Wealth Transfer Planning

The following fundamental estate tax planning techniques to consider before proceeding to more advanced means of estate tax control:

  1. Federal law allows each person one estate tax Unified Credit. Proper planning, however, is necessary to make optimum use of this credit. The equivalent value in estate assets of this credit in 2010 through 2013 is $5,000,000 (adjusted for inflation).
  1. All property passing outright between spouses who are U.S. citizens is deductible to the estate of the first spouse to die under the federal marital deduction.
  1. Gifts up to $14,000 per year per donee, or $28,000 for married couples (adjusted for inflation annually) are eliminated from the gross estate of the donor for federal estate tax purposes when made. This amount is called the annual exclusion. Gifts that do not give the donee a “present interest” in the property do not qualify for the annual exclusion.
  1. Gifts above the annual exclusion amount and gifts that do not qualify for the annual exclusion use up unified credit, but are frozen in value when made, and estate tax will not be payable on the future growth in value of such gifted assets. Each person is allowed one lifetime gift tax exemption for taxable amounts gifted above the annual exclusion amounts.
  1. Life insurance owned by persons other than the insured and payable to persons other than the surviving spouse will not be subject to tax in the estate of the insured.

The use of gifting and other tax planning devices will, of course, depend on each person’s lifestyle, relationship with lower generation family members, business need for tax minimization, and tolerance for planning complexity. Most of the estate tax saving techniques discussed herein are designed to favor families who are able to work with significant intra-family asset transfers and taxpayers engaged in active businesses.

The Unified Credit

The federal Unified Credit is available to every estate and gift taxpayer over the lifetime of the taxpayer as a dollar-for-dollar credit against the estate tax and gift tax.

The Unified Credit is based on an estate value referred to as the Applicable Exclusion Amount. The 2011 amount of the unified credit is $1,730,800, which is equivalent to the federal estate tax due on a taxable estate of $5,000,000.

An election may be made to apply the amount of applicable exclusion not used in the first estate of spouses to the second estate. This concept is generally referred to as “portability.”

Gift Planning

It is possible to begin the transfer of property to one’s heirs during one’s life through a gifting program. An individual may address specific family needs in this manner and may reduce estate values through such gifts.

Each individual may give, tax-free, up to $14,000 to as many other individuals as they desire. Thus, couples can give each child up to $28,000 per year gift tax free. This annual exclusion is adjusted annually for the cost of living. The annual exclusion is only available for gifts of a “present interest,” which means that certain gifts to a trust or on which there are restrictions that prevent the donee from having full control over the property may not qualify for this exclusion.

Amounts given to others in excess of the annual exclusion (and all gifts that do not qualify for the exclusion) are charged against the donor’s unified credit, and reduce that credit for estate tax purposes. The unified credit is a direct off-set against any gift tax generated by the gifts. This allows the further gifting of assets equal in value to the Applicable Exclusion Amount to be made without requiring the current payment of any tax. This credit is available either against the gift tax or the estate tax and any lifetime use against the gift tax ultimately reduces the amount of the estate tax credit available.

If total gifts in excess of the annual exclusion, plus any other taxable gifts, given over one’s lifetime are greater than the Applicable Exclusion Amount, the excess is taxed at rates equal to the federal estate tax rates.

Gifts within the annual gift tax exclusion of $14,000 per donor per donee, as well gifts in excess of the annual exclusion, remove the appreciation and earnings of the gifted property from the estate. Gifts above the annual exclusion amount use up unified credit, but are considered as frozen in value when made. Estate tax will not be payable on the future growth in value of such gifted assets.

One spouse may give the other spouse an unlimited amount without incurring any gift tax, since there is a gift tax marital deduction similar to the estate tax marital deduction.

Tax Advantage of Lifetime Gifts

A taxable gift removes the gift tax from the estate tax base, i.e. gift taxes are tax exclusive except to the extent that the gross estate is grossed up for gift taxes paid within three years of death. Gifts disclosed on a gift tax return may not be revalued for estate tax computational purposes, if the statute of limitations has run on the assessment of gift tax.

There is a significant mathematical tax advantage of lifetime gifts over death-time transfers, even taking into account the effect of loss of earning power of the gift tax paid.

Because of the contrast between the methods of valuation of gifts from controlling interests in business entities and the valuation of such holdings for estate tax purposes, the advantage of lifetime gifts of such interests is even greater. For example, if a taxpayer owns all the interests in an LLC, that investment will be taxed at a value substantially equal to the net worth of the LLC in his or her estate. Gifts of small portions of the taxpayer’s interest in the LLC may, however, be discounted for lack of control, lack of marketability and other factors.

Marital Deduction & Credit Trust

The Marital Deduction:

The first step in federal estate tax planning for married couples is the proper use of the federal marital deduction. The marital deduction is a feature of the federal estate tax law that allows a deduction from the value of your estate for everything that passes from you to your spouse. The deduction is limited to the type of property holding which is taxable in your spouse’s estate. For example, property left in a trust that pays the income to your spouse for life and then distributes the trust property to your children, or who your spouse may appoint among your children, is not deductible, because it is not taxable to your spouse’s estate. However, a trust, granting your spouse a power to appoint the trust property to anyone at your spouse’s death, is taxable in your spouse’s estate and is subject to the marital deduction. The unlimited Marital Deduction can delay the estate taxation of assets until both spouses have died.


A trust to your spouse to life, and thereafter to others, may, however, be deductible, if elected to be treated as a Qualified Terminable Interest in Property or QTIP. Such a trust allows your surviving spouse to have only the income from the property for life, with the property going thereafter to whomever you designate or to whom your spouse may appoint among a class of persons you designate. An election is filed on your estate tax return that the QTIP property is subject to the Marital Deduction in your estate, but taxable in the estate of your surviving spouse. Similar transfers in QTIP form may be made tax free during your lifetime.

Using the Unified Credit:

If you leave all your property to your spouse, your estate will have no estate tax, but your family property will have only one unified credit. If you were to leave the Applicable Exclusion amount to your children, your unified credit would shelter that amount, and the excess property taxable in your spouse’s estate would have another of Applicable Exclusion Amount available. The result is that, with proper planning, a married couple has the ability to exclude double the Applicable Exclusion Amount.

Individual Property Holding:

For the above approach to estate tax saving to work properly, each spouse must own individual property having a net value of at least the value equivalent of the unified credit (the Applicable Exclusion Amount). This is because we cannot predict the sequence of deaths, and the first of your estates needs a taxable value sufficient to use up the applicable unified credit. You will need to discuss your property titling with your counsel, and explore ways in which you can be sure that each of your estates will have sufficient individually taxable values.

For the above approach to estate tax saving to work properly, each spouse must own individual property having a net value of at least the value equivalent of the unified credit (the Applicable Exclusion Amount). This is because we cannot predict the sequence of deaths, and the first of your estates needs a taxable value sufficient to use up the applicable unified credit. You will need to discuss your property titling with your counsel, and explore ways in which you can be sure that each of your estates will have sufficient individually taxable values.

Credit Trust:

Assuming that you do not wish to leave the Applicable Exclusion Amount directly to your children from the estate of the first of you to die, you need to find a way to give the surviving spouse the economic benefit of the unified credit amount from the estate of the first spouse to die without rendering that amount taxable in the surviving spouse’s estate. Instead of leaving everything to the surviving spouse through the unlimited marital deduction, an amount may be left to family members, others, or to a trust commonly called a Credit trust, Family Trust or Bypass Trust, in an amount sufficient to generate an estate tax equal to the Unified Credit. Thus, there is still no Federal Estate Tax due at the first death, and the amount so left to others, or such a trust, will not be taxed at the surviving spouse’s subsequent death.

In such a trust the surviving spouse may receive all the income for life. In addition, the surviving spouse may invade this type of trust for the medical expense, support and maintenance of the surviving spouse. At the death of the surviving spouse, the trust property may be passed to the children, or others, as designated either by the first spouse to die or by the surviving spouse. This right to designate given to a surviving spouse is called a Power of Appointment. Such a power should be limited to the family members of the first spouse to die, and cannot permit the surviving spouse to appoint the property to her own uses, such as to her estate or creditors.

Life Insurance as an Estate Planning Technique

Funding Estate and Tax Costs:

One way to pay estate taxes and expenses is to set aside a portion of income to invest in the production of needed funds to be available at death. At death the family may decide how to use the cash saved, but: (1) There may not be enough time to save the needed amount, (2) Attrition through income taxation may reduce growth of the fund, and (3) The fund itself is subject to estate tax.

Life insurance may be an appropriate tool with which to address family liquidity needs in appropriate circumstances, since it provides predictable dollars at an unpredictable time. Life insurance, thus, provides liquidity exactly when needed. You can arrange insurance proceeds to be available at the death of one spouse, at the death of the survivor of the spouses, or at the death of the first spouse to die. The life insurance proceeds may avoid the imposition of estate tax if the policy is owned by family members other than the spouses, or by an irrevocable insurance trust.

Nontaxable Life Insurance:

An available planning technique to control the estate tax is to purchase new life insurance or move existing life insurance into ownership by others than the spouses, including an irrevocable life insurance trust. The proceeds of such life insurance are included in the gross estate for three years after a transfer of the policy ownership. Three years after transfer, such proceeds avoid estate taxation in the estate of the insured. Gifts of the insurance premiums to other family owners of the policy also remove the premium amounts, up to the annual exclusion limits, from the donor’s gross estate. You may make such gifts directly or through an irrevocable life insurance trust (“ILIT”). However, if an ILIT is used, special provisions are required, and specific procedures must be followed for each gift in order to qualify the gift for the annual exclusion. This is commonly referred to as a “Crummey Trust.”

An insurance trust typically has provisions allowing the trustee to buy assets from the estate or loan money to the estate. The cash in the trust from the life insurance proceeds may, thus, be transferred to the estate to be used in payment of taxes and other transfer costs. The properties of the trust are then distributed to family members named in the trust. You may also use life insurance to provide a way to augment the inheritance of heirs you do not want involved in the family business or farm. Life insurance proceeds may pass to some family members and business or farm assets to others. Ideally such insurance is set up on a nontaxable basis. Nontaxability increases the net value to the heir receiving the insurance proceeds, as compared with other heirs who will be receiving business or farm property subject to estate tax.

From the pure investment standpoint, factoring in the estate tax savings of nontaxable life insurance substantially increases the actual investment return from the standpoint of the heirs.

Advantages of Family Business Entities

Family business entities bring the following advantages to the estate planning process:

  1. Gifts of economic increments in a family business, or any other asset, can be conveniently made.
  1. The parents may make substantial gifts to other family members without loss of control.
  1. The valuation adjustments appropriate to valuing such interests provide gift leverage and the likelihood of estate value reduction.
  1. Collective management of family business, or other, assets is provided and family members may be involved and educated in management of such assets.
  1. Income may be shared among family members.
  1. Transfers of such assets, as compared with outright gifts of them, limit the exposure of the family to outside creditors and failed marriages.
  1. Unincorporated entities provide the flexibility to change the arrangements made, without untoward tax consequences.
  1. Administration of the assets held by the entity at the death of the parents is simplified.

Family businesses may be organized in a variety of forms, including corporations, limited partnerships and limited liability companies. The effect of family business entities on valuation is important from the estate and gift tax standpoint.

For federal tax purposes, interests in family business entities require valuation adjustment for: (1) The effect of the entity on the marketability of the interest and (2) The relationship of the interest to control of the entity management and economics. These adjustments can be substantial, particularly when substantiated by a competent appraisal.

Family Limited Partnerships

The Nature of Family Limited Partnerships:

The Family Limited Partnership (FLP) is a legal entity formed under a state’s Limited Liability Partnership Laws. FLPs are limited partnerships owned and operated exclusively by family members. Families can use an FLP to accomplish many things. Parents can use the FLP to transfer a family business or other assets to their children or grandchildren while still maintaining control over it all. The creation of such an entity is tax free, subject to certain limitations on the mix of assets that may be transferred, and the persons who may be initial contributors.

An FLP may have a scheduled termination date or event. Families can cancel an FLP at anytime before the scheduled termination. However, all partners must unanimously consent unless the agreement gives specific partners the right to dissolve the partnership. Upon dissolution all of the assets in the FLP will be transferred to the partners’ direct ownership in proportion to their interests in the partnership, without penalties.

The Family Limited Partnership owns the assets transferred to it, while the family members own only varying interests in the limited partnership. The FLP allows the general partners to maintain control over the properties and protects the limited partners from the debts and obligations of the partnership.

In recent years, the IRS has challenged the use of the FLP to reduce the estate tax by claiming discounts in valuing the partnership interest owned by the decedent. In general, in situations where the family fully respected the partnership as a separate legal entity and properly followed business procedures, the courts have permitted some level of discount. In cases where the decedent effectively retained control or use of the property that was contributed to the partnership, the entire value of the property, not just the proportionate share, was included in the taxable estate. Consequently, it is essential to strictly follow business formalities if this procedure is to be used.

The benefits of a FLP may also be obtained with a Family Limited Liability Company, and this discussion applies to both entities

Transferring Family Assets:

There are several characteristics of the Family Limited Partnership that make it ideal for the transfer of a family business or other family assets from one generation to the next, including:

  1. The parents can transfer most of the limited partnership to the children, or grandchildren, as limited partnership interests and still retain control over the partnership property by retaining a general partnership interest.
  1. The older generation can retain a portion of the income from the family business as compensation for running the business through the payment of management fees to them as general partner.
  1. If the family wants to shift income from one generation to the next, the Family Limited Partnership can accomplish this without additional gift tax costs. The partnership’s income may simply be sprinkled among the younger generation according to their limited partnership interests.
  1. By adjusting the value of limited partnership interests transferred to family members for lack of marketability and lack of control, the parents can maximize (leverage) the value of their estate and gift tax exclusions and exemptions. This allows the parents to transfer significant portions of the Family Limited Partnership during their lifetime without subjecting these transfers to the gift or estate tax. To obtain this valuation benefit, however, the partnership and the contributors of property to the partnership must follow strict guidelines to assure the tax integrity of partnership transactions.

When the family transfers assets into the limited partnership, these assets become the legal property of the Family Limited Partnership. Once the assets are transferred to the limited partnership, the parents retain the general partnership interests and may begin a gifting program to transfer the limited partnership interests to their children and grandchildren. The limited partnership interests are not marketable, or transferable, except among family members.

By retaining the general partnership interests (or voting interests in an LLC), the parents retain control over the family assets. The limited partners, on the other hand, cannot force any distribution, cannot dictate how the business is run, and their liability is limited to their interest in the Family Limited Partnership.

GRATs and GRUTs: Planning

The estate tax advantage of trusts, in which the remainder interest is transferred to others and the grantor retains an income interest, is that the gift element of the transaction is only the present value of the remainder interest after taking the reserved term of years into account. Such trusts may take the form of an annuity based on the value at the time of contribution (a GRAT) or be based on periodically redetermined values (a GRUT). Depending on the ages of the grantors, the monthly computation rate mandated by law and the term of years employed, the valuation leverage may be substantial. Thus, much larger values may be gifted within a given use of the Applicable Exclusion Amount than may be done through direct gifts. For example, a 10-year GRAT created in April, 2007 that pays a 6% annuity would have a gift taxable portion of only 55.55% of its value.

The gift value of the remainder interest is not eligible for the annual exclusion, and thus requires application of the grantor’s unified credit. A disadvantage of a grantor retained interest trust is that the corpus of the trust must be transferred to the remainder persons during the life of the grantor, if the entire trust value is to escape inclusion in the grantor’s gross estate.

The following factors enter into the choice of a Grantor Retained Annuity Trust or Grantor Retained Unitrust as an estate planning device:

  1. A GRAT or GRUT is an irrevocable trust. Transfers to it cannot be changed after the GRAT is set up and property is transferred to it. At the end of the term of years specified for the GRAT or GRUT the property transferred to it must be finally and irrevocably transferred to designated donees, as to which transfer the grantor cannot have an ownership interest. It should, therefore, only be used when a major gift to the donees is otherwise contemplated. A GRAT or GRUT is useful for leveraging the estate tax effect of major gifts beyond the annual exclusion level.
  1. The tax advantage of a GRAT or GRUT is obtained by the reservation of a specified annual payment to the grantor, which, if not consumed, adds to the grantor’s estate. Thus, if the payment is larger than the normal income thrown off by the property transferred to the GRAT or GRUT, the excess retained by the grantor generates estate tax and must be offset in computing the estate tax savings from the arrangement.
  1. The gift to the donees is discounted by the present value of the payments retained by the grantor. This gift is a so-called Adjusted Taxable Gift and remains part of the grantor’s estate, although its value (to the extent it does not exceed the grantor’s remaining unified credit) is frozen for estate tax purposes at the time of the transfer to the GRAT, which is another advantage of the GRAT.
  1. Gifting through a GRAT or GRUT has the risk that some or all of the property transferred to the GRAT is included in the grantor’s estate if the grantor fails to outlive the term of the GRAT. The longer the term of the GRAT the greater the gift leverage, but the higher the risk of the grantor failing to survive the GRAT term. The unified credit used up by the GRAT is not available for use in a non-trust value freezing gift and is lost for that purpose if the grantor fails to survive the GRAT term.
  1. The Grantor Retained Unitrust, or GRUT, is similar to a GRAT, except that the annual payment is a percentage of the annual value of the trust principal. The tax advantage is somewhat better (i.e., the taxable gift is smaller), but the trust property must be reappraised each year, which may be a significant administrative burden with some types of property.

Qualified Personal Residence Trust

An irrevocable trust of a residential property may be established with the trustee directed to allow the grantor the use of the property for a specified number of years. When the grantor’s trust interest terminates, the property in the trust is distributed outright to family members. Such a trust is commonly referred to as a Qualified Personal Residence Trust or QPRT.

At the time the trust is funded, a future gift is made. The value of that gift is the excess of the value of the property transferred over the value of the interest retained by the grantor. The value of the retained interest is found by multiplying by the present value of an annuity factor for the number of years the trust will run.

For example: Such a trust is created by spouses, each aged 40, in May 2007 to run for 10 years with a residence worth $100,000 initially placed into the trust. The value of the (nontaxable) interest retained by the grantors would be $41,999. The value of the (gift taxable) remainder interest in the QPRT would be $58,001. This remainder interest is a future interest gift and will not qualify for the annual exclusion, however.

The advantage of the QPRT is that it is possible for an individual to transfer significant value to family members but to incur little or no gift tax. In the example, the cost of removing $100,000 from the gross estate (plus all appreciation from the date of the gift) is the use of $58,001 of Applicable Exclusion Amount.

The entire principal (date of death value) must be included in the estate of a grantor who dies during the term of the QPRT, because he has retained an interest for a period which, in fact, will not end before his death. If any gift tax had been paid upon the establishment of the QPRT, it would reduce the estate tax otherwise payable. If the unified credit was used, upon death within the term, the unified credit used in making the gift will be restored to the estate (if the grantor’s spouse consented to the gift, his or her credit will not be restored).

The remainder person (possibly through gifts received from the grantor) could purchase life insurance on the life of the grantor. Then, if the grantor should die during the term of the trust, there would be sufficient cash to pay any estate tax.

Split Interest Purchases

Property may be purchased by the Client or Spouse and another person under an arrangement whereby the Client or Spouse buys an income interest for life and the other person buys the remainder. The value of the life interest received by the Client or Spouse expires at death and is not subject to estate tax.

The position of the IRS has been that split interest arrangements between members of the same family are not for full consideration, if only the value of the remainder is paid by the remainder person. The IRS believes that split interest purchases by members of the same family are to be treated as having been first acquired by the holder of the term interest.

The courts have, however, held that the consideration received for the sale of a remainder interest among members of the same family is to be measured only against the interest actually transferred. For example, a Federal Court approved the sale a remainder interest in his ranch by a father to his sons for an amount equal to the actuarial value of the remainder calculated according to IRS regulations. The Court held that the decedent received full and adequate consideration for the ranch and that it was not includible in the decedent’s gross estate as a transfer with a retained interest.

Charitable Trust Planning

Charitable Annuity Trusts and Unitrusts:

When a term-of-years charitable remainder annuity trust is established, a gift of cash or property is made to an irrevocable trust, and the donor (and/or another non-charitable beneficiary) retains an annuity interest in the property for a specified number of years. At the end of the term, a qualified charity receives the property in the trust. The advantage over a direct gift to charity is that the grantor retains a series of payments from the trust, but is able to deduct the actuarial value of the amount passing to charity. The value is computed in a manner similar to that of a GRAT or GRUT.

Most gifts made to a charitable remainder annuity trust qualify for income and gift tax charitable deductions (or in some cases an estate tax charitable deduction). The trust value will be removed from the grantor’s estate if the grantor outlives the term of years.

A trust qualifies as a term-of-years charitable remainder annuity trust if the following conditions are met:

  1. The trust pays a specified sum to at least one non-charitable beneficiary who is living when the trust is created. Sums are paid annually, semiannually, quarterly, monthly, or weekly.
  1. The sum paid annually must be five percent or more of the initial net fair market value of the property placed in the trust.
  1. The sum is payable each year for a specified number of years (no more than 20).
  1. No sum is paid to anyone other than the specified non-charitable beneficiary and a qualified charitable organization.
  1. When the specified term ends, the remainder interest is transferred to a qualified charity or is retained by the trust for the use of the qualified charity.

The annuity paid must be a specified amount expressed in terms of a dollar amount (e.g., each non-charitable beneficiary receives $500 a month) or in terms of a fraction or percentage of the initial fair market value of the property contributed to the trust (e.g., beneficiary receives five percent each year for the rest of his life). An income tax deduction is permitted immediately for the present value of the remainder interest that will ultimately transfer to the qualified charity. Government regulations determine this amount, which is essentially calculated by subtracting the present value of the annuity reserved for the donor from the fair market value of the property and/or cash placed in the trust. The balance is the amount that may be deducted when the property is placed in the trust.

A Charitable Unitrust is similar, except the payout is based on a percentage of current value of the trust principal, revalued at each prescribed payment date.

Trust Benefits:

The grantor of a charitable remainder trust may derive substantial benefits from the creation of such a trust. Charitable remainder trusts lend themselves to sophisticated planning with regard to appreciated assets and the use of life insurance to make up the depletion in the grantor’s estate from the charitable gift.

Appreciated Assets:

Substantial tax advantages may be gained through the contribution of appreciated securities to charitable trusts. Subsequent sale of the securities or submission of them to redemption by the issuing entity may relieve the donor of recognition of the capital gain inherent in the assets contributed. The IRS has announced, however, that it will challenge certain accelerated charitable remainder trusts, if it deems their purpose to be the avoidance of tax on capital gains realized upon sale of contributed assets after creation of the trust.

Generation Skipping Issues:

A charitable remainder trust or charitable lead trust interest given to a noncharitable beneficiary could result in a generation-skipping transfer at creation of the trust, distribution or termination.

Taxpayer Relief Act of 1997 Limitations:

Annuity trusts and unitrusts may not pay out more than 50% of the initial value or annual value of the trust property, respectively. Also, the value of the remainder interest must be at least 10% of the initial net fair market value of the property placed in the trust. The result is a substantial restriction on the use of such trusts for grantors under age 50.

Section 6166 Tax Deferral

That portion of the estate tax attributable to the value of closely held business assets included in your estate may be deferred under § 6166. The deferred tax payment bears interest at a rate of two percent on the two-percent portion, which is defined as: the tentative tax computed on the amount of $1,000,000 (adjusted for inflation annually), plus the Applicable Exclusion Amount in effect, less the Applicable Credit Amount then in effect. In 2007, the two-percent portion was $562,500.

Additional amounts of tax that are deferred under § 6166 are charged interest at 45% of a federal rate determined each calendar quarter. The rate applied to an estate is the rate for the quarter in which the death of the decedent occurred. This rate is computed at three percentage points over the short-term applicable federal rate (AFR) published monthly by the Treasury and is compounded daily. For example, the rate for the third quarter of 1998 was eight percent, which nets to 3.6%. This interest is not, however, deductible for income tax purposes.

Only certain closely-held businesses (including family farms) qualify for this special rate. The estate must consist of at least 35% active business assets.

Generation Skipping Tax Planning

While Generation Skipping Trust wills seem complex on their face, the concept is simply to assure that whatever amount you choose, up to the amount of the Generation Skipping Transfer (GST) tax exemption, transferred from you as an individual (or each of the estates of spouses) will not be taxed to the estates of your children. The GST tax exemption is the same amount as the Applicable Exclusion Amount, so that in 2011 and 2012, the GST tax exemption is $5,000,000. As a result, you are able to pass up to $10,000,000 of value through your estate (after the payment of any estate tax due in your estates) to your grandchildren free of estate tax in your children’s estates in those years. Generation Skipping transfers may be made either directly to descendants of one’s children (referred to as “direct skips”) or through a trust to hold the transferred property for the life of one’s children and then distribute to later generations. The tax is imposed on a direct skip at the time of transfer and on a trust at the time of distribution after the initial life interests.

Lifetime Generation Skipping transfers may be made, but they are subject to gift tax and will attract gift tax if in excess of the available annual exclusions and the lifetime exemption.

Typically, Generation Skipping provisions in wills first set aside the value equal to the federal estate tax Applicable Exclusion Amount, as a trust sheltered from estate tax in the estate of the surviving spouse. This trust is the same as the Family Trust, which is described above. This Trust may be adapted to be a generation skipping trust that will not be taxed in the estates of your children, if it is directed to ultimately extend for their lifetimes. If a portion of the Applicable Exclusion Amount has been used through making taxable gifts, then a second trust, typically called a GST Trust, may be created to hold an amount equal to the difference between the remaining Applicable Exclusion Amount and the GST tax exemption. The GST Trust may be qualified as a QTIP trust and treated as marital deduction property that is not taxed in the estate of the spouse creating it. These two trusts could be applied to use up your combined GST tax exemptions.

GST trusts will not be taxed in your children’s estates. Your children may receive the income from these trusts, have the right to invade the principal for support, maintenance, educational expense and medical expense and have the right to appoint the principal of the trusts among their family.

Private Annuity

When a private annuity agreement is arranged, one party (the transferor-annuitant) signs over complete ownership of property to another party (the transferee-payor). In return, the transferee makes periodic payments to the transferor for a specified period of time (usually the lifetime of the transferor). The private annuity is a useful tool for an individual who wants to spread out over his lifetime payments from selling a highly appreciated asset. The private annuity is also as a useful federal estate tax saving tool because payments end when the transferor dies and the entire value of the asset sold is immediately removed from the transferor’s gross estate. The private annuity allows someone who owns non-income-producing property to make that property productive.

The ideal transferor/payor situation is one that meets the following criteria:

  1. The transferor is in a high estate tax bracket or has no marital deduction.
  1. The property is capable of producing income and/or is appreciating rapidly.
  1. The payor is capable of paying the promised amounts.
  1. The parties trust each other (the private annuity must be unsecured).
  1. The transferor has other assets and sources of income.

Installment Sales

Installment sales to family members are designed in a manner similar to any other installment sale. An asset is transferred in exchange for a contract obligation or installment note and may include an immediate cash payment. The buyer is required to pay the seller the obligated principal amount of the note or contract, together with interest, in a prescribed manner over a prescribed time period. The manner of payment may be that of level payments, level principal payments or interest only, with the amortization period varying from the actual payment period and creating a balloon payment as part of the final payment, if desired.

Income Tax Treatment:

The seller is permitted to have the recognized gain taxed over the life of the payment schedule pursuant to the installment reporting method of § 453. The installment reporting method requires the seller to allocate basis in proportion to the amounts of principal payment from time to time. The seller is taxed each year on the difference between the principal amount paid that year and the basis allocable for that year. However, if a related buyer should resell the property to another within two years after the date of the installment sale, the seller’s deferred gain may be accelerated under § 453(e).

Installment Sale as Value Freeze:

An installment sale removes the future growth in value of the asset sold from the seller’s estate and freezes the value for estate tax purposes at the amount of the sale price. The seller can, thus, accomplish a value freeze while still receiving installment payments related to the asset that will help to stabilize the seller’s cash flow.

Estate tax treatment:

Under IRS regulations the estate tax value of a note is typically the unpaid principal value at the date of death. The value may be affected, however, by the relationship of the agreed interest rate to the financial market at the time, the solvency of the buyer and the adequacy of the security.

Self-Canceling Installment Note (SCIN)

What Is a Self-Canceling Installment Note (S.C.I.N.)?

An installment note is a promissory note (evidence of debt), usually issued in conjunction with the sale of property where at least one payment is to be received by the seller after the close of the taxable year in which the sale occurs. A self-canceling installment note is an installment note which contains a provision under which the buyer’s obligation to pay automatically ceases in the event a specified person, called the measuring or reference life (usually the seller), dies before the end of the term of the note.

When Is It Used?

An installment note is useful when you own a highly appreciated asset that you would like to sell and you want to spread the taxation on the gain over a term of years. (However, any gain attributable to excess depreciation that is subject to recapture under I.R.C. § 1245 or § 1250 is fully recognized in the year of sale. Also, under installment sale rules, all gain is recognized in the year of sale, even if payments on the note extend over several years, if the subject of the note is publicly traded stock.) Installment notes with a self-canceling provision are especially useful when one family member, typically a parent or grandparent, wishes to transfer property to another family member, typically a child or grandchild, with minimal gift and estate tax consequences.

What Are the Estate and Gift Tax Consequences?

In general, the fair market value of any unpaid installment obligation on the date of death is included in the estate of the seller. However, if the note contains a properly designed self-cancellation provision, the buyer is under no obligation to make any further payments after the seller’s premature death, which leaves no unpaid balance to be included in the seller’s estate. The self-canceling feature can be an effective means of transferring property to family members without estate or gift tax consequences in the event of the death of the seller-transferor before the last potential payment has been made under the terms of the installment note.

How Should a SCIN Be Structured?

A SCIN will avoid adverse gift and estate tax treatment only if the cancellation provision is bargained for as part of the consideration for the sale. The purchase price must reflect this bargain either with a principal risk premium (above-market sales price) or an interest rate premium (above-market interest rate), and the seller may not retain any control over the property being sold after the sale.

If the self-cancellation provision is not properly designed, the seller may be deemed to have made a part-sale/part-gift. If any of the transfer of the remainder interest (the canceled payments) is considered a gift, the entire value of the property sold, less the consideration actually paid, will be included in the decedent’s gross estate.

This problem can be avoided by structuring the note as much like a market note as possible, except for the principal or interest rate premium. Although not all issues of valuation and proper design have been resolved by regulation or by the courts, most authorities feel the debt instrument and the sales contract should both include the self-cancellation clause. To avoid retained controls, the sales contract and/or note cannot place any restrictions on the use of the property by the buyer, including any restrictions on subsequent sales. (In general, a subsequent sale of the property by the buyer within two years of the original sale will trigger recognition of any remaining deferred gain by the original seller, even if the note has not been fully repaid). Furthermore, it is advisable to avoid using the property sold as collateral for the note so the seller has no right to reacquire the property sold under any circumstances.

What Interest Rate or Discount Rate Should Be Used In A SCIN?

Selecting the appropriate market rate of interest is perhaps the most difficult step in the process of designing and implementing a SCIN. This is because of conflicting requirements under the imputed interest rules and the gift tax discounting rules. Although these rules are complex, the general rule is that the interest rate on an installment sale note must at least equal the appropriate applicable federal rate (AFR) with semiannual compounding. Failure to follow these rules may result in reapportionment of interest and principal of scheduled payments and imputation of interest income to the seller, even in periods in which he or she may not have received payments.

What Is the Maximum Allowable Term of a Self-Canceling Installment Note?

The term of a SCIN should not exceed the seller’s actuarial life expectancy. If the term of the note extends beyond the seller’s life expectancy, the IRS is likely to re-characterize the note as a private annuity for income tax purposes. In this event, the income portion of the payments is nondeductible as interest, which is likely to have adverse tax consequences to the buyer in cases where investment or trade or business property is involved.

How Is the Risk Premium Determined?

If the buyer and seller are not close family members and the transaction is at arm’s length between an informed seller and informed buyer, neither of whom is under any obligation to sell or buy, the negotiated sales price and note terms can generally be presumed to reflect an adequate premium for the cancellation feature. However, the tax laws essentially presume that transactions between close family members are not at arm’s length. Therefore, it is critical to establish the adequacy of the risk premium for the cancellation feature. Since a risk premium can only be measured relative to fair market value or the market rate of interest, it is equally critical to properly substantiate the fair market value of the property being sold and the appropriate market rate of interest.

In the case of property such as listed stocks and bonds where there is an established, well-functioning market, fair market value is simply the price at which it could be sold outright based on market prices when the installment sale commences. (Although installment sales of listed stocks are not generally recommended because of the requirement to recognize all gain in the year of sale). For other types of property, such as closely held stock, artwork, or certain real estate, a professional appraisal may be required to establish fair market value.

The mortality factors used for computing the risk premium for the cancellation feature typically are the same as those used for valuing annuities, life estates, and remainders for gift and estate tax purposes. The risk premium may take one or a combination of two forms. First, the sales price of the property may be increased above the fair market value that would be paid in an outright sale or in an installment sale without the cancellation feature. In this case, the standard AFR would be used to apportion the interest and principal components of the payments. Alternatively, the property may be sold for its fair market value, but an interest rate greater than the standard AFR may be used to apportion interest and principal.

How the principal and interest rate risk premiums are determined is perhaps best explained by example. Assume that a person, aged 60, wishes to sell property with a fair market value of $125,000 to her son in an installment sale. The son will pay $25,000 on the date of the sale and pay the balance of the note in three equal annual installments. Assuming the applicable federal short-term rate is 6.4%, three annual payments of $37,688.17 would be required to pay off the $100,000 balance on a regular non-cancelable installment sale note in three years.

Which Risk Premium Principal or Interest Rate Is Preferable?

The choice of whether to reflect the risk premium as an increase in the sales price (principal risk premium) or as an increase in the interest rate (interest rate risk premium), depends on the relative tax situations of the buyer and seller. If the risk premium is reflected in the sales price (principal risk premium), the seller will report more of each payment as capital gain and less as interest income. The buyer will pay less interest (which is deductible if the interest is investment or trade or business interest and not personal interest), but his or her basis will be higher. If the property is depreciable and the buyer and seller are in similar tax brackets, the principal risk premium may be preferred to give the buyer a larger depreciable base. However, if the property is not depreciable, the buyer may prefer the interest rate premium where the basis is lower but deductible interest payments are higher.

Is It Possible to Split the Risk Premium between Principal and Interest?

Theoretically, some appropriately weighted combination of principal risk premium and interest risk premium would be acceptable. A weighted-combination risk premium may be determined using the template in a two-step fashion. First, compute the principal risk premium and interest rate risk premium using the appropriate market rate of interest. Second, choose an interest rate somewhere between the market rate and the risk-premium-adjusted interest rate computed in the first pass and enter it as the market rate of interest in the data input section (leave the § 7520 rate as it is). The resulting principal risk premium will be lower than that computed originally using the market rate of interest. The summary statement and repayment schedule for the installment note with principal risk premium will now reflect the combined risk premiums. The interest rate premium is equal to the difference between the market rate and the second (higher) rate entered. The revised and lower principal risk premium is reflected on the summary statement. The repayment schedule will show the effects of each risk premium in the allocation of interest, gains, and basis recovery.

What Kind of Repayment Schedules Are Used in SCINs?

Installment notes may be designed with virtually any schedule of payments, but they most frequently conform to one of two basic payment schedules. Level-principal notes schedule equal periodic payments of principal on the note together with accrued interest. For example, if the principal balance of the note is $1,000 and it is to be paid off over five years, the debtor would pay $200 of principal each year together with the accrued interest. If the interest rate were 10%, for instance, the first payment would be $300, $200 of principal and $100 of interest. The second payment would be only $280, $200 of principal and $80 of interest on the remaining principal balance. Although the principal amount is fixed or level each year, the total payment declines each year because of the decreasing interest component of the payment.

Level payment self-amortizing notes are the second, and most frequently used, type of installment note. This type of note is similar to the standard home mortgage with level annual payments. With this type of note, the principal portion of each payment starts low but increases with each payment. Conversely, the interest component starts high but declines with each payment as a greater portion of the principal on the note is paid off.

In either case, the term of the installment note may be less than the amortization or principal recovery period of the note. If the amortization or principal-recovery period of the note is greater than the term of the note, the last payment in the term of the note, called a balloon payment, is larger than the rest of the payments. It is equal to the remaining principal balance of the note plus the normal payment.

For example, assume the client discussed above wants the term of the note to remain at three years, but wants the payment schedule to be based on a five-year amortization period. In this case, the first two payments would be less than the $37,688.17 determined above, but the final payment would be higher. Specifically, the first two annual payments would be equal to $25,498 and the third-year payment would be equal to $71,985. Deferring a larger portion of the repayment on the note to the later years increases the risk premium. In this case, the principal risk premium is $6,248, or $1,085 more than the $5,163 risk premium associated with three equal annual payments of $39,634. Similarly, the interest rate risk premium also increases. In this case, it is 2.8065% as compared with the 2.7826% associated with the three equal annual payments.

2015 Thomson Reuters.