Advanced Tax & Estate Planning

If you have accumulated significant assets during your lifetime, advanced tax planning can help transfer your assets to younger generations while minimizing your income and estate taxes. The federal estate tax imposes a tax of 40% on all assets in an estate in excess of $5.34 million. Therefore, if everything you own is worth more than $5 million – or is likely to be worth more than $5 million in the future – you may benefit from advanced tax planning.

The federal estate tax is coordinated with the federal gift tax, such that the amount subject to tax is based on the combined value of assets that (1) you give away during your life and (2) are transferred to your heirs as part of your estate. The tax is levied only on amounts exceeding a certain threshold level, which for 2014 is $5.34 million. This means that you have can give away $5.34 million dollars either during your lifetime or at death without incurring any estate taxes. The tax only kicks in for amounts in excess of the $5.34 million.

There are a number of strategies that can help you to keep your taxable estate below the exemption amount so that you can avoid paying any federal estate taxes. Below are some estate planning strategies that can help you to minimize, and in some cases entirely eliminate, any gift and estate tax liability.

Irrevocable Life Insurance Trusts

Life insurance can be an excellent way to provide for your family if something happens to you. But if your estate exceeds $5.34 million, half the proceeds from the policy could end up going to the government. While insurance proceeds are exempt from income taxation, they are considered part of your estate if you die owning the policy. By purchasing the insurance policy through a trust, it won’t be considered part of your estate, and your heirs can enjoy it free and clear of any taxes.

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 $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 putting it into a trust to either purchase life insurance or simply invest it so that the money appreciates 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. Note that, in order to qualify for this exclusion, payments must be made directly to the educational or medical institution. If you set up a specific type of trust, the exclusion can be used not only for present expenses, but also for health and education expenses for generations to come.

Estate Freezing Strategies

A widely-used strategy to limit estate taxes is to “freeze” the value of your estate. Suppose you have assets worth $5 million and the estate tax exemption is $5 million. If you transferred all of your property immediately, there would be no federal gift and estate tax on the transfer of your assets. In 10 years, however, that $5 million, earning a return of 7%, will grow to be nearly $9.5 million, triggering an estate tax of several million dollars. By implementing the following “estate freezing” strategies, you can freeze the value of your estate for estate tax purposes at $5 million.

Early Gifting

You may have heard the common maxim of “Give it away early” as a strategy for reducing estate taxes. Indeed, transferring your wealth sooner rather than later makes it less likely that your estate will have to pay a hefty tax later on. You will also have the benefit of seeing your heirs enjoy their inheritance while you are living.

Early gifting has a number of estate tax benefits:

By giving gifts during your lifetime, you can take advantage of the $14,000 annual exclusion (which is no longer available upon your death).

Gifting is the primary means of “freezing” the value of your estate. The value of your assets today (and thus the amount subject to estate tax) is likely less than the value of those assets in the future. You may have a piece of property that is worth $3 million today, but will be worth $6 million ten years from now, as a result of the asset’s appreciation. If you give the property away today, you will use up only $3 million of your estate tax exemption. If you wait 10 years, you will have to use up the full $5.25 million allowance and pay a gift tax on the additional $750,000 for transferring the same property.

If your children are in a lower tax bracket than you, gifting may provide income tax benefits by allowing the assets to appreciate subject to a lower tax rate.

Irrevocable Gifting Trusts

If you would like to make gifts of your assets before they increase in value, but are concerned about giving up control or access to the money, an irrevocable trust may be able to 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 so that your spouse has access to the funds. By providing your spouse with access to trust funds, you can continue to benefit from the assets as a couple.

Dynasty Trusts

A dynasty trust is a type of irrevocable trust used to transfer wealth to multiple generations while minimizing estate taxes. The trusts have no expiration date, so assets in a dynasty trust may grow for an unlimited number of future generations.

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, if $1 million of your estate assets is subject to an estate tax rate of 50%, that $1 million would shrink to $500,000 when it passes to your children. Now assume that their estate tax rate is 50% also. When your children pass away, that $500,000 you left to them could shrink to $250,000 when it is distributed to your grandchildren – only 25% of the amount that you originally left. A dynasty trust can eliminate the estate tax that is levied at each generation. Assets put into a dynasty trust can also benefit from the “estate freezing” effects explained above.

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 based on 120% of the Applicable Federal Rate (AFR) then in effect. While this technique does not entirely “freeze” your estate, it reduces any increase in the value of your estate to the applicable interest rate. The recent historically low interest rates have made GRATs a popular tool for transferring appreciation of an asset free of estate and gift tax because of the likelihood that, over a long period of time, the value of most assets will grow faster than the applicable interest rate.

The use of GRATs has 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!

Of course, few people are in the position of Mark Zuckerberg. But in today’s low interest rate environment, anyone who is concerned about estate taxes may want to consider using a GRAT. The long-term AFR (9+ years) has recently been well under 3%, while the historic long-term performance of equities is 8-12%. By using a GRAT, any appreciation over 3% can be transferred to your heirs clear of any estate or gift tax, and there is no depletion of the gift and estate tax exemption.

Qualified Personal Residence Trusts (QPRT)

A person’s most valuable asset is often their principal residence or vacation home. A common technique for transferring your home to your heirs while avoiding estate tax is the qualified personal residence trust (QPRT). To make use of the benefits of a QPRT, a person transfers their home to a trust while retaining the right to live in it for a specific term of years. The amount of the taxable gift to the beneficiaries is the value of the remainder interest in the home when the retained residence rights expire – a significant discount from its current value. When the term of the QPRT expires, the taxpayer can continue living in the home, but must pay rent to the beneficiaries of the trust.