Let's Connect

Key Estate Planning Strategies

06.01.08  |  By Deborah S. Barcham

Estate planning is more than drafting a Will. There are many considerations involved in meeting clients' estate planning needs and requirements. The following are brief explanations of some of the principal estate planning strategies. They may be helpful as an initial checklist of strategies to consider in connection with the preparation of an estate plan.

Marital Deduction - Assets transferred to a spouse, either outright or to a QTIP trust, qualify for the marital deduction and are not subject to a gift or estate tax.

Gifts - Gifts are an especially valuable strategy for estate planning purposes as they remove from the donor's estate not only the asset gifted but also the income and appreciation on such asset which would otherwise have increased the donor's taxable estate.

Annual Gift Tax Exclusion - For 2006 each person is permitted to make a gift of $12,000 annually to as many people as he or she wishes. The annual gift tax exclusion is indexed to inflation and may be expected to increase in future years. The consistent use of the annual gift tax exclusion can be an especially valuable estate planning strategy.

Gift Tax Exemption - In addition to the annual gift tax exclusion, each person has a lifetime exemption from the federal gift tax. As of 1/1/02 the gift tax exemption was set at $1 million and will remain at $1 million thereafter. It will not increase along with the increase in the estate tax exemption. In 2010 and thereafter, the top gift tax rate is to be reduced to the highest income tax rate, which in 2010 is 35%. There will be no repeal of the gift tax.

Gifting the Lifetime Gift Tax Exemption - In addition to an annual gift giving program utilizing the annual gift tax exclusion, persons with substantial assets may wish to gift all or a portion of his or her $1 million lifetime gift tax exemption. However, the portion of the lifetime gift tax exemption which is used reduces the estate tax exemption.

Federal Estate Tax Exemption - The federal estate tax exemption is $2 million in 2006, 2007 and 2008, and then will increase to $3.5 million in 2009. In 2010 the estate tax is repealed. However, in 2011 the prior federal estate tax law is reinstated with a $1 million exemption. The New York estate tax exemption remains at $1 million and will not increase along with the federal estate tax exemption.

Plan For An Exemption Of $2 Million - In the face of the many uncertainties created by the proposed revocation of the federal estate tax (2010) and then its reinstatement (2011), our advice is to assume a federal estate tax exemption of $2 million during the three (3) years 2006 through 2008, which is precisely what the law provides, and not get carried away with the thought of repeal or reinstatement until the law has been reconsidered and modified - as appears to be inevitably the case, or until we get much closer in time to actual repeal.

New York Estate Tax Exemption - The New York estate tax exemption is $1 million and is not expected to increase. Inasmuch as the federal estate tax exemption is $2 million for 2006, 2007 and 2008, a New York estate tax will be incurred if the amount of the exemption exceeds $1 million. For example, a New York estate tax of $99,600 will be incurred if the federal estate tax exemption of $2,000,000 is utilized. Unless otherwise stated, references in this article to the estate tax exemption refers to the federal and not the New York estate tax exemption.

Bypass Trust - Funds transferred to a bypass trust, sometimes called a credit shelter trust, are excluded from the surviving spouse's taxable estate, but during the term of the trust the income of the trust and possibly also the principal of the trust may be distributed to the beneficiary, in many cases the surviving spouse. The benefit of a bypass trust is that on the death of the surviving spouse the assets in the trust, including any appreciation, will pass estate tax free to the children or other beneficiaries. Because the New York estate tax exemption will not increase along with the federal estate tax exemption, fully utilizing the federal estate tax exemption to establish the bypass trust will result in New York estate taxes.

Funding a Bypass Trust with IRA Assets - Where a bypass trust is desired but there are insufficient ordinary (non-qualified) assets available to substantially fund the trust, then resort may be made to IRA assets. However, the use of IRA assets to fund a bypass trust (or a QTIP trust) is highly technical inasmuch as the IRA assets cannot be simply poured over to the bypass trust, since this would cause the IRA plan to terminate and income taxes would be due on the IRA distribution. The IRA must be continued, and this requires a Will with specific provisions and also a custom designed IRA beneficiary designation form, usually with spousal disclaimer provisions.

Contingent Bypass Trust - If clients are uncertain as to whether to utilize a bypass trust, then the Will may provide for a bypass trust contingent upon the surviving spouse disclaiming assets. Under the terms of such a Will, assets disclaimed by the surviving spouse will fund the bypass trust, which trust is usually for the benefit of the surviving spouse.

SNT (Supplemental Needs Trust) - A supplemental needs trust (SNT) provides funds for a person entitled to governmental benefits, such as Medicaid or nursing home care. Such a trust is commonly used in connection with elder law planning and is intended to supplement, but not replace, governmental benefits. If a trust is not drawn as an SNT, the government may claim that the trust use its funds prior to a beneficiary receiving governmental benefits, such as Medicaid.

Conversion to SNT - A testamentary trust, such as a bypass trust under a Will, can provide that if the beneficiary shall enter a nursing home or otherwise be entitled to governmental assistance, that the trust be converted to a SNT, thereby qualifying the beneficiary for governmental assistance and at the same time preserving the trust's assets for children or other remaindermen.

Disclaimer By Surviving Spouse - A client may fail to do estate planning and as a result leave all assets to a surviving spouse. In such a case the surviving spouse, wishing to reduce his or her taxable estate, may disclaim all or a portion of the deceased spouse’s estate. If the disclaimer is limited to no more than the deceased’s available federal estate tax exemption, no federal estate taxes will be incurred on the first estate, but it will reduce the surviving spouse's taxable estate. The downside of a disclaimer is that the assets disclaimed will pass directly on to the children and will not be preserved for use by the surviving spouse.

QTIP (Marital) Trust - Assets transferred to a QTIP trust qualify for the marital deduction. A QTIP trust is used where there is a desire (i) to have assets protected by a trust and/or (ii) to leave the remainder of the trust to the deceased’s children or other persons when the surviving spouse passes away. A QTIP trust requires at the least that all of the trust income be paid to the surviving spouse.

Disclaimer By Children - Children with substantial assets of their own may wish to disclaim all or a portion of assets left to them by their parents, so that the disclaimed assets do not increase their own taxable estates and will be passed on to their children without incurring any additional estate taxes. However, if the amount disclaimed should exceed the available GST tax exemption (see below), then the harsh effect of GST taxes should be considered.

Underqualifying the Marital Deduction - Underqualifying the marital deduction means leaving assets in excess of the available estate tax exemption to children or other non-spousal persons when use of the marital deduction is available. While this will result in estate taxes, there may be an overall savings in estate taxes because assets bequeathed to children, and the income and/or appreciation on such assets, will be excluded from the surviving spouse's taxable estate. Underqualifying the marital deduction requires careful planning.

Life Insurance - Life insurance is often an essential part of an estate plan. It provides (i) funds and security for heirs and beneficiaries, (ii) funds to pay estate taxes, and (iii) for some types of insurance policies a way to accumulate assets on a tax deferred basis. It has been compared favorably to an IRA because while the insurance policy provides income tax free funds in the event of death, the proceeds may be shielded from estate taxes (if in a trust) and the income, represented by a portion of the cash surrender value, can be withdrawn on a tax deferred basis.

Life Insurance Trust - Life insurance proceeds are included in the deceased's taxable estate if the insurance policy is owned by the insured. However, the proceeds may be shielded from estate taxes if the policy is owned by an insurance trust, provided the policy was applied for by the trustee or was transferred to the insurance trust more than three (3) years prior to the insured's death. If life insurance proceeds are paid to the surviving spouse then the marital deduction applies, but the proceeds will be includible in the surviving spouse's taxable estate. An insurance trust is commonly used to shield the proceeds from inclusion in the taxable estates of both the insured and his or her spouse.

Survivorship Life Insurance - Survivorship insurance, also called second-to-die insurance, is payable when the survivor of a husband and wife passes away and when estate taxes are usually due. If a second-to-die policy is held in an insurance trust then, subject to the three (3) year rule, the proceeds will not be subject to estate taxes on the death of the surviving spouse.

GST Planning (Generation Skipping) - Assets transferred to children may increase their estate taxes and may compound their own estate planning. However, if the assets are either given outright to grandchildren or placed in a GST tax trust or trusts for the children, to be thereafter passed on to grandchildren, then subject to the GST tax exemption (see below), such assets may be excluded from the children's taxable estates. Dynasty trusts are used where there is a desire to provide for children, grandchildren as well as later generations.

GST Tax Exemption - Every person possesses an exemption (indexed for inflation) on outright gifts or bequests to grandchildren and/or GST tax trusts for children which will eventually be distributed to grandchildren. Assets given to grandchildren or later descendants in excess of the GST exemption will be taxed at the highest estate tax rate. From 2006 through 2009 the GST tax exemption will track the estate tax exemption ($2 million in 2006, 2007 and 2008 and $3.5 million in 2009). The GST tax is in addition to the gift or estate tax, if any. Life insurance is commonly used as a method of funding GST tax trusts as well as dynasty trusts.

Living (Revocable) Trusts - A living trust, also called a revocable trust, is a popular device to manage assets and avoid probate. While probate in New York is generally quick and simple, living trusts are frequently used to manage assets for elderly clients; as a standby trust; for out-of-state real estate; for out-of-state clients; to avoid probate; and to separate the assets of husband and wife in the event of remarriage. A living trust requires a pourover Will, so that any assets remaining in the decedent's name will be poured over by the Will into the living trust, to be distributed pursuant to the trust agreement. A living trust has no advantages over a Will for estate tax purposes. Anything that a living trust can accomplish with respect to reducing estate taxes can be equally accomplished through a Will. A major drawback of a living trust is that it may not be converted to a SNT (supplemental needs trust) for the surviving spouse. This may only be done by a Will.

Transfer At Death Accounts – New York recently passed a law permitting financial accounts to be transferred at death to a designated beneficiary. Therefore, with respect to such accounts, this may obviate the need for dispositions thereof by Wills and/or living (revocable) trusts.

Coordinate Ownership of Assets With Estate Plan - All assets should be reviewed and ownership and beneficiary designations should be updated and coordinated with the estate plan. Clients who fail to do so may find that their Wills and estate plans may contemplate certain transfers, but that the manner in which assets are owned or beneficiaries designated may result in different and conflicting transfers. For example, a Will does not control jointly owned assets, which will belong to the surviving joint owner. Also, assets with beneficiary designations, such as qualified plans, IRAs and insurance policies, will be distributed as provided by the beneficiary designation form and not by the Will.

FLP (Family Limited Partnership) - A family limited partnership is useful for making gifts to family members and for managing and controlling the assets held by the FLP. An added benefit is that a valuation discount usually applies to the gift of limited partnership interests. Moreover, if the donor is not a controlling general partner then on the donor's death a valuation discount may apply to the donor's limited partnership interest. It is essential, however, that the FLP serve a business purpose, that the formalities of the FLP be fully observed, that it not be created at the "last minute", and that the interest in the FLP not constitute a “retained interest” for estate tax purposes as noted in Strangi and related cases.

APP (Asset Protection Planning) - APP may be essential to those persons who may wish to protect assets from personal claims, such as professional liability claims, or may wish to limit claims derived from the ownership of assets, such as claims arising from real estate ownership. APP takes many forms, and it may include transferring assets to a spouse, holding separate parcels of real estate in separate LLCs, converting partnerships to LLCs, setting up life insurance trusts, bypass trusts, QTIP trusts and creditor protected trusts for spendthrift children, etc. Of course, assets may not be transferred to hinder, delay or defraud creditors.

QPRT (Qualified Personal Residence Trust) - A QPRT is a device to transfer a primary residence or a vacation home to children. The remainder interest in the residence may be gifted, not at the full fair market value of the house, but at a substantially reduced value, subject to the grantor continuing to reside in the premises. For a QPRT to be effective the grantor must outlive the term of the trust. Also, the grantees will not benefit from a step-up in tax basis of the house but will take over the grantor's tax basis.

Business Succession Planning - Clients may wish to consider the transfer of business interests to children or other persons, especially if the children are actively involved in the business and/or there is a desire to provide for the continuation of the business in the event that the parent wishes to retire, becomes disabled or passes away. For many businesses, succession planning is essential.

Other Estate Planning Strategies – In appropriate situations other estate planning strategies may be utilized. These strategies include zeroed out GRATs, partnership freezes, sale of assets to children, installment sales, sale to an intentionally defective irrevocable trust, self-canceling installment notes and the joint purchase of property.

Private Annuity - In cases where a parent's health is failing but his or her life expectancy is greater than one (1) year, the parent may enter into a private annuity with his or her children whereby, in return for a lump sum payment, the children agree to pay an annuity to the parent during his or her lifetime based on the parent's life expectancy. There is a financial risk to the children if the parent should live beyond his or her life expectancy, but it may provide substantial estate planning benefits if the parent fails to live the full length of his or her life expectancy.

CRT (Charitable Remainder Trust) - A CRT, which may be in the form of a CRAT (charitable remainder annuity trust) or CRUT (charitable remainder unitrust), provides that an annuity amount will be paid to the grantor and/or spouse for a term of years or for life, and that after the term the balance in the trust will be distributed to a recognized charity or charities. A CRT created during life (and not by Will) is entitled to an income tax deduction (in an amount to be calculated). Also, no capital gains taxes apply on either the contribution of the assets to the trust or their sale by the trust. A CRT created by Will is entitled to an estate tax charitable deduction.

Private Foundations and Supporting Organizations - Many clients with charitable inclinations prefer to utilize private foundations. A private foundation offers the opportunity for a charitable deduction for those persons who wish to guide their charitable endeavors. For those persons who do not wish to create their own private foundation, many public charities will create a "supporting organization" for the donor. In many respects the donor may use the supporting organization as he might use a private foundation except the charity would expect that the donor would contribute a certain minimum amount to the charity and/or in favor of its charitable objectives and also that ultimate control will reside in the charity and not the grantor.

Section 6166 Deferral – IRC Sec. 6166 provides that if qualified business interests exceed 35% of the gross estate, as adjusted for debts, funeral and administration expenses, then a portion of the estate tax plus applicable interest may be paid over a period as long as nearly 15 years. This provision is especially important for business owners who do not wish to sell the business but wish to pass it on to family members.

Section 303 Redemption – IRC Sec. 303 provides that if business interests in a corporation constitute more than 35% of the value of the gross estate, reduced by the debts, funeral and administration expenses, then an amount not to exceed estate taxes and administration expenses may be taken out of such corporation by means of a tax-free redemption by the corporation of its stock owned by the estate.

Prenuptial Agreement - When parties are about to be married they may wish to protect their assets from marital claims that may arise from a divorce, separation or the death of a party. Prenuptial agreements are commonly utilized in such cases where a party owns substantial assets, enjoys a substantial income and/or anticipates receiving large gifts and bequests, and wishes to protect what assets he or she has for his or her children and other relatives. If the parties agree, postnuptial agreements may also be utilized.

Durable General Power of Attorney - A durable general power of attorney may be essential to handle financial matters, especially if there is no living trust, so that a spouse, child or other close relative or friend can handle assets and property in the event that the person giving the power should become unavailable, disabled or legally incapacitated.

Living Will and Health Care Proxy - A living will and health care proxy may be essential to deal with medical decisions in the event that the client is unable to make such decisions for himself or herself. Also, in view of the new privacy rules, consent should be given to doctors, hospitals and other health care providers to discuss health or treatment programs with a spouse, children or other family members.

Long Term Care Insurance - Long term care insurance usually covers both home care as well as nursing home (institutional) assistance. Except perhaps for the wealthy or for those persons with very limited resources, most persons should seriously consider the benefits that long term care insurance provides.

Elder Law Planning - In many estate planning cases there is usually a fundamental choice to either (i) retain assets and possibly undertake strategies to reduce estate taxes or (ii) pursue elder law strategies and gift assets away to children or others so as to qualify for Medicaid. Elder law planning is particularly complex and requires a detailed professional review and analysis. Of course, long term care insurance may be helpful in allowing a person to retain his or her assets and not gift them away.

References - In the interests of clarity and brevity, references have been made above to parents and children. However, many of the strategies may be equally applicable to grandchildren, nieces, nephews and other persons and relatives. Also, reference to the gift and estate tax refers to the federal gift and estate tax. State taxes may or may not be consistent therewith.

IRS Circular 230 Disclosure Notice – The advice in this article is not intended or written to be used for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code.

Caveat - The foregoing statements and explanations have been condensed in an effort to clearly convey the essence of the strategy. Estate planning is highly technical and complex and requires the assistance of a knowledgeable estate planning attorney, and there are more estate planning strategies than those mentioned above. Moreover, family needs and requirements should probably be the primary focus, with a reduction in estate taxes as a secondary but important consideration. This article is intended to inform you of issues relating to estate planning. However, the information is of a general nature and may not convey all of the essentials required or may not apply fully to your situation. For specific advice on how to apply this information to your particular situation, contact the attorneys in the LBC&C Estates and Trusts Practice Group.

Back to all Articles