By Mark W. McGorry and Stephen D. Lassar
In Brief
Preserving the Estate Through Multiple Techniques
Qualified pension profit-sharing, 401(k) plans, and various IRA alternatives continue to be the most efficient vehicles for deferring taxes and saving for retirement. Upon death, however, not only will these assets be subject to significant estate taxes but beneficiaries will also be liable for taxes on income with respect to a decedent (IRD).
Financial planners must consider a broad array of assets and balance family financial objectives. IRD assets should be part of an integrated plan utilizing various strategies. To that end, the authors present four case studies demonstrating how assets can be structured to avoid heavy taxes on IRD. ince the Employee Retirement Income Security Act (ERISA) was passed in 1974, qualified pension profit-sharing and 401(k) plans, in combination with various IRA choices, continue to be the most tax-efficient and flexible methods of reducing current business and personal taxes. These retirement plans provide the opportunity to shelter income from federal income tax and, in most cases, FICA, state, and local taxes. The combination of tax deferral and the unprecedented increase in value of financial assets in recent years is providing investors with retirement values large enough that their postretirement standard of living could easily match their preretirement standard of living. Despite some financial market setbacks in 2000, many individuals still have retirement accounts that will continue to grow throughout their lifetime. As a result, at death they will be leaving to younger generations assets that will not only be subject to significant estate taxes but will also attract taxes on income with respect to a decedent (IRD) in the hands of the beneficiaries. (There was an additional 15% estate excise tax that was repealed in 1997.) The ultimate loss to taxes commonly exceeds 75% or 80%. Nevertheless, there are strategies for deferring taxes to meet personal and business planning objectives.
Many presentations about the issues associated with IRD assets focus almost exclusively on rules and pitfalls. In reality, most practitioners are forced to plan for the use and disposition of these assets in the context of a client possessing a broad array of assets and wide variety of family financial objectives. IRD assets cannot be dealt with in a vacuum, but rather need to be part of an integrated plan utilizing various strategies.
This article will focus on integrating several strategies, including—
In order to illustrate the planning opportunities available, the authors examine several actual cases in which the assets included qualified plans (QPs) and IRAs with substantial balances.
Case Study No. 1
A couple in their mid-60s, New York State residents, have seen their net worth balloon from $3 million to more than $6.5 million during the last four years, chiefly through rapid appreciation of a stock portfolio primarily invested in large-capitalization growth stocks (e.g., General Electric). The client had read articles in financial publications about the “near total confiscation of QPs and IRAs” upon death of the last to die of the account holder or spouse. The client has approximately $1.25 million in these types of plans, with his wife listed as beneficiary. He had planned to hold the stock portfolio for life in order to get a step-up in basis, avoiding capital gains taxes for himself and his heirs. He also planned to name his wife as beneficiary of all IRAs in order to assure her of a source of income if she survived him. The client also had a number of charitable bequests in his will.
The client had more than 40% of his investment holdings in a single large-cap stock and was growing concerned about lack of diversification. He wanted to diversify his portfolio while avoiding federal and state long-term capital gains taxes. Calculation determined that there were potentially tremendous net after-tax benefits available to the client’s children if they, rather than the spouse, were named as primary beneficiary on some or all of these IRAs. However, the client remained concerned about his wife’s financial well-being if his IRAs were left solely to the children.
The client had several competing objectives:
Recommendations
Create two CRTs, retaining a life interest for the client and wife or the survivor of them. Upon their death, the remaining assets would pass to a qualifying “donor advised” public charity, which would be advised by the children.
The client transferred $1 million of the highly appreciated stock to the CRTs, which in turn sold them and reinvested the proceeds in a diversified portfolio. Because the trusts are split-interest charitable trusts, there was no capital gains tax paid at the time of the sale. The client retained a high-percentage annual distribution of more than 9% from the trusts. The charitable trusts are investing for “total return,” primarily in equities with a dividend of approximately 1% and planned holding periods of more than one year. The objective is to make most distributions at lower long-term capital gain tax rates.
The $1 million charitable gift was actually split: 40% into a charitable remainder annuity trust (CRAT) and 60% into a charitable remainder unitrust (CRUT). The CRAT has a required payment of $40,000 each year, equal to 10% of the amount transferred. $600,000 was put in a 9% CRUT which each year will pay out 9% of the value at the end of the prior year. The CRAT will protect them in a bear market by providing a steady dollar distribution. The CRUT will allow them to participate in a bull market by providing greater distributions each year.
The client also received a current income tax deduction of approximately $150,000. Because there were no noncharitable beneficiaries other than the couple, there were also no transfer taxes. In the past, it might have been advisable to include children in the class of income beneficiaries; however, the requirement under the 1997 Tax Act that the charitable deduction upon funding a CRT be at least 10% of transferred assets makes it difficult to include the younger generation unless they are at least in their 50s.
Name the children as beneficiaries of their father’s IRAs. The CRTs mentioned previously will provide a source of cash flow for both the client and wife for as long as one of them is alive. This cash flow replaces the income the wife would have as the minimum distribution from her husband’s IRAs if he predeceased her.
This will allow the children to stretch the IRA tax shelter over the course of their remaining life expectancies after the client has passed away. They will pay income tax only as withdrawals are made. Using a 10% growth assumption, the net after-tax (income and estate) distribution to the children on the present $1.25 million of IRAs will total more than $10 million over the next 40 years. As part of the diversification strategy, much of the single large-cap stock held in the IRA will be sold and reinvested within these tax-deferred accounts.
Create a grantor retained annuity trust (GRAT) and transfer an additional $500,000 of the highly appreciated stock to the GRAT. The client and his spouse are retaining a 5% annuity interest for a period of 10 years. Because of the discount inherent in this type of gift, the actual value for tax purposes will be less than $250,000. Since New York has repealed its gift tax and since the value of this gift (there were no previous taxable gifts) is significantly below the wife’s unified credit equivalent amount, there is no gift tax currently due. The GRAT will then sell the stock over several years and reinvest what it is not required to distribute to the grantor (the 5% annuity). At the grantor’s option, either the grantor or the GRAT can pay the capital gains tax on the stock sale.
Because of the transfer tax savings offered by this strategy, the client is effectively trading the ultimate loss of step-up in basis upon death for the more significant transfer tax benefits.
The GRAT’s remainderman is not the children directly but a previously established irrevocable life insurance trust (ILIT) for the benefit of their children. The parents have always funded this ILIT through annual exclusion gifts under the Crummey provisions.
Within the existing ILIT, purchase additional second-to-die life insurance as another source of liquid assets for estate taxes and to replace assets passing from the CRTs to the charity upon the couple’s death. Ideally, the premiums will be paid for life and the dividends will be used to purchase additional insurance to increase the death benefit. The client has sufficient life insurance which, together with the unified credit, will be sufficient to pay the estate taxes due on his IRAs if he dies within the next 10 years. If he lives past 10 years, the remainder interest from the GRAT will be paid over to this ILIT. This money can either be left to grow in the ILIT until needed for taxes, or some of the growth or principal can be used to pay the premiums.
In addition, the client plans to use a portion of the net after-tax distributions from the CRTs to increase coverage. Ultimately—if the client dies first and his wife does not wish to continue funding the premiums because the husband’s IRA distributions are now going to the children—she might want to be relieved of the premium burden.
In summary, the charitable transfer immediately removed $1 million from the taxable estate, allowed the sale and diversification of investments without income taxes, created a current income tax deduction, and provided a cash flow sufficient to provide a replacement source of income to the wife so that the children could be named as IRA beneficiaries and benefit from a stretch-out of the IRA. It also provided a source of premium funds for the life insurance, which is ultimately needed for estate taxes. For at least the next 10 years, the insurance trust will keep in force the existing insurance on the husband. After 10 years, the GRAT remainder interest will be available for this purpose.
It should be noted that, without the cash flow from the CRTs, it was unlikely that the wife would have been willing to support a plan which “disinherited” her from her husband’s IRAs.
Case Study No. 2
This case is a variation on the same theme: The client and her husband, also in their late 60s, have accumulated more than they ever expected. They wish to reap the benefits of a strong real estate market by selling a small townhouse property that has appreciated from a purchase price of $330,000 to a current market value of $2 million. It is currently generating $60,000 per year in pretax cash flow. They also want to create a charitable foundation and begin funding it today. The client, age 68, has accumulated almost $2 million in QPs, IRAs, and tax deferred annuities (TDA). She and her husband planned to use these savings, and possibly other investments, to meet postretirement income needs when she retires in a few years.
After reviewing the benefits to the children of having their mother’s tax deferred accounts payable to them over their life expectancies, the husband agreed to a plan to remove him as primary beneficiary. The couple also transferred the $2 million townhouse to two newly created CRTs.
Recommendations
This will allow the children to continue to maintain the IRA(s) in tax-deferred status for the balance of their life expectancy. Each year they can take as taxable distributions the required minimum (based on their life expectancy) or a greater amount if desired. Because of the 691(c) deduction, a portion of their distributions will be tax sheltered for many years.
Results. The preceding suggestions help to protect and transfer the client’s wealth through the following mechanisms:
Case Study No. 3
A client and his wife, in their late 60s, have built up rollover IRAs totaling almost $2 million. Just prior to his required beginning date, he agrees to name trusts, funded by his IRAs, for the benefit of the daughters as his beneficiaries. The trusts were drafted so as to qualify as designated beneficiaries. They were established to provide centralized wealth management and to provide for the client’s sole grandchild in the event that either child passed away before receiving all of the trust’s assets.
A major concern was providing a source of cash to pay the estate taxes on the client’s IRA assets. The client’s previous estate planning, including trust-owned second-to-die life insurance, all assumed maximizing the marital deduction upon the first death to bring the estate tax to zero. A thorough review of assets unearthed a trust-owned term life insurance policy that had been a perk of the husband’s employment under an agreement which was expiring. Rather than let that policy lapse, he agreed to make gifts to the trust to continue the policy. That $500,000 policy, which could pass to his children under the terms of the trust, along with his unused unified credit, would nearly cover the estate tax on his IRAs if he died first.
However, the client possessed a long-term problem with the term policy, which only had a guaranteed premium rate for the next 10 years. At the end of that period, the rate would likely increase so dramatically as to be uneconomical. Also, even with the increases in the unified credit through 2006, the estate tax on this growing IRA would likely not be met.
The couple’s history of charitable giving, in excess of $100,000 per year, opened up the possibility of using a charitable lead trust (CLT) as a long-term substitute for the term life insurance.
Instead of giving directly to charity each year, $50,000 per year could come from a newly created CLT funded by a transfer of $1 million from the wife. After 10 years, the family would receive the remaining principal in the CLT. Based upon a 10% total return on the CLT and a $50,000 per year payment to charity, the transfer benefit to the children would be $1.6 million at the end of 10 years. The current taxable gift would only be $650,000, which was sheltered from current taxation by the spouse’s unified credit. The 10-year term was chosen because it would dovetail with the expiration of the term insurance at the end of the 10 years. The $1.6 million would be distributed to a trust for the benefit of the daughters and continue to be invested for growth, just like the IRA, available to the children to pay the estate taxes on the IRAs.
Case Study No. 4
A 72 year-old widow’s husband had died recently, naming her as beneficiary on his $1.5 million IRA accounts. She considered disclaiming some of this to the benefit of her sons, but because the estate planning had already fully utilized his unified credit, it would have generated a sizable federal and New York State estate tax. (The husband died in 1999, prior to the effective date of the repeal of the estate tax in New York.)
The couple had been planning to make a sizable charitable gift, but the husband died unexpectedly before executing the documents. The client wanted to increase her life insurance, because a large percentage of her estate was still in illiquid closely held businesses and related real estate. The other family business owners were willing to enter into a split-dollar arrangement wherein the business would fund the life insurance but were concerned that the client’s split-dollar arrangement would become relatively ineffective by the time she reached 80 because of the annually increasing imputed term rate.
An arrangement was structured such that the charitable gift was not made directly to the charity, but rather through a charitable lead annuity trust (CLAT) over a seven-year period. At the end of seven years, the substantial remaining balance in the CLAT would pass to the noncharitable beneficiary, the trust which purchased life insurance on the client. At this point, the distribution from the CLAT to the insurance trust should be sufficient for the insurance trust to repay all split-dollar advances to the family-owned businesses, as well as all future premiums. Because of the substantial discount available on a seven-year CLAT, even after taking into account her unified credit (and the absence of New York gift tax), the out-of-pocket tax was less than $300,000. In this case, since her deceased husband had died after his required beginning date, the client had the security of income from the rollover IRAs to consider these other estate planning strategies.
In Case Studies Nos. 3 and 4, intentionally defective CLTs were used for income tax purposes. This would allow the grantor to receive a current-year charitable deduction for the discounted present value of the future charitable gifts. Additionally, the grantor, rather than the trust, would pay all of the CLT’s income taxes, allowing more benefit to incur to the family remainderman without additional transfer taxes. Also, in all of the case studies, the IRAs present considerable generation-skipping opportunities.
The Role of the CPA
The case studies illustrate some of the many ways that IRD planning can be integrated with estate planning. In each case, the role of the CPA as advisor is essential throughout the process, not only for tax advice, but also because of the role the CPA plays in helping to clarify and codify the client’s financial needs and objectives.
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