2008 CCH Whole Ball of Tax

Estate Planning Requires Flexibility When It Comes to Minimizing Taxes, CCH Says

(RIVERWOODS, ILL., January 2008) – Affluent taxpayers trying to ensure they preserve their wealth for future generations are finding that estate planning is not a one-time event but an ongoing juggling act as they try to navigate the ever-changing estate tax laws, according to CCH, a Wolters Kluwer business and a leading provider of tax, accounting and pension law information, software and services (CCHGroup.com). However, methods for minimizing estate tax are available, including basic gifting and charitable donations as well as more sophisticated trusts and family-based entities for those serious about preserving wealth.

“It’s no longer the case that you can create estate planning documents and dust them off every decade or so,” said CCH Estate Tax Analyst, Bruno Graziano, JD. “Individuals need to know what is in their estate plans, regularly revisit their plans with their advisors and make adjustments to reflect changes in the law and regulations as well as changes in their own situations.”

While estate tax ramifications have never been static, the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) has thrown a monkey wrench into estate planning for the entire decade and beyond. Under EGTRRA, the maximum estate tax rate has dropped steadily from 55 percent in 2001 to the current 45 percent and will be fully repealed in 2010 before jumping back to the pre-EGTRRA rate of 55 percent in 2011, plus a 5-percent surcharge. Lockstep with this, the dollar amount that is excludable from estate tax also has shifted, from $1 million in 2002 to the current $2 million. This will increase to $3.5 million in 2009 before the estate tax is fully repealed in 2010. Absent congressional intervention, the estate tax will come back in 2011 and the exclusion will drop back to $1 million.

Though few believe that legislators will allow a repeal of the estate tax to actually occur in 2010, no one is certain how much tax rates and exclusion amounts will be adjusted. The outcome for many estate planners now, according to Graziano, is that they have wealthy clients who have been putting off estate planning because they believe the estate tax is going away or that it will not impact their estates.

“Unfortunately, very little is likely to occur with respect to federal estate tax law in the 2008 election year, and even after that, what will happen is hard to predict. Meanwhile, these taxpayers are getting older and their estates are increasingly at risk of being subject to taxes that they could have minimized with flexible estate planning,” said Graziano.

Estate and Gift Tax Basics

It’s estimated that less than 2 percent of all Americans are affected by the estate tax. However, many of those who are potentially at risk could minimize or eliminate their estate tax, leaving more to their heirs or other designated beneficiaries, by understanding a few fundamentals. Among these are the three basic tax exclusions that come into play in estate planning:

• Annual gift tax exclusion – Gifts of any property, including money, are generally taxable for gift tax purposes. However, under the annual gift tax exclusion an individual can gift a certain dollar amount per donee each year and a married couple can gift double that amount. For 2008, the annual gift tax exclusion is $12,000 ($24,000 for a married couple electing gift splitting). Because this limit is per donee, an individual could, for example, gift $12,000 to each of his four children, with $48,000 being excluded from gift taxes; similarly a couple could gift $24,000 to each of their four children, with $96,000 excludable from gift taxes. There is no gift tax on property given to a spouse who is a U.S. citizen or to a qualified charity. Other exceptions to gift tax that are not subject to the annual limit include tuition or medical expenses paid directly to a medical or educational institution.

• Lifetime gift tax exclusion – A taxpayer who gives more than the annual gift tax exclusion to any one donee in a year is required to file a gift tax return (IRS Form 709). However, the taxpayer still does not owe a gift tax until he has given, cumulatively, more than is allowed under the lifetime gift tax exclusion. For 2008 and 2009, the lifetime gift tax exclusion remains unchanged at $1 million.

• Estate tax exclusion – Beyond a certain dollar amount, e state tax is applicable to an individual’s estate at the time of death. For 2008, up to $2 million of an estate is excludable from the estate tax. Allowable deductions that can be taken before arriving at the taxable value of the estate include debts owed at the time of death; funeral expenses paid by the estate; the marital deduction, which is the value of the property an individual passes on to a spouse; charitable deductions made by the estate; and a state “death” tax deduction for estate, inheritance, legacy or succession taxes paid to any state or the District of Columbia.

Several states impose their own estate taxes and many states also collect inheritance tax. See release 11 for more detail on state estate taxes.

Estate and gift taxes are tied together in that taxable gifts are added back in the computation of a decedent’s federal estate tax bill. Accordingly, whatever amount of the lifetime gift tax exclusion a taxpayer uses effectively reduces the amount that can pass through his estate tax free at death.

“Without limits on annual and lifetime gifts, there would be minimal tax ramifications for estates, because people could simply give their money to their children – or whomever they planned on passing their wealth to – during life and not have to worry about the taxes that would be paid on their estate at death,” said Graziano.

Beyond the Basics: Using Trusts to Minimize Estate Taxes

Affluent individuals with many potential donees and estates consisting of slightly more than the estate tax exclusion amount may be able to minimize their estate tax obligations by simply using the gift tax exclusion over several years – yet, even this technique has risks should the individual die before being able to gift the planned amount. As a result, more sophisticated estate planning techniques are available for those looking for greater security or who have larger estates with which to deal.

“There are literally dozens of techniques for estate wealth preservation, and the more that is at stake, the more complex these can become. In fact, a number of the controversial tax strategy patents that have been granted are related to complicated estate planning situations,” said Graziano. He added, however, that among the most common types of estate planning tax strategies are various types of trusts and family limited partnerships or limited liability companies.

Irrevocable trusts play an important role in estate planning. Gifts by an individual to an irrevocable trust for the benefit of others may result in payment of gift taxes, but if done correctly, when the individual who set up the trust (the grantor) dies, the trust property is not considered a part of their estate and, therefore, is not subject to estate taxes.

One type of irrevocable trust that has become popular in recent years is known as an intentionally defective grantor trust. It is designed so that gifts to the trust are complete or “effective” for gift, estate and generation-skipping tax purposes. However, they are “defective” for income tax purposes in that the grantor pays the income taxes on any revenue generated by the trust’s assets. In reality, this is a good thing because the grantor is making what amounts to an additional tax-free gift to the trust beneficiaries by doing so.

A bypass or credit shelter trust is commonly used by wealthy married couples to help ensure a surviving spouse has adequate income, while avoiding or minimizing estate tax on the remainder of the estate. Under estate tax law, an individual can leave an unlimited amount of assets to his spouse free of any estate tax. However, when the second spouse dies, his or her estate would be subject to tax on any amount above $2 million (for 2008). For a multi-million dollar estate, this could mean the first spouse’s estate tax credit was essentially wasted.

The bypass trust is usually structured to meet the following two objectives:

1. To meet the current and long-term needs of intended beneficiaries – for example, the surviving spouse, children, or others; and
2. To avoid the inclusion of trust assets in the estate of the surviving spouse on his or her death.

The bypass trust is funded up to the limit of the first spouse’s estate tax exclusion, so that amount is not subject to estate tax when the first spouse dies. Additionally, the bypass trust provides that assets in the trust will not be included in the estate of the surviving spouse, thereby bypassing the estate tax when the second spouse dies.

“There are dozens of other trusts, including qualified terminable interest property trusts, often used when a trustor has children from another marriage; irrevocable life insurance trusts, which avoid estate taxes on the life insurance proceeds payable on a decedent’s death that would otherwise be includible in his or her estate; and charitable remainder trusts, that allow you to give part of your estate to charity but enable a non-charitable beneficiary, such as a family member, to live off the trust assets over their lifetime,” said Graziano. “Each type of trust may have a variety of goals as their motivating force. But from a tax perspective, the goal of all of these approaches is to help ensure an individual is able to pass along assets to their designated heirs with minimal estate and gift tax ramifications.”

Family Limited Partnerships Keep It All in the Family

Family limited partnerships (FLPs) and family limited liability companies (FLLCs) are also popular methods for preserving wealth from one generation to the next by minimizing estate, gift and income tax liability. As with traditional limited partnerships, an FLP has at least two partners: a general partner that controls 100 percent of the assets – even though they are only required to own as little as one percent of the interest in the partnership – and a limited partner, who can own up to 99 percent of the partnership interest, but has no management or voting rights. As with other partnerships, income taxes pass through to the partners and are reported on their respective Form 1040s.

Although there may be optional variations, in a typical FLP, parents or grandparents contribute the assets to the partnership and are the general and limited partners. Subsequently, they transfer the limited partnership interests, but not assets, to their children or grandchildren, while retaining the general partnership interest and control of assets.

The value of the interest transferred in the FLP is subject to the gift tax. However, from a tax perspective, one of the advantages of FLPs is that the interest in a limited partnership has a discounted value for transfer tax purposes because it cannot be sold or otherwise converted into cash, lacks management control and voting rights. This can reduce the value of the transfer dramatically depending on the specific facts, according to Graziano.

For example, a couple forms an FLP by contributing assets of $3 million. They make a gift of 1-percent limited partnership interest to each of their three children valued at $30,000. However, because of the lack of management control and marketability of the gifted interest, a qualified appraiser determines that the children’s respective interests are worth 25 percent less than their liquidation value. Applying a 25-percent discount, each child’s limited partnership interest is worth only $22,000 for gift tax purposes, which is less than the $24,000 annual gift tax exclusion allowed to the couple. Therefore, no transfer tax applies.

With the FLP, the goal is to transfer up to the allowable 99 percent of interest in the partnership to the younger family members. Then, at the time of the senior family member’s death, only their remaining interest in the entity is subject to estate tax, and only if its value exceeds the $2 million estate tax exclusion (for 2008).

“Family members who created the wealth like FLPs because even as they are transferring the interest, they are able to maintain a certain degree of control. The entities also provide nontax benefits such as asset protection, ease of probate and centralized management, plus they’re effective at moving larger sums of money using the discounted gift tax values that would not be possible otherwise,” said Graziano. However he cautioned that the IRS frequently challenges the discounts FLPs claim, so it’s always recommended to hire a qualified and experienced professional appraiser.

In addition, the establishment and operation of these entities has come under greater scrutiny by the IRS in recent years, so it is important to follow certain formalities, including the maintenance of appropriate records and bank accounts, as well as to make sure that senior family members have sufficient assets to live on outside of whatever they contributed to the partnership.

About CCH, a Wolters Kluwer business

CCH, a Wolters Kluwer business (CCHGroup.com) is a leading provider of tax, accounting and audit information, software and services. It has served tax, accounting and business professionals and their clients since 1913. Among its market-leading products are The ProSystem fx® Office, CorpSystem™, CCH® Tax Research NetWork™, Accounting Research Manager® and the U.S. Master Tax Guide®. CCH is based in Riverwoods, Ill.

Wolters Kluwer is a leading global information services and publishing company. The company provides products and services for professionals in the health, tax, accounting, corporate, financial services, legal and regulatory sectors. Wolters Kluwer has 2006 annual revenues of €3.4 billion, employs approximately 18,450 people worldwide and maintains operations across Europe, North America, and Asia Pacific. Wolters Kluwer is headquartered in Amsterdam, the Netherlands. Its shares are quoted on the Euronext Amsterdam (WKL) and are included in the AEX and Euronext 100 indices. For more information, visit www.wolterskluwer.com.

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