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Advanced Estate Planning Techniques

The following is a brief summary of estate planning techniques that may be used to transfer wealth to younger generations while minimizing estate and gift taxes. This discussion assumes that use is already being made of an "optimal" marital deduction/unified credit tax formula in a Will or a revocable trust agreement.

Revocable "Living" Trusts

While not a tax-savings device, a revocable "living" trust may simplify the transfer of assets at death, reduce administration expenses, and provide confidentiality. Generally speaking, a revocable living trust is simply a trust established during the lifetime of the grantor (i.e., the person who creates the trust) which becomes the owner of the grantor's assets. Assets which are intended to be owned by the trust must be transferred or titled in the name of the trustee (i.e., the person or entity in charge of managing the trust). Typically, the trust is treated as the same person for income tax purposes, and no additional income tax returns need to be filed.

While North Carolina probate fees are relatively minimal (four-tenths of one percent (.4%) of the value of personal property, with a cap of $6,000), use of a properly funded revocable living trust will avoid that expense. Moreover, such a trust avoids the time and expense of preparing inventories and accountings for the Clerk of Court. Of course, these probate cost savings must be balanced against the expense of preparation of a revocable living trust, the costs and aggravation of transferring assets into the trust, and the complications inherent in managing assets inside a trust rather than in individual or joint form.

There are, however, several other, more substantial benefits that in the right circumstances may be obtained from using a revocable living trust instead of a Will. For example, if a family owns real estate in more than one state, the use of a revocable living trust could avoid the costs and complications of maintaining an estate administration in more than one jurisdiction.

Moreover, if confidentiality is important, a revocable living trust may be useful. While Wills and the inventories and accountings of probate assets are matters of public record, typically neither a revocable trust agreement nor a listing of its assets needs to be filed with the Clerk of Court. However, some disclosure of the value of the trust normally will be required on estate inventories filed with the Clerk if there are sufficient probate assets outside the trust to require a formal estate administration.

Furthermore, if a bank trust department will be managing the estate and trust, the bank's commissions generally will be lower if assets are owned by a revocable living trust at death. These savings could be substantial in some situations.

Non-Taxable Gifts

Under current law, an individual donor may make "annual exclusion gifts" of up to $13,000 each year to each beneficiary without federal or North Carolina gift tax consequences. Such gifts incur no gift tax and are in addition to the federal gift tax exclusion amount. The federal gift tax exclusion amount in 2012 is $5,000,000 (adjusted for inflation to $5,120,000).  Unless Congress acts, a $1,000,000 exclusion amount will apply in 2013 and beyond. These gifts may be made each calendar year to any number of beneficiaries. A married individual may make annual exclusion gifts of up to $26,000 per year per beneficiary by utilizing his or her spouse's annual exclusion. A gift tax return must be filed, however, in order to take advantage of the spouse's annual exclusion.

In addition to the annual exclusion gifts described above, a donor may make tuition payments to an educational institution and medical payments to a health care provider on behalf of any beneficiary without limit on amount and without incurring any gift tax. To qualify, the tuition payments must be made directly to the educational institution and may cover only direct tuition costs (i.e., not books or room and board). Likewise, any medical expense gifts must be made directly to the health care provider. These exclusions allow a parent to make additional tax-free gifts to younger family members by assuming the cost of tuition to private schools and by assuming any medical expenses not covered by medical insurance.

Use of Life Insurance

In the estate planning context, life insurance generally plays one (or both) of two roles. First, life insurance can provide a means of "leveraging" annual exclusion or taxable gifts into a significant wealth transfer to younger generations. For example, relatively small annual exclusion gifts may be used to pay the premium cost on a life insurance policy which will return a significant death benefit to the donor's children or grandchildren. Whether such "leveraging" is achieved (and the extent of such leveraging) will depend upon a number of factors, including the internal rate of return of the policy purchased and the actual life span of the insured.

Second, life insurance can play an important role in providing liquidity for the payment of taxes in an estate which holds real estate, closely-held business interests, or other assets which are not easily marketable. Any estate tax owed generally must be paid within nine months from the date of death; if assets must be sold quickly to satisfy that obligation, the estate may not realize the full potential value of those assets. In such a situation, insurance proceeds can provide a ready pool of liquid assets with which to satisfy the tax obligation.

In simplistic terms, life insurance falls into one of two categories: single-life insurance, which is payable upon the death of a single named individual; and joint-lives, (or survivorship), insurance, which is payable at the death of the second to die of two individuals. With an "optimal" marital deduction formula estate plan, a married couple can defer all estate tax until the second death; in such a situation, joint-lives insurance may be helpful because it will provide the death proceeds at the time when the death tax obligation falls due.

To be an effective estate planning tool, life insurance should not be owned by the insured or the insured's spouse. Moreover, neither the insured nor the insured's spouse should retain any significant control over the policy. Rather, the policy should be owned by the beneficiaries of the insured's estate or by an irrevocable life insurance trust created for their benefit.

Generation-Skipping Transfers

Generally speaking, the Internal Revenue Code imposes a transfer tax at each family generation. If an asset passes from a parent to a child, and then from the child to a grandchild, estate tax is imposed in both the parent's and the child's estates. If a parent passes the asset directly or indirectly to the grandchild, in order to bypass the child's estate, this transfer avoids estate tax in the estate of the child, but is potentially subject to another transfer tax, known as the generation-skipping transfer tax ("GSTT"). This GSTT is particularly onerous because it is imposed in addition to the estate tax incurred in the parent's estate, and is assessed at the maximum estate tax rate (currently 35%). As a result, when the GSTT applies, it may result in about 70% of the assets passing to the grandchild being consumed in estate taxes and generation-skipping taxes.

However, the Internal Revenue Code provides each individual with a "GST exclusion." Each individual is allowed a "GST exclusion" of $5,000,000 (adjusted for inflation to $5,120,000 in 2012); unless Congress acts, a $1,000,000 GST exclusion (adjusted for inflation) will apply in 2013. In other words, each individual may engage in generation-skipping transfers of up to $5,120,000 (in 2012) without subjecting those assets to the GSTT. A married couple may jointly make up to $10,240,000 (in 2012) of such transfers.

The well-planned use of the GST exclusion is an important component of the estate plans of high net-worth individuals who want to insulate assets from taxation in successive generations. Ideally, the GST exclusion is utilized with lifetime gifts, which may take the form of transfers to a trust which would benefit the donor's children during their lifetimes and thereafter pass to grandchildren or more remote issue. Once the gift is made and the GST exclusion applied to the trust, the trust remains exempt from further estate tax or generation-skipping for the remainder of the trust's existence. Thus, all post-gift income and appreciation would escape further transfer tax.

Several states, including Alaska, Delaware, and South Dakota, have repealed the common law "rule against perpetuities," which limits the length of time a trust may last. Therefore, if a generation-skipping trust is created under the law of one of those states, the trust may continue in perpetuity, thereby maximizing the utility of the GST exclusion. It may be necessary to use a trustee located in one of those states, or to invest trust funds in those states, in order to bring a trust within the laws of such states.

If an individual is unwilling or unable to make such a significant lifetime gift, he should consider utilizing the GST exclusion at his death. For example, instead of passing all of his estate to his children, a parent could place the first $5,120,000 (in 2012) of that estate in a generation-skipping trust, of which the children could be beneficiaries during their lifetime, but which ultimately would pass on to grandchildren or more remote generations of the family without incurring estate tax in the children's estates. Since this planning does not deprive the parent's children of access to the funds placed in the generation-skipping trust, there is little or no disadvantage to incorporating such planning in an individual's standard estate planning documents.

Family Limited Liability Company

A family limited liability company ("FLLC") provides a means by which a donor may give away the underlying equity interest in an asset while retaining managerial control over that asset. An FLLC also allows a donor to take advantage of certain valuation discounts in making gifts of interests in the FLLC. These discounts (which reflect the recipient's lack of control over the FLLC and the non-marketability of the donee's interest in the FLLC) may exceed 50%. Moreover, an FLLC provides a structure for the centralized management of family-owned property both during and after the parent's/donor's lifetime.

FLLCs are most commonly used as a vehicle for making gifts of interests in real estate, although other business or investment assets may be used to fund an FLLC. The "leveraging" offered by valuation discounting makes an FLLC an attractive way to make annual exclusion or taxable gifts. For example, if a 50% valuation discount were available, and if a FLLC held real estate worth $1,000,000, a married couple could transfer a 7.2% interest to a child without exceeding the couple's $26,000 annual exclusion gift limit. An FLLC also provides a limited "estate freeze," since any post-gift appreciation on the gifted interests in the FLLC occurs outside of the donor's taxable estate.

While FLLCs are frequently used by estate planning practitioners, donors should be aware that the estate and income tax consequences of such entities are not completely settled, and the Internal Revenue Service has attacked the use of such entities in egregious and abusive gifting situations (e.g., death bed transfers by an incompetent donor). However, for a high net-worth individual, the risk of a FLLC is manageable and the potential rewards are substantial.

Grantor Retained Annuity Trust (GRAT)

A GRAT is an irrevocable trust from which the grantor retains the right to receive annuity payments for a specified period of time. At the end of this retained term, assets in the trust pass to other beneficiaries. The annuity payments made to the grantor reduce the value of the gift of the remainder interest when the GRAT is established, so that only the net present value of the remainder interest is subject to gift tax. A GRAT produces estate and gift tax savings if the property placed in the GRAT produces a total net return (net income and appreciation) in excess of the assumed discount rate under the Internal Revenue Code.

The annuity payment may be set sufficiently high so as to create a "zeroed-out" GRAT. With a "zeroed-out" GRAT, the net present value of the retained annuity payment stream equals 100% of the value of the property placed in the trust. If stock or other assets in the GRAT appreciate in value beyond the amount necessary to produce the retained annuity payments, then the value of the trust remaining at the end of the term of the trust will pass to the designated beneficiaries free of any gift or estate taxes.

The grantor may select any term of years for the GRAT. However, if the grantor dies before the expiration of that term, any potential tax benefits are lost. Accordingly, a short-term GRAT reduces the risk that the desired tax benefits will be lost. Therefore, the most logical use of a GRAT may be to use "layered" zeroed-out two-year GRATs. The grantor would initially create a two-year zeroed-out GRAT; when the grantor receives the first year's annuity payment, that payment would be rolled into another two-year zeroed-out GRAT; and that process would be repeated each year as another annuity payment is received.

There is little downside risk with a GRAT. If the grantor dies before the expiration of the term of the GRAT, the remaining assets in the trust will be included in the grantor's taxable estate, just the same as if the grantor continued to hold the assets in his or her name outright, with an appropriate credit being given for any gift tax paid when the trust was created. Similarly, if the trust assets go down in value, so that there is nothing remaining in the trust at the expiration of the grantor's annuity payments, with a zeroed-out GRAT the grantor is returned to the same position as he or she was in before creation of the GRAT, with no tax costs having been incurred. In both cases, the grantor's loss is limited to the out-of-pocket costs associated with establishing the GRAT.

A zeroed-out GRAT is an excellent estate planning tool for someone who has already exhausted his or her applicable exclusion amount under the federal estate and gift tax laws and who is already maximizing annual exclusion gifts. Such a GRAT presents a way to pass excess growth and appreciation in assets to children without incurring any gift or estate tax. While such a technique works only if the assets placed in trust grow in value beyond the applicable federal discount rate, the grantor is generally able to identify assets which are likely to do so.

Installment Sale to a "Defective" Grantor Trust

Where a grantor has income producing assets (e.g., commercial real estate subject to a long-term lease) that the grantor expects to appreciate significantly in value, a sale of that property to an income tax "defective" grantor trust on an installment basis is an attractive estate planning technique. Such a trust is deemed "defective" for income tax purposes because the grantor is considered to be the owner of the trust for income tax purposes, with the result that the grantor and the trust are deemed to be the same "person" with respect to income tax issues. Accordingly, the sale of assets to the trust by the grantor does not result in any taxable capital gain. While the grantor would be deemed the owner of the trust for income tax purposes, the trust would be designed so that the trust assets are not includable in the grantor's taxable estate for estate tax purposes.

Typically, such a transaction takes the form of an installment sale over an extended period of time, with the trust's payment obligation to the grantor being evidenced by a promissory note. For tax reasons, the term of the note should not exceed the grantor's actuarial life expectancy. However, the note may contain a provision providing for the termination of the repayment obligation if the grantor dies prematurely. This "death-terminating" feature presents the opportunity for a windfall to the grantor's beneficiaries in the event of an untimely death. However, the use of this feature requires that a premium be attached to the promissory note, either in the form of an increased principal amount or an above-market interest rate.

This technique is useful where the property being sold will generate sufficient income to offset wholly or substantially the promissory note payments. It generally is wise to combine such a sale with a concurrent gift of other assets to the trust, to give the trust other means of repaying the note.

The benefit of this technique is that it presents the opportunity to transfer assets at no gift or estate tax cost to the beneficiaries, while having the asset pay for its own transfer by applying the income stream to the promissory note payments. Moreover, since all of the income produced by the asset is taxed to the grantor, the grantor's payment of that income tax liability is, in essence, an additional tax-free "gift" to the trust beneficiaries.

Qualified Personal Residence Trusts

Prior to 1987, "estate freezes" were a popular tax avoidance technique. The idea was that a parent would transfer appreciating assets to a child while retaining an income interest in those assets, thereby substantially reducing the value of the transferred property for gift tax purposes. Since the potential appreciation in the value of the transferred assets would benefit the child, the interest retained by the parent would be "frozen" for estate tax purposes.

The enactment of Chapter 14 of the Internal Revenue Code substantially curtailed the use of estate freezes. However, a "qualified personal residence trust" remains a permissible estate freeze technique which would allow a donor to "leverage" a taxable gift to a trust for his or her children.

With a qualified personal residence trust ("QPRT"), a parent may put a residence in trust for the benefit of a child or children, but retain the right to use the residence for a specific term of years. For gift tax purposes, the value of the remainder interest of the child is determined after subtracting the value of the parent's right to use the residence for the term of years. This valuation procedure allows a parent to discount substantially the value of the gift made to the children, and also removes from the parent's estate all post-gift appreciation in the value of the residence. The taxable gift may be discounted further where a married couple owns the residence to be placed in the QPRT, by having each spouse create a separate QPRT and taking a "fragmentation" valuation discount to reflect that each spouse holds only a one-half undivided interest in the property.

Only a "personal residence" may be transferred to a QPRT. A residence qualifies if it either is the donor's principal residence or is used primarily for residential purposes (such as a vacation home). Each donor may create up to two QPRTs.

The length of the donor's term interest in the trust is not limited and, of course, the longer the term interest, the lower the value of the child's remainder interest (and hence the lower the gift tax). As a practical matter, however, the term interest should be kept well short of the donor's life expectancy, since if the donor dies before the termination of the term interest, the full value of the residence would be included in the parent's estate for estate tax purposes (thus defeating the purpose of the trust).

While the QPRT is irrevocable once created, the trustee retains the power to sell the residence and to purchase a new residence. Accordingly, the donor's ability to change residences is not impaired by the use of a QPRT.

The QPRT is one of the few remaining "estate freeze" techniques available, and is a highly attractive estate planning technique for individuals who are already maximizing their annual exclusion gifts to family members. Moreover, with a QPRT a parent may make a significant gift to his or her children without adversely affecting his or her income.

If, at the end of the parent's term of years, the parent desires to remain in the residence, the QPRT may give the parent an option to lease the residence for the rest of his or her life. The lease payments must be a fair market rental, but the lease payments themselves present an attractive estate planning tool, since the child's marginal income tax bracket is likely to be lower than the parent's marginal estate tax bracket. Thus, assets are removed from the parent's estate at a lower tax cost.

Charitable Trusts

If a client has particular charitable institutions that he or she would like to benefit, the use of one or more charitable trusts may be appropriate and may provide the donor with income and estate tax savings. Charitable trusts fall into two broad categories: charitable remainder trusts and charitable lead trusts.

(1) Charitable remainder trust: A charitable remainder trust, which may be either a charitable remainder annuity trust or a charitable remainder unitrust, is an irrevocable trust by which a donor makes a deferred charitable gift. The donor receives an income tax deduction in the year the trust is established and funded, and the donor's estate receives an estate tax deduction at the time of death. The donor retains the right to an annual annuity or unitrust payment for a specified number of years, for his spouse, or for the lifetime of some other beneficiary, and the charity receives the remainder of the trust after the expiration of that income interest.

A charitable remainder trust is an excellent way of benefiting a charity while retaining for the benefit of the donor an income stream from the gifted property. The use of a charitable remainder trust is particularly beneficial where the donor has appreciated property which is producing little or no income. The charitable remainder trust may sell this property free of capital gains tax and invest the proceeds in high income producing assets, thereby providing the donor with an increased income stream without reducing the investment assets through capital gains tax.

Often, a charitable remainder trust is paired with an aggressive annual exclusion gifting program. With such a program, the donor would utilize a portion of the annual payments received from the trust to fund annual exclusion gifts to children or other family members. Such gifts may take the form of the acquisition of a life insurance policy in an irrevocable life insurance trust, sometimes dubbed a "wealth replacement trust" because it provides for the children funds to offset the loss of the assets passing to the charity.

(2) Charitable Lead Trusts: As its name implies, a charitable lead trust is the opposite of a charitable remainder trust. The donor creates an irrevocable trust in which the income interest is given to a charitable institution and the remainder interest is given to a child or grandchild. Like a GRAT or a qualified personal residence trust, the grant of an income interest to a charity may have the effect of reducing the gift or estate tax value of the remainder interest passing to the children or grandchildren. If the appreciation in the value of the assets placed in the trust exceeds the discount rate used to compute the value of the charity's income interest, then such excess appreciation will pass to the children or grandchildren free of estate or gift tax. Accordingly, a charitable lead trust is frequently used at death, where the granting of an interim income interest to a charity, and the concomitant deferral of the children's or grandchildren's enjoyment of the assets, substantially reduces overall estate taxes owed. As an example, Jackie Kennedy Onassis used this technique in her estate plan.

Transfers of Business Opportunities

Parents who own closely-held business interests may transfer wealth to younger generations simply by diverting new business opportunities to a child or grandchild (or to business entities owned by such beneficiaries). Arguably, a diversion of a business opportunity is a taxable gift, since such an opportunity clearly has value. However, the value of the business opportunity would be difficult to establish or appraise, thereby limiting the IRS's ability to attack the transfer. The IRS is more likely to find a taxable gift where the child's or grandchild's business is undercapitalized, so it may be wise to capitalize the business with taxable gifts before a business opportunity is diverted to the child or grandchild.

Conservation Easements

Often, the owners of relatively natural, wooded, or farm land wish to maintain the property in that form for the enjoyment of future generations. The need to pay property taxes and the imposition of estate taxes or other transfer taxes may make it difficult to retain such property in the family. Moreover, where such land has development potential, it may be valued for gift or estate tax purposes at an elevated value, making the tax burdens particularly onerous. The granting of a conservation easement on such property may alleviate this problem by limiting or prohibiting the development of the property, thereby ensuring that it will be valued for tax purposes taking into consideration the limitations imposed by the easement.

A qualified conservation easement can result in property tax savings. It can also result in estate or other transfer tax savings due to reductions in valuation. In addition, a qualifying conservation easement may produce a North Carolina income tax credit of up to 25% of the fair market value of the easement. Estate taxes may also be further reduced by a special exclusion from the estate of up to 40% of the value of land which is subject to a qualified conservation easement.

While a conservation easement can provide substantial tax savings, it must be enforceable by the organization to which the easement is granted. The donee organization may be a nonprofit land trust, other appropriate public charity which meets conservation purpose requirements, or an appropriate governmental agency. The easement must be perpetual and for an appropriate conservation purpose such as recreation, education, habitat protection, open space protection, and protection of scenic enjoyment of a visual landscape (such as along a scenic drive or river). The conservation purposes and other terms of a qualified conservation contribution are subject to a number of regulatory requirements and limitations. However, the easement may allow for continued use of the property in ways that are consistent with the conservation easement. These can include some level of timbering, certain agricultural or horticultural pursuits, hunting and other uses which are consistent with the conservation purposes of the easement.

For further information regarding the issues described above, please contact Eldridge D. DodsonJeannette A. Parrott, Gregory T. Peacock, John R. Sloan, Matthew W. Thompson, or Margaret K. Winfield.

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This article is not intended to give, and should not be relied upon for, legal advice in any particular circumstance or fact situation. No action should be taken in reliance upon the information contained in this article without obtaining the advice of an attorney.

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