“Zero Estate Tax” Estate Plan

Allow me to describe a plan which, if embraced, will allow you to pass a specific inheritance to your heirs while eliminating all federal estate tax. This plan we call the Zero Estate Tax Plan. Its purpose is to show how to arrange your affairs so as to minimize taxes and maximize benefits to you, your heirs and your community.

It may seem that the IRS would be opposed to an estate arrangement that reduces tax revenue. However, studies have shown that for each dollar of tax revenue given up as a result of charitable tax deductions, more than a dollar of charitable benefit is produced, thus reducing the burden on the government to fund charitable programs. It only makes sense that dollars generated and dispersed at the local level (by people who have a high commitment to their chosen charitable purposes) will be used more efficiently than if the dollars were run through big government bureaucracy. This approach is highly patriotic and perfectly consistent with recent presidential themes of volunteerism and philanthropy advocating the return of more responsibility and control to local communities.

“Involuntary philanthropy” has been described as making an irrevocable gift to the IRS (paying taxes). No meaningful control is retained over dollars paid to the government. In contrast, “voluntary philanthropy” allows the donor to exercise far more control over the distribution of the assets he/she has worked so hard to produce.

This plan also provides an inheritance to heirs, eliminates estate tax, and provides maximum control over those hard-earned assets. The arrangement outlined is just one of numerous possible strategies that could work. Any such plan should be custom designed to meet your specific needs.

Clearly defined estate planning goals are required in order to use this strategy. The result of failing to identify a desired outcome is that no plan is implemented. We all know that no plan is often the worst plan as far as taxation is concerned. Nevertheless, many delay making decisions because they are not certain what they really want to do and they want to retain flexibility or be able to change their mind (keep control). This plan accommodates those goals, but some decisions must be made at the outset.

The concept works so well because it takes advantage of seven tax benefits:

1. Charitable income tax deductions

2. Avoidance of long-term capital gain tax

3. Four-tier payout system

4. Tax-free compounding of assets

5. Charitable estate tax deductions

6. Annual gift tax exclusion

7. Tax-free compounding of life insurance cash values

Most people have never seen a similar plan before and most advisors are not aware of it because its logic is counter-intuitive. Conventional wisdom says, “Hold on to what you have as long as possible” (keep control). This plan calls for a gradual systematic transfer of wealth during life with the balance being transferred at death.

A graphic representation of a sample plan is provided on the previous page.

Implementation Steps

1. Contribute assets (often ones that are highly appreciated and low yielding) to Trust “C,” a tax-exempt charitable remainder unitrust, (IRC Section 664). The assets contributed are carefully selected as to type and value to maximize the use of this trust in your financial and estate plan. You can be the primary trustee of this trust.

2. Assets initially gifted to Trust “C” are sold by its trustee. If you are your own trustee and the assets are “hard-to-value” (e.g., real estate, closely-held stock, etc.), an independent special trustee must value them and handle the sale. After the assets are sold, the independent special trustee usually resigns. Suitable buyers of the gifted assets are those who are unrelated persons (IRC Sections 4941 and 4946) and can include a close corporation whose shares are held in the trust if certain procedures are followed carefully (see Revenue Ruling 78-197 and IRC Section 4941 (d)(2)(F)). You may direct the reinvestment of the sale’s proceeds thereby retaining the ability to maximize the economic benefits produced by Trust “C”.

3. When Trust “C” is properly drafted and managed, it is tax exempt and can sell its assets and not have to pay income taxes on any capital gain or ordinary income realized [IRC Section 664(c)].

4. Trust “C” provides you with an annual income stream for life which is based upon a selected percentage of the fair market value of the trust assets as revalued each year. Contributions to Trust “C” usually generate an income tax charitable deduction (IRC Section 170) that typically ranges from 20% to 30% of the value of the contribution; thus producing tax savings which further improve your cash flow.

5. Annual contributions are made to Trust “D,” an irrevocable life insurance trust. The purpose of this trust is to provide your heirs with estate tax free benefits which, when added to the proceeds from Trusts “A” and “B,” achieve your estate transfer objectives. If properly drafted, annual contributions to this trust for the purpose of paying life insurance premiums will qualify for the annual gift tax exclusion. This provision permits each trustor to transfer up to $10,000 per heir ( or $20,000 per heir if married trustors elected to “split gifts”) without paying any transfer tax. (See IRC Sections 2503(b) and 2513.

6. Trust “A” is often called a “spousal” or “marital deduction” trust. It is established to take advantage of the unlimited marital deduction (IRC Section 2056) to avoid estate tax at the death of the first spouse.

7. Trust “B” is known as a “bypass” or “credit shelter” trust. Because the unified credit against estate tax (IRC Section 1020) can be used to exempt up to $600,000 of assets in one’s gross estate from federal estate tax, Trust “B” serves as the repository for assets with at least this much value so they “bypass” taxation in the estates of both the client and the client’s spouse.

8. It is possible for the surviving spouse to be given a lifetime income trust in Trust “B” without subjecting its assets to inclusion in the surviving spouse’s estate.

9. At the death of the survivor, Trust “A” will pass up to another $600,000 free of federal estate tax to the client’s heirs, thus taking advantage of the survivor’s unified credit against federal estate tax.

10. The balance in Trust “A,” upon the death of the surviving spouse and after the $600,000 credit-shelter transfer is made to the heirs, is left to a qualifying charity (IRC Section 501 (c)(3)) thus eliminating any estate tax liability. In the diagram, this is referred to as a “Family Foundation.” This need not be a private foundation, but a segregated account under the tax and administrative umbrella of a IRC Section 501(c)(3) public charity such as your local community foundation.

11. The assets in Trust “B” are distributed to the heirs free of estate tax at the second death.

12. The assets in Trust “D” are distributed to the heirs at the second death, thus achieving all of your estate transfer objectives without any estate tax. The assets in this trust can also be free of generation skipping taxes if desired.

13. The assets in Trust “C” are distributed to the “Family Foundation” at the death of the last income beneficiary.

14. If assets you hope to “keep in the family” come to be transferred to the “Family Foundation” from Trusts “A” or “C,” the proceeds distributed to the heirs from Trust “D” can be used to purchase these assets from the “Family Foundation” thus returning control of specific family assets to the client’s heirs. Any self-dealing implications are avoided since the “Family Foundation” is actually a segregated account of a public charity.

15. The heirs, as directors of the Family Foundation, can direct the annual income produced by the account to the charitable causes of their choice (as long as the desired use of the funds falls within the scope of “public good” as determined by your community foundation.) A modest director’s fee can also be paid from the account. Empowering the heirs with such control over these assets will give them substantial influence and responsibility.

How to Get Started

Several important steps must be taken in the proper sequence to assure that the plan will operate properly. The number one step you should take is to enlist the services of a competent advisor who will:

1. determine your insurability, if applicable;

2. custom design the plan;

3. arrange for the trust documents to be drafted and establish the “Family Foundation”;

4. oversee the sale of assets in Trust “C,” when appropriate, and;

5. help reinvest the sale’s proceeds in an investment portfolio designed to accomplish your objectives.

The advisor should also be prepared to enlist the services of:

1. an independent special trustee and a qualified appraiser when hard-to-value assets are to be contributed;

2. a third party administrator which specializes in the administration of Charitable Remainder Trusts and who will give the client maximum control and flexibility, and;

3. an attorney who is thoroughly familiar with the Charitable Remainder Trust, its unique administrative requirements, and its applications in estate and tax planning.

Which of these ideas has application in your situation remains to be seen. The estate planning process is like a puzzle that begins with identifying the desired outcome that you would like to achieve. Our experience in this process is invaluable to helping you reach the appropriate outcome.