The five levels of estate planning is a systematic approach for explaining estate planning to your wealthy clients in a way that they can easily follow. Which of the five levels they’ll need will depend on their particular objectives and circumstances.
Level one: the basic plan
The situation for level one planning is that the clients have no wills or trusts in place, or their existing wills or trusts are outdated or inadequate. The clients’ objectives for this type of planning are to:
- reduce or eliminate estate taxes
- avoid probate
- protect their heirs from their inability, disability, creditors and predators
To accomplish these objectives, use pour-over wills, revocable living trusts that allocate the decedent’s estate between a credit shelter trust and a marital trust, general powers of attorney and durable powers of attorney for health care and living wills.
Level two: the irrevocable life insurance trust (ILIT)
The situation for level two planning is that the client’s estate is projected to be greater than the $2 million estate-tax exemption for 2006 through 2008 ($4 million for a married couple). In this case, the client can make cash gifts to an ILIT using his $12,000/$24,000 annual gift-tax exclusion.
Level three: family
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. If the client’s $1 million gift-tax exemption is used to make lifetime gifts, the gifted property and all future appreciation and income on that property are removed from the donor’s estate.
Many clients would be more willing to make gifts to their children if they could continue to manage the gifted property. A family limited partnership or a family limited liability company can play a valuable role in this situation. The donor is typically the general partner or manager and in that capacity, continues to manage the FLP or FLLC’s assets. The donor can even take a reasonable management fee for his services as the general partner or manager. Moreover, by gifting FLP or FLLC interests to an ILIT, the FLP or FLLC’s income can be used to pay premiums, thereby freeing up the clients’ $12,000/$24,000 annual gift-tax exclusion for other types of gifts.
Level four: QPRTs and GRATs
The situation for level four planning is the additional need to reduce the client’s estate after his $1 million/$2 million gift-tax exemption has been used. Although paying gift taxes is less expensive than paying estate taxes, most clients will not want to pay gift taxes. There are several techniques to make substantial gifts to children and grandchildren without paying significant gift taxes.
One technique is a qualified personal residence trust. 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. 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) are entirely removed from the grantor’s estate.
Another technique is a grantor retained annuity. A GRAT is similar to a QPRT. The typical GRAT is funded with income-producing property such as subchapter S stock or FLP or FLLC 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 to zero. However, if the grantor does not survive the stated term, the property is included in the grantor’s estate. Therefore, it is recommended that an ILIT be funded as a “hedge” against the grantor’s death prior to the end of the stated term.
Level five: the zero estate-tax plan
Level five planning is a desire to disinherit the IRS. The strategy combines gifts of life insurance with gifts to charity. Let’s take a married couple, both age 55, with a $20 million estate. Assume that there is neither growth nor depletion of the assets and that both spouses die in a year when the estate-tax exemption is $3.5 million, and the top estate-tax rate is 45 percent.
With the typical marital credit shelter trust, when the first spouse dies, $3.5 million is allocated to the credit shelter trust and $16.5 million to the marital trust. No federal estate tax is due. However, at the surviving spouse’s death, the estate tax due is $5.85 million. The net result is that the children inherit only $14.15 million.
Many clients would be more willing to make gifts to their children if they could continue to manage the gifted property.
With the zero estate-tax plan, the couple gifts $2 million during their lifetime (using their annual gift-tax exclusions) to an ILIT (with generation-skipping provisions) funded with a $13 million second-to-die life insurance policy. These gifts reduce the estate value to $18 million. In addition, the couple’s living trusts each leave $3.5 million (the amount exempt from estate taxes) to their children upon the surviving spouse’s death. Also, the balance of their estate ($11 million) passes to a public charity or private foundation—estate-tax free. To summarize, the zero estate-tax plan delivers $20 million (i.e., $13 million from the ILIT and $7 million from the living trusts) to the children instead of $14.15 million; the charity receives $11 million instead of nothing and the IRS receives nothing, instead of $5.85 million.
To the extent this article contains tax matters, it is not intended or written to be used and cannot be used by a taxpayer for the purpose of avoiding penalties that may be imposed on the taxpayer, according to Circular 230.
Julius H. Giarmarco, J.D., LL.M., is an estate-planning attorney with the law firm of Cox, Hodgman & Giarmarco, P.C., in Troy, Mich. His email address is firstname.lastname@example.org.