Estate Planning Strategies

There are many estate planning strategies that can reduce your exposure to the estate tax and ensure that your assets are distributed in accordance with your wishes. Every family has different estate planning goals, and your lawyer should work with you to design a plan that is best suited for you and your family.

Below is an explanation of some common strategies that may be used in structuring
your estate:

Limited Partnerships and Limited Liability Companies

Family limited partnerships (FLPs) and limited liability companies (LLCs) can be effective tools for managing family wealth and transferring assets to your children over time. However, these entities can be expensive to set up and maintain, and a poorly administered partnership can invite a challenge by creditors and an audit from the IRS. Both FLPs and LLCs are treated as partnerships for federal tax purposes, and they will both be referred to here as family partnerships.

Family partnerships are business entities under state law, but are often used in the management of family wealth and for estate planning purposes. Limited partnerships are made up of two types of interests: general partnership interests and limited partnership interests. Those who own the general partnership interests are effectively the managers of the partnership and make the day-to-day decisions about partnership operations. Those who own the limited partnership interests own an interest in the assets and income of the partnership, but have little power to affect partnership operations. When limited partnerships are used for estate planning purposes, the parents often retain the general partnership interests, and thus are responsible for partnership decisions on a daily basis. The parents then gift a certain percentage of limited partnership interests to their children, so that, over time, the children own a significant share of the family wealth. While limited liability companies are different legal entities, when used for estate planning purposes, they are often set up in a similar way to limited partnerships.

Advantages of FLPs and LLCs

Gifting Benefits. Family partnerships make it easier to gift portions of a property and are particularly useful if you have a number of properties that you’d like to transfer over time. For example, suppose you have four tracts of land, and you’d like to give each of your children a 10% interest in each tract every year for the next five years. Without a partnership, each year you would have to execute 12 transactions – four for each of your three children – and notify the gas company of each transaction. If the four properties are transferred into a partnership, you could simply transfer a 10% interest in the partnership to each of your children and achieve the same thing. There would be no need to notify the gas company of the transactions because all the royalty checks would be sent to the partnership, regardless of any gift to your children. The money can either be retained in the partnership or distributed out in accordance with each partner’s ownership interest.

Centralization of Management. The partnership can also serve to centralize management of the assets in the partnership and allow other family members to participate in deciding how to invest the royalty proceeds retained in the partnership. It may be helpful for children to become involved in the management of your assets early on, so that they can learn to effectively manage and invest the family’s assets.

Asset Protection. A partnership can also protect your assets against potential creditors. A large lawsuit can potentially wipe out your entire net worth. The partnership provides certain protections from creditors, who cannot reach the assets inside the partnership. The creditor’s only access to the partnership assets is through a limited remedy called a charging order.

Income Tax Benefits A partnership can help reduce your family’s overall income tax burden by taking advantage of the lower tax brackets of other family members. Partnership income is taxed to the individuals who hold partnership interests. For example, if a partnership is owned equally by 4 people and the partnership has $100,000 in income for the year, each person will have $25,000 of taxable income from the partnership. This can prevent any one person in the family from being pushed into a higher tax bracket.

Estate Tax Valuation Discounts. Another benefit of a family partnership is a potential reduction in estate taxes. Limited partnership shares in an FLP may be valued for estate tax purposes at an amount less than the proportionate share of the assets owned by the partnership. For example, suppose all the assets in a partnership are worth $1 million. If you transfer a 20% limited partnership interest to one of your children, for gift tax purposes, the value of that partnership interest is worth less than $200,000 because the owner of that interest has no control over the management of the partnership and might have trouble selling it to a third party.

Disadvantages of FLPs and LLCs

Family partnerships are not for everyone. For income and estate tax purposes, family partnerships must be operated like businesses. That means annual partnership meetings should be held, state filings must be kept up to date, and strict records must be kept of partnership income, expenses, contributions, and distributions. If partnership formalities are not maintained, or if the person who created the partnership retains too much control over partnership distributions, the IRS may treat the entity as if it never existed.

Another drawback of partnerships for landowners in Pennsylvania is that transferring assets into a partnership can trigger the Pennsylvania Realty Transfer Tax, a 2% tax imposed at the time of the transfer. If your gas rights are valued at $2 million, simply transferring them into a partnership can cost you $40,000 in realty transfer taxes.

Is a Partnership the Best Choice for Your Family?

Whether a partnership is the best way of managing your family’s assets depends on a comprehensive analysis of the value of your gas rights, the number of separate parcels you hold, the involvement of other family members in managing family assets, and your willingness to devote time and money to maintaining partnership formalities. Only you and your lawyer can determine whether a partnership is the right choice for you.

Irrevocable Life Insurance Trusts

Life insurance can be an excellent way to ensure that your estate has sufficient money to pay any estate tax bills in the event that sufficient cash from royalty payments or other sources is not available. This is often a good strategy for younger couples who might need their assets for retirement but are concerned about an estate tax being imposed on their children if something happened to them. If the insurance policy is purchased directly, the proceeds may add to the value of your estate and increase your estate tax bill. Purchasing the policy through a life insurance trust is a common way to avoid the insurance proceeds from being taxed as part of your estate.

Gifting Strategies

While gifts given during your lifetime are generally counted toward your total exemption amount, certain types of gifts are excluded and can be used to transfer wealth without affecting your gift or estate tax liability.

Annual Exclusion Gifts. Every person is entitled to provide annual gifts of up to $14,000 per beneficiary without it being considered a gift for federal gift and estate tax purposes. You may want to take advantage of this rule by giving your children and grandchildren annual holiday gifts, or you may want to leverage the $14,000 amount by using it to purchase life insurance or putting it into a trust to appreciate outside of your estate.

Health & Education Gifts & Trusts. Another way to transfer money to your children and grandchildren without affecting your gift and estate tax liability is by paying for their medical or education expenses. Payment for tuition or healthcare expenses is excluded from the federal gift and estate tax calculation, regardless of whether you have used your $14,000 annual exclusion for that beneficiary. If you set up a specific type of trust, the exclusion can be used not only for present expenses, but also for health or education expenses for generations to come.

Irrevocable Gifting Trusts

If you would like to make gifts of mineral rights before they increase in value, but are concerned about giving up control or access to the money, the use of an irrevocable trust may address your concerns. By creating a trust, you can take advantage of the benefits of early gifting while imposing certain restrictions on the beneficiary’s use of the money. There are also ways to structure the trust in a way that provides a benefit for your spouse.

Dynasty Trusts

A dynasty trust is a type of irrevocable trust used to transfer wealth to multiple generations while minimizing estate taxes. In the federal estate tax system, estate and gift taxes are levied every time assets change hands from one generation to the next. For instance, suppose your estate includes $1 million that is subject to the estate tax at a rate of 50%. That $1 million would shrink to $500,000 when it passes to your child. Now assume that your child’s estate is also subject to a 50% tax. When your child passes away, that $500,000 they inherited could shrink to $250,000 when it is distributed to your grandchildren. The estate tax would have eaten up 75% of the amount that you originally left. Assets transferred to a dynasty trust are subject to the estate tax only once, so your wealth can continue to provide for your descendants for generations to come.

Grantor Retained Annuity Trusts (GRATs)

A Grantor Retained Annuity Trust (“GRAT”) is a planning technique that allows you to transfer property to your heirs in exchange for income paid to you over a certain term and interest rate based on the Applicable Federal Rate (AFR) then in effect. This technique limits any increase in the value of your estate to the stated interest rate, with any additional asset appreciation inuring to the beneficiaries of the trust.

GRATs can be an ideal planning tool for assets like gas rights that are expected to significantly increase in value in the future. In the context of mineral rights, the owner of those rights transfers them into a trust in exchange for a stream of income for a certain number of years equal to the fair market value of the mineral rights, plus interest. At the end of the term, any assets left in the trust are transferred to the beneficiaries free of any estate or gift tax.

GRATs have recently MADE HEADLINES as a result of their use by the founders of Facebook.   Mark Zuckerberg, the founder of Facebook, transferred about 3.5 million shares of Facebook into a trust in 2008, in exchange for an annuity based on the then fair market value of the shares – about 83 cents per share at that time.  In 2012, Facebook shares were valued at over $30 per share in an initial public offering.  By using the GRAT, it is estimated that Zuckerberg was able to transfer over $37 million to his heirs free of any gift or estate tax.  His cofounder, Dustin Moskovitz transferred almost $150 million!