Module 3 — Planning Process & Strategies

Four major financial issues are addressed by estate planners: property distributions (selecting the most effective methods and timing of asset transfers); liquidity planning (ensuring adequate cash to carry out the plan); tax consequences (minimizing estate shrinkage due to income, death, and gift taxes); and business planning (maximizing value for business owners — covered in Module 4).

Property Distribution — Decision to Avoid Probate

Probate is the legal process that supervises the orderly settlement of a decedent’s affairs. Its purpose is to protect creditors and heirs, oversee payment of debts and legal obligations, and distribute remaining assets according to the will and applicable state laws. Without advance planning, the estateholder’s property passes to heirs through the probate process using the state’s intestacy laws.

While the probate system cannot be avoided entirely, its effects on the estate can be minimized. There are several will substitutes that avoid probate as a method of distributing property. Some — such as retirement plans and life insurance — are asset-specific. Others — such as living trusts and joint tenancy — have wider application and can pass almost any type of property to beneficiaries without probate.

Pros & Cons of Probate

Many financial planners feel the probate process is too cumbersome and routinely advise clients to avoid it. However, the probate system does offer certain advantages that should be considered before dismissing it entirely.

Pros & Cons of Joint Tenancies

Joint tenancy with right of survivorship is a commonly used and simple alternative to the probate system. Property held in joint name passes directly to the surviving co-owner(s) at death — without probate, without complex legal documents, and at little or no cost. It is sometimes called “a poor man’s will.” Upon a co-owner’s death, the survivor takes possession by presenting a death certificate and completing relatively simple forms.

Pros & Cons of Living Trusts

A living trust is created during the estateholder’s lifetime. Most popular are revocable living trusts, which allow the creator to alter the arrangement during their lifetime. In many plans, the estateholder manages the trust’s assets as initial trustee; upon death, a successor trustee operates the trust and distributes property to named beneficiaries. Like joint tenancy, trust distributions avoid the delays and publicity of probate — but unlike joint tenancy, the estateholder retains control and can restrict how and when property is distributed to heirs. Since revocable trusts do not constitute a completed gift, there are no gift tax consequences upon creation or funding. Property transferred through a revocable trust also receives a stepped-up basis at death (the grantor trust rules treat the property as still owned by the grantor).

Which Alternative Is Best?

The decision to avoid probate is not always simple. Each estateholder must review the advantages and disadvantages of available alternatives and select the one that best meets individual needs.

• Probate may be preferred for estateholders facing significant creditor claims (the short claims period offers real protection), those expecting family conflict (court supervision provides an impartial forum), or those in states with simplified informal probate procedures under the Uniform Probate Code
• Joint tenancy WROS is best suited for uncomplicated estates and primarily when spouses are co-owners. The severe tax consequences and shared control during life argue strongly against its use for non-spousal co-owners or for estates subject to federal estate taxes
• Living trusts offer significant advantages for larger, more complex estates and for those who want privacy and timely distributions. When comparing costs, estate planners must analyze who will serve as executor and trustee — fees for independent professional fiduciaries are usually higher than for family members, and annual trust administration costs do not apply with wills and probate

Timing of Distributions — Lifetime Gifts vs. Post-Mortem Bequests

Another major consideration of the estate planning team is the timing of property distributions. There are significant tax differences between lifetime gifts and postmortem bequests. Lifetime gifts typically reduce income taxes during the donor’s lifetime and reduce transfer taxes after death. Postmortem bequests do not significantly affect estate tax liability, except for the unlimited deductions for bequests to a spouse or charity. Among the tax and non-tax benefits offered by lifetime transfers are:

• Shifting income to lower-bracket taxpayers
• Reducing the size of the taxable estate (intentional defunding)
• Eliminating future appreciation from the estate (estate freezing)
• Annual gift tax exclusions
• A sense of satisfaction in seeing the gift being used
• Transferring asset management to others
• Avoidance of probate
• Speed and privacy of distribution

The following discussion centers on the tax factors involved in gift strategies. A number of other factors also affect the estateholder’s decision to make a lifetime gift or delay the bequest until after death. To obtain the tax benefits listed above, the donor must relinquish control over the property. If the donor is unwilling to relinquish control — for financial or emotional reasons — lifetime giving is not a workable estate planning tool.

Income Tax Considerations

One major tax advantage of lifetime gifts is the ability of the donor to shift income tax liability to a taxpayer in a lower tax bracket. Income shifting has two benefits: the donor’s tax liability is reduced and subsequent accumulations of income occur at lower tax rates.

Income shifting is possible because of the progressive nature of the federal income tax system. If the same marginal rate applied to all taxpayers, there would be no tax advantage in shifting income. Income shifting is most beneficial when income is transferred from high-bracket taxpayers to relatively low-taxed recipients. Historically, children of high-bracket taxpayers have been popular recipients. However, the kiddie tax limits income shifting to younger children — investment income of children under the threshold age is taxed at the parent’s rate. (The 2017 Tax Cuts and Jobs Act changed the kiddie tax to apply trust and estate income tax rates — which reach the highest bracket at very low income levels. This applies through age 18, or through age 23 for full-time students.) Children above the kiddie tax age are still excellent prospects for shifting current income. In some cases, an elderly parent in a lower bracket may also be a potential recipient for income shifting plans.

To shift income to another taxpayer, the donor must transfer ownership of the income-producing asset. This poses challenges when transferring to minors. For many practical reasons, outright gifts to minors are not recommended. Adults can shift income into custodial accounts and trusts for the benefit of minors. Income earned in a custodial account is simply taxed to the minor (possibly subject to the kiddie tax). However, gifts to a trust can pose tax planning obstacles. If the donor retains control over the trust, it is a grantor trust — income is taxed to the grantor, not the minor, so no income shifting occurs. Careful drafting can avoid the grantor trust rules, but the grantor must be willing to truly relinquish control over the trust.

The recipient need not be an individual. The donor can transfer assets and income to non-individual taxpayers such as trusts and corporations. Non-grantor trusts and estates are taxed at separate rates (which reach the highest bracket quickly). C corporations are taxed at the flat 21% corporate rate. If these entities have lower effective tax rates than the donor, effective income-shifting tactics are possible.

The most beneficial assets for income shifting are high-yielding assets with few built-in tax advantages. Taxable corporate bonds are prime candidates; tax-free municipal bonds are not (the donor is already receiving the tax benefit). Preferred stock makes a good prospect; common stocks, tax shelters, and rental real estate generally do not. In addition, if the donor has taken an investment tax credit or used accelerated depreciation on property, the property may be subject to recapture — the donor may have to repay the IRS for deductions taken earlier.

Parents of young children subject to the kiddie tax may wish to pursue a different strategy: give gifts of non-income-producing or tax-exempt assets while the children are young, with the expectation of liquidating them when the children are older and no longer subject to the kiddie tax. Growth stocks, interests in land, municipal bonds, and EE Series savings bonds are logical choices for this tactic — they allow the parent to use the annual gift exclusion while avoiding current taxable income in the child’s hands.

Basis Planning for Lifetime Gifts

Another critical income tax consideration is the cost basis of the property after the transfer. The cost basis of inherited property is stepped up to fair market value as of the date of death — since the market value is usually higher than the decedent’s original cost, the heir’s new cost basis is said to be “stepped up,” potentially eliminating capital gains on pre-death appreciation. This is not the case for lifetime gifts — the recipient’s cost basis is the lower of the donor’s original cost or the current market value (carryover basis). This different tax treatment has important planning implications.

When a donor has an unrealized capital loss on an asset, it is generally not a good idea to give that property away. The recipient’s cost basis will be the lower of original cost or current value — so the donee cannot take advantage of the capital loss. The same is true of inherited property: the heir may not write off a capital loss on their tax return. If the estateholder is considering a gift of depreciated property, the best course of action is to sell the property and give the cash proceeds. In this way the estateholder can take advantage of the capital loss on their own income tax return — a benefit neither donees nor heirs can claim.

One final consideration is the deferral of capital gains taxes. In the case of an outright sale, capital gains are recognized and taxed immediately. Under certain circumstances, the taxpayer can delay recognition of gains and the resulting tax liability. Installment sales and private annuities are two ways to defer payment of capital gains taxes — these techniques are discussed in greater detail in Module 4. Deferral of taxes, coupled with the time value of money, can result in significant benefits to the taxpayer.

Gift Tax Considerations

Annual Gift Tax Exclusion

A primary tax benefit to donors of lifetime gifts is the $18,000 annual exclusion per donee (2024). Given a long enough period of time, estateholders can transfer a significant portion of the estate’s value — totally transfer tax-free — through lifetime gifts. Married couples can “split gifts,” increasing the tax-free amount to $36,000 per donee per year. There is no limit on the number of recipients. Refer to Module 1 for a complete discussion of the federal gift tax system and its coordination with the estate tax.

Gifts Between Spouses

Gifts between spouses are totally gift-tax free, regardless of size. The typical result of interspousal gifts is tax-neutral — assuming the property would have been bequeathed to the spouse anyway. The unlimited marital deduction applies to both lifetime transfers and postmortem bequests, so there is little transfer tax incentive for selecting one type of transfer over the other. (However, for income tax purposes, a postmortem bequest results in a stepped-up basis, while a lifetime gift does not.)

One notable exception occurs when there is a large discrepancy in the size of the two spouses’ estates and the couple is planning to use a credit shelter bypass trust. Lifetime gifts between spouses can “even out” the estates so that both spouses’ unified credits are utilized regardless of which spouse dies first.

Gifts to Minors

Giving property to minors poses special challenges. Minors typically lack the maturity and legal competence to handle large outright gifts. Fortunately, several alternatives exist — guardianships, custodial accounts, and trust arrangements — which are covered in detail in Module 2.

A donor’s gift of property to a custodial account (under UGMA or UTMA) is a completed gift — subject to gift tax and eligible for the $18,000 annual exclusion. The property is generally excluded from the donor’s taxable estate, unless the donor acts as custodian (a very common occurrence). If the donor-custodian dies before the minor reaches the age of majority, the custodial property is pulled back into the donor’s taxable estate. For this reason, older donors such as grandparents should consider naming someone else as custodian — the child’s parent, for example.

Gifts in trust to a minor require more careful planning. The gift tax annual exclusion applies only to present interests; most trust gifts are future interests and do not qualify without special provisions. The tax code provides three exceptions:

• 2503(c) trusts — allow the annual exclusion even for future interests if: (1) the trustee may use trust property for the minor’s benefit before age 21; (2) the principal is released to the minor at age 21; and (3) if the minor dies before 21, the property passes to the minor’s estate. Drawback: mandatory disbursement at age 21.
• 2503(b) trusts (minor’s income trust) — must distribute all trust income to the minor at least annually. The present interest (income) qualifies for the exclusion; the future interest (principal) does not. The IRS provides tables to determine the excludable portion. The principal need not be distributed at age 21, but annual income distributions to the minor are required.
• Crummey trusts — named after the taxpayer who successfully argued for this treatment in federal court. The trust gives each beneficiary a temporary right to withdraw their share of each contribution (the lesser of the annual exclusion amount or the amount transferred), exercisable only during a brief window each year. Since the right exists — however briefly — the gift is treated as a present interest qualifying for the exclusion. The main drawback is the administrative paperwork required to notify beneficiaries annually of their withdrawal right.

Taxable Gifts

Gifts in excess of the $18,000 annual exclusion — or gifts of future interests that do not qualify for the exclusion — are taxable. The donor is responsible for any gift tax owed. As a practical matter, sizable gifts can be given without any current out-of-pocket tax liability. The tax code allows each taxpayer a lifetime applicable exclusion of $13.61 million (2024) to offset gift tax liability — only taxable gifts in excess of this amount trigger an immediate gift tax payment. See Module 1 for a complete discussion of the unification of gift and estate taxes and the calculation of transfer tax liability.

Estate Tax Considerations

If a lifetime transfer is properly executed, the property’s value is transferred out of the estate and not subject to estate taxes. One notable exception: if the grantor retains control over a trust (e.g., names himself as trustee), the trust property will be included in his taxable estate. Refer to the grantor trust rules discussed in Module 2.

Estate planners must also carefully consider special estate tax factors when making lifetime gifts of closely held business interests:

• Section 303 redemptions — allow special tax treatment for estates of small business owners who wish to redeem stock to meet estate tax and administration costs. To qualify, the stock must be included in the business owner’s estate. If the stock was given away during the owner’s lifetime, it will not be in the estate — and the special rules will not apply. Also, the business interest must represent at least 35% of the estate’s value. An estateholder may wish to transfer non-business assets out of the estate to ensure the business represents a sufficiently large proportion. If the plan relies on a Section 303 redemption, careful planning is paramount.
• Section 6166 installment payments — allows the estate to pay federal estate taxes attributable to a closely held business over up to 14 years, but requires the business to represent at least 35% of the adjusted gross estate. Transferring non-business assets as lifetime gifts can increase the business’s proportional share of the estate and help qualify the estate for this relief.
• Section 2032A special use valuation — allows certain farm and business real estate to be valued at its current use rather than highest and best use, but requires the business interest to represent at least 50% of the adjusted gross estate. The same strategy of transferring non-business assets applies. These special estate planning provisions for small business owners are covered in greater detail in Module 4.

Gift Tax Considerations — Estate Freezing

Estate freezing removes future appreciation from the taxable estate. Gift taxes are based on the property’s value at the date of the gift — so in addition to transferring the current value out of the estate, a lifetime gift also removes any future appreciation. That growth belongs to the recipient and escapes estate taxation entirely.

The estate planner must also take into account the estateholder’s age, health, life expectancy, and projected appreciation in property values. The decision to freeze an estate’s value is a complex one involving many financial and personal considerations. If the estate plan calls for freezing through lifetime transfers, the best candidates are:

• Common stocks and real estate — assets with significant growth potential
• Life insurance on the donor’s life — current gift tax value is low (interpolated terminal reserve or replacement cost), while the future estate tax value is high (face amount). The 3-year rule applies: the donor must outlive the transfer by three years or the face value is added back to the taxable estate. Policies should be transferred as early as possible, or new policies purchased directly by an ILIT.
• Business interests — using estate freezing techniques such as GRATs, GRUTs, installment sales, and private annuities. Estate planners must be careful when structuring transfers of family businesses — if documents are not properly drafted, the full value may be included in the donor’s estate at death. Business planning is covered in Module 4.
• Difficult-to-value assets — works of art or other property currently valued below the annual exclusion can be transferred by lifetime gift without an appraisal. After death, such property may be worth far more and require an expensive appraisal that the IRS may dispute. Similarly, assets that are difficult to administer (thoroughbred racehorses, complex rental real estate holdings) can be placed in trust during the estateholder’s lifetime, sparing the executor of management responsibilities and avoiding court supervision.

Liquidity Planning

Death triggers a need for cash: final expenses, debts, administration costs, estate taxes (due within 9 months of death), and survivors’ living expenses. Estate shrinkage occurs from three sources:

• Estate liabilities — debts, income and estate taxes, court and legal fees, executor and trustee commissions, last illness and funeral expenses. Typically 10%–40% of the gross estate.
• Depreciation in value — reduction in the value of assets (especially closely held businesses) that lose the owner’s management contribution at death
• Liquidation costs — appraisal fees, brokers’ commissions, and losses from forced sales of illiquid assets such as real estate and business interests

Sources of estate liquidity include liquid assets (cash, money market, marketable securities), Section 303 corporate stock redemptions (limited to estate taxes and administration costs), IRS installment payment elections under §6166 (up to 14 years for qualifying business interests), and — most effectively — life insurance. Borrowing against the estate is generally not viable — lenders are reluctant to lend to an estate, and executors become personally liable for estate debts.

Sources of Estate Liquidity

The most readily obtainable sources of cash are the estate’s liquid assets. Cash balances in bank accounts and money market funds provide the most immediate funds. Other marketable assets such as stocks and bonds can be liquidated relatively easily (perhaps under court supervision). However, as the settlement process progresses and the need for cash builds, the administrator may face the possibility of disposing of fixed assets at steep discounts. Few estateholders have sufficient cash balances and marketable assets to cover all of the estate’s needs. Estate planners can rarely rely on the estate alone to furnish the needed cash.

Borrowing to meet estate liquidity needs is generally not a viable planning option. Lenders are typically reluctant to lend to an estate. Executors and administrators become personally liable for debts taken on by the estate. Few executors are willing to assume this personal liability unless they are the sole beneficiary of the estate.

The Internal Revenue Code does allow Section 303 corporate stock redemptions to meet estate liquidity needs. Under Section 303, a corporation can repurchase shares held by a deceased stockholder, and the redemption is treated as a sale rather than a taxable dividend — provided the redemption does not exceed the amount of the estate’s final expenses, death taxes, and administration costs. This addresses only some of the estate’s liquidity needs; the estate still needs cash for debt repayment, bequests, and other obligations. Furthermore, this strategy is practical only if the corporation itself has the liquid resources to buy back the shares — otherwise the liquidity problem is simply pushed to the corporate level. Module 4 covers stock redemptions and Section 303 in detail.

Installment payment of federal estate taxes under Section 6166 is another device. While not technically a source of cash, the ability to pay death taxes over a period of up to fourteen years lessens the immediate need for cash. For estates critically short of cash, this may provide the time needed to sell assets under more favorable conditions. However, this alternative also does not solve the entire liquidity problem — the estate still needs cash to meet non-tax obligations, survivors’ living expenses, and bequests, and the installment method frequently creates its own complications.

The most convenient source of liquidity is life insurance. Life insurance creates the required resources precisely when they are most needed — upon the estateholder’s death. In essence, the purchase of life insurance is the equivalent of pre-paying the estate costs on an installment plan. Depending on the estate’s individual needs, life insurance can be owned by the estateholder, a beneficiary, a trust, or another party; can be payable to the estate or to beneficiaries directly; or can be a joint “last-to-die” policy covering the estateholder and spouse. Insurance planning strategies are discussed later in this section.

Analyzing the Estate’s Liquidity Needs

The planning worksheets allow estate planners to analyze the current situation or assess the effectiveness of proposed planning strategies “pro forma.” The worksheets answer two key questions: How much will the estate owe in federal death taxes? Will the estate have adequate cash resources to meet its obligations?

To estimate the gross estate, begin with property owned individually, add the estateholder’s share of jointly held property (full value for non-spousal WROS unless the survivor can prove contribution; one-half for spousal WROS), trust property (unless the trust is irrevocable and the grantor retained no control or benefit), vested pension benefits payable to beneficiaries, and life insurance owned by the estateholder (or transferred within three years of death) or payable to the estate.

From the gross estate, subtract final expenses and administrative costs (approximately 5%), unsecured debts, charitable bequests, and property left to a surviving spouse (the marital deduction). Add back taxable gifts made after 1976. Apply the applicable exclusion amount and available credits (including any portability credit ported from the first-to-die spouse) to arrive at the net federal estate tax liability — due within nine months of death. If the estate plan includes substantial bequests to grandchildren, the generation-skipping transfer tax must also be calculated and added to the total federal tax bill.

With an estimate of the tax liability in hand, the estate planner calculates total cash needs: final expenses, debts, federal and state death taxes, and any cash bequests. This is compared against the estate’s available liquid resources — cash, money market accounts, and insurance benefits payable to survivors. If cash needs exceed available resources, the executor will be forced to sell assets — sometimes at a substantial loss. Life insurance is the most practical way to bridge this gap.

Insurance Planning — Survivors’ Capital Needs

Life insurance serves two vital functions in estate planning: providing estate liquidity (meeting taxes, debts, and administration costs at death) and ensuring adequate resources to maintain the survivors’ standard of living.

To analyze survivors’ capital needs, estimate the survivor’s monthly income requirement and annualize it. Subtract any independent sources of income that continue after the estateholder’s death (investment income, Social Security, pension survivor benefits). The remaining shortfall is the income that must be replaced. Divide this figure by a conservative assumed rate of return to find the capital needed to generate that income stream.

In plans with a non-working spouse, estate planners must also consider the cost to replace the spouse’s non-financial contributions — child-rearing, homemaking, and other household services. If the spouse dies, those contributions must be replaced, which can significantly increase the family’s budget.

Add to the income replacement capital: final expenses, death taxes, an emergency fund, debt retirement (mortgage, car loans), and any special needs (college education for children, long-term care for an incapacitated family member). This is the estate’s total capital need. Compare it against the capital available to survivors — the net probate estate plus jointly held property, trust benefits, pension benefits, and insurance payable to survivors. If capital needs exceed available resources, additional life insurance should be purchased to cover the shortfall.

Insurance Planning Strategies — Selecting the Coverage

The type of coverage needed depends on the proposed use of the insurance proceeds. Each estate’s needs are different; planners must carefully examine the proposed use of the proceeds to find the most suitable type of coverage.

• A middle-aged couple with a taxable estate primarily concerned with estate taxes on the death of the second-to-die spouse: the most appropriate coverage is a second-to-die (survivorship) policy. The first death triggers no estate tax (unlimited marital deduction), so coverage on both lives simultaneously is unnecessary at that stage.
• A young breadwinner with a small estate and dependents: the greatest concern is replacing income for the surviving family. The most economical solution is term or convertible term insurance. As the family accumulates assets over time, the situation may shift toward permanent coverage.

Selecting the Insured

The simple answer is: insure anyone whose death creates a need for additional liquid capital. For death tax planning, the goal is coverage on the life of the last-to-die spouse — but since no one can predict which spouse will die first, four approaches exist:

• Cover both lives for the full amount — ensures cash is available regardless of who dies last. Drawback: requires two premiums; proceeds paid at the first death increase the survivor’s estate, compounding the tax problem.
• Small coverage on both lives — the survivor uses the first-death proceeds to purchase full coverage on their own life. Drawback: the survivor may become uninsurable by the time additional coverage is needed.
• Cover the wife only — since wives are statistically more likely to be the survivor. If she survives the husband, the policy fulfills its function. If she predeceases the husband, he invests the proceeds toward the future obligation.
• Second-to-die policy — pays benefits upon the death of the surviving spouse, precisely when most needed. Cost approaches premiums of two single-life policies; prospective purchasers should compare carefully before buying.

Selecting the Owner and Beneficiary

Identifying the insured is usually straightforward. Selecting the policy’s owner and beneficiary is more complicated, particularly for larger estates where tax consequences are significant.

For smaller estates (no estate tax concern): The estateholder simply owns the policy. When selecting a beneficiary, it is generally best to name a person directly rather than the estate — this avoids probate costs and delays, and shields proceeds from the insured’s creditors. If the insured is concerned about claims from the beneficiary’s creditors, naming a trust as recipient can protect the proceeds. Alternate settlement options (interest-only, life income) can also shield proceeds from spendthrift beneficiaries’ creditors.

For larger estates (estate tax concern): Insurance policy proceeds are included in the gross taxable estate if the insured owned the policy (or held any incident of ownership) at any time within three years of death, or if the proceeds are payable to the insured’s estate. For tax purposes, the insured must not own the policy. The estate should generally not be named as beneficiary — doing so subjects the proceeds to probate, creditor claims, and heir contests.

For married couples, one popular strategy is to have the spouse serve as both owner and beneficiary. This avoids inclusion in the insured’s estate and avoids probate. However, unless the spouse spends or gives away the proceeds, they will eventually be taxed in the surviving spouse’s estate — simply delaying estate taxation. To avoid this, some couples name the spouse as owner but a child as beneficiary. However, this creates an adverse gift tax consequence: the IRS treats the insurance payment as a gift from the policy owner (spouse) to the beneficiary (child). The owner and beneficiary should generally be the same person to avoid unintended gift tax consequences.

Another approach: a parent names a responsible adult child as both owner and beneficiary, with the understanding that the child will make proceeds available to the estate — by lending funds to the estate or purchasing estate assets (not by making an outright gift, which would itself be taxable). This can work well when the child is a primary estate beneficiary with a personal interest in a favorable outcome. The risk is that the child may let the policy lapse or fail to cooperate, causing the entire plan to fail.

Insurance Trust (ILIT)

An irrevocable life insurance trust (ILIT) is the most comprehensive strategy for large estates. Properly executed, an ILIT avoids many of the tax problems and uncertainties discussed above and can:

• Keep death proceeds out of both spouses’ taxable estates
• Avoid probate on the proceeds
• Eliminate adverse gift tax consequences by using a newly purchased policy (not a transfer of an existing policy)
• Provide needed liquidity — the trust documents should state that the trustee may (not shall) lend funds to the estate or purchase estate assets. Mandatory language would cause inclusion in the taxable estate; discretionary language preserves the tax benefit while still allowing practical assistance to the estate.
• Use Crummey withdrawal powers to qualify annual premium contributions for the gift tax annual exclusion

In a typical ILIT, the insured creates the irrevocable trust and names an independent trustee. Beneficiaries of the trust (typically the spouse and children) should not be named as trustees, to avoid adverse tax consequences. The trust purchases a new life insurance policy on the insured’s life and is named as the policy’s beneficiary. Annual premiums can be funded by transferring income-producing assets to the trust (trust income taxable to the grantor under grantor trust rules) or by making annual contributions (treated as gifts, qualifying for the annual exclusion with Crummey powers). Upon the insured’s death, proceeds are available for estate liquidity. The trust can also remain in existence to provide income for the surviving spouse and ultimately distribute assets to remaining beneficiaries — providing liquidity for both estates with a single structure. Revocable insurance trusts do not offer these tax benefits; this discussion relates solely to irrevocable life insurance trusts. Given the complexity of the applicable tax rules, professional legal and tax counsel is critical.

Tax Planning Strategies

For most of the 21st century, political pressure has been applied to reduce the tax liabilities that arise upon death. In 2001, Congress enacted major changes that reduced the maximum estate tax rate from 55% to 45% and vastly increased the unified credit exclusion amount — growing from $675,000 in 2001 to $3.5 million in 2009. The 2010 Act raised the exclusion to $5 million, adjusted it annually for inflation, introduced portability, and reduced the maximum rate to 35%. Permanent legislation in 2012 fixed the maximum rate at 40% where it has remained. The Tax Cuts and Jobs Act of 2017 temporarily doubled the inflation-adjusted exclusion amount for 2018 through 2025, raising it to $13.61 million in 2024. As a result, very few estates are currently subject to estate taxation, and the focus of estate planners has shifted toward income tax planning, asset protection, and other priorities in the meantime.

The tax code is a creation of Congress, which never seems satisfied with what it has created. Tax rates, deductions, exemptions, and other rules are constantly changing. A planning tool that works well under today’s tax code may not be as effective if Congress changes the rules. The following discussion explores various tools that have been effective in the past, are effective today, or may come back into greater use if the tax code changes — as is expected when the TCJA exclusion reverts after 2025. Some tools work better for one taxpayer than another for tax and non-tax reasons. All estate plans are unique depending on an individual’s financial, family, and tax circumstances. It is important to review the plan regularly to ensure it continues to fulfill its goals.

Intrafamily Distributions

In most estates, the primary beneficiaries are members of the estateholder’s immediate family: spouse and children. The most important tax planning tools for intrafamily distributions are the unlimited marital deduction and the unified tax credit — which currently shelters the first $13.61 million of estate value (2024). These tools can be used individually or in combination to create many planning strategies to eliminate, or at least minimize, federal estate taxes.

100% Marital Deduction Plan

The simplest plan for a married couple: leave everything to the surviving spouse. The estate of the first-to-die pays no estate tax. The advantage is simplicity and full spousal control. The disadvantage: if the joint estate exceeds the applicable exclusion amount, the surviving spouse’s estate faces a potentially larger tax bill — the unified credit of the first-to-die may go entirely unused.

Credit Shelter Bypass Trust (“B Trust”)

The bypass trust places an amount equal to the applicable exclusion in a trust upon the first spouse’s death; the balance passes to the surviving spouse via the marital deduction. The trust property bypasses the surviving spouse’s estate — avoiding estate tax on both the original amount and any subsequent appreciation.

With portability now available, the bypass trust plays a smaller role in basic tax planning but remains useful for:

• Sheltering appreciation from the date of first death through the survivor’s death (portability only preserves the credit amount — growth after the first death in a bypass trust is not taxed in the survivor’s estate)
• Maximizing each spouse’s individual GSTT exemption (the GSTT exemption is not portable)
• Creditor protection, protection from a subsequent spouse in remarriage, and passing assets in blended family situations

The surviving spouse may receive income from the bypass trust; may have a “five-and-five power” (greater of 5% of principal or $5,000 per year); and may invade principal for health, education, support, or maintenance (IRC §2041). The surviving spouse may also serve as trustee, though an independent trustee offers greater flexibility.

Bypass with Equalization and Disclaimer Trust

In a bypass with equalization, more than the applicable exclusion amount is placed in trust to equalize marginal tax rates between the two estates — reducing total estate taxes by “prepaying” some tax at the first death at a lower rate. The trade-off is liquidity needs and the time value of prepayment.

A disclaimer bypass trust gives the surviving spouse flexibility. The first spouse leaves everything to the survivor except the amount the survivor specifically disclaims within 9 months. The disclaimed amount flows into the bypass trust. This allows the survivor to fine-tune the plan based on current tax law, family circumstances, and financial needs.

Credit Bypass with Equalization

The federal estate tax system is highly progressive — tax rates are much higher for larger taxable estates. Under the standard credit shelter bypass plan, only the amount sheltered by the applicable exclusion is placed in trust; the rest passes to the surviving spouse. This increases the size of the surviving spouse’s estate and may push the second estate into a higher marginal bracket.

A more sophisticated technique attempts to reduce total estate taxes by equalizing the marginal tax rates of the two estates. The amount placed in the bypass trust exceeds the applicable exclusion — so a portion is taxable at the first death (presumably at a lower rate than would apply upon the surviving spouse’s death). The dilemma facing planners is deferral versus reduction: while the tax savings may appear significant, the time value of the prepaid taxes must be considered. The longer the surviving spouse lives, the less benefit there is in equalization. Additional liquidity needs at the first death must also be weighed. On the other hand, if the joint estate contains rapidly appreciating assets, prepaying taxes based on today’s lower values may offer substantial benefits.

Bypass Disclaimer Trust

Rather than constantly revising estate documents as tax laws and personal circumstances change, estate planners can build in flexibility through a spousal disclaimer. In this arrangement, the first spouse to die leaves everything to the surviving spouse, except for whatever amount the survivor specifically disclaims. The disclaimed amount flows into the bypass trust. This gives the survivor a second look at the entire family and tax situation, allowing modifications based on current conditions.

For example, if Congress has increased the unified credit amount or if the surviving spouse has adequate resources of their own, the survivor can disclaim more into the bypass trust and take advantage of the change — without the need to redraft documents.

However, the disclaimer bypass has significant drawbacks:

• The surviving spouse has only a short window to decide whether to disclaim (generally nine months from the date of death)
• An emotionally distraught survivor may be unwilling to “jeopardize my financial future” by directing assets into the bypass trust, even if it makes tax sense
• The survivor has less control over disclaimed assets than under a standard bypass trust — the survivor may not be granted a limited power of appointment over the disclaimed property (though the spouse may act as trustee and may be able to invade principal to a limited extent)

When a testator wants to provide for a surviving spouse but direct the ultimate disposition to other beneficiaries (e.g., children from a prior marriage), a marital trust is used. The two primary types that qualify for the unlimited marital deduction are:

• Power of Appointment Trust — the surviving spouse receives all income at least annually and holds a general power of appointment exercisable during life or at death. The trust property is included in the surviving spouse’s estate.
• QTIP Trust (Qualified Terminal Interest Property) — the surviving spouse receives all income at least annually; no one may hold a power to appoint the property to anyone other than the spouse. The executor must elect QTIP treatment on the estate tax return. QTIP property is included in the surviving spouse’s taxable estate. Most popular marital trust because it gives the first spouse control over the ultimate beneficiaries while qualifying for the marital deduction.

The marital trust (“A trust”) is often combined with the bypass trust (“B trust”) in an A-B plan to maximize the marital deduction, use the unified credit, provide support for the surviving spouse, and control the ultimate distribution to heirs.

Charitable Giving Strategies

Charitable gifts provide income, gift, and estate tax benefits in addition to the personal satisfaction of giving. The deduction for charitable contributions is unlimited for estate and gift tax purposes.

Split Interest Gifts

Split interest gifts allow the donor to retain one interest in property while giving the other to charity. Two primary vehicles:

• Charitable Remainder Trust (CRAT/CRUT) — the donor retains income from the property; the remainder (principal) passes to charity at death. A CRAT (Charitable Remainder Annuity Trust) pays a fixed annual amount (at least 5% of original value). A CRUT (Charitable Remainder Unitrust) pays a fixed percentage of the trust’s annually-revalued assets. CRATs/CRUTs work especially well when the donor needs income and owns highly appreciated, low-income-producing assets — the trust sells the appreciated asset tax-free and reinvests for higher income. The donor receives a current income tax deduction for the present value of the remainder interest.
• Charitable Lead Trust — the charity receives income for a stated period; afterward, the property reverts to the donor or other beneficiaries. Typically designed to take effect after death because the IRS treats it as a grantor trust (income taxable to the grantor during life).