Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail
Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail

Reduce Your Federal Estate Tax With These 4 Powerful Estate Planning Tools

As you already know, more and more successful Baby Boomers are preparing for retirement, making it more important than ever that they understand the sophisticated (and legal!) tools available to protect their estates.

This course will give you priceless strategies for protecting your estate from the death tax. If you're already retired, now is the perfect time to ensure your financial legacy pans out exactly the way you intend. If you're still building your wealth, this will give you a roadmap for providing for your children and grandchildren far into the future.

But before we move on, let's take a look at what happens when estate planning goes wrong. This letter was written by a fifth-generation rancher from Llano, Texas and originally posted here on the Policy & Taxation Group website:

To Whom It May Concern:

My name is Clayton and I have a story to tell. In the 1860’s my great-great grandfather was a cattleman. He had moved from England to Virginia and from Virginia to Texas. He began leasing land from landowners to graze cattle, all the while saving his money.

Gradually, as he saved more and more, he began purchasing small tracts from the people he was leasing from and over his lifetime he had purchased several thousand acres through hard work and frugal living, the typical American dream.

When he passed away the land then went to his children. His children continued the ranching tradition and passed it on to his five children (one of which was my grandmother). My grandmother passed away in 1997 and unbeknownst to my father (or my grandmother at the time of writing her will), he suddenly had to pay a tax, 38.5% of the estate minus a $1mil deduction, on the appraised value of the land that her grandfather had worked so hard to purchase, protect, and work. At the time, no one even knew the value of her estate because its value was in what it could produce, not what it could sell for. Her estate didn’t have many liquid assets or a large amount of cash that could pay this new debt to the IRS. So, my father set up a payment plan and began working to pay it off.

We fast forward to the Summer of 2006. My father began to get ill and since the estate tax of my grandmother had become such a burden and such a large part of our family life we got together with a team of attorneys, CPA’s, and tax planners to try and avoid the dreaded estate tax should something happen to my father. In November 2006, my father passed away. We had a written plan on how to structure the family ranch, but the majority of it we didn’t get to put into practice in enough time to steer clear of the estate tax.

So, once again, my father’s will stipulated that the family ranch would go to my brother and me. We would be the 5th generation to own and work this land. But, we had to pay for inheriting what he fought to hold on to…again! And once again, my father didn’t have much saved cash or liquidable assets. What few liquid assets he had were quickly spent on CPA’s, tax attorneys, surveyors, and appraisers to determine what we owed the IRS. So, we were forced to set up another payment plan with the IRS.

We are now burdened with two estate tax payments every year. One for my grandmother’s estate (from 1997!), and one for my father’s estate. We will be making these payments for the next 15 years. So, not only are we trying to make a small family business in ranching profitable for ourselves, we are now trying to make it profitable for the IRS so that it doesn’t end up as federal land.

For five generations my family has worked this land. Five generations have poured their blood, sweat, and tears into this land, this family business. We have diligently paid our local, state, and federal income taxes. We have sowed into our local, state, and national economy. But because we’re now defined as wealthy according to someone else’s definition of the word, it will be next to impossible to preserve our family heritage for another generation.

Thomas Jefferson once said: “A wise and frugal government, which shall restrain men from injuring one another, which shall leave them otherwise free to regulate their own pursuits of industry and improvement, and shall not take from the mouth of labor and bread it has earned. This is the sum of good government.” Ask yourself if our story is one that represents the sum of good government.

Thank you for your time.

Sincerely,
Clayton T. Leverett

Now that we've put the importance of estate planning into perspective, let's get to the powerful techniques that can help you avoid Mr. Leverett's tragic outcome.

The 4 Basic Ways You Can Reduce Your Tax Bill

To reduce your estate tax bill, you have 4 choices:

1. Leave it to your spouse. In general, any assets left to your spouse are exempt from estate tax.  That's good. But once again you're faced with what happens to the estate when your spouse passes. So you still haven't resolved the original problem.

2. Give it away while you're alive. We'll show you how with a little-used business structure called a family limited partnership (FLP).

3. Create a trust.  A trust confers to beneficiaries all the best aspects of asset ownership (namely, income streams) but shields them from all the bad (estate taxes, creditors, even income taxes).  We'll give you all the information you need to get started.

4. Leave it to charity. You've built up your estate and now you're ready to see it put to good use. Did you know there are plenty of benefits to take of advantage of while you're still living? We'll show you two structures for the investment hat trick: increased income, reduced taxes and the creation of a charitable legacy you can be proud of.

If you own your own business, you also need to take additional steps to ensure that the legacy you've spent your life building will serve your heirs well. So in addition to the Powerful Estate Planning Structures, we'll include a brief overview of strategies for the successful entrepreneur in our bonus feature, Entrepreneurs & Estate Planning: Protecting the Golden Goose.

FLPs: An Estate Planning Tool That Keeps You In Contol

Many of today's family patriarchs and matriarchs are interested in estate planning options that balance two often contradictory goals: maintaining tight control of assets during their lifetimes while minimizing estate and income tax consequences.

A Family Limited Partnership (FLP) allows you to accomplish both.

What Is a Family Limited Partnership?

An FLP is a legal entity. Instead of "shares," members own an "interest" in the partnership.

If you're already familiar with limited partnerships, then you're up to speed on the structure of the family limited partnership. A family limited partnership is simply a limited partnership with members who are all part of one family.

If you're not familiar with limited partnerships, here's a brief overview.

A limited partnership is an entity controlled by a general partner (GP). The GP is responsible for all decision-making, from minor clerical work and accounting duties to major decisions like asset sales/purchases and partnership distributions.

The GP typically only holds 1% to 5% of the total ownership in the limited partnership; nonetheless, they wield complete control over the underlying assets.  Most of interest in a limited partnership, up to 99%, is owned by the limited partners (LPs). LPs are "limited" in that they don't get to make any decisions. They are completely passive members.

Why would a partner give up decision-making power? The answer is liability. In a limited partnership, the limited partners are shielded from liability if the partnership is sued. 

How Do You Set Up an FLP?

Typically, the senior generation creates an FLP and becomes its general partner. The FLP then becomes the owner of whatever assets the general partner places in it. In exchange for contributing these assets to the FLP, the general partner receives 100% of the interest in the FLP. FLPs can hold stocks, bonds, bank accounts, mutual funds, real estate (in the form of REITs), and life insurance policies as well as other family heirlooms and assets like gold, silver, fine art, and other collectibles.

Now, since the whole point of this exercise is to provide for the next generation of family members, the GP gives away portions of its interest in the FLP to the members of the next generation. If there are 19 heirs, perhaps the GP will decide that each LP will ultimately receive 5% ownership of the FLP, with the GP retaining 5%. The general partner distributes the ownership interest to the LPs over time according to annual and lifetime gift tax exclusions. LPs can be children, grandchildren and even great-grandchildren.

What Else Can An FLP Do?

The primary goal of an FLP is to reduce income and estate taxes.

Using an FLP allows money above estate tax thresholds to be transferred to the next generation, free of estate taxes. The FLP also confers income tax advantages. Income distributions can be spread among family members who may be in a lower income tax bracket and they are an effective way of further transferring value to the next generation, over and above the allowed annual and lifetime gift tax exclusions.

Moreover, all future asset appreciation within the FLP occurs in the estates of the younger generation and will not be subject to estate taxes until their deaths, which barring unforeseen tragedy is far in the future. There will be no tax due on that appreciation when the GP dies.

But there are several other advantages to consider.

  • An FLP allows you to transfer the ownership of your assets to your heirs without relinquishing control of the assets.

  • Assets held in an FLP are largely protected from lawsuits, creditors and divorces.

  • By consolidating all family-related assets into one legal entity, the transfer of assets is simpler both during your lifetime and upon your death.

  • Continuous family ownership of assets is assured.

Because the GP can retain control of the assets being transferred, this is an ideal approach to use when the senior generation is not ready to transfer control to the younger generation. Even with ownership as small as 1%, the GP has total control over management decisions, investment of assets, and distribution of income.

If the family specifies it in the wording of the FLP, control can be transferred gradually to a new GP over time. This is an especially useful feature because control can be transferred to a new GP while ownership percentages stay the same.

FLPs also provide asset protection. Because the partners do not personally own the assets placed in the partnership, creditors can have a very difficult time getting their hands on those assets. That’s because the asset actually owned by the partner is the partnership interest. A court order is required for relinquishing partnership interests, and even then, the creditor only gets paid with the income from the FLP. Under the law, creditors can't demand distribution from the FLP or become a partner.

The consolidation of family assets simplifies the ongoing management and the eventual transfer of assets. Instead of gifting specific assets on an annual basis, interests in the FLP are transferred, resulting in a simplified, transparent and consistent approach to gifting.

When putting together an FLP, seek the help of experienced legal counsel, who can answer your questions and make sure your FLP is structured properly. Death may be unavoidable, but with an FLP, taxes certainly aren’t.

 

Shield Your Wealth With a Trust

What will happen to your hard-earned wealth when you're gone? Since you can't take it with you, you may want to set up a trust. 

A trust is a legal entity created when a person puts assets under the control of a third-party, with the ultimate goal of providing benefits to (aptly-named) beneficiaries.

When assets are placed in trust and transferred to a trustee, the assets actually become the trustee's property but without conferring the benefit of asset ownership. In other words, the trustee is a temporary steward of the assets, the legal owner, but in name only. The trustee must manage the assets according to the parameters of the trust's instructions, otherwise known as the "deed."


Any asset or investment can be placed into a trust, making them powerful estate planning tools. First, transferring your assets to a trust effectively shields them from creditors. For example, if you found yourself unable to pay back a loan you had personally guaranteed, the lender could file a personal claim against you and come after all your personal assets. But if your personal assets had been placed in a trust, the plaintiff couldn't touch them.

Trusts can also reduce your tax bill. Income earned by a trust is taxed at 33%, the same as the rate paid by corporations but lower than the highest existing marginal rate (39%) for individuals.

Generally speaking, there are two basic types of trusts: fixed and discretionary. In a fixed trust, the deed fixes the number of beneficiaries and their shares. It's the simplest and most straight forward of trusts. For example: wealthy parents may set up a trust for a child to make sure that the child is adequately cared for if the parents die.

Discretionary trusts give trustees the latitude to decide who may be a beneficiary and what each beneficiary's share should be.

Regardless of whether it's fixed or discretionary, a trust always has four basic components. Keep in mind that it's common for there to be multiple people assigned to each category:

1) The settlor -- the creator of the trust.

The settlor must be an adult (defined in this case as age 20 or over) and of sound mind. The settlor is often an individual, but it can also be a corporation or another trust.

2) The trustee -- to whom nominal ownership of the assets is transferred.

Any individual who is able to own property is qualified to be a trustee. A minor (anyone under 20) is eligible to be a trustee, but a court must appoint a surrogate to act as trustee until the minor turns 20.

If a trustee violates his or her duties as spelled out in the trust deed, the law defines this as "breach of trust."

3) The beneficiary -- who ultimately benefits from the trust.

Beneficiaries are typically immediate or extended family members, although trusts can also name other trusts as beneficiaries – say, an environmental or animal rights trust.

Only beneficiaries are legally allowed to bring court action against trustees for breach of trust.

4) The trust deed -- the legal document that established the trust and controls how it is managed.

This trust deed delineates:

  • the category and mission of the trust
  • the parties involved
  • the trustees' ability and discretion to invest the trust's assets
  • requirements for decision-making by the trustees
  • how the trust's bank account is to be operated
  • the recording of minutes when trustees meet to discuss and make decisions

Trustee decisions must be unanimous, unless the trust deed explicitly makes an exception and grants the right to make decisions based on a majority vote. At all times, trustees must keep accurate minutes – i.e., records of their meetings and decisions.

Trustees can get compensated for their time and effort in managing the trust, but the trust deed must make it clear that compensation is provided. A trustee can't be held liable for any losses incurred by the trust.

As you should with any of the structures introduced in this tutorial, if you decide it's time for you to set up a trust, make sure you confer with an attorney experienced in estate planning.

 

The Estate Planning Hat Trick

As we mentioned in our article on 3 Billionaire Habits, successful investors often have a desire -- bordering on a compulsion -- to donate their wealth to a charitable cause.

Luckily, charitable giving bestows financial as well as emotional benefits, and you don't have to be a billionaire to get them. If you want to increase your income, lower your taxes, and create a charitable legacy, you can pull off this estate planning hat trick by setting up a Charitable Remainder Unitrust (CRUT).

By setting up a CRUT, you commit to passing assets to a charity, but give yourself the flexibility to earn income from the donated assets while you're still living. 


Most successful investors have assets that have appreciated considerably since the day they were first purchased.  But when it comes time to sell, the tax bill can make you choke. 

The key goal of the CRUT is to sell a highly appreciated asset without paying capital gains tax on the profits. But along with the tax savings on capital gains, a CRUT delivers other benefits, like boosting income and diversifying portfolios. Moreover, a charitable deduction provides immediate income tax savings.

CRUT Basics

The owner of the appreciated asset is the "donor." The charity to which the donor wishes to gift the asset is called the "charitable beneficiary." The charitable beneficiary must always be an IRS-approved charity.

The "trustee" of the CRUT can be the donor, a charity, an independent trust company or another person designated by the donor. Anyone who receives income from the asset under the terms of the CRUT is called an "income beneficiary." Donors can be income beneficiaries.

The trust must name the trustee, the charitable beneficiary, the percentage to be paid to income beneficiaries and the term of the trust. The trust must also specify the annual percentage to be paid out to the donor. This amount must be between 5% and 50%. The percentage calculated must also provide for a minimum charitable deduction of 10% of the amount transferred to the CRUT.

How CRUTS Work

Generally speaking, here's how a CRUT works:

Prior to any sale, the donor transfers the asset or assets into the trust. Just about any type of asset can be contributed to a CRUT: stock, bonds, real estate, collectibles, etc. Then, the trustee -- who also can be the donor -- sells the asset, reinvesting the proceeds in whatever financial instrument is appropriate.
 
The trust's term can extend for the life of the donor, or for the life of the donor and another individual, typically a spouse. The term's parameters also can be set according to years, up to 20 years.

The trust also can be structured to accumulate distributions if annual income is insufficient to cover the distribution. This is an effective retirement planning tool if your goal is to generate income in future years, because an even higher amount can be paid out at that time. This long-term strategy can also be used to provide educational funds for children or grandchildren.

The trustee continues to manage the trust throughout its term, making investment choices and distributions to the income beneficiaries. Upon the death of the income beneficiaries, or upon reaching the term's pre-set time limitation, all the funds remaining in the trust are disbursed to the charitable beneficiary.

Savings and Benefits

The tax-savings are significant, and two-fold:

1) An immediate income tax deduction for the present value of the future gift.

Note that you must follow IRS guidelines for calculating this amount. The deduction varies based on the term of the trust, the monthly Applicable Federal Rate (AFR) published by the IRS, the distributions being paid out to the donor during the term, the frequency of the distributions, and the amount contributed. This deduction must equal 10% of the value contributed to the CRUT. The guidelines are complicated; you'll need to consult a tax attorney.

2) No capital gains taxes.

The CRUT is tax-exempt, which means there are no taxes due upon the sale of the asset. This allows you to reinvest 100% of the proceeds into another financial instrument. Because none of the proceeds are skimmed off by the tax man, you can generate higher income than would be available through an outright taxable sale.

To learn more about how to be smart when donating to charity, check out our popular educational article, Shrewd Philanthropy: How to Give Without Getting Taken.

 

Entrepreneurs & Estate Planning -- Protecting the Golden Goose

Typically, entrepreneurs consider their businesses a permanent meal ticket for their kids and grandkids.

 

Not so.

 

After years of blood, sweat and tears, many small business owners only have the business to show for it. And sometimes, not even that. Consider this sobering statistic: More than one million new ventures are launched each year in the United States. By the end of the inaugural year, only 60 percent are still operating. Within five years, only 20 percent will be in business; by the 10-year mark, only 4 percent. In other words, only 4 out of 100 survive the decade-long demarcation.

That's why, if you currently run a business, you should think about your exit strategy, vis a vis your

estate. Entrepreneurs tend to be visionaries who get caught up in the day-to-day details of running their businesses; they care more about creative fulfillment and "empire building" than about such ostensibly mundane matters as estate planning. Don't fall into that trap.

Many small businesspeople and/or their heirs are taken aback when they discover the components that the government counts when calculating their taxable estate. When adding up the value of your estate/small business, be sure to take into account the following:

  • The potential tax obligations tied to the death of the owner;

  • Full value of the property of which you are the sole owner;

  • Half the value of the property you own jointly with your spouse with right of survivorship;

  • Your share of property owned with others, such as partners and family;

  • If you live in a community property state, half the value of community property;

  • The value of proceeds of any insurance policy on your life, provided that you own the policy;

  • Your interest in vested pension and profit-sharing plans;

  • Money due to you by creditors, such as mortgages, rents, and any accounts payable for past products and services rendered.

Also ask yourself: Have you developed a specific plan in your will to provide for your heir(s) if it becomes necessary to liquidate the business after your death?

One more thing to consider is your business structure. If you don't establish a business structure that fits your circumstances right from the start, you could hobble your future estate planning opportunities.

As a general rule, if your business is a start-up or is planning to lose money during its initial phase, consider a Sole Proprietorship for the sheer sake of simplicity. As soon as your firm starts turning at least a small profit, convert to an S-Corporation to take advantage of the pass-through status, the liability protection and the ability to save on Federal Insurance Contribution Act (FICA) taxes, which include contributions to federal Social Security and Medicare program taxes. Once you're firmly in the black, a C-Corporation will address any liability concerns and you can avail yourself of the different tax brackets between your corporation and your personal taxes.

Remember, an overall lower tax burden also creates a business with a greater intrinsic value. That's an important consideration, when planning your estate.

Business structure is a highly complex aspect of entrepreneurship and you need to get it right. Consequently, consult your tax attorney for details. By heeding these basic guidelines, you can make sure that your "golden goose" doesn't turn out to be a cooked one.

 

Like the proverb says, most of us don't plan to fail, we fail to plan. And if you want financial security, the only way to get it is through a good plan. Click here to read Eight Steps to Creating a Financial Plan, and you'll be well on your way.