Family Business Center of Pioneer Valley

Family Business Center of Pioneer Valley


Kevin M. Flatley, Esquire

Director of Estate Planning, The Private Bank, BankBoston

Most people are shocked by the impact of estate taxes when assets pass to children.

If you have a $3 million estate, there will likely be an estate tax of $1 million when you die. If you are married, you can put off this tax until the death of your spouse, but the tax will be $1 million then, more or less.

If your estate grows beyond $3 million, every dollar you add to your estate is taxed at 50% to 55%. So, adding $2 million to your estate adds $1 million to your estate.

So, how do business owners plan for this tax? Most planning revolves around three gifts permitted by the tax code: $10,000 annual gifts we can make to the kids each year; the $600,000 we can give away once, either during our lifetime or at death; and the unlimited amounts we can give to charity. These $10,000 and $600,000 gifts can be doubled, if you are married.

Today, there are different strategies business owners use within these limits, and these strategies are used at different times in our lives.

An Irrevocable Life Insurance Trust

If you own life insurance, the insurance is taxed in your estate, just like your business or any other asset you own. Life insurance is generally free from income tax, but if you own the policy, it will pay estate taxes. If you own "split dollar" insurance, where your company and your family each get some of the proceeds of insurance when you dies, this insurance will be in your estate, partly through your ownership of the company, and partly because your family is beneficiary of a policy you own.

If you transfer insurance to an irrevocable trust, you can remove the insurance from your estate. Transferring the insurance does not simply involve naming a trust beneficiary; you must make the trust owner of the policy, giving up the power to change the beneficiary or to take the cash value. With split-dollar insurance, you name the trust owner of the insurance coming to your family.

To remove insurance from your estate, you need to follow the tracks laid out be a taxpayer named Crummey in the 1960s. Until Crummey went to court, the IRS' position on irrevocable trusts was that if you made a gift to a trust, this gift did not qualify the $10,000 gift tax exclusion, so as soon as you made the gift of your insurance premium, you started using up your $600,000 exemption.

Crummey contributed funds to an insurance policy owned by an irrevocable trust, and immediately gave his kids the right to take the gift back from the trust. Crummey argued that this was just like giving the kids gifts outright.

Crummey won his case, so now gifts of less than $10,000 to a "Crummey Trust" are free from gift tax. Court cases in recent years have broadened the Crummey case, to say the kids must not only be entitled to take funds as contributed to an irrevocable trust, but you also must give them notice of their right each year as funds are contributed.

It is important to note, though, that if you give your son $3,000 worth of insurance premiums through a Crummey trust, you can only give him another $7,000 this year within the $10,000 exclusion. Anything over $10,000 given in one year to one child reduces the $600,000 you can leave tax free at death.

A Family Limited Partnership

A gift of $10,000 to your son or daughter will reduce your estate by about $5000, if you own a seven figure state. Again, if you are married, these gifts can be $20,000.

By creating a family limited partnership, you can make these $10,000 or $20,000 gifts much more powerful in reducing estate taxes. Let's explore how you might do this.

If you give your 3 kids $60,000 in cash, this gift is easily valued. The kids can (and probably will) run right out to Bloomingdales and refurnish their homes.

Suppose instead you give the kids $100,000, but instead of giving them cash outright, you create a partnership under which you are the general partner, you place stock in your company in the partnership, and you give the kids "limited partnership" interests. Now, have you given them $100,000? No, you have given them as asset which they do not control, and which they cannot sell. Do you think Bloomingdales will give them $100,000 of merchandise if the kids show up with a limited partnership share (and believe me, the kids will try)?

This gift of $100,000 is not worth $100,000 because the kids cannot convert it to cash, and, in fact, we have been able to argue with the IRS that this gift is only worth $60,000 or so. So, this gift of $100,000 is worth about the same value as our cash gift of $60,000. This is a wise use of a married couple's $20,000 annual gift exemption.

This gift of an interest in a family limited partnership may also be useful for making larger gifts: in my example, if I make a second $100,000 gift to my children, I exhaust $60,000 of my $600,000 lifetime exemption. But it may be wise to exhaust $60,000 of this exemption with a gift of an asset which at liquidation is worth $100,000. I can accomplish this with a family limited partnership.

A gift of an interest in a family limited partnership is best made when the value of your company (or any other asset you place in the partnership) is relatively low. If you can give away $60,000 today which is worth $500,000 when you die, you will get al of this appreciation away from the 50% estate tax when you die.

If you feel a family limited partnership sounds almost too good to be true, be assured the IRS feels exactly the same way. Recent court cases have stated that you need a purpose for establishing the partnership other than mere tax avoidance, but often there are good business reasons to establish a family limited partnerships, aside from tax benefits.

An Irrevocable Trust with a Low Basis Asset

What do you do, though, if you are living on the other side of the tracks: your company has already grown in value, and there is no double-digit growth and not too many double-digit years left in your future?

A gift to an irrevocable trust is best made at this stage in your life when you have large capital gains built into your company, or even a common stock portfolio. An irrevocable trust can offer you the following benefits:

  1. The trustee can sell assets without capital gains, saving capital gains taxes.
  2. The trust can pay you a 7% income for life, some of which is taxed at capital gain rates.
  3. You remove the asset from your estate and save 50% to 55% in estate taxes.
  4. You receive a substantial charitable deduction.
  5. When you die, a Family Fund with a charitable purpose can continue in your name.

This is a "Charitable Remainder Trust," which allows a sale of assets with no capital gain. The charitable deduction is the difference between the value of your asset and the value of the 7% you are keeping for life. The Family fund can be operated in your name, with your children and later your grandchildren, deciding on charities. Sometimes the annual meeting of the Family Fund is the only time all year the kids talk to each other.

Notice that with a Charitable Remainder Trust, there is much more there for you and your family, than there is for a charity.

So, in summary, you have the ability to make gifts wisely. You should make gifts to your children of insurance premiums, if you are not making other gifts. If you have a fast-growing asset, this is the wisest gift to your children, either outright or in the form of a family limited partnership. If your assets have grown, and you would like to be more diversified and less dependent on your company, or a few stocks, a charitable remainder trust is a great way to diversify without paying capital gains taxes.

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