Recent developments in estate planning

By Jeffrey J. Radowich, Esq.,
and Sarah Barr Kahl, Esq., CPA

Each winter, hundreds of accountants, lawyers and other professionals creep out of tax-season hibernation for a brief peek at the latest developments in estate planning.

The prognosticators of 2006 at the Heckerling Institute on Estate Planning were abuzz about a variety of topics, including – again – whether the federal estate tax would be repealed and how the states would deal with the elimination of the credit for state death tax. As the commentators debate the impact of future legislation, the authors are reminded to step back and reconsider the crucial importance of identifying and using estate planning techniques that offer practical solutions to real-world problems.

Let us take what we learned from Heckerling and put it into practice today.

This article is the first in a series of three offering current estate planning suggestions based on recent law. The second article will focus on family limited partnerships and the third will discuss Maryland death taxes — after the Maryland legislature has dealt with pending legislation in this year’s session.

The following is a sampling of planning techniques honed after Heckerling.

Orientation

We are now in a flat tax environment with a federal estate tax of 46 percent on estates over $2 million. The generation-skipping tax exemption is also at $2 million, but the gift tax exemption remains at $1 million. Your clients can now give up to $12,000 per donee per year without using gift tax exemption.

Retirement plan beneficiaries

Now that the exemption is higher, credit shelter trusts calculated based on the full federal exemption will be larger. If your married client needs to dip into retirement plans to fund the $2 million credit shelter, beware of funding the credit shelter with the retirement plans.

Retirement plans are better left to the surviving spouse who can roll them over to his or her own account, and this income tax advantage may be worth underfunding the credit shelter trust. Designating the spouse as a primary beneficiary and the estate as a secondary beneficiary allows the spouse to disclaim if appropriate.

Avoid converting to a Roth IRA to fund the credit shelter. This approach is tempting because it stuffs the credit shelter trust with after-tax dollars. However, if the spouse is the oldest beneficiary of the credit shelter trust, the distributions will be made over his or her life expectancy, and future growth of those distributions would be subject to income tax. Again, the best choice is the spouse.

If after running the numbers and considering your clients’ goals you determine that the spouse is not the best choice, consider leaving the retirement plan directly to the younger generation. If a trust beneficiary includes only younger beneficiaries, you will maintain some level of tax deferral while funding the credit shelter amount. Do not leave the retirement plan directly to minors: You will have to go to court to appoint a guardian. Leave it to a custodian on behalf of a minor instead.

Good trusts gone bad

When an irrevocable insurance trust no longer meets a client’s needs, a new private letter ruling illustrates how to fix the problem. The best thing to do is move the insurance policy to another trust that works. This private letter ruling concludes that you can accomplish this goal using two grantor trusts without running afoul of the transfer for value rules, without triggering a three-year lookback and without realizing a gain or loss.

Step one: Create a new grantor trust that meets your client’s objectives and fund with cash or marketable securities.
Step two: Value the insurance policy. The PLR allows using interpolated terminal reserve value plus unearned premiums.
Step three: Exchange the insurance policy from the “bad” trust for assets from the “good” trust. The assets could include cash, a promissory note or a new policy.

Result: a new irrevocable insurance trust with dispositive terms now newly favored by the grantor. Of course, the first (“bad”) insurance trust must also be a grantor trust for this technique to work.

A few of our favorite grantor trusts

Leaving the door open for this technique requires that you make your insurance trusts grantor trusts for income tax purposes. There are a limited number of powers that can be added to a trust that will allow it to be taxed to the grantor for income tax purposes without being included in the grantor’s taxable estate. One method for creating these so-called intentionally defective grantor trusts is allowing a non-adverse party to add charitable beneficiaries. You can strengthen the authenticity of this power by having the non-adverse party make a few modest charitable contributions to a charity to which the grantor has not previously donated.

The only power that can be turned on and off is the power to borrow without adequate security. As long as the trustee is not forbidden in the trust agreement from lending money to the grantor without adequate security, it can be done. When the trustee lends money to the grantor, the trust becomes a grantor trust. When the grantor pays it back, the trust loses grantor trust status.

Another popular technique, the power to swap assets, works well for avoiding the three-year lookback rule of Section 2035. In this case, the grantor is given the power to swap assets in the trust with other assets. Normally, if an individual gifts an insurance policy to an insurance trust and dies within three years, the proceeds are included in the individual’s taxable estate. However, if the trust includes a power to swap assets, the grantor may swap his insurance policy with other assets in the trust, and the transfer is a swap rather than a gift and will not trigger the three-year rule.

Retirement plans, insurance trusts and grantor trusts are three planning contexts in which the techniques summarized above can have a significant favorable impact on your client’s estate planning goals.

Jeff Radowich is a partner in Venable LLP, where he practices estate planning and business continuity planning as a member of the Tax and Wealth Management Group. He has been listed continuously on the list of "The Best Lawyers in America" since 1993.

Sarah Kahl is a CPA and an associate in the group. She graduated cum laude from Georgetown Law School, and Phi Beta Kappa and magna cum laude from Franklin and Marshall College.

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