Exploring the estate tax: Part 2

This is the second of a two–part article on the federal estate tax. The first part, which was in the October issue of the JofA, discussed the unified federal estate and gift tax rules, the exemption amount, the definition of the gross estate, gifts made within three years of death, estate valuation, and portability. This part covers estate tax planning techniques, including the marital deduction and the use of various types of trusts.

Estate planning comprises all of the steps that an individual should take to minimize estate taxes, thereby maximizing the value transferred to an individual’s beneficiaries. The type of estate planning an individual needs depends on his or her circumstances, objectives, and family situation. The following is a look at how some common estate–planning techniques work and the most effective ways taxpayers can use them.

For an estate to qualify for the marital deduction, the interest passing to the surviving spouse must be a nonterminable interest. Terminable interests do not qualify for the marital deduction (Sec. 2056(b)(1)). An example of a terminable interest is where the decedent leaves property to a surviving spouse for the spouse’s lifetime, with a remainder interest to the decedent’s children. Since the surviving spouse’s lifetime interest terminates upon death, it will not qualify for the marital deduction; however, property subject to the life estate is not included in the surviving spouse’s gross estate.

An exception to the rule that terminable interests do not qualify for the marital deduction is qualified terminable interest property (QTIP). QTIP is property in which the surviving spouse has a qualifying income interest for life and the executor elects on the estate tax return to treat the property as a QTIP (Sec. 2056(b)(7)(B)(i)). The election is irrevocable (Sec. 2056(b)(7)(B)(v)). A qualifying income interest for life is one where:

If the decedent leaves property to a surviving spouse for the spouse’s lifetime, with a remainder interest to children, the transfer would not qualify for the marital deduction; however, a QTIP does qualify for the marital deduction. The QTIP would be included in the surviving spouse’s gross estate and is normally held in a trust called a marital or QTIP trust (Sec. 2044(a)).

Married couples can always defer the estate tax until the death of the second spouse because the estate tax marital deduction is unlimited (Sec. 2056(a)). Thus, if the first spouse to die leaves his or her entire estate to the surviving spouse, the estate tax base would be zero. Due to portability of the unused exclusion amount, if the decedent spouse’s estate elects portability, the surviving spouse’s estate would have to exceed $10,980,000 (twice the $5,490,000 exclusion amount for 2017) before the estate tax kicks in (Sec. 2010(c)(4); Regs. Sec. 20.2010–2; Rev. Proc. 2016–55).

Example 1

A and B are a married couple who have the following estate tax bases (before the marital deduction) upon death: A: $7,000,000; and B: $10,000,000.

Assume that both A and B die during 2017. If each spouse’s will leaves his or her entire estate to the surviving spouse, irrespective of who dies first, there would be no estate tax on the estate of the first to die since the unlimited marital deduction would reduce the estate tax base to zero. Furthermore, none of the $5,490,000 (for 2017) applicable exclusion amount would be used because the marital deduction would reduce the estate tax base to zero. Upon the surviving spouse’s death, the estate tax would be computed as shown in the table “Net Estate Tax Liability.”

Net estate tax liability

Before the unused exclusion was portable, the exclusion amount could be sheltered from estate taxes by placing the exclusion amount in a family trust, also called a bypass trust or a credit–shelter trust. The family trust would be set up to benefit the surviving spouse during his or her lifetime and, upon the surviving spouse’s death, the trust assets would pass to beneficiaries other than the surviving spouse, normally the children. The decedent would not get a marital deduction for the amount placed in the family trust since the transfer to the family trust would have been a terminable interest. Upon the surviving spouse’s death, the amount in the family trust would not be included in the survivor’s gross estate, thereby bypassing the estate. The balance of the estate not passing to the family trust would be placed in a QTIP trust, which would qualify for a marital deduction but be included in the survivor’s gross estate.

A potential downside of the family trust is that the family trust assets do not get a stepped–up basis upon the death of the surviving spouse. To allow for some flexibility, a disclaimer trust can be used, giving the surviving spouse the option to disclaim ownership of a portion of the estate (stepped–up basis) and to place the disclaimed assets in the family trust (no stepped–up basis).

Even with portability of the exclusion amount, family trusts are still widely used in estate planning. Not only does the exclusion amount bypass the survivor’s estate, but the appreciation on the family trust assets does as well. The following example illustrates the benefit:

Example 2

A and B are a married couple who have the following estate tax bases (before the marital deduction) upon death: A: $16,000,000; and B: $0.

Assume that A and B both die in 2017. Also assume that the assets appreciate 20% from the date of A’s death to the date of B’s death. There would be no estate tax upon A’s death since the marital deduction (amounts going into the QTIP marital trust) would reduce the estate tax base to the applicable exclusion amount of $5,490,000 (family trust). The gross estate tax on the applicable exclusion amount is equal to the unified credit of $2,141,800, resulting in no net estate tax liability. When B dies, B’s estate tax base would be $12,612,000, calculated as shown in the table “B’s Net Estate Tax Liability With Marital Trust.”

B’s net estate tax liability with marital trust

If A did not use the family/marital trusts and made the portability election, although A’s estate would still have no tax liability assuming full use of the marital deduction, B’s estate tax liability would be $439,200 higher, which is 40% of the 20% appreciation of $1,098,000 on the original family trust amount of $5,490,000. The calculation of B’s estate tax liability is shown in the table “B’s Net Estate Tax Liability With Portability.”

B’s net estate tax liability with portability

Greater appreciation on the family trust assets will result in greater estate tax savings. If one spouse is significantly younger than the other and the older spouse dies first, it could be 20 or 30 years before the younger spouse dies. The appreciation on the family trust assets could easily be 200% to 300%. The table “Estate Tax Savings Associated With Appreciation” illustrates the estate tax savings associated with the appreciation of the family trust assets originally funded with the exclusion amount of $5.49 million.

Estate tax savings associated with appreciation

As noted previously, a potential downside of the family trust is that the family trust assets do not get a stepped–up basis upon the surviving spouse’s death. Although there is a built–in income tax cost to the beneficiaries of the family trust equal to the appreciation of the family trust assets at the time of the surviving spouse’s death multiplied by each beneficiary’s tax rate on a taxable disposition of those assets, this cost will only be recognized if and when the beneficiary disposes of the underlying asset(s) in a taxable transaction. To minimize the built–in income tax cost to the beneficiaries, the executor can choose assets that have a low appreciation potential in funding the family trust. The QTIP trust should be funded with assets that have a greater appreciation potential since the QTIP assets will get a stepped–up basis upon the survivor’s death.

As illustrated in the table “B’s Net Estate Tax Liability With Portability,” if an individual’s estate tax plan does not include a provision for a family trust, the estate of the surviving spouse would generally have an estate tax liability greater than the survivor’s estate tax liability with a family trust provision. As a result, in most cases it would be advisable for a married individual to have the family trust in place to minimize estate taxes on the surviving spouse’s death. Furthermore, the estate tax savings associated with the appreciation of the family trust assets is 40% of the appreciation, whereas the built–in income tax cost on the appreciation ranges from 0% to 39.6% depending on the marginal tax rate of the beneficiary, considering the characterization of the underlying assets as ordinary or capital gain property.

A situation that is extremely common in family/marital trust planning is that one spouse has significantly more assets than the other spouse, as in Example 2. As a result, the estate tax savings associated with the appreciation on the family trust assets is not possible if the spouse with little or no assets dies first. The spouse who dies first would have to have assets of at least the applicable exclusion amount of $5.49 million to maximize the estate tax savings associated with the appreciation on the family trust assets. The solution is for the asset–rich spouse to transfer, by gift, assets at least equal to the applicable exclusion amount to the other spouse. The gift will not result in any gift tax since the gift tax base has an unlimited marital deduction (Sec. 2523(a)).

Referring back to Example 2, assume that A transferred half of the assets of $16,000,000 to B, leaving both A and B with $8,000,000 in assets. Irrespective of who dies first, the net estate tax liability on the survivor’s estate would be $2,848,800, a savings of $439,200 over a situation when no family/marital trust planning was initiated. The calculation is as shown in the table “Net Estate Tax With Family/Marital Trust Planning.”

Net estate tax with family/marital trust planning

Use of the family trust as an estate planning tool to bypass the survivor’s estate is only effective for married couples. Similarly, only married couples can benefit from the portability election. All individuals, single or married, can use a number of other estate planning techniques to minimize estate taxes. These include irrevocable life insurance trusts and qualified personal residence trusts.

Life insurance plays a vital role in estate planning for a number of reasons: (1) to provide income for surviving family members and (2) to pay the estate’s estate tax liability. Unfortunately, life insurance proceeds are included in the gross estate if the estate is the beneficiary or, if the beneficiary is not the estate, if the decedent possessed any incidents of ownership (Sec. 2042). To resolve this problem, the estate planner should consider creating an irrevocable life insurance trust (ILIT), which will effectively remove the life insurance proceeds from the gross estate as long as the decedent does not retain any incidents of ownership (Sec. 2042(2)).

Removing the life insurance proceeds from the gross estate can be accomplished by either transferring an existing life insurance policy to an ILIT or having the ILIT purchase a new life insurance policy. Since the ILIT cannot be changed, it is extremely important to have an estate planning attorney properly draft it. If an existing life insurance policy is transferred to the ILIT, the transfer would potentially be subject to gift taxes but only to the extent that cumulative taxable gifts exceed the applicable exclusion amount of $5.49 million (for 2017).

Furthermore, any amounts transferred to the ILIT to pay premiums on the life insurance would be potentially subject to the gift tax. To take advantage of the $14,000 per donee annual gift tax exclusion (Sec. 2503, Rev. Proc. 2016–55), the ILIT must contain Crummey withdrawal powers, which give the ILIT’s beneficiaries a noncumulative right to withdraw annually that year’s contribution (which is intended to cover premiums) to the ILIT in an amount up to the $14,000 annual gift tax exclusion (see Crummey, 397 F.2d 82 (9th Cir. 1968)). The right to withdraw funds is available only for a brief period of time, typically 30 days. The Crummey power creates a gift of a present interest to the ILIT and qualifies the premium contribution to the trust for the $14,000 annual gift tax exclusion.

For many individuals, the majority of their net worth is in their personal residence and retirement plans. Much of the value of a personal residence can be removed from the gross estate using a qualified personal residence trust (QPRT), which minimizes the amount of the value of a personal residence that is included in the gross estate. Establishing a QPRT can save estate taxes without limiting the individual’s ability to use the property as a personal residence.

A QPRT is established when the grantor irrevocably transfers a personal residence to the trust for a fixed period of time, for instance 10 or 20 years, during which the grantor retains the unrestricted right to occupy the property as a personal residence. When the fixed term ends, the property goes to designated beneficiaries (remaindermen), usually children or other family members. At the end of the fixed term, if the grantor is still alive, he or she usually leases the personal residence from the remaindermen at fair market value (FMV) (see Regs. Sec. 25.2702–5(c)).

Because the transfer of the personal residence to the QPRT constitutes a gift, the grantor will want the value of the gift to be as low as possible. This purpose is accomplished by choosing a longer fixed term for the QPRT, which results in a lower remainder interest. The gift is valued using IRS tables (Sec. 7520). Although the grantor wants a longer fixed term for gift valuation purposes, if the grantor dies within the fixed term, the entire value of the property (at date of death) is included in the grantor’s gross estate, resulting in no estate tax savings (Regs. Sec. 20.2039–1(c)). Thus, because the grantor must survive the QPRT’s fixed term to get its full benefits, the grantor should choose a fixed term that he or she has a high likelihood of outliving. When the grantor outlives the fixed term, significant estate tax savings are possible.

Only the value of the gift on the date the property was transferred to the QPRT will be included in the estate tax base. The difference between the property’s FMV on that date and the value of the gift will escape estate taxes as will any appreciation of the residence from the date of transfer to the QPRT to the date of death. Unfortunately, the significant estate tax savings do come with a cost in that the remainder beneficiaries do not get a stepped–up income tax basis in the property at the grantor’s death (Sec. 1015(a)).

About 55% of Americans have neither a will nor an estate plan; therefore, it is essential that financial planners advise clients of the importance of both. A basic estate plan would include a will, possibly a revocable living trust, and powers of attorney for medical and financial matters.

A will is essential if the client has minor children, because it enables the client to appoint an individual (normally a family member) to serve as guardian of the minor children. For a married couple, since the parents are the legal guardians of their minor children, the guardianship appointment would only be needed if the parents die simultaneously or after the second parent dies. Absent a guardianship appointment, additional legal requirements would have to be followed, and a court would eventually appoint someone as the minor children’s guardian who may not be someone the client would have wanted to serve as guardian.

For married couples with enough property and money that they have to worry about estate taxes, financial planners need to ensure that these clients have properly drafted wills with provisions that would allow a marital deduction on the estate tax return of the first to die. Without wills, the applicable state laws of descent and distribution would apply, which could result in at least some property being inherited by family members other than the surviving spouse. The unintended consequences would be a loss of at least some of the potential marital deduction and a potential estate tax liability for the estate of the first to die.

Clients need to understand the importance of formulating an estate plan sooner rather than later. For a married couple, the necessary legal documents must be in place before the first spouse dies, to take advantage of the estate tax savings on the appreciation of the family (bypass) trust assets. These legal documents would include a will that provides for the family/marital trusts or a pour–over will, where probate property pours over to an existing revocable living trust that, upon death, becomes irrevocable and provides for the family/marital trusts.

A transfer of an existing life insurance policy to an ILIT should be accomplished sooner rather than later to minimize potential gift taxes and to ensure that the life insurance proceeds are not included in the gross estate. Likewise, a transfer of a personal residence to a QPRT should be considered sooner rather than later to minimize potential gift taxes and to maximize the appreciation of the residence that escapes estate taxes.

To accomplish the estate planning needs of clients, financial planners should meet with their clients at least annually to review their estate plans as life occurrences such as marriage, divorce, and having children can affect the type of planning necessary to meet their goals.

About the author

David J. Beausejour (dbeausej@bryant.edu) is a professor of accounting at Bryant University in Smithfield, R.I., where he teaches taxation, personal financial planning, and wealth management.

To comment on this article or to suggest an idea for another article, contact Sally P. Schreiber, senior editor, at Sally.Schreiber@aicpa-cima.com or 919-402-4828.

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