Donald L. Field, Jr.
Attorney at Law
601 Montgomery Street, Suite 1088
San Francisco, California 94111
Offering planning, implementation, advice and representation of taxpayers before federal and California courts and Agencies regarding income, franchise, sales, real property, estate and gift taxes since 1979
California Estate Planning
Estate planning in California for most individuals includes consideration of a number of important goals and objectives. First, providing for disposition of your assets in the manner which you decide. Second, avoidance of a probate proceeding as appropriate. Third, minimizing estate taxes on first and second death. Fourth, providing for decision-making on your behalf in the event of incapacity. If you (or your spouse) are not a US citizen the applicability of United States (California) and foreign law to these issues must be analyzed as well, including the effect of tax treaties and protocols between the United States and the country of your citizenship. Finally, the character of your property under California law (separate property or community property) needs to be considered in light of any ante-nuptial (premarital) agreement.
Probate can be avoided by using a revocable trust to hold all of your assets (the character of property remaining the same as when contributed - community property or separate property). During your lifetimes the trust can be revoked or amended if both of you agree, and you will serve as trustees of the trust. After first death, the trust can be amended or revoked by the surviving spouse only as to the assets of the surviving spouse and any assets of the decedent given to the surviving spouse. The surviving spouse usually serves as trustee after first death. On second death an individual or institution is named as successor trustee and has responsibility for distribution of the trust assets to your beneficiaries. All of the entities which are formed as part of the asset protection plan will be held by the trustees of the trust, as will all other assets which do not have beneficiary designations and thereby avoid probate by contract.
Wills, Durable Powers of Attorney and Advance Health Care Directives
As part of the estate plan, wills should be executed by both of you to provide for any assets that are not in the revocable trust (by providing that such assets will be distributed in accordance with the trust provisions) and to nominate a guardian for your children in the event both you and your wife are not living. Each of you should execute a springing durable power of attorney for asset management (to take effect on incapacity) naming an agent to manage your assets if you are unable to do so and an advanced health care directive (also referred to as a "living will") to determine who will make health care decisions if you are unable to do so and to provide guidance as to specific health care issues.
The U.S. estate tax is generally imposed upon the value of all property comprising a decedent's (deceased person's) estate. As further described below, there are exclusions available where the surviving spouse is a US citizen and to others based on an exclusion amount which is $5.49 million. There is also a provision which allows a surviving spouse in some cases to used any exclusion amount which was not used on first death ("portability"). The maximum estate tax rate on the taxable estate is 40%.
Availability of the Marital Deduction
A very significant deduction and planning tool normally available to estates is the so-called unlimited marital deduction. The unlimited marital deduction allows the estate a deduction equal to the value of all property passing to a surviving spouse. Therefore, if all estate assets pass to a surviving spouse no estate tax is due (although the assets may be subject to estate tax upon the later death of the surviving spouse). However, the estate of a decedent is entitled to the unlimited marital deduction only if the surviving spouse is a U.S. citizen.
If the surviving spouse is not a U.S. citizen, transfers qualify for the marital deduction only in two limited circumstances: (1) the surviving spouse becomes a U.S. citizen before the U.S. estate tax return is filed, and was domiciled in the U.S. between the date of the decedent's death and the surviving spouse's naturalization; or (2) the property passes to a qualified domestic trust (QDOT) or similar contractual arrangement for the benefit of the surviving spouse.
The QDOT serves to defer the decedent's estate tax due until a later triggering event. The actual taxation of the QDOT occurs at estate tax rates otherwise available to the decedent, thereby allowing the decedent's estate to take advantage of the lower marginal rates. Triggering events resulting in taxation include the death of the surviving spouse, the termination of the trust as a QDOT, or any distribution of principal from the QDOT during the surviving spouse's life, except mandatory distributions required to qualify as a QDOT and distributions of trust principal on account of hardship.
Availability of the Lifetime Exclusion
Under current U.S. law citizens and residents are also entitled to an exclusion from estate taxes of $5,390,000. This affects any amounts which are given to a nonspouse (children, grandchildren or others) at an individual's death. The law passed also permits a surviving spouse to use the exemption of amount of the first spouse to die, if it was not fully applied at first death. See also our page on federal estate taxes.
Portability does not, howver, address asset appreciation. With traditional estate planning, the amount exempted from federal estate taxes for the first-to-die spouse is put into a trust for the benefit of the surviving spouse. The assets in this trust, no matter their amount, are outside of the estate of the surviving spouse for estate tax purposes. This means that this trust can appreciate in value to any size, and will not be subject to federal estate taxes when the surviving spouse dies. With portability, however, when one spouse dies and transfers assets and any unused portion of the federal estate tax exclusion to the surviving spouse, any appreciation on the assets of the deceased spouse will be included in the estate of the surviving spouse. If the surviving spouse's estate (including the deceased spouse's assets and appreciation on those assets) is larger than the surviving spouse's available federal estate tax exclusions (including any unused federal estate tax exclusion transferred from the deceased spouse), federal estate tax will be owed on the difference.
If you believe your total marital assets are above, or have the potential of appreciating above, the federal estate tax applicable exclusion amount, you may want to consider working with an estate planning professional to create a traditional estate plan. By doing so, you can help ensure that any potential appreciation of the first-to-die spouse's assets accumulates outside the estate of the surviving spouse.
Furthermore, portability does not apply to the generation-skipping transfer (GST) tax exemption. Individuals can exclude up to $5,390,000 worth of transfers from the GST tax. Unlike the federal estate tax exclusion, however, the GST tax exemption is not portable, as any unused portion does not transfer to a surviving spouse. You should consult your estate planning attorney to determine whether you should make a GST in the future. If so, ask how to effectively utilize all available GST tax exemptions.
Under federal tax law an individual can give up to $14,000 per year to an unlimited number of other individuals without incurring gift tax. In the case of a husband and wife, a total of $28,000 can be given each year, regardless of whether the source of the gift is community property, joint tenancy property or separate property. An individual can in addition at any time during his or her lifetime give up to $5,390,000 to individuals other than a spouse without incurring federal gift tax. All gifts to a US citizen spouse are taxfree(foreign spouses have a limit of $149,000). There is also an exclusion for gifts of medical expenses and educational expenses (paid directly to the institution) in some cases. If the annual exclusion is exceeded in any year, a gift tax return is required, even if no tax is due.
Increase in Income Tax Basis
Transfers at death (but not lifetime gifts) result in an increase in the basis for computation of capital gain for the asset transferred to the fair market value at the date of death (or an optional alternate valuation date. This means that careful consideration should be given to the selection of assets which are transferred intervivos (lifetime gifts) and those transferred at death (whether by will or by trust).
OTHER PLANNING STRATEGIES
Irrevocable Life Insurance Trust
If your estate on second death is likely to incur estate taxes any life insurance payable at that time will also be subject to tax. This can be avoided by use of a trust which owns a policy and which is the beneficiary. A trust of this type can also have provisions related to educational expenses and delay any distributions until all children have completed their education or reached designated ages.
Family Limited Partnership
A family limited partnership is a limited partnership composed of a general partner and limited partners. The general partner, who has the power to make virtually all decisions on behalf of the partnership, is generally an entity (an S corporation or limited liability company (LLC)) controlled by family members. The general partner ordinarily has a very small percentage interest in the partnership (usually one percent). The initial limited partners are the members of the older generation, who have a very large percentage interest in the partnership (usually 99 percent). Under the partnership agreement, the limited partners have no rights to participate in the day-to-day management of the partnership. The partners contribute investment assets, and profits and losses are allocated pro-rata to the partners. The limited partners may, and frequently do, make gifts of limited partnership interests to the younger generation during their lifetimes.
The principal tax advantage is a valuation discount, usually of from 30 to 48 percent on the value of the transfer subject to tax. Discounts may exceed 50 percent in appropriate circumstances, but there is penalty exposure if such a discount is completely disallowed. The transfer tax savings is generally a highly important reason for a client to utilize a limited partnership. The discount is generally greater for real estate and less for publicly traded securities. It is also generally greater when the property does not produce cash flow.
The valuation discount arises because non-controlling ownership interests in business or investment entities are not valued at the value of a proportionate interest in the underlying assets (net asset value). Recognized valuation methodology provides that such interests are entitled to discounts for lack of marketability and control. These discounts recognize the economic realities that such interests cannot be sold for net asset value because they are not marketable ? that is, they cannot be readily sold like shares of stock in a publicly traded corporation ? and they do not permit the transferee to exercise control over the activities of the business or investment entity, thus resulting in the owners? subjection to the discretion and business judgment of another party both for operating results and the timing of distributions (if any).
Trying to quantify the expected tax savings involves determining when property is likely to be sold as well as determining effective transfer tax and income tax rates. In general, the transfer tax savings must be offset against the present value (as of the time the transfer tax would have been paid) of the income tax cost resulting from the reduced basis step-up (which applies only if the estate tax applies because the limited partnership interest is included in the decedent?s estate). If property is expected to be retained in the family for many years, the income tax offset can be ignored. Also, when the property is sold there will be cash proceeds to pay the tax, which is not the case with the transfer tax.
The US Treasury has issued proposed regulations that could restrict discount strategies, but the final regulations have not yet been issued. REG–163113–02 Estate, Gift, and Generation-Skipping Transfer Taxes; Restrictions on Liquidation of an Interest.
The non-tax reasons to form a family limited partnership include:
- Transfer a group of assets into a form of ownership that is simpler to transfer (to facilitate annual and other gift-giving programs).
- Centralize management and obtain the benefit of continuity of management over the partnership?s assets.
- Provide protection to partnership assets from claims of future creditors of the limited partners and to limit the limited partners? liabilities for partnership debts.
- Provide unified control (through the general partner) over distributions of cash derived from earnings on the partnership?s assets.
- Provide flexibility in business planning not available through trusts, corporations or other business entities.
- Conduct investment and business activities in an entity that is not itself subject to federal or state income taxes.
- Avoid the delay, publicity, inconvenience and expense associated with probate administration of multiple separate investments of the partners upon their respective deaths or liquidation.
- Locks assets in the partnership for a period of time, generally not ending until the expiration of the statute of limitations for the last year during which transfers were made.
- Records must be kept, and annual tax returns must be filed, for the partnership and the corporate or LLC general partner. Appraisals must be made to establish the value of the gifted limited partnership interest. The investment in legal, accounting and appraisal fees for formation and administration are significant, but the savings achieved often exceed costs by a multiple of 20 or more.
- Use of a family limited partnership clearly increases the chance of gift or estate tax return being examined, and perhaps contested in court. There are many ?traps for the unwary? if partnership form is not respected.
- Could create or increase liquidity problems of estate by locking up assets that could otherwise be used to pay estate tax.
- Could be problems if highly leveraged real estate is being transferred to the partnership.
- Could be income tax problems if property is distributed to donees within seven years of contribution (see disguised sales rules of Sections 731(c) and 737 of Internal Revenue Code).