United States: Strategies To Reduce Estate Taxes

According to the old adage, there are two things in life you can't avoid - death and taxes. And while you certainly can't avoid the former, there are a number of legitimate ways to minimize the latter.

The traditional approach to estate planning was to leave everything to your heirs at death through your Will. Given that estate tax rates top out at a whopping 55%, this approach guaranteed that in large estates the IRS would end up with more assets than the family after both spouses passed away.

Recently, people have come to recognize that estate planning means more than drawing up a Will. In fact, the greatest tax savings are achieved by estate planning you carry out during your lifetime, not at your death. Here are some of the most popular and tax-efficient strategies to transfer wealth to the next generation and reduce your family's ultimate tax burden.

One of the simplest and most effective ways to save taxes is to start a gifting program when your children are young. First, you should take advantage of the "annual exclusion" which allows you to give an unlimited number of people $10,000 each year (or $20,000 if you are married) free of tax. In addition, under current law you can give up to $675,000 (the so-called "unified credit" amount) or double this amount if you are married, without incurring gift tax. Over the next six years, the unified credit is increasing in stages so that by 2006 you can give away $1,000,000 (or $2,000,000 if you are married) free of tax. Once you have made a gift, all of the future appreciation and income on the gifted property will grow in the hands of the younger generation and will escape the onerous estate tax at your death. Obviously, the most attractive assets to transfer to your children are those with the greatest potential for significant appreciation, such as an interest in an early stage company or employee stock options.

Gifting assets to a family trust may make the most sense. If the trust is drafted properly, you can contribute $10,000 each year to the trust (or $20,000 if you are married), even though your children may not receive the trust property for many years to come. You can also use your unified credit to fund the trust without paying any gift tax. The property in the trust can then accumulate and grow for the future benefit of your children and perhaps even grandchildren.

Trusts offer a distinct advantage over "UGMA" or "UTMA" custodian accounts because all of the property held in custodian accounts must be distributed outright to your children when they turn 21 (or 18, in some states), no matter how large the accounts are at that time. With a trust, you can decide the ages at which your children should receive the assets, or you can give your trustee discretion as to when and whether to make distributions. The more flexible approach is often desirable, since it is very difficult to predict the age at which your children will be financially responsible and mature enough to handle funds.

The creation of a family limited partnership ("FLP") has become an increasingly popular technique for long-term estate planning. The structure of an FLP is actually quite simple. First, you contribute assets to an FLP in exchange for limited partnership interests and a small general partnership interest. Then you give or sell some or all of your limited partnership interests to family members (or trusts for their benefit) while retaining the general partnership interest.

Your family members will have ownership interests in the FLP, but they will have no right to control partnership affairs. Because you retain the general partnership interest, control and management remains with you as the general partner.

The FLP allows you to reduce your taxable estate by giving assets to family members, while retaining control of the assets and the income they produce. Moreover, because your family members lack control, and because of the illiquid nature of their minority partnership interests, the value of the interests you transfer can be substantially discounted from the value of the underlying assets that you contribute to the FLP.

Because of the extensive use of FLPs in recent years, the IRS has mounted numerous attacks against their use, and continues to scrutinize FLP transactions closely, especially where aggressive discounts re taken and the FLP holds only passive investment assets. In order to minimize the risk of a dispute with the IRS, it is extremely important to have an independent appraisal that supports the amount of the discount as well as the value of the underlying assets.

Non-statutory stock options have enormous potential for future appreciation. Under the right circumstances, an option-gifting strategy can be a tremendously effective way for an employee to transfer wealth to the younger generation. Many stock option plans now permit employees to transfer their options to immediate family members, and sometimes family trusts and partnerships as well. The ideal time to make a gift is right after the options vest (i.e., become exercisable) when they are still "out-of-the-money" and have several years to run. The value of the options for gift tax purposes will be extremely low compared to what the family members may ultimately receive upon exercise.

When the family member exercises the options (typically in a cash-less exercise), the employee, if living, will recognize income equal to the spread between the exercise price and the value of the stock purchased on the date of exercise. This is in effect a tax-free gift by the employee because the family member will receive the stock with a basis equal to the stock's fair market value on the date of exercise. Therefore, if the stock is sold on or shortly after exercise, there will be little or no capital gain.

As you can see, some of the most effective strategies to minimize taxes are still the simplest. But if you don't take advantage of the techniques that are available during your lifetime, it is your family who will pay the price at your death.