Trudy Nearn, principal, Generations law firm.

Trudy Nearn, principal, Generations law firm.

Estating the Obvious

A little planning goes a long way

Back Longreads Aug 1, 2008 By Christine Calvin

Asset values are down, interest rates are down, and industry experts doubt the Obama administration will allow the current estate tax exemption to expire in 2010. That combination makes a ripe environment for creating or adjusting an estate plan, and financial advisers say acting now could save thousands — if not millions — of dollars later.

Establishing a basic estate plan is crucial for anyone wanting to avoid the costs and hassles of the court system. Trudy Nearn, founding partner of Generations estate and trust law firm in Sacramento, says establishing a will is good for covering the basics, but the more advantageous option is a trust.

In California, any assets included in a will must pass through probate, a costly six- to nine-month process that includes attorney fees, the cost of litigation, court fees, appraisal fees and a host of additional charges in the event of a real estate transaction. That’s not to mention the percentage of the gross value of the assets payable to the attorney: $23,000 in fees for the first $1 million in assets alone.

To avoid probate, it’s best for individuals or couples of moderate wealth to go with a living trust coupled with a will, durable power of attorney, an advance medical directive and a HIPAA (Health Insurance Portability and Accountability Act) release, Nearn says.

With these planning tools, all assets go to the trust, which can be modified without limits. It names an incapacitation director to make decisions in the event that the trustee cannot, allows for circumstantial allocations of the assets (equal shares to the kids unless little Joey ends up in rehab) and controls from the grave — in case you don’t want your surviving spouse spending his or her inheritance on a newer, younger version of you. A trust also allows for other built-in checks and balances and a get-out-of-probate-free card.

Nearn recommends coupling the trust with a durable power of attorney, which will name an alternate decision maker in charge of financial matters, an advanced health care directive for medical decision making and a HIPAA release, which allows a doctor to share your medical status and inform your lawyer and insurance company that you’re incapacitated.

Planning for the deathbed isn’t most people’s idea of a good time, but financial planners say it’s imperative if you want to pass on as much of your estate as possible, avoid troubling your family with lawsuits and dodge massive money grabs by Uncle Sam. It’s particularly advantageous to act now while interest and values are low, especially for high net-worth individuals facing large tax burdens, but it seems as though not everyone is listening.

“I am having a very hard time getting clients to bite on this stuff,” says Jim Deeringer, a Downy Brand partner. “I’ve maybe just had a handful this year. I’m puzzled by the lack of movement. I sent out a little alert to my higher net worth clients about six weeks ago highlighting this situation and how beneficial it is to act now. I’ve only had a few who are following up on this. It really doesn’t have anything to do with net worth. I think that, subjectively, people are just timid and uncertain.”

Estates are taxed based on the value assessed by the IRS at the time of the estate’s creation. Currently, the first $3.5 million in assets can be passed on to a beneficiary tax free, but after that, you’re facing a 45 percent hit on the remaining value. Creating trusts that offer shelter for taxable assets can save you a substantial amount of money.

And, once protected by certain estate planning tools, the appreciated value of some assets slips under the IRS radar, and sometimes it even works in your favor. Often, assets that outperform interest rates can bolster your estate without accruing taxes. To capitalize on the market’s advantages before they’re gone, here’s what you need to know about your options:
Credit Shelter or AB Trust

With a credit shelter or AB trust, two separate trusts are created upon the death of the first spouse, when the original trust bifurcates. If the value of each trust remains below $3.5 million respectively, there is no estate tax assessed on either at the death of the first spouse. The deceased person’s trust can grow above $3.5 million thereafter, and there will still be no estate tax when the second spouse dies. The survivor’s trust will be taxed upon his or her death only if it has grown above the estate tax exemption, which at that time may or may not still be $3.5 million.  

“We’re in this window of time whether limited partnerships and LLCs can still produce some very substantial economic benefits through valuation discounting.”

Jim Deeringer, partner, Downey Brand

“Most people do this because it’s not a pain in the butt for the surviving spouse, except that there are two different tax return forms every year,” Nearn says. “It’s also good for people with control-from-the-grave issues or those who have more than $3.5 million.”

For couples with more than $7 million — the maximum exemption for two trusts — or for marriages in which there are multiple sets of children or in which one spouse has a greater estate than the other, Nearn recommends a qualified terminable interest property trust.

With a QTIP, the original trust breaks into three upon the death of the first spouse. The survivor’s trust (Trust A) shelters half the assets. Trust B is filled to the maximum limit sheltered from estate tax, and Trust C gets the taxable leftovers. (For more information on QTIP trusts, see our November 2008 article at
Disclaimer Trust

What if you’re not sure how much money you’ll have when you die or what the estate tax will be years down the road? The best option might be a disclaimer trust. With this tool, the surviving spouse has up to nine months after his or her spouse’s death to determine the best way to split the trust. Perhaps one spouse wants to bestow the entirety of the trust to family but the other spouse would rather give it to charity — with the disclaimer trust, in essence, the surviving spouse wins.

“You would never select a disclaimer trust if you have control-from-the-grave issues,” Nearn says.

For very high net-worth couples — those with more than $7 million — there are other tools that can be used in conjunction with these basic options to further protect the trust from estate taxes.

You first want to maximize the use of either the AB trust or the QTIP because those are the easiest ways to secure two tax exemptions, which can save your beneficiaries more than $3.1 million in taxes on a $7 million estate, Nearn says.

If you’re worth more than $7 million, an irrevocable life insurance trust could be a good option. With an ILIT, a life insurance policy owned by the trust can be used to pay bills, and none is available for taxation. The only other way to do this is to have your children own the insurance policy; otherwise, the value of a self-owned insurance policy is added into the value of the estate and taxed accordingly.
Grantor-Retained Annuity Trust

For his high net-worth clients, Kent Silvester, a partner at McDonough Holland & Allen PC, recommends grantor-retained annuity trusts, charitable lead annuity trusts, grantor trusts and other tools that pay dividends when interest rates are low and when values are depressed.

A GRAT is an irrevocable trust into which you can place cash, stocks, mutual funds, real estate or other income-producing property, such as a business. At the end of the specified period, say two to 20 years, the assets you’ve placed into the GRAT will pass to the beneficiary.

On a GRAT, for example, if the IRS publishes a low interest rate (the June rate was 2.8 percent), and you have an asset that outperforms that rate (something generating a 10 percent return, for example), the spread between what you are producing and what the IRS is assuming is deemed a consumption of the asset’s principal.

“What’s left at the end is assumed to be a very small number, which is the amount of the gift,” Silvester says. “So if you can outperform the rate, in certain circumstances you can transfer millions of dollars for a fraction of the value of the asset.”
Sale to a Grantor Trust

Trustees wishing to manage business assets might consider selling the company to a grantor trust, Deeringer says. He tells of one client with a $12 million estate and four children. His biggest asset was an 85 percent interest in a family limited partnership. The client created a grantor trust for each child and transferred just more than 21 percent of the limited partnership to each trust. He was able to discount the value of each of these interests by about 42 percent, Deeringer says.

Appraisers will assign a sizable discount to limited partnership interests or LLC membership interests based on lack of marketability and lack of management control because the beneficiaries are passive investors lacking management control. Discounts often come in the neighborhood of 35 to 40 percent, Deeringer says.

In this case, Deeringer’s client received four 25-year promissory notes for $1.5 million. The interest rate at the time was 4.67 percent on interest-only payable notes. Upon the grantor’s death, the notes were discounted by another 40 percent because of how low the interest rate was and how long the term was. In the end, the family saved nearly $3 million in estate taxes alone.

“We’re in this window of time whether limited partnerships and LLCs can still produce some very substantial economic benefits through valuation discounting,” Deeringer says. “That may very well go away within a year because of legislation. Nobody thinks it’s going to be retroactive; you would slide under the wire, so the time to act is now.”

The Head of Estate

Gathering your thoughts and personal documents before meeting with your financial planner to establish or adjust an estate plan is essential. The more information you can provide about yourself and your desires, the more specifically tailored your estate plan can be, says CPA Francine Vorhees of Moss Adams LLP. Here is how she suggests you prepare:

Establish your goals. What keeps you up at night? If you have concerns about your children, spouse or other family members, write them down. Consider how much control you want over your assets after your death. Do you want to allocate every dollar, or are you OK allowing your beneficiary to make that determination? Are you interested in donating to charity? Do you want your children to receive assets sooner or later? Who would be the financial guardian over minor children? Make notes of all these thoughts and bring them with you when you meet with your planner.

Evaluate whether you have enough assets. “It’s not just about avoiding estate taxes,” Vorhees says. “I can save you a bunch of money in taxes, but if I destroy your family and design a plan that is too complicated, then I have done you a disservice, and that’s not my goal. My goal is for you to reach your goal.”

You may want to establish a solid financial plan before considering an estate plan. This would include listing and valuing assets. Your financial planner can help you make sure there is enough money to maintain your lifestyle for your remaining years. “If you don’t,” she says, “you don’t have an estate tax problem.”

Consider taxes, estate income and property. It costs money to have valuables appraised. Because assets in a trust are not static, if they have a ballpark figure, you should be OK to start accounting for income and taxes, Vorhees says. Once you start implementing the estate plan, then you need to have appraisals and evaluations.

Be mindful of state laws and taxes. Somebody that has had property in California for a long period under Proposition 13, for example, is paying just 1 percent of the property’s full cash value, but if the property has to be reassessed, you’re not gong to be happy. Consult your financial planning team before selling, moving or appraising assets.

Gather your documents. Keep any buy-sell agreements for your business, wills, asset titles, etc. in a well-organized place. Create a family tree and a clear, concise family history. Bring all of these items with you in writing when you meet with your financial planner. This will help him or her understand your life, assets, needs and wishes.

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