Tuesday April 23, 2024
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1.3.7 Zero Estate Tax Planning
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Zero Estate Tax Planning
Because Congress has repealed the estate tax, the question is – would you like to repeal your personal estate tax? The good news is that the increased exemption allows many persons to repeal the estate tax now.
Goals for Children
There is a two-step process in completing a successful zero estate tax plan. First, parents need to set goals for the inheritance to children. An inheritance plan is more effective if parents seek to reach the goal of enabling each child to be a better person. When there is to be a substantial inheritance, it makes sense to "diversify" the inheritance. This is similar to diversifying your investments.
Historically, when an inheritance has been transferred to a child in one large sum, the child's success in management and investment of that inheritance has not been good. One knowledgeable estate tax attorney who has assisted many individuals with very large estates conducted a brief survey of his clients. He found that the average time between a child receiving a large lump sum and making a significant expenditure of assets was 18 days.
Thus, the zero estate tax plan is best implemented if the parents plan to make transfers to children over a period of years. The distributions in large estates frequently come in four segments or layers. These are as follows:
- Gifts during life using gift exclusions, the applicable exclusion amount and leveraged transfer methods.
- Principal to the children after both mother and father have passed away.
- Income for a period of years.
- Deferred principal.
The zero estate tax plan begins with an overall objective for total distribution amounts per child. Even in large estates, this objective is often a cumulative gift to each child of perhaps $1 million or $2 million. These amounts can be transferred relatively easily with no gift or estate tax.
Zero Estate Tax Methods
Normally, the parents' objectives are to minimize capital gain and income tax during life and then to enable a transfer to children over a period of years. A transfer plan typically involves a combination of a two-life unitrust during life to allow for the tax-free sale of assets, an irrevocable insurance trust and one or more testamentary lead trusts. The parents use additional income from the unitrust during life to invest in equities or other fixed assets. Layer-one gifts to children may come from investment of this unitrust income. Some portion of the investments may then be given to the children during life.
Layers two, three and four are funded by the second estate with a combination of insurance trusts, testamentary unitrusts and testamentary lead trusts. After both parents pass away, the second-to-die insurance policy matures in the irrevocable insurance trust. This liquidity is then available for family members. Finally, a two-, three- or four-layer testamentary lead trust is funded. The lead trust moves principal through to children at stated intervals. For example, a four-layer lead trust could move assets to children after three, six, nine or 12 years.
If there is a desire to obtain greater leverage with the lead trust, then the lead trust could be combined with a family limited partnership (FLP) or limited liability company (LLC). The FLP or LLC assets can be transferred into the testamentary lead trust. After the term of years, the FLP or LLC units or shares are transferred to the children. These methods may be used to transfer substantial estates to children with zero estate tax.
The attractiveness of the zero estate tax plan is that it works regardless of actions taken by a future Congress. The zero estate tax plan will be effective should the parents pass away in the next several years. If the parents live, the parents can update the plan after the next tax act is passed to take advantage of provisions that exist in that act. Regardless of the actions of Congress, it now is possible for parents to rest soundly at night, knowing that they have a zero estate tax plan in place.
Zero Estate Tax Plans with IRAs/Pension Plans
IRAs are among the most rapidly growing assets in many estates. According to Federal Reserve information, there is approximately $3 trillion in IRAs and perhaps $12 trillion plus in total IRA, defined contribution, defined benefit and other types of pension plans.
For many professionals and employees of non-profit organizations, the IRA is often the largest asset in their estate. Some individuals now have 70%-80% of their estates in their IRA or pension plans. While pension plans and defined contribution plans are growing significantly in value, most persons who have the opportunity at retirement or at age 70½ to roll the assets over into a self-directed IRA are choosing to do so. Thus, while the aggregate assets are greater in other plans, the likelihood is high that most of the trillions of dollars in qualified plans will eventually flow into rollover IRAs.
Potential Double Tax on IRAs
In the past, a person who possessed a very large IRA faced a punishing double tax. If the estate exceeds the exemption amount, the IRA could be subject to estate tax. While counsel for these persons were commonly advising the person to take the estate tax out of the non-IRA assets and thus avoid paying a double tax of both income and estate tax, this strategy does not work for persons whose main estate asset is an IRA or pension plan. For these individuals, their executors could be forced to cash in part of the IRA, pay the income tax on that amount and then use the proceeds to pay estate tax. While there is a partial offset under Sec. 691(c), this double taxation could still result in very high levels of tax. Some individuals have actually ended up paying 60%, 70% or even more in both income and estate tax on an IRA.
Zero Estate Tax with $12 Million in IRAs
Assume that a couple has a $24.5 million estate consisting of IRAs. If they leave the entire estate to their children approximately, $2,000,000 of the estate will be taxable ($24.5 million less each parent's estate tax exemption). As a result, the children will end up with less than the full value of the estate. If the couple uses their IRAs to fund a charitable remainder trust, they will be able to obtain a charitable estate tax deduction to offset the taxable portion of the estate. Using their combined exemption and the charitable estate tax deduction generated by the CRT, the couple should be able to leave the entire amount to their children and pay no estate tax.
Zero Estate Tax with a Tandem Trust
For persons with larger estates, the basic plan can be enhanced with a testamentary lead trust. Once again, there would be a spousal unitrust funded with an IRA, an irrevocable insurance trust and a transfer of an IRA into a testamentary unitrust for the children. Normally, the last transfer would be completed after both spouses pass away.
For example, a "tandem trust" plan could provide for the transfer of assets into a testamentary unitrust for a term of 10 – 15 years and the balance of the estate into a testamentary lead trust for the same number of years. With an exemption of $11.2 million in 2018, it is possible to create a zero estate tax plan. This plan is a means for transferring the value of the estate to family with a multi-million dollar gift to charity.
As more and more individuals hold significant IRAs, the need to create zero estate tax plans that move the entire estate to children will increase dramatically. With these increases and the opportunities to create zero estate tax plans for families of larger estates, there will be tens of millions of dollars in new gifts to charity.
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