Federal Transfer Tax Systems

Gift, Estate, and Generation-Skipping Taxes This memorandum describes the federal transfer taxing systems: (a) gift, (b) estate, and (c) generation-skipping. The revenue purpose of the transfer taxes is to tax transfers of wealth from one person to another and specifically from one generation to another. Some have said the political purpose of the transfer taxes is to redistribute wealth to prevent financial kingdoms from being established and maintained. Gift and estate taxes are a unified system that conceptually mirror each other’s characteristics. Gift tax pertains to gratuitous (for less than full and adequate consideration) lifetime transfers and estate tax pertains to transfers taking effect at death. Generation-skipping tax is separate from gift and estate taxes and is imposed on lifetime or testamentary gratuitous transfers that skip one or more generations. Qualified plans, IRAs, and other “income in respect of a decedent” type assets are still subject to income taxation. Your estate may be burdened with one, some, or all of these taxes.

TIP Because potential tax burdens may be very significant, appropriate tax planning should be an important part of your estate plan.

Gift Tax Federal law imposes (excise) gift tax when property is transferred from a living person to a donee for less than full and adequate consideration. It is the donor (and not the donee) who is obligated to pay the tax for the right to give away property. The gift tax is based on the value of the gifted property at the time of the gift and the tax rate schedule. The gift tax rate increases with the value of the gift and the amount of countable previous gifts. This last statement means the next countable gift is added to all the past countable gifts for a progressive tax rate.

THIS MEMORANDUM IS AN EXCERPT FROM THE BOOK ESTATE PLANNING PRIMER: WHAT EVERYONE NEEDS TO KNOW ABOUT ESTATE PLANNING, BY TIMOTHY S. MIDURA, C.P.A., J.D., LL.M., PUBLISHED BY THE ILLINOIS INSTITUTE FOR CONTINUING LEGAL EDUCATION, COPYRIGHT © 1990-2008 – USED WITH PERMISSION.

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A common misconception is that a donee of a gift has current taxable income based on the gift. This is not true. The gift property may generate future taxable income to the donee (income generated on the property or capital gains generated on the sale of the property based on the carryover basis). The donor may owe gift tax. Generally, there is no accelerated income tax due to a gift. The federal gift tax system is designed to equate the taxation on lifetime transfers to that of death transfers. The gift and estate tax systems have been said to be unified and generally mirror one another. However, since the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA), the differences between gift and estate taxes have become more distinct. The government does not want us to avoid estate taxation by merely giving away property during our lifetimes. Further, the government has designed the gift tax system to discourage transferring property in order to shift taxable income to someone else by limiting amounts that can be transferred without gift tax to even less than estate tax transfers. Non-Countable Gifts Toward Gift Taxation There are certain exceptions when gift taxation does not apply or is not counted towards taxable gifts. These generally include •

gifts qualifying for the annual gift tax exclusion;

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gifts qualifying as tuition and medical payments;

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carry-forward gifts to 529 tuition programs;

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gifts qualifying for the marital deduction (to one’s spouse);

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gifts qualifying for the charitable deduction (to a qualifying charity for a qualifying use); and

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lifetime applicable exclusion amount gifts up to $1 million.

Annual Gift Tax Exclusion The annual gift tax exclusion is $12,000 per donor per donee. This is the amount a person can gift annually to another without incurring gift tax or generation-skipping tax. To qualify for the annual gift tax exclusion, the gift must be of a present interest (able to be currently enjoyed) and not a future interest. The annual exclusion essentially doubles to $24,000 when one’s spouse properly agrees to “gift split.” If the annual gift tax exclusion

THIS MEMORANDUM IS AN EXCERPT FROM THE BOOK ESTATE PLANNING PRIMER: WHAT EVERYONE NEEDS TO KNOW ABOUT ESTATE PLANNING, BY TIMOTHY S. MIDURA, C.P.A., J.D., LL.M., PUBLISHED BY THE ILLINOIS INSTITUTE FOR CONTINUING LEGAL EDUCATION, COPYRIGHT © 1990-2008 – USED WITH PERMISSION.

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is not fully used in its year, then it lapses and is lost. If it is fully used in its year, it renews itself in the next calendar year. The $12,000 amount will be periodically adjusted for inflation. Qualified Tuition and Medical Payments Tuition payments made directly to an education institution or medical payments made directly to a medical provider are not counted for gift tax purposes; they do not reduce the annual gift tax exclusion amount, and neither do they reduce the applicable exclusion amount. It is important to note that these must be direct payments to the provider. Qualifying these payments for gift tax exclusion is precisely defined and must be precisely implemented. Therefore, here are some precise details: •

Qualifying transfers are any amount paid on behalf of an individual as tuition to an educational organization described in Internal Revenue Code §170(b)(1)(A)(ii) for the education or training of the individual or to any person who provides medical care (as defined in Internal Revenue Code §213(d) with respect to the individual as payment for such medical care). A general way of thinking about this application is the payments to the educational institution must be to a qualified educational charity and the payments to a medical provider must qualify for a medical expense deduction on your income tax return if they were for you.

•

For educational expenses to qualify for this special treatment they must meet the following requirements: (a) the amount must be paid on behalf of an individual as tuition; (b) the tuition must be paid to an educational organization described in Internal Revenue Code §170(b)(1)(A)(ii) (this includes primary, secondary, preparatory, high schools, and colleges and universities where the primary activity is formal instruction); (c) the tuition must be for the education or training of the individual donee; (d) the tuition must be paid by the donor directly to the institution (the exclusion will not apply to the donor’s reimbursement of the donee’s payments to the educational institution); and (e) the exclusion is unavailable for amounts paid for books, supplies, or dormitory fees.

•

Also excluded from taxable gifts are payments made by the donor on behalf of the donee directly to a provider for medical care. This includes payments of medical insurance premiums. It does not include the donor’s reimbursement of medical expenses paid by the donee and also does not include payments made by the donor for expenses later reimbursed to the donee by the donee’s medical insurance.

THIS MEMORANDUM IS AN EXCERPT FROM THE BOOK ESTATE PLANNING PRIMER: WHAT EVERYONE NEEDS TO KNOW ABOUT ESTATE PLANNING, BY TIMOTHY S. MIDURA, C.P.A., J.D., LL.M., PUBLISHED BY THE ILLINOIS INSTITUTE FOR CONTINUING LEGAL EDUCATION, COPYRIGHT © 1990-2008 – USED WITH PERMISSION.

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Carry-Forward Transfers to a 529 Tuition Program Transfers to a 529 tuition program that exceed the annual gift tax exclusion amount in the year of the contribution to the program may be carried forward for four years to apply to those future years’ available annual gift tax exclusion amounts. This means you can get up to five years’ worth of annual exclusion amount in the year of funding the 529 tuition account. This is an election made on the gift tax return, Form 709. If you die before the next four years passes, then the roll-forward annual exclusion amounts will have to be recaptured on your federal estate tax return. Unified System The gift tax system is unified with the estate tax system (more fully discussed below). Lifetime taxable gift transfers (made after 1976) are aggregated with testamentary transfers for an accumulated (overall higher) transfer tax. Based on the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA), a major difference between estate tax and gift tax is that the applicable exclusion amount for lifetime gifts is and stays at $1 million. Carryover Basis When a lifetime gift is made, even though the tax rate is based on the value of the gift, the tax basis on the gifted property carried over to the donee is generally the lower of the donor’s tax basis or the value of the gift. This is referred to as “carryover basis” or “substituted basis.” This is one of the more significant differences between the gift tax system and the estate tax system. Contrast this to “stepped-up basis” for estate taxation, explained below.

TIP If estate tax planning is a concern of yours, consider using the annual gift tax exclusion to reduce estate taxes.

Estate Tax Estate tax, like gift tax, is an excise tax imposed on the privilege of transferring assets the decedent owns or is deemed to own at death. It is neither a tax on the property itself nor a tax on the privilege of a beneficiary to receive the property. The estate tax is based on the value of the adjusted taxable estate at the time of death. The estate tax increases with the value of the taxable estate and the amount of countable previous lifetime gifts (made after 1976). This last statement means the countable lifetime gifts and adjusted taxable estate THIS MEMORANDUM IS AN EXCERPT FROM THE BOOK ESTATE PLANNING PRIMER: WHAT EVERYONE NEEDS TO KNOW ABOUT ESTATE PLANNING, BY TIMOTHY S. MIDURA, C.P.A., J.D., LL.M., PUBLISHED BY THE ILLINOIS INSTITUTE FOR CONTINUING LEGAL EDUCATION, COPYRIGHT © 1990-2008 – USED WITH PERMISSION.

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are combined to increase the value of the estate for estate tax purposes. Assets deemed to be owned by the decedent, and thus includable in the decedent’s gross estate, are viewed broadly and may include beneficial interests not actually owned or may also include assets previously gifted away but over which some power has been retained. Two main differences between estate tax and gift tax are (a) step-up in basis versus carryover basis, as explained in the preceding gift tax section, and (b) estate tax is “tax inclusive” while gift tax is “tax exclusive.” “Tax inclusive” means you pay tax on a value that includes the tax you have to pay — essentially paying tax on the tax. A simplified example: If Claude wanted to give $1,000 to Geneva during his lifetime — assuming a gift tax rate of 50 percent — the gift would cost Claude $1,500 (the $1,000 gift and the gift tax of $500). In the alternative, if the $1,000 intended gift was made at Claude’s death, the gift would cost $2,000 (it takes $2,000 of assets at a 50 percent tax rate to leave $1,000). In this example, there is a 50percent tax savings by the tax exclusive nature of gift taxes. There is a tax rule, however, that attempts to equalize this situation by adding back into the taxable estate any gift taxes paid within three years of death. Generally, gift tax is cheaper than estate tax.

TIP If estate tax is a concern of yours, consider tax planning by using (a) the sheltering opportunities of the applicable exclusion amount, and (b) an irrevocable life insurance trust. If you can afford to gift during your lifetime, a strategic planning remembrance is that gift tax is cheaper than estate tax.

Generation-Skipping Tax In principle, Congress wants estate tax imposed at each generation level. It does not want someone to be able to arrange an estate to skip one or more generations without estate taxation. Therefore, there is a third transfer taxation called generation-skipping tax (GST) of the lifetime or testamentary transfer of property for less than full and adequate consideration that “skips” a generation. It is designed to disallow a tax-free generation skip so that there is the equivalent of estate tax at each generation level. The GST rate is a flat rate at the then current maximum estate tax rate. The amount of the exemption from GST is the annual gift tax exclusion amount (plus certain direct payments of tuition and medical expenses) plus the applicable exclusion amount. Gift or estate tax, however, still applies even if GST is avoided. Therefore, gift or estate tax may be incurred as well as GST! THIS MEMORANDUM IS AN EXCERPT FROM THE BOOK ESTATE PLANNING PRIMER: WHAT EVERYONE NEEDS TO KNOW ABOUT ESTATE PLANNING, BY TIMOTHY S. MIDURA, C.P.A., J.D., LL.M., PUBLISHED BY THE ILLINOIS INSTITUTE FOR CONTINUING LEGAL EDUCATION, COPYRIGHT © 1990-2008 – USED WITH PERMISSION.

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If an estate is greater than the applicable exclusion amount (or is expected to increase over time to the applicable exclusion amount) and is intended to benefit a “skip person,” then GST planning should be explored. A “skip person” is generally someone assigned to a generation two or more generations below the transferor’s generation (for instance, a grandchild or non-family member who is 371/2 years younger). Use of the GST exemption amount can save significant transfer taxes. Furthermore, the exemption of both spouses can be used to double the GST exemption. Also, the exemption would shelter appreciation of segregated assets so that, if $3 million were segregated and grew to $8 million, the result would be the entire $8 million would avoid the GST. Special allocation elections usually are necessary to maximize GST savings. GST planning is very complex. However, the tax savings with proper planning can be significant.

TIP If estate tax and GST is a concern of yours, consider tax planning by using the sheltering opportunities of the GST exemption and the other GST exclusions.

Selected Terms and Concepts of Gift and Estate Taxation Because tax planning can be such a significant part of estate planning, it is important to be introduced to key tax terminology and concepts. The following are selected gift and estate tax terms and concepts. Applicable Exclusion Amount The applicable exclusion amount is the amount of property value that can be excluded from gift tax and estate taxation. The estate tax applicable exclusion amount varies depending on the applicable year: 2008: $2 million; and 2009: $3.5 million. The applicable exclusion amount has also been referred to as the “exemption equivalent.” The gift tax applicable exclusion amount is $1 million. It stays at $1 million even though the estate tax applicable exclusion amount has scheduled increases. If someone uses their full gift tax applicable exclusion amount, then the estate tax applicable exclusion amount is also reduced by this same amount — they are unified or the same to the extent of the first $1 million. THIS MEMORANDUM IS AN EXCERPT FROM THE BOOK ESTATE PLANNING PRIMER: WHAT EVERYONE NEEDS TO KNOW ABOUT ESTATE PLANNING, BY TIMOTHY S. MIDURA, C.P.A., J.D., LL.M., PUBLISHED BY THE ILLINOIS INSTITUTE FOR CONTINUING LEGAL EDUCATION, COPYRIGHT © 1990-2008 – USED WITH PERMISSION.

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Unlike the annual gift tax exclusion, the applicable exclusion amount does not renew itself. However, as it increases, this increase becomes available. So, if someone fully used their applicable exclusion amount of $1 million in 2003, the subsequent increases become available. Applicable Credit Amount or Unified Credit The applicable credit amount is the tax credit allowed to offset gift and estate tax. It may be used only once in offsetting either gift tax or estate tax. It has the same meaning as the unified credit. This amount is the credit that creates an applicable exclusion amount by sheltering that equivalent amount of property from transfer tax. The estate tax applicable credit amount varies depending on the applicable year: 2008: $780,800; and 2009: $1,455,800. The gift tax applicable credit amount is $345,800. It stays the same even though the estate tax applicable credit amount has scheduled increases. The applicable credit amounts for gift taxes and estate taxes have the same offsetting interaction as explained for the applicable exclusion amounts.

Tax Year of Death or Gift

Gift Tax Exclusion

Maximum Gift Tax Rate

Estate Tax Exclusion

Starting Estate Tax Rate

Maximum Estate Tax Rate

2008 2009 2010 2011

$1,000,000 $1,000,000 $1,000,000 $1,000,000

45% 45% 35% 55%

2,000,000 3,500,000 Repealed 1,000,000

45% 45% n/a 41%

45% 45% n/a 55%*

* Plus five-percent surcharge for estates valued in excess of $10 million.

Note that the present tax law is scheduled for “repeal” for year 2010 and then automatically reverts to the pre-2001 tax law (the one that had the $1 million applicable exclusion amount). Marital (Unlimited) Deduction The marital deduction is a deduction allowed by estate and gift tax law that exempts transfers to one’s spouse from transfer taxation. You can transfer an unlimited amount of assets to your spouse without incurring any transfer tax if the transfer is not a “terminable interest.” A “terminable interest” is a circumstance by which the spouse’s interest in the THIS MEMORANDUM IS AN EXCERPT FROM THE BOOK ESTATE PLANNING PRIMER: WHAT EVERYONE NEEDS TO KNOW ABOUT ESTATE PLANNING, BY TIMOTHY S. MIDURA, C.P.A., J.D., LL.M., PUBLISHED BY THE ILLINOIS INSTITUTE FOR CONTINUING LEGAL EDUCATION, COPYRIGHT © 1990-2008 – USED WITH PERMISSION.

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property will terminate after a lapse of time or on the occurrence or nonoccurrence of a specified contingency (for example, remarriage). NOTE: The marital deduction is limited if the spouse is not a U.S. citizen. Marital Deduction Trust A gift in trust qualifies for the marital deduction if a. property passes from the deceased spouse to a marital trust; b. the surviving spouse is the sole beneficiary during the surviving spouse’s lifetime and all income is paid at least annually to the surviving spouse; and one of the following holds true: 1. General Testamentary Power of Appointment Trust: The surviving spouse is given a power to appoint the marital trust upon the surviving spouse’s subsequent death to whomever the surviving spouse chooses (for example, the surviving spouse’s estate or creditor’s of the surviving spouse). 2. Qualified Terminable Interest Property (QTIP) Election Trust: The executor of the predeceased spouse makes a special tax election to have the marital trust included in the gross estate of the surviving spouse. 3. Qualified Domestic Trust (QDOT): The trust has special additional requirements when the surviving spouse is not a U.S. citizen. An estate trust is another type of trust that qualifies for the marital deduction. The same rules above apply except income need not be paid to the spouse but may be accumulated. Upon the surviving spouse’s subsequent death, the estate trust is paid to the surviving spouse’s estate, including any accumulated income. Life estates and certain annuities can also qualify for the marital deduction.

TIP A typical estate planning mistake is the overuse of the marital deduction and the underuse of the applicable exclusion. Be thoughtful with respect to tax planning opportunities.

THIS MEMORANDUM IS AN EXCERPT FROM THE BOOK ESTATE PLANNING PRIMER: WHAT EVERYONE NEEDS TO KNOW ABOUT ESTATE PLANNING, BY TIMOTHY S. MIDURA, C.P.A., J.D., LL.M., PUBLISHED BY THE ILLINOIS INSTITUTE FOR CONTINUING LEGAL EDUCATION, COPYRIGHT © 1990-2008 – USED WITH PERMISSION.

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A-B Trusts Using A-B trusts is an estate tax planning technique that maximizes the tax sheltering provided by the applicable exclusion amount and defers estate tax by using the marital deduction. Trust A (or the Marital Trust) defers estate taxes by use of the marital deduction and Trust B (or the Family Trust) saves estate taxes by using the applicable exclusion amount. See the attached Classic Complex Estate Plan example.

TIP Use the A-B trust technique as a classic way of estate tax planning. It can shelter at least twice the effective applicable exclusion amount by using both spouses’ exclusions.

Credit Shelter or Applicable Exclusion Amount Shelter Utilizing the applicable exclusion amount or the applicable credit amount to shelter a pool of assets from future estate taxation is sometimes referred to as “credit sheltering.” See the attached Classic Complex Estate Plan example. Qualified Terminable Interest Property (QTIP) Qualified terminable interest property (QTIP) is an estate (and gift) tax opportunity of qualifying for the use of the marital deduction in the transfer of assets for the benefit of a spouse but restricts the spouse’s access to the principal and the ability to direct its ultimate disposition. QTIP provisions are to be considered when there is a concern about the possible remarriage of a spouse, spendthrift attitudes or other questions regarding a spouse’s personal judgment, and third-person influence or other adverse external pressures (family pressure to gift money, high pressure salespeople, etc.). A classic usage of a QTIP trust is a second marriage situation in which you want to provide financial benefit to your surviving spouse, use the marital deduction to defer taxes, and ensure your children receive the remaining trust assets. QTIP elections also have various postmortem tax planning strategies. Also, QTIP trusts are used for creditor protection purposes and splitting assets for tax discount planning.

TIP When using a QTIP trust, you may also take advantage of generation-skipping tax (GST) planning opportunities.

THIS MEMORANDUM IS AN EXCERPT FROM THE BOOK ESTATE PLANNING PRIMER: WHAT EVERYONE NEEDS TO KNOW ABOUT ESTATE PLANNING, BY TIMOTHY S. MIDURA, C.P.A., J.D., LL.M., PUBLISHED BY THE ILLINOIS INSTITUTE FOR CONTINUING LEGAL EDUCATION, COPYRIGHT © 1990-2008 – USED WITH PERMISSION.

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Step-Up in Basis Upon one’s death, the tax basis in most assets owned by the decedent is “stepped up” from the tax basis just before the decedent’s death to the fair market value of the property as of the date of the decedent’s death. The practical effect is that taxable capital gain potential disappears. Step-up does not apply to “income in respect of a decedent” (IRD) property, which includes assets such as individual retirement arrangements, qualified retirement benefits, installment sale agreements, accounts receivable, deferred income, and the like. Another exception to the basis step-up rule is for property reacquired within 12 months of the decedent’s death. For example, Chester gave to Sally certain property worth $10,000 that has a tax basis of $100. Sally’s will gives all of her property to Chester. Sally dies six months after Chester’s gift to her, so Chester gets his gifted property back. The general tax rule provides, since Sally died owning property as of her death, the property’s tax basis gets stepped up to the fair market value as of her death ($10,000). However, in this example, since the property was originally Chester’s, which he had given to Sally, and he reacquired it from Sally within 12 months of his original gift to her by reason of her death, the property does not receive a stepped-up basis, and he takes Sally’s basis of $100.

TIP Planning for the use of the “step-up in tax basis” is an important tax planning opportunity that is too often overlooked. Make a concerted effort to do “step-up” planning if it can be determined which spouse may die first.

Gross Estate Your gross estate for federal estate tax purposes is essentially all assets owned and beneficial interests in property, no matter where it is located, including the face amount of life insurance (policies in which there are incidents of ownership or incidents of ownership released within three years of death), certain retained interests and powers, and certain other interests given away within three years of death. Also, countable lifetime taxable gifts (made after 1976) are added back to achieve the highest estate tax (although not technically a part of the gross estate).

THIS MEMORANDUM IS AN EXCERPT FROM THE BOOK ESTATE PLANNING PRIMER: WHAT EVERYONE NEEDS TO KNOW ABOUT ESTATE PLANNING, BY TIMOTHY S. MIDURA, C.P.A., J.D., LL.M., PUBLISHED BY THE ILLINOIS INSTITUTE FOR CONTINUING LEGAL EDUCATION, COPYRIGHT © 1990-2008 – USED WITH PERMISSION.

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The Federal Estate Tax Return (Form 706) categorizes includable assets as follows: •

real estate;

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stocks and bonds;

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mortgages, notes, and cash;

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insurance on the decedent’s life;

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jointly-owned property;

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miscellaneous property (for example, debts due the decedent, interests in business, insurance on the life of another, claims, rights, royalties, leaseholds, judgments, trust fund shares, household goods and personal effects, farm products and growing crops, livestock, farm machinery, automobiles, and reversionary or remainder interests);

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transfers during lifetime (for example, certain transfers or released powers within three years of death, transfers intended to take effect at death, transfers with possession or enjoyment retained, right retained to designate who shall possess or enjoy, and revocable transfers);

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general powers of appointment; and

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annuities.

Adjusted Gross Estate The adjusted gross estate for federal estate tax purposes is the gross estate less deductions for administrative expenses and liabilities. Taxable Estate The taxable estate for federal estate tax purposes is the adjusted gross estate less charitable deductions, marital deductions, and state death tax deductions. There are certain “gross-ups” (add-ons) of lifetime gifts (made after 1976) that have the effect of increasing the taxable estate although not technically a part of the taxable estate.

THIS MEMORANDUM IS AN EXCERPT FROM THE BOOK ESTATE PLANNING PRIMER: WHAT EVERYONE NEEDS TO KNOW ABOUT ESTATE PLANNING, BY TIMOTHY S. MIDURA, C.P.A., J.D., LL.M., PUBLISHED BY THE ILLINOIS INSTITUTE FOR CONTINUING LEGAL EDUCATION, COPYRIGHT © 1990-2008 – USED WITH PERMISSION.

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Federal Estate Tax Calculation The estate tax calculation looks like this Total: Less: Equals: Less: Less: Equals: Add: Equals: Total: Less: Equals: Less: Equals:

gross estate funeral expenses, administrative expenses, liabilities, and losses adjusted gross estate marital and charitable deductions state estate and inheritance tax deductions taxable estate lifetime taxable gifts (made after 1976) tentative tax base calculated tax on tentative tax base (tentative tax) calculated tax on lifetime gifts (made after 1976) tentative estate tax available applicable credit amount estate tax payable (before other credits*)

* Other credits include foreign death tax credit, credit for gift tax paid on pre-1977 gifts, and credit for taxes paid on prior transfers (estate taxes paid in the last ten years by other estates and such previously taxed property included in this estate). For example, a taxable estate of $2 million produces a gross federal estate tax of $780,800. Assuming year 2008, this gross estate tax will be offset by the applicable credit amount, $780,800, thus leaving a federal estate tax of zero. The next dollar over $2 million is taxed at a rate of 45 percent. Thus, a $2.5 million taxable estate will produce federal estate tax of approximately $225,000. State estate and inheritance taxes may also be due in addition to federal estate tax. Filing of the Federal Estate Tax Return (Form 706) and payment of the estate tax are due nine months from the date of death. The due date is the day of the ninth calendar month after the decedent’s death, numerically corresponding to the date of the calendar month on which the death occurred or the next business day if the day falls on a weekend or legal holiday. A six-month extension for filing may be acquired. An extension of time to pay the estate tax may be granted for up to 12 months if reasonable cause is determined to exist by the IRS (but interest continues to be accrued). Special extended installment payments may be elected if a significant portion of the estate is comprised of closely held business or farm interests.

THIS MEMORANDUM IS AN EXCERPT FROM THE BOOK ESTATE PLANNING PRIMER: WHAT EVERYONE NEEDS TO KNOW ABOUT ESTATE PLANNING, BY TIMOTHY S. MIDURA, C.P.A., J.D., LL.M., PUBLISHED BY THE ILLINOIS INSTITUTE FOR CONTINUING LEGAL EDUCATION, COPYRIGHT © 1990-2008 – USED WITH PERMISSION.

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Fair Market Value Treasury Regulation §20.2031-1(b) defines “fair market value” as “the price at which the property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or sell and both having reasonable knowledge of relevant facts.” This is the value on which gift, estate, and generation-skipping taxes are determined. This definition is important because many people will inappropriately undervalue their assets for estate planning purposes. If asked, “What is your property worth for tax valuation purposes?” they will say a figure substantially less than their answer to the alternative question of “What would you sell your property for?” It is usually the latter answer that is more indicative of what is the true value. Many people are “cash poor” and “paper rich.” The IRS focuses on the “paper rich.” Particular problem assets to value are closely held business interests and property used in closely held businesses. Tangible personal property (jewelry, art, and other articles of household and personal effects) are also items of worth overlooked or discounted when thinking about estate planning. Too many people mistakenly believe that, for estate tax purposes, their tangible personal property “disappears” upon their deaths. These assets are too often undervalued for tax planning purposes.

TIPS Valuation is one of the most complex and uncertain aspects of estate planning and estate tax calculations. Be sure you are planning with realistic values. Make a list of all your assets. Make an estimate of estate tax upon your death (assuming you have no surviving spouse) in accordance with the preceding tax table. Do you need any additional planning for this tax payment?

General Power of Appointment A general power of appointment is the power of a person to elect to have a benefit (most often a beneficial interest in a trust) appointed in some way to either the power holder, the power holder’s estate, the creditors of the power holder, or the creditors of the estate of the power holder. The property representing a general power of appointment is included in the estate of the power holder for purposes of estate taxation. Contrast this with a limited power of appointment. A general power of appointment can be created in many different ways. It is sometimes created inadvertently, especially when a trustee of a trust is also a beneficiary or has THIS MEMORANDUM IS AN EXCERPT FROM THE BOOK ESTATE PLANNING PRIMER: WHAT EVERYONE NEEDS TO KNOW ABOUT ESTATE PLANNING, BY TIMOTHY S. MIDURA, C.P.A., J.D., LL.M., PUBLISHED BY THE ILLINOIS INSTITUTE FOR CONTINUING LEGAL EDUCATION, COPYRIGHT © 1990-2008 – USED WITH PERMISSION.

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family members who are beneficiaries. For example, a general power of appointment is created by permitting a trustee to exercise trustee powers to discharge a legal obligation of support he or she has towards someone (such as when a parent is the trustee and is able to distribute assets from the trust for food and clothing for a minor child who is a beneficiary). In addition, there is a body of law building that suggests college education is an obligation of support. This is dependent on applicable state law. When the trustee and the beneficiary are one in the same, ascertainable standards are used to avoid creating a general power of appointment. However, even the use of ascertainable standards does not completely foreclose the possibility of having a general power of appointment because there are various ways of creating such a power. For example, being able to discharge a legal obligation of support (as discussed above) or having administrative powers considered too broad (that effectively neutralize the ascertainable standards or give the beneficiary/power holder the broad powers of an independent trustee) may create a general power of appointment. Limited Power of Appointment A limited power of appointment is the power of a person to elect to have a benefit (most often a beneficial interest in a trust) appointed in almost any way to almost anyone, depending how the power is drafted, but in no event in favor of the power holder, the power holder’s estate, the creditors of the power holder, or the creditors of the estate of the power holder. The property representing a limited power of appointment is not included in the estate of the power holder for purposes of estate taxation. Contrast this with a general power of appointment. Ascertainable Standard Ascertainable standards define when trust distributions will be made. Ascertainable standards are objective and legally ascertainable. Treasury Regulation §20.2041-1(c)(2) defines “ascertainable standards” as “support,” “maintenance,” “support in reasonable comfort,” “maintenance in health and reasonable comfort,” “support in his accustomed manner of living,” “education, including college and professional education,” “health,” and “medical, dental, hospital and nursing expenses, and expenses of invalidism.” The ascertainable standard is important and necessary when a beneficiary of a trust is also acting as trustee (in situations other than a revocable self-declaration of trust). Using distribution language limited by an ascertainable standard keeps the assets of the trust from being included in and taxed to the estate (as a general power of appointment). A classic situation occurs when a surviving spouse is acting as trustee of a “family trust” (also sometimes referred to as “Trust B” or the “Credit Shelter Trust”) and he or she is also a beneficiary of such a trust.

THIS MEMORANDUM IS AN EXCERPT FROM THE BOOK ESTATE PLANNING PRIMER: WHAT EVERYONE NEEDS TO KNOW ABOUT ESTATE PLANNING, BY TIMOTHY S. MIDURA, C.P.A., J.D., LL.M., PUBLISHED BY THE ILLINOIS INSTITUTE FOR CONTINUING LEGAL EDUCATION, COPYRIGHT © 1990-2008 – USED WITH PERMISSION.

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Note that “happiness,” “welfare,” and “comfort” are not considered ascertainable standards. An ascertainable standard can be a double-edged sword. It can limit the ability to qualify for distributions as well as sometimes force the distribution. There is less flexibility in making distributions when the distribution standard is ascertainable.

TIP Care must be taken when drafting an estate tax sheltering trust (such as A-B trusts) so that a general power of appointment is not inadvertently created when the trustee is also a beneficiary. Limiting distributions by ascertainable standards is one way of avoiding a general power of appointment. However, other trustee powers may inadvertently create a general power of appointment even if an ascertainable standard is used. For example, the power of a trustee to discharge the personal legal obligation to support a trust beneficiary will create a general power of appointment that can have adverse tax consequences to the trustee or the estate.

Five and Five Power (five percent and $5,000) This is the power of a person to withdraw or to appoint to himself or herself the greater of five percent or $5,000 of some property interest (generally from a trust). A power limited to “five and five” is not considered a general power of appointment for future inclusion in one’s taxable estate when the power lapses (goes unexercised). However, the unexercised portion of principal is included in the person’s taxable estate for the year of his or her death. Needless to say, tax planning is extremely complicated and you should have the services of a very competent estate planning attorney to facilitate a tax-sensitive estate plan.

THIS MEMORANDUM IS AN EXCERPT FROM THE BOOK ESTATE PLANNING PRIMER: WHAT EVERYONE NEEDS TO KNOW ABOUT ESTATE PLANNING, BY TIMOTHY S. MIDURA, C.P.A., J.D., LL.M., PUBLISHED BY THE ILLINOIS INSTITUTE FOR CONTINUING LEGAL EDUCATION, COPYRIGHT © 1990-2008 – USED WITH PERMISSION.

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Classic Complex Estate Plan This exhibit illustrates basic documents and the expanded dimensions with the A-B estate tax trust technique

Last Will and Testament HIPAA - Health Information Release Health Care Power of Attorney

Living Will

with pourover provision

Lifetime Capacity Lifetime Incapacity

Both spouses are living One spouse deceased and One spouse living

Death Allocation Formula

Remainder of estate (after funding the Family Trust) is paid to the Marital Trust

Surviving spouse’s estate

Financial Power of Attorney

Master Living Trust

Formula based estate tax allocation Saves estate taxes by allocating the applicable exclusion amount to Family Trust

Marital Trust – A

Family Trust – B

Exclusively for spouse’s benefit Uses unlimited marital deduction to defer taxes

May be for family’s benefit Uses applicable exclusion amount to save taxes Called the “credit shelter” trust Income: various alternatives Principal: various alternatives Alternatives for various powers

All income to spouse Principal: various alternatives Alternatives for various powers No spouse living

Remainder provisions For children/descendants Until age 21: income and principal discretionary with trustee. After age 21: income distributed and principal discretionary with trustee. Distributions in thirds: ages 25, 30 & 35.

Family disaster provision

Year of Death or Gift 2008 2009 2010 2011

Applicable Exclusion Amount $2,000,000 3,500,000 0 1,000,000

THIS MEMORANDUM IS AN EXCERPT FROM THE BOOK ESTATE PLANNING PRIMER: WHAT EVERYONE NEEDS TO KNOW ABOUT ESTATE PLANNING, BY TIMOTHY S. MIDURA, C.P.A., J.D., LL.M., PUBLISHED BY THE ILLINOIS INSTITUTE FOR CONTINUING LEGAL EDUCATION, COPYRIGHT © 1990-2008 – USED WITH PERMISSION.

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