Miner & Lemon Blog

Tax Savings Series Part 7 - Don’t Pay Any More Than You Have to or How to Stick It to the (Tax) Man

           Chief Justice John Marshall once noted that "The power to tax involves the power to destroy," but now that we understand how the gift and estate tax regime operates we can consider the strategies available to prevent those taxes from "destroying" your estate.  Methods for confronting the estate tax revolve around several differing approaches, which include minimizing the size of the taxable estate, stretching out the time period in which the estate tax obligation may be met, and providing the funds necessary to meet this obligation without incurring additional estate tax in the process.

            The simplest way to significantly decrease the size of the taxable estate is to take advantage of the estate tax credit.  While this may seem obvious, many people nonetheless fail in this regard.  Why?  Because they do not engage in any tax planning prior to the death of the first spouse, and instead leave all property to the survivor.  As a result, an opportunity to pass an amount up to the exemption equivalent ($3.5 Million in 2009) without incurring any estate tax is lost. 

            Another method for reducing the taxable estate is to make lifetime gifts.  As we discussed last time, every year a taxpayer may gift up to a certain amount ($13,000 in 2009) to each person that he or she desires without incurring any gift tax.  Almost any type of present interest may be gifted, but some assets are more advantageous from a tax perspective than others.  In general, if an asset has a relatively low basis, then it will be better to hold on to that asset and dispose of it at death so that the recipient will receive a step up in basis, which will result in a lower capital gain being attributed to him or her if he or she should decide to sell that asset.

            Granting conservation easements is another way of lowering the size of the taxable estate, and also of receiving income tax deductions.  Oftentimes a conservation easement is granted that will prevent development of the land, but which allows the landowner to otherwise use and enjoy the property exclusively just as he or she had before.  Conservation easements reduce estate taxes in two ways: first, to the extent that a valuable interest in land has been given up, the value of that land for determining the size of the estate is reduced, and, second, IRC 2031(c) provides an additional exclusion regarding land upon which a conservation easement has been given.  And, for my Indiana readers, I would recommend visiting http://indianalandtrusts.org/ to find out more about local opportunities for granting conservation easements.

            Another method of particular interest to farmers is utilization of IRC 2032A Special Use Valuation.  Special Use Valuation may be elected by the decedent's estate if certain criteria are met, and allows for farmland to be appraised based upon its value as farmland as opposed to being appraised based upon its fair market value.  This can be a very effective strategy if farming operations will be continued for the foreseeable future.  Although, the aggregate decrease in value of qualified real property is limited.

            But if it is not possible to get the taxable estate below the exemption equivalent, there are still options.  The first option is to make funds available to meet the estate tax obligation without incurring additional estate taxes.  And the second option, if all else fails, is to stretch out the time in which the estate tax obligation may be fulfilled.

            Life insurance can be used to provide the cash necessary to pay off the estate tax obligation, but the problem with life insurance is that any policy owned by the decedent is includible in his or her estate and thus increases the amount of tax due.  There is, however, a way around this dilemma.  By establishing an irrevocable life insurance trust (ILIT), it is possible to make cash available without triggering an increase in the amount of tax due.  There are two tricks to making an ILIT function properly.  The first is to prevent the Trustmaker from having any incidents of ownership.  This is done by naming an irrevocable trust as the owner and beneficiary of the policy.  The second is to structure the premium payments on that life insurance policy so that those payments constitute a gift of a present interest.  In order to make this happen it is necessary that the beneficiary of the trust have an opportunity to withdraw the funds set aside for premium payments for some specified number of days (frequently thirty) after which this right may lapse.  Failure as to either of these may result in undesirable estate tax consequences.

            Finally, if it has not been possible to reduce the taxable estate to a point where no tax is due and if funds are not available to pay off the estate tax obligation, then it may be possible to stretch out the payments.  IRC 6166 states that in situations where an interest in closely held business, such as a family farm, makes up more than 35% of the value of the adjusted gross estate of a decedent who was a citizen or resident of the United States, the executor may elect to pay the tax in ten annual installments of equal amounts.  Additionally, the executor may delay making the first annual installment for up to five years, during which time only interest payments will be due.  Of course, there are several drawbacks to this strategy: interest will be incurred, the IRS may require a bond or lien, final distribution will be delayed, and if a payment is six months late, then the IRS can accelerate the estate's payment obligation.

            Please join me next time for: Indiana Inheritance Tax or One More Reason to Move to Florida.