Estate Planner May-Jun 1998
Ben Franklin said only two things in life are certain: death and taxes. When a family member is elderly or seriously ill, both death and taxes are all too certain. Although you can’t reduce the emotional impact of a family member’s death, you can reduce the tax impact with proper planning.
The term “deathbed planning” is often used to describe implementing or fine tuning the estate plan of an elderly or seriously ill person. Time is limited, yet a number of planning techniques can reduce or minimize taxes and enhance the estate that is left for the family.
Of course, initial attention should be focused on the welfare and comfort of the dying person, as well as providing for the orderly transition of the estate. These concerns include healthcare powers and living wills, durable powers of attorney, funded living trusts, and listing advisors, inventory of assets and essential documents.
But there may be time to try to reduce the tax burden for heirs. There are several places to look for possible tax savings and the techniques that are available.
Make Lifetime Gifts
Gift tax advantages. Taxable transfers made during life (gifts) are less expensive than those made at death (bequests). Why? For a gift, tax is paid on only the amount of the gift itself, while for bequests, tax is paid on the amount of the bequest plus the amount used to pay the tax on the bequest. In other words, gifts are tax exclusive and bequests are tax inclusive. But, there is often little advantage to making gifts shortly before death because the tax paid on taxable gifts made within three years of death are added back to the estate when making the federal estate tax computations.
Annual exclusion gifts. One exception is the annual exclusion gift, which allows someone to give $10,000 per year ($20,000 if the gifts are split with a spouse) to an unlimited number of recipients tax free. Each annual exclusion gift will save $3,700 to $5,000 in estate taxes, depending on the person’s estate tax bracket. Accordingly, someone with three children, two daughters-in-law and five grandchildren can make deathbed gifts of $200,000 ($20,000 x 10 recipients). The assets will still be in the family, and the estate would save between $74,000 and $110,000 in estate taxes. As a bonus, the gifts to grandchildren are not subject to the 55% generation-skipping transfer (GST) tax and do not use any of the $1 million GST tax exemption.
Gifts of controlling interests. Some gifts can make taxable value disappear. If a controlling interest, for example 52%, is held in a family business or venture, a gift of a 3% interest to family members can allow the remaining 49% to be valued for estate tax purposes without a control premium, thus lowering estate taxes.
Gifts between spouses. Gifts between spouses also can be advantageous in equalizing estates to fully use the $625,000 unified credit equivalent or in equalizing estate tax brackets. All gifts between U.S. citizen spouses are gift and estate tax free. A lifetime qualified terminable interest property (QTIP) trust might help as the vehicle for the gift.
Consider Income Taxes
Capital losses. Assets in the estate get a new basis for income tax purposes. Generally, this is a step-up in basis. But, there also can be a step-down in basis if stocks or other capital assets have a current value less than what was paid for them. These should be sold before death to recognize the losses. The losses can still be used on the income tax return and any extra losses may carry forward on a spouse’s return. Otherwise, the losses are gone and will not be available to the estate.
Deductible contributions. If deductible contributions can be made to an individual retirement account (IRA), profit sharing or other relevant account, they should be made at this time.
Deductible charitable bequests. Bequests to charity should be advanced and paid now. The estate tax consequence remains the same, but as an additional benefit, the individual will receive a current income tax deduction. If the dying family member cannot change his or her will, the charity should be willing to acknowledge that the gift is an advancement. Also, consider whether a bequest to charity can be satisfied through an IRA or qualified plan beneficiary designation; either can result in significant income tax savings. An alternative is to increase the bequest to a spouse and put language in the estate plan expressing a strong desire that the spouse make a lifetime charitable gift. The estate will still use deductions (marital instead of charitable), and the spouse then can take advantage of income tax benefits by making gifts to charity at suitable times.
Deferred income. In some situations, deferred income can be accelerated and recognized currently. The income tax paid should be less than that paid (after credits) by the estate. Here it becomes necessary to make projections and income forecasts.
Examine Business Structures
Preservation of status. The estate or living trust can be a shareholder of an S corporation for only two years. After that time, the shares need to be redeemed or passed to a qualified shareholder, otherwise the special S corporation status is lost. If the person owns S corporation stock, his or her estate plan should direct proper disposition of the S corporation shares. Special trusts eligible to own S corporation stock, known as qualified subchapter S trusts and electing small business trusts, can be created for minor children or other beneficiaries.
Pass-through taxation. The owners of certain types of business entities are taxed directly on business net earnings, whether or not they receive a distribution from the business. These entities are S corporations, partnerships, limited liability partnerships and limited liability companies. Is this an issue that needs to be reviewed in light of the designated beneficiaries of the interests under the estate plan? If there are capital losses in these entities, can these losses be extended to be used by a spouse? Partnership investments also create a special situation. When a partner dies during the year, partnership books for the deceased partner are deemed to close on the date of death. The income or loss is either allocated pro rata or an exact allocation is made. Accordingly, this can result in an overall tax mismatch of income and losses. Consider transferring this partnership interest now into joint tenancy or making provisions for a successor in interest under the partnership agreement.
Deferrals and redemptions. Special tax benefits are available when a large part of the estate consists of interests in closely held businesses. If the estate meets certain percentage qualifications and other Internal Revenue Service (IRS) tests, it can pay part of the estate taxes in installments over 15 years (with interest, of course, and for a limited partner, the interest is at the bargain rate of 2%). Also, the estate or beneficiary may be able to redeem part of any corporate stock to pay taxes and administration costs and receive favorable capital gain tax treatment. It is time to analyze the estate to see if it meets these tests.
Review Life Insurance Policies
At this point, any life insurance owned by the ill person probably will be included in the estate even if it is transferred. Yet, there may be some planning opportunities available and they need to be discussed with the insurance agent.
Repayment of loans. If any policy loans are outstanding, investigate the advantages of paying off the loans, which may increase policy dividends. If the dividends are being used to buy term or paid-up additions, in effect, the ill person will be buying more life insurance, even though he or she is not insurable. Also, some state inheritance tax laws give special tax benefits to life insurance proceeds compared with other types of assets. Further, if the estate may have creditor problems, life insurance proceeds again may receive favored treatment, so don’t let policy death benefits be reduced by an outstanding loan balance.
Waiver of premium clause. A premium waiver provision that would come into play during disability will keep the policy in force until death and may also entitle the ill person to a refund of all or part of a recent premium payment.
Change of domicile. Let’s say you have a terminally ill parent who has a substantial estate and is living in a state that has a high inheritance or estate tax. Or, perhaps probate in your parent’s state is a particularly expensive procedure. Comfort, care, treatment and all else being equal, a change of your parent’s domicile to a “friendlier” state that may have only an estate pick-up tax may be possible and practicable. Domicile may be changed upon meeting some simple criteria. The resulting savings can be significant.
Transfer by spouse. Generally, if someone receives a gift of appreciated property and dies within one year thereafter, that property will not receive a step-up in basis in the estate if the property passes back to the donor. The step-up in basis can be important because it can eliminate the 20% capital gains tax on the amount of appreciation. Therefore, gifts to an ill spouse should not be overlooked. First, there is always the possibility that the spouse will survive more than a year. Second, perhaps the transferred property can be allocated to satisfy other bequests with the transferring spouse being equalized through the marital formula.
Raising the Subject
Perhaps the most difficult part of planning in anticipation of death is raising the subject. It is impossible to be distant and detached. Yet, the benefits and tax savings that are available require a discussion to be started. Each person’s estate situation is different, and other planning opportunities may become evident only if the subject is addressed.