In This Issue

• Reducing Estate Taxes through $10,000 Annual Exclusion Gifts
• Residential Trusts: Painless Estate Tax Reduction
• GST Allocations after the 2001 Tax Act

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Reducing Estate Taxes Through $10,000 Annual Exclusion Gifts

By Todd M. Kegler

Gifting property during your lifetime is a simple way to reduce estate taxes, especially if you structure your gifts to avoid gift taxes. Currently, you may make an unlimited number of $10,000 gifts of cash or other property per person each year, completely gift tax-free. These are known as "annual exclusion" gifts. To ensure these tax savings, no individual recipient may receive from you more than $10,000 in a calendar year. (If your spouse elects to "split" the gift with you, the allowable amount increases to $20,000 per recipient, per year. More on gift splitting later.) A gift tax return is required to be filed if annual gifts to any recipient exceed $10,000. The primary benefit of annual exclusion gifts is the reduction of estate taxes. If you made the same gifts at death, the property would be included in your taxable estate, potentially reducing the amount ultimately transferred to the recipient by 37% or more.

A. What is the $10,000 Annual Exclusion?

The annual exclusion exempts from gift tax the first $10,000 of gifts made to a person during a calendar year, provided the donee receives a "present interest" in the property. Gifts of future interests in property do not qualify for the annual exclusion. A future interest is any property interest commencing in use, possession, or enjoyment some time in the future. A present interest is an unrestricted right to the immediate use, possession, or enjoyment of property or the income from property.

The annual exclusion applies annually on a per-donee basis. If in a particular year you gave $8,000 to each of your two children, none of that $16,000 would be subject to gift tax. If you gave an additional $16,000 to your nephew, the first $10,000 would qualify for the annual exclusion and the remaining $6,000 would be subject to gift tax. You would be required to report the $6,000 taxable gift on a gift tax return filed by April 15 of the year following the gift.

The $10,000 amount is indexed for inflation and will increase, in $1,000 increments, based on increases in the cost of living.

Payments you make directly to educational institutions or medical providers are not limited by the annual exclusion. For example, you could pay your grandchild's tuition (making payments directly to the institution) gift tax-free without being subject to the $10,000 per person, per year limitation.

B. Couples: Double Your Exclusion Through Gift-Splitting

Spouses may combine their annual exclusions, meaning that together they may annually gift $20,000 of property per recipient without paying gift tax. In fact, one spouse may transfer the entire $20,000, provided that the other spouse consents to having the gift treated as if it were made one half by that spouse. Under the split gift rules, the donor spouse (or each spouse if each spouse made a gift subject to gift splitting) must file a gift tax return whether or not any gift tax is payable. The consenting spouse is not required to file a separate gift tax return if: (1) the total value of gifts made by the donor spouse to any one donee is not more than twice the amount of the annual exclusion, and (2) all gifts are gifts of present interests in the property transferred.

Gift-splitting effectively enables parents to double gifts to their children, even if one parent owns all the property. For example, mom could make tax-free gifts of $20,000 to her son and $20,000 to her son's wife if dad consents to treating the gifts as being made one half by him.

C. Benefits of Annual Gift-Giving

Using the annual exclusion repeatedly over a number of years may dramatically reduce the size of your estate —and your ultimate estate tax bill. For example, if you and your spouse give $20,000 outright to each of your two children for three consecutive years, none of the $120,000 transferred (plus future appreciation) will be subject to estate tax because you moved the property out of your taxable estate. Moreover, none of the $120,000 is subject to gift tax. If, by contrast, you gave the same $120,000 to your children in a lump sum three years from now, the first $40,000 would escape gift taxation under the split-gift rules and the remaining $80,000 would be subject to gift tax.

D. Timing Your Gifts

The $10,000 annual exclusion is based on the calendar year and there is no carryover of unused amounts. Accordingly, the failure to completely utilize the exclusion in a given calendar year causes the unused exclusion for that year to be irretrievably lost. Therefore, timing your gifts is extremely important.

One planning opportunity is to straddle tax years for larger gifts. For example, if you and your spouse want to give $40,000 to a child, you could transfer $20,000 on December 31 and another $20,000 the next day, January 1. The entire $40,000 would fall within the annual exclusion of two different years under the gift-splitting rules.

E. Gifts to Trusts

Often, parents are hesitant about giving property directly to children who may lack the maturity to make wise investment and spending decisions. Rather than making outright gifts, they would prefer to give the property to an irrevocable trust that is managed by a competent trustee. The trick is to qualify the gifts to the trust for the annual exclusion.

As noted above, only present interest gifts qualify for the annual exclusion. Typically, irrevocable trusts provide children with discretionary rights to income and principal, which is not enough to give them a "present interest" in any gift their parents might make to the trust. One solution is to add "Crummey" withdrawal rights, named after a 1968 tax case in which the court held that the present interest requirement is met if a beneficiary has an unrestricted right to withdraw annual additions to trust corpus. In other words, if the trust permits a beneficiary to withdraw property gifted to the trust for some period of time, the gift will qualify for annual exclusion treatment. The theory is that if a beneficiary has the ability to the right to immediate enjoyment of the property, he or she has a "present interest" in the property. Since 1968, taxpayers have utilized Crummey trusts as a key component of their gift-giving programs and overall estate plans.

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Residential Trusts: Painless Estate Tax Reduction

By Edward C. Hertenstein

The estate tax is still with us, and the need for tax planning continues. Effective in 2002, the 2001 Tax Act increased the Federal estate tax exemption from $675,000 to $1 million and lowers the top bracket to 50%, with continuing increasing of exemptions and rate reductions through 2009. The estate tax is repealed in 2010, but is repealed for only one year and is fully restored (back to 2002 levels!) in 2011. Thus, Congress has decided (at least for now), that 2010 is a very good year to die.

If your net worth exceeds the exemption amount, you will be subject to estate tax at your death or your spouse's. The only way to reduce the estate tax is to reduce the size of your estate. You could give away (subject of course to gift tax planning) marketable stocks or cash, but depleting those assets could adversely affect your financial security and independence.

Enter the "qualified personal residence trust" or QPRT (the tax law is full of acronyms). Rather than parting with liquid assets, the idea here is to give away a "future interest" in your primary residence or vacation home while still retaining full control and rights. The effect is you are depleting "value" for tax purposes, but not diminishing your life style or financial independence.

Here's how it works: Say you transfer a $500,000 residence to a QPRT with you as trustee. You initially pick a term of years, say 10, for which you retain the right to reside in the house rent-free. At the end of the term, the house passes to a trust for your children but you remain the trustee until your death. If your spouse survives you, he or she can be the successor trustee. Acting as trustee assures you will always be able to reside in the residence, sell it or do anything you could do without the trust. No "asking" your children if you may live there.

The tax law treats the initial transfer of the residence as a taxable gift equal to the value of the residence minus the value of right to live there for a term of years. The longer the term, the less the amount of the gift (because the right to live there longer is worth more). If you are 60 years old, the value of a 10-year right to reside in a $500,000 house rent free is worth about $262,000 (based upon September 2001 IRS tables), so that the taxable gift would be $238,000. You would use $238,000 of your $675,000 exemption amount (increasing to $1 million in 2002). If the residence appreciates at 4% per year, in 10 years it would be worth $740,000. Thus, you would have transferred for tax purposes an asset then worth $740,000 at a "transfer value" of only $238,000. That is pretty good leverage. There is no additional gift tax at the end of the initial term or estate tax at your death. The estate tax savings could be more than $250,000.

But it gets even better. At the end of the 10-year term (or whatever term you initially select), although your right to live rent-free has passed you as trustee may "rent" the residence to yourself. (What!? I paid for this house once and now I have to pay rent?) Yes, but this is "good rent." You pay the rent to yourself as trustee for your children (you may accumulate it or distribute it to them), and such payments are totally gift tax free and may be structured to be income tax free as well.

One very important caveat: This is a "heads I win, tails I tie" plan. You must survive the term (however long you initially select) or the plan does not work. If you fail to survive the initial term, the residence is returned to your estate and in effect the transaction is unwound as if it never occurred (you get your used credit restored).

Thus, a 70-year-old may well want to consider a shorter term than a 50-year-old, and also will want to take into account personal health, family medical history and the like. Picking an appropriate term is an art, and in most cases you will want to be on the conservative side. We have found, though, that often people underestimate their life expectancies. We use bar charts to illustrate the risks and benefits of various terms for a given situation.

A 70-year-old choosing a 10-year term would be making a taxable gift transfer of $188,000 based upon a $500,000 residence (less than a 60-year old because of a greater actuarial chance of dying within the retained term). A 70-year old selecting a 5-year initial term would be making a gift of $320,000.

Young persons of substantial means often use QPRTs with very long terms, perhaps for vacation homes in expensive locales. For example, a 35-year-old with a $1 million home in Vail could use a 30-year QPRT at a gift tax value of only about $150,000. If it appreciated at a 3% per year, in 30 years it would be worth nearly $2.5 million. At 5% appreciation it would be worth $4.3 million. Talk about leverage.

What if you want to sell the residence? No problem. If you want to purchase a replacement residence, the QPRT is simply the seller of the old and the buyer of the new. If you do not replace the home (or buy a cheaper one), the QPRT may be structured to convert into a GRAT (another acronym for another day) meaning essentially that you would be entitled to "interest" on the funds for the balance of the initial term, and afterwards the amount would be held in trust for the children (with you as trustee).

Sound too good to be true? Evidently the Clinton administration thought so, and twice tried to eliminate QPRTs in presidential budgets. Congress, controlled by Republicans, vetoed the elimination attempts. There have been no recent indications, from either the Bush administration or Congress, to curtail the use of QPRTs. These are not "risky" trusts as they are blessed in IRS regulations.

So is a QPRT for you? If you want to reduce potential Federal estate taxes, but the idea of giving away stocks or cash does not appeal to you, a good idea to consider is a QPRT.

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GST Exemption Allocations After The 2001 Tax Act

By Scot C. Crow

The 2001 Tax Act is best known for the gradual reduction and one-year repeal of the estate and generation-skipping transfer ("GST") taxes. However, several sections of the Act dealing with the GST tax are effective immediately and have an important impact on estate planning. They were intended to be taxpayer-friendly provisions designed to reduce the likelihood that taxpayers will be harmed by an inadvertent failure to allocate GST exemption and other traps found within the complex rules relating to the GST tax. There are six principal changes, but the scope of this article is limited to the expansion of the automatic GST exemption allocation rules. To put the expansion in context, a general overview of the rules is necessary.

A. Background

All generation-skipping transfers are taxed at a flat rate equal to the highest gift or estate tax rate in effect at the time of the transfer multiplied by the GST inclusion ratio. This tax is in addition to the gift and estate taxes. A trust's inclusion ratio is determined by how much GST exemption is allocated (or deemed allocated) to the trust before a generation-skipping transfer from the trust. Every taxpayer has a GST exemption applicable to transfers during life or at death. The exemption is currently $1,060,000 and will continue to rise under the 2001 Tax Act.

An individual may allocate GST exemption to any lifetime transfers. GST exemption is deemed to be allocated, without any action on the part of the transferor, to direct skips (e.g., transfers to a grandchild) made during the transferor's life, unless the transferor elects otherwise. Under the old rules, the transferor was required to allocate GST exemption on a gift tax return for transfers that were not direct skips.

B. Expansion of Automatic GST Exemption Allocation to GST Trusts

The new rules expand the automatic GST exemption allocation rules to "GST trusts." A "GST trust" is defined broadly as a trust that could have a generation-skipping transfer with respect to the transferor. Any unused portion of a transferor's GST exemption will be allocated to property he or she transfers to a GST trust during life to the extent necessary to make the inclusion ratio for the property zero. Because most trusts have some GST potential, this definition, alone, likely includes many trusts to which GST exemption allocation would be inappropriate.

C. Exceptions to the New Allocation Rules

The new law provides six exceptions to the general definition.

1. 25% Distribution by Age 46

   A trust is not a GST trust if it provides that more than 25% of the trust corpus must be distributed to, or may be withdrawn by, a non-skip person (a) before that individual reaches 46, (b) on or before one or more dates specified in the trust that will occur before such person attains 46, or (c) on the occurrence of an event that reasonably may be expected to occur before the date on which such person attains 46.

   A trust that will terminate in favor of its beneficiary when the beneficiary reaches age 45, for example, would fit within this exception.

2. Distributions to Non-skip Persons

   A trust is also not a GST trust if the it provides that more than 25% of the trust corpus must be distributed to or may be withdrawn by one or more non-skip persons who are living on the date of death of another person identified in the instrument (by name or by class) who is more than ten years older than such non-skip persons.

   Neither (1) nor (2) applies to the common type of irrevocable insurance trust that provides for a surviving spouse and children until the survivor's death with distributions at certain ages to the children after the survivor's death. This type of trust does not fit within (1) because the death of a child's parent, in most instances, may not be reasonably expected to occur before the child reaches age 46. This type of trust also does not fit within (2) because no portion of the trust property would be distributed to the child at the death of the parent unless the child had already reached the specified age. Unless an insurance trust providing for both a surviving spouse and children falls within other exceptions to the general definition, GST exemption would be automatically to it unless the transferor takes action to elect otherwise.

   It is unclear why a distinction is made between the above-described trust and a trust solely for children. In most cases, the transferor would not want GST exemption to be automatically allocated to either type of trust.

3. 25% Distribution to Estate or Subject to Power of Appointment

   A trust is not a GST trust if it provides for mandatory distribution of more than 25% of the trust corpus to the estate of, or subjects such corpus to a general power of appointment held by, a non-skip person if such non-skip person dies on or before a date or event described in (1) or (2), above.

4. Death of Non-Skip Person After Transfer

   A trust is not a GST trust if any portion of it would be included in the gross estate of a non-skip person (other than the transferor) if such person died immediately after the transfer.

   Without more, this exception would apply to any trust with annually lapsing withdrawal rights (Crummey powers) held by non-skip persons such as the spouse or a child of the transferor. An exception to the exception provides that the value of transferred property is not considered to be includable in the gross estate of a non-skip person or subject to a right of withdrawal by reason of such person holding a right to withdraw so much of such property as does not exceed $10,000, with respect to any transferor. Thus, a Crummey trust with withdrawal rights of $10,000 per transferor or less that does not fall within any of the other exceptions will be a GST trust and the automatic allocation will occur.

5. CLATs and CRTs

   A trust is not a GST trust if it is a charitable lead annuity trust, charitable remainder annuity trust, or a charitable remainder unitrust.

6. CLUTs

   A trust is not a GST trust if it is a charitable lead unitrust the noncharitable beneficiary of which is a non-skip person.

D. Electing In and Out of the Automatic Allocation Rules

To ease the administrative burden of annually electing out of the automatic allocation rules if a transferor does not want GST exemption allocated to a particular trust, the new law permits a transferor to elect not to have the automatic allocation rules apply to any and all transfers made by such individual to that trust. It also permits a transferor to elect to treat any trust as a GST trust, whether or not it fits within the definition of a GST trust, with respect to any or all transfers made by the individual to such trust. These elections must be made on a timely filed gift taxreturn for the calendar year for which the election is to become effective.

Because the automatic GST exemption allocation rules apply to all transfers made after 2000, it is important for transferors who will be making transfers to trusts in 2001 to meet with their tax advisors to determine whether the trust are GST trusts and, if so, if the transferor should elect out of automatic GST exemption allocation.

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