Editor’s note: This is the second in a series of articles designed to help you “demystify” the estate planning process for your clients.

The first article discussed how the federal gift and estate tax exemption, unlimited marital deduction and annual tax-free gifts can be of benefit to your clients. To read, click here: /news/estate-and-gift-tax-saving-opportunities-24771.html?section=40

 

Financial advisors often find themselves in the position of educating their clients about the need for comprehensive estate planning as well as the many estate-planning opportunities that may be available to them. In this second article, we will discuss additional opportunities that may well be of great benefit to your clients.

Life Insurance

While life insurance proceeds are generally exempt from any income tax, federal estate tax will be incurred if the insured possessed any ownership interest in the policy on his or her life at the time of death. However, if life insurance policies are transferred to an irrevocable life insurance trust or another third party at least three years prior to death, the proceeds of the life insurance policies can completely avoid federal estate tax. 

The reason is that at death, the insured no longer has “incidences of ownership” in the underlying policy and, therefore, the proceeds cannot be included in his or her taxable estate under the Internal Revenue Code. Since the estate tax rate is currently at 40 percent, the tax savings potential of this strategy is quite impressive. Single life policies, either individually owned or employer provided, as well as joint and survivor life insurance policies and split-dollar purchase arrangements can be utilized under this tax-saving method through the use of a properly drafted irrevocable life insurance trust.

Charitable Gifts

Any gift to a qualified charity is fully exempt from gift and estate taxation. Trusts or not-for-profit corporate arrangements can be used and offer advantages over and above a simple charitable deduction. For example, a wholly charitable trust or a private foundation could provide a way for ongoing family participation in significant charitable endeavors even after the death of the individual who established the charitable arrangement. 

Similar objectives can be achieved by establishing a donor-advised fund under the auspices of a community foundation. This methodology can provide an appropriate memorial or legacy for the family and a source of pride for younger generations who can become involved in the management of the charitable endeavor with proper planning.

In addition, special split-interest trusts in which the family and charities have separate interests as beneficiaries can offer unique advantages. For example, under a charitable lead trust, income is paid to charity for a term of years after which the balance of the trust property is distributed to family members or other beneficiaries. A charitable remainder trust is another type of split-interest trust, in which the grantor retains the right to income for his or her lifetime, with assets ultimately passing to a charity or charities of the grantor’s choice. Both techniques allow for charitable deductions for income tax purposes under specific circumstances.

Basis Step-Up

Currently all assets includable in a decedent’s gross estate receive an income tax basis equal to the value of the asset as of date of death. This is important because the capital gains tax is computed on the excess of any sale price over and above the income tax basis.

Because of a “step-up in basis,” substantial capital gains tax can be eliminated when inherited property is sold. This should always be kept in mind before selling appreciated assets during the client’s lifetime, which could result in capital gains tax; or gifting appreciated assets during lifetime, which results in the original tax basis carrying over to the recipient of the gift—who may then have to recognize a capital gain upon the sale of the gifted property.

Further, special treatment is given to community property under the federal income tax laws with regard to a step-up in basis. Community property receives a full basis adjustment of the value of the asset upon the death of the first spouse to die. In contrast, non-community property only receives a basis adjustment upon the death of the spouse who owns the property and jointly held property only receives a 50 percent basis step-up upon the death of the first spouse to die. Community property states include Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington and Wisconsin, as well as Alaska, which is opt-in only.

Federal Generation-Skipping Transfer Tax Exemption

Transfers to future generations using multi-generational trusts or outright gifts can eliminate further estate tax on the estates of these future generations. However, in addition to the federal gift and estate taxes, there is a federal generation-skipping transfer (GST) tax that must be taken into consideration. 

The Internal Revenue Code does allow for a GST tax exemption, currently in the amount of $5.45 million, as adjusted for inflation, but the federal GST tax rate above this exemption is a flat 40 percent. Therefore, planning for the best use of the GST tax exemption often involves the use of lifetime multi-generational trust arrangements that could be funded either by making gifts during a grantor’s lifetime and/or by transfers upon the deaths of the grantor and his or her surviving spouse. When the GST tax exemption is properly utilized, assets can appreciate in value and transfer from generation to generation without the incurrence of any additional transfer taxes through the use of a multi-generational dynasty trust.

The federal GST tax exemption is not portable. A surviving spouse cannot use the GST tax exemption of his or her deceased spouse as one can do for the federal estate tax exemption.

There are many other sophisticated estate-planning techniques that can be quite beneficial under the appropriate circumstances, but the failure to take advantage of the exemptions, exclusions and deductions sanctioned by their inclusion in the Internal Revenue Code are definitely missed opportunities and should not be overlooked. With proper planning, many of these opportunities could be available and easily used to benefit your clients’ families and other beneficiaries for years to come.

Debra Smietanski is a special counsel and estate planning attorney with Foley & Lardner LLP. She focuses her practice on complex estate-planning techniques for high-net-worth individuals, and is board certified by The Florida Bar in Wills, Trusts and Estates. She can be reached at [email protected].