Estate Planning - Asset Accumulation and Preservation,
An Overview 

 

I.  Benefits of Planning an Estate with a Living Trust

II.  Life Insurance Policies, Variable Annuities and How to Own Them

III. How to Effect Tax Free Transfers of Wealth

IV. Asset Accumulation and Preservation

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I. Benefits of Planning an Estate With a Living Trust 

Living Trusts are Recommended by Most Professionals

Living Trusts Work Well in Moderate Sized Estates 

Traditional Benefits from Using Living Trusts 

• Avoid probate for both single and married persons.

• Avoid losing a $1.0 million exemption from estate taxes for married persons (which will gradually increase to: (i) $1,500,000 for estates of decedents dying in 2004-2005; (ii) $2,000,000 for estates of decedents dying in 2006-2008; (iii) $3,500,000 for estates of decedents dying in 2009, (iv) unlimited for decedent's dying in 2010, and (v) thereafter $1.0 million).
• Select trustees, whether trust companies or trusted individuals with whom you have confidence, to care for your estate and financial well-being when you are not able to handle these affairs, due to incapacity or infirmity, and for the benefit of our natural heirs, upon death.

Probate is the court process of supervising and administering estates. In California, estates must pay statutory probate fees for attorneys and executors that are based on the gross value of the estate (without any reduction for debts or mortgages) that starts at 4% of the estate value (for each the attorney and executor) and drops to 1% for estate values in excess of $1.0 million. 

In addition, because of probate court involvement, there will naturally be additional attorney and executor fees called Extraordinary Fees, that are incurred when the estate needs permission to sell property and/or take action to protect or defend assets of the estate. It must also be noted that judicial involvement will also mean that all of your financial and personal matters that are revealed in court become part of the public record and therefore available to the press and the general public. (Many members of the press maintain a daily presence at court houses just to scoop the next interesting probate, divorce, family dispute or other litigation matter on file.) 

Other Planning Benefits of Living Trusts 

• Protecting assets from creditors.

• Giving assets to a disabled or handicapped child by the creation of a Special Needs Trust, who otherwise is able to obtain state aid in order not to lose the state aid that might be available. 

• Avoiding estate taxation of life insurance proceeds (which contrary to popular belief are generally taxable in one's estate), which can reduce the insurance proceeds available to your children by up to 50%.

• Pass property to children, in trust for the benefit of grandchildren, in an attempt to avoid an estate and gift tax at the death of the children, to the extent authorized under the generation skipping transfer tax rules.  

Estate Taxes are a Second Tax, After You Have Paid Your Income Taxes

We are each given a credit against this tax that currently allows each of us to pass, by gifts during our lifetimes and at death, $1.0 million. As noted above, this credit will gradually increase the size of estates that can avoid  estate taxes (but not gift taxes) from $1.0 million, increasing to (i) $1,500,000 for estates of decedents dying in 2004-2005; (ii) $2,000,000 for estates of decedents dying in 2006-2008; (iii) $3,500,000 for estates of decedents dying in 2009, (iv) unlimited for decedent's dying in 2010, and (v) thereafter $1.0 million.  In addition, we are able to gift during our lifetimes not more than $10,000 per year (which amount is now indexed and will increase by inflation) to any person, which gift does not apply against our lifetime $1.0 million exemption. Since 1999, this $10,000 per year per person exemption will also increase as it will be indexed for inflation and rounded to the next lowest multiple of $1,000. 

Techniques to Reduce Estate and Gift Taxes:  Gifting; Entities to Retain Control over Property; Valuation Discounts and Fractionalized Ownership of Property

The problem with gifting is that once gifted the property typically is no loner  subject to continuing control by the donor, that can create other problems.   In order to solve these problems sophisticated estate planning techniques call for the formation of trusts or entities (irrevocable trusts, family limited partnerships or LLCs) to avoid giving control over the property being gifted away.  The property gifted is a share,  unit, or percentage interest in a larger property, where the control to manage and control the property is vested in a trustee, general partner or manager.  A significant by-product of these sophisticated techniques is that when a "fractionalized" interest, such as a minority share of stock, a minority partner interest is gifted, the value of the "fractionalized" interest that has been transferred  by law a lower value than the actual percentage ownership that the same interest represents of the entire asset or entity. These reductions in value are typically called "valuation discounts".

The Internal Revenue Service ("IRS") must take into account these valuation discounts, which reduce the value of the "taxable gift" and therefore also reduce the gift or estate taxes payable. Anytime that property is owned by more than one person or entity, there is "fractionalized ownership", and therefore the value of each partner's interest for estate and gift tax purposes is less than the value percentage ownership attributed to the entire property. The sum of the parts is less than the whole. A fractional ownership interest of less than 50% will generally be subject to a greater valuation discount than a 50% ownership interest.

In a community property state, husbands and wives are therefore automatically entitled to valuation discounts with respect to their property holdings. Unmarried couples, unmarried partners, and single persons who own property interests as partners" or "tenants in common" are also entitled to these valuation discounts. Estate planners who do not understand sophisticated estate planning may miss these planning opportunities when drafting the most simple estate plans. 

The valuation discounts are real and the IRS must recognize them. The IRS will argue that these same  valuation discounts must also reduce a taxpayer's income tax deduction when making gifts of fractionalized interests to a charity.  The IRS may challenge the size of the valuation discounts relative to the size of the fractional interests being transferred, however, there are acceptable and conservative valuation discounts that a taxpayer can take to avoid these challenges. 

Not all Living Trusts are Alike

"Form-book" trusts which can cost the client as much as a "tailored" trusts, are generally limited in features because they do not address the unique concerns of the client and/or may be missing provisions that can solve problems that may not be known at the time of drafting, but that may crop up later down the road. 

Special Planning Opportunities and Planning for Unmarried  Couples and "Partners"

The typical "Husband and Wife" estate plan through the use of a properly tailored living trust can without material additional costs, incorporate the following planning provisions and tax savings techniques: allowthe taxpayers to take valuation discounts to reduce estate taxes; transition retirement plan monies to heirs so that income taxes are deferrable over the lifetime of the beneficiary;  andprotect bequests from creditors of the Trust beneficiaries, achieve basic creditor protection for one spouse protecting the spouse from the creditors of the other spouse.

Planning for Unmarried Couples or Partners should take advantage of fractional ownership and valuation discount techniques, and annual tax free gifting through irrevocable trusts. While these areas of planning are more complicated, substantial tax savings and planning opportunities are available to unmarried couples or partners. 

Conclusions

II. Life Insurance Policies, Variable Annuities and How to Own Them

Whole Life vs. Term

Whole life policies in most cases are a combination of decreasing term insurance (a policy that each year decreases in the amount of the insured death benefit that is payable upon a death) and an investment in an annuity-type of investment. Each annual premium is allocated between the cost of term insurance, expenses chargeable to administer the policy, and the remaining balance, if any, is allocated to an investment account. 

The type of whole life policy will determine how the investment account is to be invested. Those policies referred to as "variable annuity contracts" invest their investment accounts in mutual fund type of investments, and allow the policy owner to direct and configure the investment portfolio account to any of the investments within the family of funds generally being administered by the insurance company. Other forms of contracts include "fixed rate" contracts and "money market" contracts. Most "money market" contracts carry a minimum rate of return, even though the actual rate will fluctuate with money market rates. 

The cash value of the whole life policy grows as a function of the increases in value of the policy's investment account. Because term insurance becomes increasingly more expensive as your age increases, the term insurance benefit payable upon a death, decreases. These decreases in term death benefit are usually made up by the increases in value of the investment account. 

Straight term policies generally do not contain an investment account or a cash accumulation. Because the cost of term insurance will go up with increases in age, a straight annually renewable term policy will increase in cost each year. Insurance companies therefore provide other options to straight term, such as 5, 10 or 15 year fixed premium term, or deceasing term, wherein the policy premium stays the same, but the death benefit payable each year decreases. This is typical of "mortgage insurance," and the term portion of whole life policies. 

Both whole life and term policies offer other policy terms and benefits, to distinguish insurance companies and their products from each other. Many policies, including term and whole life, retain the right to increase the premiums for the term portion of the policy, if the insurance company suffers "actuarial losses". As a result, the annual premium that is generally quoted (in the case of a term insurance) and the investment accumulation projected (in the case of a whole life) may not be accurate if a higher charge for the term portion of the policies are imposed, as authorized. Hopefully your agent will be able to explain that their insurance company has never imposed or taken advantage of their ability to charge the higher term rates. Many policies also offer a disability benefit called "waiver of premium" that will pay the annual policy premiums if the insured becomes disabled. 

Whole life policies are in one sense "tax shelters" in that the investment account earns income and appreciates on a tax deferred and potentially a "tax free" basis. If you cash out the policy you will then have to pay the government the income taxes attributable to the accumulated interest. However if you hold the policy until death, the entire death benefit and investment account will be paid to your beneficiaries, free of income tax. Please however recall the prior discussion that compares income tax with the estate and gift tax. The life insurance policy may still be subject to an estate or gift tax, unless other forms of planning have been implemented. 

On its face, whole life policies sound much better than term policies. Whole life policies generally pay a return that generally rival T-Bill rates and under variable annuity contracts appreciate similar to mutual funds. As noted, the accumulation under a whole life policy is tax deferred and potentially tax free. In addition the owner of the policy is given the right to borrow against the investment account at a very reasonable rate of interest. What a great way to save. However, there is a catch! 

Whole life policies are not profitable if you cancel them in their first seven (7) to ten (10) years of ownership. Insurance companies charge hefty penalties, loads, early termination fees, and other administration charges in the early years of the policy. In addition, there are a good number of lesser known companies that through smoke and mirrors cause the policy to have abnormally high loads and administration charges, to the point that they never reach the point of providing a viable investment. Some of these companies may even tout themselves as being the most solvent and most secure for your investment. However upon a closer examination the profitability of some insurance companies may be because their policy holders can never make a fair return on their investment accounts, which are continually being assessed administration charges, that make the insurance company extremely profitable and secure. 

From strictly a number crunch prospective, there is a good amount of analysis to support that you can do much better financially if you buy annual renewable term insurance and invest the difference between the reduced premium cost of the annual term insurance relative to the higher premium cost for a whole life policy. This is mockingly referred to by many insurance agents as "buying term and investing the difference." My own experience is that few people ever invest the difference wisely, which lends support to the arguments by most agents in favor of a whole life policy. 

If you did in fact buy a term policy or a decreasing term policy and invest the difference in a tax free or tax deferred investment, such as a tax deferred annuity, you would generate most of the benefits of a whole life insurance policy, with much less load and less risk. Tax deferred annuities are allowed to accumulate income on a tax deferred basis. This means that you will have to pay taxes when you reach an age that you can withdraw the funds. Early withdrawals are subject to penalties, and borrowing may not be permitted. However, a whole life policy will not be subject to income taxes on the investment account upon the death of the insured, whereas, an tax deferred annuity does not offer this tax benefit. 

Term may be the clear choice if you own a property or business that you know can and will liquidate into cash when needed in the future and you do not need the discipline and forced savings offered by a whole life premium. Your ownership of the appreciating asset becomes your investment account, that can convert to cash. You can also purchase some whole life and some term insurance, where the term policy will supplement the death benefit of the whole life policy to make sure that there is sufficient cash available to handle expenses if your are gone. 

My advice to clients is to maintain a balanced portfolio, one that has investments in stocks, bonds, mutual funds, whole life insurance, and term insurance. The real issue is whether or not you can afford the expense of maintaining a "balanced portfolio". Therefore if you have to cut, you may want to consider buying a term policy that can be converted into whole life, when you have more money to invest. 

How to Own the Insurance 

The most typical mechanism to hold life insurance that will avoid estate taxes is to hold it in an irrevocable life insurance trust. These trusts, if properly formed and funded, would become both the owner of the insurance policy and the beneficiary, thereby keeping the death benefits out of your and your spouse's estate. 

Funding to pay the insurance premiums can be accomplished by gifts to the trust. The gifts can either be subject to gift tax, or within gift tax free and within the annual exclusions for gifts of $10,000 per year per child, provided that the ultimate beneficiary of the trust (i.e. children or grandchildren) have the right to demand a distribution of the gifted cash within a period of a few weeks from the date the gift is made. If they do not demand a distribution, then the gifted monies are will be used to pay the insurance premiums. Other methods of funding include loans to the trust, or split dollar loan arrangements (typically in the form of corporate loans) whereby when the death benefit becomes payable, the lender of the monies will be paid off, with or without interest. 

Another new mechanism that is becoming popular is to own the insurance in a family partnership, whereby the insured and/or the insured's spouse and the children are partners and gifts of policy premiums are made directly to the children who then contribute the monies to the partnership. 

There are a variety of forms of trusts and partnership arrangements that can be used to own and acquire life insurance. Here again, the cost to form an entity, and the benefits desired therefrom are important factors that must be evaluated before settling on any form of entity. For example, should the surviving spouse have any access to the death benefits? What happens if under a trust or partnership arrangement a child withdraws or retains the sums contributed for his or her benefit, leaving insufficient money to pay for the insurance? Is it better just to have the children own the policy without a trust or partnership, it is certainly cheaper. 

In addition, you may want to leave the grandchildren as the ultimate beneficiaries, which will require a document that handles the "generation skipping transfer tax", when gifts are made directly to grandchildren, or when gifts are made in trust for children, and upon their death to grandchildren. This is a tax that is imposed when transfers attempt to skip a generation, and avoid the imposition of estate taxes in the next successive generation. The tax laws cannot prevent you from skipping the next generation and leaving property to your grandchildren, however, they impose a tax at the maximum estate tax rates for skips that in the aggregate exceed $1.0 million. Although commencing in 1999 this $1.0 million generation skipping tax exemption will be indexed for inflation and therefore increase, it is important to understand the significance of, and therefore be able to plan around, this additional tax that will be imposed if you attempt to leave property to grandchildren, in order to avoid your children having to pay an estate tax at their death. 

Finally, the form of ownership of the life insurance may be properly integrated into an Asset Protection & Preservation plan, or can be used to solve liquidation problems to acquire the shares or assets of a business, upon a death or retirement, or to achieve some other charitable, tax savings or estate planning goal or objective. 
 

III. How to Effect Tax Free Transfers of Wealth 

I again refer you to our Lead Article Asset Protection & Preservation - Domestic & Foreign and to Limited Liability Companies, Corporations, Partnerships, Business Trusts, Retirement Plans, and Domestic and Foreign Spendthrift Trusts for a better understanding of how traditional forms of doing business can affect and interface with planning techniques to avoid income and estate taxes. 

The most basic structures that are recommended and generally needed in most any estate that suffers income and estate tax burdens include the Living Trust and the Irrevocable Life Insurance Trust, discussed above. If you are still interested in greater savings, then the next areas to explore involve mechanisms that shift "income", asset "appreciation" and assets at "discounted" values to others. 

In the case of income shifting objectives, techniques used to achieve these objectives generally include the establishment of entities to own income producing assets, such as real properties, businesses, etc., that can pass-through desired levels of taxable income to the targeted recipients. You must note that Congress has imposed a "kiddie" tax, among other pitfalls, to make it very difficult to shift this income and tax burden. The "kiddie" tax will tax all income earned by a child under age 14 at the parent's tax rate. Other obstacles to shift income require some form of economic substance and compliance with applicable tax rules and regulations when implementing the transactions that cause the transfer. 

The Family Limited Partnership has recently been promoted as a most favored form of entity that achieves both economic substance, ease in compliance with tax rules and regulations, and enables the parent or transferor of the asset to control both the underlying asset and the income received therefrom, without necessarily violating the myriad of Internal Revenue Code pitfalls. The Family Limited Partnership can not only be used as a device to shift the income tax burden, but can also be used to shift both assets and asset appreciation and therefore reduce the estate and gift taxes attributable to that asset and eliminate the estate and gift taxes attributable to the asset "appreciation". 

This shifting of income and asset appreciation occurs because the Family Limited Partnership is a "pass-through" tax entity. This means that income earned and the asset appreciation of the assets owned by the partnership are allocable among the partners in accordance with their percentage ownership of the partnership, unless stated otherwise in the partnership agreement. An important aspect to the tax planning involved in the formation of a Family Limited Partnership focuses on how to convey, free from income and gift tax, a greater partnership percentage to those family members targeted for allocation by discounting the value of the Family Limited Partnership interests being conveyed, because of their minority and non marketable status (vis-a-vis the value of the assets owned by the Family Limited Partnership). 

Along with a transfer of the underlying interest in the Family Limited Partnership, will be a transfer of the income and asset appreciation attributable to the interests being transferred. In some cases a gift tax or income tax is payable, in others, the available unified credit, or annual exemption, can offset the cash flow impact of any taxes. There are a variety of techniques available to depress the value of an asset, so that when sold or gifted, its value for tax purposes will be reduced, in order to cause a lower tax liability. The techniques generally acceptable under the Internal Revenue Code to depress asset values must, in most cases, pass scrutiny under specific objective tests, before the IRS will recognize the technique and related transaction as "arms-length", and before the IRS will consider allowing the taxpayer to use the depressed or reduced fair market value for purposes of the gift or transaction. Use of these sophisticated techniques requires legal counsel that is knowledgeable of the rules and regulations that affect all aspects of the "pass-through" entity and all transactions in connection therewith, including both state and federal laws, in addition to applicable federal, state and local tax laws (income tax, gift tax, estate tax, sales tax, real property tax, etc.). 

An increasingly used estate planning tool is generally referred to as the Residence GRIT (grantor retained interest trust), or the Qualified Personal Residence Trust also referred to as a QPRT. This technology incorporates use of grantor annuity trusts, or "GRATs" (grantor retained annuity trusts). In the QPRT, the personal residence of the grantors is contributed to a trust, generally established for the benefit of the grantor's child or children. The grantor will retain certain rights in the personal residence, any replacement residence, or any proceeds from the sale of that residence, for a specified term that is usually the estimated actuarial life expectancy of the grantor. Because of this retained interest, the IRS (IRS) will only tax the gift to the trust on the basis of the fair market value of the residence less the actuarial value of the "retained interest", which is always a percentage of the value of the residence. The longer the term of the "retained interest" the lower the taxable gift will be. However, if the grantor does not survive the expiration of the term, then under the Internal Revenue Code (IRC), the transaction and trust will be treated for estate tax purposes as if it never occurred. Therefore, a term (or a joint term) should be selected that the grantor and in the case of a joint term, his or her spouse) believes they can and will survive. There are other issues assuming survival of the Residence GRIT term, such as where will the grantors live after the expiration of the term, and how to protect the "retained interest" from creditors. However, these issues can be resolved by use of competent and creative legal counsel. 

Another mechanism, that is similar to the Residence GRIT, is a plain GRAT. The GRAT is very similar to the Residence GRIT, except that the "retained interest" is an annuity interest, pays to the grantor periodic cash payments. The GRAT must therefore own an asset that generates cash flow that is sufficient to make the periodic cash payments to the grantor, consistent with applicable IRC regulations. In most other respects the GRAT is similar to the Residence GRIT. In fact that the Residence GRIT under a QPRT will convert into a GRAT upon a violation of specific rules and regulations that include rules that limit the use of the personal residence to only the grantor and his or her spouse. 

Still in vogue are charitable trusts, called charitable remainder trusts, that receive tax deductible gifts of property and offer the client or charitable grantor an annuity or monthly cash payment (in the form of a GRIT or a GRAT) for the rest and remainder of his, her or their lives. The plan in many cases includes the purchase of a life insurance product by using the current income "tax savings" generated from the charitable gift and tax deduction. The policy is purchased to benefit the natural heirs of charitable grantor(s), in order to replenish their inheritance that had been previously gifted to the charitable trust. If and when this form of planning works, it benefits everyone, the charity, the grantor, the heirs of the grantor and the attorneys and accountants who get paid to structure the plan and prepare the documents. 

Since most any type of entities and/or contract relationships (assuming their implementation is achieved consistent with the necessary pre-requisites of economic substance), are available to achieve a variety of income and estate tax savings objectives, it will be up to your legal counsel or tax advisor to help you understand the nature and significance of each entity and/or relationship, and to help you to select the plan that meets all of your criteria that also maintains compliance with applicable rules and regulations. Once you commence sophisticated estate and tax planning, as with asset protection and preservation techniques, there are no "canned" formats to achieve your ultimate objectives. At that point, estate and tax planning and asset protection and preservation planning may become one and the same. The unique nature of your financial holdings, their tax basis, your family situation, anticipated inheritance, your trade or business, among other factors, and your unique family, tax, economic and creditor objectives and concerns must be integrated into a tailored plan, that can achieve your ultimate goals and objectives. 
 

IV. Asset Accumulation and Preservation 

I know that if I had the secret to making millions, I would not be busy sharing it with others, I would be working my closest friends and families to generate the millions. 

Recognize that the investment markets are "smart". Unless you are on the "inside", and/or are willing to risk going to jail, you have to assume that you will not find the lucky tip of the century. There are laws that put people in jail if they share inside information, or use inside information for their own benefit. 

As far as investment advice is concerned, when Warren Buffet speaks, people listen. You should too. Alternatively, find a broker or investment advisor who has the ability to evaluate investments in a similar manner.

This not to say that the quick kill or lucky investment will not pan out. Just understand the risks relative to the loss opportunities of making sound investments. 

As attorneys, we have seen the asset accumulations and appreciations come through:
 

• inheritance
• incentive employee stock compensation arrangements
• high risk oil and gas investments
• venture capital
• lucky stock picks
• becoming a "superstar" or best selling author or musician
• the lawsuit judgment in the sky
• sale of one's business through an IPO, or in a private sale
• a golden parachute to a company executive
• steady savings and sound investment
• development and sale or licensing of new technology or business idea
• working a new business opportunity
• convincing others to invest in a great business opportunity
• brokerage of a business deal
• real estate transactions from the "go-go" real estate days, when President Reagan deregulated the savings and loan industry, among others 

You may want to add to this list and evaluate where your own potential for asset appreciation and accumulation can be found. My recommendation is that you highlight the ones that you can easily do, and do them. This will always be steady savings and sound investment. With respect any others that may be within reach, pick those closest to your personality and talent and develop a business plan. You have to have a good attitude and be able to enjoy pursuing the plan. 

Try to stay away from emotional investments or pursuits, unless in your heart it feels good whether or not it is profitable. 

And of course, as you develop your plan and can foresee the need for asset protection and tax planning, engage me to advise you. 

Good Luck. 
 
 



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