KEY ESTATE PLANNING POINTS
Louis A. Mezzullo
Luce, Forward, Hamilton & Scripps LLP
Rancho Santa Fe, CA
lmezzullo@luce.com
April 17, 2007
A.
TRANSFER TAXES
1.
Gift Tax. There is a federal, but not California, gift tax on taxable gifts in excess
of $1,000,000 per individual. The tax ranges from 41% to 45%.
2.
Estate Tax. There is a federal, but not a California, estate tax on the value of an
estate that exceeds $2,000,000 in 2007 and 2008, and $3,500,000 in 2009. The
tax rate is 45%.
Generation Skipping Transfer Tax. There is a federal, but not a California,
generation skipping transfer (GST) tax of 45% on transfers to grandchildren and
more remote descendants in excess of $2,000,000 in 2007 and 2008, and
$3,500,000 in 2009.
B.
ESTATE PLANNING TECHNIQUES IN GENERAL
1.
Annual Exclusion. The annual exclusion allows an individual to make a gift of a
present interest of up to $12,000 per year per donee without using any of the
individual’s transfer tax credit. If the individual is married, the husband and wife
may double this amount to $24,000, regardless of whether only one of them
actually makes the gift. However, if only one of them actually makes the gift, a
gift tax return will be required to take advantage of the increased amount. Note to
qualify for the annual exclusion, the gift must be a gift of a present interest; i.e.,
the donee must be able to enjoy the gift immediately. In addition, the payment of
medical expenses to a health care provider or tuition to an educational institution
also qualifies for the annual exclusion, but does not reduce the $12,000 (or
$24,000) amount otherwise available.
2.
Gift Tax Applicable Exclusion Amount. The gift tax applicable exclusion amount
is $1,000,000 and allows an individual to make gifts in excess of annual exclusion
gifts up to $1,000,000 during an individual’s lifetime without actually paying any
gift tax. This amount may be doubled to $2,000,000 in the case of a husband and
wife. Note that the use of the gift tax applicable exclusion amount uses up part of
the individual’s estate tax applicable exclusion amount.
3.
Estate Tax Applicable Exclusion Amount. The estate tax applicable exclusion
amount for the years 2006 through 2008 is $2,000,000. In 2009, the estate tax
applicable exclusion amount is increased to $3,500,000. Under existing law,
there will be no estate tax (or generation skipping transfers (“GST”) tax) for
decedents dying in 2010. In 2011, unless Congress enacts new legislation, the
estate, gift and GST taxes will revert to what they were on June 6, 2001.
4.
Marital Deduction. Transfers between spouses during lifetime and at death
generally qualify for the unlimited marital deduction. Certain transfers in trust
where the spouse or surviving spouse does not have a qualifying income interest
will not qualify for the marital deduction. If the surviving spouse is not a U.S.
citizen, the assets must pass to a qualified domestic trust in order to qualify for the
estate tax marital deduction. There is no marital deduction for gifts to a noncitizen spouse, but the annual exclusion for gifts to a spouse who is not a U.S.
citizen in 2007 is $125,000, not $12,000.
5.
Charitable Deduction. There is also an unlimited charitable deduction for estate
and gift tax purposes, in contrast to the limited charitable deduction for income
tax purposes. There are various forms that a charitable gift or bequest can take
and still qualify for the charitable deduction, including charitable remainder trusts,
charitable lead trusts, pooled income funds, and life estates in a residence or a
farm.
6.
Bypass Trust. A popular technique used by married couples is to use a trust to
take advantage of the estate tax applicable exclusion amount of the first spouse to
die by having that amount held in the trust for the benefit of the surviving spouse.
The trust would be designed so that the assets would not be included in the
surviving spouse’s estate when the surviving spouse dies. These trusts are often
referred to as credit shelter trusts or bypass trusts. By using such a trust, a
husband and wife are able to pass estate-tax free two times the estate tax
applicable exclusion amount, once at the death of the first spouse to die when the
bypass trust is created, and once at the death of the surviving spouse when the
surviving spouse’s estate is entitled to another estate tax applicable exclusion
amount.
7.
Basis of Assets Gifted or Passing At Death. Generally, the basis of an asset a
donee receives by way of gift is equal to the donor’s basis. In contrast, the basis
of a beneficiary in an asset that passes as a result of the death of an individual is
equal to the fair market value of the asset at the date of the individual’s death (or
the alternate valuation date, if elected). Consequently, if the client has assets with
a high basis and assets with a low basis, the high basis assets are better candidates
for lifetime gifts.
8.
Gifts v. Bequests. Because the gift tax is tax exclusive as opposed to the estate
tax, which is tax inclusive, it is generally advisable to make taxable gifts during a
lifetime. For example, a gift of $1,000,000 that is taxed at 50% would involve a
gift tax of $500,000. However, if the same individual died with $1,500,000 of
assets subject to estate tax at 50%, the beneficiaries would only receive $750,000
($1,500,000 estate minus $750,000 estate tax). However, if the donor of a gift
dies within three years of making the gift, any gift tax paid on the gift will be
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includable in the donor’s estate as an asset of the estate for estate tax purposes.
This inclusion eliminates the transfer tax benefit of making the gift. In addition,
because of the possibility that there may not be an estate tax in the future, many
individuals are currently reluctant to make gifts that will incur a gift tax.
9.
Prepaid Tuition and College Savings Plans. A popular and tax-advantageous way
of providing for educational expenses of children, grandchildren, and others is
through a so-called Section 529 plan. There are two types of Section 529 plans,
prepaid tuition programs and college savings plans. Under a college savings plan,
an individual makes contributions to an account that are treated as gifts to the
account’s beneficiary and qualify for the annual exclusion. In fact, the contributor
can elect to treat a contribution to a Section 529 plan in a given year as having
been made over five years for purposes of the annual exclusion. In 2007, when
the annual exclusion amount is $12,000, an individual can make a contribution to
a Section 529 plan of $60,000 without using any of his or her gift tax applicable
exclusion amount or paying any gift taxes. A husband and wife may double this
amount to $120,000. Note however that the individual would not be able to make
additional annual exclusion gifts to or on behalf of the same beneficiary during
the five-year period. If the individual dies before the end of the five-year period,
a portion of the annual exclusion will be included in the individual’s estate for
estate tax purposes. The earnings on the account accumulate income tax free and
distributions to pay qualified educational expenses are excluded from the
beneficiary’s income.
10.
Irrevocable Life Insurance Trusts. In many cases, it is advisable for individuals to
have life insurance owned by an irrevocable life insurance trust to avoid having
the proceeds includable in the individual’s estate. These trusts can be designed to
use the annual exclusion to pay the premiums by giving the beneficiaries a right to
withdraw the contribution or a portion of the contribution for a limited period of
time. This right makes the contribution a present interest. Note that if an insured
dies within three years after transferring an existing policy to an irrevocable life
insurance trust, the proceeds will be includable in the insured’s estate.
11.
Grantor Retained Annuity Trusts. A grantor retained annuity trust (known as a
“GRAT”), is a technique whereby an individual can transfer appreciating assets to
a trust, and retain the right to receive a fixed dollar amount from the trust for a
term of years. At the end of the term, the assets would pass to children or other
beneficiaries without being subject to any additional gift tax. The value of the
right to receive the dollar amount for the term of years is subtracted from the
value of the asset for purposes of determining the value of the gift to the
beneficiaries. The trust can be designed in such a manner that the value of the gift
is close to zero. A GRAT will result in tax-free transfer of appreciation in the
value of the asset in excess of the so-called 7520 rate that must be used for
purposes of valuing the retained interest. In April 2007, this rate was 5.6 %.
Consequently, for a GRAT created in April 2007 there will be a tax-free transfer
to the beneficiaries to the extent the trust assets increase in value at a rate in
excess of 5.6 %.
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12.
Qualified Personal Residence Trusts. An individual may transfer his or her
principal residence or vacation home to a trust retaining the right to live in the
home for a period of time. After the period, the home would pass to the
individual’s beneficiaries. The value of the gift, which occurs when the residence
is transferred to the trust, is the value of the home less the value of retained
interest. Because the termination of the individual’s retained right to live in the
house is not a taxable event, any future appreciation in the value of the home
passes to the beneficiaries tax free.
13.
Family Limited Partnerships and Limited Liability Companies. An individual
may transfer a business, commercial real estate, or marketable securities to a
limited partnership or a limited liability company and make gifts of limited
partnership or membership interests to achieve a number of non-tax and tax
results. Significantly, the underlying assets of the entity would not be reachable
by creditors of the donee of an interest in the entity. In most cases, the interest in
the entity would be treated as the donee’s separate rather than community
property (except to the extent that the donee participates in the business), and
there can be restrictions on the right of the donee to transfer the interest. From a
transfer tax standpoint, the value of an interest in such an entity may be reduced
by discounts for lack of control and lack of marketability.
14.
Charitable Remainder Trusts. An individual may transfer assets to a trust that
provides for payments to the individual for his or her lifetime or for a term of up
to 20 years, or to the individual and another person for their lifetimes or for a term
of up to 20 years, with the remainder of the assets passing to a charity at the end
of the non charitable beneficiary’s interest. The individual receives a charitable
deduction for income and transfer tax purposes equal to the actuarial value of the
remainder interest passing to the charity. Because the trust is exempt from
income taxes, appreciated assets can be sold by the trust and the entire amount of
proceeds can be invested. The individual receiving the payments pays taxes on
the payments to the extent they constitute taxable income. Distributions are
treated as coming from ordinary income first, then capital gains, then tax-exempt
income (non taxable), and, finally, principal (non taxable).
15.
Charitable Lead Trust. An individual may transfer assets to a trust that provides
for payments to a charity for a period of time, at the end of which the assets pass
to the individual’s children or other beneficiaries. The individual receives a
transfer tax deduction for the actuarial value of the interest of the charity, which
can equal almost 100% of the value of the assets, so that there is very little gift tax
upon the creation of the trust, but the non charitable beneficiaries receive the
assets at some point in the future without any additional transfer tax. This
technique is similar to a GRAT, except that the payments go to a charity rather
than the grantor of the trust.
16.
Installment Sale to a Grantor Trust. An individual may sell appreciated assets to a
trust that is treated as owned by the individual because he or she or someone else
retains certain powers with respect to the trust. The individual does not recognize
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any taxable gain as a result of the sale and the assets in the trust are not included
in the individual’s estate when the individual dies.
C.
17.
Grandchildren’s Trusts. An individual may transfer assets to a trust for the
benefit of a grandchild that qualify for both the gift tax and the generationskipping transfer tax annual exclusion, which, as mentioned above, is currently
$12,000 per donee per year, or $24,000 for a husband and wife.
18.
California Transfer Taxes. Note there is no California estate, GST, or gift tax.
SPECIAL CONCERNS FOR THE CORPORATE EXECUTIVE
1.
What happens with stock options when someone dies?
If the option is a qualified Incentive Stock Option (ISO), the exercise of the
option will not cause any taxable income to the holder of the option unless he or
she is subject to the alternative minimum tax (AMT). The ISO would be
exercisable by the beneficiary according to the term of the ISO.
If the option is not an ISO, it will be exercisable by the person who receives the
option pursuant to the decedent’s will or by intestate succession according to the
terms of the option. Unless the decedent reported income upon the grant of the
option, which is very unusual, the exercise will generally cause the holder of the
option to recognize ordinary income equal to the difference between the option
price and the fair market value of the stock acquired by the option holder. There
may be a deduction for any estate tax attributable to the value of the option being
included in the decedent’s gross estate for estate tax purposes.
2.
What happens to other compensation arrangements?
Such compensation, such as deferred compensation arrangements, is often
payable to a beneficiary named by the decedent. They will be subject to income
tax when received as ordinary income, but may be reduced by any estate tax paid
on the amount.
3.
Who has the right to life insurance proceeds of company provided life insurance?
Generally, the decedent will have completed a beneficiary designation form
before he or she died that will determine who is entitled to the proceeds. Often, in
order to avoid probate, the rights under the insurance arrangement have been
assigned to an irrevocable trust, which is also the beneficiary of the proceeds.
The surviving spouse and/or children are usually beneficiaries of the trust.
4.
Should in-house counsel be concerned about transfers of an owner’s shares into a
trust? Does it depend on the type of trust? What if the key owners have a buysell arrangement?
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If the trust is a revocable, lifetime trust, the owner (and usually the owner’s
spouse) will still have complete control over the stock. If the trust is irrevocable,
the trustee has control over the stock. The in-house counsel should be concerned
if the transfer is to an irrevocable trust if the transfer violates any agreement
among the owners restricting transfers.
5.
What is the difference between an executor and a trustee and which one has the
right to tell the company what to do with post-death benefits and stock? Can the
executor or trustee assume a position on the board of directors: Does this happen
automatically or will the corporate formalities have to be followed?
An executor handles the administration of decedent’s probate estate, while a
trustee administers any trusts created by the decedent. If stock or benefits pass to
the decedent’s probate estate, the executor has control over those assets, but the
executor must distribute them according to the decedent’s will. If the stock or
benefits were held or pass to the decedent’s trust, the trustee controls them, but
again they must be distributed according to the terms of the trust. Many of the
benefits will pass according to the beneficiary designation the decedent signed
before he or she died. In most cases, a California resident would have transferred
any stock he or she owned to a revocable trust (which becomes irrevocable at the
decedent’s death) to avoid probate.
An executor or trustee would not automatically become a member of the board
unless pursuant to a contractual arrangement. In any event, the corporate
formalities should still be followed.
6.
Should owners and executives of companies think about transferring stock into
trusts for heirs, and why?
An owner of an interest in a business that is likely to appreciate in value and who
has enough wealth that his or her estate will be subject to the federal estate tax
should begin making gifts of interests in the business as soon as he or she feels
confident that he or she can do without the asset or the income from the asset in
order to sustain his or her standard of living. There may also be restrictions on
the ability of the owner to make gifts of the interest, although it is typical that
buy-sell agreements permit transfers to family members. By making gifts, the
owner makes use of his or her annual exclusion, and may use up his or her gift tax
applicable exclusion amount. Any appreciation after the gift has been made will
be excluded from the owner’s estate.
7.
Why and how should an owner of a company or one of the key owners begin a
gifting program of stock in the company? What are the pitfalls of such a
program?
The owner should begin gifting when he or she feels confident that he or she no
longer needs the stock or the income from the stock to maintain his or her
standard of living. The major pitfall is the possibility that the stock would
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appreciate in value to such an extent that the owner would not have wanted the
entire increase to pass to the beneficiaries. A second pitfall is that the
beneficiaries may wind up with so much wealth that they no longer have any
incentive to lead a useful life.
8.
If an owner is making gifts, what, if any, role should in-house counsel have in
valuing the stock? What should the role of the company in general be?
Generally, a qualified appraiser should determine the value of an interest in a
business for gift tax purposes. The company’s role would be to cooperate with
the appraiser.
9.
What happens if an executive becomes incapacitated in California? Does the
spouse have the right to tell the company who gets benefits, etc.? What if the
parents want to get involved? What if a court appoints a conservator? What are
the powers of the conservator?
If the executive has signed a power of attorney for financial affairs, the person
named in the power of attorney, called an attorney in fact or an agent, has
whatever powers to act on behalf of the executive specified in the power. If the
executive has not signed a power of attorney, or the attorney in fact does not act,
then it may be necessary to appoint a conservator. A conservator will have the
powers specified in the court order appointing him or her, plus certain statutory
powers. If the interest is community property, the incapacitated executive’s
spouse may have the right to exercise whatever rights the executive had.
Generally, the spouse will not have the right to override the beneficiary
designations made by the executive. However, the spouse will have rights to onehalf of any benefits that are community property, which in most cases will be all
of the benefits to which the executive is entitled.
Parents, as such, would have no role to play, unless they are appointed as the
conservator or have been named as the attorney in fact.
10.
If an executive/owner dies and there are estate taxes to be paid from the
executive/owner’s estate, is there a possible bad effect on the company? Could
the company have to be sold to pay taxes? What can the company do to prepare
for the eventuality (i.e. the sad story of Joe Robbie and many others whose heirs
had to sell the businesses to pay estate taxes)?
Currently, the value of an estate in excess of $2,000,000 is subject to federal
estate tax at a rate of 45%. The tax must be paid nine months after the date of
death. An extension of time may be granted, usually for one-year at a time, for
reasonable cause. In addition, if more than 35% of the estate consists of interests
in closely held businesses, the tax attributable to the closely held business
interests may be paid in ten installments, beginning five years and nine months
after the date of death. The interest charged is generally below the prime rate
charged by banks. There are additional requirements that must be satisfied, and
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the tax may be accelerated if the business is sold or cash is withdrawn from the
business.
In many cases, an owner of a closely held business interest will purchase life
insurance to provide the cash to pay the estate taxes. Sometimes the life
insurance policies will be held in an irrevocable trust to keep the proceeds out of
the decedent’s estate. In addition, the company may be obligated under a buy-sell
agreement to purchase the decedent’s stock, and may have purchased life
insurance to fund the purchase.
While it is true that if the estate tax must be paid and there is no plan on how it
will be paid, the estate may be forced to sell the interest in the business to pay the
tax. In my 30 years as any estate-planning attorney, I have never seen a business
sold because of the federal estate tax.
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