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Property Titling Common Law vs. Community Property The body of law that is based on tradition and general principles is called common law.
Common law is not covered by statute; it is based on particular cases. Under common law, a husband and wife have equal ownership of all property. Community property, then, is any property that has been acquired through the efforts of either spouse during a marriage and while living in a community property state. This does not include any property gained by one spouse through a gift or inheritance. In California, the income from community property is considered to be community property, as is anything purchased with that income. According to the Texas rule (which also applies in Idaho and Louisiana), the income earned from separate property during marriage is community property, but the gain on sold separate property remains separate. Sole Ownership, Joint Tenancy with Right of Survivorship, and Tenancy by the Entireties When property is titled as belonging solely to one person, that person has total ownership with all the rights attending. In cases where property is titled for joint tenancy with right of survivorship (JTWROS), the interest of one owner will automatically pass to the other at death. This arrangement will take precedence over other ways of dividing property, including wills and trusts. In most states, though, one tenant may sever the tenancy without the knowledge of the other. Joint tenancies are most commonly created between family members. The arrangement known as tenancy by the entireties is similar to joint tenancy, except it may only be created between a husband and wife. Neither spouse is allowed to sever the tenancy without the knowledge of the other. Tenancy in Common, Trust Ownership, UGMA, and UTMA
As with the case of joint tenancy, two or more people hold interests that are held with a tenancy in common, and each person has the right to possession. Property held in this way may be held unevenly; that is, one party may own more than another. In the case of a trust ownership, a trustee is obliged to hold onto the property and maintain it on behalf of him or herself and a beneficiary. Trusts are arranged by a written agreement in which the trustee and settler set forth the terms and duration of the trust. A trust passes property outside of a probate. The Uniform Gifts to Minors Act allows securities, cash, life insurance, and annuities to be transferred as gifts to minors. These gifts may still be held in custodial form. The Uniform Transfer to Minors Act allows property interest, including real property, to be transferred.
Probate Process
In probate, the court validates the will of a deceased individual. Testate succession is when a person dies and has left a will, obligating the executor named in the will to dispose of the decedent’s property. Intestate succession is when a person dies without having left a will. The court will appoint an administrator to dispose of property, and the state will determine how the assets are conveyed. In a per stirpes distribution, larger distributions are given to those that have a closer family relationship to the deceased; in a per capita distribution, all eligible descendants will receive an equal share of property. Probate is good in that it protects creditors, provides clean title for heirs or legatees, makes the distribution of property an organized process, and establishes title in cases where it may be questioned. However, probate can be expensive, time-consuming, and controversial. The following assets are subject to probate: assets in which the decedent has sole title, assets held by tenancy in common, assets held as community property, assets disposed of by will, and contract proceeds that are payable to the estate. Probate may be avoided by: establishing joint tenancy with right of survivorship; using trusts; establishing a funded revocable living trust; creating a tenancy by its entirety; or establishing a beneficiary to transfer by contract, as for instance life insurance contracts and retirement plans. Ancillary probates may occur when a person who lives in one state and owns property in another die; a probate hearing in the state of the property will be held.
Operation of Law (Title)
Operation of law refers to the rights to a property being passed from one individual to another in accordance with the established laws. In the case of joint tenancy with the right of survivorship, for instance, the law states that there will be equal ownership and automatic survivorship, as well as an undivided right to possess the property. This type of ownership is not subject to probate; neither are interests by the entirety, an ownership arrangement that can only be set up between a husband and wife, and in which neither party can transfer property without the consent of the other. In the case of tenancy in common, ownership may be unequal and will not include automatic survivorship. This arrangement can be subject to probate, as can the decedent’s share of a community property arrangement, which can only exist between spouses and in which there is no automatic survivorship.
Transfers Through Trusts
There are three parties involved in a trust: the trustor, who creates the trust and who funds it; the trustee, who has legal title and manages the trust assets; and the beneficiary, who enjoys the beneficial interest in the trust.
In an inter vivo (living) trust, the trust is activated immediately after it is created and is funded during the lifetime of the trustor. In a testamentary trust, the creation of the trust is written into the will and activated upon the death of the trustor.
There are five main reasons for transfers through trusts: to provide for more than one beneficiary, to manage property in the event that the trustor is incapacitated, to protect beneficiaries, to avoid probate, and to reduce transfer taxes. Trusts are said to be transferred by contract if they are passed through life insurance contracts, annuities, qualified retirement plans, buy-sell agreements, or prenuptial agreements.
Wills
A will gives the testator the chance to direct the passing of his or her property and thereby avoid intestacy. Wills are revocable, and may be revised or amended by codicils. A holographic will is written entirely by the testator and may be valid without witnesses. A nuncupative will is one the testator spoke before death in the presence of a number of witnesses. A living will is a legal document that describes which medical procedures are to be used in the event that the testator becomes unconscious or incompetent. Joint wills are two separate wills that have reciprocal provisions in case of the death of one party. Pour-over wills distribute the probate assets to a previously created trust upon the death of the testator. In order to avoid controversy over a will, the testator may choose to include an in terrorem clause, which asserts that beneficiaries who unsuccessfully contest a will should have their bequests eliminated.
Powers of Attorney
The power of attorney is a right that one individual grants to another to act on his or her behalf. This power is typically witnessed and accredited. The person who provides the power is known as the principal, and the person who is appointed is called the attorney-in-fact. A durable power of attorney will not be terminated if the principal is disabled or incapacitated. A springing power of attorney will not be effective until the occurrence of some specified event. Power of attorney will apply in any situation in which the principal is unable to give an informed consent on medical decisions. In the case of property management, a durable power of attorney gives a person the right to make decisions regarding the other person’s assets. Powers of attorney may be either special, in which case they are limited by the desire of the principal, or general, in which the principal has every right the principal would have.
Advance Medical Directives
Testators may establish an advanced medical directive to establish the protocol for their medical treatment in various situations. Living wills are considered to be medical life-support directives. Advance medical directives do not designate an agent to make medical decisions. Living wills are notorious for being vague and only covering situations that have to do with sustaining life. Of course, it is impossible for a living will to cover all possible medical outcomes, and so most living wills only apply to patients who are terminally ill. In some states, individuals may deem it necessary to construct both a living will and the durable power of attorney so that they will be covered in all situations.
Estate Planning Documents Trusts Clients may want to create trusts in order to manage property in the event that they should become incapacitated or incompetent. If this individual was serving as the trustee, he or she may want to name a successor trustee to take over in the event of impairment. These trusts may be either living or testamentary. A living trust is similar to a will in that it serves as a guide for the disposition of property, has a fiduciary, and is revocable and amendable. On the other hand, a living trust will appoint a trustee rather than nominate an executor, and the formal execution requirements will be stricter for a will. Testamentary trusts, on the other hand, will take effect at the end of the probate process, will contain all of the provisions commonly found in a will, and must both appoint a trustee and nominate an executor.
Suitability of Gifting as a Planning Strategy Techniques for Gift Giving In order for a transfer to be seen as a valid gift: the donor must be capable of transferring property, the donee must be capable of receiving a possessing property, there must be acceptance by either the donee or the donee’s agent, and the donor must not have any interest in the property. The designer of a gifting program should try to give assets that have a high rate of return in order to avoid a buildup of revenue that would be taxed at the donor’s tax rate. If growth assets are given, then post-gift appreciation will not be taxed in the donor’s gross estate. A gift of income-producing property will eliminate the income tax payable by the donor on the property. In general, one should avoid giving installment obligations, since one would then have to recognize the entire untaxed proceeds at the time of transfer.
Gift Property and Strategies for Closely Held Business Owners The following kinds of property are appropriate to be given as gifts: income-producing property (rental property, e.g.); property that will probably increase in value; property that the donor owns in a state other than his or her own state of residence; and property that has already appreciated, assuming that the donee is in a lower tax bracket than the donor. Although the stock of a closely held corporation can be ideal for gift giving, one must be sure not to give too much away. This is because estates must retain a certain percentage of stock (35% of the adjusted gross estate should consist of the closely held stock) in order to qualify for privileged tax treatment.
Gifts of Present and Future Interest Gift tax exclusion only applies to gifts of present interest. In order for a gift to be considered of present interest, the donee must have the immediate right to use, possess, or enjoy the gift. If this right is delayed, then the gift is said to be of future interest. Gifts made to a trust are considered to be of present interest only if the beneficiary can immediately claim custody of the property. The most common types of future interests are reversions, in which the transferor retains a future interest in the property, and remainders, which grants the right to own and enjoy property after all previous owners’ interests end. Income beneficiaries will receive a life estate for years in the trust income, while remaindermen will receive the remainder upon the termination of the income interests. There are a few statutory exceptions to the present interest requirement. A so-called minor’s trust [also called a Section 2503(c) trust] is considered a present interest gift and qualifies for the annual exclusion. In these arrangements, the property will pass to the minor when he or she reaches the age of 21. Gifts that fall under the Uniform Gift to Minors Act or Uniform Transfer to Minors Act will be considered as gifts of present interest and will receive the annual exclusion. In Section 529 plans, the donor is allowed to donate the annual exclusion for this year and the next four years while still qualifying for the annual exclusion. If the donor should die before the completion of the years for which the gift was made, the leftover portion of the original transfer will be included in the donor’s estate.
Gift Taxation Annual Exclusion and Split Gifts In 2020, donors were allowed to exclude the first $15,000 of gifts of a present interest from the amount of the donor’s taxable gifts; this annual exclusion amount could be doubled through the practice of gift splitting with a spouse. Gifts in trust are treated as gifts to the trust’s beneficiary in determining the number of allowed exclusions. If the trustee has to distribute the income annually, the amount of income interest in the trust will qualify for the annual exclusion. Gift splitting is only available to married couples that file a joint return; one taxpayer will file the return and the other will sign consent for the gift splitting. If gift splitting is selected for a particular year, every gift is considered to have been split. Prior Taxable Gifts, Education and Medical Exclusions, and Marital and Charitable Deductions If an individual has had no prior taxable gifts, then he or she may apply the tax rates from the unified federal estate and gift tax rate schedule to the taxable gifts of the current year. If the individual has had prior taxable gifts, then the tax on gifts will be cumulative, and once the lower tax rates have been used up it will be necessary to use the progressively higher rates indicated in the Code. Any qualified payments that are made to an educational institution for tuition, to a provider of medical care, or to a political organization are fully excluded from being taxable gifts. Any gifts made to a spouse who is a US citizen are fully deductible, as are any charitable gifts. Tax Liability Gifts are taxable when made during the donor’s lifetime and when they exceed the donor’s annual exemption or are not a present interest. The taxpayer must make use of unified credit to the extent that the tax is due, and the taxpayer must pay the tax to the extent that unified credit is not available. Any gift tax that is paid without the use of unified credit in the three years following the donor’s death is included in his or her taxable estate. Net gifts are situations in which the donee has agreed to pay whatever gift tax is due. When a net gift is made: the actual gift tax liability decreases, since the gift taxes paid reduce the value of the taxable gift; the donor’s unified credit is used to calculate the donee’s gift tax liability; only the net amount of the gift is included in the estate tax calculations as an adjusted tax gift; and the gift is treated as a part sale and part gift to the degree that the gift tax paid by the donee exceeds the donor’s basis in the property.
Incapacity Planning Guardianships In financial planning, we may define incapacity (or disability) as the inability to act on one’s own behalf. There are numerous means of caring for an individual, his or her dependents, and his or her property if that individual should become incapacitated. A guardianship is an arrangement established by the state after an interested party brings an action. Guardianships are established to care for an individual’s dependents when that individual has been declared incompetent, mentally ill, etc. In a typical guardianship, there will be a ward (the protected person), a guardian (also known as a conservator), and a state administrating body. In a voluntary guardianship, the ward may choose his or her guardian. These are typically just interim arrangements until more permanent solutions can be made. Care of Person and Property In order to be prepared in the event that a client becomes incapacitated, a financial planner should establish provisions for long-term health care, for protecting property from the claims of the state or others, for changing taxes, and for managing the financial affairs of a client. If, rather than having a conservatorship, a financial planner has durable power of attorney, he or she will be able to: avoid public proceedings over the status of the principal, avoid delays and legal hang-ups, and keep ownership vested in the principal. The advantages of a living trust over a conservatorship are that it is more flexible, it has smaller administrative costs, and it grants broader management authority. The advantages of a living trust over durable power of attorney are that it assures that transactions will be completed, and management and distribution terms are typically more specific. Disability Insurance and Long-Term Care Insurance A good disability insurance policy will: provide partial rather than total disability; apply specifically to an occupation; be renewable and noncancelable; cover disability from both accident and illness; pay at least 60% of take-home pay; pay at least through age 65; offer cost-of-living adjustments; offer standard-of-living adjustments; and have a three-month waiting period. A good long-term care policy will: be guaranteed renewable for life; have a three-month waiting period; provide coverage for both skilled and intermediate care; provide long-term coverage for Alzheimer’s disease; provide a favorable benefit period; and will not require the insured to be hospitalized before entering a nursing home. Business Disability Coverage If a business’ owner or one of its key employees becomes disabled, the business could be seriously damaged. This scenario is especially dangerous in small businesses. Disability insurance is often procured to cover business overhead, key person disability, salary continuation for owners and key employees, or a disability buy-sell agreement. Business overhead policies are those that cover the business’ ongoing operations costs while the owner is disabled. Key person insurance helps a business find a temporary replacement for a key employee, replace the revenue lost by the disability of this employee, and fund a search for a replacement. A buy-sell plan shifts ownership from the disabled individual to a group of other employees.
Estate Tax Calculation Gross Estate According to Section 2033, gross estate includes the value of “all property to the extent of the decedent’s interest therein.” Section 2034 includes dower and curtesy interest in the gross estate, and Section 2035 includes any gift tax paid on gifts within three years of death. Section 2036 includes in the gross estate the value of any interest in property the decedent transferred if the decedent retained for life the right to earn income from or the enjoyment of that property, and any property in which the decedent has designated the persons who shall enjoy the property or the income from that property. Section 2037 covers transfers that occur at death, and asserts that the decedent must have retained a reversionary interest in the property that exceeds 5% of the value of the property. This reversionary interest must include the possibility that the property transferred by the decedent may return to the decedent, or his or her estate, or that the decedent may retain a right of disposition. Section 2038 of the Code includes in the gross estate those transfers that contain the power to alter, amend, revoke, or terminate. Section 2039 includes in gross estate the value of any annuity or other payment that is received by the beneficiary, and Section 2041 includes any property that is subject to a general power of appointment at the time of the decedent’s death. Interests arising at death may be excluded from gross estate. It is a common practice to create an irrevocable life insurance trust so that the proceeds may be kept out of the estate. It should also be noted that any power of appointment that is limited by an ascertainable standard relating to health, education, support, or maintenance is not a general power of appointment. Deductions, Adjusted Gross Estate, and Taxable Estate The following items may be deducted from the value of gross estate: funeral expenses; debt and mortgages; certain taxes payable at death; administrative expenses regarding the disposition of assets; and losses incurred while administering the estate. Adjusted gross estate is calculated by subtracting expenses, debts, and losses from the gross estate. Both charitable contributions and transfers made to a surviving spouse may be deducted from the adjusted gross estate. Taxable estate, then, is calculated by subtracting the charitable deduction and the marital deduction from the adjusted gross estate. Adjusted Taxable Gifts Rule and Tentative Tax Base An individual’s adjusted taxable gifts are the taxable portions of all gifts that occurred after 1976. Gifts are taxable to the extent that they exceed any allowable annual gift tax exclusion, gift tax marital deduction, and gift tax charitable deduction. The only reason for adjusted taxable gifts entering into the estate tax equation is so that they will move the decedent’s taxable estate up into the appropriate marginal rates. If a gift is added to the gross estate, the value of the gift is the fair market value of the property as of the date of death. Gifts that can be included in a decedent’s gross estate are not considered to be adjusted taxable gifts. If a taxable gift should be added to a taxable estate, the value on the date of the gift will apply. In order to derive the tentative tax base, simply add adjusted taxable gifts to the taxable estate. Credits An individual’s tentative tax payable will be decreased by the amount of gift tax that is either paid or payable on gifts included in the tax base. The gift tax is not a credit. Instead, it is a reduction of estate tax—the dollar amount of the unified credit after application. As for the unified credit, it has to be used the first time a gift tax or estate tax must be paid. Taxpayers cannot pay tax in lieu of using a unified credit. The total tax on the net gift will be computed, and then some or all of the credit will be applied against the total tax due. The balance will be the net tax due. If the credit isn’t fully used in one transaction, the balance will carry over to the next transaction. Credit that remains after calculating the tax due at death, however, cannot be used. If a piece of property has been taxed in the estate of another person either ten years before or two years after the death of the decedent, it may be eligible for the credit for taxes on prior transfers. This credit is limited to whichever is less: the amount of the federal estate tax attributable to the transferred property in the transferor’s estate, or the amount of federal estate tax attributable to the transferred property in the decedent’s estate. If the transferor died either within two years before or within two years after the death of the decedent, the credit will be the smaller of the two limitations. If the transferor died more than 2 years before the decedent, the credit will be reduced by 20% for every 2 years by which the transferor’s death preceded, up to ten years. As for the state death tax, it does not reduce the total estate tax; it merely divides the total death taxes between the state and federal governments.
Satisfying Liquidity Needs Sale of Assets During Lifetime There are a few basic guidelines to remember when considering the sale of various assets during one’s lifetime for the purpose of satisfying liquidity needs. Typically, it is best to sell assets that have a built-in loss. Death will eliminate this potential tax benefit by stepping down the basis of the value on the date of death. It can also be a good idea to sell high-basis assets, since the sale of these will create little or no taxable gain. On the other end of the spectrum, low-basis assets are not a very good option for sale. The tax on these assets will be eliminated if they are held until death, and the beneficiary will receive a new basis at the fair market value.
Powers of Appointment Use and Purpose The power of appointment is the power to appoint some other person to receive a beneficial interest in some piece of property. The person who grants this power is called the donor, and the person who receives the power is known as the donee. The people to whom the holder gives power are the appointees. When the power of appointment is allowed to lapse, the people who receive the power are known as the takers in default. A power of appointment is general if there are no restrictions placed on it, and special (or limited) if restrictions are placed on it. A power of appointment will be used when the owner of estate wants someone else to make decisions concerning the estate, when the estate owner does not know the estate’s future needs, when the assets would be subject to the generation-skipping transfer tax, or when the estate owner seeks to qualify assets for the marital deduction but would like to retain the right to control who will receive the property. 5 or 5 Power The so-called 'five or five power' is used to avoid both estate and gift taxes. Right of invasion will have to be made noncumulative. The property that is subject to the general power of appointment will be included in the estate of the holder only to the extent that the property that could have been appointed by the exercise of the power (but has lapsed) goes over whichever is greater, $5,000 or 5% of the total value of the funds subject to the power at the time of the lapse. The failure to exercise will result in gifts to the remainderment of the trust, with a yearly reduction by the amount of the holder’s life estate in the lapsed amounts. If a beneficiary has 5 or 5 power and fails to exercise it in a given year, the beneficiary will become the grantor of that portion of the trust over which the power has lapsed. Crummey Provisions Even though gifts placed in an irrevocable trust are considered to be gifts of a future interest, if a lapsing power to withdraw, otherwise known as a Crummey power, is placed, then the future interest will be converted into a present interest. In such a scenario, the beneficiary will have a noncumulative right to withdraw a certain amount of property that has been transferred to the trust within a certain predetermined period. If this right is not exercised, the annual transfer amount remains in the trust to be managed by the trustee. The taxable gift made by a Crummey trust beneficiary will be a transfer subject to gift tax, which uses up a bit of unified credit. For the purposes of calculating estate tax, the property subject to the lapsed power will be included in the beneficiary’s estate as a transfer in which interest has been retained. Tax Implications Section 2514 states that the exercise or release of a general power of appointment shall be deemed a transfer of property by the individual possessing such power. Section 2514(e) states that the lapse of a power will be treated as a release only to the extent that the property to which it pertains exceeds whichever is greater, $5000 or 5%. According to Section 2041, the donee’s gross estate will include all property subject to a power of appointment at the time of the death of the decedent. On the other hand, the existence of a special power of appointment or the exercise, release, or lapse of that right will not force inclusion in the power holder’s gross estate. The exercise, release, or lapse of such a special power will trigger the imposition of any gift tax.
Trusts Classification Simple trusts are simply conduits through which income is forwarded to beneficiaries, though no principal is distributed. The trust will pass its income through to the beneficiaries, who will then report the income in the same category as it was held in the trust, and then pay taxes on it according to their own tax bracket. Complex trusts are those irrevocable trusts that neither distribute principal nor accumulate some fiduciary accounting income. Revocable living trusts are subject to the right of rescind and amend, become irreversible upon the death of the grantor, are includible in the estate, and do not trigger any gift tax at the time they are created. Irrevocable living trusts cannot be revoked by the grantor after their creation unless with the consent of all beneficiaries. Also, they may be subject to a gift tax at the time of transfer and may have both income and estate tax benefits. Rule Against Perpetuities The rule against perpetuities requires a time period for a trust to terminate and distribute its property. In order to meet the requirements of this rule, an interest must vest within 21 years after the death of someone at the moment of the transferor into an irrevocable trust. Violations of the rule against perpetuities will cause the interest concerned to become void, and the interest will revert to the transferor or to the transferor’s successors. The provisos of the rule do not allow us to wait and see whether any grandchildren will be born. These arrangements typically allow the transferor to control a property for his or her life, and for the lives of his or children and grandchildren, but no longer. Selected Provisions If trust documents contain a spendthrift clause, it is to protect the assets of the trust from the “spendthrift” ways of the trust’s beneficiaries. A provision of this kind might prevent a trust beneficiary from assigning his or her interest in the trust corpus. Also, these kinds of provisions can prevent creditors from getting at trust assets by any legal or equitable process. A perpetuity clause prevents interests from being invalidated under the rule against perpetuities. This provision will usually identify all of the people in a trust that are to be calculated. Sprinkling provisions give the trustee the authority to allocate income and corpus among trust beneficiaries in accordance with their need. Support provisions limit the trustee’s right of distribution to the amount of the trust’s assets needed to discharge the obligation of support to one or more specified beneficiaries.
Taxation of Trusts and Estates
When property is transferred to a revocable trust there is no resulting taxable gift, since there has not been a completed gift. When property is transferred to an irrevocable trust, a taxable gift is created, and the grantor will be subject to a gift tax liability on the actuarial value of both the income stream and the remainder interest transferred to the beneficiaries of the trust. As for federal estate taxes, the assets of a revocable trust will be included in the gross estate of the deceased grantor. All of the assets transferred to an irrevocable trust will avoid probate and inclusion in gross estate, provided that the grantor does not retain: a life income interest or right to enjoy the property, a reversionary interest of more than 5%, a right to determine the beneficial enjoyment of trust assets, a right to change the beneficiary designation, or a right to change the trustee.
Qualified Interest Trusts Grantor Retained Income Trusts (GRITS) In a grantor retained income trust (GRIT), property is transferred into an irrevocable trust, in which the grantor will retain the right to income for a period of years, and after which time the trust will end and the property will be transferred to the remainderman. If the transferor is still alive at the end of the income period, all the beneficial interest in the trust will cease, and the asset will be out of the transferor’s estate. However, taxable gift value will be included in the estate tax base as an adjusted taxable gift. The main reason for setting up a GRIT is to leverage the applicable exclusion amount to avoid estate tax (not gift tax). To calculate the value of the gift, take the fair market value of the property and reduce it by the retained interest. This will equal the retained interest that is considered a gift. This is a future interest, which is discounted. Grantor-Retained Annuity Trusts, Grantor-Retained Unitrusts, and Qualified Personal Residence Trusts Grantor-retained annuity trusts are arranged to make fixed payments to the grantor at least every year. In a grantor-retained unitrust, the required payment will be determined every year as a percentage of the fair market value of the trust property, and the value of the assets will be recalculated every year. A qualified personal residence trust is allowed to hold an interest in only one residence. If a grantor survives the term of a qualified personal residence trust, he or she does not have to leave the residence: instead, he or she can rent it as a remainderman. This transaction must be arranged arm’s length and at a fair rental value. It is not permitted for the settler, the spouse of the settler, or some entity that is controlled by the settler or the spouse to purchase the residence from the trustee. Tangible Personal Property Trusts and Limitations on the Valuation of Remainder Interests Many individuals will resist setting up a tangible personal property trusts because it can be difficult to value a term interest for tangible personal property. The zero valuation rule of Section 2702 will not apply to tangible property in situations where the failure of the interest holder to exercise those rights would not substantially affect remainder interest. Also, no depreciation deduction is allowed. Meanwhile, Section 2702 can limit the advantage of a grantor-retained trust by valuing the income interest at zero when the transfer is made to a family member. The entire value of the transferred property will immediately be subject to a gift tax. In order to be qualified, a retained income interest must be paid annually and there has to be an exact way of calculating interest.
Charitable Giving Considerations for Contributions and Transfers It is possible to transfer an unlimited amount of property to qualified charities without incurring any federal gift taxes. There is no limit to the size of the gift tax charitable deduction. Charitable organizations will incur no income tax liability as the result of the gift, and they will not be subject to any income tax on the income derived from the transferred property. The transfers made during the individual’s life will not only provide an income tax deduction, but will also subtract property from the estate of the taxpayer. Most people consider making a lifetime gift to charity so that they can use the unlimited charitable deduction to either reduce or avoid gift tax liability while removing the value of the asset from the donor’s potential gross estate. Qualifying for a Charitable Income Tax Deduction Public charities are any publicly supported charitable, scientific, religious, medical, or educational nonprofit organizations. Any groups that prevent cruelty to children or animals, as well as any governmental groups that use donations specifically for public purposes, may be included in this category. In order to make a contribution that qualifies as a charitable deduction for the purposes of income taxes, the contribution must: be made to a qualifying organization; be a gift of property, rather than time or service; be made before the end of the year in which the deduction will be claimed; have a value greater than any value received from the qualifying organization; and must be claimed by the taxpayer as an itemized deduction. Income Tax Charitable Deduction Limitations Any charitable contribution to a qualified charity will reduce current income taxes. Regardless of the size of the gift; however, no federal gift tax will be due on a gift to a qualified charity. Gifts made to qualified charities may also make an individual eligible for a deduction from the federal estate tax up to the value of the gift. The qualified charity will not be required to pay tax on the receipt of either lifetime gifts or bequests. In general, no income tax will be payable by qualified charities on the income earned by donated property. As for federal income taxes, the type of property transferred will determine the percentage limitations on the amount that can be claimed as a charitable contribution deduction.
Charitable Remainder Trusts (CRTs)
In a charitable remainder trust (CRT), the donor retains a limited right to enjoy the property, but still receives an income tax deduction and reduces his or her federal estate tax. A CRT must have at least one noncharitable income beneficiary, and it must have an irrevocable remainder interest to be held for or paid to a charity. The grantor will retain the right to change the charitable remaindermen without this resulting in inclusion in the grantor’s estate. If a trust is not funded, assets will be included in the estate and it will be impossible to claim the income tax charitable deduction. In a CRT, the beneficiary will receive income for a period of life or no more than 20 years, and the remaining amount will go to charity.
Charitable Remainder Unitrusts (CRUTs)
In a charitable remainder unitrust (CRUT), the amount of the income tax deduction will equal the total value of the property less the present value of the retained interest income. In a CRUT, the income recipient is a noncharitable beneficiary (most often, the donor). The noncharitable beneficiary will receive a fixed percentage of the net fair market value of the principal; this percentage cannot be less than 5% or more than 50% of the annual value. The remainderman is the charity, and additional contributions are allowed. The remainder interest at inception must be greater than or equal to 10% of the original value of the property transferred to the trust. CRUTs may have sprinkling provisions and they may hold tax-exempt securities.
Charitable Remainder Annuity Trusts (CRATs)
In a charitable remainder annuity trust (CRAT), the income tax deduction equals the total value of the property less the present value of the retained interest income. As with the other CRTs, the income recipient will be a noncharitable beneficiary (the donor, typically). Either a fixed amount or a fixed percentage of the initial value of the trust must be paid to the noncharitable beneficiary; the annuity percentage cannot be less than 5% or more than 50% of the initial fair market value of all the property transferred in trust. At inception, the remainder interest must be greater than or equal to 10% of the original value of the property transferred to the trust. The remainderman is the charity, and additional contributions are not allowed.
Charitable Lead Trusts
Unlike in a charitable remainder trust, in a charitable lead trust the donor gives away an income stream and receives a remainder interest. In a charitable lead trust, the donor will place an income-producing property in a reversionary trust and will direct that the income from the trust be directed to a designated charity for a period of time no greater than 20 years. At the end of this period, the property will revert back to either the donor or to some other noncharitable beneficiary. Through this process, the donor will receive a large income tax deduction for the year in which the trust is funded, with the value of the deduction being the present value of the total anticipated income during the period in which the charity receives the income. These trusts will typically be set up as grantor trusts with annual income taxable to the donor.
Charitable Lead Unitrusts (CLUTs) and Charitable Lead Annuity Trusts (CLATs)
In a charitable lead unitrust (CLUT), a fixed percentage of the net fair market value of the principal will be payable to the charitable beneficiary. This percentage can be no less than 5% and no greater than 50% of the annual value. Additional contributions are allowed in a CLUT, and the donor can pay up to income and then make up the deficiency in subsequent years. In a charitable lead annuity trust (CLAT), either a fixed amount or a fixed percentage of the initial value of the trust must be payable to the charitable beneficiary. The annuity percentage can be no less than 5% and no more than 50% of the initial fair market value of all the property transferred in trust. In a CLAT, additional contributions are not allowed, and the trust must invade the corpus when the income is insufficient for payout.
Pooled Income Funds
Pooled income funds will be created and managed by a public charity rather than by a private donor. The donor is required to contribute an irrevocable, vested remainder interest to the charity. It is called a pooled income fund because the properties are commingled with properties transferred by other donors. These funds are not allowed to invest in tax-exempt securities, and no donor or income beneficiary is allowed to be a trustee. Donors must retain a life income interest, and each beneficiary must receive a pro rata share of income, every year, based on the rate of return earned by the fund. Sprinkling provisions are not allowed in these funds, though additional contributions are.
Private Foundations and Other Types of Charitable Gifts
Private foundations, which are typically arranged by a family in order to meet some charitable goals, can be established by either a corporation or a trust. These foundations allow individuals to make contributions, gifts, and bequests, which can then be distributed to public charities. Many of these family foundations are designed to promote the family name; if they are organized properly, they may be exempt from federal income tax and any gifts or bequests made to the foundation may be deductible. In a net income with makeup CRUT, any payments to a beneficiary are limited to whichever is lower, the set percentage or the actual income of the trust. These always contain provisions for “make up” if the income is less than the set percentage. In a wealth replacement trust, charitable remainder trusts are combined with irrevocable life insurance trusts to replace the asset the heirs of the donor would be losing.
Life Insurance in Estate Planning
Using life insurance as part of estate planning will provide income for the family of the decedent, will fund business continuation agreements, and will provide cash for the payment of the decedent’s debts, estate expenses, and taxes. However, if these arrangements are set up poorly, it may result in the death proceeds being included in the gross estate. If the owner and beneficiary are being selected while the estate is less than the applicable exclusion amount (AEA), then no transfer taxes will be expected, and the selection is easy and flexible. If the spouse is chosen as the owner and beneficiary at a time when the estate is likely to exceed AEA, the proceeds will probably be subject to transfer taxation on the second death, and a taxable gift will occur when the noninsured spouse is named owner and someone else is beneficiary. When a child is named as the owner and beneficiary, he or she may turn over assets to provide liquidity, or may purchase estate assets to avoid making a gift.
Life Insurance Trusts
Life insurance trusts are considered to be irrevocable trusts. Usually, an irrevocable life insurance trust is the best choice. If the trust is not irrevocable, IRC Section 2038 will draw insurance proceeds into the estate of the trustor. It is not possible for the trustor to be named as a beneficiary, so the trustee will be both the owner and the beneficiary. If the purpose of the trust is to pay estate taxes upon the death of the second spouse, then a second-to-die policy is appropriate; if the purpose is to replace the financial contribution of the deceased spouse, then a term policy will be more appropriate. Irrevocable life insurance trusts will exclude insurance proceeds from income and estate taxation for both spouses, exclude insurance proceeds from the probate estates of both spouses, and ensure that the responsible party will have the necessary liquidity after death.
Estate Taxation
The adjusted taxable gift of the decedent will include the value on the date of the gift minus the annual exclusion for any life insurance policy the decedent transferred after 1976 and more than three years before death. The replacement cost of any policy owned by the decedent on the life of another person is included in the gross estate of the decedent. The life insurance proceeds on the life of the decedent will also be included, assuming that the decedent made a transfer of any incidents of ownership in the policy within three years of death. The proceeds of life insurance receivable by a representative, as well life insurance receivable by any other parties, will be included in the gross estate if the decedent possessed any of the incidents of ownership at death.
Gift Taxation Transfer of Life Insurance Any transfers of ownership during the life of the insured will trigger a gift in the approximate amount of the cash value of the policy. If the owner and the beneficiary of the policy are different, the gift tax may be applied upon the death of the insured. Should a donor give a life insurance policy and then die within three years, the value of the proceeds are brought back into the estate of the donor. Any premiums paid within three years by the insured for a policy that he or she does not own will not be pulled back into the estate as per Section 2035. If these premiums exceed the annual exclusion, they may constitute a taxable gift. Any transfer of a policy by gifting can be subject to the gift tax; this tax will be based on the valuation of the policy at the time of the gift and not on the value of the proceeds at the time of death.
Estate Taxation Valuation of Gifts of Life Insurance When a gift of life insurance is not a paid-up policy, it will be valued at the replacement cost for a comparable contract with the same company. When the gift is a new policy that is either transferred immediately after purchase or is purchased for another person, the gift is valued as the gross premium paid by the donor. If the gift is an already-existing policy for which future premiums will be payable, it will be valued as the policy’s interpolated terminal reserve plus the unearned portion of the paid premium; in other words, the value of the policy’s reserve at the date of the gift, plus the amount of gross premium paid, which is not yet earned by the insurer. Life insurance policies that are transferred into irrevocable trusts are gifts of future interest to the beneficiary of the trust.
Use of Life Insurance in Estate Planning Income Taxation The proceeds of any life insurance policy paid by reason of death cannot be included in the deceased’s gross income, or in the beneficiary’s gross income, for federal income tax purposes. The only exception to this rule is the transfer for value rule: when a life insurance policy is acquired by another person for a valuable consideration, the difference between the death proceeds of the policy and the cost basis of the purchaser can be included in the gross income of the beneficiary. This rule does not apply to gifts of policies, or to the following purchasers: the insured, the insured’s partner or partnership, a corporation in which the insured is a shareholder or officer, the insured’s spouse, or a purchaser whose adjusted basis is determined by reference to the transferor’s adjusted basis.
Minority Discounts
Minority discounts are valuation discounts that are allowed on the interest in a business when that business is not a controlling interest. In almost every situation, more than 50% of the voting shares will constitute a controlling interest and less than 50% will constitute a minority interest. The discount afforded for a minority interest will depend on a few factors, for instance the minority owner’s degree of control over corporate policy, or the minority owner’s ability to realize his or her own pro rata share of the entity’s net assets by liquidating his or her interests in the entity. It is possible to obtain minority discounts between 15 and 50% percent for transfer tax valuation. Some of the factors that will influence the size of the discount include the quality of management, size of business, history of profitability, and the degree of the company’s financial leverage.
Marketability Discounts
The lack of an established market will make it more difficult to sell certain stocks than those business stocks that are publicly traded. Some examples of stock that may have poor marketability include restricted stock, stock in a closely held business, and partnership interest. It is possible to obtain a marketability discount between 15 and 50% for transfer tax valuation. Marketability discounts may apply to both minority and majority interests. There are numerous factors that will influence the size of a marketability discount, including the extent of resale restrictions, SEC restraints on marketability, dollar value of the sale, the growth expectations of the firm, and the size of the company’s total assets and equity.
Blockage Discounts and Key Person Discounts
It may be possible for large amounts of stock on a certain exchange to be given a blockage discount if it is determined that the simultaneous sale of this stock would have a depressing effect on the market price. If the block of stock represents a controlling interest in the corporation, then a premium may be attached to its value. It may also be possible to obtain blockage discounts for massed amount of other valuable property. A key person discount may be given to a business that has lost some significant person who was responsible for its goodwill. Typically, the IRS will require an executor to prove that it would not have been possible to avoid the loss, even with the purchase of key employee insurance.
Valuation Techniques and the Federal Gross Estate Tax Fair Market Value and Valuing Real Estate The valuation date for an estate account may either be the date of death or some alternate valuation date. Tax will be imposed on the fair market value of the property on the date of transfer. Fair market value is defined as the price a willing buyer would pay a willing seller under normal circumstances. There are a few special cases in which this definition of fair market value must be qualified. When valuing real estate, the value will depend on location, size, shape, condition, and any other factors particular to the land. A co-ownership discount may be applied if one of the co-owners declines either to sell his or her interest or to buy the interest of the estate, thereby impairing the marketability (and hence the value) of the property. Valuing Insurance Policies, Annuities, and Bonds If the donor of an insurance policy is not the insured, the value of the gift will be the replacement cost of the policy. Annuities, meanwhile, will be valued differently depending on whether they are commercial or private. Since commercial annuities are contracts offered by companies constantly in the business of selling annuities, they can be valued at the price at which the company will issue a comparable contract. The value of a private annuity contract is determined by the present value of the future payments required under the contract. The fair market value of publicly traded bonds is simply the mean between the highest and the lowest quoted selling price on the date of death. In cases where there was no trading on the valuation date, the mean price from the closest trading date is weighted inversely by the number of days from the valuation date. Valuing Stock The valuation of publicly traded stock is accomplished by finding the mean between the highest and lowest selling prices on the applicable valuation date. If the stock was not traded on the valuation date, one must use the mean of the high and low prices on the nearest trading date and then weight that mean according to the number of days from the valuation date. The valuation of closely held stock is a much more complicated process and involves such factors as: the nature and history of the business, the book value of the stock, the earning capacity of the company, the company’s capacity for paying dividends, the outlook for the industry in which the business operates, and the fair market value of the stock of comparable companies. Valuing Life Estates, Remainders, and Reversions The valuation of life estates, remainders, and reversions is quite simple. For all of these, fair market value is the same as present value. In order to determine present value, one must look at the appropriate IRS tables to find the present worth of an annuity, of an income interest, or of a remainder interest. The IRS tables will show the factors for these three present worth calculations at various interest or discount rates. There will also be a distinct table that can be used to adjust for situations in which annuity or income interest is for a certain term, and when the annuity interest is payable over the life of a certain person. Still another table will give the factors used when the annuity or income interest is payable for the joint lives of two parties.
Marital Deduction (Estate Tax) Characteristics and Terminal Interest Rule Any amount of property may qualify for the marital deduction, though it may not be applied to a terminable interest. The 100% marital deduction is simple, inexpensive, and gives the surviving spouse total control over assets. On the other hand, the unified credit of the decedent will go unused, and this may cause the estate tax between the two spouses to be slightly higher. A terminable interest is one that ends upon some event or contingency. A terminal interest, on the other hand, is a property interest subject to a future absolute or contingent termination of the surviving spouse’s interest. Moreover, it is an interest in which the possibility of termination is created by the decedent, and in which some other person or entity will possess or own the property. QTIP Planning and the Prior Transfer Credit Individuals may elect for a prior transfer credit if they want the spouse who dies first to have power over the ultimate disposition of qualified terminable interest property (QTIP). In order for a property transfer to receive QTIP treatment: one spouse must make an irrevocable election for QTIP and the surviving spouse must receive a qualified income interest for life. A qualified income interest is one in which income is paid at least annually, the value of the property may be subject to federal estate tax as gross estate, and the surviving spouse is entitled to receive all income from the property. If a property is treated as QTIP and qualifies for the marital deduction, it must be included in the surviving spouse’s gross estate. Special Planning for Noncitizen Spouses and Bypass Planning According to IRC Section 2506(d), the marital deduction cannot be used if the surviving spouse is not a US citizen. The marital deduction is allowed, however, for property that is placed in a qualified domestic trust that passes to a surviving spouse who is not a US citizen. Bypass trusts are used to take advantage of the unified credit. They are funded with assets equal to those of the exemption, and the leftover property can be divided in any proportion between a trust and the qualified terminable interest proper (QTIP) trust. The assets in a bypass trust will be taxed upon the death of the first spouse, even though the use of the unified credit will mean no tax is due. It will bypass the estate of the surviving spouse for tax purposes. Bypass trusts give a spouse the right to some income, without that income being included in his or her estate at death.
Deferral and Minimization of Estate Taxes Deductions and Credits Significant estate tax savings may be obtained by interspousal gifting. Any contributions to qualified charities will also be fully deductible for both the estate and gift taxes. The cost of a funeral, the debts of the decedent, and any losses incurred during the administration of the decedent’s estate may be fully deductible. There is also a credit for pre-1977 gifts, though the amount of this credit is limited to whichever is less, the gift tax or the estate tax on property included in the estate. The prior transfer credit will be allowed for property that is included in the transferor’s estate provided that the transferee dies within 10 years of the transferor. Credits are also allowed for most of the foreign death taxes that are paid on property included in the US gross estate but located in a foreign country.
Lifetime Planning Techniques
The Certified Financial Planner Board of Standards has outlined the following steps in estate planning. First, the planner must explain to the client the estate planning process; the planner must also explain the role of the planner and the role of the client in this process. The planner should then obtain the information about the client that will be necessary to make estate-planning decisions. The planner should then review these facts and make some preliminary recommendations to the client. The planner should then establish a plan that distributes the wealth of the client to the appropriate people, in the appropriate amounts, and at the appropriate times. When a plan has been decided upon, the planner and client should begin implementing the plan. Finally, the planner needs to constantly monitor the progress of the plan, making any adjustments necessitated by performance or changes in the law.
Postmortem Planning Techniques Qualified Disclaimers Postmortem estate planning includes filing the right tax returns, making the right elections, planning estate distributions, determining whether any disclaimers can and should be made, and selecting the appropriate valuation date for assets. A disclaimer is a way of changing an estate plan. Specifically, it is the formal refusal of an inheritance of property from a decedent. In order to be a qualified disclaimer, which will not be a taxable gift, the disclaimer must be: irrevocable and unqualified; in writing; delivered to the grantor or to the grantor’s legal representative within nine months of the date of transfer; and must be one in which the disclaiming person receives no benefit from the property disclaimed. Alternative Valuation Date Sometimes, an executor will choose to value an estate six months after the date of death if this will reduce the value of the estate for tax purposes. The kinds of properties that can decline in value after the death of the owner are most commonly securities, or closely held business stock. Any assets that are disposed of between the date of death and the alternative valuation date will be valued on the date of disposition. Any wasting assets will be valued as of the date of death, no matter whether an alternative valuation date has been selected. These wasting assets include annuities, leases, patents, and installment sales. Deferral of Estate Taxes and Corporate Stock Redemptions When an estate tax is deferred, it may then be paid over the next 14 years; the first four payments are interest-only payments beginning the year after the due date, and the next ten are payments of the estate tax. In order to defer an estate tax, the value of the decedent’s interest in the business must be at least 35% of the value of the adjusted gross estate and it must be an interest in a closely held business. As for corporate stock redemptions, in most cases in which a closely held corporation buys back stock from shareholders, the proceeds must be treated as dividend income. However, a corporate stock redemption may be claimed under Section 303, in which case proceeds are classified as long-term capital gain. Postmortem Use Valuation According to Section 2032(a) of the Code, executors may elect for special use valuation for any real estate that is used in a closely held business or for farming. This reduced valuation will be made on the basis of current actual use rather than on highest and best use. There are five requirements that must be met in order for a property to receive special use valuation: it must be held for qualified use and actively managed by the decedent for most of the past eight years; the value or real and personal property must be 50% or more of the gross estate after deduction of secured debt and mortgages; the real property portion must be at least 25% of gross estate after deduction of secured debt and mortgages; the qualifying property must pass to qualifying heirs; and on the date of the decedent’s death, the property must be used as a farm or in a closely held business. Qualified Family-Owned Business Exclusion and Optimal QTIP Planning Under Section 2057 of the Code, a family-owned business deduction can be coordinated with a unified credit, such that as the unified credit increases, the deduction decreases. This deduction may not exceed $675,000. In order to claim this deduction, the decedent must have been a US citizen and must have materially participated in the business for most of the past eight years; the interest must be a qualified family-owned business; and the net value of the business passing on to qualified heirs must be at least 50% of the decedent’s adjusted gross estate (AGE). As for electing to classify property as qualified terminal interest property, this can help property qualify for the marital deduction. This is not a good idea if the surviving spouse is already in possession of a large estate, however, because adding more property will only increase his or her estate taxes.
Monetary Settlement Planning When an individual receives monetary payments in a structured settlement, the payments are spread out over time. Money paid in a legal settlement can either be paid as lump sums or as structured settlements. Big financial windfalls, like lottery winnings, are subject to income taxes and may be disbursed over time. Retirees may receive a lump sum distribution from a qualified retirement plan if they have held the plan for at least five years, but they may suffer from having all the income tax assessed in one fiscal year. Insurance proceeds can either be received as a lump sum or as an annuity; lump sum payments are not taxed. In a systematic withdrawal plan, the client can slowly transfer money to an IRA account.
Disposition of Estate Tax Implications of Various Estate Plans Any income generated by the property will be taxed to the donee after the transfer. The basis of the donee will be whichever is less: fair market value or the donor’s basis (adjusted for paid gift tax). Transfers in which the donor can unilaterally retrieve the property will not trigger the gift tax. Completed gifts, however, will give the donor a gift tax liability for however much fair market value on the date of the gift exceeds available annual exclusion and/or any permissible charitable or marital deductions. Whereas a donor doesn’t have to pay the gift tax on funds used to pay the gift tax, an estate will have to pay taxes on the funds used to pay estate taxes. Completed gifts that do not involve a retained interest typically affect the calculation of a decedent’s potential estate tax by either decreasing the value of the gross estate, increasing the value of the adjusted taxable gift, or decreasing the tax base. Section 2503 (c) Minor’s Trust and Crummey Trust Any income derived from custodial property will be taxed to the minor at the kiddie rate, regardless of whether it is distributed. It will not be taxed to the extent that it is used to discharge a parental obligation of support (in this case, it will be taxed to the parent). An irrevocable transfer will trigger a gift-tax liability. The gift will be one of present interest, which qualifies each dollar of gifted custodial property for a dollar of annual exclusion. As for a Section 2503(b) mandatory income trust, it will be subject to income tax as an entity separate from the beneficiaries. And, since income must be distributed to the income beneficiaries, it will also be taxable to them at the appropriate tax rate. The irrevocable transfer will also create a gift tax liability.
Estate Planning for Nontraditional Relationships
If an individual has children from another relationship and wants to make sure that they receive part of an estate, one can establish a trust, place the property in a joint tenancy with the right of survivorship, or perform lifetime gifting. As for adopted children, for probate purposes adopted children are allowed to inherit property from the adopted parent but not from the natural parent who gave them up. Partners in a same-sex relationship, individuals in a communal relationship, or cohabitating partners of different sexes are not eligible for the marital deduction, so estate taxes cannot be deferred. In such relationships, it is important to include very specific bequests in the will.
Generation-Skipping Transfer Tax (GSTT) Basics and Direct Skip When a deceased individual’s property is passed to someone two generations younger than the individual, the generation-skipping transfer tax (GSTT) is applied. This tax exists because the IRS wants property to be taxed for each generation and does not want people to avoid taxation by passing property to their grandchildren. The tax will be imposed at the highest federal estate and gift tax rate. A direct skip is a transfer made directly to a person two generations away. In such a case, the transferor will pay the GSTT at the time of transfer. In a direct skip, the GSTT is tax exclusive, meaning that the taxable amount does not include the amount of GSTT. Taxable Distributions and Taxable Terminations For the purposes of determining GSTT, a taxable distribution is any distribution of income from a trust to a skip person that is not otherwise subject to estate or gift tax. In such a case, the transferee will have to pay the GSTT if it is a taxable distribution. If the trust is to pay the tax for the transferee, the payment will be treated as an additional taxable distribution. The tax payable on a taxable distribution is tax inclusive. A taxable termination, on the other hand, is a situation in which the end of an interest on property held in a trust causes all of the interest in the trust to be in the hands of the skip person. In this case, the trustee will pay the GSTT, and the tax payable will be tax inclusive. Taxable terminations cannot occur as long as one nonskip person has a present interest in the property.
Generation-Skipping Transfer Tax on Lifetime Transfers Outright Transfer of Cash or Property An individual will be considered two or more generations away from another if he or she is a grandchild, great niece or nephew, or any generation beyond. The GSTT is a separate tax from the unified gift and estate tax, and is levied in addition to these taxes. To each generation-skipping transfer, there is applied a flat tax equal to the highest gift and estate tax rate. The GSTT applies to: property placed in trust; transfers involving the creation of life estates; remainders; and insurance and annuity contracts. The GSTT is subject to the predeceased ancestor exception: if the parent in a line of descent dies before the transfer, then lower generations will move up a generation. Transfer in Trust It is possible for a gift that qualifies for the gift tax annual exclusion to still be subject to the generation-skipping transfer tax. This gift in trust will only qualify for the annual exclusion from generation-skipping transfer tax if it meets two requirements: first, the trust must state that it will make no distribution to any person other than the beneficiary during his or her lifetime; and second, upon the death of the beneficiary, the trust assets must be includible in the beneficiary’s gross estate for federal tax estate purposes. In order to fulfill these requirements and qualify for the exclusion, grandparents will often set up a Section 2503(c) or Crummey trust for their grandchild. Exemptions and Exclusions Any outright lifetime gifts that qualify for the gift tax annual exclusion will be automatically excluded from generation-skipping transfer tax. There is also such a thing as generation-skipping transfer tax exemption. In married couples, each spouse will have a GSTT exemption. Thus, each spouse can use this exemption to avoid the generation-skipping transfer tax, and so the exemption can be doubled. Also, qualified medical and educational payments may be excluded from the GSTT; in other words, the payments of medical expenses, tuition, or other school expenses can be excluded from the generation-skipping transfer tax.
Income in Respect of a Decedent (IRD) Assets The phrase “income in respect of a decedent” refers to amounts that were due to a decedent but which were not included in taxable income in the year of his or her death. IRD, then, could be salary that was earned but never paid. If the taxpayer was not paid until after his or her death, this amount may not be included on his or her final income tax return. Some other examples of IRD include the forgiveness of debt on an installment note, distributions made after death from a qualified plan or IRA, dividends on stocks paid after the death of the stockholder, the posthumous completion of a decedent’s contingent claim to sales proceeds, or the posthumous collection of sale proceeds.
Income in Respect of a Decedent (IRD) Income Tax Deduction
Income in respect of a decedent (IRD) will be subject to both estate and income tax. However, the holder of IRD will be entitled to an income tax deduction for the portion of estate taxes attributed to owning IRD in the gross estate. Also, an income tax deduction will be allowed for the generation-skipping transfer taxes that are ascribed to IRD items included in a taxable termination, or in direct skips caused by the death of the transferor. A deduction will be allowed for each year the IRD is included in income. In order to compute this deduction, all items treated as IRD in the gross estate are aggregated, and the total is reduced by all the deductions in respect of a decedent in order to arrive at a total. The value of the IRD will then be whichever is less: the lesser of the amount included in gross estate or the amount included in income. Estate taxes are then recalculated by excluding the net value from the gross estate. The difference between the original estate tax and the recalculated estate tax is the IRD deduction.
Use of Intra-Family Transfers of Assets in Estate Planning The most common use of intra-family transfers in estate planning strategies is to pass assets to other members of the family to reduce or avoid taxes. While the gift tax may not be avoided altogether, this strategy may help the advisor transfer income from one family member in a higher tax bracket to another family member in a lower tax bracket. It should be noted that the gift tax exclusion is $15,000 (as of tax year 2020) for single filers, and $30,000 for those filing as “married filing jointly.” Intra-family transfers are also useful for transferring capital assets with low cost bases to others as well. The most common types of transfer relationships are spouse to spouse, child to child, and grandparent to grandchild.
Wills as They Pertain to Estate Planning The estate planning will is a document that assists individuals (usually referred to as grantors) in distributing their property after their death. The will is not valid until after the grantor dies. To be legally recognized, the grantor must be at least 18 years old, be of sound mind, sign and date the will in the presence of at least two witnesses, appoint an executor, name the beneficiaries, and declare that they intend to create a will. Legal wills will help prevent a decedent’s estate from being held up in probate, where the estate of the decedent may be subject to more taxes.
The most common type of will is the simple will. This written document is more likely to hold up in court than verbal wills.
Durable Power of Attorney
The power of attorney document is a document that may be prepared to allow another individual, also known as the attorney in fact or AIF, to act and transact on behalf of the individual for whom the document is prepared (the principal). The purpose of this document is to assist elderly people who may not be able to travel, or United States citizens living abroad who need a presence in the U.S. to assist with legal matters. Occasionally, they are drafted for convenience sake, in the event that the individual does not want to deal with such matters. A durable power of attorney document will persist to be valid in the event that the principal becomes incapacitated. Durable power of attorney may be either immediately effective, or springing, meaning that the AIF’s powers do not come into effect until the principal is incapacitated. Powers of attorney cease to be valid at the death of the principal.
Medical Powers of Attorney and Living Wills
Often people confuse medical powers of attorney with living wills. While they share a common use, they differ radically in content. A living will is a document that states a person’s wishes regarding certain life-and-death medical matters. With a medical power of attorney, however, the principal appoints an attorney in fact (AIF) to be able to make other and more general health-care decisions for them. This is most useful when caring for a friend or relative who suffers from dementia, and may not be able to make coherent decisions about their health on their own. In short, living wills provide directives to medical personnel about an end-of-life event, whereas medical powers of attorney provide the attorney in fact with the power to make general health-care decisions for the principal.
Avoidance of Estate Taxes Through the Use of Lifetime Gifting Strategies
Gifting money from an estate is an effective way to reduce taxes before it comes time to settle the estate. The maximum amount that an individual may gift per year without incurring the gift tax is $15,000 (per recipient) as of 2020. For taxpayers who file “married filing jointly,” the maximum for the couple is $30,000. Alternatively, the taxpayer can pay qualified college expenses or medical expenses on behalf of another to reduce the estate. There is no limit to these strategies. There is also no limit to the transfer of assets between spouses. This helps when one spouse is in much poorer health but may have many more assets than the other. As long as there exists a qualifying relationship between the giftor and giftee, these are legal and useful strategies for reducing the taxpayer’s estate taxes.
Inter-Vivos and Testamentary Charitable Giving in Reducing Estate Taxes
The use of the terms inter-vivos and testamentary differentiate the time period in which the charitable giving is performed. Inter-vivos giving means that the charitable gift was given while the taxpayer was alive, and testamentary gifts are those gifts given after the person has passed away. The ways in which inter-vivos gifting is accomplished are through the use of charitable trusts (i.e., charitable remainder trust), the establishment of private charitable foundations, setting up donor-advised funds, and just giving cash or non-cash donations. Through the use of appropriate estate planning techniques, decedents may establish charitable trusts and private charitable foundations after their death. They may also give directly from their estate through instructions contained in their will, or establish that spousal disclaimers be passed to charity.
Marital Deduction and Bypass Trusts
The marital deduction and bypass trusts are used for estate planning when a person dies and leaves a surviving spouse. In the event that the decedent chooses the marital deduction option, his or her spouse must inherit all of the deceased’s property, but the deceased’s estate receives the full marital deduction when settling the estate’s taxes. This may be helpful at the time, but it creates a large tax consequence at the death of the second spouse. Bypass trusts are set up to address this problem. If a bypass trust is used, the marital deduction may not be taken. When the taxes for an estate are settled using a bypass trust, the executor may apply a “unified credit” and take the applicable tax reduction. This amount is set aside, and the surviving spouse does not receive this amount but may use it for health, education, maintenance, and support without tax consequences. The most effective strategy is to put the most highly appreciated assets in the trust so that they are not taxed at fair market value.
Satisfying Liquidity Needs Through Life Insurance Having quick and easy access to cash is essential in the expedient settlement of estates for expenses such as funeral costs and debts owed by the deceased. Life insurance is often regarded as the best and most efficient means of providing liquidity to assist in estate settlement. Life insurance proceeds are paid tax-free, so there will be no additional tax at the liquidity event. The proceeds are made immediately available so that expenses may be paid in a timely fashion. Having life insurance also prevents the decedent’s heirs from having to take loans to pay expenses. Additionally, the typical life insurance plan will be purchased for much less than the death benefit. This assists in paying expenses associated with the estate without having to pay a larger portion of the estate’s assets, which would have been necessary if the decedent had not purchased the life insurance policy. Using an Installment Plan Through IRC Section 6166 Having quick and easy access to cash is essential in the expedient settlement of estates for expenses such as funeral costs and debts owed by the deceased. In the event that life insurance proceeds are not available to cover expenses, the heirs may have to take loans or apply for installment plans to cover expenses. If the estate taxes are from a closely held business interest (must be greater than 35 percent of the estate), then the heirs may pay the taxes from the estate in 10 equal installments under Internal Revenue Code 6166. The payments may be made over 14 years, and interest-only payments may be made during the first four years. To qualify under Code 6166, the business must have been a sole proprietorship, partnership, or corporation, and continue to operate after the decedent’s death. The interest paid on IRC 6166 tax installments may not be deducted from the payers’ adjusted gross income.
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