To keep my clients from being overwhelmed by the complexity of the subject, I like to divide estate planning into three boxes and pull the boxes out one at a time.

Box One - "Who Gets What When." In Box One the discussion revolves around the personal lives of the beneficiaries, use of trusts to provide asset protection for the beneficiaries, choice of trustees, business succession, etc. In essence, in Box One we look at nontax issues.

Box Two - Static Analysis. In the second box the discussion revolves around alleviating the tax consequences if my client(s) were to die today. Typically, the subjects include (i) making sure the exemption equivalents (i.e., the amount each spouse may pass free of estate and gift taxation) are fully utilized regardless of the order of deaths, (ii) placing life insurance in irrevocable trusts so the proceeds are not added to the taxable estate and (iii) discount theory.

Discount Theory. The latter subject is worthy of a digression. The transfer tax (i.e., estate and gift taxation) is based on the fair market value of the property transferred. Fair market value is generally determined by reference to a hypothetical sale between a willing buyer and willing seller with each being reasonably informed of the material facts. The keys to understanding discount theory are (i) the property which is taxed is the property which is transferred and (ii) each transfer is a separate taxable event. That is, there is no aggregation.

For example, suppose Mr. Client owns 100% of the stock of SmallCo and the company is worth $1 million. Suppose further that he gifts 20% of the stock to each of his 5 children. The total taxable gifts would be a lot less than $1 million because each gift would only be a 20% interest, thus qualifying for a minority discount for lack of control.

Consider another example. Suppose Blackacre is worth $1 million and that Mr. Client transfers a 1% interest in it to his wife. The value of his 99% interest might only be $750,000 because no one would want to buy a 99% interest.

And consider yet another example. Suppose Mr. Client and his wife transfer all of their investment assets to a partnership with themselves as the only partners. If Mr. Client dies his taxable estate includes his partnership interest, but not the assets held in the name of the partnership.

Suppose further that the partnership agreement provides that a transferee of Mr. Client would not have the right to participate in any partnership level decisions unless the other partner(s) agreed. Mr. Client’s partnership interest might only be worth, say, 60% of the share of the partnership assets represented by Mr. Client’s partnership interest because a buyer would not have control.

Box Three - Dynamic Analysis. Freezes. In the third box we address asset appreciation and, to a lesser degree, asset protection. In a nutshell, the problem is how to keep the IRS from participating in the future appreciation of one’s assets.

The simplest technique is to gift the property to one’s beneficiaries now, rather than waiting until the property has appreciated in value. Of course, Mr. Client may not wish to give up control. So the discussion revolves around various techniques (e.g., QPRT’s, GRAT’s and sales to bypass trusts) which are designed to shift future appreciation free of transfer tax while retaining control.

Typically, the plan includes a regular gifting program to take advantage of the $13,000 annual exclusion from gifts. Properly designed, the gifts would not result in a loss of control and the beneficiary would not actually get his or her hands on the gifted property.

For an example of a leveraged freeze, see the discussion involving QPRT’s in "Estate Planning for a Florida Homestead."

©2010 Steven M. Chamberlain, Esq. All rights reserved. Republication with attribution is permitted.