The following descriptions of estate planning techniques are for general information purposes only. They should not be relied upon in making estate planning decisions. They are intended only to give a general understanding of how these techniques work so that the reader can have a more informed conversation with his or her estate planning attorney. The reader should consult with his or her estate planning attorney regarding his or her particular circumstances.

QTIP Trust for Surviving Spouse

A typical basic tax-smart estate plan will create an irrevocable trust upon the death of the first spouse to die. This trust is usually known as a By-Pass Trust or a Credit Shelter Trust. The purpose of this trust is to preserve the deceased spouse’s estate tax exemption. (See “Basic Estate Tax Information” on this website.) The balance of the deceased spouse’s assets will usually pass to the surviving spouse.

Some couples, however, choose to place the balance of the deceased spouse’s assets in yet another irrevocable trust, rather than leave them to the surviving spouse outright. This second irrevocable trust is known as a QTIP marital trust. There are three reasons why the couple might decide to use a QTIP trust.

The first reason for using a QTIP trust is that the deceased spouse might want to ensure that those assets pass to his intended beneficiaries when the surviving spouse dies. If the assets are left to the surviving spouse outright, she would be able to leave them to whomever she wants upon her death. However, if the assets are placed in trust, they will pass according to the terms of the trust when the surviving spouse dies. This type of arrangement is particularly common where either the husband or the wife, or both, have children by a prior marriage.

The second reason for placing the balance of the deceased spouse’s assets in trust is to protect the assets from the surviving spouse’s creditors. If the assets are left to the surviving spouse outright, they will be subject to her creditors. However, if the assets are left in trust, and if the trust is properly designed, the assets will generally not be subject to the surviving spouse’s creditors as long as they remain in the trust. Note, however, that this protection is not generally available against tax liens. (See “Asset Protection” below.)

The third reason for using a QTIP trust is to preserve the deceased spouse’s generation-skipping transfer tax exemption, to the extent this exemption has not been fully utilized by the Credit Shelter Trust. (See “Generation-skipping Transfer Tax” below.)

Property that goes into a QTIP trust escapes estate taxation at the death of the first spouse because it is passing to a trust for the benefit of the surviving spouse and therefore receives the benefit of the marital deduction. Accordingly, the tax code requires that the trust truly exist for the benefit of the surviving spouse. It requires that the surviving spouse receive all of the net income from the QTIP trust at least annually. It also requires that no funds from the trust be distributed to anyone other than the surviving spouse during the surviving spouse’s lifetime.

The surviving spouse may serve as trustee of the QTIP trust, and may be given powers to enable her to alter who the beneficiaries of the trust will be after she dies.

Lifetime Gifting and the Time Value of Money

Lifetime Gifting

Each year, a person can give up to $18,000 to any person (and to as many persons as he or she wants) without any tax consequences. A married couple can give $36,000 to each such person every year. (See “The Gift Tax” under “Basic Estate Tax Information” on this website.)

Every dollar that a person gives away is a dollar that will not be included in the person’s estate for estate tax purposes. Thus, at a 40% estate tax rate, every dollar that is given away during life (up to $18,000 per recipient) can save 40 cents in estate tax.

Consider a married couple with three children, each of whom is married and also has three children. The couple thus has three children, three sons- or daughters-in-law, and nine grandchildren, for a total of fifteen family members to whom annual $18,000 gifts can be made. The husband and the wife can each give $18,000 to each of those fifteen family members. The total gifts that can be made each year is 15 x $36,000 = $540,000. By transferring $540,000 per year in annual gifts, the couple is reducing the amount that will be included in their estates by $540,000, thereby saving over $200,000 in estate taxes. If the couple were to make such gifts every year for ten years, the gifts would total over $5 million, and the estate tax savings would be over $2 million.

Of course, a person should make lifetime gifts for estate planning purposes only if and to the extent that he or she can do so comfortably, without adversely affecting his or her financial security. One should never undertake the gifting techniques discussed here unless one has ample funds with which to do so.

The Time Value of Money

Of course, the previous example really tells only part of the story. If the couple in that example had not made those annual gifts, the money would have remained in their hands where it would have grown. The funds would have generated income and, if invested well, would have appreciated in value. When money grows at the rate of 5%, it doubles roughly every 12 years. Over the course of many years, the $5 million that the couple did not give away would have perhaps doubled or tripled or grown even more, in their hands. These additional millions of dollars of income and appreciation would also be subject to estate tax when they died. However, by making the gifts, they not only put the gifted amounts into the hands of the younger generations. They also put the income and appreciation of those funds into the hands of the younger generations. The money grows in the hands of their children and grandchildren – not in their own estates. Thus, the estate tax savings in the previous example may be many millions, not just $2 million.

Fractional Interest Discounts

Valuation discounts that result from fractionalizing ownership of assets are a very potent estate tax reduction tool. Consider the following example:

A person is the sole owner of an apartment building worth $1 million at the time of her death. In this case, the value of the apartment building ($1 million) will be included in the person’s estate for federal estate tax purposes. Suppose, however, that the apartment building is owned 98% by the deceased person, 1% by the her son and 1% by her daughter. What will be the value of the deceased person’s interest in the apartment building? $980,000? Not at all. No buyer would pay $980,000 for a 98% interest in a $1 million property. The buyer would demand a discount in the purchase price to reflect the lack of control and lack of marketability. As it turns out, those discounts can be substantial. 25% to 35% is not unusual. Thus, the deceased person’s 98% interest in the apartment building will be valued at approximately $635,000 to $735,000 for estate tax purposes, and the tax due will be approximately $100,000 to $140,000 less than it would be if she owned the entire building.

Income Tax Basis Issues

In general, appreciated property that is included in a person’s estate receives a step-up in income tax basis to fair market value upon the person’s death, whether or not any estate tax was actually due. Thus, property can be sold soon after death without incurring capital gains taxes, even if the property had a low income tax basis in the hands of the deceased person.

Appreciated property that is the subject of a lifetime gift, on the other hand, does not receive a step-up in basis. The basis in the hands of the recipient is the same as the basis in the hands of the person who made the gift. For that reason, it is usually better to make a gift of cash than a gift of low-basis property. It may be best to hold the low-basis property until death, when it will receive a step-up in basis.

Property that has depreciated in value (i.e. property on which the market value is lower than the basis) will get a step-down in basis at death. Thus, it may make sense to sell such property before death so that the loss can be taken on the taxpayer’s income tax return. If the property is sold after death, the opportunity to take advantage of the loss will have been missed.

Similarly, property that has depreciated in value will get a step-down in basis when it is the subject of a lifetime gift. Thus, when a gift is made of such property, one forfeits the ability to take a deduction on the loss. It may make more sense to sell the property, take the loss, and give the intended recipient the proceeds of the sale.

Many estate planning techniques involve the making of sizable lifetime gifts. Where the gifts consist of property other than cash, the benefits of making the gifts may be diminished if the recipient of the property also receives a low carry-over income tax basis.

529 Educational Savings Plans

Educational savings plans, also known as 529 plans (so named for the section of the federal tax code under which they are authorized), permit a person (often a grandparent) to make substantial gifts to pay for a beneficiary’s education and to have the income and appreciation on the gifted funds grow tax-free.

A person can give $18,000 to any person (and to any number of people) each year without gift tax consequences. A person can also pay the medical and educational expenses of any other person to an unlimited amount, without gift tax consequences, as long as the payments are made directly to the provider of the medical or educational services.

Similarly, a person can contribute $18,000 per year per beneficiary to a 529 plan. Amounts contributed count against the $18,000 annual gift. With a 529-plan, however, the person making the gift can front-end load five years of gifts. Thus, $90,000 can be given at once, though no more non-taxable $18,000 gifts can be given by that person for that beneficiary for another five years.

In Utah, a state income tax credit may be available for contributions to a 529 plan.

All amounts in the plan grow income-tax-free, for purposes of both federal and Utah income taxes. Withdrawals from the plan are exempt from federal and Utah income tax as long as they are used for qualified higher education expenses at an eligible educational institution. Qualified higher education expenses generally include tuition, fees, books and supplies. They also generally include room and board if the student is attending school at least half-time. Eligible educational institutions generally include both public and private colleges, community colleges, vocational schools and graduate schools.

Each account may have only one beneficiary. The beneficiary of the account can generally be changed to another member of the beneficiary’s family. Funds in the account may adversely impact a beneficiary’s eligibility for financial aid.

The Utah Educational Savings Plan is the only authorized educational savings plan in Utah. UESP offers several investment options. More information is available at www.uesp.org.

Family Limited Partnerships

Family limited partnerships can be convenient vehicles for making gifts to children and grandchildren. Family assets can be bundled into a family limited partnership, and gifts of small limited partner shares can then be given to family members. The advantages of this approach are several. First, it enables the senior generation to make gifts without exhausting their cash resources. Second, it enables the gifts of hard assets to be made without transferring control of those assets. The senior generation (or perhaps the intermediate generation) will be the general partners of the partnership, and will control partnership decisions. Third, if the partnership has a diversified portfolio of assets, the recipients receive fractional shares of that diversified portfolio, rather than fractional interests of one particular asset. Fourth, the recipient’s access to funds can be restricted by the terms of the partnership agreement and by the general partners’ decisions regarding what distributions will be made. Fifth, a measure of asset protection is available inasmuch as a recipient’s creditors would have only limited rights if they were to attach a limited partner’s interest. Sixth, the partnership can be a helpful tool to teach grandchildren about investing, since they will be limited partners and will have interests in the partnership.

In addition, the fractionalized nature of partnership shares can produce substantial estate and gift tax savings. The tax savings that are available through fractional interest discounts are discussed above under “Fractional Interest Discounts.” The same principle is often applied to family limited partnerships that may hold one or more pieces of real estate or other assets. If the decedent owns 98% of the partnership interests, her interest in the partnership will be valued at a discount for estate tax purposes. Moreover, the gifts of partnership shares will themselves receive valuation discounts because they represent fractional interests of the partnership. A partnership must never be created for the purpose of achieving these tax results. However, if the partnership exists for other valid business reasons, as discussed above, these tax consequences can be very beneficial.

Some of the disadvantages and risks associated with a family limited partnership are: (1) The gifts of partnership shares will have a carry-over basis in the hands of the recipients. (See “Income Tax Basis Issues” above.). (2) Federal and state income tax returns must be prepared and filed for the partnership each year, which will generate accounting fees. (3) The partnership is a separate legal entity and must be treated as such. Separate bank accounts must be maintained for the partnership, and there must be no commingling of partnership funds and personal funds. Careful record-keeping is required. (4) Annual registration fees must be paid to the State.

Substantially the same benefits are available through the use of limited liability companies (LLCs), and LLCs also carry substantially the same potential disadvantages.

Life Insurance Trusts

Life Insurance in General

Many families carry life insurance for the purpose of replacing the income that would be lost if the family bread-winner were to die. In addition, some families that have a family-owned business have life insurance to help them pay the estate tax that would be due if the owner of the business were to die. Without the life insurance, the family might have to sell the business in order to pay the estate tax.

In general, the death proceeds of a life insurance policy will be subject to estate tax if the decedent owned the policy at the time of her death or if the decedent’s estate is named as the policy beneficiary. In order to avoid taxation of the policy proceeds, it is often advisable to have the intended beneficiary of the policy also be the owner of the policy.

Life Insurance Trusts

Many people who have insurance on their lives have created irrevocable trusts to hold the insurance policies. In these cases, the trust is both the owner of the policy and the beneficiary of the policy.

This type of arrangement accomplishes at least two important objectives. First, it helps ensure that the policy’s death proceeds will not be subject to estate tax, as described above. Second, it places the policy’s death proceeds into a trust from which the funds can be paid out to the trust beneficiary over a period of time, as prescribed in the trust, rather than having the beneficiary receive all of the money at once.

The Generation-skipping Transfer Tax

What is the GST Tax?

The generation-skipping transfer tax, commonly known as the GST tax, was created to plug a perceived hole in the estate tax. Prior to the GST tax, a decedent could leave property directly to her grandchildren and, in doing so, circumvent a layer of estate tax. It would work this way:

For ease of illustration, assume a 50% estate tax and a 50% GST tax.

Suppose a grandmother were to leave property to her son. The property would be subject to a 50% estate tax at the grandmother’s death, and the son would receive 50 cents on the dollar. Years later, the son dies and leaves the same property to his daughter. The property is again subject to a 50% estate tax upon the son’s death, and the daughter receives only 25 cents of each dollar that the grandmother owned when she died.

But suppose the grandmother, mindful of the fact that her son has ample funds, leaves the property directly to her granddaughter. The property is still subject to a 50% estate tax upon the grandmother’s death, but the second 50% estate tax has been eliminated, and the granddaughter receives 50 cents on the dollar, not just 25 cents.

With the GST tax, Congress imposed an additional 50% tax on the direct transfer to the granddaughter, so that at the grandmother’s death, there will be a 50% estate tax and a 50% GST tax, and the granddaughter will receive only 25 cents on the dollar.

The GST tax also fixes another similar loophole in the estate tax. This loophole related to gifts in trust. Suppose, at her death, the grandmother were to create an irrevocable trust of which her son is the income beneficiary and his daughter (her granddaughter) is the remainder beneficiary. The property would be subject to a 50% estate tax at the grandmother’s death, as it goes into the trust. The trust would thus receive 50 cents on the dollar. The son would receive the net income from the trust throughout his lifetime. Years later, when the son dies, the trust terminates and the trust property is distributed to the daughter. If the trust is designed properly, the trust property is not part of the son’s estate, and is not taxed in his estate. The daughter receives 50 cents of each dollar that the grandmother owned when she died. The trust thus circumvents the double layers of estate tax described above.

With the GST tax, Congress imposed a 50% tax on the distribution of the trust property to the granddaughter, so that at the grandmother’s death, there will be a 50% estate tax, and at the son’s death, there will be a 50% GST tax on the trust distribution. Again, the granddaughter will receive only 25 cents on the dollar.

Exemptions to the GST Tax

Just as there are various exemptions to the estate tax and the gift tax, there are exemptions to the GST tax.

For practical purposes, any gift that would be exempt from the gift tax will also be exempt from the GST tax. Thus, an $18,000 gift to one’s grandchild will not have any GST tax consequences, nor will direct payment of a grandchild’s medical or educational expenses to the provider of those services.

In addition, each person has an $13.61 million GST exemption. Lifetime generation-skipping taxable gifts use up the $13.61 million exemption dollar-for-dollar, reducing the amount of GST exemption that will remain at death. If the $13.61 million exemption is exhausted during the donor’s lifetime, additional generation-skipping gifts will require payment of the GST tax on April 15 of the year following the year in which the gifts are made.

The $12.92 million GST tax exemption can be used to exempt direct gifts to a grandchild from the GST tax, or it can be allocated to a generation-skipping trust to make the trust GST-exempt. If a trust is exempt from the GST tax, all growth in the value of the trust assets will also be GST-exempt.

Suppose an unmarried grandfather gives $20,000 in cash to his granddaughter. This is the only gift he ever makes during his lifetime. The first $18,000 will be exempt from the gift tax and from the GST tax. The next $2,000 will use up $2,000 of his estate tax exemption and $2,000 of his GST tax exemption. At his death, he will have remaining $13,608,000 of estate tax exemption and $13,608,000 of GST tax exemption.

Suppose instead, the grandfather gives $20,000 to his son. Again, this is the only gift he ever makes during his lifetime. The first $17,000 will be exempt from the gift tax. The next $3,000 will use up $3,000 of his estate tax exemption. Because the gift is to his son, there will be no GST tax consequences at all. There is no generation-skipping transfer. At his death, he will have remaining $12,917,000 of estate tax exemption and the full $12.92 million of his GST tax exemption.

Note: A gift to a non-relative who is more than 37 ½ years younger than the person making the gift will be treated as a generation-skipping transfer.

Charitable Remainder Trusts

In very general terms, a charitable remainder trust is a trust that has one or more individual lifetime beneficiaries and one or more charitable remainder beneficiaries. If the lifetime beneficiary receives annuity payments the trust is known as a charitable remainder annuity trust (CRAT). If the lifetime beneficiary receives unitrust payments (i.e. a fixed percentage of the value of the trust each year) the trust is known as a charitable remainder unitrust (CRUT). At the death of the lifetime beneficiary, the balance remaining in the trust is distributed to the charitable beneficiaries.

The tax benefits of a charitable remainder trust are two-fold: First, when the trust is established, the creator of the trust receives an income tax deduction for the present value of the contribution to the trust that will eventually pass to charity, determined on an actuarial basis, using the ages of the individual lifetime beneficiaries. Second, if low-basis assets are contributed to the trust, they can, in some circumstances, be sold in the trust without triggering capital gains taxes.

The best time to create a CRT is generally when interest rates are low, so as to maximize the income tax charitable deduction.

QPRTs

QPRT is an acronym for “Qualified Personal Residence Trust.” A QPRT is an irrevocable trust to which the creator of the trust transfers either her primary residence or her vacation home. The purpose behind a QPRT is entirely tax-driven. A QPRT enables a person to transfer wealth to her beneficiaries at a greatly reduced gift tax cost.

Suppose a mother is already taking full advantage of the $18,000 annual gift tax exclusion described above. She wants to make a large gift to her daughter. If she transfers $500,000 to her daughter, she will use up $500,000 of her estate tax exemption, and she will have $500,000 less of her estate tax exemption remaining at her death.

Suppose, however, she makes a gift of her residence, worth $500,000, to a QPRT. During the term of the QPRT, the mother will have the right to continue to live in the home. When the QPRT ends, the residence will be distributed to the daughter. The mother can then continue to live in the home by paying a fair market rent to her daughter. The initial term should be at least three years, and can be as long as the creator wants.

At the time the QPRT is created, the mother makes a taxable gift to the daughter equal to the present value of $500,000 (the value of the house), as determined by the term of the QPRT and interest rates at the time. If the QPRT term is five years, the value of the gift is the present value of a $500,000 payment to be received five years in the future.

Care must be exercised in choosing the length of the term. The longer the term of the QPRT, the greater the tax savings. But if the creator dies during the QPRT term, there will be no tax savings at all; it will be as if the QPRT had never been created.

The best time to create a QPRT is generally when interest rates are high and real estate values are low.

Some of the disadvantages and risks associated with a QPRT are (1) the creator might die within the QPRT term, (2) the property might depreciate in value, (3) the beneficiaries receive a carry-over income tax basis in the residence, whereas the residence would have received a step-up in basis if the creator had owned the property at her death, and (4) the legal and accounting costs associated with creating the QPRT, transferring the residence to the QPRT, obtaining a real estate appraisal of the residence and preparing the gift tax return.

Before creating a QPRT, one should be confident that one is not going to want to sell the home during the term of the QPRT. Sale of the residence is permitted, but it almost always results in headaches for everyone involved.

GRATs

GRAT is an acronym for “Grantor Retained Annuity Trust.” GRATs are entirely tax-driven. A GRAT is an irrevocable trust to which the creator of the trust transfers property that he believes will appreciate significantly in value.

A typical GRAT will provide for large annuity payments to the creator. Over the term of the GRAT, most of the property that was initially transferred to the GRAT will be returned to the creator in the form of annuity payments. Over the term of the GRAT, one hopes that the property will have experienced substantial appreciation in value, and at the termination of the GRAT, the property remaining in the GRAT (i.e. the amount of the appreciation) will be distributed to the beneficiaries.

The value of the gift at the time the GRAT is created is discounted to reflect the fact that much of the property contributed to the GRAT will be returned to the creator, leaving relatively little value for the beneficiaries, other than the hoped-for, but speculative, appreciation. Indeed, in some cases, the value of the gift for gift tax purposes will be zero, even though substantial value ends up in the hands of the beneficiaries if the value of the asset does in fact appreciate.

Generally, the longer the term of the GRAT, the smaller the value of the gift for gift tax purposes. However, if the creator dies during the term of the GRAT, the benefits are lost; it is as if the GRAT had never been created.

The best time to create a GRAT is generally when interest rates are high, but the timing of a GRAT is usually driven by the expectation that the value of the property will appreciate significantly in the near future.

Asset Protection

For a discussion of creditor protection vehicles that are available in Utah, see “Asset Protection in Utah” on the home page of this website, or you may click on UtahAssetProtection.org.

Special Needs Trusts

When a disabled individual is eligible to receive governmental assistance to provide for his or her basic needs, the individual’s family will sometimes want to create a trust to provide additional support for him or her. However, a person is ineligible for government assistance if his or her assets or income exceed certain levels. The family members will therefore want to make sure that the existence of the trust will not render the disabled person ineligible for government assistance.

In those situations, an irrevocable trust can be created that provides only for the disabled person’s supplemental needs. The terms of the trust must provide that trust funds may not be used for the disabled person’s basic support. Such a trust can preserve the person’s eligibility for government assistance.

Supplemental needs can include telephones, computers and other electronic equipment; recreational activities, such as cultural experiences, vacations or summer camp; and even personal grooming and medical costs, such as eye glasses, hair and nail care, dental care, medication, therapy and mechanical beds, but only to the extent that any such item is not provided by or reimbursed by a governmental program. Please consult with your own attorney to determine what expenditures can be made from a special needs trust in your situation without rendering the disabled individual ineligible for government assistance.

It is also possible to create a special needs trust with the disabled person’s own assets. However, it is important to understand that such a trust must be irrevocable, and the disabled person may not have the ability to withdraw the assets or demand distributions from the trust.

The rules governing Medicaid eligibility can be very complicated. Please consult with your attorney regarding your particular circumstances.

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