Why Do We Need Estate Planning?

Why Do Estate Tax Planning?

  • Protecting lifestyle and cash needs of surviving spouse;
  • Protecting liquidity of estate and to provide for estate taxes and other expenses due within 9 months of death;
  • Protecting inheritance of children.

The Survivor’s Choice (Disclaimer) Trust or the Unified Credit Trust

As a general rule, estate tax planning is generally recommended for those NJ residents who decease with assets with a date of death value in excess of $675,000, which is the threshold for New Jersey estate tax filing and possible estate tax liability.  For those clients who are not domiciled in New Jersey, the value of the estate is generally those that are in excess of the federal exemption amount, in excess of $5.43 million.

The uncertainty which has prevailed in federal estate tax law since the passage of the massive federal tax legislation which took effect on January 1, 2002, has led those of us who practice in the estate tax planning arena, to re-evaluate how we do traditional federal estate tax planning.  New Jersey, on the other hand, has held the line on the artificially low estate tax exemption threshold used under federal estate tax law in 2001.  Although there are bills in the NJ legislature which would increase the estate tax threshold to $1 million, no bill has passed.

On January 1, 2013, Congress passed, and the President signed, on January 2, 2013, The American Taxpayer Relief Act of 2012 (the “Act”), a permanent fix for the federal estate tax rules so that the federal exemption amount, adjusted for inflation after 2011 means that a person who dies in 2015 can transfer up to $5.43 million (or $10.86 million for a married couple, as adjusted by lifetime taxable gifts) at death without incurring any federal estate taxes.  The Act permanently capped the maximum estate and GST tax rate at 40% and also makes the concept of portability of the estate and gift tax exemption amount, permanent.  However, the GST exemption amount is not subject to portability.

Prior to the passage of the estate tax legislation, estate tax planning for estates in excess of $675,000  was generally performed with the use of the Will which included the Tax Credit Trust, Unified Credit Shelter Trust, By-Pass Trust or “A”/”B” Trust.  Prior to the permanent passage of the $5 million exemption amount, and even now, with Congress’ propensity to tinker with the tax code, we always have some uncertainty in the federal estate tax area.  Whether to use the Credit Shelter Trust, traditional for years in federal estate tax planning, or the “Survivor’s Choice Trust”, will likely depend on the particular facts and circumstances of your client’s estate plan, whether federal or state driven.

The “Survivor’s Choice Trust”, unlike the Credit Shelter Trust, provides the surviving spouse with greater flexibility in determining just how much of the decedent spouse’s estate should be left outright to the surviving spouse and how much should be left in trust to be sheltered by the existing exemption amount.  However, the Survivor’s Choice Trust also places a greater burden on post-mortem estate tax planning with respect to decisions to be made by the surviving spouse as well as the professionals who are assisting, such as the attorney, accountant or certified financial planner.   In addition, there is a greater emphasis on the timing of the post-mortem planning since a qualified disclaimer (pursuant to Internal Revenue Code Section 2518) must generally be filed with the appropriate surrogate court within nine months after date of death.  If a disclaimer is to be used solely for state purposes, and not to be qualified under IRC Section 2518, the NJ Surrogates’ Court has permitted the filing of a disclaimer beyond the nine month period.

The Survivor’s Choice Trust provides the type of flexibility that the Credit Shelter Trust does not with respect to the needs of the surviving spouse.  With the Credit Shelter Trust, a set amount of assets was required to be transferred into the trust, usually by way of a formula.  With the uncertainty of what type of legislation Congress will pass hopefully pass in the next few years, the use of the Credit Shelter Trust might create a situation where the amount required to be transferred into the trust is more than is needed under current law at the time of death.  As a result, the surviving spouse does not have the ability to access the needed inheritance which is now in a trust controlled by a trustee, albeit, friendly in most cases.  With the Survivor’s Choice Trust, it is the surviving spouse who determines how much of the decedent spouse’s estate is transferred outright and into the trust, thereby permitting the surviving spouse the needed assets and control of the flow of funds.

The Survivor’s Choice Trust is only one vehicle used to reduce federal estate taxes.  When one or both spouses have life insurance, the irrevocable life insurance trust should be considered.

Irrevocable Life Insurance Trust

The irrevocable life insurance trust is the owner of the life insurance policy on the life of the insured and is also the recipient of the life insurance proceeds which would otherwise be included in the estate of the spouse who owns the policy.  Since the life insurance trust is a separate entity, the life insurance proceeds, when payable to the trust as the beneficiary, is not included in the estate of either spouse but passes to the children (or other beneficiary) after providing the surviving spouse with income for life.


Gift-giving is one effective way of reducing the estate.  Under Rev. Proc. 2012-41, the annual gift exclusion amount went up to $14,000 ($28,000 if married and the non-giving spouse elect to make a gift of $14,000 as well).  This is the first time there has been an increase in the annual gift exclusion since 2009.   If the value of the gift given to a donee is in excess of $14,000 ($28,000 if married), the donor will be subject to gift tax although whether the donor actually sends a check to the IRS will depend on several factors, such as how much of the lifetime gift exemption has previously been used..  The amount of the gift will be reflected in the value of the estate at death and the unified tax credit given to the estate will be reduced accordingly.  With respect to GST planning, the Act makes permanent the unification of the estate tax and GST tax exclusion amounts.  For 2015, a person can transfer up to $5.43 million to grandchildren without paying any GST tax.

Intentionally Defective Grantor Trust (“Idgt”)

Sophisticated estate tax planners have long used the oddly named intentionally defective grantor trust (IDGT) as an effective estate planning tool. The IDGT can freeze the value of an asset for estate planning purposes, while effectively transferring funds out of the estate free of gift taxes. The IRS, with one caveat, recently reaffirmed this planning technique (see Rev. Rul. 2004-64).

How The Idgt Works

Example: Individual G creates an irrevocable inter vivos trust as the grantor, using an unrelated third-party trustee. He then sells to the trust an asset which is likely to appreciate, in return for an installment note (usually with a balloon payment), bearing an interest rate at the applicable Federal rate (AFR). The trust beneficiaries are G’s heirs. To make certain that the asset’s fair market value is reflected by the installment note, G has the asset appraised. This ensures that the transfer is not treated as a gift under Sec. 2512(b).  If G has no seed money (some commentators have suggested that 10% of the value of the asset to be purchased should be the “seed” money gifted to the trust initially by G) to fund a purchase of the asset by the trust, then, in certain circumstances, G can transfer the property to the trust, thereby triggering the unified gift exemption amount and causing the filing of a gift tax return for the year in which the gift to the trust was made by G.

By intentionally retaining a minor power (discussed below), G triggers the Sec. 671 grantor trust rules, causing the trust’s net income to be taxed to G (in the same way as a revocable living trust). Some of the more commonly retained minor powers that trigger these rules include G’S rights under Sec. 675(4) to substitute property of equal value for the property originally transferred, and to borrow from the trust without adequate security under Sec. 675(2).

Although the ‘trust is disregarded for income tax purposes (i.e., all income from the trust asset is reported by G directly on his individual return, and the gain on the sale, as well as the interest income/expense on the installment note, is completely disregarded), the transfer is respected for estate tax purposes (i.e., the asset is no longer in G’s estate); for such purposes, G owns an installment note.

Because G must report the asset’s income, he must pay the related income tax. Thus, while the asset’s future appreciation and any income received from it grow shielded from estate tax, G continues to pay the income tax on the earnings accruing to the beneficiaries. By paying an expense which is economically that of the beneficiaries, the IDGT in effect allows G to make additional gifts without paying gift tax or using his annual exclusion. As a result, an asset with annual taxable income (as well as potential future appreciation) is more suitable for an IDGT than, for example, raw land or a non-dividend-paying stock.

Rev. Rul. 2004-64

For any grantor trust established after Oct. 3, 2004, Rev. Rul. 2004-64 will nullify the technique described above by including the trust assets in the grantors estate under Sec. 2036(a)(1) if the trust’s governing instrument or local law requires the trust to reimburse the grantor for the income tax he or she paid on the trust income. If the trust’s governing instrument or local law provides only that the trustee has the discretion to reimburse the grantor for taxes paid, this will not cause the trust assets to be included in the grantor’s estate, unless it can be shown that there was a pre-existing arrangement between the grantor and the trustee for such reimbursement. Thus, mast documents should be drafted by legal counsel experienced with IDGTs and local mast law.


An IDGT can often be more advantageous than the commonly used grantor retained annuity trust (GRAT), because it does not require the grantor to live for a set period of time in order to remove the appreciating asset from the estate (as is required under a GRAT).  Additionally, the AFR interest paid under the installment note, which flows back into the grantor’s estate, is less than the 120%-of-AFR annuity payment which is required under the GRAT rules.

Sophisticated taxpayers, who wish to engage in an asset freeze, while transferring additional sums free of gift tax, should consider an IDGT.

Why We Need A Life Insurance Trust

The primary role of life insurance in estate planning is to provide cash at the death of the insured in order to provide for survivor lost income, to provide for a cash inheritance and to provide for the payment of expenses of the estate of the deceased insured, including the payment of taxes at death. The Irrevocable Life Insurance Trust (“ILIT”) is a legal entity which created inter vivos which allows the insured to set aside assets, usually insurance policies, which are potentially shielded from estate taxes while making the assets available to family members immediately after the death of the insured.  The benefit of having the ILIT is the payment of estate settlement expenses and inheritance estate tax free.  In exchange for this benefit, the insured must surrender control over the insurance and any other assets held in the trust.

    1. Irrevocability – The ILIT must be irrevocable when created. Retaining the right to exercise any control over the assets held in the trust will cause the trust property to be included in your estate and subject to estate tax.  Furthermore, the terms of the trust and the beneficiary designations must also be irrevocable.  This is an important distinction in contrast to the Revocable Living Trust where a grantor always has the right to terminate, change or revoke any or all provisions of the trust.
    1. Payments of Premium; Crummy Powers – The trustee, in order to make the required premium payment to the insurance company in order to keep the policy in force, will usually receive gifts from the insured or the insured’s spouse. The whole concept of the “gifts” to the trust is to qualify the payments for the gift tax annual exclusion.  Normally, a premium payment from the insured or the insured’s spouse is deemed to be a gift of a “future interest” because the trust beneficiaries do not possess a present right to receive benefits during the lifetime of the insured.  The gift tax annual exclusion is only permitted for “present interest” gifts.  However, if the beneficiaries are given “Crummy Powers”, that is, the right of a beneficiary to request the trustee to distribute premium payment gifts of a “present interest” to them currently, the premium gifts made to the trust are considered gifts of a present interest, qualify for the gift tax annual exclusion of $14,000 for each trust beneficiary or $28,000 per beneficiary with the consent of the insured and his or her spouse.
    1. Limiting Right of Withdrawal – Under Section 2514(e) of the Internal Revenue Code (“IRC”), the right of withdrawal for each beneficiary must be limited to the greater of $5,000 or 5% of the trust corpus. This limit is necessary so that the withdrawal beneficiaries will not be deemed to have made a gift to the other trust beneficiaries when the power of the withdrawal beneficiary lapses.  In the case of only one trust beneficiary, the limitation is not a concern since a failure to exercise the withdrawal power will not result in a transfer to anyone other than the beneficiary who failed to exercise the withdrawal right.  Accordingly, the sole beneficiary can be given a withdrawal right equal to $14,000.
    1. Trustees – A major objective of the trust is to avoid having the trust assets included in the estate of the Grantor or the Grantor’s spouse. Accordingly, the Grantor cannot act as the trustee since the Grantor would retain rights over the transferred property which would cause inclusion in the Grantor’s estate.  However, to ensure some limited control over administration of the trust assets, the Grantor’s spouse can be appointed as the trustee.  However, a trust must be drafted in order to having the Grantor’s spouse as the owner of the trust.  Consequently, the trust must restrict the spouse-trustee’s powers by eliminating any general power of appointment as defined under IRC Section 2041.  In doing so, the trust also eliminates the powers under IRC Section 678 that would cause income inclusion to the Grantor’s spouse.  Consequently, a Co-Trustee must be named to exercise discretionary powers not available to the Grantor’s spouse.  There is no limitation on how many trustees may be appointed.
    1. Administration of the Trust; Taxes; Fees – Once the trust is set up, the trustee can purchase additional life insurance for the insured without having the insurance subject to the 3-year transfer rule.  The trustee accounts to the beneficiaries, usually at quarterly internals, distributes income (and any principal) at least quarterly to the named beneficiary, usually the surviving spouse and prepares or causes to prepare Fiduciary Income Tax Returns on Form 1041 if the trust has taxable income in any year.  The trust has its own Employer Identification Number issued to it by the Internal Revenue Service.  The trustee has broad powers to administer the trust and has the ability to do whatever it takes to carry out its duties as a fiduciary.  A trustee has the right to statutory fees based on income and corpus.
    1. Spendthrift Provisions – The assets of the trust are usually insulated from attack by creditors. A “Spendthrift Clause” in the trust is incorporated to protect a beneficiary from his or her own acts or indiscretions.  This includes the sale or assignment of an interest in the trust to be established for his or her benefit.  The clause will usually  protect beneficiaries from creditors in the event of a business failure or an aggrieved spouse in a divorce proceeding.
    1. Execution of Trust – There are no set rules which govern the execution of an irrevocable trust agreement under state law. Accordingly, once the agreement is drafted and is ready for execution, an attorney may want, but is not required, to have it witnessed in the same formality as one would have a will executed.
    1. Post-Execution – The attorney must advise the client to execute change of ownership forms with the insurance company who has issued the policy if existing policies are to be transferred into the trust. An attorney must review with the client which policies are in force, how to set up the checking account for the trustee, the mechanics of paying the premium and providing advice on how to give notice to beneficiaries each year with respect to the “Crummy Powers.”  Merely setting up a trust for a client and not advising with respect to the mechanics of transferring existing policies or instructions on what the trustee should do in purchasing new insurance for the client could lead to a malpractice action against the attorney.