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Estate Planning Comes Down to Tax Risk Versus Reward
Individuals and couples with significant assets may look at estate planning and ask, “How difficult can this be? All I really need to do is make sure my assets get to the right people or institutions, and that I minimize the tax implications.”
Well, that’s easier said than done. On the surface transferring wealth may look straightforward, but the execution is a different story.
It’s true that a “simple” estate plan involves several core documents, including wills, powers of attorney, a marital property agreement, and revocable trusts. It is important that these documents are drafted correctly and reviewed often to avoid unintended consequences.
However, these documents don’t accomplish much when it comes to tax efficiency. In that area, you and your tax advisor need to manage risk by going through a risk/reward analysis.
Gifting techniques offer low risk and modest returns
On the spectrum of estate planning strategies, there are relatively risk-free (meaning a low risk of an IRS audit) wealth transfer techniques, with corresponding low rewards.
Let’s assume that you have a taxable estate for tax purposes, and that you gift one share of XYZ Corporation stock, a publicly traded company, to your child in 2015 when the stock is valued at $1. If the stock appreciates to $2 in 2016, you would have saved $0.40 in transfer taxes ($1 of appreciation multiplied by the transfer tax rate of 40 percent).
Family limited partnerships may be worth the risk
There is no risk in a gifting technique, but there is also little reward. If you put the same share of XYZ stock in a family limited partnership (FLP), and then gift one unit of the FLP to your child, some interesting things happen.
For tax purposes, the gift of the FLP unit will be valued at a discount; let’s assume it’s 20 percent. So the $1 of stock will be valued at $0.80, and if the stock appreciates to $2, you would have saved $0.48 in transfer taxes ($1 of appreciation plus the $0.20 discount multiplied by the 40 percent tax rate). On a percentage basis, this is a much bigger tax reward.
This technique is not without significant risk — the IRS has targeted FLPs for some time, seeking to disallow discounts for partnerships that are established and maintained incorrectly. But if the FLP is managed carefully and adheres to all the partnership requirements, the risk may be worth the reward.
Trusts and other estate planning tools
Most advisors will recommend that you connect your estate and financial plans, which opens further risk/reward scenarios and decisions. If you start bringing in trust instruments, such as spousal access trusts, credit shelter trusts, and grantor trusts, things start to get even more complicated. Complexity often brings risk, but risk may also bring a greater reward.
How we can help
Your tax advisor can assist you in implementing a wide range of advanced tax-saving strategies to direct more of your estate to the people and institutions that matter to you. The decisions you make should begin with a careful look at risk versus reward analysis.