition of trust assets. Section 678 trusts are eligible S corporation shareholders, so you can use them to pass S corporation stock to your spouse.

3. Qualified subchapter S trusts (QSSTs). One problem with the Section 678 trust is that the beneficiaries can freely invade the trust principal. In some cases, though, you want to place restrictions on trust beneficiaries--children can't get their hands on trust assets until they reach a certain age, for example.

That's where a QSST comes in. As the name suggests, these trusts are eligible S corporation shareholders, but they still permit the grantor to put strings on the assets placed in trust.

In order to qualify as a QSST: * The trust can have only one current income beneficiary.

* That income beneficiary must be the only one who can receive trust assets, and the assets must be distributed to him when the trust terminates.

* The income beneficiary's interest must end if he dies while the trust still exists. (In other words, his estate can't inherit the interest.)

* The income beneficiary must elect QSST status.

Observation: You can transfer nonvoting S corporation stock to a QSST, retaining voting stock and thus control of the business.

A QSST can also serve as a Q-TIP trust. Thus, you can use a QSST to leave your S corporation shares to a surviving spouse for her lifetime, defer estate tax with the unlimited marital deduction, and direct the stock to the ultimate beneficiaries you choose.

4. Testamentary trusts. As opposed to a living trust, created while the grantor is still alive, a testamentary trust is created in a will. If you leave your S corporation stock to a testamentary trust, the shares must be transferred to an eligible shareholder within 60 days. However, complications will arise if you leave S corporation stock to a testamentary trust with multiple beneficiaries with an ineligible beneficiary. So plan carefully.

5. Successor trusts. When the grantor or the income beneficiary of an eligible S corporation trust dies, a successor will step into his shoes. Again, this "successor trust" must not have an ineligible beneficiary. Depending on the circumstances, the trustee has from 60 days to two years to transfer the stock to eligible shareholders. It helps if the original trust has separate S corporation share certificates, for the trustee to divide among several eligible shareholders.

Observation: Trusts are basic estate planning tools. S corporation owners need to be able to use trusts, but they must proceed with caution. Working with a knowledgeable attorney is essential.

IN BRIEF:

* S corporations enjoy several tax advantages but corporations must meet several criteria in order to qualify.

* Among those criteria, only certain types of trusts can hold S corporation shares.

* Owners of S corporations may want to use trusts in order to pass the company to family members, defer and save estate tax and provide protection to family members who need it.

* S corporation owners can use trusts to reach these goals, but they must proceed with caution.

GENERATION-SKIPPING TRUSTS (GST)

Enjoy double shelter from estate tax.

If your parents have been successful enough to build a sizable estate, chances are that you have substantial assets, too. In that case, passing along an inheritance can be extremely taxing.

Example: Joe Smith dies and leaves his widow Susan with a $2.5 million estate, including a house, insurance proceeds, pension fund, shares in a family business and other assets. Susan dies and leaves everything to Joe, Jr., and Mary, her two children. After estate tax, about $1.6 million will be left.

But that $1.6 million will be added onto all of Joe, Jr.'s, and Mary's other assets. By the time they die, their assets might be so great that they're in a 50% or 55% estate tax bracket (or even a higher one, if taxes are raised in the interim). Assuming a 50% bracket, only $800,000 will be left for the grandchildren, out of the grandparents' $2.5 million estate.

To reduce the tax bite, Susan could leave her $2.5 million directly to her grandchildren. Then, only one estate tax would be due, and the grandchildren would net about $1.6 million instead of $800,000. However, this strategy poses two problems:

* Joe, Jr., and Mary, who are doing all right now, might run into financial difficulties and need the money.

* Inheritances left to family members more than one generation down the line may be subject to a "generation-skipping tax." If so, an extra 55% GST would be due at Susan's death, reducing her estate to around f$720,000.

MILLION-DOLLAR LOOPHOLES

Fortunately, there is a $1 million exemption to the GST ($2 million for married couples). Using this exemption will help solve both problems.

Example: In her will, Susan leaves $1 million to two trusts, one for each of her children. The money actually is left to her grandchildren, although her children may be entitled to a lifetime income. This income, plus the $600,000 they'll inherit (her $1.6 million after-tax estate minus the $1 million left to the two trusts) will help them ride out any future financial storms.

Observation: Your will or trust documents should state that estate tax will be paid out of your residuary estate so you won't waste your GST exemption.

The $1 million left to the grandchildren won't be subject to estate tax at Susan's death or at the deaths of Joe, Jr., and Mary. The grandchildren will get the entire $1 million, plus any asset appreciation or undistributed income.

Observation: You also can use your $1 million GST exemption with a lifetime gift, setting up an irrevocable trust and naming your child as trustee, with grandchildren as co-trustees or successor trustees. Your children and grandchildren also can be beneficiaries. In case of an emergency, the trustee can distribute or loan funds to the beneficiaries.

Such trusts can be structured to last through your lifetime and your children's lifetime until the last of your grandchildren dies, when the assets will pass to your great-grandchildren. Thus, the trust can provide decades of asset protection and wealth-building, along with estate tax avoidance.

APPRECIATION

For all that time, the trustee can invest the funds in growth stocks, municipal bonds, life insurance other vehicles. Even if the $1 million eventually grown to $2 million, $5 million $10 million at the time of your death, no GST will be due, as long as the original gift was covered by the GST exemption.

If you use your $1 million GST exclusion while you're alive, you must irrevocably elect this exclusion on a gift tax return, after the property transfer. If you make a gift to your grandchildren and don't allocate your GST exclusion, all the assets that pass to your grandchildren at your death (including any appreciation) will be subject to the 55% GST.

You can set up a GST trust as a Q-TIP trust. After your death, your surviving spouse gets a lifetime income and a limited right to the trust assets. Estate tax (on your estate) will be deferred until your survivor's death. Then the trust fund will pass to your children and grandchildren without another round of estate tax.

Or, you could leave $600,000 worth of GST exemption to a credit shelter trust, for your children and grandchildren. This trust will avoid both estate tax and GST. The other $400,000 of GST exemption can be allocated to a Q-TIP trust.

INVESTING

If you give money to a GST trust during your lifetime, what's the best way for the trustee to invest?

* Municipal bonds are a conservative way to increase assets steadily, tax-free.

* Growth stocks are more volatile but the long-term returns should be much higher. As long as the stocks don't pay significant dividends and you hold trading down, the annual tax bill won't be great.

* Life insurance can cover one spouse or both. The death benefit will be tax-free while tax-free loans and withdrawals from the cash value can provide emergency funds.

If the insured person or persons dies relatively soon, life insurance will have a greater payoff than stocks or bonds. After 20 or 25 years, though, stocks or bonds likely will generate a higher return.

Recommendation: A mix of munis, growth stocks and life insurance can generate trust fund growth under any circumstances.

IN BRIEF:

* If you inherit money from your parents, and you already have substantial assets of your own, your parents' assets may be reduced by two rounds of estate tax.

* To avoid this problem, you can leave money directly to your grandchildren, but there's a 55% generation-skipping tax on such transfers.

* Fortunately, each person gets a $1 million exemption from the generation-skipping tax.

* Therefore, you can leave up to $1 million in generation-skipping trusts and so can your spouse.

* Such trusts can be structured to pay income to your children, if necessary, and eventually distribute assets to grandchildren or great-grandchildren, with no reduction for estate tax.

* Although there's a $1 million limit to the amount that's exempt from the generation-skipping tax, all future appreciation also will avoid that tax.

* For security, assets distributed to a generation-skipping trust can be divided among municipal bonds, growth stocks and live insurance.

ASSET PROTECTION TRUSTS (APT)

Move your wealth beyond the reach of the U.S. judicial system.

U.S. courts are continually recognizing new "rights" for plaintiffs at the expense of people trying to hold onto their wealth. Anyone with substantial assets, professionals and business owners in particular, may be vulnerable to large judgments. Liability insurance and incorporation are still necessary but they're not guaranteed to protect your personal wealth.

In response, offshore asset protection trusts (APTs) have been created to provide increased asset protection. With an APT, your assets are held in a trust set up outside the reach of the U.S. judicial system. A creditor must prevail in a foreign court before he can get his hands on those assets.

Observation: In some overseas jurisdictions, you can retain control and enjoy the benefits of trust assets, even while they're protected. That's not possible with a domestic trust.

A favorite APT jurisdiction is the Isle of Man, a British Commonwealth located in the Irish Sea. Many Americans like to use British trusts because of the location, the language, the political and economic stability. Other APT havens include the Bahamas, Belize, British Virgins, Caymans, Cyprus, Gibraltar and Turks and Caicos.

SELECTING SITUS FOR ADDED SAFETY

However, many asset protection experts prefer the cook Islands, in the South Pacific. The Cook Islands International Trust Act prohibits the enforcement of foreign judgments. Litigants are forced to bring actions all over again, in a Cook Islands court.

In the Cook Islands, therefore, judgments issued by U.S. courts aren't automatically recognized, as they are in most of the world. Instead, a claimant must hire an attorney who practices in the Cook Islands and that attorney must be paid, win or lose; no contingency fees are permitted there. In court, the burden of proof rests on the creditor, who must satisfy a criminal standard (beyond a reasonable doubt) in order to prevail.

The Cook Islands law also addresses the issue of "fraudulent conveyance." If you transfer assets merely to put them out of the reach of creditors, the transaction will be considered fraud and disregarded. The same outcome generally results if you transfer assets merely to thwart potential creditors--the visitor who's sure to sue you next week for the broken hip suffered while tripping on your dog's bone and falling down on your steps.

Fraudulent conveyance is less likely to be a problem if you use an APT as a vaccine rather than a cure. Establish a trust and shift assets while you have no major claims or likely claims pending. If you shift assets in 1994 and your visitor stumbles in 1999, it will be hard to make the case that assets were transferred to thwart future bone trippers.

Observation: In the Cook Islands, if a trust has been in place for a year before an action is brought, the transfer is not considered fraudulent.

LIMITING THE TARGET

Most people, though, aren't so prescient as to shift assets years in advance. Often, transfers are made with creditors nipping at their heels. In these situations, avoiding a fraudulent conveyance claim is more difficult.

Recommendations: You should stay solvent, at least on paper, while moving the most tempting assets out of easy reach.

Establishing an APT won't allow you to cheat or maim your fellows with impunity. Instead, the idea is to reduce your financial profile you present to would-be claimants.

Many lawyers lower their sights when they discover anything foreign is involved. To press a suit successfully, a plaintiff must overcome so many barriers, with no certainty of success, that frivolous suits will be abandoned while the playing field is leveled for serious actions. Settlements may be reasonable instead of ridiculous.

APTs aren't for everyone. The price tag is high and shopping around for discounts isn't recommended; you want a lawyer who knows how the game is played.

Typically, the process starts by creating a family limited partnership. You and your spouse might control a 1% general partnership interest as well as a 99% limited partnership interest. Then, your most attractive, most liquid personal assets are transferred into this partnership.

You and your spouse can transfer the limited partnership interests to your kids and possibly other relatives. You can avoid gift tax by using the annual exclusion ($20,000 worth of assets per married couple per recipient per year) or you can eat into your $600,000-per-person estate tax exemption if they choose. The entire 99% limited partnership interest can be given away, if desired.

CONTROL

Giving away 99% of your assets to your son-in-law may not be your idea of great planning, but don't worry. As long as those assets are held as limited partnership interests, the owner has no control. You and your spouse, as is reduced to 1%. You decide whether or not to make cash distributions to ship. The limited partners are purely passive participants.

But the limited partners own those assets. Not only is that another obstacle for creditors to clear, it can reduce your estate tax obligation.

Observation: The estate planning purpose might persuade a judge that the entire transaction had a reason other than thwarting creditors.

For extra protection, the 99% limited partnership interest (regardless of ownership) can be transferred to an offshore APT. Transferred on paper, at least. Your brokerage account, for example, still stays in New York or San Francisco or wherever. You may have a hard time convincing a court that the fourplex apartment you own near Chicago is held in the Cook Islands, but you can borrow against your equity and move the cash into the trust.

For creating the limited partnership and the APT, you'll probably pay a lawyer around $15,000, plus another couple of thousand a year to compensate the local trustee. The trustee should be someone with no U.S. connections, out of reach of the U.S. judicial system.

Recommendation: Your APT documents should prevent the trustee from doing anything major with your assets (e.g., stealing them) without your permission.

If you're considering an offshore trust, don't expect tax shelter--these trusts are designed to be "tax-neutral." However, assets in an APT can pass to your heirs without going through probate.

In General, offshore APTs make sense for people with over $500,000 in personal wealth to protect. The more you're worth and the greater the hazards you face, the more an APT can make sense. However, your legal position probably will be stronger if you keep some money in your own name, within reach of creditors, rather than move everything overseas.

IN BRIEF:

* Increasingly, Americans who have managed to accumulate any wealth find their assets threatened by capricious court decisions.

* In an effort to provide extra protection, you can establish a trust outside the U.S., in a jurisdiction where the courts are not so favorable to plaintiffs.

* Asset protection trusts are most effective if they're set up before you're involved in a dispute even threatened with a dispute.

* When you set up an APT, you can keep your assets in the U.S., under your control, even the trust paperwork is offshore.

* In most cases, the first step in the APT process is to create a family limited partnership and transfer assets to it, after which the partnership interests are moved into an APT.

* These legal maneuvering will cost at least $15,000, so it makes sense only if you have substantial assets to preserve.

* Once you have an APT in place, and your assets are out of easy reach, claimants' lawyers may not pursue frivolous actions against you while meritorious complaints may be settled on reasonable terms.

INVESTMENT TRUSTS

Some trusts earn while they protect.

For most of this report, we have discussed trusts that serve as vehicles to protect your assets and pass them on to your heirs. They are cozy arrangements between you, your family and your lawyer. However, there is another class of trust--investment trusts. These are investment opportunities, made available to hundreds or even thousands of potential shareholders. Such trusts may be divided into units and offered to the investing public, like stock in a publicity traded company.

Still, at their roots, these trust offer the same essential benefit that the other trusts we've discussed provide: They protect a portion of your assets from tax collectors. Trusts aren't subject to the corporate income tax; therefore, a successful venture may have more money to pass through to investors, who are called unit-holders rather than shareholders.

Investment trusts offer many of the same advantages as publicly traded corporations. Units can be brought for modest amounts of money and sold with relative ease. Tax reporting is simple. In addition, unit-holders aren't exposed to liability from business operations. Therefore, investment trusts have become popular in recent years. Here are some of the major types:

REAL ESTATE INVESTMENT TRUSTS (REITs)

REITs are companies committed to real estate; shares trade like common stocks, giving investors a passive, low-cost, liquid play on real estate. REITs owe no corporate tax as long as they pass on 95% of their net income to investors every year. As a result, REITs often have large amounts of cash flow to pay out to shareholders.

Although there are mortgage REITs and hybrids, the excitement in the 1990s has centered on equity REITs, which own properties. From October 1990 to October 1993, the equity REIT index gained 73%, reaching an all-time high, before backing off a bit by year-end.

One reason REITs were such strong performers is the yield they offer. Ever since late 1990, interest rates have plunged and investors have backed off from low-yielding CDs, money market funds, T-bills, etc. Instead, they turned to higher-paying alternatives, such as REITs. In 1994, equity REITs were yielding nearly 7% on average, which was much higher than many other types of investments.

Not only do REITs offer high yields, they have tax advantages, which were enhanced by the 1993 tax act. Because of their structure, equity REITs can pass through deductions such as depreciation and interest as well as cash flow. Thus, some REIT distributions are partially tax sheltered.

As is the case with all real estate shelters, the taxes investors avoid today must be paid tomorrow. If you buy ABC REIT at $14 per share and receive a $1 dividend, fully sheltered, your basis drops from $14 to $13 per share. Ultimately, your basis will drop to $12, $11 and so on. If you eventually sell at $15, you might have a taxable gain of $4 per share ($15 minus $11) rather than $1 per share ($15 minus the $14 purchase price).

This can be an excellent arrangement if you're in a high tax bracket. On untaxed distributions, you avoid paying taxes at rates up to 39.6%. Not only are taxes on those distributions deferred, when they're ultimately paid they'll probably be long-term capital gains, now taxed no higher than 28%.

Observation: REIT investments are one of the few means still available for converting ordinary income to capital gain.

The 1993 tax law contained another blessing for REITs. For decades, they have been subject to the "five or fewer" rule: No fewer than five individuals can own more than 50% of a REIT's shares. The idea is to keep rich families from putting real estate into a REIT, exempt from corporate income tax.

Over the years, foreign pension funds and domestic mutual funds were exempt from this rule. Domestic pension funds, though, were not excluded. The 1993 tax bill leveled the playing field. Thus, the demand for REITs from domestic pension funds has increased, putting upward pressure on prices.

What are the risks? REITs have become bond proxies, and they soared when interest rates swooned. But if inflation picks up and interest rates increase, REIT shares might tumble, even if the underlying real estate is unaffected. REITs are interest-sensitive, reacting more to movements in the stock market than in the real estate market.

If REITs appeal to you, you need to choose specific issues in which to invest. Recommendation: Analyze equity REITs as you'd analyze any equity investment. Look at the management team, the line of business and the operational structure. The current dividend yield is far less important than a REIT's potential for raising future dividends.

Some analysts favor apartment REITs because so few apartments are being built in the 1990s while demand from renters is increasing. Others like health care REITs, especially those focusing on long-term care. With increasing emphasis on health care cost control, it makes sense to move patients from an acute-care hospital costing $1,200 a day to a nursing home bed costing $600 per day.

Shopping center REITs--probably the most plentiful--have their adherents, too. Shopping centers generally weren't as overbuilt as office or apartments in the 1980s. Moreover, shopping center leases usually call for tenants (retailers) to pay some kind of overage if sales increase. If inflation picks up, which would hurt REITs, shopping centers would have built-in lease escalators as an offset.

But it isn't enough to focus on apartments, say, or shopping centers. Within each category there will be sinners and losers. Proper analysis requires a close look at a REIT's finances, the soundness of its properties and dozens of other details.

If you are reluctant pick individual REITs, you can use mutual funds. By investing in such mutual funds, you can invest in liquid, professionally managed real estate investments without having to analyze individual issues.

ROYALTY TRUSTS

A royalty trust usually is created by an energy company, which assigns the royalties on specific oil and gas properties to a trust. Then, trust units are sold to investors. The units may trade like common stock.

unit-holders are entitled to royalties--sales proceeds minus all production costs. The trust pays no corporate income tax so the tax obligation flows through to investors. Meanwhile, depletion and other deductions also flow through, reducing the personal income tax that's due.

Often royalty trusts generate extremely high income. However, when the oil and gas run out, that's it. There's nothing left to sell, no return of principal.

In 1993, energy companies found a way to spice up royalty trusts: they added Section 29 properties.

For years, Section 29 of the Internal Revenue Code provided some prime tax shelter opportunities. Section 29 provided tax credits for certain types of nonconventional energy sources, including natural gas produced from tight sands, Devonian shale and coal-bed methane. The more energy produced and sold, the greater the tax credits.

Observation: These credits could be used against your regular income tax; there are none of the income limits that often come into play with some other tax credits.

To get these credits, thousands of nonconventional wells were drilled after Section 29 was enacted in 1980. For those who found the right kind of energy, up to 10 years' worth of credits were available. Thus, wells drilled in the late 1980s and early 1990s can produce tax credits as well as gas for many years to come. Unfortunately, the Section 29 expired at the end of 1992 and were not renewed.

CAUTION

Too Much of a Good Thing. As you might expect, most of the drilling was done by natural gas companies. Such companies had as many tax deductions as they have income. Others had such slight tax obligation, they couldn't use all their credits. Thus, many of these credits were being wasted. So they spun off their Section 29 credits to royalty trusts.

When you add Section 29 tax credits to a standard royalty trust, you get an even better tax deal for investors. That was the case with the Williams Coal Seam Gas Royalty Trust, launched in 1992. Williams Cos., which owned 144.5 billion cubic feet of Section 29 gas, sold nearly 6 million units to investors, keeping almost 4 million units for itself.

The initial offering price was $20 per unit. Trading on the New York Stock Exchange, the price shot up to $29 and retreated to around $25, in 1994. The cash payout then was over $2 per unit, a yield of around 8%. Thanks to the depletion allowance, that distribution will be largely untaxed.

What's more, each unit generates around $2 worth of tax credits. If you buy 1,000 units, for example, for $25,000, you get to reduce your federal income tax liability by $2,000. That's an addition to the tax-sheltered cash flow. Altogether, the after-tax yield on these units is over 15%

Williams Coal Seam isn't the only trust in the sea. Eastern American Energy, Burlington Resources and Torch Energy Advisors all have similar Section 29 royalty trusts, also trading on the NYSE. They all offer liquidity, cash flow and tax shelter similar to the Williams trust.

Of course, you don't get 15% returns without a catch or two.

First, as is, the case with any royalty trust, your assets are literally depleting with each barrel of oil or cubic foot of natural gas that's produced or sold. That's why you're entitled to depletion deductions.

Moreover, you're accepting operating risks when you invest in a royalty trust. If prices rise, your income will increase--but your cash flow can run dry if prices fall. Plus, as production falls, you'll receive fewer tax credits, because those credits are tied to the amount of gas produced.

There's no free lunch and there's no safe 15% return in a 3% world. But, as long as you realize you're investing in a depleting asset, Section 29 royalty trusts are among the top tax shelters available.

UNIT INVESTMENT TRUSTS

These trusts, also called unit trusts, can hold almost any type of security. The securities are bought with the proceeds of the initial offering and held for a certain time period. There's generally no buying or selling, after the initial purchase, so management costs are low.

However, if you buy units in the trust, you can sell if you wish, either to the trust sponsor or to another investor.

Although some unit trusts hold stocks, few investors want to own an unmanaged stock portfolio. Therefore, most unit trusts hold bonds.

The advantage to owning a bond unit trust, in addition to low management cost, is simplicity. The trust buys a portfolio of bonds and holds on until maturity. Investors collect the same amount of interest until the bonds are called or redeemed, at which time principal is returned. As long as investors don't sell prematurely, they'll receive a fixed income with virtually no risk of principal.

OBSERVATION: Some unit trusts hold taxable bonds, but those holding tax-exempt bonds are far more common.

If you had bought unit trusts in the late 1970s or early 1980s, you had a great deal. You might have locked in 10% or 12%, tax-exempt, and enjoyed that high yield until call or maturity, while other bond yields fell in later years. However, with current bond yields at their lowest point in decades, unit investment trusts aren't nearly so attractive. Other investment trusts offer a greater potential yield to shareholders.

IN BRIEF

* Some investment vehicles are also called trusts. Shares in the trusts, which are sold to investors called unit-holders, offer many of the advantages as publicly traded stock.

* Real estate investment trusts (REITs) invest unit-holders' money in real estate. REITs are required to distribute 95% of their annual profits to unit-holders, making REITs attractive investments.

* Some experts prefer REITs that hold apartment properties. Others recommend shopping center REITs.

* Royalty trusts offer unit-holders a portion of the profits derived from oil and gas properties. The problem: When the energy runs out, the royalties cease, and principal investments are not returned to unit-holders.

* Unit investment trusts can hold almost any kind of security, although most specialize in bonds. At present, these trusts have lost much of their luster because the rate of return on bonds is low.

MULTIPLE TRUSTS

When two (or three, or many more) trusts are better than one.

Each of the trusts described in this report is a powerful tool when properly created and used in the right circumstances. Sometimes, the results can be even better if several trusts are combined in one financial strategy.

Example: Len is a 68-year-old business owner, He has three children, ages 35 to 44, from his first marriage, which ended in divorce. Len's second wife, Carrie, is 55--just over 10 years older than Len, Jr., Len's oldest child. Carrie has two children from her first marriage. Len expects to die before Carrie, and to leave an estate worth $2 million. A traditional estate planning strategy might have Len:

* Create a revocable trust and transfer assets into the trust so that they will avoid probate.

* Leave $600,000 to his children, in a credit shelter trust, to fully use his estate-tax exemption.

* Leave the remaining $1.4 million to Carrie, avoiding estate tax. However, at Carrie's death, she can leave that $1.4 million--Len's $1.4 million--to her own children, so Len's children would receive nothing beyond that first $600,000. So Len changes his strategy somewhat:

* Instead of leaving $1.4 million to Carrie, he leaves $1.4 million to a Q-TIP trust. With a Q-TIP, Carrie gets the income from the $1.4 million as long as she lives. (In some circumstances, the trustee may let her dip into trust principal, as well.) But, at her death, the trust funds go where Len has directed them: to his children. Therefore, he is certain that his money will wind up where he wants it.

Moreover, if the Q-TIP is drawn up properly, that $1.4 million will qualify for the unlimited marital deduction. No estate tax will be due until Carrie's death, when the money will pass to Len's children.

OVERVIEW

Len's family situation still poses problems, though. Carrie, his second wife, is 55, 10 years older than Len, Jr. If both Carrie and Junior live to their life expectancies, Carrie will die just a few years before Junior. Junior won't have much time to enjoy his share of the $1.4 million, even though he and his siblings are the Q-TIP beneficiaries.

Len buys two life insurance policies, making his children the beneficiaries of both. One is the second-to-die policy that most married couples can use to cover estate tax. When both Len and Carrie die, Len's three children will receive enough life insurance proceeds to cover the tax payments on the Q-TIP trust's assets. In addition, Len takes out a single-life policy on his life. At Len's death, his three children will receive $1 million right away. Thus, they won't have to go through life waiting for Carrie to die to get their inheritance.

Both policies are held in life insurance trusts to avoid estate tax on the proceeds. To avoid confusion, Len sets up a separate trust for each policy.

Buying two large insurance policies is expensive. After paying for all the life insurance, Len figures he'll have only $1.2 million left for the Q-TIP trust, not $1.4 million. But Len figures it's worth it for the peace of mind. After his death, Carrie will be well provided for, living off the income of the $600,000 credit shelter trust and the $1.2 million Q-TIP trust.

The result of all Len's planning:

* His children will have an immediate, tax-free $1 million at his death.

* His widow will have lifetime income from a $1.8 million estate ($600,000 in the credit-shelter trust, $1.2 million in the Q-TIP trust).

* The entire $1.8 million will eventually go to Len's three children.

* No one in the family will be out-of-pocket to pay any estate tax, thanks to good planning and the second-to-die life insurance policy proceeds held by a life insurance trust.

An alternative:

Len could combine a charitable remainder trust with a life insurance trust. With a charitable remainder trust, as explained earlier, he would give away assets to a charity, receive the income from those assets for his and Carrie's lifetimes, and set up a life insurance trust to buy a policy on his life to replace some or all of his children's foregone inheritance.

MULTIPLE TRUST LIMITS

Don't think you have to stop at one trust. Depending on your individual situation, you may be better off using two or more. Just be sure that you're working with a knowledgeable, experienced and reputable attorney--and that you fully understand all the implications of your actions.