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The Use of Gifting and Trusts to Avoid Death Taxes

By: Kimberly A. Paton, Esq.


Our regular readers know that I recommend that all of our clients have 3 basic estate planning documents a Will, a Living Will and a Power of Attorney. These (a) ensure that your assets are properly distributed at your death; (b) ensure that your wishes regarding life support are effected and, (c) protect you in the event you are unable to handle your assets.

If your assets exceed $1 Million, we recommend some additional estate planning techniques to avoid taxes at your death.  Federal Estate Taxes are currently 50% of assets over $1 Million. Additionally, if you leave money to somebody other than your spouse, children, or grandchildren, there are NJ Inheritance Taxes of as much as 16% on all of such inheritance.

You have worked hard to accumulate your wealth.  If you do not want 50% or more of this wealth to go to the government on your death, the sooner you act, the more wealth you can protect for your loved ones. Here are some excellent techniques to consider.

Lifetime gifting is an extraordinarily good method to reduce death taxes. You are allowed to gift a loved one $11,000 annually without incurring gift taxes.  (This is the Annual Exclusion Amount). When you gift this money, it is out of your estate, so there will be no Estate Taxes on it when you die.  Additionally, all growth and income on the $11,000 is out of your estate (more tax savings).  You can make this gift annually. Let's say you use this program annually for 20 years and have one child.  You will have gifted $220,000 without paying gift or Federal Estate Taxes.  Those assets could be worth $400,000 after twenty years of gifting. That means that you have saved approximately $200,000 in Federal Estate Taxes. (A married couple can gift $22,000 annually, and double the tax saving.  If you have more than one child, you can save more taxes.)

Many times our clients do not wish to make these gifts to their children outright.  In this case, we use trusts, rather than waste the opportunity. A trust allows you to gift money to your loved ones now to save taxes, but keeps strings on the beneficiary's use of the money.

The use of trusts also may allow you to feel more comfortable making large gifts. Since you are preparing the trust you can control how and when your loved ones receive their money.  For example, you can specify that the beneficiary receives 10% of the trust at age twenty-five; 25% at age thirty; 25% at age thirty-five; and the balance of the trust at age forty. Alternatively, you could keep the money in trust for the beneficiary's life. You could name a group of beneficiaries (your children) and specify that the trustee shall disburse money as needed without necessarily being equal. You could protect your spouse by keeping the money in trust and available for her/him until she/he dies and then let the trust monies distribute to the children.

You also name the trustees.  You can choose a close relative or a professional trustee, or both. A close relative will protect your family -- encouraging education; purchase of a house or business by distributing the necessary funds; discouraging frivolous spending by withholding funds. Under the right circumstances, you or your spouse can be a trustee.  A professional trustee has the necessary experience with investing large sums of money and will not be affected by emotions.

In some circumstances, we can prepare the trust to specify that your spouse has access to the trust money for her/his life and after her/his death the children receive the money as you  have predetermined; maybe a further trust. Remember, that you decide how much to gift, or not to gift, each year.

You can increase the tax savings by taking advantage of the following:

  1. Investing in Life Insurance.   The trust(s) can protect even more money for your children if the trust(s) invest(s) a part of the $11,000 per year in life insurance policies on your lives. This will maximize the inheritance that the child(ren) receive. Assume that the trust buys a $1 Million policy and pays $5,000 per year.  After twenty years, the trust has only paid $100,000 in premiums and the children will receive $1 Million in proceeds entirely free of Federal Estate Taxes.
     
  2. Making Larger Gifts. If you have sufficient assets you can make additional gifts to the children's trusts over and above the $11,000 now. Any excess gift will reduce the Unified Credit available to you at your death, however, you will save significantly more taxes.  Currently, you are allowed to gift or leave your children $1 Million without paying Federal Gift Estate Taxes. If you gift the children the $1 Million currently, that will go to the children free of Federal Gift/Estate Taxes.  This goes into a trust for proper handling and distribution. Again, that $1 Million gift will be out of your estate together with all growth and income.  In twenty years, this trust could be valued at $4 Million.  All of which would get to the child(ren) without Federal Estate Taxes. (Potentially a $2 Million tax savings.) 

    Frankly, in the right fact pattern (great wealth, advanced age, terminal illness), it is advisable to gift more than $1 Million and actually pay the gift taxes attributable to such excess gift because gift taxes are paid only on the actual gift, so the taxes are less initially and you have removed more wealth from your estate.  For example, assume that you have already made a $1 Million gift (tax free), if you make another $1 Million gift today, you will pay about $500,000 in taxes.  Therefore, you have removed $1.5 Million from your estate. Forget growth for a moment.  Assume you died yesterday and you had the $1.5 Million in a bank account, Estate Taxes are paid on the whole account, approximately, $750,000.  Gifting the money nets a $250,000 tax savings.
     
  3. Gifts Other Than Cash.   You do not have to gift cash. You can gift real estate, pieces of your business interest, stock, etc.  In fact, many times gifting business interests yield larger tax savings. The documents can be drafted so that you keep total control of the asset even though you have gifted an interest in the assets; the children cannot sell their interest; and you can receive a commission for handling/controlling the asset. Additionally, because you have kept control of the asset, you can discount the value of the gift by approximately 25%.

    As such, you could fund the trust with $1.3 Million of business partnership interest, declare only a $1 Million gift so that you pay no Federal Gift Taxes. Therefore, you have removed $1.3 Million from your estate today which is likely to equal approximately $5 Million in 20 years.

    Note that we would maximize the benefits and your control by using family limited partnerships/LLCs along with the trusts.  Note further that when you gift an asset, the beneficiary takes your basis. So there may be capital gains payable when the child sells the gift.  However, these taxes are generally less than Estate Taxes.
     
  4. Unmarried couples. If you have a life partner, but are not married, the NJ Inheritance Tax is 15% on assets bequeathed to your partner in addition to any Federal Estate Taxes.  By gifting monies to your life partner annually, you can avoid both levels of taxation. You can make those gifts in trust so that you can designate that when your life partner dies, any remaining trust funds will go to your children, family, charity, etc. - whoever you choose.  Finally, if the trust is for the benefit of your life partner and your children, we can reduce the tax rate for NJ Inheritance Taxes to something less than 15%.
     
  5. Second Marriages. Trusts are a great way to ensure that your current spouse is provided for during her/his lifetime and ensure that your assets reach your children after her/his death.  Typically, these trusts are in your Will and not prepared or funded during your lifetime.  However, under the right circumstances these trusts work and are available.

These are the more common trusts used to avoid taxes along with gifting. There are additional types of trusts that can be implemented depending on your goals, assets and family situation.

If you would like to review the above trusts or other types of gifting arrangements, please contact me to schedule a convenient time to review the techniques, your goals and your assets so that we can prepare the most beneficial tax plan for you and your family.

Kimberly A. Paton, is a Partner at WJ&L, LLP, who practices in the Estate Planning, Probate and Elder Law areas of our practice.

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