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 addition to having to settle taxes, creditors must be paid in full before heirs can receive their inheritances.
Liquidity planning is part of estate planning, so let’s look briefly at some effective liquidity planning 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 the annual exclusion limit can be made to any number of individuals in each calendar year. Gifts that do not qualify for the marital deduction, charitable deduction, or the 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. The way to reduce taxes is to use the applicable exclusion amount to its fullest while still applying the unlimited marital deduction.
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. 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.
Reducing Taxes Using a Qualified Personal Residence Trust
Your residence is probably your most important asset. 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. The QPRT has no income tax consequences during the term of the Trust. You may still live in the home, 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.
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. If a person dies without a Will, that is, intestate, title to the property will pass under state intestacy laws to “heirs at law.” 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.
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.
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. As long as your estate is less than the current allowed amount, it will pass to your heirs tax free. However, if your life insurance policy pushes that amount up over the allowed amount, they will incur estate taxes at a rate of 40 percent.
The solution to this problem is the Irrevocable Life Insurance Trust (ILIT). 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 to pay for the insurance premiums.
