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 illiquid (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 nonliquid assets to pay settlement costs, income or even estate taxes, 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:
- Reduce taxes by fully using the $5.49 million Applicable Exclusion Amount at death (for the year 2017), making annual gifts, and using other planning techniques such as GRATs and QPRTs (discussed below).
- Reduce expenses by avoiding or minimizing Probate and using a Living Trust or properly drafted Will.
- 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 $14,000 (in the year 2017) can be made to any number of individuals in each calendar year. Gifts that do not qualify for the marital deduction, charitable deduction, or $14,000 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 2017 is $5.49 million in gift tax and $5.49 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 at the surviving spouse’s death 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:
- 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.
- 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, an Irrevocable Trust. It 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.
Reducing Expenses By Avoiding Probate and Using a Revocable Living Trust or By Minimizing Probate and Using a Well Drafted Will.
When an individual dies owning property titled in his or her name, normally that property must go through a judicial process called Probate. The Probate court enters a decree stating who succeeds to the ownership of the property. Without Probate, title to the property would remain in the name of the individual who has died. Title would be clouded and the property could not be sold or transferred because a potential purchaser would have no way of determining who can legally execute a title transfer such as a deed. The judicial decree resolves this uncertainty.
If a person dies without a Will, that is, intestate, title to the property will pass under state intestacy laws to “heirs at law.” The person appointed to administer the estate of someone who dies without a Will is called an administrator.
If a person dies leaving a valid Will, that is, dies testate, title to the property will be distributed to the beneficiaries specified under the provisions of the Will. A Will can name the person who is to administer the estate (the executor).
Why would you want to avoid or minimize Probate?
- Time. Probate is often a slow and time-consuming process. If everything goes smoothly, it can be completed in as little as six months. In many cases, it can take from one to three years. If you have an intricate estate or someone is contesting the Will it can go on for many years.
- Cost. Every state has different Probate costs and it can be very expensive. For the most part, if Probate is minimized or avoided your heirs will inherit more, and receive it quicker.
- Privacy. If Probate is not minimized or avoided, everything that happens in Probate court will be available to the general public. You can become a target for criminals or eager sales people. Everything you receive could be in the public records. If your estate is not planned properly to avoid or minimize probate, a complete stranger can look up your records and you could become a target for the unscrupulous.
Because Probate can be time-consuming, expensive, and leaves you vulnerable, many people plan in advance to avoid it. When you make a Revocable Living Trust, a device in which you hold property as a “Trustee,” your surviving family members can transfer your property quickly and easily, without Probate. More of the property you leave goes to the people you want to inherit it. The impact of Probate can be minimized if you have a well drafted Will which opts into and out of the state’s applicable Probate statutes and the title and beneficiary designations on your assets “dove tail” into your estate plan.
Increasing Liquidity Through an Irrevocable Life Insurance Trust
Insurance is an effective strategy to ensure that your heirs do not have to sell some or all of your estate’s assets in order to cover the income or estate tax liability. It is an effective way to create estate liquidity. However, it can also be costly if not done correctly.
In 2017, as long as your estate is less than $5.49 million, it will pass to your heirs tax free. However, if your life insurance policy pushes that amount up over $5.49 million, they will incur estate taxes at a rate of 40 percent. For example, let’s assume that your estate is worth $3.5 million. Your estate could pass to your heirs tax free. However, once you add in the $3 million death benefit of your insurance policy, you have increased your estate’s value to $6.5 million, thus exposing $1,010,000 to a 40 percent estate tax! That is a large chunk of money that your heirs will no longer receive!
The solution to this problem is the Irrevocable Life Insurance Trust (ILIT). With an ILIT, you name a Trustee other than yourself. The Trustee is often the person you wish to designate as a beneficiary of an insurance policy. The Trustee will have to follow the instructions you provide in your Trust documents.
Once the Trust is created, the Trustee purchases a life insurance contract on your life with funds you have provided. Because the insurance is owned by the ILIT and not by you, the life insurance proceeds are not included in your estate for estate tax calculations. You can use the gift tax rule, the ability to give $14,000 to any number of people, to pay for the insurance premiums. Your Trustee will then notify the beneficiaries that a gift has been made in their name and they have 30 days to withdraw this gift. Once they don’t exercise this option, the Trustee will use these funds to pay the insurance premium. This written notification of your gift to your beneficiaries is called the Crummey Letter, so named after the man that first initiated this process. An annual Crummey Letter to your beneficiaries is an essential element of a successful ILIT.
With the ILIT, you control who receives the proceeds, and how they receive them. Additionally, an ILIT can keep the value of the policy out of the value of your estate and out of the hands of creditors.
Some people assume that they can simply have someone else be the owner of their policy and avoid creating an ILIT. Although this can work, the ILIT solves the following problems:
- The ILIT Trustee cannot reassign the policy, pledge it as collateral, or pay off creditors with the policy’s value.
- The ILIT Trustee must keep the policy in force and cannot spend the premiums on anything else.
- The ILIT Trustee is a Trustee and not an owner. This means that if a Trustee gets divorced, the ex-spouse will have no claim on the policy.
- You will be able to control how the beneficiaries spend the policy’s proceeds.
The use of these strategies will help to reduce taxes, reduce expenses, and increase liquidity. By talking with a qualified estate planning attorney, you can find out which of these tactics will work best for your needs.