June 29, 2023
Tax Planning for Trusts and Estates
I. CHOOSING THE STRATEGY TO USE FOR DIFFERENT TYPES OF PROPERTY
a. Real Property
A qualified personal residence trust (“QPRT”) is a technique for gifting residential property at discounted values. The QPRT is an irrevocable trust, which becomes the legal owner of the home during the trust term. The grantor would continue to live in the home during the term of the trust, and continue to pay the real estate taxes, mortgage and maintenance expenses; the taxes and interest can be deducted on the grantor’s personal income tax return, as it was before. The grantor must remain personally and contractually bound to the trustee to pay off the mortgage indebtedness in order for the amount of the mortgage to be disregarded for valuation purposes. At the end of the term, the beneficiaries would legally own the home but the grantor’s spouse may have the right to live in the house for his/her lifetime. At that point, the grantor may also remain living there due to spouse’s life estate. Should the grantor’s spouse predecease, the grantor could remain living in the house as long as fair market rent is paid. The term of the trust is a period of years, selected by the grantor. The longer the term, the greater the tax benefits. However, if the grantor does not outlive the term, any tax benefit of this strategy is lost.
An example is helpful to illustrate how effective the QPRT can be as an estate tax savings vehicle. The sixty-five (65) year old grantor’s home has an appraised value of $650,000 today. If the grantor selected a 5-year QPRT term, the amount of the actual gift for tax purposes is not $650,000; it would be reduced to about $530,309. This is because the subject of the gift is the present value of the remainder interest at the end of the QPRT term; the discount takes into account the fact that the children must wait until the trust term ends to receive anything. The potential value of the home after 5 years, assuming an annual growth rate of 4%, would be approximately $800,000. Therefore, you could remove an asset, having a future value of $800,000, from the grantor’s estate today, where the measure of the gift for tax purposes would be only $530,309. There may not be any gift taxes due on the transfer since such gift would qualify for the $5,340,000 unified credit exemption equivalent.
The advantages of the QPRT are as follows:
- The computation of the gift of the remainder interest does not contemplate future growth in the value of the property. Therefore, any post-transfer appreciation inures to the beneficiaries free of gift or estate tax. In the above scenario, almost $130,500 escapes taxation in the grantor’s estate.
- The trust is a grantor type trust which permits you to retain possession and enjoy the tax-favorable attributes of owning the residence.
- At the end of the term, the grantor may continue to live in the house as long as the grantor’s spouse is also living there or, if he/she is not, the grantor must pay fair market value rent to the beneficiaries. This “rent” is another way to transfer wealth out of the grantor’s estate free of gift taxes. The rental income would be taxable to the beneficiaries but because income tax rates are lower than estate tax rates, this is an economically efficient way to transfer additional wealth to your family.
The disadvantages of a QPRT are as follows:
- The gift is considered a gift of a future interest and the $14,000 annual exclusion is not available for this transfer.
- If the grantor does not survive the term of the trust, the house would be included in the grantor’s estate at its fair market value as of the date of death, as if the trust were never created. The term selected for the trust should, therefore, be one that you can reasonably expect to survive. The trust document will still legally control the ownership and disposition of the house regardless of whether or not you survive the term for tax purposes.
- The original tax cost in the residence is carried over to the ultimate beneficiaries. It will not be stepped up to market value at your death since it would not be part of your estate. As stated above, the income tax (capital gains) rate is lower than the estate tax rate, so the tax on the appreciation is less onerous than if the grantor’s estate were taxed on the eventual appreciated market value of the home at the grantor’s death.
Drafting Tip: Always consider having a grantor trust continue as the owner of the home after the term expires up until the grantor or the grantor’s spouse death.
b. Closely Held Companies
Sale of Stock to an Intentionally Defective Grantor Trust for a Note: This estate planning method allows for the “freezing” of the future appreciation of assets for tax purposes. The grantor would sell assets to a trust for a Promissory Note (the “Note”). The Note would pay the interest at the prevailing applicable federal rate. At the end of the term of the Notes, the principal amount would be paid to the grantor in cash or in-kind (interests in your limited liability companies), or restructured. Most importantly, the portion of assets sold to the trust will be “frozen” in value on the date of the sale. Accordingly, all future growth and appreciation over the grantor’s lifetime would occur outside of his/her estate. Thus, for every dollar of growth, $.55 of tax should be saved and passed on to the children. The estate tax consequences with respect to the Note in the transaction will depend on whether the grantor survives the term of the Note. If the grantor does not survive the term of the Note, the value of the Note should be included in the grantor’s estate. Since the Note never appreciates like the real estate, the “freeze” has been accomplished.
The intentionally defective grantor trust purposely created as a Grantor Trust for income tax purposes. Grantor Trust under IRC §675 (also see Rev. Rul 2004-64, 2004-2; and Rev. Rul 2008-16). A TIN and Form 1041 are always required under general method.
Beneficiary Defective Grantor Trust: A beneficiary of the trust is treated as the Grantor for income tax purposes. Grantor Trust to beneficiary under IRC §678(a). A TIN and Form 1041 are always required under general method.
Drafting Tip: Be sure to use a grantor trust trigger that does not also cause inclusion in grantor’s estate. Typically the power to substitute based on Revenue Ruling 2008-22 to be safe.
Grantor Retained Annuity Trust: A GRAT is a gifting vehicle used primarily to transfer income-producing assets at discounted values. The grantor of a GRAT receives an annuity from the trust until the end of the trust term, at which time it passes to the remainderman. The value of the gift is calculated to be the discounted present value of the remainder interest, at the prescribed IRS rates, taking into account all of the annuity payments to the grantor and projected future appreciation. The GRAT is structured to require that the grantor be paid a fixed annual payment during the trust term. If there is insufficient cash flow from income to meet the annuity requirement, the trust must use principal to meet this obligation. If the actual growth of the trust assets outperforms the IRS assumptions, the remaindermen would receive, in effect, a tax-free gift to the extent of the excess appreciation. The risk is the same as with the QPRT, where the grantor must outlive the term of the trust in order for the technique to be effective. If the grantor dies during the term, the value of the trust assets at the date of death are included in the grantor’s taxable estate.
Assume that you decided to transfer your entire interest in a closely held company to a GRAT for a term of 10 years. Using an annual payout to the Grantor of 11.24947% per year or, $1,124,947, the value of the taxable gift on the transfer of a $10 million interest, would be $8.63. You would have to reflect $8.63 on a gift tax return, but assuming the trust earns 8% per year and appreciates an additional 4% each year, at the end of 10 years, the trust will have grown to a value of $11,610,278.12. As you can see, over $11.6 million is passed to future generations free of transfer tax under this scenario.
c. Retirement Plans and Beneficiary Designations
Estate planning for retirement plans has significantly changed as a result of recent IRS changes. What has not changed, is the fact that when the owner of a retirement account dies, the assets in the account will be subject to both income and estate taxes. Considerable sums of retirement assets (up to 80%) can be lost to these two taxing regimes if these assets are not the subject of prudent planning.
Without any planning in place, the retirement assets are usually distributed in full upon the death of the owner or the surviving spouse as the case may be, triggering the combined 80% tax rate. The objective of estate planning with retirement assets is to postpone, for as long as possible, the distribution of funds from the retirement accounts upon the death of the owner and or his/her spouse. This intentional delay of distributions allows the retirement assets to continue to grow income tax deferred over the lives of the chosen beneficiaries, thereby taking full advantage of tax-free compounding. To illustrate, a retirement account owned by a 50 year old individual worth $500,000 today could theoretically pass over $6 million in total future distributions to a surviving spouse and his/her adult children if the distributions are stretched out over their respective life expectancies. The effect of tax deferred compounding is even more profound when grandchildren are named as beneficiaries due to their longer life expectancies. In order to minimize plan distributions and extend the tax-deferred growth period as long as possible, estate planning for these assets should focus on the beneficiary designations. The new IRS rules make naming younger beneficiaries and deferring income taxes much easier than it was in the past.
Naming the plan owner’s spouse as a primary beneficiary affords the greatest flexibility in prolonging the distribution period after the owner’s death because the spouse can elect to treat the account as their own. The surviving spouse can then select new beneficiaries such as the children (or eventually, grandchildren). By the surviving spouse naming the children as the beneficiaries the required annual distributions will be less because of the younger beneficiaries’ longer life expectancy. Under the rules, it does not matter if the surviving spouse dies before or after age 70½, because the beneficiaries still can elect to withdraw the account over their own life expectancy. This technique will substantially postpone income taxes and is the most effective means to preserve retirement assets. However, the retirement accounts are still subject to estate taxes of up to 40% Federal upon the surviving spouse’s death. In order for this income tax planning to work effectively there must be other liquid assets outside of the retirement account with which to pay this estate tax. Otherwise, most of the assets in the retirement account will have to be distributed immediately upon death in order to pay the estate tax. This distribution will trigger current income tax and any deferral benefits are lost. Frequently, the funds used to pay the estate tax and preserve the retirement account are provided by a survivorship life insurance policy held in an irrevocable trust as discussed earlier.
Revocable “Stretch” IRA Trusts
Estate planning with retirement plans is complex. When the owner of a retirement account dies, the assets in the account will be subject to both income and estate taxes. Considerable sums of retirement assets (up to 80%) can be lost to these two taxing regimes if prudent planning is not implemented with respect to those assets.
The objective of estate planning with retirement assets is to postpone, for as long as possible, the distribution of funds from the retirement accounts upon the death of the owner. This intentional delay of distributions allows the retirement assets to continue to grow income tax deferred over the lives of the chosen beneficiaries, thereby taking full advantage of tax-free compounding.
In order to postpone the distributions of funds from the retirement accounts upon the death of the owner, the designated beneficiary must “stretch” the payout over his or her life expectancy. As such, the designated beneficiary takes only the Minimum Required Distribution (MRD) each year over his or her life expectancy and such MRDs are subject to income tax based on the beneficiary’s tax rate. Ifatrustiscreated,theCodeallowsaninheritedretirementplantobestretchedoutoverthelifeexpectancyofatrustbeneficiaryifcertainrequirementsaremet.
The IRA Trust would be the primary beneficiary of a portion of a retirement account and as such, upon death of the owner, that portion of the account should be rolled over into a decedent’s IRA to be held in the separate trust for the benefit of the individual beneficiary specifically named in the trust. Please note if only one (1) Revocable IRA Trust is created for the benefit of several beneficiaries collectively, then the decedent’s retirement accounts would be stretched out over the life expectancy of the oldest beneficiary and the retirement accounts will be fully liquidated prior to the younger beneficiary’s own retirement age. Therefore, a greater benefit is achieved if separate trusts for each beneficiary are created.
The IRA trust is revocable during the account owner’s lifetime. A revocable trust is a device where you, as the person creating and funding the trust, known as the “Grantor,” can maintain control over the trust assets during his/her lifetime and retain the right to revoke or amend the trust. The trust would become irrevocable upon grantor’s death and can no longer be changed at that time.
The IRA Trust is also recommended for two additional reasons. First, if the retirement plan is substantial, the beneficiary(ies) do not receive such a large sum of funds outright. Second, it will minimize the income tax implications of the beneficiary(ies) receiving a lump sum withdrawal.
The trust principal (in this case the annual minimum IRA distributions received by the Trustee) are held in separate trusts for the beneficiary(ies) lifetime(s). The trust will protect against the beneficiary’s future potential divorce, claims and lawsuits. Any amounts of income and principal can be distributed to the beneficiary in the absolute discretion of a Trustee.
II. MARTIAL DEDUCTION PLANNING QUALIFICATIONS AND BASIC FORMULA APPROACHES
QTIP Trusts: A Last Will and Testament is fundamental to any estate plan. A typical Will passes the entire estate to the surviving spouse, and as a result, valuable tax credits are lost despite portability. Estate taxes are payable upon the death of the second spouse, because transfers to a spouse upon the first death are exempt from tax due to the unlimited marital deduction. Upon the death of the first spouse, assets valued at $5,340,000 are placed into a trust called a “Credit Shelter Trust” or “Bypass Trust”. The surviving spouse can enjoy all of the income and/or principal during his/her lifetime while any principal remaining at his/her death passes to the children. Any amount in excess of the $5,340,000, not placed in the Credit Shelter Trust can be left to the surviving spouse outright or in a QTIP marital trust. The $5,340,000 in value that funds the Credit Shelter Trust is not subject to estate taxes when the first spouse passes away because it is excluded by the exemption amount (provided that the $5,340,000 credit was not exhausted through lifetime gifts), nor is the remainder of the estate that passes to the QTIP trust because of the marital deduction. All of the assets remaining upon the death of the second spouse, including the value of the QTIP trust, are subject to taxes to the extent they exceed that spouse’s $5,340,000 exemption.
Disclaimer Trusts: A typical Disclaimer Trust is established when a surviving spouse disclaims any property that is given outright to him or her upon the decedent’s death. The reason a spouse would make such a disclaimer is to make use of the credit for the applicable exclusion amount, should the decedent’s estate be taxable.
If all of the decedent’s property is left outright to a surviving spouse, the credit for the applicable exclusion amount may not be properly utilized even under the recent portability rules.
If property is disclaimed into a trust for the surviving spouse, and a marital deduction is not taken on that trust, then that specific property in the trust is not included or taxable in the surviving spouse’s estate. The disclaimed property will, in effect, guarantee the use of the credit for the applicable exclusion amount, and thus, will not be taxable upon the death of the surviving spouse. The disclaimer arrangement provided for in the decedent’s Will allows a large degree of flexibility for such tax planning at the time of the first spouse’s death since the executor can control the amounts that will be disclaimed and subsequently excluded from estate taxes.
Under IRC §2518, the term qualified disclaimer means an irrevocable and unqualified refusal by a person to accept an interest in property but only if:
- such refusal is in writing:
- such writing is received by the transferor or his legal representative within nine (9) months of the date of the transfer creating the interest;
- disclaimant has not accepted the interest or any of its benefits; and
- disclaimed interest passes without the direction on the part of the disclaimant.
The terms of Disclaimer Trust provide that the surviving spouse will receive all of the income from the trust, to be paid at least quarter-annually, and the surviving spouse may receive principal payments in the discretion of the Co-Trustee, other than the surviving spouse, if he/she is a Co-Trustee. The Disclaimer Trust may also provides the surviving spouse with the right to withdraw the greater of $5,000 or 5% of value of the trust principal each year; and/or the right to withdraw from the principal any amounts needed for her health, education, support and maintenance, without the discretion of the Co-Trustee. These various features allow the surviving spouse to receive all of the income and some or all of the principal of any disclaimed amounts that he/she may need during her lifetime, without disrupting the tax benefits. The Disclaimer Trust, however, cannot contain a special power of appointment in the spouse to dispose of trust assets.
III. CHARITABLE DEDUCTION PLANNING
a. Charitable Gifts: Gifts to qualified charities are income tax deductible. In addition, the charitable component of a split interest trust (one where a portion of the trust has a charitable beneficiary, and another portion has a non-charitable beneficiary) is a reduction of total taxable gifts made during the year. The deduction is unlimited as long as the gift is made without restrictions on the use of the property donated. Qualified charities include any corporation organized for religious, charitable, scientific, literary or educational purposes. In addition, a charitable gift to the donor’s own private foundation qualifies for the deduction.
b. Charitable Remainder Trust: A charitable remainder trust (CRT) is an irrevocable trust (an example of a split interest trust) to which the grantor contributes assets retaining a stream of income for either a term of years or for life, with the remainder passing to charity at the end of the term. The grantor is allowed an income tax deduction for the present value of the remainder interest that passes to charity, and the property contributed is permanently removed from his gross estate. The IRS requires the grantor to take an annual distribution of not less than 5% of the trust’s value. The present value of the charity’s remainder interest must be at least 10% of the trust’s original value in order to ensure that the charity will receive some benefit at the end of the term. The duration of the trust may be a term of years not to exceed twenty (20), for the life of the donor, or the life of the donor and his survivor.
A CRT allows an individual to convert highly appreciated non-income producing or low income producing assets, such as appreciated securities into high income generating investments, without the burden of a capital gains tax, while retaining an income stream and ultimately providing a benefit to charity. Since there is no capital gains tax on the sale of securities inside the CRT, I suggest funding this trust with low basis securities. After the securities are sold, the proceeds would be invested in income producing assets, such as bonds. This would ensure adequate income to meet the annual payment requirement to you. Further, you could maintain control of the trust by acting as trustee.
The CRT can be designed as either a charitable remainder unitrust, “CRUT,” or a charitable remainder annuity trust, “CRAT”. A CRUT allows the donor to receive an annual payment expressed as a percentage, at least 5% of the trust’s fair market value, computed each year. This will provide an increasing cash flow in a climate of rising asset values, which would serve as a hedge against inflation. In a declining market, the decreasing values will reduce the unitrust payment. The CRAT provides an annuity payment which is fixed at the creation of the trust and is unaffected by changes in the value of the trust assets.
Assume your client contributed $1 million of highly appreciated stock to a CRUT for his lifetime and retained an income stream of 7% of the trust’s value payable every year. The charitable remainder could be for the benefit of your client’s private foundation (discussed below). Your client would receive a current income tax deduction equal to the present value of the remainder interest, which is about $260,000, representing an income tax savings of approximately $103,000. The trust could then sell the stock without paying any taxes on the capital gains. The entire $1 million proceeds could then be reinvested in fixed income securities and the trust could pay out income an annuity of 7% or approximately $70,000 to your client for the rest of his lifetime. Upon his death, the remainder would pass to your client’s foundation.
c. Private Foundations: A private foundation can be established to act as the recipient of charitable interests that might be created as part of an estate plan. Establishing a foundation allows flexibility with regard to the timing of when charitable gifts may be disbursed to the ultimate charitable recipient because the foundation is only required to make annual contributions to qualified charities equal to 5% of its annual value. Therefore, if the foundation’s assets’ growth rate is in excess of 5%, the value of the foundation will appreciate over time. A private family foundation could bear your client’s name and your client could be actively involved in its management.
Drafting Tip: Follow IRS regulations explicitly when drafting CRT. They actually provide CRT language.
Circular 230 Disclosure:
*** The Treasury Department has newly promulgated Regulations effective June 20, 2005, that applies to those attorneys and accountants (and others) practicing before the IRS that require such individuals to provide extensive disclosure in certain written communications to clients. In order to comply with our obligations under these Regulations, we want to inform you that since this communication is not intended to and does not contain such disclosure, you may not rely on any tax advice contained in this document to avoid tax penalties.
I. CHOOSING THE STRATEGY TO USE FOR DIFFERENT TYPES OF PROPERTY
a. Real Property
A qualified personal residence trust (“QPRT”) is a technique for gifting residential property at discounted values. The QPRT is an irrevocable trust, which becomes the legal owner of the home during the trust term. The grantor would continue to live in the home during the term of the trust, and continue to pay the real estate taxes, mortgage and maintenance expenses; the taxes and interest can be deducted on the grantor’s personal income tax return, as it was before. The grantor must remain personally and contractually bound to the trustee to pay off the mortgage indebtedness in order for the amount of the mortgage to be disregarded for valuation purposes. At the end of the term, the beneficiaries would legally own the home but the grantor’s spouse may have the right to live in the house for his/her lifetime. At that point, the grantor may also remain living there due to spouse’s life estate. Should the grantor’s spouse predecease, the grantor could remain living in the house as long as fair market rent is paid. The term of the trust is a period of years, selected by the grantor. The longer the term, the greater the tax benefits. However, if the grantor does not outlive the term, any tax benefit of this strategy is lost.
An example is helpful to illustrate how effective the QPRT can be as an estate tax savings vehicle. The sixty-five (65) year old grantor’s home has an appraised value of $650,000 today. If the grantor selected a 5-year QPRT term, the amount of the actual gift for tax purposes is not $650,000; it would be reduced to about $530,309. This is because the subject of the gift is the present value of the remainder interest at the end of the QPRT term; the discount takes into account the fact that the children must wait until the trust term ends to receive anything. The potential value of the home after 5 years, assuming an annual growth rate of 4%, would be approximately $800,000. Therefore, you could remove an asset, having a future value of $800,000, from the grantor’s estate today, where the measure of the gift for tax purposes would be only $530,309. There may not be any gift taxes due on the transfer since such gift would qualify for the $5,340,000 unified credit exemption equivalent.
The advantages of the QPRT are as follows:
- The computation of the gift of the remainder interest does not contemplate future growth in the value of the property. Therefore, any post-transfer appreciation inures to the beneficiaries free of gift or estate tax. In the above scenario, almost $130,500 escapes taxation in the grantor’s estate.
- The trust is a grantor type trust which permits you to retain possession and enjoy the tax-favorable attributes of owning the residence.
- At the end of the term, the grantor may continue to live in the house as long as the grantor’s spouse is also living there or, if he/she is not, the grantor must pay fair market value rent to the beneficiaries. This “rent” is another way to transfer wealth out of the grantor’s estate free of gift taxes. The rental income would be taxable to the beneficiaries but because income tax rates are lower than estate tax rates, this is an economically efficient way to transfer additional wealth to your family.
The disadvantages of a QPRT are as follows:
- The gift is considered a gift of a future interest and the $14,000 annual exclusion is not available for this transfer.
- If the grantor does not survive the term of the trust, the house would be included in the grantor’s estate at its fair market value as of the date of death, as if the trust were never created. The term selected for the trust should, therefore, be one that you can reasonably expect to survive. The trust document will still legally control the ownership and disposition of the house regardless of whether or not you survive the term for tax purposes.
- The original tax cost in the residence is carried over to the ultimate beneficiaries. It will not be stepped up to market value at your death since it would not be part of your estate. As stated above, the income tax (capital gains) rate is lower than the estate tax rate, so the tax on the appreciation is less onerous than if the grantor’s estate were taxed on the eventual appreciated market value of the home at the grantor’s death.
Drafting Tip: Always consider having a grantor trust continue as the owner of the home after the term expires up until the grantor or the grantor’s spouse death.
b. Closely Held Companies
Sale of Stock to an Intentionally Defective Grantor Trust for a Note: This estate planning method allows for the “freezing” of the future appreciation of assets for tax purposes. The grantor would sell assets to a trust for a Promissory Note (the “Note”). The Note would pay the interest at the prevailing applicable federal rate. At the end of the term of the Notes, the principal amount would be paid to the grantor in cash or in-kind (interests in your limited liability companies), or restructured. Most importantly, the portion of assets sold to the trust will be “frozen” in value on the date of the sale. Accordingly, all future growth and appreciation over the grantor’s lifetime would occur outside of his/her estate. Thus, for every dollar of growth, $.55 of tax should be saved and passed on to the children. The estate tax consequences with respect to the Note in the transaction will depend on whether the grantor survives the term of the Note. If the grantor does not survive the term of the Note, the value of the Note should be included in the grantor’s estate. Since the Note never appreciates like the real estate, the “freeze” has been accomplished.
The intentionally defective grantor trust purposely created as a Grantor Trust for income tax purposes. Grantor Trust under IRC §675 (also see Rev. Rul 2004-64, 2004-2; and Rev. Rul 2008-16). A TIN and Form 1041 are always required under general method.
Beneficiary Defective Grantor Trust: A beneficiary of the trust is treated as the Grantor for income tax purposes. Grantor Trust to beneficiary under IRC §678(a). A TIN and Form 1041 are always required under general method.
Drafting Tip: Be sure to use a grantor trust trigger that does not also cause inclusion in grantor’s estate. Typically the power to substitute based on Revenue Ruling 2008-22 to be safe.
Grantor Retained Annuity Trust: A GRAT is a gifting vehicle used primarily to transfer income-producing assets at discounted values. The grantor of a GRAT receives an annuity from the trust until the end of the trust term, at which time it passes to the remainderman. The value of the gift is calculated to be the discounted present value of the remainder interest, at the prescribed IRS rates, taking into account all of the annuity payments to the grantor and projected future appreciation. The GRAT is structured to require that the grantor be paid a fixed annual payment during the trust term. If there is insufficient cash flow from income to meet the annuity requirement, the trust must use principal to meet this obligation. If the actual growth of the trust assets outperforms the IRS assumptions, the remaindermen would receive, in effect, a tax-free gift to the extent of the excess appreciation. The risk is the same as with the QPRT, where the grantor must outlive the term of the trust in order for the technique to be effective. If the grantor dies during the term, the value of the trust assets at the date of death are included in the grantor’s taxable estate.
Assume that you decided to transfer your entire interest in a closely held company to a GRAT for a term of 10 years. Using an annual payout to the Grantor of 11.24947% per year or, $1,124,947, the value of the taxable gift on the transfer of a $10 million interest, would be $8.63. You would have to reflect $8.63 on a gift tax return, but assuming the trust earns 8% per year and appreciates an additional 4% each year, at the end of 10 years, the trust will have grown to a value of $11,610,278.12. As you can see, over $11.6 million is passed to future generations free of transfer tax under this scenario.
c. Retirement Plans and Beneficiary Designations
Estate planning for retirement plans has significantly changed as a result of recent IRS changes. What has not changed, is the fact that when the owner of a retirement account dies, the assets in the account will be subject to both income and estate taxes. Considerable sums of retirement assets (up to 80%) can be lost to these two taxing regimes if these assets are not the subject of prudent planning.
Without any planning in place, the retirement assets are usually distributed in full upon the death of the owner or the surviving spouse as the case may be, triggering the combined 80% tax rate. The objective of estate planning with retirement assets is to postpone, for as long as possible, the distribution of funds from the retirement accounts upon the death of the owner and or his/her spouse. This intentional delay of distributions allows the retirement assets to continue to grow income tax deferred over the lives of the chosen beneficiaries, thereby taking full advantage of tax-free compounding. To illustrate, a retirement account owned by a 50 year old individual worth $500,000 today could theoretically pass over $6 million in total future distributions to a surviving spouse and his/her adult children if the distributions are stretched out over their respective life expectancies. The effect of tax deferred compounding is even more profound when grandchildren are named as beneficiaries due to their longer life expectancies. In order to minimize plan distributions and extend the tax-deferred growth period as long as possible, estate planning for these assets should focus on the beneficiary designations. The new IRS rules make naming younger beneficiaries and deferring income taxes much easier than it was in the past.
Naming the plan owner’s spouse as a primary beneficiary affords the greatest flexibility in prolonging the distribution period after the owner’s death because the spouse can elect to treat the account as their own. The surviving spouse can then select new beneficiaries such as the children (or eventually, grandchildren). By the surviving spouse naming the children as the beneficiaries the required annual distributions will be less because of the younger beneficiaries’ longer life expectancy. Under the rules, it does not matter if the surviving spouse dies before or after age 70½, because the beneficiaries still can elect to withdraw the account over their own life expectancy. This technique will substantially postpone income taxes and is the most effective means to preserve retirement assets. However, the retirement accounts are still subject to estate taxes of up to 40% Federal upon the surviving spouse’s death. In order for this income tax planning to work effectively there must be other liquid assets outside of the retirement account with which to pay this estate tax. Otherwise, most of the assets in the retirement account will have to be distributed immediately upon death in order to pay the estate tax. This distribution will trigger current income tax and any deferral benefits are lost. Frequently, the funds used to pay the estate tax and preserve the retirement account are provided by a survivorship life insurance policy held in an irrevocable trust as discussed earlier.
Revocable “Stretch” IRA Trusts
Estate planning with retirement plans is complex. When the owner of a retirement account dies, the assets in the account will be subject to both income and estate taxes. Considerable sums of retirement assets (up to 80%) can be lost to these two taxing regimes if prudent planning is not implemented with respect to those assets.
The objective of estate planning with retirement assets is to postpone, for as long as possible, the distribution of funds from the retirement accounts upon the death of the owner. This intentional delay of distributions allows the retirement assets to continue to grow income tax deferred over the lives of the chosen beneficiaries, thereby taking full advantage of tax-free compounding.
In order to postpone the distributions of funds from the retirement accounts upon the death of the owner, the designated beneficiary must “stretch” the payout over his or her life expectancy. As such, the designated beneficiary takes only the Minimum Required Distribution (MRD) each year over his or her life expectancy and such MRDs are subject to income tax based on the beneficiary’s tax rate. Ifatrustiscreated,theCodeallowsaninheritedretirementplantobestretchedoutoverthelifeexpectancyofatrustbeneficiaryifcertainrequirementsaremet.
The IRA Trust would be the primary beneficiary of a portion of a retirement account and as such, upon death of the owner, that portion of the account should be rolled over into a decedent’s IRA to be held in the separate trust for the benefit of the individual beneficiary specifically named in the trust. Please note if only one (1) Revocable IRA Trust is created for the benefit of several beneficiaries collectively, then the decedent’s retirement accounts would be stretched out over the life expectancy of the oldest beneficiary and the retirement accounts will be fully liquidated prior to the younger beneficiary’s own retirement age. Therefore, a greater benefit is achieved if separate trusts for each beneficiary are created.
The IRA trust is revocable during the account owner’s lifetime. A revocable trust is a device where you, as the person creating and funding the trust, known as the “Grantor,” can maintain control over the trust assets during his/her lifetime and retain the right to revoke or amend the trust. The trust would become irrevocable upon grantor’s death and can no longer be changed at that time.
The IRA Trust is also recommended for two additional reasons. First, if the retirement plan is substantial, the beneficiary(ies) do not receive such a large sum of funds outright. Second, it will minimize the income tax implications of the beneficiary(ies) receiving a lump sum withdrawal.
The trust principal (in this case the annual minimum IRA distributions received by the Trustee) are held in separate trusts for the beneficiary(ies) lifetime(s). The trust will protect against the beneficiary’s future potential divorce, claims and lawsuits. Any amounts of income and principal can be distributed to the beneficiary in the absolute discretion of a Trustee.
II. MARTIAL DEDUCTION PLANNING QUALIFICATIONS AND BASIC FORMULA APPROACHES
QTIP Trusts: A Last Will and Testament is fundamental to any estate plan. A typical Will passes the entire estate to the surviving spouse, and as a result, valuable tax credits are lost despite portability. Estate taxes are payable upon the death of the second spouse, because transfers to a spouse upon the first death are exempt from tax due to the unlimited marital deduction. Upon the death of the first spouse, assets valued at $5,340,000 are placed into a trust called a “Credit Shelter Trust” or “Bypass Trust”. The surviving spouse can enjoy all of the income and/or principal during his/her lifetime while any principal remaining at his/her death passes to the children. Any amount in excess of the $5,340,000, not placed in the Credit Shelter Trust can be left to the surviving spouse outright or in a QTIP marital trust. The $5,340,000 in value that funds the Credit Shelter Trust is not subject to estate taxes when the first spouse passes away because it is excluded by the exemption amount (provided that the $5,340,000 credit was not exhausted through lifetime gifts), nor is the remainder of the estate that passes to the QTIP trust because of the marital deduction. All of the assets remaining upon the death of the second spouse, including the value of the QTIP trust, are subject to taxes to the extent they exceed that spouse’s $5,340,000 exemption.
Disclaimer Trusts: A typical Disclaimer Trust is established when a surviving spouse disclaims any property that is given outright to him or her upon the decedent’s death. The reason a spouse would make such a disclaimer is to make use of the credit for the applicable exclusion amount, should the decedent’s estate be taxable.
If all of the decedent’s property is left outright to a surviving spouse, the credit for the applicable exclusion amount may not be properly utilized even under the recent portability rules.
If property is disclaimed into a trust for the surviving spouse, and a marital deduction is not taken on that trust, then that specific property in the trust is not included or taxable in the surviving spouse’s estate. The disclaimed property will, in effect, guarantee the use of the credit for the applicable exclusion amount, and thus, will not be taxable upon the death of the surviving spouse. The disclaimer arrangement provided for in the decedent’s Will allows a large degree of flexibility for such tax planning at the time of the first spouse’s death since the executor can control the amounts that will be disclaimed and subsequently excluded from estate taxes.
Under IRC §2518, the term qualified disclaimer means an irrevocable and unqualified refusal by a person to accept an interest in property but only if:
- such refusal is in writing:
- such writing is received by the transferor or his legal representative within nine (9) months of the date of the transfer creating the interest;
- disclaimant has not accepted the interest or any of its benefits; and
- disclaimed interest passes without the direction on the part of the disclaimant.
The terms of Disclaimer Trust provide that the surviving spouse will receive all of the income from the trust, to be paid at least quarter-annually, and the surviving spouse may receive principal payments in the discretion of the Co-Trustee, other than the surviving spouse, if he/she is a Co-Trustee. The Disclaimer Trust may also provides the surviving spouse with the right to withdraw the greater of $5,000 or 5% of value of the trust principal each year; and/or the right to withdraw from the principal any amounts needed for her health, education, support and maintenance, without the discretion of the Co-Trustee. These various features allow the surviving spouse to receive all of the income and some or all of the principal of any disclaimed amounts that he/she may need during her lifetime, without disrupting the tax benefits. The Disclaimer Trust, however, cannot contain a special power of appointment in the spouse to dispose of trust assets.
III. CHARITABLE DEDUCTION PLANNING
a. Charitable Gifts: Gifts to qualified charities are income tax deductible. In addition, the charitable component of a split interest trust (one where a portion of the trust has a charitable beneficiary, and another portion has a non-charitable beneficiary) is a reduction of total taxable gifts made during the year. The deduction is unlimited as long as the gift is made without restrictions on the use of the property donated. Qualified charities include any corporation organized for religious, charitable, scientific, literary or educational purposes. In addition, a charitable gift to the donor’s own private foundation qualifies for the deduction.
b. Charitable Remainder Trust: A charitable remainder trust (CRT) is an irrevocable trust (an example of a split interest trust) to which the grantor contributes assets retaining a stream of income for either a term of years or for life, with the remainder passing to charity at the end of the term. The grantor is allowed an income tax deduction for the present value of the remainder interest that passes to charity, and the property contributed is permanently removed from his gross estate. The IRS requires the grantor to take an annual distribution of not less than 5% of the trust’s value. The present value of the charity’s remainder interest must be at least 10% of the trust’s original value in order to ensure that the charity will receive some benefit at the end of the term. The duration of the trust may be a term of years not to exceed twenty (20), for the life of the donor, or the life of the donor and his survivor.
A CRT allows an individual to convert highly appreciated non-income producing or low income producing assets, such as appreciated securities into high income generating investments, without the burden of a capital gains tax, while retaining an income stream and ultimately providing a benefit to charity. Since there is no capital gains tax on the sale of securities inside the CRT, I suggest funding this trust with low basis securities. After the securities are sold, the proceeds would be invested in income producing assets, such as bonds. This would ensure adequate income to meet the annual payment requirement to you. Further, you could maintain control of the trust by acting as trustee.
The CRT can be designed as either a charitable remainder unitrust, “CRUT,” or a charitable remainder annuity trust, “CRAT”. A CRUT allows the donor to receive an annual payment expressed as a percentage, at least 5% of the trust’s fair market value, computed each year. This will provide an increasing cash flow in a climate of rising asset values, which would serve as a hedge against inflation. In a declining market, the decreasing values will reduce the unitrust payment. The CRAT provides an annuity payment which is fixed at the creation of the trust and is unaffected by changes in the value of the trust assets.
Assume your client contributed $1 million of highly appreciated stock to a CRUT for his lifetime and retained an income stream of 7% of the trust’s value payable every year. The charitable remainder could be for the benefit of your client’s private foundation (discussed below). Your client would receive a current income tax deduction equal to the present value of the remainder interest, which is about $260,000, representing an income tax savings of approximately $103,000. The trust could then sell the stock without paying any taxes on the capital gains. The entire $1 million proceeds could then be reinvested in fixed income securities and the trust could pay out income an annuity of 7% or approximately $70,000 to your client for the rest of his lifetime. Upon his death, the remainder would pass to your client’s foundation.
c. Private Foundations: A private foundation can be established to act as the recipient of charitable interests that might be created as part of an estate plan. Establishing a foundation allows flexibility with regard to the timing of when charitable gifts may be disbursed to the ultimate charitable recipient because the foundation is only required to make annual contributions to qualified charities equal to 5% of its annual value. Therefore, if the foundation’s assets’ growth rate is in excess of 5%, the value of the foundation will appreciate over time. A private family foundation could bear your client’s name and your client could be actively involved in its management.
Drafting Tip: Follow IRS regulations explicitly when drafting CRT. They actually provide CRT language.
Circular 230 Disclosure:
*** The Treasury Department has newly promulgated Regulations effective June 20, 2005, that applies to those attorneys and accountants (and others) practicing before the IRS that require such individuals to provide extensive disclosure in certain written communications to clients. In order to comply with our obligations under these Regulations, we want to inform you that since this communication is not intended to and does not contain such disclosure, you may not rely on any tax advice contained in this document to avoid tax penalties.