LIFETIME GIVING REMAINS A USEFUL ESTATE PLANNING STRATEGY
FALL 2000 REPORT

Congress recently failed to override President Clinton's veto of a Republican-sponsored bill to repeal the Federal estate tax. The bill, viewed by the President to be "fiscally irresponsible and unfairly beneficial to the wealthy," would have phased out the current Federal estate tax (which is imposed on estates greater than $675,000 in 2000 and 2001, or $1.3 million for family-owned farms or businesses), gift tax and generation-skipping transfer ("GST") tax by 2009. Until 2009, estate tax rates would have been lowered by one or two percent each year until the top rate was brought down to 42.5% from 55%. Although President Clinton has subsequently stated that he would sign a Democrat-favored plan that would provide for certain tax relief for business and farm owners, for now the unified gift and estate tax under Federal law continues to be a formidable obstacle to transferring wealth.

In light of the veto, the significant tax-saving strategy of gifting property to lower generations during life rather than at death remains an attractive estate planning technique for high net-worth individuals. In general, if a taxpayer transfers property during life rather than at death, he or she pays any gift tax from property other than the gifted property. This can be beneficial since the payment of gift tax removes assets from the taxpayer's estate for estate tax purposes. By contrast, when a taxpayer leaves property to his descendants at his death, his estate pays the estate tax out of the transferred property. This is a harsh result since the estate tax is imposed on the dollars used to pay the estate tax liability. For this reason, the estate tax is characterized as "tax inclusive" taxes while the gift tax is characterized as a "tax exclusive" tax. Although the proposed elimination of the estate and gift tax would have simplified things by making this distinction irrelevant, thereby alleviating the need to construct complicated tax-sensitive estate plans, the veto preserves two primary advantages inherent in lifetime gifting : (1) the transfer of property at a lower tax cost and (2) the shielding of future appreciation on the property from further tax. Provided a client is willing to part with the use and ownership of assets, there are ways in which those assets may be passed to family members without incurring estate or gift tax consequences.

Education and medical payments are a simple gift-giving idea. Many clients are aware that the current Federal gift tax rules allow a taxpayer to give up to $10,000 per year to each of an unlimited number of individuals without gift tax consequences (the "$10,000 annual exclusion" under section 2503(b) of the Internal Revenue Code). Many clients are not aware, however, that the gift tax rules also provide for another effective yet straightforward method of transferring wealth to lower generations at no gift tax cost -- the educational and medical exclusion of section 2503(e). Under section 2503(e), a taxpayer may exclude from taxable gifts any amount paid on behalf of an individual as either (i) tuition to a qualified institution or (ii) payment for medical services provided to that individual. There is no dollar limit to the education/medical exclusion (unlike the $10,000 annual exclusion) and the payments can benefit any number of individuals. For the exclusion to apply, however, the gift tax rules require that the tuition or medical payment be made directly to the institution or person providing the educational or medical services and not as reimbursement to the individual (or the individual's parent) for his or her expenses. In addition, the educational exclusion only covers payments for tuition (either full-time or part-time), but not related items, such as books, supplies, room and board. The medical exclusion only covers payments that are not reimbursed by the individual's insurance and that directly relate to the diagnosis, cure, treatment or prevention of disease, including amounts paid for elective procedures, psychiatric treatment, in-home health care, transportation essential to medical care and medical insurance. Because educational and medical payments are excluded for purposes of both the gift tax and the GST tax (a 55% tax generally imposed on certain substantial transfers to grandchildren), a grandparent could make tax-free educational or medical payments on behalf of his or her grandchildren without having to apply any portion of his or her Unified Credit exclusion amount ($675,000 in 2000 and 2001) or GST tax exemption ($1,030,000 in 2000).

Using the section 2503(e) exclusion now to provide future benefits. The IRS has taken the position that the current purchase of an interest in a pre-paid, non-refundable tuition plan will qualify for the education exclusion, provided the plan relates solely to funding tuition as opposed to other related educational expenses. Many states have Qualified State Tuition programs, although such plans have certain applicable restrictions and, in some cases, unanswered questions.

Can a senior family member make a substantial transfer now to benefit future descendants? In an appropriate circumstance, a taxpayer could take advantage of the educational/medical exclusion by creating a trust today designed to make future education and medical payments on behalf of children, grandchildren and more remote descendants for the maximum duration allowed under state law. Upon creating such a trust, the taxpayer would irrevocably transfer assets to the trust, and could make further irrevocable additions to the trust in subsequent years. During the trust term, the trustee would invest the assets and could make qualified tuition or medical payments on behalf of the beneficiaries as needed; any unconsumed assets could be invested for continued growth. To avoid having the trust assets become subject to the GST tax before the termination of the trust, the trust instrument would provide for annual distributions of a portion of the trust property to a charitable organization. If the taxpayer anticipates that substantial assets will remain in the trust upon eventual termination and wishes to avoid GST consequences at that time, a charity may be designated as the ultimate remainderman. To avoid adverse gift tax consequences associated with any transfers to such a trust, the taxpayer will have to either shield each transfer with a portion of his or her Unified Credit or grant "withdrawal powers" to current trust beneficiaries (so long as the gift tax law continues to effectively treat transfers subject to such powers as qualifying for the annual gift tax exclusion). Provided the governing document meets certain technical requirements, this type of trust presents an opportunity for a senior family member to create a fund today that will utilize the educational/medical exclusion for future generations of descendants without Federal gift or GST tax consequences.