UPDATED: Jul 3, 2020
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The Five Levels of Estate Planning
By Julius H. Giarmarco
As an estate planning attorney, I’m often confronted with the challenge of explaining to wealthy clients the various estate planning strategies available to them. Many people are prone to inaction when it comes to estate planning because the number of planning alternatives their advisers present to them is so overwhelming.
In explaining these alternatives, I believe firmly that it’s not what you say but how you say it. If clients have a general understanding of their estate planning options, they’re much more likely to implement a comprehensive and sophisticated estate plan.
“Five Levels of Estate Planning” is a brochure I developed to explain estate planning to wealthy clients in a way they can easily follow. Which of the five levels they’ll need to complete will depend upon their particular objectives, facts and circumstances.
Each level begins with the situation that defines that particular level. Then I enumerate the objectives to be accomplished at that level. Next, I list the tools and techniques to accomplish those objectives. Finally, I describe the disadvantages, if any, to those tools and techniques.
The basic premise behind “The Five Levels of Estate Planning” is that the only way to reduce estate taxes is to make gifts. Except for outright gifts, there are basically only three types of gifts a client can make.
First, there are cash gifts to irrevocable life insurance trusts. Life insurance is an ideal gift because it leverages the client’s $10,000/$20,000 annual gift tax exclusion, $600,000/$1.2 million estate/gift tax exemption, and $1 million/$2 million generation-skipping tax exemption.
Second, there are gifts that shift or reduce value. The family limited partnership, grantor retained annuity trust and qualified personal residence trust can all be used to take advantage of fractional and split interest discounts.
Third, there are gifts to charity, including gifts to private foundations. Charitable gifts are 100 percent estate and gift tax deductible and, if made during a lifetime, qualify for income tax deductions (subject to certain limitations).
Level One: The Basic Plan
The situation for Level One planning is that the clients have no wills or trusts in place, or that their existing wills or trusts are outdated or inadequate. The objectives for Level One planning are:
To take advantage of the unlimited marital deduction and both spouses’ $600,000 exemptions; To avoid the costs, delays and publicity of probate; To make certain that what they have goes to whom they want, when they want and how they want; and To protect the heirs from their inability, their disability, their creditors and their predators. The tools and techniques to accomplish these objectives are pour-over wills, revocable living trusts that allocate the Unified Credit to a Bypass Trust and the balance of the trust property to a Marital Trust (i.e., the so-called A-B Trust), general powers of attorney, durable powers of attorney for health care and living wills. Since all of these documents can be amended or revoked, there really is no disadvantage to doing Level One planning.
Level Two: The Irrevocable Life Insurance Trust
The situation for Level Two planning is that the client’s estate is projected to be over the $600,000 exemption equivalent ($1.2 million for a married couple). Based on figures recently released by the U.S. government, less than 1.5 percent of all Americans qualify for Level Two planning. Needless to say, it’s that same 1.5 percent that estate planning lawyers and insurance professionals seek as clients.
The strategy for Level Two planning is for the client to use his or her $10,000/$20,000 annual gift tax exclusion to make cash gifts to an irrevocable life insurance trust. The trust will include Crummey withdrawal powers so that gifts to the trust will qualify for the $10,000/$20,000 annual gift tax exclusion.
Moreover, by allocating a portion of the client’s $1 million/$2 million generation-skipping tax exemption to those gifts, the trust can provide benefits to children, grandchildren and perhaps even great-grandchildren for periods of 90 years or longer without estate taxes. These trusts are sometimes referred to as “dynasty trusts.”
I explain to my clients that using an irrevocable life insurance trust is the ultimate gifting strategy because:
Nothing will grow more on the date of their death than their life insurance policies; Gifts to an irrevocable life insurance trust can easily be funded with the grantor’s $10,000/$20,000 annual gift tax exclusion; and the insurance proceeds can eventually be used to pay the grantor’s estate taxes thereby using “discounted” dollars to pay those taxes.
Level Three: Family Limited Partnerships
The situation for Level Three planning is that the client has a projected estate tax liability that exceeds the life insurance purchased in Level Two. I tell my clients that the single biggest mistake many wealthy people make is to wait until death to use their $600,000 exemption. At death, the $600,000 exemption is only worth $600,000. However, if the $600,000 exemption is used to make lifetime gifts, then the gifted property, and all future appreciation on that property, is removed from the donor’s estate.
Most of my clients don’t mind making gifts to their children if they can continue to manage the gifted property. This is where a family limited partnership plays a valuable role. The donor is typically the general partner and in that capacity continues to manage the partnership’s assets (typically real estate, marketable securities or both). The donor can even take a reasonable management fee for his or her services as general partner.
Another benefit the family limited partnership provides is a discount (for lack of control and marketability) when valuing the limited partnership interests gifted to the donor’s heirs. The family limited partnership is also an excellent asset protection tool. Finally, by gifting limited partnership interests to an irrevocable life insurance trust, the partnership’s income can be used to pay premiums, thereby freeing up the grantor’s $10,000/$20,000 annual gift tax exclusion for other gifts.
Level Four: QPRTs and GRATs
The situation for Level Four planning is the further need to reduce the client’s estate after his or her $600,000/$1.2 million exemption has been used. Although the gift tax is less expensive than the estate tax, most of my clients still don’t want to pay gift taxes. Thus, there are basically only two ways left to make substantial gifts without paying significant gift taxes.
One technique is a qualified personal residence trust (QPRT) and the other is a grantor-retained annuity trust (GRAT). A QPRT allows the grantor to transfer a residence or vacation home to a trust for the benefit of children, while retaining the right to use the residence for a term of years (typically between 10 and 20 years).
By retaining the right to occupy the residence, the value of the remainder interest is reduced, along with the taxable gift. If the grantor survives the term, the residence (and the future appreciation thereon) is entirely removed from the grantor’s estate.
A GRAT operates similar to a QPRT. The typical GRAT is funded with income-producing property such as Subchapter S stock or limited partnership interests. The GRAT pays the grantor a fixed annuity for a specified term of years. Because of the retained annuity, the gift to the remaindermen (the grantor’s children) is substantially less than the current value of the property.
Both QPRTs and GRATs can be designed with terms long enough to reduce the value of the remainder interest passing to the children to a nominal amount or even zero. However, if the grantor does not survive the stated term, the property is included in the grantor’s estate. Therefore, I typically recommend an irrevocable life insurance trust as a hedge against the grantor’s death prior to the end of the stated term.
Level Five: The Zero Estate Tax Plan
The situation for Level Five planning is the desire to disinherit the IRS. The Level Five strategy combines gifts of life insurance with gifts to charity. The concept is best understood by way of example. Let’s take a married couple, both age 55, with a $5 million estate. Let’s also assume that there is neither growth nor depletion of the assets.
With the typical A-B Trust, $600,000 is allocated to a family trust and $4.4 million to a marital trust when the first spouse dies. No federal estate tax is due. However, on the surviving spouse’s death, the marital trust is taxed at $1.868 million (after subtracting the surviving spouse’s $192,800 credit). The net result is that the children inherit only $3.132 million.
With the zero estate tax plan, the couple gifts $500,000 ($33,333.33 per year for 15 years) to an irrevocable life insurance trust funded with a $3.8 million second-to-die life insurance policy. In addition, the couple’s living trusts each leave $600,000 to their children upon the death of the surviving spouse. No estate tax is due on those transfers. The balance of their estate (i.e., $4.5 million – $1.2 million = $3.3 million) passes to charity — estate tax free!
To summarize, the zero estate tax plan delivers $5 million (i.e., $3.8 million from the insurance trust and $1.2 million from the living trusts) to the children instead of $3.132 million; charity receives $3.3 million instead of nothing; and the IRS receives nothing instead of $1.868 million! Moreover, the $3.132 million the children receive with A-B Trust planning would be taxed again at their deaths, while the $3.8 million of life insurance in a dynasty trust is not taxed in the estates of the children, grandchildren and perhaps even great-grandchildren. The bottom line is that with the zero estate tax plan, clients can choose children and charity over Congress.
While the zero estate tax plan works with any qualified charity, the charity of choice is the donor’s private foundation. Upon the death of the surviving spouse, the private foundation receives that portion of the estate in excess of the couple’s combined $1.2 million exemption. The foundation carries the donors’ name in perpetuity and is managed by the donors’ descendants.
The private foundation must make minimum disbursements each year to qualified charities. As directors of the foundation, the donors’ descendants will enjoy the self-esteem and public notoriety that comes from benefiting charity, and they can even draw reasonable and customary salaries for carrying out their administrative duties as directors.
Estate planning for the wealthy is complicated. It’s not easy for clients to determine which advanced estate planning tools and techniques to implement. “The Five Levels of Estate Planning” is a framework that attempts to simplify that decision-making process.
Julius H. Giarmarco is a partner in Cox, Hodgman & Giarmarco. He specializes in estate and business planning for owners of closely held businesses, professionals and people with large estates.
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