Death duties are the heaviest taxes the government imposes on individuals, in-
tentionally designed to turn heirs of haves into those who have less. Many among the new GOP majority in Congress want to ease the burden slightly by raising to $750,000 for individuals (or $1.5 million for married couples), from $600,000 (or $1.2 million), the amount that can be excluded from estate taxes. But even if the rules aren't changed, loopholes in the existing laws are big enough to drive a Mercedes through. They are called trusts, and they can shelter some wealth even into the third generation.
There are trusts whose main goal is not tax avoidance but exercising control from beyond the grave--to prevent a ne'er-do-well child from squandering the funds, for example. But mostly, trusts are designed to elude estate taxes by enveloping assets in a kind of legal shrink-wrap. They don't have to be impermeable--many trusts can provide current income for you or your surviving spouse while shielding principal from the Internal Revenue Service. And the wrap can be highly elastic: Some $100,000 worth of growth stocks in a trust for your 10-year-old child could, 40 years later when you die, be worth a tax-free $2.2 million, assuming an 8% annual return.
The rules are complex. Some trusts are revocable, becoming part of your estate at death. But only the irrevocable type are useful for tax avoidance. Probably the most common irrevocable setup is the life-insurance trust, which removes death benefits from a taxable estate. This trust has other advantages: It avoids probate, meaning the proceeds are immediately available to heirs. And it allows you considerable control over how funds are distributed. "This eliminates some concern over a child receiving a huge lump sum and wasting it," says John Donlon, advanced underwriting officer for the U.S. headquarters of Sun Life Assurance Co. of Canada in Wellesley, Mass.
It's best to set up a life-insurance trust before buying the policy. Otherwise, if you die within three years of transferring an existing policy, the proceeds revert to your estate. Once you establish the trust, you can't borrow against the policy or change beneficiaries. And you must designate a trustee to manage the assets. To avoid having to pay gift taxes on the annual premiums, many people make the payments using all or part of the $10,000-a-year gift that could be given to each beneficiary tax-free.
Another irrevocable trust arrangement can help protect both a spouse and the children. A husband (or wife) can pass unlimited assets to a spouse tax-free, but then his children would not benefit from his $600,000 estate-tax exemption after his wife dies. The solution: Set up what are called A and B trusts, which would preserve the combined $1.2 million exclusion for both parents.
HOME SECURITY. The way it works is that the husband creates an "A," or marital, trust for his wife and a "B," or bypass, trust for the kids. He can put unlimited assets into the A trust and assets worth up to $600,000 in the B trust. (He could put in more but would have to pay gift tax on the excess.) The wife can be trustee of and use principal and income from both trusts. Yet up to $1.2 million can pass without estate tax to the kids.
A different irrevocable marital trust, useful for estate planning rather than tax avoidance, is the Q-tip, or qualified terminable interest property trust. Usually established in the will, the Q-tip lets you pass interest in your property to your spouse but specify to whom it will revert upon your spouse's death. This could assure that if the husband dies and the wife remarries and has a second family, his children still get the asset.
A useful way to remove an expensive home from the estate is by locking in its lower value, before it appreciates, through a QPRT, or qualified personal residence trust. Say spouses in their mid-40s each cede their one-half interest in the $600,000 family home to their children but retain the right to live there for 20 years. "The right to occupy the home for that long is probably equal to about two-thirds of the value," says David Gerson of Ernst & Young in New York, "so the gift is one-third," or $200,000 in this example. The husband and wife both take $100,000 from their $600,000 pots. By the time the heirs receive the property, it could be worth a lot more, but no tax will be due. Catch: When the 20 years is up, the couple will have to pay market rent to their kids. Also, if either dies, the trust dissolves, and the house is back in the estate.
A QPRT is a type of grantor-retained interest trust (GRIT) that can be used to benefit family members. Other GRITs, which can own securities as well as real property, benefit nonrelatives. The point is the same: to establish the tax basis now, when the value of sheltered assets is low, rather than at death.
If you have a very high-growth asset, such as insider's stock, a grantor-retained annuity trust, or GRAT, can remove the future appreciation from your estate. To achieve any benefit, the asset has to grow more than the IRS's current discount rate of 9.4%. Say a person places securities worth $1 million in the GRAT, agreeing to draw out a fixed amount each year for the next 20 years. The present value of this annuity arrangement is a mere $43,500, according to IRS tables, which is applied against the $600,000 exemption.
If you beat the tables, you could bequeath a bonus. After the annuity payments, a stock returning 13% a year on average would produce a trust worth $485,000 in 20 years--more than a tenfold increase over the exemption amount. Withdrawals are mandatory. So if the asset returns less, you could draw out principal until the trust is depleted, and you're not better off than you were when you started--plus you've forfeited $43,500 of your exemption and the high cost of creating such a trust. GRATs of less than $1 million are uneconomical.
One popular trust, used more for its current tax benefit than estate-tax purposes, is a charitable remainder trust. It allows you to bequeath property to a charity, take an immediate tax deduction, and use it or retain the income while you live. Say you have $20 million worth of stock in a high-growth company, which pays little or no dividend. Put it into the trust and sell it, so you avoid capital-gains taxes, and invest the proceeds in something with high current income. "Now, I've got the whole $20 million earning money for me," says Robert Lipsey, general counsel of Mid-Atlantic Cos., estate planners in Mt. Laurel, N.J.
FREEBIE. The maximum tax rate on trust income is the same as the top income-tax rate, but you get there quicker--currently, after just $7,500. Unless you or your heirs need the cash, therefore, fund your trusts with growth assets, such as prime undeveloped land or small-cap stocks.
As you plan, don't forget that you are also allowed to give anyone you choose an after-income-tax gift of up to $10,000 each per year, on which the recipient pays no tax whatsoever.
Trusts can be intimidating, but they aren't necessarily expensive to create: a few hundred dollars for the commonest types, up to perhaps $20,000 for complicated plans. Uncle Sam could face a stiffer tab, from the point of view of lost revenues. That could make your trust your last laugh.
A Matter Of Trusts
Life-insurance trust Shelters life-insurance proceeds from estate and income taxes; irrevocable; can't change beneficiaries; can't borrow against the policy.
A and B trusts Allow grantor to pass unlimited assets tax-free to spouse in an "A" marital trust while retaining a $600,000 estate-tax exemption for other heirs in a "B" bypass trust; irrevocable.
Q-tip (qualified terminable interest property trust) A planning--rather than tax-avoidance--vehicle that lets a husband or wife pass property to the surviving spouse and specify to whom it will go upon the spouse's death.
QPRT (qualified personal residence trust) A way to remove a house from an estate and still retain the right to live in it for a set number of years; dissolves if you die before the trust term is up; you must pay market rent to stay put after the term expires.
Charitable remainder trust Lets you bequeath property to a charity, take an immediate tax deduction on its value, and use it or retain the income it produces while you live.
GRAT (grantor-retained annuity trust) Lets you set aside money or securities, receive an annuity for a fixed number of years, and reduce the value of the gift to heirs for tax purposes; expensive to create; if you die prematurely, the GRAT reverts to your estate.