We believe that the most significant tax burden in this first year of the Third Millennium will continue to result from estate taxes imposed at death rather than from income taxes imposed during life, even if Congress enacts estate, gift, and generation-skipping tax ("transfer tax") reform legislation this year. Many believe that 2001 will bring significant transfer tax reform; we share that belief, and therefore wish to begin with a brief review of last year's transfer tax reform efforts, to be followed by a summary of some current estate planning concepts and techniques that might be of value.
1. Transfer Tax Reform. There were two basic proposals last year, a Republican plan and a Democratic plan, but neither became law. Transfer tax reform is likely to occur in the near future, but what reforms will be enacted is difficult to predict. Any repeal of transfer taxes is likely to become effective only in 2010 or later, thus requiring tax planning until then and providing a future administration the ability to postpone or reverse the repeal.
Last year's Republican plan would have reduced the maximum transfer tax rates immediately to 50%, and thereafter by 1% or 2% each year (from 49% in 2003 to 40.5% in 2009). Transfer taxes would have been eliminated in 2010. The "applicable exclusion amount" (discussed in paragraph 3 below) would not have been increased, but would have been converted from a "credit" (of $220,550) to a "deduction" (of $675,000); a $675,000 deduction is more valuable than a $220,550 credit because taxes are reduced at the highest rather than the lowest brackets. In 2010 the adjusted ("stepped-up") basis rules would have been eliminated, except for (i) assets with a net equity of $3,000,000 passing to a surviving spouse and (ii) assets with a net equity of $1,300,000 passing to others. The "double" basis adjustment for community property (discussed in paragraph 10 below) would have been eliminated.
Last year's Democratic plan would have reduced transfer taxes immediately by 20% (e.g., the maximum rate would have been reduced from 55% to 44%). The "applicable exclusion amount" would have been increased immediately to $1,000,000 (or $1,100,000 depending on the version of the bill), with eventual increase in 2006 to $1,200,000 (or $2,000,000 depending on the version of the bill). Valuation discounts (discussed in paragraph 15 below) would be eliminated for businesses owned by the taxpayer's family and for non-business assets (such as marketable securities).
Thus, the Democratic plan would have provided greater immediate benefits for most taxable estates, but eventually the Republican plan's benefits would have been more valuable. Although transfer taxes are likely to be reduced soon, tax strategies still should be employed in 2001, including tax-free (or even taxable in some cases) gifts (discussed in paragraph 4 below). And the non-tax benefits of a good estate plan (e.g., protection of beneficiaries) will be unaffected by tax reform. We therefore hope that the following discussion of estate planning ideas will be of interest to you. Estate planning in 2001 should be undertaken keeping in mind that Congress may repeal or reduce transfer taxes, and President Bush is unlikely to veto that legislation.
2. Revocable Trust. Although not a tax-saving device, the revocable trust is a valuable estate planning technique, used primarily to avoid the inconvenience and extra costs of a probate administration of an estate upon death. Many of the post-death income tax advantages previously available to probate estates have been eliminated, thus making the revocable trust even more attractive for wealthier clients. We suggest that you consider using a revocable trust rather than a Will as your primary estate planning vehicle.
3. Transfer Tax Exclusion. Most clients currently take advantage of the "applicable exclusion amount" granted to each person for estate and gift tax purposes by either making gifts in that amount during life or by establishing an "Exclusion" (or "By-Pass" or "Credit Shelter" or "Residual") Trust at death. The "exclusion" amount increases gradually under current law to $1,000,000 (in 2006). The third increase, to $675,000, was effective January 1, 2000, and the fourth increase (to $700,000) is not scheduled until January 1, 2002. Failure to take advantage of both spouse's "exclusions" may result in additional estate taxes of more than $500,000 at the surviving spouse's death. After your cumulative lifetime and testamentary transfers exceed the "exclusion amount," gift and/or estate taxes are imposed at marginal rates ranging from 37%* to 55% (with a 5% surtax added to estates between $10,000,000 and $17,184,000).
* 39% after the "applicable exclusion amount" is increased to $850,000 (currently scheduled for January 1, 2004); 41% after the "applicable exclusion amount" is increased to $1,000,000 (currently scheduled for January 1, 2006, but perhaps sooner if Congress "accelerates" the increase).
4. Annual Gift Program. A lifetime gift-giving program could reduce your overall transfer tax costs considerably. By making significant lifetime gifts, your donees will receive all future appreciation of and income generated by the transferred property free of transfer taxes. Every individual may transfer cash or other property worth $10,000 (the "annual exclusion" amount) each year to each of as many donees as the donor selects without incurring any gift or later estate tax. An inflation adjustment will apply when that adjustment would increase the annual exclusion amount by $1,000 (e.g., to $11,000; not expected until 2002 or later). You may make these gifts (known as "annual exclusion" gifts) outright or via custodianships or trusts, although careful planning is needed if trusts are to be used. For example, it is very important to assure that any trust for a grandchild contains special provisions in order to ensure that gifts made to that trust are exempt from the "generation-skipping" transfer tax (discussed in paragraph 7 below). We recommend that you review all existing trusts for grandchildren to ensure that they contain the provisions necessary to avoid the "generation-skipping" tax before making additional "annual exclusion" gifts thereto. In addition, no gift taxes are imposed if you pay a donee's tuition or medical expenses (payments must be made directly to the school or health care provider), and you may prepay tuition under certain circumstances. Even if your annual gifts are not "tax-free" as described above, if your aggregate gifts do not exceed the "applicable exclusion amount" (or twice that amount for married couples), no gift tax will be payable at the time of the gift. If you make gifts in excess of the "applicable exclusion amount," your transfer tax payment will be accelerated, but your gift tax dollars generally will not be subject to transfer taxes. You must be aware, however, that paying gift taxes now may result in an unnecessary tax payment if transfer taxes are repealed at a later date! Certain valuation advantages (such as "minority" discounts) that might be unavailable at death often are possible in connection with lifetime gifts (e.g., see paragraph 15 below).
5. Education Savings Plans (Section 529 Plans). Section 529 Plans are sponsored by state governments, and are available to high income taxpayers. Income earned by your account is tax deferred, and when funds are paid to the beneficiary for college or graduate school expenses (including tuition, room, and board), the income is taxed at the beneficiary's tax bracket. Assets in your account can be used to pay education costs at any public or private college, and need not be in the State that sponsors the Plan. You can contribute up to $50,000 per beneficiary (typically your child or grandchild) in the first year, and treat it as an advance payment of your $10,000 annual gift tax exclusions for the next 5 years. The maximum amount you can contribute overall is based on the estimated future cost of attending the most expensive college in the State, the age of the beneficiary, and projections about the future earnings. The maximum amount will probably exceed $100,000 (e.g., California maximum currently ranges from $115,622 to $165,886). You can change beneficiaries or withdraw the money at any time, although there may be adverse tax consequences if your account is not used for educational expenses of the beneficiary or other members of the beneficiary's family. The funds in a Section 529 Plan are managed by a well known investment manager selected by the State.** The annual administrative fee varies, and the percentage of the Plan assets allocated to stock vs. bonds depends on the Plan and the age of the beneficiary. More information on the Plans offered by the various States is available at http://www.savingforcollege.com; full details on the California plan are available at http://www.scholarshare.com or by calling 1-877-728-4338.
** For example, California, New York, and seven other states have selected TIAA-CREF; Delaware has selected Fidelity Investments; Iowa has selected Vanguard Group; Maine has selected Merrill Lynch; Rhode Island has selected Alliance Fund.6. Life Insurance. All estate tax on life insurance proceeds may be avoided on the death of the insured through proper planning. Insurance proceeds can be available free of estate tax to the surviving spouse, but by designating other family members or a trust for their benefit as owners and beneficiaries, estate taxes can be avoided in both spouses' estates. "Joint life" (or "survivorship" or "second to die") policies make life insurance planning affordable for many more people. You should consider the ownership and beneficiary designations for any newly acquired life insurance carefully before the policy is purchased. You also should review the ownership and beneficiary designations of your existing policies.
7. Generation-Skipping Transfer Tax. The "generation-skipping" transfer ("GST") tax generally imposes an additional transfer tax (at a 55% rate) on property transferred to grandchildren and other younger beneficiaries by lifetime gift or at your death, and whether outright or via trust. You may take advantage of certain techniques to avoid or substantially reduce this GST tax. One technique involves making "tax-free" gifts as described in paragraph 4 above via an "annual exclusion" gift program to grandchildren (either outright or via trust) and by paying a grandchild's tuition and medical expenses (again, direct payments to the school or health care provider are required). Another technique involves use of your lifetime GST exemption (different from your "exclusion" for gift and estate tax purposes) to establish a "dynasty trust" (which can invest in life insurance policies or other property) to enable a substantial amount of property to pass to grandchildren, great-grandchildren, and later generations free of any estate or GST tax. You also may wish to include in your estate plan a special GST marital deduction provision to assure that both spouses can use their respective GST exemptions. An inflation adjustment annually increases (in $10,000 increments) the GST exemption amount; the third adjustment was effective on January 1, 2001, and increased the GST exemption to its current $1,060,000. Thus, unfortunately, the GST exemption will continue to be different from the transfer tax "exclusion" discussed in paragraph 3 above when that "exclusion" finally reaches $1,000,000 (currently scheduled for 2006).
8. Marital Deduction; Noncitizen Spouse. The vast majority of married couples combine the transfer tax "exclusion" discussed in paragraph 3 above with the unlimited marital deduction to assure that no estate taxes are payable until the death of the surviving spouse. The unlimited marital deduction generally is available for gifts and bequests to spouses; those gifts and bequests can be outright transfers or can be made via trusts (although not all types of trusts will qualify for the marital deduction). Severe restrictions, however, are imposed on the ability to defer estate taxes if the surviving spouse is not a United States citizen (the surviving spouse's residence is not a factor). Under these rules, property passing to the non-citizen surviving spouse must be held in a special type of trust (a "qualified domestic trust") in order to qualify for the marital deduction. In addition, although gift taxes cannot be deferred via the marital deduction, you may make "annual exclusion" gifts (discussed in paragraph 3 above) of a maximum of $106,000 (rather than $10,000) in 2001 to your noncitizen spouse (subject to annual inflation adjustments). You should review your estate plan now if either spouse is not a U.S. citizen.
9. Estate Planning for Nonresident Aliens. Several interesting planning opportunities may exist for a nonresident alien ("NRA") (a noncitizen who is not a U.S. resident). An NRA may avoid transfer taxes completely by structuring his or her holdings so that no U.S. "situs" assets are owned directly (U.S. "situs" assets may be held by a wholly-owned foreign corporation). If your spouse is not a U.S. citizen, you may wish to defer estate taxes by use of a "qualified domestic trust" (discussed in paragraph 8 above). Lifetime gifts by an NRA of U.S. "situs" intangible personal property (such as stock or partnership interests) are not subject to U.S. transfer taxes, even though these items would be subject to U.S. estate taxes if owned by the NRA at death. An NRA also may wish to establish a trust to hold property for U.S. resident children or other family members to provide them with tax-free income and arrange for the trust property to pass to other family members free of gift, estate, and GST taxes.
10. Community Property v. Joint Tenancy. For income tax purposes, both "halves" of appreciated community property owned jointly by a husband and wife receive a "step-up" in basis upon the death of either spouse. Because only one-half of the basis of property held in joint tenancy receives a basis "step-up" at the death of the first spouse, we generally recommend that legal title to appreciated assets owned jointly by spouses and not held in a revocable living trust be held as "community property" rather than as "joint tenants." California will recognize a new form of legal title for real estate effective July 1, 2001: "Community property with right of survivorship." Estate tax reform, however, may result in elimination of all or a part of the basis adjustment at death.
11. Charitable Tax Planning. There are several techniques that you can use to transfer significant wealth to your intended beneficiaries in a tax-favored manner and at the same time benefit charity. This is particularly true if you contemplate a sale of highly appreciated assets; a charitable remainder trust can be used to advantage in these circumstances. A "testamentary" charitable remainder trust also may provide your heirs with income tax advantages if estate tax reform eliminates the basis adjustment at death. You also may be able to arrange to receive a lifetime annuity in exchange for cash or appreciated property, or even for agreeing to transfer your residence to a charity at your death (or at the death of the surviving spouse). You also may be able to transfer property to your descendants without (or with reduced) transfer taxes by establishing a charitable lead trust. If tax reform eliminates estate taxes, those of you whose charitable gifts were motivated by tax savings may wish to revise your estate plan; conversely, you may feel more able to make charitable gifts without any estate tax burden.
12. "Buy-Sell" Agreements/Options. A "Buy-Sell" or option agreement (whereby a person grants to a family member or business associate the right to acquire assets at an established price) can be used to advantage to restrict ownership of a business, to establish the value of an asset for estate tax purposes, and to provide a market for the asset to allow owners to plan for liquidity. This estate planning device is subject to restrictions, but some of these restrictions do not apply to agreements made before October 9, 1990. You therefore should be very careful if you wish to modify "Buy-Sell" or option agreements made prior to October 9, 1990.
13. Employee Benefit Plans and IRA's. Assets in pension and profit-sharing plans, IRAs, and other employee benefits can be subject to severe taxes at death. You should review your plan benefits to determine whether you can avoid these taxes and whether your plan benefits are coordinated with your estate plan. These assets still can be the most advantageous to use for charitable gifts at death, including charitable remainder trusts.
14. Subchapter "S" Corporations. The use of Subchapter "S" corporations has become less popular because of the increased use of family limited partnerships and LLCs (discussed in paragraph 15 below). Care must be taken, however, with respect to existing Subchapter "S" corporations. For example, upon the death of a Subchapter "S" corporation shareholder, Subchapter "S" corporation status can be lost unless the decedent's shares pass to a qualified shareholder in a timely manner. All Subchapter "S" corporation shareholders therefore should assure that their estate plans allow for the continuation of Subchapter "S" corporation status.
15. Family Partnerships and LLCs. A "family limited partnership" or LLC (limited liability company) can be an excellent estate planning vehicle for clients who own valuable assets. You can maintain full management control of your investments and also control distributions to the limited partners (or LLC members). A family partnership or LLC also can be advantageous if a family member encounters creditor problems in the future. Gifts of limited partnership interests (or LLC interests) to your beneficiaries or to trusts for their benefit can qualify for the gift tax "annual exclusion" (discussed in paragraph 4 above), and the value of those gifts can reflect the "discounts" available for minority and nonmarketable interests. "Discounted" values also can be used in connection with sales to desired limited partners, including family members or trusts for their benefit.
16. Durable Powers. It is becoming more important to plan for the risk of lifetime incapacity. A Durable Power of Attorney can provide lifetime asset management, especially if your estate plan does not include a revocable living trust. A Durable Power of Attorney for Health Care (or Health Care Directive) permits you to designate someone to make health care decisions on your behalf if you become unable to do so, enables you to express your desires with respect to those decisions under various circumstances, and also can be used to make known your desires that artificial life-prolonging measures not be employed on your behalf. Appropriate health care documents for your children (both minors and adults) also should be completed. California made major changes in its Health Care Power of Attorney Law, effective July 1, 2000, but there is no need to sign a new form because of the new law (a Durable Power of Attorney for Health Care signed prior to 1992, however, probably is ineffective today).
There may be other estate planning opportunities not discussed herein that may be of interest to you. Please call us to discuss your questions regarding estate and tax planning matters.
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