April 1999 Bulletin

Protect your estate

'Most everyone recognizes the need to plan, but they're too busy with
medicine. . . .

How you, not the IRS, can control your assets after death

By Carolyn Rogers

Estate planning is simply the process of determining and then protecting your assets against confiscation by the government, says Raymond C. Odom. It's also a way to shield those assets from erosion due to death-related expenses, administrative costs and litigation.

"If you look at estate planning in that larger sense," says Odom, vice president and senior trust administrator at First Chicago (a Bank One company), "it helps you to avoid thinking of it as simply drafting a will. A will tells your executor who to give your property to, but does nothing to protect your assets against taxes, transfer costs and unnecessary expenses. Estate planning addresses all of those issues."

It's also important to dispel the myth that estate planning is only for the very wealthy, according to Cynthia Hinds, vice president of Lakewood, Colo.-based Hinds Financial Group. Hinds has presented the "Life After Orthopaedics" retirement course at the Academy's Annual Meetings the last two years.

"Estate planning is actually very basic," Hinds says. "It can become very sophisticated and complicated, but you shouldn't assume that you have to be extraordinarily wealthy to benefit."

"Bottom line, it's a control issue," Odom says. "By using estate planning techniques, you can actually give yourself control of your assets after your death, rather than simply delegating that responsibility to the IRS."

Given those facts, it's troublesome that approximately 80 percent of the orthopaedic surgeons who Joseph Casselli comes into contact with "don't know what they're doing" when it comes to estate planning. "That's not to say that 80 percent are stupid," explains Casselli, president of Cass Financial Strategies Inc., Dublin, Ohio. "Most everyone recognizes the need to plan, but they're too busy with medicine and they just don't take the time. And of the 20 percent that do plan, they don't plan completely or they plan partway."

Dan S. Donley, estate planning coordinator at First Chicago, who works with the Orthopaedic Research and Education Foundation (OREF), agrees.

"All of my orthopaedist clients are concerned about estate planning," he says, "but typically they say: 'I'm aware of the need for estate planning, I know I have to do it, but let's do it next month.' That type of feedback is very common."

The motivation to begin serious estate planning comes once surgeons understand the potential losses that can result from a lack of preparation, according to Casselli.

"In the estate planning programs I've taught for the Academy, much of my presentation focuses on the potential loss of as much as 75 percent of the estate to taxes, if attempting to pass wealth on to the next generation," he says. "That's a very important estate planning concern, and it gets their attention."

So when should you start?

"In terms of the 'right age' to start planning," Donley says, "I've had orthopaedic surgeons that started their plans as early as age 42, and as old as 74. As far as a specific dollar amount, there are special variables to consider. A general rule of thumb, however, is if a married couple has a net worth of over $1.3 million in 1999, they should consider talking to an estate planner."

But where do you start?

Casselli offers the following seven basic steps to estate planning:

  1. Acknowledge the need for the planning process.
  2. Gather and organize your financial data so that you are ready to begin planning.
  3. Search for the services of qualified estate planning advisors.
  4. Once the plan is completed, evaluate all options.
  5. Discuss options with legal counsel, etc.
  6. Implement, implement, implement.
  7. Review strategies every two or three years or as required by changes in tax law.

Hinds stresses the need to consult several advisors, not just your attorney.

"The process should entail other advisors, be it your accountant, insurance agent or financial advisor, because they bring a different perspective," she says. "And to the degree that it's possible, family members, your spouse and adult children should be involved as well."

"You shouldn't overlook the importance of the trustee of any trust established in your estate plan," Donley said. "The trustee is the person who will carry out your plan. Design of your estate plan is important, but implementation and completion are critical to its success."

Step number seven, "Review strategies every two or three years," is also key, according to Hinds.

"A problem I see quite often is that people complete a plan, and then they don't go back and look at it. Some of these plans are really out of date and can cause problems."

Now that you have a "to do" list, what pitfalls should you try to avoid? Caselli offers the following list of common estate planning mistakes:

Casselli explains that last pitfall: "People need to understand that you can control the dollars you would otherwise pay to taxes by repositioning those dollars to your charitable works."

"A good estate plan for a high net worth individual will always require the use of charitable giving," Odom agrees. "People need to know that the only reason for the estate tax is to avoid allowing a large accumulation of wealth in a family lineage. Therefore, the tax is completely voluntary-the only one if its kind-because you can avoid it by giving to charity. So the real issue is simply will you pay tax to the IRS so they can make a charitable distribution, or will you give funds directly to charity, such as OREF, and reduce your taxes, thereby increasing the amount going to your heirs?"

To accomplish these goals, several estate planning tools are necessary. Some of the most common tools, are the marital deduction and bypass trust, the irrevocable life insurance trust, balancing ownership of assets and annual gifting.

Marital deduction and bypass trust ("A/B Trust")

"The A/B trust or "marital trust/family trust" is the planning cornerstone for any combined marital estate worth over $650,000 (as of 1999)," Donley says.

As background, Donley explains a key issue in estate planning-the unified credit applicable exclusion amount.

"In 1999, each U.S. citizen or resident can transfer $650,000 of property without paying gift taxes or estate taxes, or a total of $1.3 million for a married couple. Under the 1997 tax legislation, this amount is scheduled to increase in slow, uneven steps over 10 years until it reaches a maximum of $1 million for an individual, or $2 million for a married couple, in the year 2006. Most A/B trusts now in existence use flexible language that will automatically adjust the terms of the trust to reflect whatever the new shelter amount is in a given year."

The "A/B" trust arrangement is useful, Donley says, because it provides a means of accomplishing two objectives: First, it takes advantage of both spouses' $650,000 exclusion from federal estate tax, not just one. Secondly, it achieves this tax goal while allowing the surviving spouse maximal use and control of the entire family estate.

While both spouses are alive, Donley continues, a single Living trust will be in place, that is revocable and completely in their control. The Living trust ends at the first death, by splitting into two new trusts ("A" and "B" or marital trust and family trust). The trustee, usually the survivor or trust company, divides the Living trust property and places the required amount in each of the two trusts, "A" and "B." The trust document is worded so that the federal estate tax applicable exclusion amount is placed into the irrevocable "B" trust, which is usually established for the ultimate benefit of children and grandchildren. This applicable exclusion amount must be used at the time of the first death, or it is wasted. The ability to make the IRS. treat the "B" trust as taxable in order to use up the unified credit while allowing the surviving spouse nearly full control over the "B" trust is key to taking full advantage of the $650,000 exclusion amount. The surviving spouse's rights to property in the "B" trust may include:

The "A" trust, also called the Marital Deduction trust, is completely under the control of the surviving spouse, who usually has the power to withdraw all of the trust assets at any time.

Irrevocable Life Insurance Trust (ILIT)

"You must have a trust-an irrevocable life insurance trust-to remove life insurance from of your estate," Odom says. "Trusts are used to facilitate the fact that most people have a desire to minimize transfer taxes by using up their allowable tax credit while providing for their surviving spouse and/or children. In the case of insurance policies, the failure to have an insurance policy owned by a trust which is set up to benefit your spouse and or children will result in the IRS taking up to 55 percent of the insurance proceeds you thought were going to help your family."

An ILIT is simply a trust established by an individual, the 'grantor,' during his or her lifetime, which cannot be amended or revoked

"In most cases," Donley says, "the ILIT serves a twofold purpose: to shelter the life insurance proceeds from federal estate taxes and to make proceeds available to the grantor's estate for payment of estate settlement costs, such as estate taxes, debts and costs associated with probating the estate."

As a general rule, Donley says, any life insurance policy that is owned by the insured at his death is subject to federal estate taxes. However, in the case of the ILIT, which owns the policies from inception, the insured should not be deemed to have any "incidents of ownership" over the life insurance policies. Rather, the trustee of the ILIT will be owner and beneficiary of the policies on behalf of the trust. The trustee, therefore, is responsible for the payment of the premium. However, the grantor of the trust will usually make cash gifts to the ILIT to pay the premium. Donley also notes that existing life insurance policies may be transferred to an ILIT.

"But two factors must be considered when contemplating this course of action, he point out. "First, in order for the policy to be exempt from federal estate tax it is necessary for the insured to survive the transfer by more than three years. If death occurs within three years of the transfer, the policy will be subject to estate tax. Second, since the transfer of the policy to the ILIT is considered a gift, the gift tax implications must be addressed."

Balancing ownership of assets

The failure to have enough assets in each spouse's name to allow them to fully utilize their tax credit can cost each spouse up to $350,000 in taxes, according to Odom.

"As with all tax credits, the only way a taxpayer can use this benefit is by generating tax and then using up credit. Taxpayers who leave everything to their spouses avoid estate tax at the death of the first spouse, but lose the benefit of the credit because their estate was not taxed. The surviving spouse will certainly use the credit applicable to their individual return, but loses all of the benefit from the deceased spouse's credit, which could have passed up to $1 million (as of 2006) of property tax-free. Therefore, making sure that assets are put into each spouse's name and that there is a mechanism for triggering the use of the tax credit without depriving the surviving spouse of the use of any assets is a minimum requirement."

Annual gifts

One of the easiest and most effective ways to transfer wealth to the next generation is by using annual gifts that are under $10,000 per person.

"The real sizzle to this technique is to give away something that has a value which is significantly more than $10,000 and which does not allow the recipient to consume the gift or to spend the money," Odom says.

An example of how estate planners leverage annual exclusions can be found by looking at the family limited partnership (FLP).

"An FLP is just like the old real estate partnerships popular in the 1970's tax shelters," Odom says.

In an FLP, there is general partner who has very little ownership in, but all the control over the assets. There are also limited partners who have no control over the assets and have liability only to the extent of their investment. Therefore, the problems, restraints and complexity of liquidating a limited partnership interest significantly depresses the value of a limited partnership interest.

"For example," Odom says, "suppose an FLP has $202,000 of assets. The father who established the partnership and owns all the units desires to give his son a $10,000 gift in order to decrease the father's estate and provide money for the child' future college expenses. Instead of giving the son $10,000 in cash, the father could give the son limited partner shares that have a value that could be as high as $20,000. However, because of the son's lack of control-his lack of ability to liquidate his shares without getting his father's permission-the shares are only worth $10,000 on the 'open market.' The father, by this fairly simple task of creating and transferring his assets into an FLP has now been able to give away $20,000 and not lose any control. This example shows the tremendous power of annual gifting when it is combined with other tax-advantage entities, such as partnerships, limited liability companies and trusts."

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