Techniques to reduce or eliminate estate taxes
Marital deduction and unified credit planning for a married couple
If a married couple's combined assets exceed the value of one person's applicable exclusion amount ($2,000,000 from 2006-2008 and $3,500,000 in 2009), it is necessary to engage in estate planning to avoid estate tax on the second death. The basic estate planning technique to avoid an estate tax on the second death is a will or trust with a two-share arrangement. This technique is commonly called credit shelter planning and is sometimes called the A - B trust arrangement. Whatever you call it, this technique will permit up to double the applicable exclusion amount to pass to children or other designated beneficiaries without payment of estate tax on either spouse's death. Under present law, the estate tax is set for repeal in 2010 and reinstated in 2011, with an applicable exclusion amount of $1,000,000. (See 2001 Tax Relief Act.)
To make credit shelter planning work, a mechanism, must be in place to permit each spouse to use enough of his or her applicable exclusion amount upon death to avoid estate taxes on both deaths. This can be done through formula provisions, disclaimers, or a partial election of the estate tax marital deduction. The idea is to use some or all of the first-to-die's applicable exclusion amount to set aside property and protect it from estate tax on the second death. If a couple's combined assets are valued at two full applicable exclusion amounts or more ($4,000,000 or more from 2006-2008 ), the amount set aside on the first death would have to be the first-to-die's full applicable exclusion amount ($2,000,000). If a couple's combined assets are worth less than $4,000,000, the amount set aside should be large enough to insure the surviving spouse will not have property worth more than $2,000,000 when he or she dies.
This separation of ownership can be accomplished by having each spouse own assets separately, having assets separately owned by each person's revocable trust, or by having assets owned in a joint revocable trust. When trusts are used to divide ownership, the husband and wife can serve as co-trustees of the trusts and, for all practical purposes, they both will continue to participate in the management, investment, and other decision making for all family assets as they did before the division.
In an estate plan using credit shelter planning, the separate wills or revocable trusts of both the husband and wife, or the joint revocable trust will contain provisions that divide the property of the first-to-die or the joint trust property into two parts. The first part, which may be called the credit shelter share, credit shelter trust, bypass trust, or family trust, will be the amount protected by the applicable exclusion amount of the first-to-die. This amount can be distributed to a credit shelter or family trust for the benefit of the surviving spouse and the children, to a credit shelter trust solely for the benefit of the children, or directly to the children. This amount will not be subject to estate tax upon the second death, no matter how much it grows between deaths, because it will be forever protected by the applicable exclusion amount of the first-to-die. If there is any remaining amount of the first-to-die's property or joint trust property not protected by the first-to-die's applicable exclusion amount, that amount will be allocated to a marital share. The marital share could be distributed outright to the surviving spouse, distributed to his or her revocable trust, or distributed to a marital trust or survivor's trust for the benefit of the surviving spouse.
If the applicable exclusion amount of the first spouse is used for a credit shelter trust benefiting the surviving spouse and the children, the surviving spouse may have significant rights with respect to the property of the trust. He or she may be the trustee of the trust, receive all the income from the trust, and withdraw trust property as needed for his or her health, education, support, and maintenance. The surviving spouse may also be permitted to withdraw up to $5,000 or 5% of the trust property annually for any reason and be permitted to appoint the property of the trust at his or her death among the most deserving of the couple's children.
If the amount not protected by the first-to-die's applicable exclusion amount is held in a marital trust or survivor's trust for the benefit of the surviving spouse, the trust terms may be very broad or restrictive, depending on the family situation. If broad powers are desired, the surviving spouse may receive all the income from the trust and be permitted to withdraw principal for any reason. He or she may also appoint the trust property at death to anyone. If the family situation involves a second marriage and children exist from the first marriage, more restrictive terms may be desired. In that case, the surviving spouse may be limited to only receiving all the income from the trust and the trust will provide that the assets will pass to the children of the first marriage when the surviving spouse dies.
Let's apply this credit shelter trust and marital trust concept to our original example of Sam and Irene (see topic entitled "Estate Planning"). Instead of the ownership in our previous examples, Sam and Irene divided their $4,000,000 of assets into equal shares and created wills or revocable trusts with a credit shelter/marital trust arrangement or they transferred their jointly owned assets into a joint revocable trust with such an arrangement. We will assume Sam dies first.
Sam's Estate
Gross Estate: $2,000,000
Marital Deduction: 0
Taxable Estate: $2,000,000
Applicable exclusion amount in credit shelter trust for Irene and children): $2,000,000
Amount Taxed: 0
Tax: 0
Irene's Estate
Gross Estate: $2,000,000
Marital Deduction: 0
Taxable estate: $2,000,000
Irene's applicable exclusion amount: $2,000,000
Amount Taxed: 0
Tax: 0
Amount passing to children free of tax: $4,000,000
Charitable deduction and unified credit planning for a single person, widow, or widower
When a single person, widow, or widower owns property in excess of the applicable exclusion amount at his or her death, credit shelter planning can be used in combination with the unlimited charitable deduction to eliminate or reduce estate taxes. The widow or widower using this technique gives the applicable exclusion amount outright or in trust to his or her children or other relatives. The remainder of the estate then passes outright or in trust to charitable beneficiaries. If the bulk of the estate is a family farm, ranch, or business, the special value reductions permitted for such property can be combined with the credit shelter planning to pass up to $2,900,000 to qualified relatives of the deceased.
Because of the lack of a marital deduction, estate planning for single persons, widows, and widowers may need to include techniques to remove property from the person's estate before or after death. There are many techniques that can work very well to reduce or eliminate estate tax when the estate of a single person exceeds his or her applicable exclusion amount or the combined estates of a married couple exceed twice the applicable exclusion amount.
Basics of the Generation Skipping Tax
The generation-skipping transfer tax is a flat tax imposed at the highest estate tax rate. It is imposed when property passes to beneficiaries who are two or more generations younger than the giver's generation. For example, if a giver were to establish a trust for a child for life with the remainder on the death of the child passing to the grandchildren, a generation-skipping transfer tax could be imposed on the property in the trust at the child’s death.
The tax is also imposed where an interest in property is transferred to a beneficiary in a generation which is two or more generations below that of the giver, e.g., a transfer by a grandparent to a grandchild or to a trust for a grandchild. In this situation the tax becomes very burdensome because it means that if someone makes a gift during life to a grandchild (or to a trust for a grandchild), or upon death makes transfers to a grandchild (or to a trust for a grandchild), the transfer will be subject to two taxes - a gift or estate tax and the generation-skipping transfer tax.
In tax years 2006-2008, there is a $2,000,000 exemption from the generation-skipping transfer tax available to each person without regard to whom or how the generation-skipping transfers are made. Therefore, a person can establish a trust for children for life and then for grandchildren for life with a remainder to great grandchildren and fund it with up to $2,000,000 either during life or upon death, and the trust would be exempt from the generation-skipping transfer tax for the duration of the trust and would avoid estate tax at the death of the child and at the death of the grandchild. The transfer into the trust would be subject to either federal gift or estate tax depending upon whether it was made during life or at death. The $2,000,000 generation–skipping exemption will increase with the estate tax applicable exclusion amount (See 2001 Tax Relief Act).
If the assets of a single person will not exceed $2,000,000 at the death of the person, they will be covered by the exemption if the person has not used the exemption during life. If the total assets of a couple will be worth between $2,000,000 and $4,000,000 at the death of the surviving spouse, the assets will be exempt from the generation-skipping transfer tax, if the couple’s estate planning instruments are drafted with this tax in mind, and the property is titled correctly.
Because the generation-skipping exemption is not transferable between spouses, it is important to ensure that each spouse has adequate assets in his or her sole name (or in his or her revocable trust) to use the exemption regardless of order of death. Also, it might be desirable to leave more property to children and not to skip directly to the grandchildren if part of the exemption has already been used.
A direct gift to a grandchild that qualifies for the $12,000 annual gift tax exclusion or for the medical or education tuition gift exclusion, will also avoid generation-skipping transfer tax.