Law Offices of Zachary Zaharek Office: (949) 274 – 5839 Email: zaharek@lawyer.com www.willtrustllc.com
IRREVOCABLE LIFE INSURANCE TRUST
If you are single and your net estate (including your life insurance) is more than the federal estate tax exemption ($1.5 million in 2004 and 2005), or if you are married and your total net estate is more than two exemptions ($3 million in 2004 and 2005), an irrevocable life insurance trust can reduce your estate taxes. Remember, life insurance proceeds for which you have any "incidents of ownership" (policies you can borrow against, assign, or cancel, or for which you can revoke an assignment, or name or change the beneficiary) are included in your taxable estate when you die. And, in 2004, estate taxes now start at 45% of every dollar over $1.5 million and quickly go up 48%. Very simply, an irrevocable life insurance trust owns your insurance policies for you. And since you don't personally own the insurance, it will not be included in your taxable estate. So your estate will pay less in estate taxes, and more of your estate will go to your family. Of course, you could have another person (like your spouse or an adult child) own your insurance for you. That would also keep it out of your estate, but you would not have as much control over the policy. This person could change the beneficiary, take the cash value or even cancel the policy. With an irrevocable life insurance trust, the trustee you select (it must be someone other than you) must follow the instructions in your trust. An irrevocable life insurance trust also gives you more control over how the proceeds are used. For example, you could direct the trustee to make the funds available to pay estate taxes and other final expenses. You could provide your surviving spouse with a lifetime income and keep the proceeds out of both your estates. You could also keep the proceeds in trust and provide periodic income to your children or other loved ones, without giving them the full amount. Existing policies can be transferred into an irrrevocable life insurance trust, but if you die within three years of making the transfer, the death benefits of the policies will be taxed as part of your estate. There may also be a gift tax. The trustee can also purchase a new policy. But it must be done in a special way so you don't incur a gift tax. Currently, using annual tax-exempt gifts, you can give up to $11,000 ($22,000 if married) each year to one or more beneficiaries of the irrevocable
life insurance trust. (The actual amount given will depend on the premium for the policy.) But instead of giving this money directly to the beneficiaries, you give it to the trustee for them. The trustee then notifies each beneficiary that a gift has been received on his/her behalf and, unless the beneficiary elects to receive the gift now, the trustee will invest the funds-by paying the premium on the insurance policy. Of course, for this to work, the beneficiaries must understand not to take the gift now. (By the way, the written notification to the beneficiaries is known as a "Crummey letter," named after the man who first tested it and had it approved by the IRS.)
CHARITABLE LEAD TRUST
A charitable lead trust is, in some ways, similar to a charitable remainder trust. You transfer an asset to the trust, which reduces your taxable estate and saves estate taxes. But with a charitable lead trust, the charity receives the income and your beneficiaries will eventually receive the principal. And since the beneficiaries must wait a while before they can receive the asset, its value is reduced for gift tax purposes. So you will pay substantially less in gift tax than if you left the asset to them outright. A charitable lead trust would be appealing if you currently do not need the income, or if you have current charitable commitments you would like to continue in the future, and you want someone other than the charity (perhaps your spouse, children or grandchildren) to eventually have the assets. For example, Jacqueline Kennedy Onassis included a charitable lead trust provision in her estate plan. The assets in the trust would benefit charities for 24 years, then go to her grandchildren. Unfortunately (for the charity), the trust was optional and no assets were transferred into it. PRIVATE CHARITABLE FOUNDATION
Instead of giving all that tax money to Uncle Sam after you die and letting Congress decide how to spend it, you can set up your own charitable foundation, donate your assets to it and keep some control over how the money is spent! (The IRS does have a few restrictions on how the money is used.) You can set up the foundation while you are living, or it can be established after you die. To qualify, a small percentage of the trust assets must be distributed to charity each year. But you can name whomever you wish to run the foundation, including your children, and the foundation can pay them a reasonable salary. You can be very specific about which charities you want to support, or you can leave that up to the trustees of the foundation to decide (within the IRS guidelines, of course). The tax benefits of setting up your own foundation can be substantial. You can save estate, capital gains and ordinary income taxes: • The assets you give to the foundation will be removed from your taxable estate. So, for example, if you give your entire estate to the foundation (or the entire amount over the estate tax exemption), your estate will pay no estate
taxes! • There will be no capital gains tax when the assets are sold by the foundation, so it's great for appreciated assets. • And, if you donate publicly traded securities to a private foundation, you can get a charitable income tax deduction for their full fair market value - up to 30% of your adjusted gross income. (The deduction is less than the 50% limit for standard charitable contributions because this is a private charitable foundation.) QUALIFIED PERSONAL RESIDENCE TRUST
A qualified personal residence trust lets you continue to live in your home but transfer it to your children now so you will save estate taxes when you die. When you set up a qualified personal residence trust, you transfer your home or vacation home to an irrevocable trust. For a specified period of time (often 10 to 15 years), you retain the right to use and live in the residence. After that time, the residence transfers to your beneficiaries (usually your children). In effect, you are giving your home to your children today. But because your children will not receive it until sometime in the future, the value of this gift is discounted (reduced). This uses less of your federal gift and estate tax exemption than if you had kept the home (and any future appreciation) in your estate. If you die before the term of the trust is over, there is no penalty. Your home will just be included in your taxable estate, which is what would happen anyway without the trust. If you live longer than the duration of the trust and want to keep living there, you will have to pay rent (at fair market value). And, of course, the house will not receive a stepped-up basis when you die. So you will want to see whether it's better for your beneficiaries to save the capital gains taxes or to save the estate taxes. GRANTOR RETAINED ANNUITY TRUST (GRAT) AND GRANTOR RETAINED UNITRUST (GRUT)
GRATs and GRUTs have much in common with the qualified personal residence trust. The main difference is that a GRAT or GRUT lets you transfer any asset (not just your home) out of your taxable estate. And, with a GRAT or GRUT, you receive an income, instead of continuing to live in your home, for a set number of years.
When you set up a GRAT or GRUT, you transfer an income-producing asset (like a family business, stocks or real estate) into an irrevocable trust for a set number of years. During this time, the trust pays you an income. If the income you receive is a set dollar amount and does not fluctuate each year, the trust is a GRAT (that's why it's called a grantor retained annuity trust). If the income is a percentage of the trust assets and the amount of income you receive fluctuates each year, the trust is a GRUT. At the end of the trust term, the asset will be owned by the beneficiaries of the trust (usually your children) and will not be included in your estate when you die. However, if you die before the trust term is over, the asset will be taxed as part of your estate. Like the qualified personal residence trust, the beneficiaries will not receive the asset until sometime in the future (when the trust term is over). So the value of the gift you are making (transferring the asset to the trust is considered a gift) is reduced. This uses less of your federal gift and estate tax exemption than if you had kept the asset (and any future appreciation) in your estate. A GRAT or GRUT can be a great way to save estate taxes by transferring an asset (especially a business) and any future appreciation, to your children at a discounted value, especially if you want (or need) the income. FAMILY LIMITED PARTNERSHIP.
A family limited partnership lets you transfer assets like a family business, farm, real estate or stocks to your children now, yet you keep full control. Because you are removing these assets and any future appreciation on them from your taxable estate now, you reduce the amount of estate taxes that will have to be paid after you die. A family limited partnership is especially useful as a preventative measure when real estate or a family business might otherwise have to be liquidated to pay estate taxes. When you set up a family limited partnership, you transfer the assets into the partnership in exchange for partnership shares. You control the general partner shares and can, over time, gift limited partnership shares to your children, removing the value of the gifted partnership interests from your estate. Though you have a fiduciary obligation to the other owners, you control the family limited partnership as the general partner. You determine how the assets are managed, when income is distributed and how the partnership is run. Limited partners (you and/or your children) are passive -- they have no say in how the partnership is managed. Losses and profits are allocated among the partners, but no income is distributed unless you, as the general partner, decide to do so.
Partnership shares cannot be sold or transferred without your approval. And because there is no market for these shares, their value is discounted. (What would someone pay for minority shares in assets over which they would have no control?) So you are able to transfer these assets to your children at a discounted value and remove them from your taxable estate...all without losing control. If you gift shares in increments of $11,000, there is no gift tax. (Larger gifts can be applied to your federal gift tax exemption.) And since you are making gifts based on current value, not the appreciated value when you die, this lets you, in effect, freeze the value of your estate at the time the gifts are made. A family limited partnership gives you more control than a corporation, in which even minority stockholders (either your children or their creditors) can have substantial voting rights and can force sales, distributions or even liquidations. You also have some protection from your children's creditors. If a creditor is awarded a limited partnership interest, the creditor has no more rights than the previous limited partner. OFFSHORE ASSET PROTECTION TRUST
OFFSHORE ASSET PROTECTION TRUST Because malpractice and liability insurance costs are so high -- and lawsuits so common - some people have turned to offshore asset protection trusts as a way to protect their assets and still keep control. (Recently, several states including Alaska, Delaware and Utah have changed their laws and now allow similar trusts here in the U.S. These trusts, called domestic asset protection trusts, operate differently from the offshore trusts described here.) Those who are at a higher risk include lawyers, doctors, architects, entrepreneurs, contractors, property developers and accountants. Offshore asset protection trusts are created under the laws of a foreign country (often the Isle of Man, Cayman Islands, or the Cook Islands) that does not enforce the judgments of other countries. A common way to set up one of these trusts is to transfer your assets to a limited partnership. As the general partner, you could keep only 1% of the shares, but full control. The other 99% of the shares would be transferred to the foreign trust. Your assets, however, do not have to leave the country until they are actually threatened. Even so, to be on the safe side, your attorney may suggest that you transfer your assets now to your offshore trustee. If you are sued in this country and a judgment is awarded, it has no effect in the country where title of your assets is held (in your foreign trust). The case would have to be retried in the foreign country. But first a local attorney would have to be hired and the witnesses
would have to go there to convince the court to even accept jurisdiction over the case, which is usually a good deterrent. An asset protection trust cannot be set up after someone has filed suit against you or if a lawsuit is imminent. That would be considered a fraudulent transfer. So it must be set up before then. Also, an offshore asset protection trust does not affect your taxes. You would still pay income, gift and estate taxes as you do now. But it can potentially save money by reducing the need for insurance. Eliminating your insurance "deep pockets" and having your assets held by a foreign trust can go a long way toward discouraging lawsuits. Of course, an offshore asset protection trust is not without risk. It is subject to foreign rules, which can change at any time. Also, a foreign trustee must be involved. PROTECT AGAINST THE GENERATION SKIPPING TRANSFER TAX If some or all of your estate bypasses your children and goes directly to a grandchild, there could be another tax called the generation skipping transfer tax (GSTT). This can happen intentionally, if you "skip" the living parent (your child) and leave an inheritance directly to your grandchildren. It can also happen unintentionally. For example, if the inheritance is in a trust for your child, he or she dies after you but before receiving the full amount and, under the terms of the trust, your grandchildren will receive their parent's remaining inheritance, it could then be subject to the GST tax. Why do we have this tax? Well, in the past, generation skipping trusts were common, especially among the wealthy. The grandfather would set up a trust that distributed only income (no principal) to his children. The trust principal would be distributed later to his grandchildren and future generations. This allowed the trust assets to grow tax-free and appreciate in value. And it avoided the heavy taxation that would have occurred if each generation had been taxed on the full inheritance. The Rockefellers are one family who used this concept to great advantage, building (and retaining) considerable wealth for several generations. Eventually, of course, Uncle Sam decided he wanted his share of taxes, just as if each generation had received its inheritance and paid taxes on it. So, if you leave substantial assets to your grandchildren and future generations - bypassing your children's generation - these assets may be subject to the generation skipping transfer tax. (This tax also applies if you leave assets to a non-relative who is more than 37 1/2 years younger than you.) The bad news is that this is a very expensive tax. It is equal to the highest federal estate tax rate in effect at the time. In 2004, the top rate is 48%. And the GST tax is in addition to the federal estate tax!
So if, for example, $10 million of a $15 million estate was left directly to the grandchildren in 2004 with no estate planning, $4.8 million (48% of $10 million) would be paid in estate taxes. Another $2,496,000 (48% of the remaining $5.2 million) would be paid in GST taxes. The grandchildren would only receive $2,704,000--a little more than one-fourth of their $10 million inheritance. Now the good news is that most people won't be affected by the GST tax--because everyone has an exemption from this tax. In 2004, the GSTT exemption is $1,500,000. So, in 2004 you and your spouse together can leave up to $3,000,000 to your grandchildren and future generations without having to pay the generation skipping transfer tax. But just like the federal estate tax exemption, you have to plan ahead so you don't waste one of these GST tax exemptions. One way is with the A-B-C living trust (as explained in Part Three of "Understanding Living Trusts®"). When one spouse dies, the estate can be divided in half. The deceased spouse's $1.5 million GST tax exemption can be applied to his/her half (Trust B + Trust C). And when the surviving spouse dies, his/her GST tax exemption can be applied to Trust A. This makes full use of both exemptions. Your attorney, of course, may suggest other planning options. QUALIFIED DOMESTIC TRUST
Using a qualified domestic trust is the only way your estate will be allowed to use the marital deduction if your spouse is not a U.S. citizen. That's because Uncle Sam doesn't want noncitizen spouses to inherit sizeable estates and then return to their homelands without paying any estate taxes. Remember, the marital deduction lets you leave your spouse an unlimited amount of assets with no estate taxes when you die. Uncle Sam plans to collect the taxes when your surviving spouse dies. But if your spouse takes the assets and leaves the country, Uncle Sam is left empty handed. So, in 1988, Congress decided to eliminate the unlimited marital deduction for noncitizen spouses. This means that, when you die, everything in your estate over the federal estate tax exemption will be taxed - unless your estate planning includes a qualified domestic trust (QDOT or QDT). The QDOT works a little like the C Trust explained in Part Three of "Understanding Living Trusts.®" The assets that are transferred to this trust (probably all of your assets over the amount of the federal estate tax exemption) are not taxed when you die, so the entire estate is available to provide for your surviving spouse. The trust (not your spouse) owns the assets, but your spouse can receive income from it and, with the trustee's approval, may also receive principal.
To make sure estate taxes are paid when your spouse dies, at least one trustee of the QDOT must be a U.S. citizen or U.S. corporation. (Sometimes a surviving spouse wants to return to his/her homeland and finds it would be easier to have the trust administered there. But some countries do not authorize trusts or allow trusts to have U.S. trustees. For these situations, Congress recently passed legislation that will allow the requirement for a U.S. trustee to be waived and will allow a similar legal arrangement to be used instead of a trust.) The income your spouse receives from the QDOT is taxed as ordinary income in the year it is received. But any principal your spouse receives (unless the distribution is due to "hardship" as defined by the IRS), plus assets remaining in the QDOT when your spouse dies, will be taxed as if they were part of your estate when you died (at your highest estate tax rate). Without a QDOT, these estate taxes would have to be paid when you die. But with a QDOT (just like a C Trust), the taxes are delayed until your surviving spouse dies. So more is available to provide for your spouse. Of course, if your spouse becomes a U.S. citizen before the assets are transferred to the QDOT, you would not need one. Law Offices of Zachary Zaharek Office: (949) 274 – 5839 Email: zaharek@lawyer.com www.willtrustllc.com