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CALIFORNIA ESTATE PLANNING
Estate planning in California for most individuals includes consideration of a number of important goals and objectives. First, providing for disposition of your assets in the manner which you decide. Second, avoidance of a probate proceeding as appropriate. Third, minimizing estate taxes on first and second death. Fourth, providing for decision-making on your behalf in the event of incapacity. If you (or your spouse) are not a US citizen the applicability of United States (California) and foreign law to these issues must be analyzed as well, including the effect of tax treaties and protocols between the United States and the country of your citizenship. Finally, the character of your property under California law (separate property or community property) needs to be considered in light of any ante-nuptial (premarital) agreement.
Probate Avoidance
Probate can be avoided by using a revocable trust to hold all of your assets (the character of property remaining the same as when contributed - community property or separate property). During your lifetimes the trust can be revoked or amended if both of you agree, and you will serve as trustees of the trust. After first death, the trust can be amended or revoked by the surviving spouse only as to the assets of the surviving spouse and any assets of the decedent given to the surviving spouse. The surviving spouse usually serves as trustee after first death. On second death an individual or institution is named as successor trustee and has responsibility for distribution of the trust assets to your beneficiaries. All of the entities which are formed as part of the asset protection plan will be held by the trustees of the trust, as will all other assets which do not have beneficiary designations and thereby avoid probate by contract.
Wills, Durable Powers of Attorney and Advance Health Care Directives
As part of the estate plan, wills should be executed by both of you to provide for any assets that are not in the revocable trust (by providing that such assets will be distributed in accordance with the trust provisions) and to nominate a guardian for your children in the event both you and your wife are not living. Each of you should execute a springing durable power of attorney for asset management (to take effect on incapacity) naming an agent to manage your assets if you are unable to do so and an advanced health care directive (also referred to as a ?living will?) to determine who will make health care decisions if you are unable to do so and to provide guidance as to specific health care issues.
ESTATE TAXATION
The U.S. estate tax is generally imposed upon the value of all property comprising a decedent?s (deceased person?s) estate. As further described below, there are exclusions available where the surviving spouse is a US citizen and to others based on an exclusion amount which was $3.5 million in 2009.
Availability of the Marital Deduction
A very significant deduction and planning tool normally available to estates is the so-called ?unlimited marital deduction.? The unlimited marital deduction allows the estate a deduction equal to the value of all property passing to a surviving spouse. Therefore, if all estate assets pass to a surviving spouse no estate tax is due (although the assets may be subject to estate tax upon the later death of the surviving spouse). However, the estate of a decedent is entitled to the unlimited marital deduction only if the surviving spouse is a U.S. citizen.
If the surviving spouse is not a U.S. citizen, transfers qualify for the marital deduction only in two limited circumstances: (1) the surviving spouse becomes a U.S. citizen before the U.S. estate tax return is filed, and was domiciled in the U.S. between the date of the decedent?s death and the surviving spouse?s naturalization; or (2) the property passes to a qualified domestic trust (QDOT) or similar contractual arrangement for the benefit of the surviving spouse.
The QDOT serves to defer the decedent?s estate tax due until a later triggering event. The actual taxation of the QDOT occurs at estate tax rates otherwise available to the decedent, thereby allowing the decedent?s estate to take advantage of the lower marginal rates. Triggering events resulting in taxation include the death of the surviving spouse, the termination of the trust as a QDOT, or any distribution of principal from the QDOT during the surviving spouse?s life, except mandatory distributions required to qualify as a QDOT and distributions of trust principal ?on account of hardship.?
Availability of the Lifetime Exclusion
Under current U.S. law citizens and residents are also entitled to an exclusion from estate taxes of $2,000,000 for 2006-2008 and rising to $3,500,000 by 2009 before the estate tax is scheduled to be eliminated in 2010 (only to be reinstated in 2011 if the U.S. Congress does not act to permanently eliminate the estate tax). This affects any amounts which are given to a nonspouse (children, grandchildren or others) on first death. See our page on federal estate taxes
Sample Alternate Dispositive Provisions - Married Couple with Minor Children
Assuming that the married couple's intentions with regard to disposition of their estates on second death are for all of their property to pass to their children, if they are minors at that time (this assumes the premature death of both parents before they have completed college) the assets will be held in trust until they reach designated ages. If either or both of the children are not living on second demise, the usual provision is for that child?s share to be given to that child?s children in equal shares. If there were no children of that child, the share would go to the other surviving child. Alternate beneficiaries should also be considered in the unlikely event that none of the children (or any children they may have) are alive on second death.
With regard to first demise, taking into account possible estate tax savings, there are several possible dispositions:
1. All property of the decedent (the decedent?s share of community property and the decedent?s separate property) is given outright to the surviving spouse.
A. There is no estate tax on first death as a result of the unlimited marital exclusion for transfers to a spouse during life or at death.
B. On second death the estate will be reduced only by the nonspousal exclusion ($2,000,000 for 2006-2008, $3,500,000 in 2009) for the second spouse to die.
2. All property of the decedent (the decedent?s share of community property and the decedent?s separate property) is given to a QTIP trust for the benefit of the surviving spouse.
A. There is no estate tax on first death as a result of the availability of unlimited marital exclusion for transfers at death to a QTIP trust.
B. The property in the QTIP trust remaining at second death is already given to children.
1) During the lifetime of the surviving spouse the surviving spouse receives income and can use principal for ?health, education, maintenance, and support?.
C. On second death the estate will be reduced only by the nonspousal exclusion ($2,000,000 for 2006-2008, $3,500,000 in 2009) for the second spouse to die.
3. An amount equal to the nonspousal lifetime exclusion from estate taxes ($2,000,000 for 2006-2008, $3,500,000 in 2009) is given to a Bypass trust for the benefit of children and all remaining property of the decedent (the decedent?s share of community property and the decedent?s separate property) is given to a QTIP trust for the benefit of the surviving spouse.
A. There is no estate tax on first death as a result of the availability of:
1) The nonspousal lifetime exclusion from estate taxes ($2,000,000 for 2006-2008, $3,500,000 in 2009) for the Bypass trust ; and
2) The unlimited marital exclusion for transfers at death to a QTIP trust.
B. The property in the Bypass trust remaining at second death is already given to children.
1) During the lifetime of the surviving spouse the surviving spouse receives income and can use principal for ?health, education and support?.
C. The property in the QTIP trust remaining at second death is already given to children.
1) During the lifetime of the surviving spouse the surviving spouse receives income and can use principal for ?health, education, maintenance, and support?.
D. On second death the estate will be further reduced by the nonspousal lifetime exclusion from estate taxes ($2,000,000 for 2006-2008, $3,500,000 in 2009) for the second spouse to die.
E. The amount to be given to the Bypass trust can be a fixed amount, rather than the maximum available nonspousal lifetime exclusion applicable in the year of the first death.
4. All property of the decedent (the decedent?s share of community property and the decedent?s separate property) is given to a QTIP trust for the benefit of the surviving spouse.
A. The surviving spouse has the option to disclaim any part of the decedent?s property, in which case such property is given to a Disclaimer trust (identical in provisions to a Bypass trust) for the benefit of children.
B. There is no estate tax on first death as a result of the availability of:
1) The nonspousal lifetime exclusion from estate taxes ($2,000,000 for 2006-2008, $3,500,000 in 2009) for the Disclaimer trust; and
2) The unlimited marital exclusion for transfers at death to a QTIP trust.
C. The property in the Disclaimer trust remaining at second death is already given to children.
1) During the lifetime of the surviving spouse the surviving spouse receives income and can use principal for ?health, education and support?.
D. The property in the QTIP trust remaining at second death is already given to children.
1) During the lifetime of the surviving spouse the surviving spouse receives income and can use principal for ?health, education, maintenance, and support?.
E. On second death the estate will be further reduced by the nonspousal lifetime exclusion from estate taxes ($2,000,000 for 2006-2008, $3,500,000 in 2009)for the second spouse to die.
Lifetime Gifts
Under federal tax law an individual can give up to $13,000 per year to an unlimited number of other individuals without incurring gift tax. In the case of a husband and wife, a total of $26,000 can be given each year, regardless of whether the source of the gift is community property, joint tenancy property or separate property. An individual can in addition at any time during his or her lifetime give up to $1,000,000 to individuals other than a spouse without incurring federal gift tax. All gifts to a US citizen spouse are taxfree(foreign spouses have a limit of $120,000). There is also an exclusion for gifts of medical expenses and educational expenses (paid directly to the institution) in some cases. If the annual exclusion is exceeded in any year, a gift tax return is required, even if no tax is due.
Increase in Income Tax Basis
Transfers at death (but not lifetime gifts) result in an increase in the basis for computation of capital gain for the asset transferred to the fair market value at the date of death (or an optional alternate valuation date. This means that careful consideration should be given to the selection of assets which are transferred intervivos (lifetime gifts) and those transferred at death (whether by will or by trust).
Irrevocable Life Insurance Trust
If your estate on second death is likely to incur estate taxes any life insurance payable at that time will also be subject to tax. This can be avoided by use of a trust which owns a policy and which is the beneficiary. A trust of this type can also have provisions related to educational expenses and delay any distributions until all children have completed their education or reached designated ages.
Family Limited Partnership
A family limited partnership is a limited partnership composed of a general partner and limited partners. The general partner, who has the power to make virtually all decisions on behalf of the partnership, is generally an entity (an S corporation or limited liability company (LLC)) controlled by family members. The general partner ordinarily has a very small percentage interest in the partnership (usually one percent). The initial limited partners are the members of the older generation, who have a very large percentage interest in the partnership (usually 99 percent). Under the partnership agreement, the limited partners have no rights to participate in the day-to-day management of the partnership. The partners contribute investment assets, and profits and losses are allocated pro-rata to the partners. The limited partners may, and frequently do, make gifts of limited partnership interests to the younger generation during their lifetimes.
Tax Advantages
The principal tax advantage is a valuation discount, usually of from 30 to 48 percent on the value of the transfer subject to tax. Discounts may exceed 50 percent in appropriate circumstances, but there is penalty exposure if such a discount is completely disallowed. The transfer tax savings is generally a highly important reason for a client to utilize a limited partnership. The discount is generally greater for real estate and less for publicly traded securities. It is also generally greater when the property does not produce cash flow.
The valuation discount arises because non-controlling ownership interests in business or investment entities are not valued at the value of a proportionate interest in the underlying assets (net asset value). Recognized valuation methodology provides that such interests are entitled to discounts for lack of marketability and control. These discounts recognize the economic realities that such interests cannot be sold for net asset value because they are not marketable ? that is, they cannot be readily sold like shares of stock in a publicly traded corporation ? and they do not permit the transferee to exercise control over the activities of the business or investment entity, thus resulting in the owners? subjection to the discretion and business judgment of another party both for operating results and the timing of distributions (if any).
Trying to quantify the expected tax savings involves determining when property is likely to be sold as well as determining effective transfer tax and income tax rates. In general, the transfer tax savings must be offset against the present value (as of the time the transfer tax would have been paid) of the income tax cost resulting from the reduced basis step-up (which applies only if the estate tax applies because the limited partnership interest is included in the decedent?s estate). If property is expected to be retained in the family for many years, the income tax offset can be ignored. Also, when the property is sold there will be cash proceeds to pay the tax, which is not the case with the transfer tax.
Non-Tax Advantages
The non-tax reasons to form a family limited partnership include:
Transfer a group of assets into a form of ownership that is simpler to transfer (to facilitate annual and other gift-giving programs).
Centralize management and obtain the benefit of continuity of management over the partnership?s assets.
Provide protection to partnership assets from claims of future creditors of the limited partners and to limit the limited partners? liabilities for partnership debts.
Provide unified control (through the general partner) over distributions of cash derived from earnings on the partnership?s assets.
Provide flexibility in business planning not available through trusts, corporations or other business entities.
Conduct investment and business activities in an entity that is not itself subject to federal or state income taxes.
Avoid the delay, publicity, inconvenience and expense associated with probate administration of multiple separate investments of the partners upon their respective deaths or liquidation.
Disadvantages
Locks assets in the partnership for a period of time, generally not ending until the expiration of the statute of limitations for the last year during which transfers were made.
Records must be kept, and annual tax returns must be filed, for the partnership and the corporate or LLC general partner. Appraisals must be made to establish the value of the gifted limited partnership interest. The investment in legal, accounting and appraisal fees for formation and administration are significant, but the savings achieved often exceed costs by a multiple of 20 or more.
Use of a family limited partnership clearly increases the chance of gift or estate tax return being examined, and perhaps contested in court. There are many ?traps for the unwary? if partnership form is not respected.
Could create or increase liquidity problems of estate by locking up assets that could otherwise be used to pay estate tax.
Could be problems if highly leveraged real estate is being transferred to the partnership.
Could be income tax problems if property is distributed to donees within seven years of contribution (see disguised sales rules of Sections 731(c) and 737 of Internal Revenue Code). Contact us now for estate planning services
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