Five levels of wealth planning

The Five Levels of Estate Planning is a systematic approach to explaining estate planning in a way you can easily follow. Which of the five levels you need to complete is based on your specific objectives and circumstances.

Level One: The Basic Plan

The situation for level one planning is that you don’t have a will or living trust, or your existing will or living trust is outdated or inadequate. The objectives for this type of planning are:

o reduce or abolish inheritance tax;

o avoid the costs, delays and publicity associated with probate in the event of death or disability; and

o protect heirs against their insolvency, their disability, their creditors and their predators, including ex-spouses.

To accomplish these goals, you would use a will of endowment, a revocable living trust that divides a married person’s estate between a credit collection trust and a spousal trust, general powers of attorney for financial matters, and durable powers of attorney for health care, and living wills.

Level Two: The Irrevocable Life Insurance Trust (ILIT)

The situation for level two planning is that your estate is expected to exceed the estate tax exemption. While there is currently a lapse in estate and generation-skipping transfer taxes, it is likely that Congress will reintroduce both taxes sometime this year (perhaps even retroactively). If not, on January 1, 2011, the estate tax exemption (which was $3.5 million in 2009) becomes $1 million and the top estate tax rate (which was 45% in 2009) becomes 55%. In any case, you can donate money to an ILIT using your annual gift tax exclusion of $13,000/$26,000 per beneficiary.

Level Three: Limited family partnerships

The situation for level three planning is that you have an expected estate tax that is higher than the life insurance policy you bought in level two. If your $1 million gift exemption ($2 million for married couples) is used to make lifetime gifts, the gifted property and all future appreciation and income on that property will be removed from your estate.

More people would be willing to make gifts to their children if they could continue to manage the gifted property. A family limited partnership (FLP) or a family limited liability company (FLLC) can play a valuable role in this situation. You will normally be the managing partner or manager and will continue to manage Forever or FLLC assets in that capacity. You can even charge a reasonable management fee for your services as a general partner or manager. Additionally, by gifting FLP or FLLC interest to an ILIT, the income from the FLP or FLLC can be used to pay premiums, freeing up your annual gift tax exclusion of $13,000/$26,000 for other types of gifts.

Level Four: Qualified Personal Residence Trusts and Grantor Retained Annuity Trusts

The situation for level four planning is the added need to reduce your estate after your $1 million/$2 million gift exemption has been used. Although paying gift tax is cheaper than paying estate tax, most people don’t want to pay gift tax. There are several techniques for making substantial gifts to children and grandchildren without paying significant gift taxes.

One technique is a qualified personal residence trust (QPRT). A QPRT allows you to transfer a property or holiday home to a trust for the benefit of your children, while retaining the right to use the property for a period of years. By retaining the right of occupancy, the value of the residual interest is reduced, along with the taxable gift.

Another technique is a retained annuity (GRAT). A GRAT is similar to a QPRT. The typical GRAT is funded with income-producing properties, such as subchapter S shares or FLP or FLLC interests. The GRAT pays you a fixed annuity for a certain period of years. Due to the deducted annuity, the gift to the survivors (your children) is substantially lower than the current value of the home.

Both QPRTs and GRATs can be designed with terms long enough for the value of the residual interest passed down to your children to be reduced to a nominal amount or even zero. However, if you do not survive the stated term, the property will be included in your estate. It is therefore recommended that an ILIT be funded as a “hedge” against your death before the end of the stated term.

Level Five: The Zero Tax Plan

Level five planning is a desire to “disinherit” the IRS. The strategy combines life insurance donations with charitable donations. Take, for example, a married couple, both 55 years old, with a $20 million estate. Suppose there is no growth or depletion of assets and both spouses die in a year when the estate tax exemption is $3.5 million and the top estate tax rate is 45%.

With the typical spousal credit recovery trust, when the first spouse dies, $3.5 million is allocated to the credit relief trust and $16.5 million to the spousal trust. There is no federal estate tax due. However, upon the death of the surviving spouse, the estate tax due is $5.85 million. The net result is that the children inherit only $14.15 million.

With the zero-tax plan, the ILIT (with generation-skip provisions) is funded with a $13 million life insurance policy. These gifts reduce the value of the estate to $18 million. In addition, the couple’s trusts each leave $3.5 million (the amount exempt from estate taxes) to their children upon the death of the surviving spouse. The balance of their estate ($11 million) will pass tax-free to a public charity or private foundation. To recap, the zero-tax plan returns $20 million (i.e. $13 million from the ILIT and $7 million from the living trusts) to the children instead of $14.15 million; the charity receives $11 million instead of nothing; and the IRS receives nothing, instead of $5.85 million.

In short, with some advanced planning, it’s possible to reduce estate taxes, avoid probate, set out your wishes, and protect your heirs from creditors, ex-spouses, and estate taxes.

TO THE EXTENT THIS ARTICLE CONTAINS TAX MATTERS, IT IS NOT INTENDED OR WRITTEN TO BE USED AND MAY NOT BE USED BY ANY TAXPAYER FOR THE PURPOSE OF AVOIDING PENALTIES THAT MAY BE IMPOSED ON THE TAXPAYER, ACCORDING TO CIRCULAR 230.