MORE TRUST TYPES
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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
Manx 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 (REITSs) -
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 TRUSTS -
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.
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