By: Irwin Scherago ischerago@mlg.com

Thirty-five years ago (it seems like two minutes) my friend and confrere at Eastman Dillon Union Securities, Tony Rice, said "Irwie, the first and foremost concept in all investing is protecting your capital. Because, once the capital is lost, it takes an awfully long time to get it back." These were the sage words of a twenty-four year old. The words were true in 1963 and they are no less true in 1999.

With a Federal and New York state income tax chipping away 34% of income at the $40,000 tax bracket; 35% at the $100,000 bracket; 41% at the $150,000 and 44% at the $275,00 bracket, it is small wonder that big starting salaries do not seem half as large after the income tax bite.

Thus, it takes a good 30 years for a "non-entertainer" or a "non-athlete" to amass his or her $3,500,000 to $4,000,000 estate. Typically, when an individual has amassed the $3,500,000 estate, it is allocated as follows: 12-1/2% is in a residence ($500,000); 62-1/2% is in a retirement plan ($2,500,000); and approximately 25% ($500,000) is in a non-sheltered stock portfolio, or walking around money (bank accounts, etc).

The $3,500,000 estate, built up over thirty years (with a 10% compound interest growth), would mean investing approximately $21,000 annually, after taxes. Total funds, invested over the 30years, would be roughly $638,000 after taxes. Thus, in order to have $638,000 to invest over 30 years, before living expenses and income taxes, one's gross income would approximate $1,046,000. As you can see, amassing an estate of $3,500,000 is no mean feat and once one has attained that level, one should use every legal and affordable means to protect the estate capital from erosion by estate taxes.

-A-
THE ESTATE TAX BITE
(Single Person or Surviving Spouse)
Death in 2000* and in 2006

*The year 2000 was chosen primarily for the New York State reading audience because New York State will completely eliminate its estate tax as of February 1, 2000. The State will simply take the Federal credit for State death taxes paid as its estate tax and New York will join most of its sister States by imposing a "sponge" or "sop" tax for estate taxes.

THE UNIFIED CREDIT AGAINST
FEDERAL ESTATE AND GIFT TAXES

In 1997, the Internal Revenue Code was amended to increase the credit for estate and gift taxes. This much bally-hooed bonanza (really no bonanza at all) increased the credit for estate and gift taxes paid, incrementally over a nine year period, from $192,800 to $345,800 thus increasing the exemption for estate taxes from $600,000 to $1,000,000. If inflation increases (or the value of money decreases) by 6% per annum, the $1,000,000 exemption in 2006 will be equal to the $600,000 exemption in 1997.

Nevertheless, never look a gift horse in the mouth. Congress could have been stuck in the impeachment process in 1996 and 1997 and we would not have even received this chary benefit.

For ease of reference, the table below sets forth the Unified Credit against tax and the Federal Exemption Equivalent.

-B-

THE DOUBLE TAX HIT ON RETIREMENT PLANS

Historically, pension and profit-sharing plans were the creme de la creme of tax shelters. The taxpayer received an income tax deduction for the contributions to the plan (around first base heading for second); the monies compounded income tax free in the plan (around second base steaming towards third base); the maximum income tax on plan distributions was 25% (around third base heading for home); and the death benefit passed estate tax free (you scored with only a 25% tax on the retirement plan and 75% going to your beneficiary).

It is sad to say, in pension taxation, history was not a prelude. Today, you get your income tax deduction for retirement plan contributions and, while the assets are in the plan, they compound income tax free, but, upon retirement and at death, the income and estate tax impact, together, erode plan assets by 67% to 75%.

Assume a $3,000,0000 estate, with no surviving spouse, and plan assets of $1,500,000. The calculation below shows the estate and income tax result in both the year 2000 and 2006.

Income Tax on Retirement Plan:

As the figures above show, what was once the creme de la creme of tax shelters, retirement plans have turned into the drek-de-la-drek of tax shelters, with about as much appeal as a reverse mortgage (which will be subject of another article–this will be a fun article to read if you enjoy the rape of the elderly and the indigent).

METHODS TO REDUCE, AMELIORATE AND,
PERCHANCE, TO ELIMINATE THE ESTATE TAX BURDEN

All methods available for the reduction, amelioration, or attempted elimination of the estate tax burden come with a cost. The cost is either (1) loss of control by conveying assets to trusts or to children using valuation discounts; or (2) the payment of money, cash on cash, for life insurance premiums on the life of the elder generation, moneyed, prospective decedent.

PAYING ESTATE TAXES AT A DISCOUNT

The Qualified Personal Residence Trust (QPRT) is a time value of money discounting device. It can be one of the most useful vehicles for making a gift of an asset at a reduced value for gift tax purposes. The reason that the QPRT is so valuable is that you are using a non-income producing asset to create the estate/gift tax savings.

Steps to Creating a QPRT

1) Deed. Taxpayer coveys, by deed, his or her interest in a personal residence free-standing dwelling; cooperative apartment; condominium; houseboat or Morsan tent) to a trust created by the taxpayer.

2) Trust Instrument. The taxpayer is the grantor and the trustee of the trust.

3) Trust Term. The taxpayer provides for a trust term in which the taxpayer continues to reside in the residence (10, 15, 20 years). At the end of the trust term, the residence is deeded to the beneficiaries of the trust.

4) Option to Rent. At the end of the trust term, the taxpayer can have the option to rent the premises from the beneficiaries (usually the taxpayer's children) at the fair market rental value.

5) Change Insurance Designations. It is vital that, simultaneously with the recordation of the deed conveying the residence to the QPRT, that the name on the "Homeowners" insurance policy and the "Title" insurance policy be changed, as follows:

(a) Homeowners policy should read "Martin Monroe, as Trustee of Monroe Qualified Personal Residence Trust and Martin Monroe, individually."; and

(b) The title insurance policy should be amended to read in the exact manner as provided for the Homeowners policy. This change of insured party can be accomplished by paying the title company to recertify the policy into the trust and trustee name. Clear this with the title company BEFORE making the conveyance. If the title company balks, then simply use a Warranty Deed instead of a Bargain and Sale Deed.

Taxematical Workout of QPRT

In all tax and investment transactions we must ask, "Is it worth it? What is the work out?" You should know the benefits of a transaction going in and have a pretty good idea of the benefits and the downside on the way out.

Example:

In July, 1998 a 65 year old woman created a QPRT with a term of 12 years. The value of the residence (per appraisal) is $1,100,000. The Applicable Federal Rate for July 1998 (Section 7520 rate) was 7%.

DOWNSIDE TO QPRT

1. Must Survive the QPRT Term. If taxpayer does not live the full QPRT term, then the asset is back in his or her gross estate, albeit at a "stepped up" basis.

2. Children (Beneficiaries) Could Have Capital Gain. If the grantor's cost basis is very low, i.e. $150,000 against a market value at the time of sale of $1,100,000, then the children (beneficiaries) would have a taxable gain for income tax purposes of $950,000 and a capital gains tax of 26.3% (in New York State) of $250,000. If you deduct the capital gains tax ($250,000) from the estate tax savings computed above ($180,000) the family in this situation loses by $70,000. Thus, you must always push the pencil. The higher the cost basis for the residence put into the QPRT, the greater the overall tax benefit will be.

(a) This gains tax can be reduced by $130,000 if the taxpayer (Grantor of the Trust) wishes the Trust to sell the premises before the end of the Trust Term and uses two (husband and wife) $250,000 exemptions ($500,000 x 26%).

(b) As nearly as possible, taxpayer's high basis personal residence or vacation homes.

GRANTOR RETAINED ANNUITY TRUST

The Grantor Retained Annuity Trust (or Unitrust) ("GRAT" or "GRUT") involves creating a living trust into which a taxpayer conveys income producing assets and reserves to himself or herself an income for a term of years. The income reserved must be in the form of an annuity or the Internal Revenue Service will not permit a time value discount for computing the gift.

In the example below, it is assumed that Martin and Mary Monroe convey two $500,000 portfolios to two GRATs, reserving $30,000 (6%) of income from each. If Mary's GRAT has a term of 15 years, and Marty's GRAT has a term of 10 years, the gift tax value of the GRATs would be: $241,000, or a discount of 52% for Mary's GRAT; and $294,000, or a discount of 41% for Marty's GRAT. The estate tax savings would be $255,300 as follows:

*Note: Gift tax returns will be due for each of the gifts made by Marty and Mary by the April 15th in the year following the year of the gift. For 1999, there would be no Federal gift tax due because of the Federal Credit (Table B above) and no New York State gift tax because New York exempts the first $300,000 of gifts from taxation in 1999. In the year 2000, New York will eliminate its gift tax.

Why Use Two GRATS With Married Taxpayers?

Two GRATs are indicated when there is a significant difference in the ages between the husband and the wife, or in the health of the husband and the wife, and the individuals wish to be certain that at least one of the retained interests in the GRATs will be eliminated from the gross estate. Ideally, a husband and wife would live out the full term of the GRAT and, in doing so, the retained interest is excluded from the gross estate of the individual who created the GRAT. Were we to put $1,000,000 in a GRAT for Mary, or $1,000,000 in a GRAT for Marty, and one of them did not live out the GRAT term, then there would be no exclusion of the $1,000,000 from the gross estate. Thus, I am a firm believer in two GRATs, hoping that the full $1,000,000 will be excluded from the gross estate but at least likely to get the benefit of one GRAT exclusion.

Using Two QPRTs This reasoning can also be applied to "splitting"the value of a high priced personal residence into two QPRTs as Tenants-In-Common or, in the case of two valuable residences, the principal residence can be transferred to one spouse's QPRT and the vacation home to the other spouse's QPRT.

GIFTING MINORITY INTERESTS IN BUSINESS ENTERPRISES

If a taxpayer has an operating business (manufacturing, service, real estate) then the taxpayer can give away a minority interest in his/her corporation, partnership, or limited liability company at a valuation for gift tax purposes which is less than the true, full, fair market value of the enterprise.

The discount from the full, fair market value is recognized business-wisely, and tolerated by the Internal Revenue Service, because an interest that is less than 50% of ownership in a closely held business generally has no control and most usually is not freely marketable.

The lack of control and free marketability of a minority interest in an enterprise results in a reduced value of the gifted (transferred) shares, or membership interest, or partnership interest (Revenue Ruling 93-12).

The Mathematical Workout Assuming A owns the XYZ Company. XYZ is appraised at $2,000,000. (The appraisal must be attached to the gift tax returns. All gift tax returns are due April 15th of the year following the gift). A gives each of three children a sixteen percent interest in XYZ.

*Note: The Internal Revenue Service is taking the position that since the minority interest has no control and cannot be freely conveyed, the gift is a gift of a future interest and the annual exclusion for gifts of present interest is not allowable.

Benefits of Gifts of Minority Interests

The benefit of giving minority interests in an enterprise is manyfold:

(1) Tax-wisely a gift is being made at a reduced value for estate and gift tax purposes.

(2) The younger generation comes into the business but they do not control the enterprise until the elder generation is ready to retire.

(3) The control exercised by a majority interest (51%+) does not result in any portion of the gifted minority interest being included in the gross estate of the majority interest owner at his or her death (there is no Section 2036 control as in trust situations).

(4) A judgment creditor of the minority interest shareholder of a corporation, partner of a partnership, or member of an LLC will have no access to the business enterprise and can only wait for the liquidation of the enterprise to realize upon their judgment.

(5) The discount for estate and gift tax purposes is immediate. There is no waiting period as with a QPRT or GRAT to realize the tax savings. The QPRT or GRAT are "time value" discounts while the minority interest discounts are control and lack of marketability discounts which are in effect from the date of the gift.

LIFE INSURANCE

Life insurance is the creme de la creme of estate planning tools. Life insurance initially owned by a beneficiary (child or trust for benefit of child) will not be includible in the gross estate of the insured/grantor.

Life insurance on the life of a single individual, or second to die survivorship life insurance, would cost as low as $22.23 per thousand or $22,230 for $1,000,000 of life insurance. This combines 50% term and 50% whole life. If the term/whole life blend is altered to $350,000 term and $650,000 whole life, the cost would be $26,225 for $1,000,000 of insurance and, finally, as is illustrated below, if one pays a $30,000 premium, the term/whole life mix would be $744,000 whole life and $256,000 term.

The purchase of a life insurance policy is always a socio-philosophical decision as well as a financial one. How much do I owe my children and how much must I alter my life style to transfer my estate to them without estate tax or with almost no estate tax?

Once one answers the question that he/she would like to have as much of his/her estate pass to the children free of estate taxes, the second questions is "What is the cost?"

If one is annually saving the amount of the premium, then this savings should be done through the vehicle of life insurance. If one is not saving that sum, then one should dedicate some of one's IRA distribution to that investment.

Large IRA Accounts Are A Source For Payment of Premiums

One ready source for the payment of life insurance premiums is one's IRA. The IRA is a bundle of income waiting to be taxed.

At death, as much as 75% of an IRA will be taken by taxation (Estate and Income Tax). Thus, a sound strategy is to use an IRA to pay premiums for life insurance which will replace dollars lost to estate taxes.

The insurance premium calculated above for $1,000,000 of insurance is assumed to be $30,000. It is assumed that the taxpayer's IRA earns $71,000 (a conservative 4%). One further assumption is that minimum IRA distributions of $67,749 will be required in 1999.

The table below sets forth the amount of the IRA needed to be allocated to the premium payments for the purchase of $1,000,000 of life insurance. Three difference premium costs are used.

C

ESTATE TAX WORKOUT FOR MARTY AND MARY MONROE
WITHOUT INSURANCE AND WITHOUT A QPRT

D

ESTATE TAX WORKOUT IF INSURANCE IS PURCHASED

BLENDING IN THE LIMITED LIABILITY COMPANY

Marty and Mary Monroe have investment realty totaling $1,000,000. They have a house, but a QPRT cannot be used because the house is partially rented. A QPRT can only be used with a residential dwelling–no mixed use.

Assuming Marty and Mary give away 48% of their investment realty valued at $480,000, the value for gift tax purposes would only be $312,000, after the application of a 35% minority discount. Again, Marty and Mary would still receive 52% of the income from the rental property (their retained interest).

The gift would not be made until January 2, 2000 because there will be no New York State gift tax after December 31, 1999. If Marty and/or Mary gave away LLC interests in 1999, together with the GRATs, they would be making a taxable gift (for New York and Federal purposes) of $450,000 and $397,000 and each would pay a New York gift tax.

The net estate tax benefit of the gift of 48% of a $1,000,000 enterprise for the family Monroe is the savings of another $92,000 in estate taxes (the valuation discount 36% x $480,000 equalls $168,000 x 52%.)

E

GRATs And LIFE INSURANCE

If Marty and Mary use the blend of two GRATs and one life insurance trust of $1,000,000, the estate tax work out would be as set forth in the Schedule below:

*Note: The Monroes still control, and get the benefit of, their portfolio in a GRAT for 10 to 12 years and they have kept control (after the GRAT) of $760,000 of liquid assets. The life insurance is being paid out of Marty's IRA and Marty and Mary still have income of $150,000 from their cash, securities and GRAT and realty.

The estate assets available for the family Monroe by the use of two GRATs and $1,000,000 of life insurance increases from $3,534,000 (Table C) to $4,789,000 (Table E above), an increase of $1,255,000 by the judicious use of the discounting methods available to them.

As was stated in the opening paragraph of this article, one must vigorously protect his or her capital or stand by and watch it be eroded by estate taxes. The various discounting methods (QPRTs, GRATs, LLC, Minority Interest Gifts and Life Insurance) are all aids to reducing the tax bill on an estate. One taxpayer cannot, and probably should not, use all the methods unless he or she goes for the arcane and esoteric. To this writer, the most efficient method to reducing one's estate tax bill is by purchasing life insurance with excess disposable personal income (money being saved which will be taxed in the estate) or by using large retirement plan balances (IRAs) which will be eroded by 75% at death. Too often this writer and other consultants are confronted with a client saying "Write a $30,000 check for life insurance? I give my kids the $30,000 annually. Why should they wait for me to die? No, I'll give it to them and let them worry about the tax."

The children who receive the annual gifts will, in all probability, spend the money and not invest the annual exclusionary gift. The extra $10,000 given to each child may afford them a life style they should not have (the swimming pool, the country club, etc.). Annual giving to a grandchild's preparatory school or college is wholly exempt from gift tax and that giving should be continued. Any giving in excess of a grandchild's education should be put into a policy, or two, of life insurance which will defray the estate tax bomb which will be detonated after death.