Estate planning techniques for today's economy.

Estate planning techniques regarding the transfer of assets to heirs are especially beneficial now that interest rates are low.

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The following tactics can help your clients to minimize taxes, review their estate plan, make adjustments to their plan based on market conditions and values, and initiate an estate plan to protect their beneficiaries. These techniques are not all encompassing, but are some of the most frequently recommended to clients.

Make Gifts of Assets While the Values are Low

By gifting assets now when real estate, securities and other assets are are valued lower than they have been in the recent past--clients can take advantage of a correspondingly reduced gift tax.

If the gifts at death are large (more than $1 million) and would trigger a gift tax, consider that large lifetime gifts can be more advantageous than leaving assets to beneficiaries at death. This is because gift taxes paid on gifts more than three years before the donor's death are not includable in the donor's gross estate, which makes the gift lax rate about 30 percent less than the estate tax rate [IRC Sec. 2035(b)].

Since the estate tax is tax-inclusive, estate taxes are paid on the assets used to pay the estate taxes, similar to federal income taxes. By contrast, the gift tax on gifts made more than three years before death is tax-exclusive. The gift tax is based on the value of the property gifted without adding to the gift the amount of the gift lax paid. Also, gifts produce tax savings that cannot be achieved through transfers at death because any future appreciation after the gift is made, and income from the gift, escapes taxation.

Gift Partial Interests in Property to Take Advantage of Discounts and Leverage Lifetime Gifts

For example, Mom gifts an undivided interest in an asset directly to Son or trust for the benefit of Son. A 50 percent interest in a piece of property is worth less than 50 percent of the- total appraised value of the properly. Because Mom is giving away less than 100 percent of her property, a fractional interest discount can be deducted from the value of the property. Therefore, a donor can gift more with less .gift tax cost.

Example: If the properly was worth $500,000, but a 50 percent interest was only worm $212,500 $250,000 less a 15 percent discount), the portion subject to gift tax would be $212,500, not $250.000.

Gift Interests in a Family LLC to Take Advantage of Discounts and Leverage Lifetime Gifts

This has been one of the more popular estate planning techniques. Here's how it works: Dad transfers appreciating assets to an LLC and, after an appropriate period of time, gives membership interests in the LLC to family members or trusts for their benefit. The appropriate period of time to wait is subjective, based on facts, circumstances and types of assets being contributed to the LLC.

The transaction could be recharacterized by the IRS as an indirect gift using the step transaction doctrine, but this can be avoided if there is a legitimate and significant nontax reason for forming and funding the entity.

In determining the value of the gift, the net asset value of the interest in the LLC is discounted, possibly by more than 50 percent, which allows Dad to leverage the lifetime gift and retain control over the gifted property.

Make Low Interest Rate AFR Loans to a Generation-Skipping Trust (or Children or Grandchildren) for Investment Opportunities

This is popular with clients who may not want to pay gift tax. The IRS requires that the loan must bear interest at the Applicable Federal Rate.

Example: Mom makes an interest-only loan to a generation-skipping trust (or to children or grandchildren) and charges the appropriate AFR. To the extent the borrower invests the loan proceeds in a business enterprise, security portfolio or other investment, and achieves a total return (income and growth) in excess of the AFR, the appreciation in excess of the AFR occurs outside Mom's estate and, therefore, escapes estate tax.

Use a Charitable Lead Trust to Leverage the Generation-Skipping Tax Exemption

Example: Dad creates a charitable lead unitrust with a generation-skipping trust as the remainder beneficiary. Here, the lead interest (income each year) is distributed to charity (in many instances, a family foundation), with the remainder interest being distributed to children or grandchildren at the end of the term. A charitable lead trust offers a way to benefit charity and keep the capital in the donor's family.

Use a Grantor Retained Annuity Trust (GRAT) to Transfer Appreciation to Children

Example: Dad transfers assets worth $1 million to an irrevocable trust, which calls for the trustee to pay Dad $50,000 per year for 10 years. At the end of the 10-year term, the trust assets are distributed in equal shares to Dad's three children. For gift tax purposes. Dad's retained life interest is valued at $400,375, and he has made a taxable gift to the three children totaling $599,625. If the assets are invested in a portfolio of marketable securities that yield 1.5 percent dividends and 6 percent annual growth, the remainder at the end of the 10-year period is valued at $1 .360,812, but the taxable gift was only $599,625. Therefore, the difference of $761,187 escapes taxes, an approximate savings of $342,534 (45 percent of $761,187).

Make Installment Sale of Assets to a Defective Grantor Trust 

Example: Mom creates an intentionally defective grantor trust (a trust that is taxable to Mom for income tax purposes, but not taxable as part of Mom's estate) and selects the beneficiaries of this trust, typically the children or grandchildren, or both. Next, Mom funds the trust with cash or other assets.

The funding of the trust will be a taxable gift but, to offset this tax. Mom can use some or all of her gift tax unified credit applicable exclusion amount [$1 million under IRC Sec. 2505(a)], and possibly part of her generation-skipping tax exemption [$3.5 million under IRC Sec. 2010(c)].

After the trust is funded. Mom sells selected assets to the trust in exchange for a cash down payment and a promissory note representing the balance of the purchase price, which must be the fair market value.

Because transactions between Mom and the grantor trust have no income tax consequences, there is no capital gain or loss recognized on the sale of the asset to the trust. Also, Mom is not taxed on interest payments on the note. Mom does continue to be taxed individually on all income or loss generated by assets held by the trust as though the trust did not exist, which further reduces her estate.

Estate and gift tax savings result if the assets held by the trust have a total net return (income and capital appreciation) that exceeds the interest rate on the note.

Sell Assets for a Self-Canceling Installment Note

Example: Mom sells an asset to Daughter for the fair market value of the asset in exchange for a debt obligation that is canceled automatically if the seller's death occurs before the note is paid. Because the note is canceled, there is nothing left to be taxed in Mom's estate.

A self-canceling note is useful where the client is in bad health, but not terminally ill, and wishes to transfer an asset to a beneficiary.

The term of the note must be less than the seller's life expectancy. If the seller dies before the end of the term, the note is canceled and there may be some gain to recognize for income tax purposes, but the balance of the payments is not included in the seller's estate.

Use a Qualified Personal Residence Trust to Leverage the Transfer of a Home

A Qualified Personal Residence Trust works similarly to the GRAT described earlier, except the personal residence is contributed to the irrevocable trust. The grantor retains the right to use and occupy the residence for a term of years and, at the end of the term, the remainder interest passes to the children or other beneficiaries. If the grantor lives to the end of QPRT term, all of the appreciation on the home passes to the beneficiaries.

At the end of the term, the grantor can still live in the house, but will have to pay rent [o the beneficiaries, who will then be the owners. Some clients see this as a downside because they do not like the idea of paying rent to their heirs, but this strategy is actually a way to get more-money out of the taxable estate (through the rent payments) without incurring any gift tax.

Make Sure the Basic Estate Planning Is Done

Discuss with your client whether they have set up a living trust and if they have transferred the assets into the trust. Assets that are not in the trust's name at date of death may be subject to probate, which would add additional administrative expenses in settling the estate.

Ask clients if their life insurance is sufficient lo take care of their liquidity needs at death, continuing living expenses and special needs. Perform a life insurance checkup for your client and review the policies. Are both spouses insured, even if one is a stay-at-home spouse? Should an irrevocable life insurance trust be set up to hold the life insurance and remove it from the taxable estate? Perhaps they need to have their life insurance policies appraised to determine if they hold some added hidden value (value in excess of the cash surrender value).

Check to see if beneficiary designations for insurance, retirement plans and annuities are current. Many clients forget to change these as life and family situations change and these assets could end up going to the wrong beneficiaries.

Utilize Post-Mortem Estate Planning Techniques

It's never too late. It's still possible lo salvage some estate tax savings through post-mortem estate planning, which involves taking advantage of numerous elections available to reduce or defer estate taxes.

Examples include:

* Using corporate redemptions to pay estate taxes, funeral expenses and administration costs.

* Taking advantage of special-use valuations of real property used in farms or other businesses.

* Utilizing the family owned business deduction.

* Deferring the payment of estate taxes attributable to a closely-held business.

* Disclaiming (not taking) any assets that otherwise would be inherited from the decedent. When a beneficiary disclaims an asset, it will be transferred to whoever would have received it if the initial beneficiary had predeceased the decedent. Thus, the asset will not be included in the initial beneficiary's estate.

* Making partial marital deduction elections to pay some estate tax upon the death of the first spouse, thereby making the overall tax for both spouse's estates less than if no estate tax is paid on the first death.

By DONITA M. JOSEPH, CPA.

Donita M. Joseph, CPA, is a partner with Windes & McClaughry Accountancy Corporation and chair of the CalCPA Estate Planning Committee. You can reach her at [e-mail]. For more information on the CalCPA Estate Planning Committee, visit www.calcpa.org/EPforum.