The five levels of estate planning — updated
By Julius Giarmarco
Giarmarco, Mullins & Horton, P.C.
The five levels of estate planning is a systematic approach for explaining estate planning to your clients in a way that they can easily follow. How many of the five levels your client needs to complete is based on his/her particular objectives and circumstances.
Level one: The basic plan
The situation for level one planning is that the client has no will or living trust in place, or his/her existing will or living trust is outdated or inadequate. The objectives for this type of planning are: (1) to reduce or eliminate estate taxes; (2) to avoid the cost, delays and publicity associated with probate in the event of death or incapacity; and (3) to protect heirs from their inability, their disability, their creditors and their predators, including ex-spouses.
To accomplish these objectives, the client would use a pour-over will, a revocable living trust, general powers of attorney for financial matters, durable powers of attorney for health care and living wills. For married clients, level one planning will also take maximum advantage of both spouses' estate tax exemptions (currently $5 million per person).
Level two: The irrevocable life insurance trust (ILIT)
The situation for level two planning is that the client's estate is projected to be greater than the estate tax exemption. As a result of the Tax Relief Act of 2010, the amount a decedent can exempt from federal estate taxes is $5 million ($10 million for married couples). The exemption is indexed for inflation beginning in 2012. Amounts in excess of the exemption are taxed at 35 percent. However, without further Congressional action, on Jan. 1, 2013, the $5 million exemption drops to $1 million, and the tax rate increases to 55 percent.
The most popular way to provide liquidity to pay estate taxes is to establish an irrevocable life insurance trust. The grantor can gift to the ILIT up to $13,000 per beneficiary. These gifts then can be used by the trustee to pay premiums. The grantor also can use some of his/her $5 million gift tax exemption to make additional gifts to the ILIT. For married grantors, those amounts can be doubled. Upon the grantor-insured's death, the insurance proceeds (which are both income and estate tax free) can provide liquidity to the grantor's estate to pay estate taxes. In essence, the ILIT allows estate taxes to be paid for the estate rather than from the estate. Level three: Family limited partnerships
In level three planning, the client is in a situation where they have a projected estate tax liability that exceeds the life insurance purchased in level two. If the client's $5 million gift tax exemption is used to make lifetime gifts, the gifted property and all future income and appreciation thereon are removed from the client's estate.
Clients would be more willing to make gifts to their children and grandchildren if they could continue to manage the gifted property. A family limited partnership or a family limited liability company can play a valuable role in this situation. The client would typically be the general partner of the FLP or the manager of the FLLC and, in that capacity, continue to manage the FLP or FLLC's assets, and even take a reasonable management fee for the same.
The limited partners/non-voting members do not participate in the management of the FLP or FLLC. Thus, gifts of limited partnership interests in an FLP or gifts of non-voting membership interests in an FLLC may be eligible for valuation discounts (for lack of control and lack of marketability), thereby leveraging the donor's $13,000 annual gift tax exclusion and $5 million gift tax exemption. Moreover, by gifting FLP or FLLC interests to an ILIT, the FLP or FLLC's income can be used to pay premiums, thereby freeing up the client's $13,000 annual gift tax exclusion for other types of gifts.
Level four: QPRTs, GRATs and IDGTs
In level four planning the client has an additional need to reduce the client's estate after the $5 million gift tax exemption has been used. There are several techniques to make substantial transfers to children and grandchildren without paying significant gift taxes.
One is a qualified personal residence trust. A QPRT allows the grantor to transfer a residence or vacation home to a trust for the benefit of his/her children, while retaining the right to use the residence for a term of years. By retaining the right to occupy the residence, the value of the remainder interest is reduced, along with the taxable gift.
Another technique is a grantor retained annuity trust. A GRAT is similar to a QPRT. The typical GRAT is funded with income-producing property, such as Subchapter S stock or FLP or FLLC interests. The GRAT pays the grantor a fixed annuity for a specified term of years. Because of the retained annuity, the gift to the remaindermen (the grantor's children) is substantially less than the current value of the property. Both QPRTs and GRATs can be designed to reduce the value of the remainder interest passing to the grantor's children to a nominal amount or even zero. However, if the grantor does not survive the stated term, the property in the QPRT or GRAT is included in the grantor's estate. Therefore, it is recommended that an ILIT be used as a hedge against the grantor's death prior to the end of the stated term.
A third technique is an intentionally defective grantor trust. For estate tax purposes, gifts to IDGTs are completed gifts and outside of the grantor's estate. But, for income tax purposes, the grantor is treated as the owner of the trust and, therefore, the grantor is taxed on the trust's income. Assets can be sold (on installments) by the grantor to his/her IDGT income and capital gains tax free. All future appreciation and income on the assets sold (in excess of the interest paid on the note) are removed from the grantor's estate. Moreover, the income tax the grantor pays on the IDGT's income further reduces the grantor's estate. The excess cash flow in the IDGT is often used to purchase life insurance to provide estate liquidity.
Level five: The zero estate tax plan
Level five planning is a desire to "disinherit" the IRS. The strategy combines gifts of life insurance with gifts to charity. For example, take a married couple with a $20 million estate. Assume there is neither growth nor depletion of the assets and both spouses die in a year when the estate tax exemption is $5 million (per spouse), and the top estate tax rate is 35 percent. Thus, the estate taxes due would be $3.5 million ($20M - $10M = $10M x 35 percent), and the heirs would inherit $16.5 million.
With the zero estate tax plan, an ILIT is funded with a $10 million second-to-die life insurance policy. Assume that annual exclusion gifts of $26,000 per child (totaling $2 million) are gifted to the ILIT during the couple's lifetime. These gifts reduce the couple's estate to $18 million. The couple's living trusts each leave $5 million (the amount exempt from estate taxes) to their children upon the surviving spouse's death. The balance of their estate ($8 million) passes to a public charity or private foundation estate tax free (because of the unlimited charitable deduction).
To summarize, the zero estate tax plan delivers $20 million to the children ($10 million from the ILIT and $10 million from the living trusts) instead of $16.5 million; it delivers $8 million to charity instead of nothing; and it delivers nothing to the IRS, instead of $3.5 million.
In summary, with advanced planning, it is possible for your clients to reduce estate taxes, avoid probate, set forth their wishes, and protect their heirs from creditors, ex-spouses and estate taxes.
TO THE EXTENT THIS ARTICLE CONTAINS TAX MATTERS IT IS NOT INTENDED OR WRITTEN TO BE USED AND CANNOT BE USED BY A TAXPAYER FOR THE PURPOSE OF AVOIDING PENALTIES THAT MAY BE IMPOSED ON THE TAXPAYER, ACCORDING TO CIRCULAR 230.