Thursday, August 26, 2010

Succession Planning in Uncertain Times

These are challenging times for analyzing potential estate tax burdens. Last year, individuals could pass $3.5 million in assets upon their death free of federal estate taxes. Now in 2010, there is no federal estate tax whatsoever (maybe). Next year, current law would revert the exemption back to $1 million.

The impact of a $1-million estate tax exemption is significant. Many more Americans will potentially be faced with a maximum estate tax rate of 55%. Whether the law will change at this point is uncertain. A bill was recently introduced that would increase the exemption to $3.5 million retroactively back to Jan. 1. Unfortunately, the reality is that we simply do not know what will happen.

Whether a new estate tax law is enacted, or we revert to a $1 million exemption, the best approach is to put a sound, well thought-out estate plan in place now. This article outlines various tools available to reduce or even eliminate the estate tax burden, regardless of the exemption amount.

1. Properly drafted living trusts

Living Trusts have become an increasingly popular technique for avoiding lengthy, expensive and public court processes such as probates and conservatorships in the event of a person’s death or mental incapacity. Probate avoidance alone can mean large savings in the cost of estate administration.

Beyond saving estate administration costs and maintaining privacy, a properly drafted Living Trust can also mean substantial estate tax savings. For example, suppose Husband and Wife, with a taxable estate of $2 million, have a simple Living Trust that directs the transfer of all of their property to the other upon the first spouse’s death, and equally to their children thereafter. Assume Husband dies first, leaving everything to Wife. On Husband’s death, no estate tax will be owed because of the unlimited marital deduction, which defers estate taxes until a surviving spouse’s death. When Wife dies, however, she will only be able to pass the exemption amount in the year of her death before triggering an estate tax. Therefore, assuming an exemption of only $1 million when Wife dies, the children would receive approximately 50 cents on the dollar for all assets in excess of $1 million.
A better plan for Husband and Wife would have provided that an amount up to the exemption would be left in a tax-sheltered trust, frequently referred to as a “bypass trust,” for Wife’s benefit. Wife could then use the bypass trust to support herself during her lifetime, with the bypass trust going to the children free of estate taxes upon Wife’s death.

2. Planned gifting beyond the living trust

For wealthier individuals, basic Living Trust-based tax planning is not enough. In those situations, consider reducing the size of the estate through techniques such as those discussed below.

A. Irrevocable Life Insurance Trust

Suppose Husband and Wife were unable to totally avoid estate taxes despite the use of a bypass trust. In those cases, serious consideration should be given to preparing a specially designed trust commonly known as an Irrevocable Life Insurance Trust, or “ILIT.” If an ILIT is used to purchase life insurance, death benefits are kept out of the estates of both Husband and Wife (and therefore not subject to estate tax). The difference between having Husband or Wife own the policy, as opposed to having it owned by an ILIT, is staggering. For example, a $1 million life insurance policy kept out of the parents’ estates can prevent the children from having to pay roughly $500,000 of those proceeds for estate taxes. That means the full $1 million can pass to the children income and estate tax free.

B. Family Limited Partnerships (FLP’s) and Family Limited Liability Companies (FLLC’s)

Think of these entities just as you would any business, except they are owned by members of the same family. Parents initially contribute certain assets into a partnership or LLC in a manner that allows them to retain full control over those assets (just as any general partner or managing member would). The power for estate tax reduction comes from giving interests in these entities to the next generation during the parents’ lifetime. Since the gifts typically involve minority interests, the gift tax value can be discounted to reflect lack of marketability and control.
In many cases, these types of gifts have been discounted 40% or more. A 40% discount on a family entity could potentially provide for a gift-tax-free transfer of over $1.3 million more than could be achieved without the use of such an entity. Further, all income and appreciation flowing from the gifted property escapes both income and estate taxation at the parents’ generation. It may be important to act quickly with this type of gifting strategy, as there is a significant threat of legislation greatly reducing or even eliminating these discounts.

C. Charitable Giving

Where one has true donative intent, charitable contributions through gifts made outright or in trust may reduce the taxable estate. Private foundations are also becoming a popular tool for charitable giving. These arrangements are beyond the scope of this article, but merit consideration for the charitably inclined.


Planning for the worst in these uncertain times is critical. Regardless of estate size, proper planning will reduce both time and expense in estate administration, and leave loved ones with the clarity they deserve.