Common Estate Planning Techniques and Documents

It is possible for the value of the entities which receive the management fee and the incentive fee for new hedge funds to completely escape estate taxes if the ownership of these entities is properly structured. The income from these entities can actually be used to lower estate tax values instead of increase them. This summary is designed to explain some of the more common estate planning techniques.

In determining the size of an estate for estate tax purposes, one must consider life insurance proceeds, employee plan benefits, IRAs, and the possibility that you or your spouse may inherit property in the future. Every estate where there may be assets in excess of $2 million dollar exemption amount in 2008 should be planned to legally avoid unnecessary estate taxes, which will be imposed at varying rates, depending upon what state the decedent lives in, but easily could be at 50% rates or higher above the exemption amount.

Basic Estate Planning Documents

• Durable Powers of Attorney. A durable power of attorney is used to vest someone whom you trust the authority to act on your behalf. A durable power of attorney could be indispensable should you become incapacitated. However, these documents may be abused by the holder of the power in the future, and one should think about that seriously before executing a power of attorney. In New York, as a substitute for a power of attorney, a Guardianship proceeding may be undertaken, which will provide judicial supervision over those given power over one's assets in the event of disability. Furthermore, our experience has been that many financial institutions prefer that powers of attorney be executed on their own forms.

• Health Care Proxy. There is a special statutory form that allows you to appoint a person to make health care decisions for you should you be unable to make such decisions for yourself.

  Download Health Care Proxy (PDF)

• Living Will. This document is designed to provide limitations on the type of medical care that one receives, such as no tube feeding or CPR. It is not necessary to use this form, if a Health Care Power of Attorney is executed.

  Download Living Will (PDF)

• Letter of Wishes. This is not a legally binding document in New York, but many clients decide to write a personal letter to be opened in the event of death, describing where they would like to be buried, the type of funeral and other arrangements that they would like to be handled in a private manner.

• Living Trust. We do not recommend a Living trust for many clients. It is an unnecessary expense that often proves to be a financially cumbersome chore. For the right situation, we find that it is much more suitable than a power of attorney. However, a living trust is typically freely revocable and amendable by the person who creates it during life. The trust can contain explicit instructions to take care of oneself during life, and can also be drafted to continue after death. The trust can contain within it most of the estate planning provisions normally found in a will. The trust should appoint a co-trustee or successor trustee. Under New York law, one may now serve as the sole trustee of a living trust.

• Pour Over Will. A Pour Over Will pertains to the portion of one's estate not already in the trust will simply "pour over" into the trust at death. Unlike a Will, the provisions of a living trust are not guaranteed to be a part of the public record. In many counties in New York, if one has a Pour Over Will, the Court will require that the trust referred to in the Will be submitted to the Court. Privacy of the contents of a living trust that a Will pours over into is not certain. Your Will should appoint an executor.

• Will. A Will should designate an executor, whose responsibilities include determining the assets of your estate, file any required estate tax returns, pay required estate taxes, pay creditors and distribute the assets to the beneficiaries. We will generally recommend, for a variety of reasons, that there be several trusts within the Will. Trusts created in a Will are called "Testamentary Trusts", and those created during lifetime are sometimes referred to as "Intervivos Trusts". The Trustees of Testamentary Trusts need to be designated in one's Will, as is the person or persons (a "Guardian") who minor children will live with after the death of both parents. After death, in New York, a Will is filed with a Court in a proceeding called "Probate", which involves proving that a Will was indeed the last validly executed Will. Unlike other states, in New York, the probate process does not have minimum statutory fees for attorneys handling the estate, and for most clients, the probate process in New York works well, and generally in a much less expensive manner than many clients anticipate.

• Division of Trust Estate at Death. If the combined value of one's estate (including life insurance, IRA benefits, etc.) exceed $2,000,000 (scheduled to increase to $3.5 million in 2009, but then be reduced to $1,000,000 in 2011); we recommend that the living trust divide your estate into two or more shares. Our most common recommendation is that the property be divided into a Credit Shelter Gift and a Marital Deduction Gift, both of which are in the form of trusts for several reasons.

• The Credit Shelter Gift. The Credit Shelter Gift is designed to shelter an amount equal to the available estate tax exemption equivalent so that no federal estate tax is ever paid. The idea is that an amount equal to the exemption equivalent is either left to your descendants (outright or in trust), or, it can be placed in trust for the life of your spouse and then transferred to your descendants (either outright or in further trust), where, in either case, it will escape taxation in the estate of the surviving spouse.

  This technique can be utilized during life or at death. Of course, if utilized during lifetime, the tax leverage can be many times greater, but there is a price: you have to be in a position to afford to part with the money, since you lose the right to use it after the gift is made. (If your spouse is a beneficiary, however, you may obtain some indirect benefits from a lifetime gift.)

  The use of this technique can be expected to save at least $750,000 in estate taxes in a taxable estate exceeding $1.5 million. Of course, if the sheltered $1,500,000 (or such larger amount as is then applicable) appreciates over the lifetime of the surviving spouse, the estate tax savings will be commensurately greater. This amount ($2,000,000 in 2008, plus post death appreciation), is not subject to estate tax in the estate of the person creating the trust, because it is less than the estate tax exemption equivalent, and it is not ever subject to estate tax again so long as it is held in trust. It can be held in trust for as long as 21 years after the death of some person living at the death of the person creating the trust. This means estate tax can be skipped in your estate, your spouse's estate, your children's estates, and maybe even your grandchildren's estates, particularly if you have grandchildren living at your death. If any of these people need access to the trust in the interim, it will be there for them. If not, it will be available to the next generation free of estate tax.

• The Marital Trust. An estate tax deduction is available for certain gifts made outright or in trust to a spouse. The Marital Gift encompasses any assets not needed to fund the Credit Shelter Trust. This means that there will be no estate tax due in the estate of the first spouse to die. The marital deduction gift is frequently held in trust in order to give the spouse protection from creditors and to assure that the amount remaining in the trust will eventually pass to the children, or as otherwise directed by the first spouse to die. We recommend that most clients place marital gifts in trust so that the assets are protected from the spouse's creditors. For most people, car accidents are the most likely cause of an unexpected death. Even if one's spouse has insurance in the event of a car accident in which the other spouse dies, why expose the assets unnecessarily to the spouse's creditors? If there are no creditors of the spouse and none are likely to occur, and if there are no adverse estate planning reasons (based upon the state of the estate tax law at the time of one's death), then the marital trust can be "unwound" and the assets simply distributed to the surviving spouse. Our approach is to try to protect against the unknown risks and preserve the assets for one's family, and make decisions as to distributions from trusts in the future, when the circumstances of the surviving spouse is clearer.

• Generation Skipping Transfer (“GST”) Tax Planning. Under former law, in an estate that might exceed $1 million, the Marital Deduction Trust should be further divided into a Generation Skipping Exempt Trust and a Nonexempt Trust. If it is necessary to shelter money from the generation skipping penalty tax, and this division of the estate would preserve this benefit. A Generation Skipping Exempt Trust operates on the same principal as the Credit Shelter Trust and is designed to skip estate taxes in lower generations. As the estate tax law may change in the future to where dividing trusts into different parts is advantageous, our Will forms provide express authority for this to be done.

  The GST amount is not subject to estate tax or GST tax in the estate of the person creating the trust to the extent it is less than the estate tax applicable exclusion. It is not ever subject to estate tax again (or to GST tax at all), so long as it is held in trust. It can be held in trust for as long as 21 years after the death of some person living at the death of the person creating the trust. This means estate tax can be skipped in your estate, your children's estates, and possibly your grandchildren's estates, particularly if you have grandchildren living at your death. If any of these people need access to the trust in the interim, then it will be there for them. If not, it will be available to the next generation free of estate tax. The reason for the GST tax is to limit the use of this technique to trusts under a certain size.

• Trusts For Children For Life.Instead of leaving your property outright to your children or other beneficiaries on the death of the surviving spouse, consider leaving it to them in trust for life. Each child can be appointed trustee of his or her own trust at whatever age you think appropriate. The fact is that the property is in trust does not mean that your children will not be able to enjoy the use of the property. There are a number of advantages to this plan. The separate property character is preserved during the children's lifetimes and this can be an important advantage in the event of divorce. In addition, the property can be protected from creditor's claims should a child fall on hard times. Finally, careful use of the generation skipping exemption may allow all or a part of the property to pass to your great-grandchildren someday, without being subjected to estate taxes in your children's estates.

• Transparent Trust Provisions. The IRS issued a ruling in 1995 that allowed a beneficiary to fire and replace the trustee of their trust without having the assets of the trust included in their estate. These provisions, which have a number of technical requirements to work in accordance with the IRS rulings, can give almost effective control by the beneficiary over the trust, and some call these types of trusts "Beneficiary Controlled Trusts." In these types of trusts, the Trustee is often given the power to distribute all the assets to the beneficiary, for any reason. Additionally, since the beneficiary can fire the Trustee for any reason, then the beneficiary now has a "check and balance" over the Trustee. A spouse or child who is given such a power will be able to regard the trust as a "transparent" inconvenience, but a tool which provides asset and divorce protection, as well as possibly estate and generation skipping tax protection.

• Coordination of Nonprobate Assets with Overall Estate Plan. It is important that nonprobate assets such as life insurance, joint tenancy bank accounts, IRAs and qualified plan death benefits pass in a manner that does not disrupt the estate plan. This can be a time-consuming task. Simply designating the surviving spouse as the beneficiary of all nonprobate assets can be disastrous. We find major mistakes in most new client's estate plans, due to the lack of proper coordination. This will lead to estates paying hundreds of thousands of unnecessary estate taxes, and in many cases, over a million dollars of extra estate taxes, even when the client has valid credit shelter wills.

  In the case of life insurance, the best solution is often to create a separate life insurance trust as the death beneficiary.

• IRA and Qualified Plan Beneficiary Trusts. In the case of IRAs and qualified plan death benefits, designating the surviving spouse as the death beneficiary is usually preferable for income tax planning purposes and may be the only alternative that avoids unnecessary complexity, but it may mean that the full credit shelter amount is not available to fund the credit shelter trust, unless other assets are sufficient. If other assets are not available, we often recommend that a credit-shelter formula having a special type of trust be designated as an IRA or plan beneficiary.

  Large bank accounts, stock brokerage accounts and certificates of deposit should seldom, if ever, be held in joint tenancy with right of survivorship or otherwise be payable to a third party at death.

Instructions for Clients Who Have Executed Life Insurance Trusts (PDF)

Business Estate Planning

As the owner of a closely held business, there are a number of concerns that must be addressed or considered in any good estate plan.

• Buy-Sell Agreement. If you wish to keep the business in the family, it may be necessary to prepare a buy-sell agreement between the owners. This is not a simple matter. Recent changes in the law have made it difficult if not impossible to determine the price of a closely held business that will be recognized for estate tax purposes.

  It may be that all you really need is an option to purchase the stock of the other owners upon their deaths since you can control the disposition of your stock under your will. On the other hand, a funded buy-sell agreement could provide your estate with the necessary liquidity.

• Funding the Buy-Sell Agreement. Each owner must be assured that the funds will be available to fund the buy-sell agreement. Life insurance is an effective vehicle for accomplishing this task.

• Employee Stock Ownership Plan (“ESOP”). An ESOP is a type of qualified pension plan that can borrow money to buy stock in a corporation. The sale of stock to an ESOP can be tax deferred forever, and if all the stock is owned by an ESOP, the company can be exempt from federal income taxes, and (in virtually all states) all state income taxes. After the sale to an ESOP, the business owner can remain in control of the business, subject to the rules under ERISA.

Intermediate Estate Planning Documents

Intermediate estate planning primarily involves the use of irrevocable trusts and life insurance.

• Annual Exclusion Gifts/Educational Gifts/Gifts For Medical Care. Under IRC §2503(b), each donor is allowed to make gifts, free of gift or other transfer tax, including generation skipping tax, each calendar year, to one or more persons, in an amount not exceeding $11,000 with respect to each person. This limit applies separately with respect to a husband and wife, and there is no limit on the number of donees. The gift must ordinarily be of a present interest, which means it cannot be a gift in trust or a gift of any other future interest. There is an important exception to this rule in the case of annual withdrawal trusts discussed below.

  IRC §2503(e) contains a separate exemption from the transfer tax, including generation skipping tax, for any amounts paid on behalf of an individual as tuition to certain educational organizations or to a person who provides medical care (within the meaning of the statute). This exception has a lot of potential for avoiding transfer tax, particularly in the case of grandchildren.

• Crummey Trusts/Annual Withdrawal Trusts. In order for the annual exclusion to apply ($11,000 per donor/per donee) a gift is supposed to be made immediately and not in the future. For this reason, an ordinary irrevocable trust will not qualify. However, the trust can contain a feature known as a withdrawal right that can cause gifts to the trust to qualify. As simple as this sounds, the tax effects of such a feature are very complex. With care, a trust can be drafted to qualify for the annual exclusion without attracting gift, estate or generation skipping taxes, but some drawbacks will have to be accepted as the price.

• Annual Exclusion Gifts of Undivided Interests in Real Estate. Making annual gifts of undivided interests in real estate is often a very effective technique. Because the gifts would be in undivided interests, a valuation discount should be available. If this technique is utilized, it is extremely important to have a good appraisal of the value.

• Annual Exclusion Gifts of Undivided Interests in a Family Business. Making annual gifts of stock in your corporation to your children is another technique that should be considered. Because the gifts would represent a minority interest, a minority discount should be available, we recommend having an appraisal done before making such gifts.

• Irrevocable Trust. An irrevocable trust allows you to exercise some control over property that you give to your loved ones during life. By making a present gift during lifetime, all of the income and appreciation on the property from the time of the gift to the date of your death is effectively transferred tax free. In addition, the effective gift tax rates are substantially less than the estate tax rates (33% vs. 50% for example). Up to $11,000 per donor/per donee can be transferred tax-free each year.

  By making the gift to a trust instead of outright, you can exercise some control over the use to which the property will be put (for example, by keeping it in the family), and in addition, you can give the beneficiary the added benefit of receiving a gift that can be protected to some extent from the beneficiary's creditors (including a spouse). If the gift is within the available generation skipping transfer tax exemption, another advantage is that it may pass to the donee's children (for example) without being subject to estate tax in the donee's estate.

• Life Insurance. Life insurance is a perfect asset for an irrevocable trust, although an irrevocable trust will usually be funded with other types of property as well. The reason life insurance is so suitable is that it performs the function of providing the liquidity needed by an estate at death. The difference between the value of life insurance during life and at the moment of death is dramatic, meaning that the difference between the gift tax paid (if any) and the estate tax that would be paid is equally dramatic.

  If life insurance is transferred by the insured and the insured dies within three years, the proceeds of the policy will be includible in the insured's estate. If an irrevocable trust purchases a life insurance policy in the first instance (so that there is no transfer), the three-year rule may be avoided.

• Lifetime Funding of Bypass Trust. One of the best estates planning techniques for a person who has a stable marriage and who can afford it is to make a gift in trust now. This benefits the other spouse, remainder to the children, using the available lifetime unified credit exemption equivalent, which is $2,000,000 in 2008. All of the income and appreciation in the trust is removed from both spouse's estates. Ideally, the spouse would not invade the trust at all, but the option would be there. Although the property has been given away, if the marriage survives, the property is still available to at least one party in the marriage.

• Grantor Trusts Where the Grantor In Effect Pays the Donee’s Income Taxes. The tax law requires that income on a trust established by a grantor be taxed to the grantor under certain conditions. That type of trust is called a "grantor trust." The grantor of a grantor trust has no choice but to pay the income tax on that trust for at least as long as the trust is in existence and the grantor is still living. Historically, the IRS has never treated this incident of the tax law as a gift.

  By placing property in trust, and paying the income tax outside the trust, the trust grows at a compounded rate, as if tax free. If $2 million is given to a trust on which someone else pays the taxes, earning approximately 10% per annum, the trust will be worth close to $15 million 20 years later, and will be worth $42 million in 30 years. The $15 million to $42 million in the trust can be sheltered from generation skipping and estate taxes for about 100 years or more.

• Grantor Retained Annuity Trusts and Unitrusts/Gift of Remainder Interest. If a gift of a remainder interest in a trust is made to a beneficiary who is a descendant, the asset must pay you a market rate of return during the term of the trust. In many cases, this takes most of the leverage out of the gift of the remainder. The retained interest must be an annuity interest based upon the original value (a grantor retained annuity trust, or GRAT), or a unitrust interest based upon the market value each year (a grantor retained unitrust, or GRUT). Under the right circumstances, the value of the gift for transfer tax purposes can be close to zero.

  A GRAT is particularly attractive if it can be funded with stock in a pass through entity (S-corporation, limited liability partnership, etc.) with a historically low rate of dividends or distributions, which is expected to generate higher rates of return in the future.

  A GRAT will be a grantor trust, which means that the grantor must pay income taxes on all of the income of the trust, not just the income used to pay the annuity. Consider this example:

  Closely held stock having a fair market value of $1 million, is transferred to a GRAT paying a guaranteed 8% annuity to the grantor for 20 years. Assume that if the federal and state income tax rate is 50%, and that the donor would owe $80,000 in tax annually from the income generated by the S corporation. The GRAT is required to pay the donor 8% of $1 million, or $80,000, which the donor, in turn, uses to pay the income tax. 20 years later, when the GRAT terminates, (a) the GRAT would have accumulated $1 million if the stock is in the GRAT consistently, (b) the donor has paid virtually no transfer tax, (c) the donor's estate has not really been augmented at all by the annuity (since it went to pay income taxes), and (d) even if the stock had not appreciated during the 20 years, the trust would still be worth $1 million. In effect, the donor will have transferred $1 million dollars paying no transfer tax. If the underlying value of the stock increases during this period, the results are more dramatic. Perhaps this technique can be made even more attractive if the property continues to be held in trust (as a grantor trust) following the termination of the retained interest.

• Additional Leverage Through Borrowing. Further leverage can sometimes be obtained by having the trust for children (or GRAT) purchase property from the grantor (such as closely held stock) on an installment note secured by the property purchased.

• Gift of Remainder Interest in Home Following a Term of Years. This technique is known as a Qualified Personal Residence Trust. The technique contemplates that you will give your home away after a period of time, say 25 years. The gift takes place in the present, so that the value of the gift is typically only a small fraction of the full value of the home, since the value is discounted by the value of your right to use the property during the term. If you live beyond the term of the trust, the property passes to your children or in a trust for them, escaping any other transfer taxes. If, however, you were to die during the term of the trust, the full value of the residence would be included in your estate.

• Charitable Remainder Trusts. Appreciated property can be transferred to a charity without recognizing capital gain. In return, the charity can give you the right to annual payments of income based on the fair market value of the property, either as initially valued (a charitable remainder annuity trust) or as revalued annually (a charitable remainder unitrust). To the extent that the value of your right to the income is less than the value of the transferred property, you can get a charitable income tax deduction.

• Family Limited Partnerships. This is a technique for investing and managing family wealth. This technique can be very useful in preserving a business and other investments of the partnership. One significant feature of a family partnership is that it may very well have a transfer tax value that is much less than the value of the underlying assets. We often see family limited partnerships that are likely to be attacked by the IRS upon an estate tax audit due to the way that they have been created and held by the person who created them. There are ways, however, to substantially reduce the risk of estate tax inclusion.

Common Estate Planning Mistakes

In almost all new client situations that we review, we find certain things that should be corrected. The following list identifies some of the mistakes:

• Wills are out of date and refer to estate tax exemptions that have changed. The estate tax law has changed dramatically in the past ten years, and many older wills have clauses in them which no longer fully protect against estate taxes as completely as they could.

• Assets are not coordinated with the Wills. If all a couple's assets are titled as joint tenants with right of survivorship, the credit shelter formula provisions described on this site will not be able to operate properly, and usually unnecessary estate taxes will have to be paid one day.

• Failure to take advantage of annual exclusion gifts to lower estate taxes. Just as accumulating wealth typically involves compounding money over time, so does a lot of estate planning. Small annual gifts to the right kinds of trusts can dramatically lower estate taxes, and properly designed trusts allow the assets to be available to one's spouse, should the assets later be needed.

• Failure to coordinate IRA and Pension accounts. These are often client's largest assets, aside from their homes, and how those funds will be distributed upon one's death needs to be thought through in conjunction with the increased exemption from estate taxes. Couples whose total assets are below $3 million but above $1.5 million are particularly vulnerable to paying estate taxes that could have been completely avoided.

• Waiting until a serious medical condition arises before seeing an estate planner. To take full advantage of many of the common techniques, estate plans need time and years for them to work the best.

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