Often, some of the most valuable estate planning results are achieved not by using the big-picture items like bypass trusts, discounts, or note sales, but rather by the aggregate of a variety of seemingly less significant planning steps. Consider some of the following strategies.
While asset allocation decisions receive considerable attention, too often asset location decisions (i.e., deciding which investments hold which assets) do not receive the focus that is warranted. Many assume that assets producing current income should be held inside tax deferred plans (e.g., IRAs), where they will not be subject to current income tax until distributions are made, and growth assets that do not generate current income should be held outside tax-deferred accounts. Similarly, when growth assets are sold, they are taxed at favorable capital gains rates when held in a personal account, but if held inside a tax-deferred plan, that gain could be taxed as ordinary income.
These decisions should be refined further for many individuals, however. If the person has an irrevocable grantor trust, the determination of whether that trust should hold growth assets might hinge on whether the trust has a swap power or can be merged into a new trust that does have such a power. In that event, the growth can occur outside the estate, but be brought back into the estate by exercise of the power to substitute. In such situations, growth assets can be concentrated in the grantor trust and other equities in the non-qualified personal assets. If the individual has a credit shelter trust or other non-grantor irrevocable trust, consideration should be given to the tax status, distribution pattern, and right to distribute capital gains from that trust in order to determine optimal asset location decisions.
With 5 million baby boomers retiring annually, where they choose to spend their postretirement years is an important question. While state income taxation, costs of living, and state estate tax considerations are all relevant, CPAs should review potentially differing treatment of retirement assets prior to the move. If an individual is contemplating a change in domicile, review the tax laws in the current and future home states as to retirement assets. Some states offer varying special tax treatment for retirement plan assets, and it may prove advantageous to withdraw more funds before or after the move.
CPAs are well versed in the need for a business entity to own commercial real estate and operating business interests, the appropriateness of having legal documents (e.g., shareholders’ agreement for a corporation), and other basics. Nevertheless, it is remarkable how often individuals fail to address obvious and basic entity planning. Many individuals have no legal documentation for entities other than the certificate forming the entity; this gap could result in costly litigation if another equity owner is disabled, dies, or leaves. Even pedestrian documents often include some dispute resolution and transition provisions. Frequently, individuals will have rental real estate or business activities held in their own names and not in entity solution; this ensures no asset protection in the event of a suit relating to the entity. CPAs should review an individual’s balance sheet, identify commercial real estate and business activities, and request copies of all legal documentation for these entities to ascertain their status. If issues are suspected, legal counsel should be brought in, but CPAs should never assume that entities or documents exist, or that the individual has permitted counsel the opportunity to properly address this.
There has been much discussion about the 3.8% NIIT (Net Investment Income Tax) surtax (IRC section 1411), but few individuals have taken fundamental and simple planning steps. Changing trustees to achieve a better result should be considered. For many modern trusts, a trust protector may be named who can easily and efficiently change current trustees to those selected for better state income tax or surtax results. For grantor trusts, the grantor is the litmus test; for non-grantor trusts, the tests are applied at the trust level [Treasury Regulations section 1.1411-3(a)(1)]. For new trusts, the named trustee of any nongrantor trust created for a real estate client should be determined ahead of time, as this could be critical to the trust being deemed to materially participate for purposes of the passive loss rules (IRC section 469) and the 3.8% surtax (section 1411) [Frank Aragona Trust v. Comm’r., 142 T.C. 9 (Mar. 27, 2014)].
Should an individual ever contribute to a nondeductible IRA? Many commentators believe nondeductible IRAs are a poor choice because the same funds invested outside the IRA would not generate taxable income until sold, could qualify for favorable capital gains treatment, and if held until death would receive a step-up in basis. This perspective, however, ignores the asset protection benefits of a nondeductible IRA, which should be considered when appropriate. These can provide a simple, no-cost means of creating a small, protected pot of assets.
IRC section 1031 tax-deferred exchanges have been in the planning toolkit for a long time, but they deserve additional consideration in light of the step-up in basis planning that has recently dominated the estate tax planning landscape. If an individual is evaluating the benefits of removing an asset from her estate versus retaining the asset to obtain a step-up in basis, the possibility of a tax-deferred exchange may solve the issue. If the property is likely to appreciate significantly but can qualify for a future 1031 exchange, then perhaps it should be transferred out of the estate and the tax deferral used to address the loss of step-up in basis. CPAs should be aware, however, that the recent Green Book has proposed limiting the benefit of a 1031 deferral to $1 million.
In a Graegin loan transaction, a family entity or trust (e.g., an irrevocable life insurance trust owning the life insurance) can loan cash to a cash-strapped estate to pay taxes. If the loan is properly crafted (i.e., repayment is prohibited), it can enable the estate to deduct all of the interest to be paid over the term as an immediate expense, thereby reducing taxes on the estate [Estate of Graegin v. Comm’r., 56 TCM (CCH) 387 9TC 1988)]. The leverage that a Graegin transaction can provide to a typical insurance arrangement can be substantial, adding the potentially large interest deduction to the benefit of growing the life insurance outside the developer’s estate. With the increased focus on maximizing income tax step-up in basis planning, especially for depreciable real estate, the benefit of retaining real estate in the estate and growing an insurance policy outside the estate in an irrevocable life insurance trust (ILIT) enhanced by the Graegin arrangement is clear.
While these strategies may provide only a small benefit individually, their aggregate effect can substantially improve estate savings for individuals, and therefore CPAs should not overlook them.