Estate tax exclusion set to increase to $3.5 million in 2009; multitude of strategies available for transferring wealth.

Louis A. Mezzullo, a partner in the Rancho Santa Fe office of Luce, Forward, Hamilton & Scripps LLP, and a nationally known estate planning attorney, offers this primer in estate planning:

TRANSFER TAXES

* Gift Tax: There is a federal, but not a California, gift tax on taxable gifts in excess of $1 million per individual, with tax ranges from 41 percent to 45 percent.

* Estate Tax: There is a federal, but not a California, estate tax on the value of an estate that exceeds $2 million in 2007 and 2008, and $3.5 million in 2009, with a tax rate of 45 percent.

* Generation-Skipping Transfer Tax: There is a federal, but not a California, generation-skipping transfer tax of 45 percent on transfers to grandchildren and more remote descendants in excess of $2 million in 2007 and 2008, and $3.5 million in 2009.

ESTATE PLANNING TECHNIQUES

* Annual Exclusion: The annual exclusion allows an individual to make a gift of a present interest of up to $12,000 per year per recipient without using any of the individual's transfer tax credit. If the individual is married, the husband and wife may double this amount to $24,000, regardless of whether only one of them actually makes the gift. However, if only one of them actually makes the gift, a gift tax return will be required to take advantage of the increased amount.

* Gift Tax Applicable Exclusion Amount: The gift tax applicable exclusion amount is $1 million, and allows an individual to make gifts in excess of annual exclusion gifts up to $1 million during an individual's lifetime without actually paying any gift tax. This amount may be doubled to $2 million in the case of a husband and wife. Note that the use of the gift tax applicable exclusion amount uses up part of the individual's estate tax applicable exclusion amount.

* Estate Tax Applicable Exclusion Amount: The estate tax applicable exclusion amount for the years 2006 through 2008 is $2 million. In 2009, the estate tax applicable exclusion amount is expected to increase to $3.5 million. Under existing law, there will be no estate tax (or generation skipping transfer tax for decedents dying in 2010). In 2011, unless Congress enacts new legislation, the estate, gift and generation-skipping transfer taxes will revert to what they were on June 6, 2001.

* Marital Deduction: Transfers between spouses during their lifetime and at death generally qualify for the unlimited marital deduction. Certain transfers in trust where the spouse or surviving spouse does not have a qualifying income interest will not qualify for the marital deduction. If the surviving spouse is not a U.S. citizen, the assets must pass to a qualified domestic trust in order to qualify for the estate tax marital deduction. There is no marital deduction for gifts to a non-citizen spouse, but the annual exclusion for gifts to a spouse who is not a U.S. citizen in 2007 is $125,000, not $12,000.

* Charitable Deduction: There is also an unlimited charitable deduction for estate and gift tax purposes, in contrast to the limited charitable deduction for income tax purposes. There are various forms that a charitable gift or bequest can take and still qualify for the charitable deduction, including charitable remainder trusts, charitable lead trusts, pooled income funds, and life estates in a residence or a farm.

* Bypass Trust: This popular technique is used by married couples to take advantage of the estate tax applicable exclusion amount. When the first spouse dies, that amount is held in the trust for the benefit of the surviving spouse. The trust would be designed so that the assets would not be included in the surviving spouse's estate when he or she dies. These trusts are often referred to as credit shelter trusts or bypass trusts.

* Gifts vs. Bequests: Because the gift tax is tax exclusive, as opposed to the estate tax, which is tax inclusive, it is generally advisable to make taxable gifts during a lifetime. For example, a gift of $1 million that is taxed at 50 percent would involve a gift tax of $500,000. However, if the same individual died with $1.5 million of assets subject to estate tax at 50 percent, the beneficiaries would only receive $750,000 ($1.5 million estate, minus $750,000 estate tax). However, if the donor of a gift dies within three years of making the gift, any gift tax paid on the gift will be includable in the donor's estate as an asset for estate tax purposes. This inclusion eliminates the transfer tax benefit of making the gift. Also, because of the possibility that there may not be an estate tax in the future, many individuals are currently reluctant to make gifts that will incur a gift tax.

* Prepaid Tuition and College Savings Plans: A popular and tax-advantageous way of providing for educational expenses of children, grandchildren, and others is through a so-called Section 529 plan. There are two types: prepaid tuition programs and college savings plans. Under a college savings plan, an individual makes contributions to an account that is treated as gifts to the account's beneficiary and it qualifies for the annual exclusion. The contributor can treat a contribution to a Section 529 plan in a given year as having been made over five years for purposes of the annual exclusion. In 2007, when the annual exclusion amount is $12,000, an individual can make a contribution to a Section 529 plan of $60,000 without using any gift tax applicable exclusion amount or paying any gift taxes. A husband and wife may double this amount to $120,000. However, the individual would not be able to make additional annual exclusion gifts to, or on behalf of, the same beneficiary during the five-year period. If the individual dies before the end of the five-year period, a portion of the annual exclusion will be included in the individual's estate for estate tax purposes.

* Irrevocable Life Insurance Trust: In many cases, it is advisable for individuals to have life insurance owned by an irrevocable life insurance trust to avoid having the proceeds included in the individual's estate. These trusts can be designed to use the annual exclusion to pay the premiums by giving the beneficiaries a right to withdraw the contribution, or a portion of the contribution, for a limited period of time. If an insured dies within three years after transferring an existing policy to an irrevocable life insurance trust, the proceeds will be includable in the insured's estate.

* Grantor Retained Annuity Trust: A grantor retained annuity trust permits an individual to transfer appreciating assets to a trust, and retain the right to receive a fixed dollar amount from the trust for a term of years. At the end of the term, the assets would pass to children or other beneficiaries without being subject to any additional gift tax. The trust can be designed in a way that the value of the gift is close to zero.

* Qualified Personal Residence Trust: An individual may transfer his or her principal residence or vacation home to a trust retaining the right to live in the home for a period of time. After the period, the home would pass to the individual's beneficiaries. The value of the gift, which occurs when the residence is transferred to the trust, is the value of the home less the value of retained interest. Because the termination of the individual's retained right to live in the house is not a taxable event, any future appreciation in the value of the home passes to the beneficiaries tax free.

* Family Limited Partnerships and Limited Liability Companies: An individual may transfer a business, commercial real estate, or marketable securities to a limited partnership or a limited liability company, and make girls of limited partnership or membership interests to achieve a number of non-tax and tax results. The underlying assets would not be available to creditors, and, in most cases, this would be treated as separate, rather than community property--unless the recipient participates in the business. There also can be restrictions on the fight of the recipient to transfer the interest.

* Charitable Remainder Trust: An individual may transfer assets to a trust that provides for payments to the individual for his or her lifetime or for a term of up to 20 years; or to the individual and another person for their lifetimes or for a term of up to 20 years, with the remainder of the assets passing to a charity at the end of the non-charitable beneficiary's interest. The individual receives a charitable deduction for income and transfer tax purposes equal to the actuarial value of the remainder interest passing to the charity. Because the trust is exempt from income taxes, appreciated assets can be sold by the trust and the entire amount of proceeds can be invested. The individual receiving the payments pays taxes on them to the extent that they constitute taxable income.

* Charitable Lead Trust: An individual may transfer assets to a trust that provides for payments to a charity for a period of time. At the end, the assets pass to the individual's children or other beneficiaries. The individual receives a transfer tax deduction for the actuarial value of the interest of the charity, which can equal almost 100 percent of the value of the assets, so that there is very little gift tax. But the non-charitable beneficiaries receive the assets at some point in the future without any additional transfer tax. This technique is similar to a grantor retained annuity trust, except that the payments go to a charity rather than the grantor of the trust.

* Installment Sale to a Grantor Trust: An individual may sell appreciated assets to a trust that is treated as owned by the individual, because he or she or someone else retains certain powers. The individual does not recognize any taxable gain as a result of the sale, and the assets in the trust are not included in the individual's estate upon death.

* Grandchildren's Trusts: An individual may transfer assets to a trust for the benefit of a grandchild that qualify for both the gift tax and the generation-skipping transfer tax annual exclusion--currently $12,000 per recipient per year, or $24,000 for a husband and wife.