SPECIALIZED TRUSTS and ESTATE PLANNING TOOLS

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X. SPECIALIZED TRUSTS and ESTATE PLANNING TOOLS

A. Overview
B. The Marital Deduction and Bypass Trust (the "A/B Trust")
C. The Life Insurance Trust
D. The Crummey Trust
E. Trusts for Minors under Tax Code sections §2503(b) and §2503(c)
F. The Charitable Remainder Trust (CRT)
G. The Qualified Terminable Interest in Property (QTIP) Trust
H. The Family Limited Partnership (FLP) and "Valuation Planning"
I. The Grantor Retained Annuity Trust (GRAT)
J. The Qualified Personal Residence Trust (QPRT)
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X. SPECIALIZED TRUSTS and ESTATE PLANNING TOOLS

A. Overview.

These are motivated by a desire to pass more wealth to survivors, by saving federal estate tax, while retaining the maximum control permitted by law. They are generally not used for those whose estate (combined marital estate, if married) is expected to be under $1.5 million, since there will be no federal estate tax anyway. Under the 2001 Tax Relief Act, this $1 million figure will rise to $3.5 million over the next few years. Then, the federal estate tax is set for complete elimination in 2010, but the entire 2001 tax law automatically expires only a year later, in 2011. So, if no further legislation is enacted, we would be back to the law as it existed before the 2001 Tax Relief Act. That law provided for the estate tax to continue, with the threshold to reach a maximum of only $1 million.

There remains strong opposition to the total repeal of the estate tax. Additionally, if the rosy economic forecasts that encouraged the tax cut don't come true, there will be additional pressure on lawmakers to "un-repeal" the estate tax well before its scheduled end in 2010. The situation is, therefore, as confusing and uncertain as could be, and folks would be wise to stay in touch with their advisors in the years ahead.

Meanwhile, it is probably safer to plan on the estate tax surviving in some form. At least know where you stand - don't underestimate the future value of your estate! This is a very common mistake. Often, people "forget" assets such as life insurance policies and retirement accounts, both of which are included - with everything else you own.

B. The Marital Deduction and Bypass Trust (the "A/B Trust")

This is the tax planning cornerstone for many combined marital estates (i.e., all property owned by the husband, the wife, and jointly) worth over $2.0 million (in 2006 - 2008). This threshold for the usefulness of the "A/B Trust" will increase over the next few years, as the amount of each individual's shelter against the federal estate tax increases. (See "F.Y.I." below.) With the A/B Trust arrangement, a married couple can pass a combined estate of $4.0 million or less to their children without any federal estate tax, assuming both spouses died in 2006 through 2008.

F.Y.I. The principal of this technique remains valid under the 2001 Tax Relief Act. Many 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. (That might or might not be what you want, however.) We will continue to refer to "$2.0 million" simply to have a figure for discussion.

People invariably get confused when this (or any) Trust arrangement is first explained. Rest assured, this is not nearly as complicated as rocket science - but it is just as unfamiliar. That is what the problem is, and why a little study is necessary. The very concept of a "Trust" is not something most of us have any experience with at all, and we cannot show you a picture. A Trust is an intangible creature of the law. But it is an entity that can own real things. That is the key.

Remember, just think of a Trust as a vessel, or "holding tank," into which money and property can be "poured." This is done by transferring it to the Trustee. Usually, husband and wife serve as their own Trustees, at least initially. A formal transfer of property to themselves - as Trustees - is still required, however.

All the rules and the scheme of ultimate property distribution are decided in advance, with the help of a lawyer, and written into the Trust document. Most people specify the broad outline of their intentions at the time the Trust is prepared, but leave themselves (or whoever else wears the hat of Trustee) great discretion as to all kinds of details. Flexibility later on makes people more comfortable today in implementing the "A/B" plan.

While both spouses are alive, in the community property states, there can be a single Initial Trust, that is revocable and completely in their control. It is similar to, and serves all the purposes of the "simple" living Trust, discussed earlier. The Initial Trust ends at the first death, by splitting into two new Trusts ("A" and "B"). (This happens simply because there is a paragraph in the Initial Trust stating that, upon the first death, the "A" and "B" Trusts are to be created. If separate husband and wife Trusts have been set up, it is only the original Trust of the deceased spouse that ends at this point, and the "A" and "B" Trusts are still created.)

Most planners in the other ("common law," rather than "community property") states have preferred to use separate trusts for the husband and wife. Although a joint husband-wife trust is simpler to understand and set up, there are good (but complicated) tax reasons why attorneys in common law states have not felt comfortable with the joint trust approach. (A couple of IRS rulings in 2002, however, have begun to increase their comfort level.) In any event, the tax-saving principles described for the joint trust here are the same in separate trust situations.

The Trustee (usually, the survivor) divides the Initial Trust property and places some in each of the two, "A" and "B." The "B" Trust (for the "Below-the-ground" spouse) is irrevocable, and makes use of the deceased spouse's estate tax shelter. That is the tax objective here of the "B" Trust. The "B" Trust is established (usually) for the ultimate benefit of children and (eventually) grandchildren.

The Trust is worded so that the federal estate tax "shelter limit" (or "credit shelter" or "applicable exclusion amount") is placed in the "B" Trust. (For 2006 - 2008, $2.0 million.) Remember, this shelter must be used at the time of the first death, or it is wasted. (The "B" Trust is also called the "Bypass Trust," because property in it bypasses taxation.)

The tax goal of the "B" Trust is to get this money out of the couple's combined estate, so that it escapes estate taxation after the second spouse's death, too - not just the first. To illustrate how this works, let us look at a common - and costly - alternative arrangement.

If a couple uses simple Wills alone, the first spouse to die usually passes his/her entire estate to the survivor with no tax at all, because of the unlimited marital deduction. But in so doing, the chance to use one of the couple's two $2.0 million tax shelters is lost. Upon the second death, only the second spouse's shelter is available. Every dollar over $2.0 million will be taxed at rates that start around 40% !

Of course, sometimes the estate is large enough so that the surviving spouse can afford to part with $2.0 million upon the first death. If so, no Trust is necessary to make use of the decedent's shelter. One of the decedent's options is to just make an outright bequest of any amount to anybody. The first $2.0 million would be sheltered from federal gift and estate tax.

Most families, however, face a major dilemma: Tax planning is fine, but Mom and Dad usually do not want the survivor of them to lose the benefit and security of that $2.0 million. Keeping control of the full family estate is a much higher priority than tax savings in most family situations.

Fortunately, the law allows the survivor to retain nearly full control over the "B" Trust for practical purposes, and still take advantage of the $2.0 million tax shelter. So, property in the "B" Trust will not be included in the estate of the second spouse to die, and thus escapes estate tax. Yet the surviving spouse's rights to property in the "B" Trust include:

- All annual income produced by the "B" Trust.

- The annual, but non-cumulative right to withdraw the greater of $5,000 or 5% of the "B" Trust principal, for any reason. ("Mad money.")

- The right to invade this principal, if necessary, but limited to an "ascertainable standard" relating to the survivor's "health, education, maintenance or support." (Precise wording of the Trust is absolutely crucial here to avoid tax trouble.)

What is the survivor not allowed to do with "B" Trust funds? Really, the only prohibited expenditures would probably not be very likely, anyway. "B" Trust money should not be used, for example, to buy a boat or a collection of antiques. (The "A" Trust could be used for such purchases, however.)

As a practical matter, the limitations of the "B" Trust are unlikely to constrain the way the surviving spouse chooses or can afford to live.

The "A" Trust (for the "Above-the-ground" spouse) is also called the "Marital Deduction Trust." Property in this Trust is absolutely and completely under the control of the surviving spouse, who can even revoke the Trust at any time. If somebody else is serving as Trustee, he/she/it must take orders from the survivor, if given. Alternatively, the survivor can just fire the Trustee.

The reason the A/B Trust arrangement is so useful is that it provides a means of doing two things: First, it takes advantage of both spouses' $2.0 million shelter 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.

The $2.0 million shelter is a "use it or lose it" break available only at the time of each person's death. The "B" Trust is a way for the first-to-die spouse to "stake his/her claim" to the tax shelter, to avoid losing it. That is where the big tax benefit comes from.

Strictly from the standpoint of estate tax, the "A" Trust is unnecessary. The survivor has total control over the "A" Trust, and we recall the basic rule presented earlier: There is no tax advantage in that situation. But the other significant advantages of a Trust (e.g., professional investment expertise; management in case of disability) still weigh in favor of using the "A" Trust. (The alternative is to simply use a "B" Trust for its tax advantage, but give all other property to the surviving spouse outright, with no "A" Trust at all.)

BEWARE ! For any Trust to work at all, it must own property; there must be a formal transfer to it. If the A/B Trust is to be established in a Will, rather than as part of a living Trust, an important step must be taken to get the most (or maybe any) benefit out of each spouse's $2.0 million shelter: Each spouse must own $2.0 million in assets -separately.

This might involve some shuffling of title documents, but it is essential. Why? Remember that, in many families, all property is owned by Mom and Dad jointly, with right of survivorship. If so, this property passes at death, outside the Will (no matter what kind of Will it is). Nothing would then be left to place in the Trusts, and the whole plan would completely fail.

BEWARE ! In community property states, a spouse might have a half interest in an asset, even if his/her name is not on the document of ownership. Therefore, any Trust in one of these states should be drafted with particular care to allow allocation of assets appropriately.

C. The Life Insurance Trust

This is a widely used, but unfortunate name for a Trust that is not really a special breed. A "life insurance" Trust is just any Trust, usually irrevocable, that is permitted by its terms to buy insurance. The Trust should be authorized to hold a wide range of investment vehicles, with no requirement that life insurance be purchased.

BEWARE ! The folks at IRS do not like the fact that life insurance enjoys some unique tax advantages. They search for ways to justify taxing it. Although many "Insurance Trusts" are named as such, placing the "I" word on the cover of the document only raises a red flag unnecessarily. It suggests that the Trust was created with tax planning in mind, and might be a good place for the IRS to look more closely. Instead, why not just call it "The Jones Family Irrevocable Trust"?

Why use a Trust to own insurance policies, anyway? First, remember that proceeds from policies you own will be included in your estate, even though paid to a third party. If an irrevocable Trust owns the policy, however, death proceeds can be received by the family income tax-free (as usual), yet not be included in your taxable estate. But a Trust is not necessary to get this result. For example, if a child owns, pays for and is beneficiary of a policy on the life of a parent, he/she can receive the policy proceeds with no tax consequences to anyone.

The real value of using a Trust to hold insurance is to provide for the use and management of the policy proceeds according to your wishes. The beneficiaries might not be old enough to manage a sizeable lump sum of money. Even if age is not a problem, lack of financial and investment savvy might be. Finally, having just lost a loved one, survivors tend to just not care about money matters. This is a terrible time to have to make important decisions. Not coincidentally, it is also a time when grieving spouses are most vulnerable to bad advice and scams.

To avoid estate taxation, the estate owner/insured must avoid all "incidents of ownership" in the policy. Obviously, this is why the insured should not own the policy outright. The IRS, however, looks (way) beyond the obvious for any controlling "strings" or links between the insured estate owner and the policy on his/her life. If any such connection is found, IRS often argues it is an "incident of ownership," requiring that the policy proceeds be included in the decedent's taxable estate. Unfortunately, "incidents of ownership" is not a clearly-defined concept, and the court decisions have not been uniform. So be careful, and seek good advice on this point.

Too often, an irrevocable life insurance Trust is prepared by an attorney as part of a family estate plan, but little guidance is offered on avoiding tax pitfalls. The family breadwinner, for example, often has a life insurance policy already, and is simply told by his/her lawyer to make it a gift to the Trust. That is easily done. It might not be so simple, however, to do it in a way that severs all the insured spouse's "incidents of ownership" in the policy, to achieve the desired tax result. This is a matter on which professional tax advice should be sought.

Ideally, somebody other than the insured (or spouse) should be used as the Grantor of the Trust (e.g., an adult child) to apply for and buy the policy to begin with. If the child lacks funds to pay the premiums, this can be handled by unrestricted parental gifts of less than $12,000 per child from each parent, each year (as of 2006). Parents can always voice their desire as to how their gifts should be spent.

But if a formal agreement were made that the gifts would be used for insurance, IRS might consider that an "incident of ownership" in the policy by the parent. On the other hand, one has to assume the kids are not stupid. If they are not, it should be clear that future gifts would be in serious doubt if this year's money is used to make a down payment on a luxury car.

Often, it is just not practical to obtain new life insurance. If the ideal situation is not attainable, you should recognize several potential problems to work around. Again, these arrangements should not be made without the advice of an attorney and/or accountant experienced in these matters.

An existing policy can avoid inclusion in your estate if transferred to an irrevocable Trust (and if you, as the insured/former owner retain no "incidents of ownership"). Try to wait three years before dying, however. Policies transferred to a life insurance Trust within three years of death will be included in the estate anyway. (Other property is not treated this way.)

When we speak of "transferring" life insurance policies here, it is always meant that the transfer will be a gift, and this is important. As a piece of property, an existing life insurance policy may also be sold by its owner. But in this situation, the special tax treatment given to the insurance is lost. The buyer is treated as having made an ordinary personal financial investment, and the proceeds will be taxed as income when received.

In the intra-family context, accordingly, there should seldom - if ever - be anything of value exchanged when a life policy changes hands. There is still the federal gift tax to consider, however. The taxable value of the policy must be established, and this is not always easy. Remember that a policy placed in Trust, is not a gift the beneficiaries can presently use, so the annual $12,000 gift tax exclusion (in 2006) is not available. The policy cash value is often worth more than $12,000, anyway.

A favorite area of IRS scrutiny is the source of premium-payment funds into the Trust. If it is determined that the funds are, in practical terms, under the insured's control, the proceeds may be included in his estate, even though the policy is owned by the Trust. (That is why, although the insured estate owner might hope his gifts will be used for premiums, the gifts must truly be free and clear, with no requirement as to how the money is spent.) Certainly, too, the insured should not be a Trustee of the life insurance Trust or the policy proceeds may be included in his/her taxable estate.

The Trustee of an irrevocable life insurance Trust must be viewed by IRS as truly independent. Of course, the Trustee is made well aware of the family's situation and desires, and might be expected to honor them. But he/she/it cannot just be a stand-in for the insured estate owner. (That is one advantage of using an institutional Trustee.) If the Trustee is believed to be a mere puppet of the Grantor, the policy proceeds will not be removed from the taxable estate. The primary (but not the only) purpose of the Trust would then be defeated.

TIP: Remember, too, that when IRS challenges something - like the independence of a Trustee - the examination is done after the fact, with 20/20 hindsight. The examiners do not care how good an arrangement looks "on paper." The focus is on what actually happened, and what the final result was. (This advice applies to all tax questions and strategies, not just Trusts. That is why it is pointless to get too "cute" with one's tax planning.)

BEWARE ! Sometimes, people run into trouble just because of what could have happened under the terms of the Trust in question. Example: Assume the Trustee of your life insurance Trust is not specifically prohibited from expenditures in fulfillment of your legal obligations, i.e., the Trustee could buy groceries for the kids, without violating the terms of the Trust document. (Remember, the Trust might well have liquid assets during your lifetime, besides the policy.) Assume further that the Trustee never did so, or had any thought of it. Still, IRS might argue that IF you had been in a bind, the Trustee could have helped you out. Therefore, your so-called "irrevocable insurance Trust" was just a nice, big safety net, that you were fortunate enough not to need. So, IRS might say, never mind the Trust; the policy proceeds should be included in the taxable estate anyway.

D. The Crummey Trust

This Trust takes its name from the court decision in the case of Mr. Crummey versus the IRS. The Grantor's motivation is to create an estate for his/her survivors, through annual gifts, made in a way that discourages the beneficiaries from spending the gifts immediately. The simple way to do that is to make outright gifts, and just tell the recipients of your wish that the money be saved for college, for example. Sometimes, however, a large estate owner has many gifts to make over the years to many people, and lacks confidence that these wishes will be consistently honored by all. This might be due to the immaturity of the beneficiaries. Frequently, too, the estate owner is most concerned about a beneficiary's spouse pressuring the beneficiary to spend any gift money as soon as the check arrives. In that situation, the Crummey Trust is often used.

This Trust was "invented" by Crummey's attorney so that his client could make gifts in Trust, but still take advantage of the $12,000 annual (as of 2006) gift tax exclusion from federal gift and estate tax ($24,000 per married couple). That is the important feature of the Crummey Trust because, as we will see, gifts to many other kinds of Trusts do not qualify for the $12,000 annual exclusion.

The Crummey Trust is a means of serving two of the Grantor's purposes: First, annual gifts are a great way to slowly reduce the taxable estate, while passing along wealth to the next generation. As long as the gifts are made in $12,000 (or less) "chunks" (as of 2006) that qualify for the annual estate and gift tax exclusion, none of the estate owner's $2.0 million tax shelter is wasted on them, so it can be saved for use at his death. More total wealth is thus protected from tax.

Secondly, when the gifts pay for insurance on the estate owner's life, the ultimate benefit to the children can be far greater than the amount given, because the policy proceeds at death might be more than the premium dollars paid to that point. For this reason, the Crummey Trust is commonly used as part of the estate owner's life insurance plan, although it does not have to be.

One faces special problems when making gifts in Trust, however. The $12,000 annual tax exclusion (as of 2006) pertains only to gifts of a present interest in property (e. g., cash, free and clear) - not a future interest. Many people are not aware of this restriction. It means that a gift to many Trusts would NOT qualify for the tax exclusion: Since the terms of many Trusts would not allow the beneficiaries to have unrestricted, immediate access to that gift, it would be a non-qualifying gift of a future interest.

The Crummey Trust is intended to get around this problem. Gifts are made to the Trust, which is irrevocable. (The Grantor cannot end the Trust or take his/her money back, although future gifts can certainly be halted, if desired.) The Crummey Trust beneficiaries are given only a short period of time each year (e.g., 30 days) in which they are permitted by the Trust document to withdraw the gift money from the Trust, free and clear, for completely unrestricted use.

The Grantor hopes they will not do that - and is free to say so - but there can be no formal agreement that the gift money will not be withdrawn. Likewise, there can be no formal requirement that the Trustee pay life insurance premiums with the gift money, although that is very often the Grantor's stated desire.

The right to withdraw the gift must not be illusory, and the Crummey Trust beneficiaries must be formally advised of it in a letter each year. In the original Crummey case, the court decided that this limited access is enough to make the gift a present interest. On these conditions, the gift to a Crummey Trust qualifies for the annual $12,000 (as of 2006) gift tax exclusion . It is fair to call the Crummey Trust a tax "gimmick," but one that is perfectly legal and very widely used.

Unfortunately, absolute technical compliance with the law - each and every year - is burdensome. A failure to comply could have terrible tax consequences. Not surprisingly, these Trusts face particularly close IRS scrutiny. Potentially worse, the Crummey Trust rules are subject to modification. As a creature of past and future judicial decisions, rather than statute, these rules are not written in stone.

The Crummey Trust is a very common feature of estate plans designed by good estate planning attorneys. For the above reasons, however, it should be used with caution. We will shortly see that, in many cases, there are other ways to make gifts to the children in Trust, while getting the benefit of the $12,000 (as of 2006) annual exclusion from gift tax.

Again, there is a simple alternative to the Crummey Trust, that should work fine for many families with mature children as beneficiaries: Make an outright gift of cash, without using a Trust, but announce the "hoped for" use of it, e.g., the purchase of insurance on your life, grandchild's college fund or other investment. If your son-in-law takes the gift and buys a fishing boat instead, maybe then see a lawyer about drafting a Trust. (Of course, any money given to the children this way would be included in their estates - IF they haven't spent it before they die.)

Remember, though, any asset purchased, including life insurance, will be the child's property. As such, it is subject to the claims of his/her creditors, and to the risk of being "cashed in" later and spent. That is often why people use Trusts to begin with. It might be that the beneficiaries can be relied upon to at least initially honor the donor's wishes, but the donor is worried about his children's' future temptation to spend the gifts. If this is the situation, consider using an irrevocable Trust, but without the Crummey provision.

In other words, give the money outright, but "hope" it is immediately re-gifted to the Trust for the intended use. Such a gift will qualify for the $12,000 annual gift tax exclusion, without having to jump through the Crummey "hoops." Once this re-gifting is done, there would be no purpose for the Crummey provision; that year's gift would be safely in Trust and untouchable by the beneficiaries if they are tempted later to get to it.

(Remember, however, that the child making a gift into a non-Crummey Trust would be using up his/her own $2.0 million federal estate tax shelter. Depending on the likely size of the child's estate, this might or might not be an important consideration.)

E. Trusts for minors under tax code §2503(b) and §2503(c)

These Trusts can serve Crummey Trust purposes in many situations. Gifts to these Trusts - by law - qualify in whole or part for the annual gift tax exclusion. The rules are plainly written in the federal statute books -not in a web of written court opinions. Therefore, there are no Crummey compliance worries. These Trusts are irrevocable, yet permit some control over the timing of wealth transfer to the next generation.

In the §2503(c) Trust, annual income may be accumulated and not paid out, but the Trust must provide that, if necessary, both income and the entire principal can be used for the minor's benefit. The law states that if the Trust is worded that way, gifts to the Trust will qualify for the $12,000 annual exclusion from gift tax. There is one serious drawback to the §2503(c) Trust: When the beneficiary turns 21, he or she must be given the right to receive all §2503(c) Trust assets in an outright distribution. The beneficiary can, however, elect to allow the Trust to continue.

In the §2503(b) Trust, annual income cannot be accumulated (must be paid to the beneficiary each year), but the Trust principal need not be made available for distribution upon the beneficiary's 21^st birthday. Unlike the §2503(c) Trust, the §2503(b) Trust principal is not required to ever be distributed to the income beneficiary; it can go to somebody else.

Since the beneficiary has no immediate (if any) right to the Trust principal, the beneficiary's only present interest in the §2503(b) Trust is an income interest, the right to receive annual income payments from Trust investments. Therefore, the amount of each gift that qualifies as a present gift is the present value of the series of income payments that the gift will produce over the years. A financial calculation is necessary.

Both types of §2503 Trusts can be receptacles for annual gifts, including gifts used by the Trustee to pay life insurance premiums. If the insured (or spouse) is the Grantor, Trust income should not be used to pay premiums, or the Grantor will incur income tax liability on the income so used, and might be considered the owner of the policy for estate tax purposes. This is an often overlooked point. So consider using Trust principal or yearly gifts to pay premiums. (Or use another Grantor.)

Potentially significant income tax savings are possible once the irrevocable Trust beneficiary reaches age 14. Trust income is then taxed at the child's rate, which is presumably lower than the parents'. Before age 14, any investment income below a fairly low level (adjusted annually), will be taxed at the child's low rate. Beyond that amount, however, §2503 Trust investment income will be taxed at the parents' (higher) rate. (This is called the "kiddie tax.")

Property (e. g., a mutual fund account) expected to increase greatly in value over time makes an ideal gift into a §2503 Trust. Decades of price appreciation can be excluded from one's estate if it occurs after that property is irrevocably placed in Trust. This is terrific - as long as the donor does not decide later that giving away the property was a mistake.

F. The Charitable Remainder Trust (CRT)

Here, the Grantor has a charitable motive and wants a big current income tax deduction, too. Often, however, the Grantor does not want to give up all benefit of the property to be donated. If the Grantor needs lifetime income, a CRT, which is irrevocable, can be an extremely useful tool.

This is a very complex topic, with many variations on a common theme. Great flexibility is possible, but very competent advice is required. Tax laws and rulings pertaining to CRTs will always be subject to changes that could drastically affect what was a well-conceived arrangement when drafted. So an important clause in any of these Trusts can be included, giving the Trustee the right to "doctor-up" the Trust in the future, to comply with presently unforeseen tax law changes. This provision should allow you - and your lawyer - peace of mind, with regard to tax issues. Note, however, that you cannot reserve the right to just end the CRT.

In the most basic form of CRT, called a Charitable Remainder Annuity Trust (CRAT), a pre-selected, fixed dollar payment is made from the Trust to the Grantor each year for life, or for a certain term of years, with the remainder (i.e., the left over Trust principal) to a charity or educational institution at the Grantor's death. In a more commonly used variation, called a Charitable Remainder Unitrust (CRUT), the Grantor receives a fixed percentage of the Trust's value each year, rather than an unchanging dollar amount.

The CRUT is often preferred because it can provide inflation protection: As the Trust (presumably) grows in value each year, so, too, will the dollar amount of the Grantor's annual draw. Additionally, the CRUT, but not the CRAT, permits additional contributions in the years after the trust is set up.

Some people use a special type of CRUT as a retirement savings vehicle. Usually, a CRUT pays the Grantor a percentage of trust assets each year irrespective of trust income. That's great for many folks who aren't getting a paycheck any more. But a CRUT can also be designed to keep its early-year payments low. CRUT payouts can be limited to just the income actually earned, with no dipping into principal - yet. If the CRUT funds are invested in assets that yield little or no current income, payments to the Grantor in the early years of the trust will be minimal.

That suits many retirement savers who don't want or need more taxable income right now. During the working years, they can make partially tax-deductible contributions to one or more CRUTs and let the money grow tax-deferred. Meanwhile, the Trustee retains and keeps track of the annual payments the Grantor could have received if he had taken his full percentage of CRUT assets each year as called for when the CRUT was established. Then, during the Grantor's retirement years, the accumulated CRUT payouts that he didn't need earlier are made up to him.

With either a CRAT or CRUT, the remainder interest that will eventually go to charity has a value today, established with a financial calculation, using an "assumed" future interest rate. (After all, a promise that property will go to charity in the future is worth something today.)

The IRS publishes the interest rate each month to be used in this calculation of the value - in today's dollars- of the charity's right to receive the remainder of Trust assets at the specified future date. That is the amount the Grantor is giving away. It is, therefore, the value of the current income tax deduction. A big additional benefit is that the donated property, and all future price appreciation, is removed from the Grantor's taxable estate.

The IRS rate is 6.0% in September, 2006, and is assumed in this very simple example:

A $1,000,000 CRAT is established, providing the Grantor (or somebody of his/her choice) with a fixed, $75,000 (taxable) payment each year for 10 years. The present value of that 10 year stream of payments is $552,007. Subtracting that figure from the full $1,000,000 placed in the Trust results in $447,993 - the present value of the charity's remainder interest in this CRAT. In other words, we're putting a price tag today on the value of a lump sum the charity will not get for 10 years. That's the value of the donation. For the same CRAT, but with a 15 year stream of payments, this remainder (and value of the donation) would have a present value of $271,581.

Note that when the IRS interest rate goes UP, the present value of the income stream goes DOWN. The result is that the remainder (and therefore the tax deduction) also goes UP when the official interest rate rises, and vice versa. The present value of the remainder also DECREASES as the length of the trust term INCREASES, and vice versa. (This makes sense because a longer trust term means the charity will have to wait longer for its payday, and more benefit from the trust will have gone to the Grantor.)

Those present values of the remainder interest represent the income tax deductions that would be available to be taken in the year the CRAT is established. (Ten and fifteen year terms have been arbitrarily chosen for illustration. Usually, the Grantor wants to receive annual payments for life. In that case, the actual figures would depend on the Grantor's life expectancy, taken from an official table.)

The Trust also provides that if income is insufficient to make the annual payments, Trust principal can be invaded. This is a "safety feature" that helps provide peace of mind about giving away the money. Note that computational rules - as a practical matter - may limit the usefulness of the CRT to taxpayers much below age 50 who desire to receive payments for life.

Often, part of the tax savings from the deduction is given to the children, who buy life insurance on the Grantor to fund a "wealth replacement Trust," so that their "inheritance" will not be reduced, despite the gift. In these cases, everybody wins.

This strategy can be especially useful in dodging an income tax bullet - capital gain. If a Grantor owns property that has increased in value since acquisition, there is generally income tax due on the gain if and when the property is sold. For property that has been held over decades, that potential gain - and tax - can be enormous. If a CRT is set up, the property is donated and the charitable Trustee sells it, however, there will be no tax.

Example: The Smiths' largest asset is a block of IBM stock, purchased many years ago for a small fraction of its $1 million value today. If they sell it themselves on the open market, most of the proceeds will be taxed as a capital gain, probably at 15%. But if the stock is placed in an irrevocable CRT, the Trustee can then sell it and pay no tax. The full $1 million is then available for the Trustee to invest to provide lifetime income for the Smiths. Their current income tax deduction equals the value of the remainder interest in the Trust, to go to the qualified charity selected.

The CRT is also an excellent tool for those without appropriate beneficiaries. Indeed, in many situations, the CRT is the closest thing to "tax magic" that exists.

G. The Qualified Terminable Interest in Property (QTIP) Trust

This is a good arrangement for those entering second marriages with substantial estates already. It provides lifetime income for the surviving current spouse, while leaving the remainder of Trust property to the children of a previous marriage (or others). In other words, although the surviving spouse has an income interest in the QTIP Trust , he/she cannot decide to whom the property shall pass after his/her death. Distributions are not permitted from a QTIP Trust to anyone but the surviving spouse during his/her lifetime.

A bequest to a QTIP Trust, by law, "qualifies" for the unlimited marital deduction for estate tax purposes, even though the surviving spouse's rights to Trust assets are less than total. (Ordinarily, a bequest to a spouse would not be able to take advantage of the marital deduction unless it were given outright - free and clear, with no limitations as to how or to whom the surviving spouse could dispose of the property.) This is important because it avoids (or at least delays) the imposition of federal estate tax on the property placed in the QTIP Trust. Note that all Trust assets are included in valuing the survivor's estate for tax purposes, just as they would be if left outright to the survivor.

H. The Family Limited Partnership (FLP) and "Valuation Planning"

These are best suited for an estate consisting largely of real estate or a family business, but not a professional practice or firm. (The use of money or capital resources must be a major income producing component of the enterprise - as opposed, for example, to a medical practice, where personal services generate the income.) The FLP is an "ordinary" limited partnership, organized under state law, in which the partners happen to be a small, closely related group.

What are limited partnerships? First, one must understand the general partnership: This is a group of individuals who have agreed to collectively own and manage some form of property or business. No organizational papers need to be filed. Each partner has a share of income and management voting rights proportional to his/her percent ownership. But each partner, personally, is fully liable for 100% of all partnership debts and other liabilities.

General partnerships are not useful for estate planning. Parents want to transfer property to their kids to avoid its inclusion in their taxable estate, but they do not want to give up the control that goes with that transfer of ownership. Also, the unlimited liability of all partners is an unacceptable risk in most families.

How are limited partnerships different from general partnerships? They have two classes of partners - general and limited. General partners run the business, regardless of the percentage they own. They have unlimited liability. That means that if partnership property were insufficient to satisfy creditors, any other, individual property of the general partners could be at risk. In the typical FLP, these are the parents.

Limited partners have no control and limited liability - their amount at risk is limited to their ownership stake. In the FLP, the children are the limited partners. (Note that limited partnerships do have to file papers with the state, and comply with state limited partnership laws.)

What's so good about the limited partnership? It was designed by law as a form of business organization that any group of investors might use to undertake a business or financial venture. But its structure also happens to facilitate parents' estate planning. So increasingly, the limited partnership is being used, where appropriate, as a means of holding and distributing family wealth. The operation and benefits of a FLP are best illustrated by example:

Family property (e.g., stock in the family company, and/or real estate) is placed in the name of the partnership, which is divided (on paper) into 100 "units" of 1% each. The parents assume two ownership and management roles. Wearing the hats of general partners, Mom and Dad take 2 units, and hold 98 units as limited partners. At this point, they fully control the partnership business and property in their role as general partners. They also happen to own 100% of everything, anyway - for now.

The parents begin a series of yearly gifts (each worth $12,000 or less, as of 2006) of partnership units to children or grandchildren. The plan is to slowly reduce their taxable estate, by taking advantage of the annual exclusion from federal gift and estate tax of $12,000 per person, to each donee (as of 2006). The making of gifts is simpler using partnership "units," especially when several different, and difficult to divide assets are owned.

What about the parents losing management control by giving away an increasing share of ownership to the children over time? No problem. The parents remain firmly in control, due to their role as general partners. This has nothing to do with their ownership percentage. To ensure continued family control, the partnership agreement provides that the share of any partner who wants to sell his/her share must sell it to the parents at a fair market price.

When a distribution of FLP property is made to a partner, there is generally no taxable gain recognized at that time by the recipient, even though the property might have increased in value since the FLP acquired it. In contrast, taxable gain would be recognized if a corporation were used to hold appreciated assets distributed to a shareholder.

Protection from creditors and lawsuits is much greater if Mom and Dad's property is placed in a FLP. Then, the parents own only a "partnership interest" - not the actual property contributed. So that is the maximum a creditor stands to get. In practice, even if he successfully sues, a creditor would generally be entitled only to the rights to future income that go with the parents' partnership interest. (Note, however, that if property is transferred for the purpose of defeating the rights of an existing creditor, the conveyance can sometimes be "undone" in court.)

The FLP can offer family income tax savings. The total tax paid by all family members on partnership income can be decreased when it is allocated to those in a lower tax bracket than Mom and Dad. This advantage can be enhanced by paying family members reasonable and appropriate salaries, if justified by actual services performed. Remember, however, that if Mom and Dad are truly "running the show" they must pay themselves a reasonable salary. The IRS won't allow them to forego reasonable compensation so that more income becomes available to allocate to family partners in lower tax brackets.

"VALUATION PLANNING." The division of property ownership into "units" results in another tremendous advantage of the FLP: The partnership units given away undergo a "magical" decrease in their value - for gift and estate tax calculations. This means that more true wealth can be "squeezed into" every $12,000 gift, and more can be protected by the $2.0 million (in 2006 - 2008) credit shelter.

"Value," as used in tax matters, most commonly means fair market value to the public. For property interests that are not publicly traded every day, as are big company stocks and bonds, the determination of value can be difficult and open to argument.

We can start with the truism that, "the whole is worth more than the sum of the parts." Conversely, the total value of 100 individual unit "slices" of FLP property is less than that of the whole estate, if appraised as one "pie." E.g., a 10% stake in a FLP that owns a $100,000 building is worth less than $10,000.

Why? For one thing, minority share owners have 0.0% day to day control over the property and the income it produces. None of them has the power to sell the actual assets and "cash out" the partnership's stake in that investment in favor of another - only the general partners can make that decision. All the minority owner can do is sit tight, or maybe "cash out" himself, by asking for fair market value for his/her interest. But what is "fair market value"?

Go try to offer to the public something called a "partnership unit."! Would most of the public even know what that is? And even if a prospective buyer understood the operation of a limited partnership, who would want to be in a minority business arrangement with members of another family? In other words, because of all its drawbacks, a minority interest in property is not very "marketable" - which is an independent basis for claiming an additional discount in its value.

For these reasons, "valuation discounts" of 30% to 35%, and even much more are often accepted by the IRS. Indeed, fractional share owners of any form of family-owned property or business have something that is not easily marketable to the general public. This is the essence of "valuation planning."

The idea of "fractionalizing" family property is an important estate planning concept at the heart of several widely used techniques. This kind of planning is complicated, requiring the help of an accountant and qualified appraiser, as well as a lawyer. But the ultimate estate tax savings can be huge. Because of this, make no mistake: Especially in an intra-family situation, the IRS does not like valuation discounts based on "lack of marketability" or "minority interest." Never has, never will. This reality must be prudently factored into your planning. In other words, don't get too cute or too greedy - whatever you are doing.

TIP: For those daring enough to claim aggressive valuation discounts, one prominent estate planning attorney has suggested a clever strategy to keep the IRS at bay: The estate owner bequeaths a desired share of his "fractionalized" property, knowing that at death his representative will claim a very low value when filing the estate tax return. But the estate owner also directs that all of his wealth above a certain dollar value will go to charity - which would result in an estate tax deduction. So where does this leave the Tax Man? Sure, he can challenge in court the low value claimed for the "fractionalized" estate property, and he might win. But what's in it for the IRS? Nothing! After all, even if the estate property does end up being valued highly, anything beyond that pre-chosen dollar value goes to charity, not Washington. The estate owner hopes the IRS will quickly recognize the likely outcome of this situation and pick on somebody else.

The FLP can be so attractive a tool, that a cautionary note is in order. The tax law requires a legitimate non-tax, business purpose for the use of a FLP, or it will be ignored by the IRS. The FLP is coming under increasing IRS scrutiny on this very basis.

Putting aside income and estate tax savings, there are certainly valid non-tax motivations for parents to give to their children and grandchildren. The transfer of an ownership interest in the family company, for example, might help provide the younger generation with business savvy and wisdom in handling money. Yet Mom and Dad might not feel comfortable giving an increasingly large percentage of stock ownership to the children. The giving of FLP units does not also give increased management control of the company that the parents might fear would occur with a direct gift of company stock.

Some of the other important non-tax purposes of the FLP include the partial protection against creditors (discussed above) and preventing family assets from being wasted by the younger generation or entangled in a divorce. FLP ownership units given by the parents to a child are not easily converted to cash, or co-mingled with other assets. Since the gifted units remain separate and clearly identifiable as such, they will usually not be "on the table" if the child ends up in divorce court dividing property some day.

Another non-tax advantage of using the FLP to hold family wealth is the convenience and possible cost savings of centralized of asset management. If the family owns real estate in another state, placing it in the FLP can also avoid the need for probate proceedings in that state. (A Will or Trust would still be needed in the family's home state, however, to dispose of any FLP units still owned by the parents when they died.)

Lifetime gift giving can be made much more convenient with the FLP, and this is a non-tax advantage. When the family estate consists of diverse assets owned by the FLP, Mom and Dad can parcel out gifts of FLP units much more easily than fractional shares in real estate or business interests.

BEWARE ! Many FLPs have been created solely as repositories for assets like publicly traded stocks, bonds, life insurance or a vacation home. These FLPs appear to lack any valid business purpose. When such FLPs - or any techniques - are used strictly to obtain "valuation discounts," or other tax advantage, they invite IRS scrutiny or a challenge. From a conservative viewpoint, these FLPs are therefore risky, and are likely to become increasingly so.

Certainly, there is plenty of legal authority to support the taxpayer, should the IRS challenge an FLP owning, for example, nothing but publicly traded mutual funds. Indeed, there appear to be few occasions on which the IRS has actually successfully raised such a challenge - yet. But the IRS does not like tax gimmicks, and has a variety of time-honored legal theories on which to rely in fighting them. Moreover, the legal positions and auditing priorities of the IRS are always subject to change. So, only one piece of firm advice can be offered here on the "aggressive" use of the FLP: Discuss the situation in detail with a competent tax advisor.

I. The Grantor Retained Annuity Trust (GRAT)

This is an irrevocable Trust, good for shifting some of the value of an asset out of the estate. The Grantor places assets in Trust for the ultimate benefit of the children (i.e., they have a remainder interest), but retains the right to an annual pay out for a period of years.

Example: Grantor creates a GRAT and transfers $300,000 in mutual fund shares into it. The Trust provides that the Grantor will get a $6,000 annual pay out for 15 years, after which the Trustee will make a complete and final distribution of the shares to the Grantor's children.

At this point, there has been a taxable gift - but not of the full $300,000, because there are "strings" attached. After all, the money is not available to the children for 15 years. This is how tax savings are possible. At the end of 15 years - IF the Grantor is still alive - the value of the mutual fund shares, including any price increase, will have been removed from Grantor's estate and will not be subject to tax upon his death. The GRAT is also a good way for the owner of a growing, closely held business to retain an income for himself, while passing the business along to his heirs before any more (taxable) growth occurs.

By accepting some gift tax liability at the time the GRAT was set up, the Grantor has reduced his estate tax liability later, and the heirs end up with more. If the grantor dies within the term of the Trust, all property is included in the estate, and there are no tax consequences - just as if nothing had been done.

The key to the GRAT technique (and the Charitable Remainder Trust) is the relative values given the two interests involved: The gift of the remainder interest in the Trust principal, and the value of what the Grantor has retained - the present right to collect a certain cash pay out from the Trust each year for "X" years. There is a financial calculation that depends on the current interest rate published by IRS, the number of years during which Grantor will take the Trust payout, and the amount of the payout. The greater the annual pay out, and the number of years of payments, the greater will be the value the Grantor has retained for himself, and the smaller will be the value the IRS gives to what is left over, which is the taxable gift. (In the CRT, of course, "what is left over" goes to charity, so there is no taxable gift. This value will therefore be the amount of the donation and current income tax deduction.)

J. The Qualified Personal Residence Trust (QPRT)

This is an irrevocable Trust, similar in concept to a GRAT, with a confusing name. It is a good method of shifting the value of the family home out of your estate, for the purpose of lowering the ultimate estate tax.

The house is placed into Trust for the future benefit of the children. The value today of this remainder interest is a taxable gift. As with a GRAT, the Grantor accepts some federal gift tax liability now, to save more on federal estate tax later. What is retained here by the Grantor is not income, but the right to live in the house for a term of years. If the Grantor outlives that term, the value of the house - plus any property appreciation since it was transferred to the Trust - passes to the children with no additional federal estate tax. As with a GRAT, if the Grantor does not survive the term of the Trust, it has no tax effect.

The QPRT does, however, have two significant drawbacks: First, the children will have received the house by lifetime gift, not inheritance, so there is no step-up in the tax basis of the property. For homes purchased decades ago at a fraction of today's price, this means that income tax (at the 15% capital gains rate) must be paid on the increase in value - if the property is ever sold by the children. (Recall that, because the basis of inherited assets is "stepped up," a lifetime of value appreciation can totally escape income taxation.) The Grantor should crunch the numbers to see which scenario will most likely result in the lowest total tax.

Secondly, if the Grantor does survive, he/she must start paying the children fair market rent, or the IRS might look at this as a sham transaction. Payment of rent can be viewed as a further opportunity to pass wealth to the children, while decreasing the size of the taxable estate. A long term lease can provide the security they seek, if the payments are real and reasonable in amount. But this adds an element of insecurity to the arrangement and is difficult to accept psychologically for many people.

Note that a new tax regulation - applicable to QPRTs created after May 16, 1996 - has eliminated the common technique of permitting the Grantor the right to buy back the residence for his continued occupancy at the end of the Trust term. Now, the Trust document must specifically prohibit such a buy back. Indeed, this area is a good example of how the IRS looks at the "substance" of an arrangement over its "form," scrutinizing "cute" transactions and changing the rules in the middle of the game, when necessary. So even if one has a QPRT created prior to the regulation's effective date, the "buy back" technique should be used only with great caution, if at all.

Note, finally, that even if your state has an inheritance tax, it might well have no gift tax. If not, the QPRT (and the GRAT, above) can also save state death tax. If the Grantor outlives the Trust, the house would be considered a gift, not subject to the state tax, if any, on inheritances.

Your comments, suggestions and constructive criticism are welcome.