Simplicity Comes To Complicated Estate Tax Planning

Not Possible, you say? Ah, but it is...

"Ah’m rich, but I ain’t stoopit!"

Yet this blather you’re hearing from your estate planning lawyer is absolutely incomprehensible. And those 90 page trusts he mails you. "Please review and let me know if you have any questions." Oh, PLEASE. REALLY. Is he serious?

(For 2 points, who said that?) You really can understand what’s going on. Trust me and read this month’s issue of Tax Geek.

First, low hanging fruit

Here are the standard-issue tax devices:

• No Tax At All, Ever. Pass assets tax free via the unified credit to your heirs. Charitable contributions pass assets tax free to charities.
• Tax Later. Defer tax on anything that goes to your spouse. Tax free if she spends it, but taxed if she dies with it

Then the complicated stuff

A good estate plan for someone with wads of lolly (like you) should do this:

• Shrinkage. It should shrink the apparent value of your assets for tax purposes—make $100 look like $70 to the IRS.
• Freezing follows shrinkage (at least in the tax world). If the IRS thinks you have $70, make sure it stays that way. When the stock market doubles, make sure that the doubling doesn't get taxed to you.
• Disposal. Get rid of whatever you're left with. The IRS can only tax you on what you own when you die.

There are only two ways you can leave money to someone and entirely avoid estate tax: use the unified credit or gifts to charity.

Unified Credit: $675K Goes Tax Free

First, the unified credit. This is a concept familiarto most people, though maybe not by the geeky jargon I’ve used. For deaths in 2000, the first $675,000 going to your heirs (let’s exclude your spouse for the time being) is free of estate tax. This slowly ratchets up to a $1,000,000 amount in 2006 (though this is subject to change at the whim of Congress. And bet on a Congressional Whim if budget surplus targets are not met in 2003).

Unified Credit In The Flesh!

Look at your standard issue revocable living trust at the section that describes what happens after the first spouse dies.

You SHOULD see a provision that creates a trust called a "bypass trust" or "credit shelter trust" or something like that. You won't see any dollar amounts, if the trust was done right, because this tactic is hidden in a complex boilerplate formula. If you actually read it, you’ll glaze like a doughnut. (Fun trick: ask your tax lawyer to explain a reverse pecuniary formula! Watch him squirm!)

But the idea here is to carve off $675,000 (up to $1M eventually) and set it aside for your heirs, estate tax free. (For the brainiacs—of  COURSE this is too simple. Relax and look at the big picture).

Whatever you give to charity when you die is not taxed. This carries with it an unfortunate side-effect: your kids don’t get the money—the charity does. You’ll probably need some actual charitable bones in your body to like this. But even if you’re an exhibit at the Naked Greed Zoo, a charitable contribution is not completely useless: there are many ways to balance the blessings of naked greed against a selfless gift to the less fortunate. We can dig SOME tax savings out of the mud. But if you have $100 and want it all to go to your kids, forget it. This won't work.

Tax it later: give it to your spouse

You have to be married for this one. Anything you leave to your spouse when you die is free of estate tax. But it defers the tax--it doesn't eliminate it. Anything your spouse doesn't spend is taxed when she dies. "Tax free if you spend it!" sounds like a pretty good bequest, doesn’t it? Want to see this beast in its native habitat? Again, please turn in your hymnals, ummm, in your garden variety revocable living trust, to the section that deals with events after one spouse dies.

You will see something like a "marital trust" or a "QTIP trust" or maybe just a gift of the deceased spouse’s property to a "survivor’s trust." Again, your average tax lawyer's not aiming for clarity. The tactic channels money in one way or another to the survivor. The different methods are just more or less restrictive on the survivor’s ability to spend the whole wad.

Out of the easy stuff and into the difficult

But we’re Big Pants people. We need MORE. Here’s where the exotic tax creatures play: strange trusts, odd annuities, limited partnerships, bizarre gifts. Things that don’t look like their names, don’t act as they should, cost a ton to set up and are impossible to understand.

Three steps: shrink, freeze, dispose

Here’s what I do when I approach a large estate plan. First, shrink the assets. Make that $100 your heirs get look like $70 to the IRS. Second, freeze the value of your estate at that lower level. Make future appreciation go to your heirs tax free. Third, take that frozen, shrunken lump of pitiful nothing you have left, and get rid of it in a tax-smart way. If you keep this three-step process in mind, a lot of the complexity will start to fall into place.

Shrinkage

Prime example of this tactic—the family limited partnership. This is where you put an asset into a partnership with specially designed characteristics. If you are successful, the partners now own partnership interest that are worth less than the assets inside the partnership. You can see cousins of this beast on the NYSE: closed-end mutual funds trading at a discount to net asset value. A family limited partnership is a roll-yer-own closed end mutual fund.

Recent experience from actual IRS audits tells me you can shrink things 30% using this process. This means that if nothing else is done, you have changed the result from a tax on $1,000,000 (lets say $500,000 of tax) to a tax on $700,000 (or $350,000 of tax). Far from being voodoo and untested, this is now a mainstream estate planning technique.

Next, the freeze. So you made $1,000,000 look like $700,000. But the market doubles. Now that $700,000 is worth $1,400,000. Those tax problems you’d licked are back. Whad-dya do now?

You want that appreciation to be taxed to someone else—like your heirs—not you. And this can be done. One technique was mentioned in Tax Geek 1.01: the sale to an intentionally defective grantor trust. There are other tools, of course, but we’re running out of space.

Disposal

The final step is "get rid of it." The IRS only taxes dead people on what they own. So don’t "own" it. Give it away to your heirs. In a tax-smart way, of course. And don’t forget the real world problems. Don’t drop a money bomb on someone who can’t handle it.

Simple, isn’t it?

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