Estate planning is a very important process in maintaining and efficiently transferring the wealth you've accumulated throughout your life. A large part of that process involves finding ways to transfer your assets to the next generation in the most tax-efficient manner possible. This task is complex, and often overwhelming to do alone, which is why many individuals seek professional assistance. This article doesn't attempt to give you advice on creating an estate plan, nor should you take it as legal advice. It is simply intended to help you identify common issues that many people face and the strategies used to deal with them so that you can proactively focus your attention in those key areas. (With some preparation, you can save your heirs from paying a hefty estate tax. Here are some tips, read Getting Started On Your Estate Plan.)
TUTORIAL: Estate Planning Basics
Generation skipping is exactly as it sounds. In countries that allow it, many people will often choose to transfer a portion of their estate assets to their grandchildren rather than transferring the full estate directly to their immediate children. This strategy skips the second generation, and transfers the assets straight to the third generation, which saves the assets from being eventually taxed twice. Normally the assets would be taxed once when transferred from you to your children (second generation) and again when your children transfer it eventually to your grandchildren (third generation).
Quite often, the most balanced strategy is to transfer enough of your assets to your children that you think they will need, and the excess over that amount would be transferred to your grandchildren. This strategy both covers the needs of your children and secures the future for your grandchildren in a tax-efficient way. However, it is important to note that some countries discourage the use of this strategy by applying a generation skipping tax, so its effectiveness will vary. (Learn more in Spoil Your Grandkids, Cut Your Tax Bill.)
2. Spousal Exemptions
In some countries, such as the United Kingdom, certain tax exclusions exist that allow the transfer of smaller estates without an inheritance tax being levied upon the assets. For example, the tax exclusion in the U.K., as of 2009, amounted to £312,000 worth of assets that could be transferred tax free upon the death of a spouse.
For couples, this means that they have two exclusions available to them: One when the first spouse passes away, and the second when the remaining spouse dies. Thus, when the first spouse dies, it is often most beneficial to transfer £312,000 from the estate to a third-party if you eventually intend to bequest the assets to them anyway, and the rest to the surviving spouse. The tax benefits of this tax exclusion would be wasted if the entire estate is transferred over to the spouse upon death. (Check out the perks designed to promote and preserve your post-work savings - if you're married, that is. Check out The Tax Benefits Of Having A Spouse.)
For example, consider Jim and Sally Smith who have estate assets worth £1,000,000. If Jim passes away, £312,000 of their assets can be transferred out of the estate to a third-party with zero inheritance tax. Sally would then be left with assets worth £688,000. Now, when Sally passes away, the tax exclusion can be applied again to transfer another £312,000 out of the estate, leaving only £376,000 that would be subject to inheritance tax.
The less tax-efficient alternative would have been to transfer the entire £1,000,000 to Sally when Jim died, which results in only one tax exclusion available to be used upon Sally's death. This alternative leaves £688,000 of assets subject to inheritance tax versus £376,000 in the previous example. Assuming a 40% inheritance tax rate, the difference in taxes paid would have been £275,200 compared to the lower £150,400. So using this less efficient strategy would have decreased the value of the Smiths' estate by £124,800.
3. Valuation Discounts
Valuation discounts can be an area where you can find significant tax savings if you own a business or assets that are difficult to value. In general, when assets are transferred, a tax will be applied to the fair market value of the assets, but if the fair market values of your assets are hard to determine, there may be certain discounts that can be applied to reduce the taxable value of your transferring assets. (Learn more in What's the difference between book and market value?)
For example, if shares in a privately run family business are going to be transferred, a discount for lack of liquidity and a discount for having a minority interest may be applicable. The valuation process for a privately held company normally involves the use of a valuation model to determine the intrinsic value of the shares, and once that is determined, a valuation discount is usually applied to account for the lack of liquidity of the shares not being traded on a public exchange. The value of this discount can vary depending on the situation, but it can usually range from 10-35%. This means that if the intrinsic value of your shares were estimated at $1 million, then after applying a discount for lack of liquidity, the transfer value would range from $650,000 to $900,000.
In addition, if you are planning to transfer shares in a privately owned company in which you are only a minority shareholder, then a discount to account for this lack of control may also be applicable. This discount for a minority interest can also be large, potentially ranging up to 40%.
By applying these discounts to your assets, you reduce the asset's taxable basis, and thus the total taxes you pay. A common strategy in some countries is for individuals to create a family limited partnership (FLP) and put their assets into an FLP to artificially create conditions that may justify using illiquidity and minority discounts. Instead of giving out the assets directly, minority interests in the FLP are given to each individual, and this may make it eligible for valuation discounts. However, simply putting cash and cash equivalents into a FLP will typically get you very little or no discounts. (Understanding how this measure works in the market can help keep your finances afloat, check out Diving In To Financial Liquidity.)
4. Charitable Gratuitous Transfers
In many estate plans, individuals will often set aside assets to give to a charity upon their death. But is it better to donate assets to charity when you die or while you are still alive? Often, in many cases, it is most advantageous to the charity to donate during your lifetime. This is because most countries do not levy gift taxes on charitable donations, and second, you can get an income tax deduction for your donation. In addition, if the organization you are donating to is exempt from paying investment taxes, the earlier you donate, the more the value of your donation can compound tax-free.
Estate taxes and wealth transfer taxes are complicated topics, and many of these strategies may work in some but not all countries. This article simply introduced some of the more common strategies used so that you are aware of them and can allow you to make a broad plan for your estate. It is always advisable, however, to have a lawyer or tax specialist help you with setting up a plan for the transfer of your estate assets. (For more on estate planning, check out Estate Planning: 16 Things To Do Before You Die.)