Estate Planning
The importance of identifying objectives
Good estate planning basically involves achieving estate planning goals in the most efficient way while seeking to minimize taxes and other costs.
The primary emphasis is properly on the individual’s objectives. Sometimes, however, the objectives (including charitable goals) are not clearly framed. A good professional advisor can help bring those objectives into clear focus.
The tax laws, of course, sometimes tend to shape the estate plan. Due to major tax legislation enacted in 2001, estate plans may need to be examined in light of the fact that many more persons are no longer subject to the same level of gift and estate taxes as in past years. Careful planning can help reduce or eliminate any estate and gift taxes that may still be due.
When it comes to charitable gifts and bequests, there is a broad range of options afforded by the tax law. These often include one or more very attractive ways to achieve important non-charitable objectives, such as providing for one’s spouse, children, or other special person, while achieving substantial tax savings.
In any event, for many persons estate plans cannot be called complete unless charitable giving wishes have been considered.
Tax planning note
As noted above, in 2001 Congress enacted legislation that brings substantial changes to gift and estate tax law. Many provisions of the 2001 Tax Act are phased in over a multi-year period that began in 2002. Check for latest provisions before finalizing plans, because tax law changes are likely to occur in 2009 or 2010.
Federal gift and estate tax considerations
One of the most important aspects of the Economic Growth and Tax Relief Reconciliation Act of 2001 has been the provision for gradual relief from the federal estate tax.
The amounts exempt from estate tax each year steadily increase through 2010, when the estate tax will be repealed. The top estate tax rate was reduced from 55% to 50% in 2002 and is being further reduced over time. Many expect Congress to take steps that will further modify estate and gift tax laws in coming years.
Note the phase-in schedule put in place by the 2001 Tax Act:
Because of the terms of the 2001 Tax Act, many Americans have seen their estate tax liability eliminated due to the increases over time in the threshold amount beyond which the tax applies.
It continues to be possible to transfer unlimited amounts to a spouse during one’s lifetime and at death, so with proper planning it will continue to be unnecessary for married couples to pay estate tax at the death of the first spouse.
As in the past, unlimited amounts can still be left for charitable purposes free of estate and gift taxes.
Gift tax retained
Even after 2010, the 2001 Tax Act retains the gift tax for lifetime transfers. Beginning in 2002, as in the case of the estate tax, the exemption for lifetime gifts was raised to $1 million. Unlike the estate tax, however, the amount exempt from gift tax is not scheduled to increase above that amount.
Amounts given to others beyond the amounts shown below will be subject to tax at the same rate as estate tax rates until 2010, when the maximum gift tax rate will be the same as the highest individual income tax rate, scheduled under the terms of the law to be 35% at that time.
Congress is thus phasing out the tax due on assets passed at death, but has retained the transfer tax on certain amounts given to others during one’s lifetime.
Elimination of “stepped-up basis”
Beginning in 2010, property inherited by heirs beyond exempted amounts will be subject to capital gain taxes when it is sold, as there will no longer be a “step-up” in basis for property inherited from others, as is the case under current law.
As a result of the 2001 tax law, the process of estate planning will assume new dimensions; many will want to make significant revisions in their plans. It should be noted that the 2001 tax legislation includes a “sunset” provision that will repeal all changes brought about by the 2001 Tax Act unless Congress acts before the end of 2010 to continue the tax cuts. Many people will want to take into account the possibility that federal estate taxes may again be imposed at a future date or that various states may choose to change their estate tax laws.
Because of uncertainty regarding future laws and other factors, planning tools that help transfer assets tax-effectively to loved ones and charitable interests during lifetime rather than at death may assume even greater importance than in the past.
Annual gift exclusion: In addition to the amounts shown in the previous charts, an individual can give up to a certain amount each year to as many other persons as he or she wishes without having to pay tax on the gifts (IRS section 2503(b)). For many years, the annual gift exclusion amount was $10,000. Since 1999, however, it has been indexed for inflation, and since 2006 the amount has been $12,000. Check for the current amount before completing gifts.
The annual gift exclusion, however, is available only with respect to gifts of “present interests.”
Gift-splitting: Gift-splitting by spouses permits a gift made by one spouse to be treated as having been made one-half by each spouse (IRC section 2513). Gift-splitting allows the annual exclusion to be effectively doubled. It also “shifts” half of any taxable portion of the gift to the non-donor spouse for purposes of the unified gift and estate tax credit.
Gift-splitting can be accomplished only by filing a timely federal gift tax return (Form 709) and signifying consent to gift-splitting on the return (IRC section 2513(b)). An election to split gifts applies to all gifts made during the calendar year by the spouses (IRC section 2513(a)(2)).
Charitable gifts and bequests: In general, any amount can be given to a qualified charity during life or at death, free of federal gift and estate taxes, because of the unlimited gift and estate tax charitable deductions (IRC sections 2055 and 2522).
In the case of an outright donation in excess of the annual exclusion amount, the first portion of the gift qualifies for the annual gift exclusion under IRC section 2503(b); the balance of the gift qualifies for the gift tax charitable deduction.
Combined charitable and marital deduction planning techniques: Federal estate tax law allows an unlimited marital deduction for qualified transfers to one’s surviving spouse (IRC section 2056). Combining the benefits of the unlimited marital deduction with the benefits of the unlimited charitable deduction can be especially advantageous.
Example #1: Mrs. Taylor wishes to leave $25,000 by will to a charitable organization. Rather than leaving the bequest directly to the charity, she includes the $25,000 in the amount she leaves to her husband (tax free under the marital deduction).
Mr. Taylor then voluntarily gives the $25,000 to the organization—saving personal income taxes. This plan can work well when both spouses share the same charitable objectives because it provides both estate and income tax savings.
Example #2: Mr. Smith wants to establish a trust under his will to provide an income to his wife for her life. He and his wife agree that the remainder interest in the trust should go to a favorite charitable organization.
Mr. Smith’s will can establish, for example, either a “QTIP” trust with a charitable remainder (IRC section 2056(b)(7)) or a qualified charitable remainder annuity trust or unitrust, as defined in IRC section 664.
In either case, assuming all applicable requirements are met, the assets left to the trust will be fully shielded from estate tax at both Mr. and Mrs. Smith’s deaths because of the unlimited marital and charitable deductions.
In the preceding example, the “QTIP” trust would allow for considerable flexibility, in that Mrs. Smith would receive all trust income for life and could be given the right to receive trust principal under whatever terms and conditions Mr. Smith wished to provide.
Charitable remainder trusts: The charitable remainder annuity trust or unitrust, on the other hand, would provide Mrs. Smith with either (1) a fixed annuity type of payout or (2) a payout equal to a fixed percentage (e.g., 6% or 7%) of the annually determined asset value of the trust. Apart from the annual payout, Mrs. Smith could not receive any amounts of trust income or principal.
Applicable law provides for a minimum payment percentage of 5%, a maximum payout rate of 50%, and a 10% minimum charitable remainder amount for charitable remainder trusts. Particular care should be given to drafting provisions of testamentary charitable remainder trusts.
Generation skipping transfer (GST) tax: The GST tax can play a major role in overall estate planning, as well as in charitable gift planning.
For example, if a grandparent establishes a charitable remainder unitrust under his or her will that is to make a payout to the grandchildren for a term of 20 years, the payments received by the grandchildren will be “taxable distributions” for GST tax purposes (as defined in IRC section 2612). If GST tax is in fact imposed on the payments, the grandchildren (or their guardians) will be responsible for paying the tax (IRC section 2603(a)(1)).
The grandparent, however, can eliminate any GST tax on the payments by allocating a sufficient amount of the GST tax exemption (IRC section 2631) to the unitrust. This $1 million exemption amount was indexed for inflation, rounded down to the nearest $10,000, or $1,100,000 in 2002, and is scheduled to increase in size with the estate tax exemption over time ($2 million in 2008, and $3.5 million in 2009).
The amount of the exemption required to be allocated is equal to the amount of assets left to the unitrust minus the estate tax charitable deduction allowed with respect to the trust (IRC section 2642(a)). As in the case of other estate taxes, the GST tax is scheduled to be repealed in 2010 subject to the sunset provisions of the law.
Charitable lead trusts: A charitable lead trust is a trust that makes an annuity or unitrust payout to a qualified charitable organization for a specified term of years (or for a life or lives) and then distributes its assets, usually to the donor’s children or
grandchildren (see IRC sections 2055(e)(2)(B), 2522(c)(2)(B)).
The initial present value of the charitable payout qualifies for the gift or estate tax charitable deduction, as the case may be. The taxable transfer to the heirs, therefore, is equal to the difference between the amount given to the trust and this present value.
For a person who has a large estate—especially an unmarried individual who cannot take advantage of the marital deduction—the lead trust is often an option well worth considering from gift and estate tax standpoints. The lead trust may offer welcome opportunities to reduce or eliminate estate and gift taxes that may still apply in the wake of the 2001 tax law changes.
One caution: In the case of a charitable lead annuity trust that distributes its assets to the donor’s grandchildren or other “skip persons,” special GST tax rules apply. For details, see IRC section 2642(e).
Power of attorney: In some cases, a donor has established a plan of regularly making charitable gifts. If asked, the donor might well reply that he or she would like the plan to continue in the event he or she becomes incapacitated.
If this is the person’s wish, assuming he or she creates a durable general power of attorney, an express provision should be included in the power directing the attorney-in-fact as to the making of contributions out of the donor’s assets.
Contributions made pursuant to such a provision will be deemed to be made by the donor.
Conclusion: There are, of course, many more “technical” considerations to estate and gift planning than those covered in this technical advisory section.
If we may answer questions you have concerning the tax or design aspects of a charitable gift or bequest, please feel free to call or write in confidence without any obligation.
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