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DIVERSIFYSTRATEGIES

FOR ANBy combining properly structured lifetime gifts with testamentary bequests-perhaps making

use of trusts, and family annuities and partnerships-estate taxes can be reduced dramatically .

EFFECTIVEESTATE PLAN

JOSEPH R . POZZUOLO and WILLIAM C . HUSSEY, Attorneys

The approach of the new millen- ing of a will for the individual and his or hernium is an opportune time to spouse. While superstition and phobia preventreexamine clients' financial futures, many from drafting this most basic of estateincluding the prospect of death and planning documents, it also prevents such indi-the imposition of death taxes on viduals from taking advantage of several tes-

accumulated assets in their estate . The ongoing tamentary devices for reducing death taxes . Foraging of the baby boomer population and the individuals with a gross estate valued atpassage of TRA '97, with its sweeping changes $650,000 or more who are subject to filing ato many aspects of the estate tax system, further federal estate tax return, the use of testamen-necessitates an examination of the needs of many tary trusts can provide several distinct taxfamilies and the potential solutions to their estate advantages .planning problems . For those who have not yet Tax deferral trusts . The marital deduction,looked into their and their families financial if properly used, offers an invaluable techniquefuture, it is never too early (or too late) to begin to reduce federal estate taxes . Any married indi-the process of securing their legacies .

vidual may leave an unlimited amount of theWhile death and taxes are the two certain- adjusted gross estate tax-free to the surviving

ties of life, with proper planning and the use spouse .' A marital bequest trust, structuredof well-founded techniques, death taxes do not to be the primary vehicle for receiving mar-have to be punitive or impose a "penalty" on ital deduction assets, can provide muchhard-earned accumulated family assets at needed flexibility in the combined estatedeath . Presented here is an overview of the many plans of spouses .techniques that maybe used to reduce (and for

The marital deduction trust should besome individuals eliminate) federal and state funded with that part of a taxable estate of thedeath taxes on their estates .

first to die, which when added to all qualify-ing assets passing to the surviving spouse isexactly enough (and no more) to reduce the

Testamentary devisesOf all the techniques and devices, proper JOSEPH R . POZZUOLO is a senior membe r, and WILLIAM

estate planning

begins

the draft-

C. HUSSEY is an associate of Pozznolo 6 Perkiss, P.C., inP

gnecessar y g ns w

Philadelphia, Pennsylvania .

AUGUST 1909

PRACTICAL TAXSTFATEGIES

federal estate tax payable, after application ofthe entire applicable credit amount (alsoknown as the "unified credit'T remaining atthe death of the first spouse, to the lowest pos-sible figure . This strategy emphasizes thedeferral of death taxes until the death of thesurvivor . Alternative testamentary strategiesinclude the tax-rate equalization and surtaxavoidance formulations .

The marital deduction trust would direct thatthe income be distributed to the survivingspouse and permit the trustee to use the prin-cipal for the surviving spouse's health, support,maintenance, and education and to maintainthe surviving spouse's accustomed standard ofliving . Additionally, the surviving spouse maybe given the right to terminate the trust at anytime or to make gifts from the trust to him-self or herself, children, and grandchildren . Inessence, the surviving spouse would have theopportunity to deplete this trust, the propertyof which is includable in the surviving spouse'sestate for death tax purposes .

In many instances (such as a second mar-riage), a spouse may wish to provide for the sur-viving spouse during the survivor's lifetime butstill be able to direct the ultimate dispositionof the assets to other remainder beneficiaries,such as his or her own children or grandchil-dren. Moreover, the spouse may also wish toprovide for continuing professional financialmanagement of the family assets for the sur-vivor's benefit and be certain that on the sur-vivor's death, the other beneficiaries of the estateare provided for as well . This result may be

PSACTICALTMSTPATEGIES AUGUST 1999

achieved by the executor's designation of themarital deduction trust assets as a qualified ter-minable interest property (QTIP) bequest .'

Under a QTIP marital deduction trust, thetrustee would be directed to pay all the incomefrom the trust to the surviving spouse at leastannually (or at more convenient intervals) dur-ing their lifetime .' In addition, the trustee wouldbe authorized to pay as much of the principalas is necessary to maintain the same standardof living and for the health, support, mainte-nance and education of the surviving spouse .At the survivor's death, however, although theremaining portion of this trust would beincluded in the surviving spouse's estate fordeath tax purposes, the balance of the trust fundcan be paid over automatically to the childrenor co-mingled with other trusts for the chil-dren under the client's will and other establishedtrusts for the children's benefit .

Besides the tax advantages, one of the mostimportant nontax advantages of a QTIP trustis that it assures that the assets are carefullyinvested by the trustee, thereby protecting theentire family from unsound investment poli-cies . The assets in the trust may also be pro-tected from family creditors and will not besubject to the administration costs in the sur-viving spouse's estate, which may result in sub-stantial administrative savings . Finally, on thesurviving spouse's death, there is absoluteassurance that the remaining assets of the trustwill be distributed according to the dece-dent's wishes . Subject to certain exceptions, theauthors generally wholeheartedly recommendthe use of QTIP trusts to their clients .

Non-marital deduction trust. In conjunc-tion with the marital bequest trust, a non-mar-ital deduction trust (also known as a "unifiedcredit trust," "non-marital trust," "residualtrust," "bypass trust," "B trust ;'"family trust,""children's trust:' etc.) using the unified taxcredit offers an invaluable technique to reducethe federal estate death taxes at the death of thefirst-to-die to avoid a double estate tax .

The unified credit is a dollar amount allot-ted to each taxpayer that can be appliedagainst the gift tax and the estate tax. For 1999,the unified credit offsets the tax on the first$650,000 of assets . The credit is scheduled toincrease incrementally to offset aggregateasset transfers of $675,00 in 2000 and 2001,$700,000 in 2002 and 2003, $850,000 m2004,$950,000 in 2005 and, ultimately, $1 million in2006.' Therefore, the unified credit trust

ESTATE PLANNING OVERVIEW

should be funded with $650,000 of assets fordecedents dying in 1999 .

The trust can be structured such that the sur-viving spouse will receive the income in quar-terly or other convenient installments duringhis or her life . Further, the trustee can bedirected to use as much of the principal of thistrust to provide the surviving spouse with what-ever is necessary for the surviving spouse'shealth, support, maintenance, and education .The surviving spouse may also be given the rightto draw from the principal of this trust anannual payment of the greater of $5,000 or 5%on a noncumulative basis .

Both estates may avoid a sizable federal estatetax on the property being placed in these trusts .In many larger combined estates, the survivor'sestate may be taxed at a marginal federal rateof 55% plus the 5% percent surcharge on the$650,000 dollars of property which would oth-erwise be placed in this trust, resulting in a sav-ing of approximately $390,000 in federal estatetax (plus administrative fees and probate costsat the survivor's death) .

In short, a zero tax marital bequest trust(sheltered by the marital deduction) contain-ing the minimum amount necessary to elim-inate the need to pay federal estate tax, coupledwith a unified credit trust containing themaximum amount which can be shelteredfrom estate tax by the available credits (includ-ing without limitation, the applicable creditamount), results in the largest marital bequestfund of all the alternative testamentary dis-positive plans and gives the surviving spousemaximum use of the family's economic wealth .It eliminates all federal estate tax on the estateof the first to die and decreases the cumula-tive total federal estate tax liability on bothspouses' estates .

Generation skipping transfer tax

Another consideration in the testamentary andoverall estate plan is avoidance of the gener-ation skipping transfer tax (GSTT) . Withoutusing exemptions, the GSTT is applied as a flatrate equal to the highest current estate taxbracket (currently 55%) on every generationskipping transfer .' A generation skippingtransfer is any transfer of property by gift orat death to any individual who is of a genera-tion, as determined by the Code, that is two ormore generations below that of the transferor .Thus, it affects such potential beneficiaries as


grandchildren, great nieces and nephews, andyounger generations .' The tax applies to out-right transfers and to transfers in trust, estatesfor years, insurance and annuity contracts, andother transfers involving life estates andremainders .

Exemptions. Since every individual is allowedto make wholly GSTT exempt transfers, in theaggregate, of up to $1 million (indexed for infla-tion beginning in 1998'), either during lifetimeor at death, and with estate planning encom-passing proper allocation of these exemptions,up to $2 million can be transferred free of thisburdensome surtax by the spouses. Further-more, certain transfers do not trigger theimposition of the GSTT ; if they had been madeby gift, they would qualify as free from gift tax(such as direct payments made for the donee'seducational or medical expenses, Section2503(c) trusts, and some transfers that pass gifttax free under the annual exclusion rules) . Thus,careful timing and substantive allocation of giftsand bequests can minimize or eliminate theimpact of GSTT on the spouses' estates .

For succession planning purposes, a GSTTtrust may provide the ability to remove estatetax on the death of the children by passing thoseassets through to the succeeding generation,the decedent's grandchildren . A GSTT trust maybe used in conjunction with the marital

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PRACTiCAL TAX STRATEGIES

bequest (including QTIP) trust and unifiedcredit trust discussed above . In addition, thechildren may have the right to receive theincome of the trust and, subject to the discretionof the trustee, principal from the GSTT trustfor their health, maintenance, support and edu-cation . Moreover, if the GSTT trust is fundedproperly, any appreciation in the principal ofthe trust will also be exempt from the GSTT,even if it exceeds the $1 million exemption oneventual distribution to the grandchildrenand other skip persons .

A close examination of the family's assetsand needs will usually indicate the proper com-bination of testamentary trusts needed, whenused in conjunction with lifetime planning tech-niques discussed below, which are appropri-ate to protect the family assets and effectuatethe testator's desires .

Lifetime gifts

Lifetime gifts, either directly or in trust, shouldbe considered an important part of the estateplan. Gift giving generally should also bestructured to avoid gift tax, which wouldreduce the unified credit available at death .' Asdiscussed above, the unified credit is the dol-lar amount allotted to each taxpayer that canbe applied against the gift tax and the estate tax .Application of the unified credit against the gifttax reduces (by the amount used) the credit oth-erwise available against any estate tax laterimposed on transfers at death ." The annual gifttax exclusion, however, provides that outrightgifts of up to $10,000 (with this limit indexedfor inflation, in incremental increases of $1,000,beginning in 1998 11 ) may be made during eachdonor's lifetime (resulting in a total of $20,000from both spouses) to each donee (such as a childor grandchild) in each calendar year withoutincurring gift tax and without using any por-tion of the unified credit. Such gifts have the effectof reducing the donor's gross estate while alsoshifting the income earned and the apprecia-tion on the transferred gifts to the donees .

Tax advantage. Even taxable lifetime gifts havethe advantage of being made on a tax-exclu-sive basis, rather than on the tax inclusive basis(as are transfers occurring on death) . Basically,this means that in a lifetime gift transfer,there is no tax on the tax .

Example. Betty transfers $1 million worth ofassets as a lifetime gift . The gift tax rate is 55% .Thus, the transaction reduces Betty's wealth by

PRACTICAL TM STRAnGIES AUGUST 1999

$1,550,000 ($1 million in assets plus $550,000gift tax) . In contrast, a $1 million transfer atdeath would take $2,222,222 ($1 million assetstransferred plus $1,222,222 in estate tax) of herassets, a difference of over $670,000 (all of whichmust be liquid funds) ."

Many estate planning devices take advan-tage of the annual exclusion and the time valueof money to further "leverage" the beneficialuse of lifetime giving .

Lifetime transfers to minors

Special consideration should be given totransfers to children and others who are underage 21 at the time of transfer . Generally, a giftmust be of a "present interest" (i .e ., the abil-ity to enjoy theeconomic benefitof the property atthe time of trans-fer) in order toqualify for theannual exclusion ."Certain transfers,however, may be made that delay the receiptof the property by a minor, but still qualify forthe annual exclusion .

Under Section 2503(c), a gift for the ben-efit of a minor will qualify if the principal andincome therefrom are available for the use ofthe minor prior to age 21, and payable outrightto the minor on attaining age 21 . 10 A trust maybe structured to meet these requirements sothat additions to the trust will also qualify forthe annual exclusion .

Also, a gift made to a custodian for the ben-efit of the minor under either the Uniform Giftsor Transfers to Minors Act enacted by moststates will qualify for the annual exclusion ."

The donor may also want to consider thetransfer of assets to children and grandchildren,if any, under Section 2503(e) . A Section2503(e) qualified transfer of funds maybe madedirectly to an educational institution as atuition payment for a donee without being sub-ject to gift tax . This transfer must be madedirectly to the institution for tuition expensesonly. Payments, however, may be for the fulltuition without depletion of the $10,000/$20,000exclusion or the unified credit. Therefore, thespouses can annually give each child andgrandchild (or other person) $20,000 andfull tuition to a qualified educational institu-tion without incurring gift tax or diminishing


the available unified credit . Similarly, Section2503(e) provides that a transfer of funds maybe made directly to a provider of medical careas payment for such care, without gift tax con-sequences or using the donor's unified creditor annual exclusion .

Irrevocable life insurance trust

Under existing laws, proceeds of insurance poli-cies on the life of a decedent are included inthe decedent's estate if any of these occur :1 . The proceeds are payable to or for the

benefit of the decedent's estate .2. The decedent held an incident of owner-

ship in the policies at the time of hisdeath .

3 . Having transferred the policy during life-time, the decedent dies within three yearsafter the transfer."Irrevocable life insurance trust . Under the

existing rules, an irrevocable trust can pur-chase and pay for life insurance policies with-out the proceeds of such policy being includedin the taxable estate of the deceased. Also, theclient can assign the ownership of any exist-ing insurance policies on his or her life to anirrevocable trust . Then, if the client survivesthe transfer by three years, the arrangementwill not be deemed a transfer in contempla-tion of death ." The provisions of an irrevo-cable life insurance trust can be the similar tothose under the unified credit trust discussedabove or the client may elect to have alterna-tive dispositive provisions (such as to providefor the special needs of a child or other fam-ily member) .

The primary goal of such a trust is to shiftthe ownership of the policies on the life of theinsured (i .e., divest the insured of "incidents ofownership"), thus removing the policy proceedsfrom the federal taxable gross estate at the deathof the insured or the spouse of the insured .

During the lifetime of the surviving spouse,this estate planning technique will afford theeconomic benefit of the proceeds of the insur-ance policies on the life of the insured whileallowing the proceeds to escape death taxationin both estates with the potential maximum fed-eral estate tax savings of 55% to 60% . Also, byproviding the family with a cash fund that canbe used to loan money to or purchase assetsfrom the estate at the discretion of the trustee,an irrevocable life insurance trust can providethe necessary liquidity for the payment of death


taxes without subjecting the proceeds of thepolicy itself to depletion by those taxes .

If and when additional insurance is neededor desired, it can and should be purchased bythe trustee directly, without ever becoming apart of the spouses' respective estates and elim-inating the three year "contemplation of death"rule involved when transferring existing poli-cies under Section 2035 .

FLPs

The family limited partnership (FLP) can bea valuable estate planning tool because it canprovide :1 . A mechanism for permitting experienced

family members to manage family assets .2 . Protection of assets from the claims of

creditors .3 . A form of ownership that facilitates the

making of gifts because it permits indi-rect transfers of a pro rata interest in thepartnership assets .A limited partnership is an ideal form of busi-

ness entity to indirectly transfer interests in fam-ily assets to younger family members becauseolder family members (or an entity controlledby them) can serve as the general partners andcontinue to manage the assets while the youngerfamily members, who will receive limited part-

AUGUST 1999

PRACTICAL TAXSTNATEGIES

nership interests, receive equity, income, immu-nity from partnership creditors and, to a greatextent, from their own creditors as well ."

An FLP may be used to fractionalize a mar-ried couple's interest in business assets, realestate, or even marketable securities, to cre-ate valuation discounts by giving or selling suchassets to other family members . Generally, afractional interest may be subject to three dis-counts and two premium adjustments toarrive at the proper value of the limited part-nership interest :1. Minority interest discount (reflecting the

lack of control of such interest) .2 . Lack of marketability discount (lack of

liquidity of the asset) .3 . Blockage discount (increased availability

of the asset drives down price but rarelyapplied) .

4. Control premium (applicable to a major-ity owner who may exercise unfetteredcontrol of the entity) .

5. Swing vote premium (based on the abilityof a fractional share to carry a majorityproposal) ."The limited rights of a limited partner to

obtain a pro rata share of the partnership assetscan justify a substantial reduction in the valueof a gift of limited partnership interest via a lackof marketability discount . The fair marketvalue of both the retained and transferred inter-ests may also be discounted to reflect the dif-ficulty of selling fractional, not readilymarketable, interests in businesses or proper-ties (even though all of the FLP interests arestill retained by the family) ." Furthermore, whenthe surviving spouse dies, the estate may claimsuch discounts in the value of the retained inter-ests due to the fact they are fractional interestsand not readily saleable to a third person .

PRACTICAL TAX STRATEGIES

AUGUST 1999

An FLP established in accordance withstate law may also be treated for federal incometax purposes as a genuine partnership . Finally,gifts of such an interest in a family partnershipqualify for the $10,000 dollar annual gift taxexclusion ($20,000 for married couples) .'

An FLP is a vehicle that may be used to trans-fer ownership of assets to other members of thefamily, thereby reducing the size of the estatesduring the client's lifetime, without loss of con-trol. The ability to control the management andoperations of the underlying assets maybe ofutmost concern when the underlying assetrequires professional management for whichthe limited partners (i .e ., the children andgrandchildren) are not yet prepared . Of course,by transferring some assets into an FLP and giv-ing limited partnership interests to children andgrandchildren, for each dollar of assets so trans-ferred, the client may save up to 55% in estatetax, 5% percent more in surtax avoidance, andtake advantage of the discounted fair marketvalue to leverage the gift tax exemption .

LLCs and other entities

The limited liability company (LLC), like theFLP, may offer the client the benefit of trans-ferring assets (at a discounted rate) to youngerfamily members while retaining control overthe investment of the family assets . As moststates have now enacted legislation providingfor the LLC form, the use of an LLC hasgained greater popularity in the estate plan-ning area . Significant differences in thoseenacting statutes, however, call for a close exam-ination of the family's personal needs and thebenefits and detriments of selecting the par-ticular form of entity.

Corporate and other business interests,particularly closely held entities, are also can-didates for lifetime transfers to younger gen-erations . Unlike the FLP or LLC however,transfers of fractional interests, if made in theform of voting securities, in such corporationsmay eventually cause the transferor to even-tually lose voting control of the entity .

Transfers by gift of these fractional businessinterests may have several additional advan-tages :1 . The gross estate is reduced by the present

value of the interest .2 . Appreciation of the interest and the

future income stream are also removedfrom the gross estate .


3. The transfer may motivate a youngerfamily member to take greater interest inthe management of the business or otherassets and, thus, provide a greater chancethose assets will be properly managedafter the client's death .

4. A written agreement among the stake-holders in the entity (e.g ., a limited part-nership agreement, or a shareholders'agreement) can provide the family withmany different options as to the manage-ment of the entity and provide that theinterests will remain in the familythrough the use of buy-out and redemp-tion clauses . (These agreements may alsoserve as evidence supporting the valua-tion discounts discussed above .)

Grantor retained interests

Substantial estate tax savings may be effectuatedthrough the use of a personal residencegrantor retained income trust (GRIT) orqualified personal residence trust (QPRT) foreither a primary residence or one secondaryresidence, such as a summer home, or both .For example, this type of trust would allow theclient to transfer a summer home to a trustwhile retaining the right to use the residencefor a specified term of years and reducing estatetaxes by eliminating the asset from theirgross estate."

In addition, GRITs can substantially discountthe value of the transferred asset for gift tax pur-poses . The fair market value of the gift in a GRITis reduced by the term interest retained by thegrantor (i .e ., the cost of the donee's wait to receiveit) . Thus its gift tax value is lowered, and thegift tax incurred or unified credit depletion isminimized." Furthermore, 100% of the post-transfer appreciation in the transferred prop-erty's value will escape both estate and gift taxes,making it an excellent "estate freezing" device .

Where the transfer is made to a close fam-ily member, however, the requirements ofChapter 14 of the Code must be met 24 The sec-tions contained in Chapter 14 effectively valuethe retained interest at $0, such that the gift taxis imposed on the full fair market value of theasset . In order to avoid this harsh result, theretained interest must be either of three types :1 . An annuity payment (i .e ., a "GRAT") .2. A unitrust payment computed annually

on the fair market value of the trustassets (i .e ., a "GRUT") .

ESIATE PLANNING GVERVILW

3. A remainder interest following an annu-ity or unitrust interest .Each of these interests is intended to reflect

the appropriate valuation of the annuitytables used and to prevent abuse of the GRITby the placement of non-income producing,high capital growth assets in the GRIT . Evenso, appropriately structured GRITs, GRATs,GRUTs, and QPRTs, which meet (or avoid)these requirements, are a viable and highly use-ful planning technique .

A grantor retained unitrust (GRUT) is anestate planning device through which theclient can transfer an asset other than a per-sonal residence into a trust while retaining anannuity payment for a term of years (i.e., a fixedpercentage of the trust assets' value eachyear) . A GRAT differs from a GRUT in that itis an irrevocable right to receive a fixedamount at least annually, payable to or for thebenefit of the holder of the term interest . AGRAT or GRUT can remove the value of theasset from the gross estate, and thereby, willeliminate the federal estate tax on that asset andits appreciation in value, and will leverage thegift tax exemption through discounting the val-uation of the taxable gift by the value of theretained interest .

Appropriate assets. This may be an effectiveestate planning device for assets such as an own-ership interest in a closely held business orinvestment properties, which are likely toappreciate significantly and have the self-generated cash flow to support an annuity (orunitrust) payment.

If the GRAT or GRUT donor outlives thespecified term, none of the trust's assets willbe included in the donor's gross estate . If, how-ever, the donor predeceases the annuity term,the value of the assets in the GRIT and GRATwill be includable in the donor's gross estate,and any used unified credit or gift tax paid willbe restored to the estate . The net effect of suchrecapture is the same as if no transfer hadoccurred . To ameliorate such consequences, thebeneficiary can purchase insurance on thedonor's life and carry that life insurance dur-ing the period of time in which the donor's deathwould cause estate tax inclusion .

CRTs

A charitable remainder unitrust (CRUT) andcharitable remainder annuity trust (CRAT) canallow the grantor/client to make an immedi-

AUGUST 1999


THE GSTTAPPLIES TOOUTRIGHTTRANSFERSAND TOTRANSFERS INTRUST,ESTATES FORVEARS,INSURANCEAND ANNUITYCONTRACTS,AND OTHERTRANSFERSINVOLVINGLIFE ESTATESANDREMAINDERS.

ately deductible gift in trust to a charity, butkeep (or give to another beneficiary) the rightto receive regular payments from the trust forlife or a period of years (not to exceed 20 years)before the charity receives the remainderinterest of the trust.'' The advantages of thisestate planning technique are as follows :

The grantor may take an immediate char-itable income tax deduction for the fairmarket value of the remainder interestthat passes to the charity .If appreciated assets are used to fund thetrust, capital gains taxes will go unrecog-nized on the sale of the assets by thecharitable remainder trust (CRT) untilactual distribution of the proceeds to thebeneficiary. (The CRT is not taxableunless it has unrelated businessincome.")Without the capital gains tax, all of theproceeds of the sale of assets are availablefor reinvestment, which increases theincome the noncharitable (and charita-ble) beneficiary can receive .The assets contributed to the CRT willescape death taxes even if the grantorretained an annuity for their lifetime .ceuT. The trust instrument in a CRUT

must provide to the noncharitable beneficiarya variable payout based on the annual valua-tion of the trust assets . This payout must be paidat least annually and must be a fixed percent-age of not less than 5% of the net fair marketvalue of the trust assets (and generally limitedto not more than 15% percent to prevent


AUGUST 1999

abuse of the CRT form by the grantor, but statu-torily capped at 50%"), or the payout may belimited to the net income of the trust with thedeficiency to be made up in later years (a "NIM-CRUT") . The payout period may extend for aterm of up to 20 years or for the life or lives ofthe beneficiaries ." Since the trust assets are val-ued annually, the grantor may make additionalcontributions to the trust subsequent to the ini-tial funding . Following the termination ofpayments to the beneficiaries, the remainderinterest is transferred to the designated qual-ified charity or retained in the trust for the char-ity's benefit .

If the noncharitable beneficiary of theCRUT is not the donor or the donor's spouse,the donor will be subject to gift tax only on thevalue of the income interest passing to the ben-eficiary, calculated as the present value of thebeneficiary's right to receive the fixed annu-ity for the life of the beneficiary or terms ofyears. Moreover, the IRS has determined thatthis type of interest will qualify as a presentinterest gift for gift tax exemption purposes .Thus, the grantor and spouse are entitled to a$10,000/$20,000 dollar annual exclusion foreach beneficiary if the trustee is required tomake annual distributions to the beneficiary .

cRAT. Similar to a CRUT, the CRAT providesafixed annuity to the grantor for a period of years(not to exceed 20 years) or for the life or livesof the grantor or his designated beneficiaries ."The annual annuity payment must be valuedat a minimum of 5% of the initial fair marketvalue of the transferred property (and not toexceed 50% of such value) . Unlike a CRUT, how-ever, no further contributions may be made toa CRAT. Finally, following the termination ofthe individual beneficiary's income/annuityinterest, the remainder interest will pass to orin trust to the qualified charity.

Both the CRUT and CRAT provide theadvantages discussed above . The subtle dis-tinctions between the two, however, allow theclient to select the CRT that best suits thatclient's needs .

Retirement plan distributions

Any qualified retirement plans and IRAs main-tained for the client's benefit must be appro-priately integrated within the comprehensiveestate plan. Although income taxes are deferredon the contributions and earnings of such retire-ment plans, they are not structured for perpetual


tax sheltered wealth accumulation . Thus, thereare numerous rules regarding distributions andsignificant penalties for noncompliance . Somepenalties are as great as 50% . 3° Therefore, allqualified plan and IRA death benefits must becoordinated into the estate plan to minimizeor avoid penalty taxes, maximize funds avail-able for the ultimate beneficiaries, defer dis-tributions from the plan as long as possible, andprovide flexibility after death .

Post-mortem strategies are significant in dis-tribution planning because tax laws affectingretirement plans change frequently, and thereare many key variables impossible to predictwith complete accuracy-such as health, lifeexpectancy, order of death, and investmentearnings . One of the most important consid-erations is the proper structuring and desig-nation of a lifetime or testamentary trust as therecipient of the proceeds on the death of thequalified retirement plan or IRA owner . There-fore, a detailed discussion should be held byand among the client and his or her advisorsregarding the incorporation of retirementplans and IRAs into the total estate plan tosimultaneously achieve optimal income andestate tax savings and flexibility.

Private annuity

A private annuity is an estate planning tech-nique that can be used to transfer a sizable asset,such as real estate or a business from the estatefor federal estate tax purposes . The client canconvey the complete ownership of an asset toa transferee, who is the natural object of hisbounty (i .e ., a child), who promises to makeunsecured periodic payments to the client fora period (usually for his or her lifetime or a jointand survivor annuity for the lives of bothspouses) . Any type of property may be trans-ferred in this manner, such as real estate,stocks, or a business interest . The optimal assetsto transfer are ones that are income produc-ing or will rapidly appreciate and will not besubject to debt, depreciation, or investmentcredit recapture .

In a private annuity arrangement with theclient as the sole annuitant, the annuity pay-ments will cease at the client's death, and thetransferred asset is not includable in his or hergross estate for federal estate tax purposes. Fur-thermore, there will be no gift tax implicationsif the annual payments made to the client bythe transferee are actuarially determined to be


equivalent to the fair market value of theasset so transferred . 31

The advantages to be gained from a privateannuity are :1 . A stream of income for life .2 . The (legal) avoidance of gift tax .3. The removal of the transferred asset

(including any appreciation in its value)from taxable gross estate, thereby elimi-nating up to a maximum of 55% federalestate tax on the value of the asset .

Stepped-up basis

In selecting a dispositive estate plan, consid-eration should also be given to the Section 1014basis adjustment . The surviving spouse receivesa new income tax basis for property includedin the marital bequest trust, and the bypass trustreceives a new income tax basis for the non-marital property (i .e ., a stepped-up-or, per-haps, a stepped-down-basis to the property'svalue at the decedent's date of death) .

When the surviving spouse dies, a furtherincome tax basis adjustment would be madefor the marital trust, which is includable in theirgross estate . In contrast, bypass trust propertydoes not receive another basis adjustmentbecause it isnot includedin the surviv-ing spouse'sgross estate .These basisadjustmentscan be favor-able because they produce a "tax-free elimi-nation of capital gain income tax" when theassets are eventually sold. Thus, before lifetimegifts are made to deplete a portion of the tax-able estate, some consideration must also begiven to the type of asset being transferred andthe step up in basis for income tax purposeswhich occurs at death .

compare taxes. The key element is to balancethe ultimate payment of income and capitalgains taxes versus the toll imposed by the estatetax. The types of assets transferred should beexamined for growth rate, basis, and holdingperiod and a rough calculation made of theprobable tax consequences if transferred cur-rently. It is possible through discussion that amore appropriate asset may be identified fortransfer during life . Given the current marginaltax brackets however, it is probable that for high

AUGUST 1999

PRACTICAETM STBATEGIES

net-worth individuals, any transfer will be bet-ter than none at all .

Springing durable power of attorney

As a final nontax consideration, a compre-hensive estate plan should provide for the con-tinuing management of family assets andadministration of affairs in the event of the phys-ical or mental incapacity of either or bothspouses. Through the execution of a power ofattorney, the client can delegate to another,referred to as the attorney-in-fact, the author-ity to take acts on behalf of the principal .

Some of the benefits of preparing a powerof attorney are :1 . The client can enjoy the security of

knowing that his or her financial andhealth care needs and concerns will behandled in a manner that is consistentwith his or her own intentions .

2. The client, rather than a court, appointsthe person he or she believes is the mostcompetent to manage the principal'saffairs . This may include the power tocontinue to make estate planning deci-sions on the client's behalf, such as thecontinuation of a gift-giving programbegun by the client prior to incapacity .

3. The client will circumvent the expenseand delay of a court appointed commit-tee, conservator, or guardian . The man-agement of an individual's assetsthrough judicial intervention requiresestablishing, to the satisfaction of thejudicial tribunal, that a person whoseassets are to be administered hasreached a level of diminished capacity .This procedure involves levels ofscrutiny and due process that, in thefinal analysis, result in both delays andsubstantial financial costs-includingongoing expenses for court accountings,as well as separate applications to thecourt whenever a major transaction is tobe undertaken .Definition. A durable power of attorney is one

that is not terminated by subsequent incapacityor disability of the principal, but will cease onthe principal's request, or discontinue auto-matically on death .

Many individuals, however, are uncom-fortable with immediately vesting the powerto manage their financial or health affairs toan attorney-in-fact . One method that cir-

PRAC11CALTAXSTSATEGIES

AUGUST 1999

cumvents these concerns is the "springing"durable power of attorney. The springingpower is simply a grant of authority that doesnot go into effect until a disability occurs . Oncethe principal becomes disabled or incompe-tent, the attorney-in-fact is vested with all theauthority he would have had under an imme-diate appointment as an attorney-in-fact . Theadvantage of the springing power is that no con-trol is transferred over the assets until there isan actual need . This type of appointmentrequires a statement in the instrument that spec-ifies when the power will arise .

The critical issue with the springing poweris determining a "triggering" event that prop-erly defines when a disability has occurred .Often, the solution is to require that one ormore physicians or other trusted persons cer-tify that the individual is incapacitated . In allinstances, there must be clear and precise lan-guage in the instrument that defines the trig-gering event and creates an objectivemechanism for determining when such anevent has occurred .

Conclusion

The conservation and distribution of theclient's estate to efficiently and effectivelyaccomplish his or her tax and nontax objec-tives is one that requires coordination of sub-stantial assets with the components of asophisticated estate plan . Unless such a planis properly formulated, federal estate tax canconsume over half of the value of the taxablegross estate . Through the integration of tes-tamentary trusts together with the appropri-ate family limited partnerships, life insurancetrusts, GRITs, CRTs, and private annuities, aclient can reduce the size of the taxable estate,eliminate the estate surcharge, minimize com-bined estate tax liability, and optimize the lever-aging of the unified credit .

Furthermore, even the most perspicaciousestate planning strategies are subject to changealong with the tax laws . As a result, regularreview of an estate plan is necessary to ensurethat the latest available planning options arebeing used . ∎


MOTES1 Section 2056 .2 Section 2010(c) .3 Section 2056(b)(7) .° Section 2056(b)l7)(B)(ii((I( See Streer and Strobel,

"Review Wills for Recent QTIP Changes," 60 Tax'n Acc'-tents 138 (March 1998) .

8 Section 2010(c) .6 Section 2641 .7 Sections 2611 and 2651 .8 Section 2631 (c) .9 See Zaritsky, "Adapt Gift-Giving Strategies to Fit Spe-

cial Circumstances," 62 PTS 348 (June 1999) .10See Sections 2010, 2012, and 2504 .11 Section 2503)b)(2) .12 Compare Sections 2001 (b) and 2502 .13 Section 2503(b) .14 Section 2503(c) .13 See Rev. Rul . 59-357, 1959-2 CB 212 . See also West,

"Gifts to Minors Can Be Tied Up With More Than PrettyRibbons," 60 Tax'n Acc'tants 353 (June 1998) .

"Sections 2035(a) and (d)(2), and 2042(2) .17 Id.

18 See, e .g ., the Pennsylvania Revised Uniform Limited Part-nership Act (15 Pa . Cons . Stat . ch . 85) .

1B See, e .g ., In Re Estate of McCormick, TCM 1995-371 ;Moore, TCM 1991-546 ; In re Estate of Berg, TCM 1991-279; In re Estate of Wildman, TCM 1989-667 .

20Id.

21 But see Adler, "Wrong Wording Kills Exclusion for Lim-ited Partnership Interest," 61 Tax'n Acc'tants 80 (August1998) .

22 But see Regs . 25 .2702-5(b) and (c) .23 But see Section 2702 .24 See Section 2702 ; Reg . 25 .2702-3 .25 See Section 664 .26 Section 664(c) .27 Section 664(d)(2)(A) .28

1d

29 Section 664(d)(1((A) .30 See, e .g ., Section 4947 .31 See Webel, "Private Annuity Passes Wealth to Family

Members-Other Than Uncle Sam," 61 Tax'n Acc'tants68 (August 1998) ; Ayers and Streer, "Declining InterestRates Enhance Appeal of Private Annuities," 62 PTS 144(March 1999) .

ESTATE PLANNING OVERVIEW AUGUST 1999

P9ACTICAL TAX STRATEGIES

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