Friday, March 5, 2010

How Do I Know If My Estate Has Enough Liquidity?

What Is Estate Liquidity and Why Do I Need It?

Estate liquidity refers to the ability of your estate to pay taxes and other costs that arise after your death using cash and cash equivalents. If your property is mostly non-liquid (e.g., real estate, business interests), your estate may be forced to sell assets to meet its obligations as they become due.
Estates are often cash poor. Unless sufficient liquidity has been provided, the forced sale of non-liquid assets to pay settlement costs can compound estate shrinkage. In these situations, the buyer always has the upper hand. But even people of modest means who never considered themselves rich enough to need much estate planning can be in for a shock. In addition to having to settle-up with Uncle Sam and state tax collectors, creditors must be paid in full before a taxpayer's heirs can receive their inheritances.

Liquidity planning is part of estate planning. There are generally three ways to deal with the liquidity issue:
1. Reduce taxes by fully using the $2 million Applicable Exclusion Amount at death (for the year 2007), making annual gifts, and using planning techniques such as GRATs and QPRTs.

2. Reduce expenses by avoiding Probate and using a Living Trust.

3. Increase the cash and liquidity of the estate through conversion of assets and the use of life insurance.

Let’s look briefly at all of these techniques.

Reducing Taxes Through the Applicable Exclusion Amount and Gifting

You can give assets with unlimited values to your spouse, as long as your spouse is a U.S. citizen, and to qualified charities. Gifts totaling up to $12,000 (in the year 2007) can be made to any number of individuals in each calendar year. Gifts that do not qualify for the marital deduction, charitable deduction, or $12,000 annual exclusion are taxable gifts, but no gift tax has to be paid until your cumulative lifetime gifts exceed the "applicable exclusion."

Upon death, your Gross Estate includes the current fair market value of all property interests held by you at the time of your death. There are deductions for debts, administrative expenses, qualified transfers to spouses, and transfers to qualified charities. The net amount is the taxable estate. To the extent the applicable exclusion has not been utilized for lifetime gifts, it will be applied to the taxable estate. The applicable exclusion amount for 2007 is $1 million in gift tax and $2 million in estate tax.

The way to reduce taxes is to use the applicable exclusion amount to its fullest while still applying the unlimited marital deduction. Simply leaving your assets to your spouse will create a higher tax burden since your applicable exclusion amount will be forfeited. A qualified estate planning attorney can help you determine the best way to minimize taxes using the applicable exclusion amount.

Reducing Taxes Using a Grantor Retained Annuity Trust

A Grantor Retained Annuity Trust (GRAT) is a tax-saving Irrevocable Trust in which you transfer property to a Trust, but receive a fixed income stream until termination, at which time the Trust’s remainder beneficiaries receive the assets. A GRAT is used to reduce gift taxes on the transfer of assets to the next generation. It is best used with highly-appreciating assets, including closely-held stock.

The value of the gift is determined when the Trust is funded, so any appreciation of the assets passes gift tax-free to the remainder beneficiaries. However, the funding of the GRAT is a taxable gift from you.

The principal advantages of a GRAT include:

• The appreciation of the assets is moved out of the estate and avoids gift tax.

• Gift taxes are greatly reduced.

• Compared with a direct gift, you maintain control of the assets for a longer period.

• You maintain some or all of the income from the transferred assets for the term of the GRAT.

• So long as you survive the term of the GRAT, the assets used to fund the GRAT are not taxed in your estate upon your subsequent death.

Two cautions apply to a GRAT, however:

1. If you die during the Trust term, all or most of the Trust assets would be included in your estate. Therefore, the Trust term must be carefully selected to provide a great likelihood that you will outlive the term of the Trust.

2. You will lose the economic benefit of the assets during some portion of your remaining lifetime.

Reducing Taxes Using a Qualified Personal Residence Trust

Your residence is probably your most important asset. Traditionally, the home has been a good financial investment. It has been an investment that has risen steadily over the past several decades with less volatility than the stock market. The home also has important attributes from tax, estate planning, and asset protection perspectives. Your home can enable you to do advanced estate planning such as a Qualified Personal Residence Trust (QPRT).

With a QPRT, you can make a gift of an interest in the home to your children. If your home grows in value faster than the interest rate assumed by the IRS, the additional growth is passed without any tax. During the term of the QPRT, you can continue to live in the home.

A QPRT is an Irrevocable Trust that allows you to retain the exclusive use of the residence for a term of years selected by you. If you survive the term of the Trust, the QPRT terminates and the residence is either retained in further Trust for, or distributed to, one or more third-party beneficiaries, such as your children or grandchildren.

The QPRT has no income tax consequences during the term of the Trust. You may still use the principal residence capital gain exclusion and deduct mortgage interest and property taxes. During the term of the Trust, you may sell the house and purchase a replacement residence. If the residence sold is not replaced, the QPRT pays an annuity to you.

The "catch" is that after the term of the Trust, you will no longer have the right to live in the residence. At this point, the beneficiaries could lease the residence for fair rental value to you.

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