Minimizing estate taxes is a perpetual challenge

Yes, death and taxes are inevitable. But that doesn’t mean they have to go together. By taking advantage of all the exemptions, deductions and estate planning strategies available, you can leave the legacy you desire to your loved ones, not Uncle Sam.

Estate tax

The 2010 Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 retroactively brought back the estate tax for 2010 (along with the unlimited step-up in basis), but, through 2012, provided an exemption increase and a rate reduction compared to 2009. (See the Chart “Transfer tax exemptions and highest rates.”)

The act also temporarily provides exemption “portability” between spouses. (See “What’s New! More flexibility — temporarily — for married couples.”)

GST tax

The generation-skipping transfer tax generally applies to transfers (both during life and at death) made to people two generations or more below you, such as your grandchildren.

The GST tax also had been repealed for 2010, and the 2010 Tax Relief act brought it back with the same exemption amounts as for the estate tax through 2012. However, the act set the GST tax rate for 2010 at 0%.

This is likely because, unlike the estate tax where the elimination of the step-up in basis limitation could be provided to essentially offset liability from the return of the estate tax, there was no such offset that could make up for tax liability due to the return of the GST tax in 2010. Such a retroactive tax would likely have brought lawsuits.

That’s not an issue after 2010, so the GST tax rate goes back up to 35% to match the top estate tax rate in 2011 and 2012. (See the Chart “Transfer tax exemptions and highest rates.”)

Gift tax

Gifts to your spouse are tax-free under the marital deduction (a limit applies to noncitizens), but most other gifts are potentially taxable. The gift tax was never repealed, and it follows the estate tax exemptions and top rates for 2011 and 2012. (See the Chart “Transfer tax exemptions and highest rates.”) Any gift tax exemption used during life reduces the estate tax exemption available at death.

If you can afford to do so without compromising your own financial security, consider using part or all of your gift tax exemption during 2012, in case the high exemption isn’t extended.

But keep in mind that you can exclude certain gifts of up to $13,000 per recipient each year ($26,000 per recipient if your spouse elects to split the gift with you or you’re giving community property) without using up any of your gift tax exemption. So first consider maximizing your annual exclusion gifts.

Tax-smart giving

Giving away assets now will help you reduce the size of your taxable estate.

Here are some additional strategies for tax-smart giving:

Choose gifts wisely. Take into account both estate and income tax consequences and the economic aspects of any gifts you’d like to make:

To minimize estate tax, gift property with the greatest future appreciation potential.

To minimize your beneficiary’s income tax, gift property that hasn’t already appreciated significantly since you’ve owned it.

To minimize your own income tax, don’t gift property that’s declined in value. Instead, sell the property so you can take the tax loss and then gift the sale proceeds.

Plan gifts to grandchildren carefully. Annual exclusion gifts are generally exempt from the GST tax, so they also help you preserve your GST tax exemption for other transfers. For gifts that don’t qualify for the exclusion to be completely tax-free, you generally must apply both your GST tax exemption and your gift tax exemption.

So, for example, if you make an annual exclusion gift to your grandson when the GST tax is in effect and you want to give him an additional $30,000 in the same year to help him make a down payment on his first home, you’ll have to use $30,000 of your GST tax exemption plus $30,000 of your gift tax exemption to avoid any tax on the transfer.

Gift interests in your business. If you own a business, you can leverage your gift tax exclusions and exemption by gifting ownership interests, which may be eligible for valuation discounts. So, for example, if the discounts total 30%, you can gift an ownership interest equal to as much as $18,571 tax-free because the discounted value doesn’t exceed the $13,000 annual exclusion. Warning: The IRS may challenge the value; a professional appraisal is strongly recommended. (For more on transferring interests in your business, see “Succession within the family.”)

Gift FLP interests. Another way to benefit from valuation discounts is to set up a family limited partnership. You fund the FLP and then gift limited partnership interests. Warning: The IRS is scrutinizing FLPs, so be sure to set up and operate yours properly.

Pay tuition and medical expenses. You may pay these expenses for a loved one without the payment being treated as a taxable gift, as long as the payment is made directly to the provider.

Trusts

Trusts can provide significant tax savings while preserving some control over what happens to the transferred assets. Here are some trusts you may want to consider and the estate tax benefits they provide when estate tax is a concern:

Marital trust. This trust is created to benefit the surviving spouse and is often funded with just enough assets to ensure that no estate tax will be due upon the first spouse’s death. The remainder of the estate, which would equal the estate tax exemption amount, is used to fund a credit shelter trust.

Credit shelter trust. Also referred to as a bypass trust, this is funded at the first spouse’s death to take advantage of his or her full estate tax exemption. The trust primarily benefits the children, but the surviving spouse can receive income, and perhaps a portion of principal, during his or her lifetime. (For information on exemption portability and credit shelter trusts, see “What’s New! More flexibility — temporarily — for married couples.”)

QDOT. A qualified domestic trust can allow you and your non-U.S.-citizen spouse to take advantage of the unlimited marital deduction.

QTIP trust. A qualified terminable interest property trust passes trust income to your spouse for life, with the remainder of the trust assets passing as you’ve designated. The trust gives you (not your surviving spouse) control over the final disposition of your property and is often used to protect the interests of children from a previous marriage.

ILIT. An irrevocable life insurance trust owns one or more policies on your life, and it manages and distributes policy proceeds according to your wishes. An ILIT keeps insurance proceeds, which could otherwise be subject to estate tax, out of your estate (and possibly your spouse’s). You aren’t allowed to retain any powers over the policy, such as the right to change the beneficiary. The trust can be designed so that it can make a loan to your estate for liquidity needs, such as paying estate tax.

Crummey trust. This trust allows you to enjoy both the control of a trust that will transfer assets at a later date and the tax savings of an outright gift. ILITs are often structured as Crummey trusts so annual exclusion gifts can fund the ILIT’s payment of insurance premiums.

GRAT and GRUT. Grantor-retained annuity trusts and grantor-retained unitrusts allow you to give assets to your children today — removing them from your taxable estate at a reduced value for gift tax purposes (provided you survive the trust’s term) — while you receive payments from the trust for a specified term. At the end of the term, the principal may pass to the beneficiaries or remain in the trust. In a GRAT, the income you receive is an annuity based on the assets’ value on the date the trust is formed. In a GRUT, the payments are a set percentage of the assets’ value as redetermined each year.

QPRT. A qualified personal residence trust is similar to a GRAT except that, instead of holding assets, the trust holds your home — and, instead of receiving annuity payments, you enjoy the right to live in your home for a set number of years. At the end of the term, your beneficiaries own the home. You may continue to live there if the trustees or owners agree and you pay fair market rent.

Dynasty trust. The dynasty trust allows assets to skip several generations of taxation. You can fund 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 beneficiaries have restrictions on their access to the trust funds, the trust is excluded from their estates. If any of the beneficiaries have a real need for funds, the trust can make distributions to them. If you live in a state that hasn’t abolished the rule against perpetuities, special planning is required. A dynasty trust can help you take full advantage of the currently high GST tax exemption if you can afford to fund the trust before 2013.

Life insurance

Life insurance can replace income, offer a way to equalize assets among children active and inactive in a family business, provide cash to pay estate tax or be a vehicle for passing leveraged funds free of estate tax.

Life insurance proceeds generally aren’t subject to income tax. But, if you own the policy, the proceeds will be included in your estate:

Ownership is determined by several factors, including who has the right to name the beneficiaries of the proceeds. Generally, to reap maximum tax benefits you must sacrifice some control and flexibility as well as some ease and cost of administration.

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 ILIT.

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. •

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