Here’s a look at the most important estate planning tools and how you can use them to minimize taxes and maximize your estate’s value as the tax rules change over the coming years. You’ll learn how the marital deduction, lifetime gift and estate tax exemptions, various trusts, life insurance, family business structures, charitable contributions, and other estate planning techniques can help you achieve your goals. You will also see why it will be helpful to seek professional financial, tax and legal advice about ways to use these techniques effectively. Please let us know if you have any questions about how they might apply to your situation.

The Marital Deduction

The Marital DeductionThe marital deduction is one of the most powerful estate planning tools. Any assets passing to a surviving spouse pass tax free at the time the first spouse dies, as long as the surviving spouse is a U.S. citizen. Therefore, if you and your spouse are willing to pass all of your assets to the survivor, no federal estate tax will be due on the first spouse’s death — even without any estate tax repeal.

But this doesn’t solve your estate tax problem. First, if the surviving spouse does not remarry, that spouse will not be able to take advantage of the marital deduction when he or she dies. Thus, the assets transferred from the first spouse could be subject to tax in the survivor’s estate, depending on when the surviving spouse dies. Second, from a personal perspective, you may not want your spouse to pass all assets to a second spouse even if it would save estate taxes.

Preserve both exemptions with a credit shelter trust

Since assets in an estate equal to the exemption amount are not subject to estate taxes, a married couple can use their exemptions to avoid tax on up to double the exemption amount. (See Chart 1). An effective way to maximize the advantages of the exemption is to use a credit shelter trust.

Let’s look at an example: As shown in Chart 2, left column, Mr. and Mrs. Jones have a combined estate of $4 million. At Mr. Jones’ death in 2008, all of his assets pass to Mrs. Jones — tax free because of the marital deduction. Mr. Jones’ taxable estate is zero. Shortly thereafter, and still in 2008, Mrs. Jones dies, leaving a $4 million estate. The first $2 million is exempt from estate tax, but the remaining $2 million is subject to $900,000 in taxes, leaving only $3,100,000 for the children.

The problem? Mr. and Mrs. Jones took advantage of the exemption in only one estate.

Let’s look at an alternative: As shown in Chart 2, right column, Mr. Jones’ will provides that assets equal to the exemption go into a separate trust on his death. This “credit shelter trust” provides income to Mrs. Jones during her lifetime. She also can receive principal payments if she needs them to maintain her lifestyle. Because of the trust language, Mr. Jones may allocate $2 million, his exemption amount, to the trust to protect it from estate taxes. If there were remaining assets (assets over $2 million), they would pass directly to Mrs. Jones.

Chart 2

How to reduce estate taxes with a credit shelter trust

Case Study I

Splitting Assets Without Splitting Up The Marriage
Does it matter which spouse dies first? Maybe. Let’s go back to our friends, the Joneses. Assume Mr. Jones owns $3.5 million of assets under his name and Mrs. Jones has $500,000 under her name. If Mr. Jones dies first, the credit shelter trust can be funded with $2 million from his assets. But if Mrs. Jones dies first, only the $500,000 under her name would be available to fund the trust. Mrs. Jones’ estate can take advantage of only $500,000 of her $2 million exemption amount.

To take maximum advantage of the credit shelter trust strategy, be sure property in each estate totals at least the exemption amount. Ensuring each spouse has enough assets may require reviewing how your assets are currently titled and shifting ownership of some assets. Even if you can’t perfectly divide assets, any assets owned up to the lifetime exemption limit will reduce the total tax.

A warning here is appropriate: Assets can generally be retitled between spouses without any negative tax consequences, so long as both spouses are U.S. citizens. Moreover, there may be state issues in certain limited situations. Seek professional advice before transferring titles.

Because the $2 million trust is not included in Mrs. Jones’ estate, her taxable estate drops from $4 million to $2 million. Thus, the tax at her death is reduced, as both spouses’ exemptions are used. By using the credit shelter trust in Mr. Jones’ estate, the Joneses save $900,000 in federal estate taxes.

The Joneses do give up something for this tax advantage. Mrs. Jones doesn’t have unlimited access to the funds in the credit shelter trust because, if she did, the trust would be includable in her estate. Still, Mr. Jones can give her all of the trust income and any principal she needs to maintain her lifestyle. And the family comes out ahead by $900,000. But the outcome would be quite different if both spouses didn’t hold enough assets in their own names. (See Case study I.)

Control assets with a QTIP trust

A common estate planning concern is that assets left to a spouse will eventually be distributed in a manner against the original owner’s wishes. For instance, you may want stock in your business to pass only to the child active in the business, but your spouse may feel it should be distributed to all the children. Or you may want to ensure that after your spouse’s death the assets will go to your children from a prior marriage.

You can avoid such concerns by structuring your estate plan so your assets pass into a qualified terminable interest property (QTIP) trust. The QTIP trust allows you to provide your surviving spouse with income from the trust for the remainder of his or her lifetime. You also can provide your spouse with as little or as much access to the trust’s principal as you choose. On your spouse’s death, the remaining QTIP trust assets pass as the trust indicates.

Thus, you can provide support for your spouse during his or her lifetime but retain control of what happens to the estate after your spouse’s death. Because of the marital deduction, no estate taxes are due at your death. But the entire value of the QTIP trust will be included in your spouse's estate.

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Control assets with a QTIP trustLife Insurance

Life insurance can play an important role in your estate plan. It is often necessary to support your family after your death or to provide liquidity. Not only do you need to determine the type and amount of coverage you need, but also who should own insurance on your life to best meet your estate planning goals.

Support your family

When you quantify the numbers to determine what cash flow your family will need, the result may be surprisingly high.

Your first goal should be taking care of the people you care about. Carefully analyze how much they’ll need to replace your lost
earning power. The first question is whether your spouse is employed. If your spouse is, consider whether becoming a single parent will impede career advancement and earning power. If your spouse isn’t employed, consider whether he or she will start to work and what his or her earning potential will be.

Next, look at what funds may be available to your family in addition to your spouse’s earnings and any savings. Then estimate what your family’s living expenses will be. Consider your current expenditures for housing, food, clothing, medical care, and other household and family expenses; any significant debts, such as a mortgage and student loans; and your children’s education, which can be difficult to estimate.

How do you determine the amount of insurance you need? Start by calculating how much annual cash flow your current investments, retirement plans and any other resources will provide. Use conservative earnings, inflation and tax rates. Compare the amount of cash flow generated with the amount needed to cover your projected expenses. Life insurance must cover any shortfall. When you quantify the numbers to determine what cash flow your family will need, the result may be surprisingly high. Remember that you may be trying to replace 25 or more years of earnings.

Avoid liquidity problems

Insurance can be the best solution for liquidity problems. Estates are often cash poor, and your estate may be composed primarily of illiquid assets such as closely held business interests, real estate or collectibles. If your heirs need cash to pay estate taxes or for their own support, these assets can be hard to sell. For that matter, you may not want these assets sold.

Even if your estate is of substantial value, you may want to purchase insurance simply to avoid the unnecessary sale of assets to pay expenses or taxes. Sometimes second-to-die insurance makes the most sense. (See Planning tip 5.) Of course, your situation is unique, so please get professional advice before purchasing life insurance.

Planning tip 5

Consider Second-To-Die Life Insurance

Second-to-die life insurance can be a useful tool for providing liquidity to pay estate taxes. This type of policy pays off when the surviving spouse dies. Because a properly structured estate plan can defer all estate taxes on the first spouse’s death, some families find they don’t need any life insurance then. But significant estate taxes may be due on the second spouse’s death, and a second-to-die policy can be the perfect vehicle for offsetting the taxes. It also has other advantages over insurance on a single life. First, premiums are lower. Second, uninsurable parties can be covered. But a second-to-die policy might not fit in your current irrevocable life insurance trust (ILIT), which is probably designed for a single life policy. Make sure the proceeds are not taxed in either your estate or your spouse’s by setting up a new ILIT as policy owner and beneficiary.

Choose the best owner

If you own life insurance policies at your death and you die while the estate tax is in effect, the proceeds will be included in your taxable estate. Ownership is usually determined by several factors, including who has the right to name the beneficiaries of the proceeds. The way around this problem? Don’t own the policies when you die. But don’t automatically rule out your ownership either.

Determining who should own insurance on your life is a complex task because there are many possible owners, including you or your spouse, your children, your business, and an irrevocable life insurance trust (ILIT). Generally, to reap maximum tax benefits you must sacrifice some control and flexibility as well as some ease and cost of administration.

To choose the best owner, consider why you want the insurance, such as to replace income, to provide liquidity or to transfer wealth to your heirs. You must also determine the importance to you of tax implications, control, flexibility, and ease and cost of administration. Let’s take a closer look at each type of owner:

You or your spouse. Ownership by you or your spouse generally works best when your combined assets, including insurance, don't place either of your estates into a taxable situation. There are several nontax benefits to your ownership, primarily relating to flexibility and control. The biggest drawback to ownership by you or your spouse is that, on the death of the surviving spouse (assuming the proceeds were initially paid to the spouse), the insurance proceeds could be subject to federal estate taxes, depending on when the surviving spouse dies.

Case Study II
In An ILIT We Trust
Walter was the sole income provider for his family. While working on his estate plan, he and his advisor determined he needed to purchase life insurance to provide for his family if something happened to him. After calculating the size of the policy his family would need, Walter had to determine who should own it.

Because his children were still relatively young, Walter ruled them out as owners. He was concerned that if his wife were the owner and something happened to her, his children would lose too much to estate taxes. So Walter decided to establish an ILIT to hold the policy. Despite the loss of control over the policy, Walter felt the ILIT offered the best protection for his family, even if the estate tax was no longer an issue.

Your children. Ownership by your children works best when your primary goal is to pass wealth to them. On the plus side, proceeds are not subject to estate tax on your or your spouse's death, and your children receive all of the proceeds tax-free. There also are disadvantages. The policy proceeds are paid to your children outright. This may not be in accordance with your general estate plan objectives and may be especially problematic if a child is not financially responsible or has creditor problems.

Your business. Company ownership or sponsorship of insurance on your life can work well when you have cash flow concerns related to paying premiums. Company sponsorship can allow premiums to be paid in part or in whole by the company under a split-dollar arrangement. But if you are the controlling shareholder of the company and the proceeds are payable to a beneficiary other than the company, the proceeds could be included in your estate for estate tax purposes.

An ILIT. Aproperly structured ILIT could save you estate taxes on any insurance proceeds. Thus, a $1 million life insurance policy owned by an ILIT instead of by you, individually, could reduce your estate taxes by as much as $450,000 in 2008. How does this work? The trust owns the policies and pays the premiums. When you die, the proceeds pass into the trust and aren't included in your estate. The trust can be structured to provide benefits to your surviving spouse and/or other beneficiaries. (See Case study II.) ILITs have some inherent disadvantages as well. One is that you lose control over the insurance policy after the ILIT has been set up.

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Annual GiftingAnnual Gifting

Even with exemptions and insurance proceeds out of your estate, you still can have considerable estate tax exposure. One effective way to reduce it is to remove assets from your estate before you die. Even with the pending estate tax repeal in 2010, this strategy makes sense — as long as you can make the gifts without incurring gift tax — because the estate tax might not actually be repealed, and even if it is, the tax will return in 2011 if there’s no further legislation.

Case Study III
The Early Bird Catches The Tax Savings
Five years ago, Mr. and Mrs. Brown had a combined estate of $5 million, which in 2008 would give them a federal estate tax exposure of $450,000, even if they took advantage of each of their $2 million exemptions. But Mr. and Mrs. Brown began a gift program, giving their combined annual exclusion amount ($22,000 in 2004, and 2005, and $24,000 in 2006, 2007, 2008) to each of their two sons, two daughters-in-law and four grandchildren annually. These gifts reduced their combined estates by $928,000, resulting in a combined estate tax exposure of $32,400 in 2008. That’s an estate tax savings of $417,600.

The savings may actually be even greater. If Mr. and Mrs. Brown hadn't made the annual gifts, those assets might have generated income or appreciated in value each year. This additional income and appreciation would have been includable in their estate. By making the gifts to their children and grandchildren, they passed on not only the $928,000 of assets free of tax, but also the future income and appreciation of those assets.

Taking advantage of the annual gift tax exclusion is a great way to reduce your estate taxes while keeping your assets within your family. Each individual is entitled to give as much as $12,000 per year per recipient without any gift tax consequences or using any of his or her gift, estate or GST tax exemption amount. The exclusion will increase only in $1,000 increments, when warranted by inflation. Case study III shows the dramatic impact of an annual gifting program.

Make gifts without giving up control

To take advantage of the annual exclusion, the law requires that the donor give a present interest in the property to the recipient. This usually means the recipient must have complete access to the funds. But a parent or grandparent might find the prospect of giving complete control of a large sum to the average 15-year-old a little unsettling. Here are a few ways around that concern:

Take advantage of Crummey trusts. Years ago, the Crummey family wanted to create trusts for their family members that would provide restrictions on access to the funds but still qualify for the annual gift tax exclusion. Language was included in the trust that allowed the beneficiaries a limited period of time in which to withdraw the funds that had been gifted into the trust. If they didn't withdraw the funds during this period, the funds would remain in the trust. This became known as a “Crummey” withdrawal power.

The court ruled that, because the beneficiaries had a present ability to withdraw the funds, the gifts qualified for the annual gift tax exclusion. Because the funds weren’t actually withdrawn, the family accomplished its goal of restricting access to them.

The obvious risk: The beneficiary can withdraw the funds against the donor’s wishes. To protect against this, the donor may want to explain to the beneficiaries that they’re better off not withdrawing the funds, so the proceeds can pass tax-free at his or her death. Your tax or legal advisor can counsel you about other ways of drafting the document to protect against withdrawals.

Establish trusts for minorsEstablish trusts for minors. An excellent way to provide future benefits (such as college education funding) for a minor is to create a trust which provides that:

  • The income and the principal of the trust be used for the benefit of the minor until the age of 21, and
  • Any income and principal not used passes to the minor at 21 years of age.

A trust of this type qualifies for the annual gift tax exclusion even though the child has no current access to the funds. Therefore, a parent can make annual gifts into the trust while the child is a minor. The funds accumulate for the future benefit of the child, and the child doesn’t even have to be told about the trust. But one disadvantage is that the child must have access to the trust assets once he or she reaches age 21.

Chart 3

The power of giving away appreciating assets

Municipal Bond Appreciating stock
Value of gift $12,000 $12,000
Income and appreciation (5 years) 2,750* 7,000*
Total excluded from estate $14,750 $19,000
By giving an appreciating asset, Cathy removes an extra $4,250 from her estate.
* These amounts are hypothetical and are used for example only.
Source: U.S. Internal Revenue Code

Leverage the annual exclusion by giving appreciating assets

Gifts don’t have to be in cash. Any asset qualifies. In fact, you will save the most in estate taxes by giving assets with the highest probability of future appreciation. Take a look at Chart 3. Cathy gave her daughter a municipal bond worth $12,000. During the next five years, the bond generated $550* of income annually but did not appreciate in value. After five years, Cathy had passed $14,750 of assets that would otherwise have been includable in her estate.

*This amount is hypothetical and is used for example only.

But suppose Cathy gave her daughter $12,000 in stock instead of the bond. If the stock generated no dividends during the next five years but appreciated in value by $7,000, Cathy would have given her daughter $19,000 of assets — and taken an additional $4,250 out of her estate.

Remember that a recipient usually takes over the donor’s basis in the property gifted. If an asset worth $12,000 cost the donor $8,000, the recipient takes over an $8,000 basis for income tax purposes. Therefore, if the asset is then sold by the recipient for $12,000, he or she has a $4,000 gain for capital gains tax purposes.

Consider whether “taxable” gifts make sense

You will save the most in estate taxes by giving assets with the highest probability of future appreciation.

The estate and gift tax system is a combined one with two notable differences between the taxes: 1) the gift tax isn't scheduled to be repealed, and 2) the gift tax exemption remains at $1 million while the estate tax exemption has increased. Taxable gifts equal to or less than the gift tax exemption amount made by an individual create no gift tax, just as assets in an estate equal to or less than the estate tax exemption amount create no estate tax. But note that this is on a combined basis. In other words, if you make $200,000 of taxable gifts during your life, the amount of assets in your estate that will avoid estate taxes will be reduced by $200,000. You can use the exemption during life or at death, but not both.

Because many assets appreciate in value and there’s no guarantee the estate tax repeal will last beyond 2010 (or even that Congress won’t pass further legislation repealing the repeal or reducing the exemption increases), it may make sense to gift up to the exemption amount if you haven’t already. (See Case study IV.)

Remember, each spouse is entitled to his or her own exemption. If a couple uses up their gift tax exemptions by making $2 million in taxable gifts in 2008 and after five years the assets have increased in value by 50%, they’ll have removed an additional $1 million from their combined taxable estate without having to use an additional portion of their exemptions.

Case Study IV
When “Taxable” Gifts Save Taxes
Let’s say John has an estate of $3 million (and thus has substantial estate tax exposure). In 2008 he has already given $12,000 for the year to each of his chosen beneficiaries and then gives away an additional $1 million of assets. Assume that, in the next five years, those assets will increase in value by 50%. John uses his $1 million gift tax exemption by making the taxable gift. Therefore, his estate can’t use that amount as an exemption. But by making the taxable gift, he also removes $500,000 of future appreciation from his estate within five years. This amount escapes the estate tax.

Leverage your tax-free gifts with an FLP

Family limited partnerships (FLPs) can be excellent tools for long-term estate planning, because they can allow you to increase the amount of gifts you make. But the IRS frequently challenges FLPs, so caution is needed when implementing them. This type of partnership converts an estate plan into a family endeavor, allowing you to remain actively involved throughout your lifetime. FLPs are special because they may allow you to give assets to your children (and grandchildren) at discounted values for gift tax purposes.

Here’s how it works: First you select the type of assets (such as real estate or an interest in a business) and the amount (based on the gift tax rules discussed earlier) and place them into the FLP. Next you give some or all of the limited partnership interests to your children and grandchildren.

The limited partnership interests give your family members ownership interests in the partnership, but no right to control its activities. Control remains with the small percentage (at least 1%) of partnership interests known as general partnership interests, of which you retain ownership. The result is that you can reduce your taxable estate by giving away assets (the partnership interests), while retaining control of the underlying assets and the income they produce.

Because the limited partners lack any control, these interests can often be valued at a discount. Recent court cases have given the IRS more ammunition to attack FLPs. Please seek professional advice about how this or any other legislation might affect the outcome when you create an FLP or make a gift of FLP interests. In any case, when making a gift of an FLP interest, obtaining a formal valuation by a professional business appraiser is essential to establish the value of the underlying assets and of the partnership interests.

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Charitable Contributions

If you share your estate with charity, it will cut your estate tax bill. Direct bequests to charity are fully deductible for estate tax purposes. Leave your entire estate to charity, and you’ll owe no estate taxes at all. In addition to tax advantages, contributing to charity is a good way to leave a legacy in your community or to instill in your heirs a sense of social responsibility.

But what if you want to make a partial bequest to charity and a partial gift or bequest to your natural beneficiaries? A trust can be the answer.

Provide for family today and charity tomorrow with a CRT

Your will can create a trust that will pay income to beneficiaries you name. At the end of the stated period, the remaining trust assets pass to your charitable organization(s) of choice. This is a charitable remainder trust (CRT).

For example, let’s say you want to make sure your elderly father is provided for after your death. Income from the trust created upon your death goes to him until he dies. At that time, the remainder passes to charity. You get what you wanted — you provide for both your father and charity. And, since you are making a partial charitable donation at the time of your death, your estate receives a deduction for a portion of the trust’s value. Government tables determine the size of the estate tax deduction based on the value of the trust assets, the trust term and the income to be paid to the beneficiary. The value of the income interest given to the noncharitable beneficiary is a taxable bequest.

Take the reverse approach with a CLT

Now let’s reverse the situation. You wish to provide income to a charity for a set period after your death, with the remainder passing to your beneficiaries. The charitable lead trust (CLT) provides a way to do this — and obtain a partial charitable deduction for your estate.

Gain an income tax deduction with lifetime charitable gifts

You can use the above techniques during your lifetime as well. And if you create a charitable trust during your life, you may be entitled to an income tax deduction for the portion that government tables calculate to be the charitable gift. This way, you can reduce both your income and estate taxes.

Planning tip 6

Leave A Legacy With A Private Foundation Or Donor-Advised Fund

You can form a private foundation to support your charitable activities or to make charitable grants according to your wishes. If the foundation qualifies for tax-exempt status, your charitable contributions to it will be deductible, subject to certain limitations.

An alternative to consider is a donor-advised fund. Generally, such funds are sponsored by a large public charity that allows you to make contributions that are used to create a pool of funds you control. Thus, a donor-advised fund is essentially a small-scale private foundation that requires much less administration.

Whether a private foundation or a donor-advised fund is right for you depends on various factors. Although there may be less incentive to create such vehicles in light of the increasing estate tax exemption (and potential repeal), they are still viable options worth exploring.

The benefits are even greater if you fund the trust with appreciated assets. Let’s say you transfer appreciated securities to a CRT. After receiving the stock, the trustee sells it and reinvests the proceeds. Because a CRT is tax exempt, no capital gains tax is owed. The trustee is able to reinvest the full proceeds, thus increasing the annual cash income to you or your chosen
beneficiaries. (The income distributions are taxable.) See Planning tip 6 for more ideas on incorporating charitable giving into your estate plan.

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Strategies for Family-Owned Businesses

Few people have more estate planning issues to deal with than the family-business owner. The business may be the most valuable asset in the owner’s estate. Yet, two out of three family-owned businesses don’t survive the first generation. If you are a business owner, you should address the following concerns as you plan your estate:

Who will take over the business when you die? Owners often fail to develop a management succession plan. It is vital to the survival of the business that successor management, in the family or otherwise, be ready to take over the reins.

Who should inherit your business? Splitting this asset equally among your children may not be a good idea. For those active in the business, inheriting the stock may be critical to their future motivation. To those not involved in the business, the stock may not seem as valuable. Perhaps your entire family feels entitled to equal shares in the business. Resolve this issue now to avoid discord and possible disaster later.

How will the IRS value your company? Because family-owned businesses are not publicly traded, knowing the exact value of the business is difficult without a professional valuation. The value placed on the business for estate tax purposes is often determined only after a long battle with the IRS. Plan ahead and ensure your estate has enough liquidity to pay estate taxes and support your heirs.

Take advantage of special estate tax breaks

Current tax law has provided two types of tax relief specifically for business owners.

Section 303 redemptions. Your company can buy back stock from your estate without the risk of the distribution being treated as a dividend for income tax purposes. Such a distribution must, in general, not exceed the estate taxes and funeral and administration expenses of the estate. One caveat: The value of your family-owned business must exceed 35% of the value of your adjusted gross estate. If the redemption qualifies under Section 303, this is an excellent way to pay estate taxes.

Planning tip 7

Protect Your Interests With A Buy-Sell Agreement

A buy-sell agreement offers three key benefits:

  1. It provides a ready market for the shares in the event the owner’s estate wants to sell the stock after the owner’s death.
  2. It sets a price for the shares. In the right circumstances, it also fixes the value for estate tax purposes.
  3. It provides for stable business continuity by avoiding unnecessary disagreements caused by unwanted new shareholders.

Estate tax deferral. Normally, estate taxes are due within nine months of your death. But if closely held business interests exceed 35% of your adjusted gross estate, the estate may qualify for a deferral of tax payments. No payment other than interest is due until five years after the normal due date for taxes owed on the value of the business. The tax related to the closely held business interest then can be paid over as many as 10 equal annual installments. Thus, a portion of your tax can be deferred for as long as 14 years from the original due date. Interest will be charged on the deferred payments. (See Case study V.)

Ensure a smooth transition with a buy-sell agreement

A powerful tool to help you control your — and your business’s — destiny is the buy-sell agreement. This is a contractual agreement between shareholders and their corporation or between a shareholder and the other shareholders of the corporation. (Partners and limited liability company members also can enter into buy-sell agreements.)

The agreement controls what happens to the company stock after a triggering event, such as the death of a shareholder. For example, the agreement might provide that, at the death of a shareholder, the stock is bought back by the corporation or that the other shareholders buy the decedent’s stock.

A well-drafted buy-sell agreement can solve several estate planning problems for the owner of a closely held business and can help ensure the survival of the business. (See Planning tip 7.)

Remove future appreciation by giving stock

One way to reduce estate taxes is to limit the amount of appreciation in your estate. We talked earlier about giving away assets today so that the future appreciation on those assets will be outside of your taxable estate. There may be no better gift than your company stock — this could be the most rapidly appreciating asset you own.

Case Study V
Sometimes Putting Off Until Tomorrow Makes Sense
Lee owned a small manufacturing company that accounted for 50% of his estate. When he died in October 2007, his estate’s total estate tax liability was $1 million. Half of the liability was due at the normal due date of his estate’s tax return in July 2008 (nine months after Lee’s death). The other $500,000 of liability could be paid in 10 installments, starting in July 2013 (five years and nine months after Lee’s death) and ending in July 2022. Lee’s estate would also have to pay interest on the unpaid liability each year, but at special low rates.

For example, assume your business is worth $500,000 today, but is likely to be worth $1 million in three years. By giving away the stock today, you will keep the future appreciation of $500,000 out of your taxable estate.

Gifting family business stock can be a very effective estate tax saving strategy. But beware of some of the problems involved. The gift’s value determines both the gift and estate tax ramifications. The IRS may challenge the value you place on the gift and try to increase it substantially. Seek professional assistance before attempting to transfer portions of your business to family members.

Finally, the IRS is required to make any challenges to a gift tax return within the normal three-year statute of limitations, even though no tax is payable with the return, but only if certain disclosures are made.

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Special Strategies for Special Situations

Standard estate planning strategies don’t fit every situation. Single people, unmarried couples, noncitizen spouses, individuals planning a subsequent marriage and grandparents are among those who might benefit from less common techniques. In this section, we look at several special situations and estate planning ideas that may apply to them.



For single people, the scheduled repeal of the estate tax is especially helpful because it eliminates (at least temporarily) the disadvantage of not having the unlimited marital deduction, which allows a spouse to leave assets to a surviving spouse’s estate tax free. But a will or a living trust can ensure that your loved ones receive your legacy in the manner you desire. In addition, with the use of trusts, you can provide financial management assistance to your heirs who aren't prepared for this responsibility.

Subsequent marriages

Estate planning for subsequent marriages can be complicated, especially when children from a prior marriage are involved. Finding the right planning technique for your situation can not only ease family tensions but also help you pass more assets to the children at a lower tax cost.

A QTIP marital trust can maximize estate tax deferral while benefiting the surviving spouse for his or her lifetime and the children after the spouse’s death. Combining a QTIP with life insurance benefiting the children or creatively using joint gifts or GST tax exemptions can further leverage your gifting ability. (See “QTIP Trusts” for more on QTIP trusts.)

A prenuptial agreement can also help you achieve your estate planning goals. But any of these strategies must be tailored to your particular situation, and the help of qualified financial, tax and legal advisors is essential.

Unmarried couples

Because unmarried couples are not granted rights automatically by law, they need to create a legal relationship with a domestic partnership agreement. Such a contract can solidify the couple’s handling of estate planning issues.

In addition, they don't have the benefit of the marital deduction. There are solutions, however. One partner can reduce his or her estate and ultimate tax burden through a traditional annual gifting program or by creating an irrevocable life insurance trust or a charitable remainder trust benefiting the other partner. Again, these strategies are complex and require the advice of financial, tax and legal professionals.

Noncitizen spouses

The marital deduction differs for a non-U.S. citizen surviving spouse. The government is concerned that, on your death, your spouse could take the marital bequest tax free and then leave U.S. jurisdiction without the property ever being taxed.

Thus, the marital deduction is allowed only if the assets are transferred to a qualified domestic trust (QDOT) that meets special requirements. The impact of the marital deduction is dramatically different because any principal distributions from a QDOT to the noncitizen spouse and assets remaining in the QDOT at his or her death will be taxed as if they were in the citizen spouse’s estate. Also note that the gift tax marital deduction (for noncitizen spouses) is limited to a set amount annually.


You may be one of the lucky ones who aren't only personally financially well of, but whose children are also financially set for life. The downside of this is that they also face the prospect of high taxes on their estates. You may also want to ensure that future generations of your heirs benefit from your prosperity. To reduce taxes and maximize your gifting abilities, consider skipping a generation with some of your bequests and gifts.

But your use of this strategy is limited. The law assesses a GST tax equal to the top estate tax rate (see Chart 1) on transfers to a “skip person,” over and above the gift or estate tax. Keep in mind that this tax is being repealed along with the estate tax in 2010. A skip person is anyone more than one generation below you, such as a grandchild or an unrelated person more than 37 1/2 years younger than you.

Fortunately, there is a GST tax exemption, which in 2008 equals the estate tax exemption of $2 million. (Also see Chart 1.) Each spouse has this exemption, so a married couple can use double the exemption. If you exceed the limit, an extra tax equal to the top estate tax rate is applied to the transfer — over and above the normal gift or estate tax.

Case Study VI
Skipping Out On Estate Taxes
Saul and Eleanor have accumulated a sizable estate, as has each of their children. Because their children are financially secure, Saul and Eleanor have structured their wills so that the full generation-skipping transfer (GST) tax exemption amount from each of their estates goes to their grandchildren after both of their deaths. By doing this, they are each able to take advantage of their generation-skipping transfer tax exemption. Although their estates must pay estate taxes, they avoid having their assets taxed again in their children’s estates. They can also pass the future appreciation on those assets to their grandchildren tax-free.

Outright gifts to skip persons that qualify for the annual exclusion are also exempt from the GST tax. A gift or bequest to a grandchild whose parent has died before the transfer is not treated as a GST.

Taking advantage of the GST tax exemption can keep more of your assets in the family. By skipping your children, the family may save substantial estate taxes on assets up to double the exemption amount (if you are married), plus the future income and appreciation on the assets transferred. (See Case study VI.) Even greater savings can accumulate if you use the exemption during your life in the form of gifts.

If maximizing tax savings is your goal, consider a “dynasty trust.” The trust is an extension of the GST concept. Rather than the assets being included in the grandchildren’s taxable estates, the dynasty trust allows assets to skip several generations of taxation. This is available only in jurisdictions that have abolished the “rule against perpetuities.” Talk with your tax advisor for more information on how this may affect your estate plan.

Simply put, you create the trust either during your lifetime by making gifts or at death in the form of bequests. The trust remains in existence from generation to generation. Because the heirs have restrictions on their access to the trust funds, the trust is sheltered from estate taxes. If any of the heirs have a real need for funds, the trust can make distributions to them.

Community Property Issues

Planning tip 8

Determine Your Domicile

There is no one definition or single set of rules establishing domicile. Because you can have a residence in, and thereby be a resident of, more than one state, domicile is more than just where you live. Domicile is a principal, true and permanent home to which you always intend to return, even if you are temporarily located elsewhere.

Ten states have community property systems: Alaska (elective), Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington and Wisconsin. Under a community property system, your total estate consists of your 50% share of community property and 100% of your separate property. What’s the difference?

Community property usually includes assets you and your spouse acquire under two conditions: 1) during your marriage, and 2) while domiciled in a community property state. (See Planning tip 8.) Each spouse is deemed to own a one-half interest in the community property, regardless of who acquired it. For example, wages and other forms of earned income are treated as community property, even if earned by only one spouse.

Separate property usually includes property you and your spouse owned separately before marriage and property you each acquire during marriage as a gift or inheritance that you keep separate. In some states, income from separate property may be considered community property.

In most community property states, spouses may enter into agreements between themselves to convert separate property into community property or vice versa. This can be an important part of your estate plan.

Remember, marital rights are expanded

Community property and marital rightsCommunity property states start out with greater protection for the surviving spouse because he or she is deemed to own 50% of any community property interest. But some states go much further, and the laws can be complex. For example, rules may vary depending on how many children you have and how much the surviving spouse owns in relation to the decedent.

In some cases, the surviving spouse is entitled to full ownership of property. In other situations, he or she is entitled to the income or enjoyment from the property for a set period of time. Seek professional advice in your state, especially if your goal is to limit your surviving spouse’s access to your assets.

Plan carefully when using a living trust

If a living trust isn't carefully drafted, the property may lose its community property character, resulting in adverse income, gift and estate tax consequences. For example, improper language can create an unintended gift from one spouse to the other. To avoid any problems, the living trust should provide that:

  • Property in the trust and withdrawn from it retains its character as community property,
  • You and your spouse each retain aright to amend, alter or revoke the trust, and
  • After the death of one spouse, the surviving spouse retains control of his or her community interest.

(For more on living trusts, see “Will or Living Trust?”)

Reap the basis benefit

Community property owners receive a double step-up in basis benefit.

Assets are usually valued in your estate at their date-of-death fair market values. (Sometimes assets are valued six months after death, but only if the estate has dropped in value since the date of death.) For example, stock you purchased for $50,000 that is worth $200,000 at the time of your death would be valued in your estate at $200,000.

The good news is that your assets receive a new federal income tax basis equal to the value used for estate tax purposes. (In 2010, with the estate tax repeal, the step-up in basis will be limited. But the laws are complex, so consult a professional advisor on how this change will affect your estate plan.) In our example, your heirs could sell the stock for $200,000 and have no gain for income tax purposes. Their income tax basis would be $200,000 instead of your $50,000.

Assets receive a federal income tax basis step-upCommunity property owners receive a double step-up in basis benefit. If the $200,000 of stock in the previous example were community property, only one-half of the stock ($100,000) would be included in the estate of the first spouse to die. But, the income tax basis of all of the stock rises. Therefore, the surviving spouse could sell his or her 50% share of the stock at no gain, as well as the decedent’s 50% share.

Sometimes the basis rule works against you. If property is valued in your estate at less than the cost to you, the heirs still receive an income tax basis equal to the date-of-death value. If you had purchased stock for $75,000 that was valued in your estate at $50,000, your heirs would receive a basis of $50,000. If the heirs later sold the stock for $100,000, they would have to realize a gain of $50,000 ($100,000 — $50,000) rather than a gain of $25,000 ($100,000 — $75,000).

Watch out for unwanted tax consequences with ILITs

Several community property state issues must be taken into account to avoid unwanted tax consequences when an ILIT owns a life insurance policy. These typically relate to who owns the policy before it is transferred to the trust, whether the future premiums are gifted out of community property or separate property.

For example, if you give an existing policy that was community property to an ILIT and the uninsured spouse is a beneficiary of the trust, the estate of the surviving uninsured spouse could be taxed on 50% or more of the trust. However, proper titling of the policy, effective gift agreements between spouses and proper payment of premiums can avoid this problem. Be sure to get professional advice on these arrangements.

(See above for more on ILITs.)

Distinguish between separate and community property for FLPs

For community property state residents, it is important to state in the FLP agreement whether the FLP interest is separate or community property. In addition you should consult your attorney to determine if a partner’s income from an FLP is community property or separate property.

(See above for more on FLPs.)

Get spousal consent before making charitable gifts

Under the community property laws in many states, a valid contribution of community property cannot be made to a charity by one spouse without the consent of the other spouse. Consent should be obtained before the close of the tax year for which the tax deduction will be claimed.

(See above for more on charitable contributions.)

Enjoy easier generation-skipping transfers

Community property can be the perfect vehicle for generation-skipping transfers. In 2008, a married couple with $4 million of community property would qualify for effective use of this strategy without needing to transfer any assets to each other.

(See above for more on generation-skipping transfers.)

Weigh your property treatment options

You don’t always have to follow the property system of your state of domicile or the state in which you buy real estate. For example, if you live in a community property state and want to avoid having to obtain your spouse’s consent to sell or make gifts of community property, you may elect out of community property treatment. But you also can retain community property treatment if you move from a community property state to a separate property state.

To do this, consider establishing a joint trust to hold the community property when you move to the new state or simply prepare an agreement outlining the status of the assets as community property. But you must ensure the community property assets remain segregated. If they become intermingled with separate property assets, you could lose the community property status.

Another option is to leave assets in a custody account governed by the laws of the community property state. It may be possible to retain the community property nature of the assets by simply segregating them from other assets on arriving in the new state. But make sure the estate planning documents that dispose of the segregated assets should provide for the disposition of only one-half of the assets at the death of each spouse.

Be sure to execute similar strategies if you have separate property that you wish to remain separate when you move to a community property state. Again, to retain its separate property status, it cannot become intermingled with community property. Make a well-thought-out decision about how you would like your property to be treated.

If you aren’t concerned about the limits on community property and are interested in obtaining its tax advantages but don’t reside in a community property state, consider taking advantage of the Alaskan system, which allows nonresidents to convert separate property to community property. Note that implementing such a decision is complex, involves placing property in trust, and requires careful planning and coordination with your advisor.

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