How to - and not to - give it awayNovember 21, 2012: 11:39 AM ET
By Maggie McComas
This is a sidebar that ran with Should You Leave it All to The Children? in the September 29, 1986 issue of Fortune.
FORTUNE -- Go ahead, give it all to darling daughter Debbie. And while you're at it, disinherit John Jr. He can't spend it in reform school anyway. But remember, merely putting such desires in a will may not ensure that your estate winds up in the right hands.
Debbie may need some elaborate trust arrangements. She is too young to handle all that wealth now, and her favorite beau is a no-good whose principal aspiration is to marry your money. You must also make sure Johnny will not have his day in court and collect an inheritance anyway. Finally, you must account for that other needy, if much-unloved, relative that estate planners refer to simply as "Uncle." If your estate runs into the millions, he could get 55 cents on the dollar.
The first estate-planning priority is usually to provide for the surviving spouse; the kids can always inherit the second estate. You can leave your entire estate to your spouse without paying federal estate taxes. But if you do that, you will miss an additional break: $500,000 can go to your children or other beneficiaries tax-free. Next year the limit will rise to $600,000. If you hang in till then, you can use the $600,000 exemption two ways. First, you can leave that amount to the children outright. Or you can set up a $600,000 trust that gives income to your spouse and principal to the children when your spouse dies.
If you set up a "qualified terminable interest property," or QTIP, trust, you can control the destiny of the unlimited amount you leave to your wife tax-free. After you are gone, your spouse will collect the income on the trust but will not be able to tap the principal, except in emergencies. When the spouse dies, the principal will go to the beneficiaries you have chosen, probably your children. Your spouse's estate will have to pay taxes, but only on the amount over the $600,000 exemption. The QTIP trust is popular in the case of second or third marriages. It prevents the surviving spouse from diverting the wealth to someone other than the original heirs.
Tax incentives should make you want to give some of your estate away while you are still alive. Every year you can give $10,000 to each of your children or anyone else. Your spouse can give another $10,000 to each. Thus a couple can pass $20,000 a year to a child.
A logical gift for children is an asset that may well appreciate, such as a growth stock or undeveloped real estate. Such a gift will not hurt your pocketbook much and could easily fall under the annual exemption. But if you continue to hold on to the asset, it could trigger a huge tax later on.
Larry Biehl, a financial adviser in San Mateo, California, recommends another way to avoid estate taxes. When you purchase a condominium, say, you can divide the ownership into two parts: a "lifetime interest," which you buy, and a "remainder interest," which your child buys. The Internal Revenue Service requires that the child put up the money, although gifts from grandparents could boost his purchasing power. Your life expectancy, according to IRS actuarial tables, determines how the ownership is split -- 80% to 20%, for example. When you die, the lifetime interest is legally dissolved and -- presto -- the child assumes full ownership tax-free.
After a lifetime of lavishing gifts on the kids, you might want to turn over most of your estate to your grandchildren. In the past that made sense, particularly since wealth could pass to several generations in trust, with estate taxes paid only once. Congress tightened this loophole in 1976 with a tax on "generation skipping" trusts, though direct transfers to grandchildren were not affected. The current tax reform bill would also apply the generation-skipping tax to direct transfers. But only the very rich need worry: You can leave up to $2 million to each grandchild without paying the extra levy.
If you do plan to skip your children altogether, you had better say so in your will. If you simply omit any reference to Johnny in that document, rather than specifically disinheriting him, he might have the makings of a successful will challenge.
Where big bucks are involved, a will contest can be a real grave-spinner, like the case brought by the children of multimillionaire Charles S. Payson who died last year at 86. Most of Payson's wealth came from industrialist Payne Whitney, the father of his first wife, Joan. When she died in 1975, the bulk of her $172-million estate went to Charles.
His will gave his son a cemetery plot, land, and personal property; his three daughters got only some paintings. Payson gave $20 million in cash, stock, and real estate to his second wife, Virginia, and put much of the rest in a QTIP trust. The income from the trust goes to Virginia.
But this case demonstrates a flaw in the QTIP setup: stepmother Virginia and the Payson children are of the same generation (at 56, she's younger than two of them), so the "kids" may not live long enough to collect the QTIP principal. Charles's children are challenging the will on many grounds, including a claim that the second Mrs. Payson had used "undue influence" in directing so much wealth her way.
Such squabbling is not limited to the rich. "Will contests are more a matter of frustrated expectations than anything else," says Jonathan Blattmachr of the New York Law firm Milbank Tweed Hadley & McCloy. Blattmachr tells of a widower who sought to leave 95% of his $200,000 estate to his impoverished daughter and 5% to his son, a successful doctor, who was worth about $2 million. The son challenged the will and settled out of court for another $5,000.
"Uncle's" appetite for a share shows up dramatically where estate assets are hard to value, notably family-held companies. For example, take the estate of Samuel I. Newhouse, the newspaper king who died in 1979. In valuing his Advance Publications Inc., estate experts at Chemical Bank looked at price-earnings ratios of similar but publically traded companies and set a market price of about $1 billion. The bank then assigned a substantial part of the value to the nonconvertible preferred stock, owned by the Newhouse heirs. The patriarch's holdings, all the common stock, came to only $179 million.
The IRS saw things differently. It calculated the company's market value at $1.5 billion, then discounted that price by the cost of liquidating the preferred stock. (The assumption is that an outside buyer would have balked at the burden of paying the preferred dividend.) The remaining value, all assigned to Newhouse's estate, was $1.2 billion. In 1983 the IRS mailed off a "notice of deficiency" to the estate, levying more than $609 million in additional taxes and a $306-million penalty for fraud. The valuation is still in dispute.
Marion Fremont-Smith, an estate planner at the Boston law firm Choate Hall & Stewart, suggests that founders of growing companies consider swapping their common stock for preferred stock and a new issue of common. Such transactions are tax-free. The preferred shares can provide steady income for an aging founder, while the new common stock can be given to children through annual exclusions and the one-time exemption. Their stock will appreciate as the business thrives. So if you want to leave your children a legacy, let it be something other than a dunning notice from the IRS.