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The Three Tiers of Estate Planning

As an Estate Planning Attorney for over 33 years, you start to see trends in planning, common fears that clients face and strategies that gain in importance and favor, to only fall out of favor for more recent trends and strategies.  I have practiced Estate Planning thru numerous Presidents and changes in Congress and tax laws.  I practiced during the uncertainty “sea saw years” when there was estate tax repeal, and then “sunset” and then estate tax reinstated.   (the years 2001 thru 2013)   And now, we find ourselves again in uncertainty.  Under the recently passed Trump Tax act we learned that the Estate Tax would not be repealed as many thought.  Instead, we saw the Federal Estate Tax Exemption double from $5,500,000 to $11 million per person?  But, how long will this Trump Tax Act last?  Will the midterm elections bring a change in control in the House and the Senate?  Will the Federal Exemption drop back down to $5,500,000?  Living thru these tumultuous years, and having talked to literally thousands of clients and having conducted hundreds of seminars, my message is simple.  The Estate Tax has already been repealed for over 99% of Americans as a result of the 2013 Tax Act that increased the Federal Exemption to $5 million per person. And now, under the Trump Tax Act, it is less than 1 tenth of 1% that is still subject to the estate tax.

As a result of these years of experience, I have come to realize that there are basically three tiers of Estate Planning.

Estate Planning: Tier 1

The Lower tier applies to all Americans and is the basis for all Estate Plans, no matter how rich or modest.   The Middle Tier applies to people that have needs beyond basic Estate Planning, such as Tax Planning or Asset Protection Planning. These are clients that have worries and fears beyond the average American.   And the Top Tier applies to the wealthy.  These are people that will always have tax problems, even if the estate tax is repealed.  These are people that realize with estate tax repeal, comes the loss of “stepped up basis” and capital gains and income tax issues become more significant.  In short, the Top Tier needs complicated tax planning, whether it is Estate Tax Planning or Income Tax Planning.   In conducting hundreds of seminars, the single question at the end is almost unanimous, “So, what should we do with today’s Tax Laws and economic environment.    What Estate Planning should we embrace?  Over my 33 years, these three Tiers have remained unchanged.  What has changed is only the percentages of the population in each Tier.   As the Federal Estate Tax Exemption continues to increase, the Top Tier continues to shrink and the Middle Tier gets larger.  The Bottom Tier remains relatively constant.

Tier One, or the Lower Tier, will always have the largest percentage of the population.  In today’s economic environment, and with the Estate Tax already “repealed with the current $11 million exemption, these clients, our bread and butter clients, will always need a Last Will and Testament, Durable Power of Attorney, Health Care Power of Attorney, and Living Will.  In my opinion, every American should have these basic documents.  And, most of this Lower Tier should also have a Revocable Living Trust.  Although I do agree that not everyone needs a Revocable Trust, I also know that a client would never be worse off for having a Trust, but could be much worse off by not having a Trust.  So, in my professional opinion, the average middle American client should add a Trust to these basic documents.  There are plenty of Articles written as to the advantages of having these basic documents.  It is not the purpose of this Article to go into that detail.  It is my only purpose to state in no uncertain terms, every adult should have these basic documents.  These documents have no tax planning or asset protection planning.  These documents are designed to avoid probate, carry out the wishes of the client and pass the assets to the heirs with the least amount of time and expense.

Tier Two, or the Middle Tier are clients that have some concerns beyond basic Estate Planning.  These are clients that have some tax concerns, whether or not the tax is the Federal Estate Tax or the Federal and State Income Taxes.  These clients may not currently have an Estate Tax problem, but with appreciation in value of the estate coupled with longevity, they are likely to end up in an Estate Tax situation.  Or, these people have a large sum in IRAs or other income tax-deferred vehicles.  These people also tend to be entrepreneurs and have family businesses.  Because of the ups and downs in the economy, these clients are concerned about asset protection and preserving the assets they have accumulated.  In Tier Two, we put some estate planning strategies that are very effective to reduce taxes and provide asset protection.  Yet, they are not expensive to implement nor are they expensive to maintain.  These are strategies that are employed to “get out in front of a tax problem rather than chase it from behind”.  Tax planning is always easier and more flexible if embraced before the problem exists.  These are strategies where you are anticipating the problem in the future, rather than having the problem today.  These clients tend to have a net worth that exceeds $10million or they have retirement assets that exceed $1 million.  They may have a family business.  They may be in a risky profession that could lead to malpractice or other creditor claims.  They are concerned about asset protection as well as taxes.

Estate Planning: Tier 2

In my professional opinion Tier Two Estate Planning would consist of all of the documents recommended in Tier 1, plus of one or more of the following additional Trusts or strategies:

  1. Irrevocable Life Insurance Trust – A Trust designed to remove the proceeds and death benefit from an estate tax liability. Yes, it is true that life insurance is generally not subject to income taxes.  But, it is also true that if not properly structured inside of a certain type of Trust, the life insurance proceeds are subject to the Federal Estate Tax.  This Trust is easy to set up, not very expensive and easy to maintain.  Furthermore, it usually does not require the filing of separate income tax returns.  This type of Trust also provides excellent asset protection.
  2. The Qualified Personal Residence Trust (QPRT) – This Trust only applies to your primary residence as well as one other vacation property.  It does not apply to rental properties or investment real estate.  This Trust has a dual purpose.  It removes the value of your residence from the Estate Tax system, yet only uses a small fraction of your $11 million Federal Exemption.  It also removes the equity in your house beyond the reach of creditors.  With the state homestead exemption of being only $150,000 in equity, many of our clients have homes that are worth $500,000 or more.  Sheltering that equity into a QPRT can make sense even if the client does not have a Federal Estate Tax problem.  Once again, easy to set up, not very expensive and virtually no annual maintenance.  The greatest potential creditor in Tier Two is the cost of long-term care or assisted living as we age.
  3. Stand Alone IRA “Look Thru” Trust – These are clients that have large amounts of their retirement assets or maybe IRAs. Generally, I like to see at least $1million in retirement assets to embrace this strategy.  These clients aren’t concerned about the Estate Tax.  They are more concerned about the income tax consequences to the IRA, particularly at their death.  These clients also realize that their chosen beneficiaries may make a foolish choice to cash in the IRA early even with the heavy income tax consequences.  These clients want to protect the heirs from their own greed and poor tax planning choices.  They realize the power of income tax deferral and they want to guarantee that deferral continues for their chosen beneficiaries, even while a spouse to that beneficiary has dreams of an expensive vacation, car or cabin in the woods. Statistics show that income tax was very important to a client in setting up the IRA, and tax deferral is still available to the beneficiary of the IRA, yet statistics show that a very large percentage of the inherited IRAs are cashed in early and income tax deferral is lost and large income taxes are paid up front.
  4. Asset Protection Planning strategies such as a Limited Liability Company to limit liability to riskier type assets like rental properties and shelter the equity in passive activities like stocks and bonds. Also, a certain type of Irrevocable Trusts can be embraced to achieve Asset Protection.  Once again, the purpose of this article is not to go into detail on Asset Protection strategies, but instead, list it as a Tier Two type of strategy for clients with issues that cannot be resolved by basic estate planning documents in Tier One.
  5. Charitable Remainder Trusts – These Trusts have significant value in saving income taxes on the growth of assets as well as achieving some Charitable Income Tax Deductions on creating the Trust, even though charity does not receive any assets until the client passes away. As previously stated, as the Federal Estate Tax diminishes in importance, Income Tax savings strategies will gain in popularity.  These types of Trust have tremendous value especially in creating retirement income for clients that are more concerned about having enough income for their retirement more than they are concerned with passing a legacy to the kids.  This Trust does require filing a separate income tax return, but it achieves tremendous income tax benefit.  The big thunder in this type of Trust is that the assets inside of the Trust increase in value without an income tax on any of the build-up or on the interest and dividends earned by the Trust.  In other words, it acts much like an IRA in achieving Income Tax Deferral.

As the Federal Estate Tax Exemption increases to $11 million under the Trump Tax Plan, the people who are in Tier Three are shrinking and following down into Tier Two.   Essentially, we are seeing in Estate Planning what we are seeing in social status, the middle class is shrinking and the gap between Tier One and Tier Three is widening.

Estate Planning: Tier 3

And last, we have Tier Three strategies or the Top Tier.  These are people that already have tax problems, or have a significant closely held business or are in constant search of strategies that will reduce the Estate Tax liability or reduce Income Tax liability from their large salaries or distributions from retirement accounts.  These are people that probably waited too long to embrace Tier Two strategies and thus find themselves chasing the problem from behind.   And, as we discussed, Estate Planning is much more flexible if strategies are embraced in Tier Two and a client gets out ahead of the problem instead of chasing it from behind.  Tier Three strategies are complicated and tend to have annual maintenance.  They are relatively more expensive to implement than are Tier Two strategies.  But, they are highly successful in reducing tax liability, whether it is Estate Tax liability or Income Tax liability.  These strategies also tend to be more closely watched by the IRS and the rules are so complex that many estate planners practice in this area so infrequent that it is impossible for them to keep up with the changes and the education needed to thoroughly embrace the benefits of these strategies.

In Tier Three we are seeing clients who already have assets that exceed the amount of the current Federal Estate Tax Exemption.  If they are single, their assets exceed $11, million and if married they exceed $22 million.  They own a family business that has a strong potential of increasing in value, or they own significant amounts of real estate or stocks or other appreciating assets.  These are clients that are worried about Asset Protection.  They are also concerned about the amounts that they pay in income taxes.  These are clients that no matter what the tax laws are in Washington they see the benefit in Tax Planning.  They understand that with every new Congress or every new President that Estate Taxes that were repealed could be reinstated.  They also understand that when Congress lowers one tax they tend to increase another.  As stated above, as Estate Taxes on the Federal level are reduced, we will see income taxes and capital gains taxes becoming more of an issue.  We will also see that the various States will get into the death tax business.

 

  1. Family Limited Partnerships – I have personally stated that in my opinion, this is the most powerful Estate Planning strategy that I have seen over my 33 years of experience. This is the strategy that allows a client to “discount” the value of their estate by as much as 35% or 49% of actual fair market value.  This strategy also has tremendous asset protection qualities.  However, as typical for Tier Three strategies, they tend to be more expensive and tend to have annual maintenance costs and fees.  However, they have tremendous tax benefits.
  2. Spousal Gift Trust – sometimes referred to as a “Living Credit Shelter Trust” or perhaps a “Prefunded B Trust” – This Trust allows a client to remove assets from the estate for Estate Tax reasons, but yet have indirect access to the assets thru the client’s spouse. Its main thunder is to remove assets that have a significant chance to increase in value significantly.  The IRS has always been very flexible and liberal in their rules to allow clients to give away the potential appreciation value in an asset without paying any gift tax on the appreciation in value or use any of the clients Federal Estate Tax Exemption, that can also apply to lifetime gifts as well as transfers at death.   This Trust also has tremendous asset protection value exclusive of its estate tax elimination advantage.  It also has an annual maintenance cost to it by requiring a separate income tax return.  Also, this is what the author uses the analogy of a “high-performance airplane” (the author is a pilot) and requires annual “flying lessons”.  But, like the Family Limited Partnership, it has tremendous tax savings features.
  3. Creating a Stand-Alone Gift Trust for the children or the grandchildren. Like the Spousal Gift Trust above, the thunder in this strategy is to remove potential appreciation in value of an asset from the estate tax system.  And, because it does remove assets from an estate tax calculation, it also puts the assets beyond the reach of a creditor.  And, like the Spousal Gift Trust above, this Trust requires the filing of a Gift Tax Return to create the strategy.  It also requires separate annual income tax returns.
  4. Creating a Beneficiary Defective Trust – BDIT – (Beneficiary Defective Trust) – This is a Trust where someone like a parent or other relative creates a trust for the benefit of our client. And, instead of this Trust being funded by the client “gifting” assets into the Trust, it is funded by the client “selling” assets into the Trust.  And, like the other two trusts above, it primary has value in removing the appreciation in value of the assets from the estate and achieving creditor protection.  This Trust does not require a Gift Tax Return but it does require an annual Income Tax Return.

I hope that you have found this Article useful in knowing the amount of estate planning you should embrace for you and your family.  It is meant to be a guide and a suggestion, not a hard-line rule.  It is also helpful to show you that there are many estate planning strategies above and beyond the basic Last Will and Testament and Revocable Trust.  Whatever you do, do something.  Start with Tier One and get the good foundation you need for a successful estate planning.  It doesn’t hurt to start with Tier One, and then progress up to Tier Two if needed, or ultimately don’t we all dream of being in Tier Three.  The minute you win the $100 million-dollar lottery you are instantaneously a Tier Three client.  Call me or email me directly if you have any questions.  Matt Dana, matt.dana@danawhitinglaw.com or 602-762-8089.

Matt Dana

Matt Dana

The Dana name has become the symbol of a quality Estate Plan in Arizona. It has taken over 34 years to develop and continues to strive for excellence in the Estate Planning community. At its core is Estate Planning lawyer Matt Dana. [Learn more about Matt]

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