Some individuals wish to provide outright gifts to their heirs, commonly to be used to purchase a home (but could be for other uses). This can be achieved through the use of their annual gift exclusion, which is currently $14,000 per donee (in other words, you can give $14,000 to as many people as you wish). Assuming that this amount will not be adequate for a specific purpose (such as helping a child purchase a home), a portion of the lifetime gift tax credit may be used, however, this is not the best use of this credit. Ideally, an individual should use their gift tax credit to transfer a highly appreciated asset. This ensures that any future appreciation on the asset will avoid estate tax.

Also remember that an individual can pay for qualified tuition costs and for medical expenses of other individuals, without limitation. This can be an excellent tool if you want to pay for a child or grandchild’s college education.

Advantages:

• • • Achieves significant gifting for home ownership or other purposes;
    • Removes the amount given from the donor’s estate;
    • No gift tax.

Disadvantages:

• • • Uses a portion of the lifetime gift tax credit, which may not be an efficient use of the credit;
    • Once the gift is made, it cannot be revoked1.

EXAMPLE:

• • You are married with two adult children. Your children could use assistance in purchasing homes.
    • • The current annual gift exclusion is $12,000/donee, per year. Several strategies exist, for example, to loan money to the children for a down payment on the home, and then forgive the loan on a yearly basis, using the annual gift exclusion as the basis for forgiving the loan.
      • The current lifetime gift tax credit is $5,490,000/donor. In other words, an individual can give up to $1,000,000 in gifts, during their lifetime, without incurring a gift tax. These gifts will, however, reduce the individual’s estate tax exemption. See the discussion of this issue under the “Fractionalized Gifting” section of this memorandum.
      • Often, individuals who wish to maintain control on the use of a gift (for example when annual gifts are made to grandchildren) will create irrevocable trusts for each beneficiary, thereby ensuring that the gift is used in the manner the donor intended.

You have two options:

• • • You could loan each of them the down payment on their home, in whatever amount you choose, and then forgive the loan at the rate of $28,000 each year (or if you want to make the gift to their spouse as well, you could forgive another $28,000 for their spouse each year…for a total of $56,000/year). This would assist them in obtaining a home, and you would be forgiving the debt yearly, using your annual gift tax exclusion, thus it will not impact the amount you can leave when you die. This has the added benefit of removing the amount loaned from your own estate and thus, when you die, there is no estate tax due on this amount.
    • You can simply give them the down payment on the home. If, for example, you give each of your children $400,000, you can apply this amount against your estate tax exemption. Therefore, when you two die, instead of being able to leave $10,980,000 to your heirs estate tax free, that amount will instead be $10,180,000 because you gave away $800,000 during your lifetime. The benefit is that the amount you gave away during life did not continue to grow inside your estate, and thus become taxable on death.

Establishing Separate Trusts for Each of Your Grandchildren

Another option for reducing your estate tax and providing for your family would be the establishment of separate trusts for each of your grandchildren. Using this technique, an individual trust would be created for each grandchild. Each trust will state the trust’s purpose (e.g., to provide for education, a wedding, health care, etc.) and terms (e.g., the child cannot receive distributions until they receive a Bachelors degree). Each year you will fund each trust with your annual gift tax exclusion (currently $12,000). Your contribution will be held in trust and invested. The appreciation as well as the transferred funds themselves will remain outside of your taxable estate.

This option will provide you with the ability to transfer funds out of your estate for estate tax purposes while allowing you to fully utilize your annual tax-free gifts. Further, you will have the ability transfer wealth to your grandchildren during your lifetime and retain control as to how the money is used.

Advantages:

• • • Control – you can control how funds are used by your grandchildren
    • Anyone can contribute to this – parents of the children, aunts, uncles, etc. could all contribute
    • Reduces your estate by gifting.

Disadvantages:

• • • The costs of establishing these trusts would be approximately $1500 to $2500 per trust
    • Each trust would have to file its own tax return
    • Someone besides yourself would have to serve as trustee
    • The trusts would be irrevocable
    • Things may be simplified by establishing a Education 529 Plan
    • Could give to an UTMA account.

Fractionalized Gifting

Currently, every individual has a $1 million lifetime gift tax credit. Every individual’s lifetime gift tax credit amount is separate from their annual gift tax exclusion amount. The current lifetime gift tax credit of $1 million means that each individual may gift $1 million dollars (above and beyond their $12,000 per person, per year exclusion) to anyone they want without paying gift tax. However, any amount of their lifetime gift tax exclusion that they use will be counted against their estate tax exclusion. Today the estate tax exclusion is $2 million. For example, if an individual gifts $750,000 over and above their annual exclusions during their lifetime, this means that they have used up $750,000 of their $2 million estate tax exclusion. Thus, at death, they would only receive an estate tax exclusion of $1,250,000. Ideally, if an affluent individual owns real estate, gifts of fractional interests in this real estate (other than the personal residence) will produce the best result from a planning perspective.

There are various IRS accepted valuation discounts. Essentially, once property is owned by more than one person, the IRS considers that piece of property to have a lower fair market value. The IRS rationale is that the piece of property is worth less to an unrelated, third party buyer, because if a third party purchases the Hess’ remaining interest in the property, the third party would only own a portion of the property with the remainder owned by the Hess’ children. The third party would be joint owners with strangers which is less appealing (and less valuable) than sole ownership, thus a third party buyer would not pay full value for that property. Therefore, the IRS allows a discount on the value of the property. This discount can be anywhere from 10% to 40%.

Advantages:

• • • Reduces the Estate for estate tax purposes;
    • Creates a deeper valuation discount for fractionalized properties;
    • Requires no payment of Gift Tax because the lifetime gift tax credit is used;
    • If the property that is fractionalized produces income, that income must be shared proportionately with all interest holders (subject to the terms of the LLC agreement, if there is one) – this can be an advantage because it transfers income into the hands of the children/heirs, typically at a lower tax rate.

Disadvantages:

• • • An appraisal to establish the valuation discount would be necessary, and is fairly costly;
    • Unless the fractionalized property is owned by an LLC, there can be issues with control when the property needs to be sold or refinanced. This can be resolved by creating an LLC for the property (which has asset protection advantages), or simply by creating a contractual agreement between all of the parties.

Private Family Foundation

A private family foundation is a separate tax-exempt entity, afforded tax-exempt status under section 501(c)(3) of the Internal Revenue Code, created for the purpose of charitable giving. There is great flexibility in how the money contributed to a private family foundation may be used. Families sometimes use a private family foundation as an opportunity in which family members can collectively work toward common charitable goals and as a way to leave a legacy of charitable giving to future family generations.

A private family foundation can be established during life or at death. You decide the charitable purpose of the private family foundation and the foundation applies for qualification as a 501(c)(3) charity. If the foundation is established during your life you will make contributions to the foundation.1 The contributions may be used as a current income tax deduction, limited to the applicable amounts.2 If the foundation is established at your death, DenHerder & Associates can amend your estate plan so that a private family foundation will be established only to the amount necessary so that no estate taxes are paid upon your death. The private family foundation rules require a minimum of five percent (5%) of the assets of the foundation be distributed to qualified charities each year. The assets in the foundation are invested in the manner you chose (subject to certain rules). Ostensibly, the assets in the foundation will deliver a return greater than the amount you are required to give. Thus, the foundation can last for generations to come.

Whether the foundation is established during life, or at death, your children, or whomever you choose, can sit on the board and can be paid a salary for their time and effort in this position. This salary can act as a vehicle to create an income stream for your children/heirs. Although the income will be taxed to your children/heirs as ordinary income, the income tax rate is less than the estate tax rate. In addition, some families use the Foundation to hold annual meetings in various locations around the world, paid for by the foundation. (Note: a family must be careful to document the business purpose and necessity for the travel, such as leaving a sizable donation at the location visited).

The use of a private family foundation can be an excellent way to bring a family together to discuss, investigate and wisely choose charities to which to give. It can be a tool to bring younger generations to the Board to train them for a lifetime habit of responsible giving.

Advantages:

• • • Creates a unified family cause;
    • Promotes charitable giving;
    • Creates a lasting family legacy;
    • Reduces or eliminates Estate Taxes;
    • Creates an income stream for children/heirs;
    • Give family members a “career” of giving;
    • Eliminates a charity’s ability to “micro-manage” the surviving spouse, under an AB Trust, on how assets of the trust are invested and used. No accounting to charitable beneficiaries would be required.

Disadvantages:

• • • Costs to establish may be high;
    • A separate tax return for the Private Family Foundation must be filed each year;
    • The foundation is typically structured as a corporation and all corporate formalities must be followed;
    • Your children would rather your estate pay the estate taxes and they receive the rest, rather than having the taxable value of your estate placed in a foundation.

EXAMPLE:

Private Foundation established at the death. Assumes a $28,000,000.00 estate; $2,000,000.00 will go the beneficiaries free of estate tax (this would be $4,000,000.00 for a married couple). The trust can be amended to state that a certain percentage or all of the estate that exceeds the estate tax exemption, flows to a private family foundation created at death, for whatever purpose the donor’s determine, with whichever board of directors they choose. Therefore, at death, the beneficiaries split $2,000,000.00 tax free and whatever portion of the estate the donor chooses goes to a private family foundation with their chosen board of directors (presumably, the children), each to receiving a salary and a “job of giving.”

Private Family Foundation established during life. The private family foundation would be funded during the donor’s life, for example, with $2,000,000. The donor would receive an income tax deduction, limited to applicable amounts (see footnote 5). The donor can serve as the President of the Board. The donor can run foundation meetings with their board and determine the course of the foundation. They may take a salary (or not), and give salaries to other board members (the children). The foundation must give five percent (5%) of its total assets to charity each year (In year one, this amount would be $100,000.). The advantage is seeing the foundation run – funding family board meetings in interesting locations, determining the future of the foundation. On death, the donor would want to fund the foundation with a more significant amount from their estate plan. (Note: this could be any amount, it doesn’t just have to be the amount necessary to eliminate estate tax … it could be more or less).

Establish a Private Family Foundation with a Charitable Remainder Trust during life. The donor would fund a charitable remainder trust with $2,000,000. They will receive a current income tax deduction which can be carried over for five (5) years. They will receive an income stream for life. After both of their deaths, the remainder flows into a private family foundation

Charitable Remainder Trust with Wealth Replacement Vehicle

A charitable remainder trust (“CRT”)1 is a trust that allows an individual to donate property to the trust and the trust, in turn, provides an income stream to the donor for his/her/their lifetime; and on death, the balance of the assets in the CRT are transferred to charities of the donor’s choice. If the gift is made during the donor’s lifetime, an income tax charitable deduction, equal to the fair market value2 of the amount that will eventually pass to charity, subject to the charitable deduction limitations3, will be allowed.A CRT can be funded with most assets. Generally, an individual will fund a CRT with a substantially appreciated asset or assets that are likely to appreciate in the future. In this way the donor is freeing his/her estate from additional estate tax on the appreciation. Additionally, a CRT does not pay any capital gains taxes and therefore is an ideal vehicle for selling substantially appreciated assets. If real estate is transferred to the CRT, and the donor does not want the real estate to be sold (such as transferring an apartment complex to the CRT), there must be a sufficient income stream from the asset to satisfy the income payments to the grantor/non-charitable beneficiary. A donor’s children (or other heirs) may not be wild about this strategy, because they will receive nothing in the deal. To assuage the situation, a life insurance policy can be bought naming their children/heirs as beneficiaries4. The income stream from the CRT can be used to make the life insurance premium payments. The policy would act as a wealth replacement vehicle and the donors will have effectively passed the value of the asset to their children gift and estate tax free while reducing the value of their estate for estate tax purposes and leaving a valuable gift to charity5.

Advantages:

1) Reduce the value of the Estate for estate tax purposes;

2) By creating a CRT, the donor is making a charitable gift. Accordingly, the donor can claim an income tax charitable deduction for the value of the property that will pass to charity;

3) The donor can name the trustee of the trust;

4) The charity beneficiaries can be changed throughout the donor’s

lifetime;

5) The charitable beneficiary can be a private family foundation set up by the donor;

6) If the donor were to sell appreciated property, the entire amount of capital gain realized is taxed in the year of sale. By contrast, through the establishment of a CRT with long-term appreciated property, the trust sells the property. The trust is tax exempt (unless is has “unrelated business taxable income”) so it generally pays no capital gain tax on the property’s appreciation when it sells and reinvests the trust assets;

7) Any appreciation will be transferred tax free.

Disadvantages:

1) Initial cost of creating a Charitable Remainder Trust;

2) The donor will lose control of the assets placed into a CRT. The trustee must control all the asset investments;

3) This is an irrevocable trust, i.e. it cannot be changed. Once it is created, it can be very difficult to revoke;

4) A separate tax return must be filed each year.

EXAMPLE:

The donor transfers real estate with an estimated FMV of $12,000,000.00, to a CRT taking a 6% annuity interest in the property for life. Assuming that Donor husband is sixty-six (66) and Donor wife is sixty-one (61) years of age, the value of the remainder interest1, the value that will go to charity, is approximately $4,000,000.00 and their annual payout would be $720,000.00 (the income stream that would come to Lawrence and Suzanne during their lifetimes). They will receive a charitable deduction of $4,000,000.00 in the year of transfer2. The $720,000.00 annual payout can be used to pay the annual premiums on a life insurance policy. For example, a $15,000,000.00 second-to-die life insurance policy may be purchased outright for approximately $4,000,000.00. Therefore, in a little over five years the annuity payments coming to the donor would repay them for the policy premiums (but there may be an associated gift tax. Actual calculations would need to be explored). When both of the donors are gone, the insurance proceeds will pass to their children estate and gift tax free.

Charitable Lead Trust

A charitable lead trust (CLT) is the reverse of a CRT. With a CLT, the donor transfers property to the CLT which pays either a fixed amount or an annual percentage of the property to a charity for a term of years or for the lifetime of the donor. At the end of the trust term the remaining assets in the trust and any appreciation that has been realized pass to the beneficiaries of the donor’s choice, typically the donor’s children. Although there is typically no income tax deduction to the donor on the creation of a CLT3, the donor’s estate and gift tax is greatly reduced. The donor will pay gift tax on the value of the property that eventually passes to the chosen beneficiaries. However, the donor can utilize his gift tax exclusion to reduce this amount.

Advantages:

1) The donor greatly reduces any gift and estate tax that would otherwise be due;

2) Any appreciation will be transferred tax free to the children/heirs;

3) The donors are making a charitable gift, while still benefitting their children/heirs.

Disadvantages:

1) The donor will lose control of the assets placed into a CLT. The trustee must control all the asset investments;

2) This is an irrevocable trust, i.e. it cannot be changed. Once it is created, it can be very difficult to revoke.

3) Initial cost of creating a Charitable Lead Trust (although this can be drafted as an amendment the donor’s Revocable Living Trust, and not created until the death of the donor(s));

4) A separate tax return must be filed each year.

EXAMPLE:

The donors transfer appreciated stock and/or real estate with a FMV of $10,000,000, to a charitable lead annuity trust to pay 10% to the church of the donor’s choice for their lives, with the balance going to the donors’ children upon the death of both donors. Assuming donor husband is sixty-six (66) and donor wife is sixty-one (61) years of age, the value of the gift to the children will be approximately $2,000,000.00. If both donors use their lifetime gift tax exclusion amount, there will be no gift tax on the transfer. The charity will receive $1,000,000 each year of the donors’ lives; and on their death, their children would receive the remainder of the property in the trust (and if the property was left in tact, this would be the entire property, provided it created a sufficient income stream to pay the annuity to charity), including any appreciation on the property, gift and estate tax free at the surviving spouse’s death.

Irrevocable Life Insurance Trust (w/CRT [see above])

An ILIT is a trust that owns life insurance policies and thus removes the policy proceeds from the donor’s estate that would otherwise be included for estate tax purposes. The ILIT is established and funded with one or more life insurance policies. The ILIT is the beneficiary of the life insurance policy, but the terms of the trust determine who can actually own the policy proceeds.

EXAMPLE:

You create an ILIT and fund it with a life insurance policy. The life insurance policy is paid for each year using the annual exclusion of both husband and wife. Assuming that they name their children as beneficiaries, this will allow for policy premium payments of up to $72,000 per year4 to be used, gift tax free. The policy proceeds will pass to their children estate and gift tax free.

Qualified Personal Residence Trust

A Qualified Personal Residence Trust (QPRT) is a useful tool for transferring the primary residence or vacation home to a transferee during life while reducing the gift tax that would otherwise be applicable. The IRS specifically allows the use of a QPRT under section 25.2702-5(b) of the IRC. The grantor transfers his/her primary residence to a QPRT with the retained right to use the home for a period of years. At the end of the term of years the primary residence will be owned outright by the remainder beneficiary, presumably the donor’s children. For valuation purposes, the remainder interest (the value of the gift) will be substantially less than transferring the property outright. Therefore, the gift tax will be substantially reduced.

Advantages:

1) The home will be removed from the estate for estate tax purposes;

2) Paying gift tax during life is less than paying estate tax at death (inclusive v. exclusive);

3) Any future appreciation will pass tax-free to the remainder beneficiaries;

4) This can be used with a primary residence and/or one vacation home.

Disadvantages:

1) Cost to create the QPRT;

2) The donor will have a gift tax liability in the year of the transfer;

3) If the donor outlives the term of years, the donor will have to pay a fair rental value to remain in the home to the remainder beneficiaries. However, this could be a benefit because the donor would be transferring funds to their children/heirs in the form of rent. This rent would be subject to income tax (at the child’s rate), but it is less than gift or estate tax;

4) If the donor does not outlive the term of years, then the value of the property will be included into their estate for estate tax purposes. Also, the estate will receive a credit for any gift tax paid so they will be no worse off than if they had never created the QPRT in the first place (except for legal fees in creating it).

Family Limited Partnership

A Family Limited Partnership (“FLP”) is a limited partnership that is formed to manage and control jointly-owned family assets. All the formal requirements for setting up a limited partnership are required. Upon formation, certain assets are transferred into the FLP for ownership, management and control. In a typical FLP, the donor (or an LLC) serves as the general partner with a one percent (1%) interest while the donor, children and/or siblings share the limited partnership interests. This structure offers excellent asset protection. Even if the FLP is sued, and a creditor obtains a charging order5 the partnership can limit distributions (for legitimate reasons) to reduce exposure.

Additionally there are estate and gift tax advantages in creating an FLP. By fractionalizing the interests between the donors, children and/or siblings there are Internal Revenue Service accepted valuation discounts that can substantially reduce the value of the property for estate and gift tax purposes. The donors may be subject to gift tax on the transfer of assets to the FLP, however, this is more than made up for in the tax benefits received as a result of valuation discounts. Additionally, the donor’s gift tax exclusion can be applied to the gift to reduce the impact of gift tax even further.

The FLP has come under IRS scrutiny in recent years and have deterred families from creating these entities. However, as long as there is a “legitimate business purpose” for creating one, such as protecting assets from creditors or to manage assets more effectively, then the IRS will most likely accept them.

If a donor already owns real estate in Limited Liability Companies (which is an excellent asset protection vehicle), the addition of an FLP would simply give a potentially deeper valuation discount to the underlying properties, and would have the added benefit of further creditor protection in the event a charging order is obtained.

Advantages:

1) Although the donors have given away limited partnership interests, they have retained full control over the management and use of the assets as the sole general partners;

2) Estate and gift taxes are greatly reduced;

3) All appreciation will be out of the donor’s estate because a completed gift has been made;

4) Provides asset protection for the limited partners.

Disadvantages:

1) Cost for creation;

2) Requires strict record keeping;

3) Requires a separate tax return;

4) Nearly every FLP established will be audited by the IRS. The IRS may find that it is not a valid entity if there is no substantial, documented, business purpose, and create substantial tax problems for the donor.

EXAMPLE:

The donor transfers real estate or an LLC or stock, with a combined fair market value of $33,000,000.00, to a Family Limited Partnership. The donors are general partners (or perhaps a new LLC owned by the donor is the general partner) with a one percent (1%) interest in the FLP. The donors transfer to themselves and to their children the limited partnership interests (in varying percentages). A gift of the fair market value of the limited partnership interest that passes to the children has been made and a gift tax will be due. However, the IRS will apply several discounts to this gift, such as a minority interest discount, lack of marketability discount, among others. For purposes of this example we can assume a modest thirty percent (30%) discount rate6. Therefore, the amount of the gift will be reduced by thirty percent (30%) and any appreciation will pass to the children gift and estate tax free. The donors retain all management and control over the assets transferred and are provided additional asset protection to the limited partners.

Self-Canceling Installment Note

A self-canceling installment note is a technique used to sell an asset in exchange for an interest bearing promissory note. The note carries with it the added feature of forgiving any remaining payments on the note in the event of the seller’s death. To compensate for this feature the note must carry a higher interest rate. This type of note must not be for a period greater than the life expectancy of the seller to avoid treatment as a Private Annuity transaction, which may have adverse tax consequences.

Advantages.

1) The asset would be transferred to the children/heirs during the sellers’ lifetime. The transfer should be made with an appreciating asset. Any future appreciation will not be subject to gift or estate tax;

2) It will not use any of the lifetime gift tax credit because this is a sale;

3) The sellers’ children/heirs will have a stepped-up basis in the asset to the FMV because they are purchasing the asset at FMV. Additionally, they will be given an interest deduction from ordinary income on the interest payment made each year;

4) The gain can be deferred if the sellers are eligible for installment sale treatment.

Disadvantages.

1) The sellers’ children/heirs will have to come up with an annual interest payment to the sellers;

2) If both sellers outlive the re-payment period, then their estate will have increased for estate tax purposes. This increase will occur because of the interest payments made by the children/heirs;

3) This strategy can have an adverse effect on the size of the estate unless the transferred asset has appreciated at a greater rate than the rate of the return than the promissory note was paying;

4) The sellers will recognize gain on the transaction, although the gain can be deferred each year if they are eligible for installment sale treatment.

Private Annuity Trust

The seller of an asset will transfer the asset to the trustee of a trust in return for an annuity for life. The trustee can then sell the asset and will be responsible for investing and managing the trust assets. The trust is deemed to buy the asset for FMV so that the trust now takes a cost basis at FMV. When the trust sells the assets for FMV it has incurred no gain b/c of its cost basis. The seller can then defer the gain for his/her life expectancy and as payments are made.

Advantages.

1) The seller will defer the gain on the asset until it is distributed to him/her based on their life expectancy and will then pay the capital gains, depreciation recapture or ordinary income taxes due;

2) Any appreciation will be passed estate tax free to the beneficiaries of the trust, usually the sellers’ children/heirs.

Disadvantages.

1) The seller has no control over the assets as they cannot be the trustee;

2) If the assets are not invested properly and/or if the investments do not grow as expected, the seller will not receive the anticipated annuity payments.

3) These transactions are coming under increased scrutiny with the IRS; and are less favored with advisors.

Tax-free Charitable Transfers from IRAs

The Pension Protection Act of 2006 (PPA), was signed into law by President Bush on August 17, 2006. The majority of the PPA is designed to prevent employers from under funding their pension plans. The PPA also allows taxpayers to donate money to a charity directly from their IRA account. The charitable distributions will be tax-free and avoid the penalty for early withdrawal.

If you are a retiree with money in your IRA and have a desire to make charitable gifts, the PPA may be appealing to you. Under normal circumstances, when you withdraw funds from your IRA you must pay income tax based on your applicable rate. The PPA allows you to transfer funds directly from your IRA to a designated charity without paying any income tax.

To make this transfer you must be 70 ½ years of age or older; the transfer must go directly to an IRS qualified charity; gifts cannot exceed $100,000 per taxpayer, per year; and the gift must be outright. Unless Congress acts, the section of the PPA allowing for tax-free charitable transfers directly from IRAs will be available only until 2007.

Advantages.

1) The donor is making a gift to public charities of his/her choice;

2) The gift may be made directly from an IRA, that has not been previously taxed;

3) Reduces the total estate of the donor for estate tax purposes;

4) No cost to establish.

Disadvantages.

1) Since the distribution will not be included in taxable income, individuals will not be able to claim a tax deduction for the charitable contribution.

Change in Estate Tax Laws

Currently each citizen of the United States has an estate tax exemption of $2,000,000 per person. That means that each person can leave up to $2,000,000 estate tax free. The laws are slated to change in 2009 and raise the estate tax exemption to $3,500,000. A married couple would have a total of $7,000,000 estate tax exemption and would not, absent an increase in wealth, be subject to estate tax in 2009. This law brings the estate tax exemption back down to $1,000,000 in 2011. The uncertainty of the tax law makes it advantageous for the client to structure their estate with the view that they will be subject to estate tax.

Conclusion

As illustrated in this outline, there are many options available for transfer of assets. An in-depth discussion to ascertain your goals and desires would eliminate some techniques, and highlight others. Together, with your financial advisors, we can collaboratively develop a plan that meets your needs!