Estate Tax Planning for 2011...Part 2

With the Holidays upon us, I thought I would go away from my normal format of two informational items and an Estate of the Month to just finish up Part II on how to plan for the return of the Federal Estate Tax in 2011.

Review Life Insurance Policies and Correct Ownership

As I described in my October Newsletter, life insurance death benefits are not subject to the income tax but depending on ownership of the life insurance policy proceeds from the death benefits can boost an estate above the exemption levels and be subject to the estate tax. Removing the incidents of ownership of your life insurance policy is the key to removing life insurance death benefits from your estate. Removing ownership could be as simple as transferring ownership from the insured to another person, like a spouse, or creating an irrevocable life insurance trust or ILIT (see November's "Basics of Estate Planning" for more details on ILITs).

Intra-Family Loans

In affluent families, one way to work around gift tax issues is to establish an intra-family loan. This is generally done between parents and children of amounts over the annual gift tax exemption. Intra-family loans are a particularly good planning tool for the next several years because of the historically low interest rates available. The IRS sets a monthly rate for intra-family loans to prevent families from loaning money to other family members at insignificant rates. For example, the current annual Applicable Federal Rates for November are 0.32% for short-term loans of three or fewer years, 1.52% for mid-term loans in excess of three years and fewer than nine years, and 3.53% for long-term loans in excess of nine years.

The intra-family loan can also include balloon payments at the end of the term and the lender can forgive interest payments via the annual gifting rules. However, there could be income tax issues for the lender-parent on the forgiven interest payments.

Grantor Retained Annuity Trusts

A grantor retained annuity trust, or GRAT, is another good planning tool in low interest environments. A GRAT is an irrevocable trust designed to transfer the appreciation on assets contributed to it with minimal or no gift-tax consequences. An individual transfers assets to a GRAT retaining an interest in the trust for a certain time period. The GRAT makes payments from the assets back to the individual in the form of annuity payments. If the assets transferred into the GRAT appreciate more than the annuity payments, the GRAT is required to pay out the excess amount transfers to the individual's beneficiaries tax-free. The annuity payments owed by the GRAT are established by the "hurdle" rate determined by the IRS - for December 2010 that rate is 1.83%. Further, the value of the assets remaining in the GRAT, including appreciation, is excluded from the individual's net worth for estate tax.

There are several drawbacks to GRATs. If it turns out that the asset has appreciated less than the payments owed from the GRAT to the individual of the GRAT, the trust fails. The asset returns to the grantor but another GRAT can be created with the same assets. If the individual that created the GRAT dies during the repayment period, the entire value of the assets in the GRAT, including appreciation, will be subject to estate tax in the grantor's estate. Thus, the GRAT time period should be set to one the individual will live beyond. Currently, a GRAT term can be as short as two (2) years, but Congress is considering making the minimum GRAT term ten (10) years.

Even with Congressional indecisions on numerous tax issues, you can still take steps to limit the impact of the return of the federal estate tax. Hopefully, you can take advantage of the planning tools I have described in the last two months. Happy Holidays and see you in the New Year!