Asset valuations and your estate plan go hand in hand

If your estate plan calls for making noncash gifts in trust or outright to beneficiaries, you need to know the values of those gifts and disclose them to the IRS on a gift tax return. For substantial gifts of noncash assets other than marketable securities, it’s a good idea to have a qualified appraiser value the gifts at the time of the transfer.

Adequately disclosing a gift

A three-year statute of limitations applies during which the IRS can challenge the value you report on your gift tax return. The three-year term doesn’t begin until your gift is “adequately disclosed.” This means you need to not just file a gift tax return, but also:

  • Give a detailed description of the nature of the gift,
  • Explain the relationship of the parties to the transaction, and
  • Detail the basis for the valuation.

The IRS also may require certain financial statements or other financial data and records.

Generally, the most effective way to ensure you’ve disclosed gifts adequately and triggered the statute of limitations is to have a qualified, independent appraiser submit a valuation report that includes information about the property, the transaction and the appraisal process.

IRS-imposed penalties

Using a qualified appraiser is important because, if the IRS deems your valuation to be “insufficient,” it can revalue the property and assess additional taxes and interest. If the IRS finds that the property’s value was “substantially” or “grossly” misstated, it will also assess additional penalties.

A “substantial” misstatement occurs if you report a value that’s 65% or less of the actual value — the penalty is 20% of the amount by which your taxes are underpaid. A “gross” misstatement occurs if your reported value is 40% or less of the actual value — the penalty is 40% of the amount by which your taxes are underpaid.

Before taking any action, consult with us regarding the tax and legal consequences of any estate planning strategies. In addition, we can help you work with a qualified appraiser to ensure your gifts are adequately disclosed.

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Life insurance and an estate plan may not always mix well

A life insurance policy can be an important part of an estate plan. The tax benefits are twofold: The policy can provide a source of wealth for your family income-tax-free, and it can supply funds to pay estate taxes and other expenses.

However, if you own your policy, rather than having, for example, an irrevocable life insurance trust (ILIT) own it, you’ll have to take extra steps to keep the policy’s proceeds out of your taxable estate.

3-year rule explained

If you already own an insurance policy on your life, you can remove it from your taxable estate by transferring it to a family member or to an ILIT. However, there’s a caveat.

If you transfer a life insurance policy and don’t survive for at least three years, the tax code requires the proceeds to be pulled back into your estate. Thus, they may be subject to estate taxes.

Fortunately, there’s an exception to the three-year rule for life insurance (or other property) you transfer as part of a “bona fide sale for adequate consideration.” For example, let’s say you wanted to transfer your policy to your daughter. You could do so without triggering the three-year rule as long as your daughter paid adequate consideration for the policy.

Determining adequate consideration isn’t an exact science. One definition is fair market value, which is essentially the price on which a willing seller and a willing buyer would agree.

Triggering the transfer-for-value rule

The problem with the bona fide sale exception is that, when life insurance is involved, it may trigger another, equally devastating, rule: the transfer-for-value rule. Under this rule, a transferee who gives valuable consideration for a life insurance policy will be subject to ordinary income taxes on the amount by which the proceeds exceed the consideration and premiums the transferee paid.

So, in the previous example, even if your daughter purchased the policy for the appropriate amount to avoid the three-year rule, she could be subject to some income tax when she receives the proceeds.

Recipe for success: Selling to a trust

It may be possible to avoid the three-year rule — without running afoul of the transfer-for-value rule — by selling an existing life insurance policy for adequate consideration to an irrevocable grantor trust. A grantor trust is a trust structured so that you, the grantor, are the owner for income tax purposes but not for estate tax purposes.

While there’s been talk of an estate tax repeal, it’s still uncertain if and when that will happen. So if your estate is large enough that estate taxes could be an issue, it’s best to continue to factor that into your planning. Please contact us if you have questions about how you should address your life insurance policy in your estate plan.

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