PRESERVING YOUR ASSETS How to Pay Zero Estate Taxes While the top federal rate is an unfriendly 55%, you may be able to head it all off with an asset shift here, a trust there.
(MONEY Magazine) – Capital punishment by confiscation!'' ''Draconian!'' ''Apocalypse!'' No, you're not in Paris in 1789, when the aristocracy was learning firsthand about homelessness -- and headlessness, for that matter. The scene is Washington, D.C., June 1989, at the National Conference on Financial and Estate Planning. For two days, financial planners and estate lawyers bemoaned the arrogant acquisitiveness of federal estate taxes. Intoned Stephan R. Leimberg, professor of taxation and estate planning at the American College in Bryn Mawr, Pa. and co-chairman of the event: ''Congress is breaking up family wealth.'' Pity the poor rich, you might say. But wait. If you expect to leave a legacy of $600,000 or more, a middle-class amount today, your estate may well be guillotine-bound if the fiscal Robespierres in Congress have their way. Some of them are even talking about cutting the present $600,000 estate-tax exemption. There's no need for panic in the streets. With proper planning, even the affluent can arrange their estates to keep them intact for their heirs. But don't try to meet the challenge yourself. Your direct adversaries are what Leimberg calls ''hair-pullingly complex laws.'' If you make a mistake, more of your estate will likely go to the tax collector and less to your heirs. Before entering the morass, hire an expert guide -- an attorney who specializes in estate planning. He or she can help you determine the best ways to dodge or diminish death taxes based on your marital status, the size of your estate and whom you choose as heirs. An estate lawyer might charge as little as $300 for a simple trust and $1,000 or more for the more complicated ones. (See the table at right.) Here's how the most popular tax-trimming techniques work:
First of all, if you can afford to be generous, remove assets from your taxable estate by giving them away while you're alive. Individuals may give as much as $10,000 a year to each of as many people as they wish without incurring federal gift tax; for married couples giving jointly, the maximum is $20,000. Above those limits, the gifts are taxable, and you must report them to the Internal Revenue Service on Form 709. After you die, the total amount of taxable gifts that you made in your lifetime will be subtracted from your $600,000 exemption for federal gift and estate taxes. Estate-tax law features an even larger loophole for the lawfully wed. You can make gifts of any size and leave an estate of any value to your spouse tax-free.
-- Family Trusts
The marital deduction may merely postpone, not eliminate, estate taxes. For example, assume that you die and leave $800,000 to your spouse. No taxes are due immediately, but when your spouse dies, estate taxes could amount to $75,000; $22,800 of that amount is credited to your estate for state death taxes, leaving a total federal liability of $52,200. (That works out to a top rate of 39%. A maximum rate of 55% applies to estates of $3 million and above.) Had both you and your spouse taken full advantage of your $600,000 federal tax exemptions, you could have passed as much as $1.2 million to your ultimate heirs tax-free. Consider the estate plan set forth in wills drafted for stockbroker William J. Eck Jr., 57, and his wife Lillian, 56, of Boulder, Colo. by attorney Steven R. Hutchins of Baker & Hostetler in Denver. If William dies first, up to $600,000 of his assets will go into a trust -- sometimes called a bypass, credit-shelter or family trust -- for Lillian's benefit. She will receive income from the trust and each year is entitled to withdraw as much as 5% or $5,000 of the principal, whichever is greater. In addition, the trustee has the discretion to give her more money from the principal for any reasonable need, such as her support or medical bills. After Lillian's death, the Ecks' five children, who range in age from 23 to 31, will become the trust's beneficiaries. No estate tax will be due on property in the trust, no matter how valuable it becomes, because the property won't be included in Lillian's estate and the amount contributed to it by William was within his $600,000 exemption. If Lillian dies first, her assets would be used to fund a similar tax-free bypass trust for William. Any additional assets of William's or Lillian's that do not go into the bypass trust will fund another trust that qualifies for the marital deduction; either Lillian or William is free to dissolve that trust. Says William Eck: ''We hadn't written a will since the late 1960s, when our financial and personal circumstances were entirely different. Now I feel confident we're up to date.'' Unlike the Ecks, you may want to consider a permanent marital deduction trust if your spouse lacks the ability to manage money. One type of trust is a general power of appointment trust, which lets your spouse decide after you die whom he or she wants to name as the trust's ultimate beneficiary. The second is a QTIP (short for qualified terminable interest property) trust, which enables you to keep your estate out of the hands of your spouse's future mate should there be one. Your spouse gets lifetime income from the trust, but the principal goes to your choice of heirs when your mate dies.
-- Life Insurance Trusts
Since life insurance payouts are often large enough to trigger estate taxes, you may not want to own your policies. You can remove them -- even employer- paid group term policies -- from your taxable estate by placing them in an irrevocable life insurance trust. In addition, you must give up all ownership rights, including the ability to borrow against the policies and change the beneficiaries.
A life insurance trust can backfire if you die within three years of setting it up. In that case, your insurance will be included in your taxable estate. The only way around the three-year rule, says Arthur D. Kraus, chairman of the Associates in Financial Planning Group in Los Angeles, is to take reduced paid-up insurance on your current policies and have the trustee buy a new policy on your life for the trust. If you don't favor that option, your attorney should include a clause in the trust document stating that if you die within three years, the insurance will be paid directly to your spouse or to a marital deduction trust. Of course, insurance is an excellent way to ensure that your heirs won't have to sell your prized possessions at fire-sale prices to raise cash to pay estate taxes. For example, Lee Freeby, 62, and his wife Shirley, 53, of Oak Harbor, Wash. have established a life insurance trust that contains a $1 million second-to-die policy on their lives. The policy, which carries an $8,000-a-year premium, is roughly a third less expensive than insuring the Freebys separately because it will pay off only after the second spouse dies. At that time, the insurance proceeds will be used to buy all or part of the Freebys' biggest illiquid asset from their estate, a 24-unit apartment building in Long Beach, Calif. As a result, the estate will have enough cash to cover estate taxes, and the real estate can be managed by the trust for the couple's two sons, Lee Jr., 20, and Randall, 18. The trust will dissolve when both children have reached the age of 25. They will then become the owners of the building as tenants in common.
One tax-avoidance trust that deserves wider use is the GRIT, which stands for grantor retained income trust. Says Leimberg: ''Singles with estates of more than $600,000 and married couples with $1.2 million or more should consider GRITs, especially if they own property that's appreciating rapidly.'' When you set up a GRIT, you place property in the trust, which is irrevocable, and then receive all the trust income for up to 10 years. Neither you nor your spouse can serve as trustee. When the trust terminates at the end of the number of years you have selected, up to 10, the property then passes to the beneficiaries of your choice. What makes a GRIT particularly appealing is the fact that the IRS assumes that you have contributed to the trust only the actuarial value of the property that eventually passes to your heirs. That amount, which comes to a fraction of what you put into the trust, is called the trust's remainder interest. ; Let's say that a widow places securities worth $1 million in a GRIT from which she will receive income for 10 years. The IRS uses special tables to calculate the value of the widow's income interest and the trust's remainder interest. Recently, the value of the income interest in this example came to $600,152, and the trust's remainder interest was $399,848. Since the remainder interest is well under the $600,000 limit, there is no estate or gift tax. Assuming that the securities in the trust appreciate at the rate of 6% a year, $1,790,848 will eventually pass to her heirs tax-free. The GRIT has one major disadvantage: if the widow dies before the trust terminates, the securities will be included in her taxable estate. Her heirs could protect themselves, though, by buying insurance on her life to pay the estate tax.
-- Charitable Giving
You can also pluck property from your taxable estate by giving it to your favorite charity either while you are alive or in your will. Says Conrad Teitell, a White Plains, N.Y. attorney who specializes in legal issues affecting charitable giving: ''When you give during your lifetime, you in effect get two tax deductions for one gift. You remove property from your taxable estate, and you get an income tax charitable deduction.'' There are even ways that you can give assets to charity and keep on collecting income from them. After your death or the death of a surviving beneficiary, the property passes to the charity. Since you retain income from your gift, however, the tax deductions you receive will be smaller than what you might get from an outright gift. If you have $25,000 or more to give and want to collect income from it for life, set up a charitable remainder annuity trust. Such trusts pay out a fixed amount annually, typically 6% to 9%. A charitable remainder unitrust is more appropriate if you worry about inflation. In a unitrust, you'll receive an amount determined each year by multiplying a fixed percentage that you choose when you create the trust, generally 7% to 8%, by the market value of the trust's assets. Often, a grantor names his or her spouse as beneficiary, in which case the trust may also qualify for the marital deduction. But you can also select other beneficiaries. For example, Emmett Bashful, 72, former chancellor of Southern University at New Orleans, created a unitrust in 1985 to eventually benefit the school. The trust, now worth $120,000, produces an annual income of about $12,000 that is ^ divided among five of Bashful's relatives. His wife Juanita, 69, and his daughter Cornell Nugent, 46, each receive a third of the income, while his three sisters divide the remainder equally. Says Bashful: ''I created the trust because I wanted my family to enjoy some of my money before I go up to the clouds, so to speak. And I named Southern University as the trust's ultimate beneficiary because it has offered opportunities to the disadvantaged and been a godsend to Louisiana.'' In general, you get a charitable deduction in the year that you create a remainder trust. The deduction depends on your age, the age of any other income beneficiary, the amount of annual income payments, and the value of the assets that you placed in the trust. For example, Emmett Bashful claimed a $9,342 deduction on his 1985 tax return. Often the best gifts are appreciated assets such as securities or real estate that provide little income. When the trustee eventually sells such assets, the capital gain is not taxed, and therefore the full amount is available to earn income for you. If you want to protect $200,000 or more for your heirs and don't need it for income, look into a charitable lead trust. The charity receives income until the trust terminates, at which time the assets are distributed to your heirs. While you get no deduction to apply against income, the trust reduces, and can even eliminate, gift or estate tax on the value of the property that passes to your beneficiaries. A final word of warning to the superrich: Uncle Sam may slap yet another levy on your legacy -- the generation-skipping tax, which is separate from gift and estate tax. The Tax Reform Act of 1986 retroactively repealed the old generation-skipping tax. It was imposed if you used a trust to avoid estate taxes by transferring assets to a beneficiary who is at least two generations your junior. The new generation-skipping tax applies both to outright gifts and to transfers in trust. The tax rate is equal to the maximum gift- and estate-tax rate of 55%. Fortunately, exceptions to the new generation-skipping tax rules cover just about everyone but the subjects of Lifestyles of the Rich and Famous. You are entitled to a $1 million exemption ($2 million for married couples giving jointly). And until next Jan. 1, you may give up to $2 million tax-free to each of as many grandchildren as you wish; the limit is $4 million for married couples. In addition, the tax doesn't apply in the case of assets left to the children of a deceased son or daughter.
CHART: NOT AVAILABLE CREDIT: NO CREDIT CAPTION: Sizing up tax-cutting trusts Determining what trust will best minimize your estate taxes is a matter of your marital status, the size of your estate and your choice of heirs. The accompanying article explains the differences in detail. This table summarizes seven trusts commonly used to trim estate taxes.