Defective by design For decades estate planning has focused on avoiding or minimizing federal estate, gift and generation-skipping transfer taxes. During the last several years, however, income tax has taken on a more significant role. That’s not to say income tax wasn’t a factor before. But until recently, it was overshadowed by transfer tax considerations. Now that the federal estate tax exemption has climbed to $3.5 million, fewer people are subject to federal estate tax. If you’re among those for whom estate tax has become less of a concern, it’s a good idea to review your situation and consider such estate planning strategies as income defective and estate defective trusts. Income defective trusts Irrevocable trusts have long been a highly effective tool for minimizing transfer taxes. When you contribute assets to an irrevocable trust, you freeze their value for transfer tax purposes. Although you’re subject to gift tax on their fair market value, the assets are removed from your estate so that future appreciation in value passes to your children or other beneficiaries tax free. There are, however, certain situations where the assets can be returned to your estate. An intentionally defective irrevocable trust allows you to transfer even more wealth tax free. With careful drafting, you can ensure that the trust assets are removed from your taxable estate while rendering the trust “defective” only for income tax purposes. By reserving certain minor powers over the trust — such as the right to exchange trust assets with property of equal value or to borrow from the trust without adequate security — you ensure that the trust will be treated as a “grantor trust” for income tax purposes without bringing the trust assets back into your estate for estate tax purposes. This is significant because you are treated as the owner of a grantor trust for income tax purposes, which means that you report the trust’s net income on your individual tax return. As a result, the trust assets grow without being eroded by income taxes, leaving a greater amount of wealth for your beneficiaries. Essentially, by paying the trust’s taxes, you make an additional tax-free gift to your heirs. This type of “income defective trust” can be a powerful tool for reducing estate taxes, but it also comes at a potential income tax price, because the basis in the recipient’s hands will be the lesser of your basis or fair market value at the date of transfer. In contrast, when assets are transferred at death, they receive a “step-up” in basis. In other words, an asset’s tax basis is reset to its fair market value at the time of the transfer at death. Thus, if your heir sold the asset immediately after your death at the same fair market value, the sale wouldn’t trigger any capital gains taxes. Suppose, for example, that you place $500,000 in assets in an income defective trust for the benefit of your child, and your basis in the assets is $400,000. When you die, the trust assets, which are distributed to your child, are valued at $1.5 million. If your child sells the property, he or she will realize a $1.1 million capital gain, resulting in $165,000 in income tax (presuming the current long term, 15% rate and ignoring any state tax). This price may be worth paying if, assuming a 45% marginal rate, it would avoid the $450,000 in estate taxes on the appreciation in value of the trust assets. But what if your wealth is within the $3.5 million exemption amount, so that removing the appreciation from your estate would yield no tax benefit? Under those circumstances, a different strategy might be called for. Estate defective trusts An estate defective trust is the opposite of an income defective trust: It’s designed so that your beneficiaries are treated as the owners for income tax purposes, and the assets remain in your estate for estate tax purposes. This allows you to take advantage of two important income tax planning benefits: 1. You can use an estate defective trust to shift income to family members in a lower tax bracket. 2. By retaining the trust assets in your estate, your beneficiaries will enjoy a stepped-up basis in the assets, reducing or eliminating capital gains taxes if they sell the assets. Consider this example: John, who is in the 28% federal income tax bracket, owns property that generates $30,000 annually. His tax basis in the property is $300,000, but its fair market value has grown to $900,000. John’s net worth is well within the $3.5 million estate tax exemption amount, so he’s not concerned about estate taxes. John transfers the property to an estate defective trust for the benefit of his daughter, Beth, a 25-year-old graduate student with no other income. By shifting the income to Beth, the family saves more than $5,500 per year in federal taxes. State tax savings could further add to the benefits. Bear in mind, though, that there may be other factors to consider when deciding whether this type of income shift is beneficial. In addition, because the property remains in John’s estate, Beth receives a stepped-up basis in the property when John dies, avoiding $600,000 in capital gains (or more, if the property has appreciated further). Keep in mind that the success of an estate defective trust depends on the assumption that you’ll have little or no estate tax liability. If that assumption proves wrong — because, for example, your wealth increases unexpectedly or Congress reduces the estate tax exemption — this strategy could backfire. The future of estate tax laws As of this writing, absent new legislation, the estate tax (but not the gift tax) will be repealed in 2010 and then reappear in 2011 with a top rate of 55% and an exemption amount of only $1 million. Also, in 2010, a stepped-up basis will be available for only a limited amount of property. If these changes take place, the estate defective trust will lose some or all of its appeal. But it’s widely believed that Congress will revise the estate tax laws this year. Plan carefully The effectiveness of the estate defective trust and other estate planning strategies depends on what Congress and the president decide to do about the federal estate tax laws. Keep an eye on legislative developments and talk with your advisors about their implications for your estate plan. • |