If you live in Massachusetts or own Massachusetts real estate and the total value of your (and your spouse's) assets is at least $1 million (the Massachusetts estate tax exemption amount), you may want to utilize one or more of the estate tax savings techniques summarized below, in order to save estate taxes for your estate, your spouse's estate and even potentially for your children's future estates. Some of these techniques are particularly advantageous now, given the increased gift and generation-skipping transfer (GST) tax exemption amounts and the current low-interest rate environment.
Please consult with your Day Pitney Individual Clients Department (ICD) attorney to determine how best to take advantage of these tax-saving techniques for your own financial circumstances.
- Division of Assets Into Family Trust/Marital Trust. In general, to save estate taxes, married couples should have estate plans that utilize both spouses' federal and Massachusetts estate tax exemptions. Typically, this is achieved through revocable trusts that divide the property of the first spouse to die into a Family Trust (for the surviving spouse and children or other beneficiaries), holding up to $1 million, and a Marital Trust (for the surviving spouse only), holding the balance of the property of the first spouse to die. This utilizes the first spouse's exemptions while allowing any estate taxes to be deferred until the surviving spouse's death, when that spouse's exemptions will also be available to help reduce estate taxes. For this technique to work, the couple's property must be owned appropriately between them (in general, roughly half of the assets should be owned by each spouse), so each spouse has enough assets to fund his or her Family and Marital Trusts and thereby shelter his or her federal and Massachusetts estate tax exemptions, regardless of which spouse dies first.
- Irrevocable Life Insurance Trusts. If the technique described above does not eliminate all projected estate taxes for a married couple—or for an unmarried individual—and there is a significant amount of life insurance, establishing an irrevocable trust to own the insurance policies will reduce estate taxes. This is the case because, in general, insurance proceeds from life insurance policies owned by properly structured irrevocable trusts escape estate taxation (as well as income taxation), but the transferor/insured should not be a beneficiary or trustee of the trust. Payments of annual insurance premiums are considered to be gifts by the creator of the trust to the trust beneficiaries, but typically these can be made to be gift tax-free by qualifying as gift tax "annual exclusion" amounts (see Point 3, below) by including limited withdrawal rights for trust beneficiaries.
Gifting/ In General. For additional estate tax savings, gifts may be made to children (and other beneficiaries), either outright or in trust, which will reduce the size of your future estate.
- "Annual Exclusion" Gifts. Gifts within the "annual exclusion" amount ($13,000 in 2011 and 2012) to any individual in any calendar year do not use up any of your federal gift or estate tax exemptions. Such gifts are particularly helpful to reduce estate taxes because the amount gifted, plus future appreciation, escapes federal and Massachusetts estate taxation entirely (unlike larger gifts—see Point 4, below). As noted above, gifts to properly structured trusts may also qualify as annual exclusion gifts, which is particularly useful for young beneficiaries.
- "Taxable" Gifts. If "annual exclusion" gifts will not reduce the size of the estate sufficiently, larger gifts may be made. Note, though, that a federal gift tax will be due if total lifetime "taxable gifts"—gifts other than annual exclusion gifts—exceed the gift tax exemption amount (currently $5 million) and that taxable gifts are added back to the estate when calculating the federal estate tax. Post-gift appreciation is not added back, though, which helps reduce estate taxes. (When calculating the Massachusetts estate tax, such excess gifts, but not appreciation, are added back only to determine whether the $1 million filing threshold is met but not to calculate the actual tax owed.)
- Gifts and "Sales" to "Intentionally Defective Grantor Trusts" (IDGTs). Gifts of any size may be made to standard irrevocable trusts that hold all property for the benefit of any named beneficiaries or to other trusts such as GRATs, QPRTs and CLTs (see points 5-7, below). The federal gift tax exemption is best utilized by gifts to standard irrevocable trusts, because all post-gift appreciation escapes federal estate taxation and no portion of the gift is returned to the creator of the trust.
The trust can be structured so the trust pays any income taxes attributable to trust income, including capital gains, or so the trust's creator pays such taxes. If the trust's creator is responsible for the income taxes, the trust is referred to as an Intentionally Defective Grantor Trust, or IDGT. Advantages of this are that the trust is undiminished by income taxes and can accumulate or be used for the next generation "tax free" and the settlor in essence is able to make the functional equivalent of a gift tax-free addition to the trust each year while reducing the size of his or her own estate by the amount of income taxes paid.
Instead of making a gift to an IDGT (for example, if someone has already used all gift tax exemptions), one may transfer property as a "sale" to an IDGT in exchange for a promissory note issued to the settlor. This allows a transfer to be made to such a trust that has a zero value for gift tax purposes. The note can provide for interest to be paid at the low "Applicable Federal Rate" (AFR). (In November 2011, the "midterm" AFR rate—for loans of between three and nine year—is only 1.2 percent, while the "7520" rate applicable to GRATs (see Point 5, below) is 1.4 percent.) A low interest rate is desirable, because this allows more trust property to remain in the trust, appreciate and pass estate tax free to beneficiaries.
- Gifts to Grantor-Retained Annuity Trusts (GRATs). Gifts to GRATs enable the settlor to shift a portion of the future appreciation in the property to the next generation at reduced gift and estate tax costs. In this technique, the settlor transfers to the trust property that is likely to appreciate significantly in a relatively short period of time. As part of the arrangement, the settlor will receive back from the trust a calculated amount each year (annuity payments), for a period of years selected by the settlor (the term), based on the IRS-issued "Section 7520 rate" (1.4 percent for November 2011). Typically, the present value of all annuity payments is made to equal the value of the property transferred to the trust, so that no taxable gift is made and no gift tax exemption is used (a "zeroed out" or "Walton" GRAT).
If the actual growth rate exceeds the Section 7520 rate, property will remain at the end of the GRAT's term, which may then be held in trust for, or pass outright to, children and other descendants on a gift and estate tax-free basis.
- Gifts to Qualified Personal Residence Trusts (QPRTs). A QPRT is an irrevocable trust that is funded with a personal residence (either the principal residence or a vacation home) in which the settlor retains a right of use for a term of years (analogous to a GRAT). At the end of the designated term, the settlor's interest ends and others named in the trust become the beneficiaries. At that point, the trust can continue or terminate, whichever the settlor has specified. Continued use of the personal residence by the settlor after the designated term ends will generally only be allowed upon payment thereafter of fair-market-value rent by the settlor. So long as the settlor survives until the expiration of the term of years, the QPRT will not be taxed as part of the settlor's estate.
QPRTs are less advantageous in low-interest rate environments such as the current environment because the calculated taxable gift upon funding the trust will be relatively higher, but because real estate values are low now, this argues in favor of QPRTs. Additionally, QPRTs do not permit a step-up in basis for capital gains tax purposes at the settlor's death, so one must analyze whether estate tax savings will outweigh the capital gains tax increase caused by the QPRT.
- Gifts to Charitable Lead Trusts (CLTs). A CLT allows members of one's family, or others, to receive the trust assets when the charitable "lead interest" ends. If the circumstances are favorable, a CLT allows one to leverage the use of the gift or estate tax exemption. The value of the remainder interest, for gift or estate tax purposes, may be significantly less than the initial value of the property, depending on the terms of the trust and the applicable interest rates. CLTs are more advantageous in low-interest rate environments (unlike Charitable Remainder Trusts, in which the placement of the charitable and noncharitable interests are reversed as compared to CLTs).
- Allocating Generation-Skipping Transfer (GST) Tax Exemption to Gifts to Certain Trusts. Whether taking place at death or during life, all transfers to noncharitable beneficiaries that involve a distribution to a beneficiary, such as a grandchild, who is more than one generation younger than the donor or creator of a trust are potentially subject to an additional transfer tax known as the generation-skipping transfer tax. A substantial exemption from this tax—$5 million per transferor in 2011—is now available. One may "allocate" the available GST exemption to transfers made to an insurance trust or an IDGT, for example, which may be very advantageous from an estate and GST tax viewpoint.