THIS IS A VERY OLD POST – THE CONCEPTS REMAIN BUT LAWS ARE DIFFERENT – TALK TO YOUR ATTORNEY FOR THE LATEST

This blog post is a modification of a letter I sent to an actual client recently. I have generically made it available to all high net worth families here. Of course if you want me to review your estate, or your loved one’s estate, let’s talk about YOUR options personally!

Dear Sample High Net Worth Client:

Thank you so much for coming into my office on April 1st to talk about your estate plan. I have reviewed the value and basis numbers given to me by your accountant and provide the following review.

Let me start by saying that I have absolutely no idea what the federal gift and estate tax exemption will be going forward.  Having said that, I do read a lot and go to a lot of estate planning seminars but I really do not “know” what the law will be.  Also, to state the obvious, we do not know when you will die or what your assets will be worth at that time.  The laws are very uncertain to say the least.  Any action you take has to include considerations for gift, estate, income and even property tax; along with the personal analysis that must be factored in to any estate planning choices.

As we discussed under the current tax law you can gift during life or death (in combination) $5.12m tax free.  Your current total estate is about $8.6m in the calculations from your CPA but that includes $1.6m on your husband’s side of the trust (the B trust) and $7m on your side of the trust (the A trust).  It’s the $7m that I am focusing on here as those are the assets that could be taxed when you die. 

As of today you can give away $5.12m but as of January 1, 2013 the law is set to revert to $1m.  The amount above $1m would be subject to tax at 35% and thus a potential tax bill of about $2,500,000 at your death.  Let me clearly state that if no action is taken by our friends in Washington DC the law will revert to $1m. That’s the way the law is actually written now.

As I told you one of the key issues with the current tax law is that you can give away up to $5.12m during life or at death.  For the past 10 years the gift tax exemption (during life) was set at $1m while the estate tax exemption (after death) varied between $1m and unlimited. Thus you could die with billions of dollars in 2010 and pay zero estate tax but if you had given away money while still alive that year you could only give $1m tax free.  Thus, the current $5.12m gift exemption is a huge benefit if people can take advantage of it.  However, to really take advantage of it you have to give more than $1m this year. 

Certainly any amount of gift is great as it reduces your estate and, most importantly, gets the future appreciation out of your estate.  Getting the appreciation out is important as that appreciation could be subject to tax at your death if still in your estate.  However, to really get some bang for your gifting buck, and take advantage of the current law, you would need to give more than $1m this year.

As I type that let me state that though the law, if it is changed, might not be changed until after the presidential election we are encouraging clients to act now as we will not have time to help everybody in December. In 2010 when they made the previous huge estate tax law change it was done around December 15th.  That just doesn’t give enough time to help everybody if action is needed.  In fact, we are planning to sending out letters to our entire database of clients and past clients, in the next couple of weeks, which could make us very busy as the year goes on.

In the simplest of terms, if you want to take full advantage of the current law, I would advise you to give away up to $5.12m to the boys this year.  I would encourage you to use two separate irrevocable trusts so as to give the boys creditor protection. I would probably recommend a standard irrevocable trust which would be “defective” as to income so that you would be responsible for the income tax.  That way the trust could stay in tact as much as possible.  You could use other A trust assets as well as the income from the B trust to pay that tax. You might make the boys the trustee and add an independent trustee (non-relative) as a “distribution trustee” who could approve or disprove any distributions.  It gives a small amount of protection to you but it does give the boys added creditor protection for after your death. 

In a way you could say the trusts are really the boys trusts as they would be designed to benefit them.  That is they would receive the creditor protection of a third party trust, which is key, but they would retain control over investments, purchases, and how the money would be distributed at their death.  I do this for a lot of clients and think it is good estate planning.

The biggest “problem” is you would be giving this money away and it would be out of your control. Obviously you trust your boys, or you wouldn’t have come in to talk about your options, but I realize it is a big step.  There are ways to keep more control with you, by using a family limited partnership (or LLC) for example but it adds a lot of complexity and cost.  Additionally, other than the control factor I don’t think your estate needs an FLP.

You could put the house into the boy’s trusts or, what is more common to do, would be to use a qualified personal residence trust (QPRT). A QPRT is an irrevocable house trust that gets the house out of your estate for a reduced tax cost. I believe we spoke about this at our meeting. Basically you give away a future interest in your mom and the IRS lets you take a discount for the current value of that future interest. It’s a very common estate planning tool that a lot of people are using right now.  A QPRT even provides creditor protection for you so it’s a great estate planning vehicle to consider!

Before I go on let me say that there are counter-balancing tax considerations that need to be made.  Under current law when a person passes assets at death there is an estate tax (35%).  However, under current law the assets pass with a “stepped up” basis for income (capital gains) purposes. This step up is really huge as the boys would be able to sell assets, at your death, without any income tax.  I use 25% as an estimated combination of federal and state capital gains tax (15% federal and 10% state) but the federal is set to go to 20% on January 1^st.  Yes, there might be an estate tax if you die with the assets but capital gains would be avoided. The point is it’s a gamble!

In conclusion doing the trusts for the boys would be a wise thing to consider but is certainly not “mandatory” due to the counterbalancing tax considerations.  If you chose to not do an irrevocable trust you might think about doing a complete restatement of your revocable trust so as to create creditor protection trusts for the boys for whatever they inherit.  Your previous attorney, though well known, did not set up your trust to maximize creditor protection for your children. 

Please contact me with questions. 

Sincerely,

John B. Palley