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“Why Would I Ever Want to Harvest a Capital Gain?”

Investors must be aware of the income tax implications of their trading activities. Most know that selling a financial security is a taxable event* and that doing so will usually create a realized capital gain (or loss). Brokers have long advised their clients to “harvest” capital losses as year end approaches since such a realized loss can be used to offset realized capital gains that may have been taken earlier in the tax year. The Internal Revenue Code even allows net realized capital losses (limited to $3,000 annually) to be used to offset ordinary income reported elsewhere on a client’s tax return. This loss harvesting strategy has been practiced for years and is well established in the investment/income tax toolbox. However, far fewer investors are cognizant that harvesting long term capital gains on investments (as opposed to losses) may also be a wise strategy for certain taxpayers.

What is a “Springing” Power?

Several recent posts have explained the functions of various estate planning tools that are known by their acronyms, such as QTIP and ILIT. This last posting in our series will cover the term ”springing”. A springing power is given to an attorney-in-fact or a trustee when a certain specific event occurs. Springing powers are most commonly found in the estate planning documents that are drawn up to prepare for possible incapacity or mental incompetence. Good examples are durable powers of attorney for financial affairs and/or medical affairs. These instruments appoint someone to handle the financial or medical affairs of another individual. However, the attorney-in-fact who is named in these documents does not receive the power immediately. Rather, the authority and power to make the financial or medical decision “springs” into being when the principal (who executed the document) is declared incompetent or unable to make such decisions for themselves.

What is a QTIP Trust?

The estate planning process has a great deal of complexity and legal jargon. Likewise, there are many acronyms and abbreviations. Our most recent posting discussed the ILIT which is an irrevocable life insurance trust. This estate planning tool comes into play when large amounts of cash are anticipated to be needed at death to pay an estate tax bill. Today, we will cover the acronym “QTIP” which stands for “Qualified Terminable Interest Property”. The QTIP is a special exception to normal IRS regulations regarding the need for a gift or bequeathal between spouses to be complete and unencumbered. The QTIP strategy is usually employed in the case of a blended family.

What is an ILIT?

The estate planning process has a great deal of complexity and legal jargon. Likewise, there are many acronyms and abbreviations. One of the acronyms we would like to cover is the ILIT. ILIT stands for “irrevocable life insurance trust” and it can be a very useful tool for dealing with estate taxes. Let’s suppose an individual has founded a successful business which he/she would like to pass on to the children. Like many entrepreneurs, the patriarch/matriarch of this family business has reinvested nearly all of their extra cash into the business and its value has grown to millions of dollars. Even with the currently high estate tax exemption amounts ($11.7 million per person, indexed for inflation), it is easy to see how a very successful family business or farm could easily reach a value exceeding these thresholds. If the founder/owner of this business suddenly passed away, transferring its value to the next generation could be problematic because estate taxes are typically due nine months after the date of death. Where would the next generation come up with the cash to pay the estate transfer taxes that would become due? Since most excess cash has been redeployed back into the business for years, how could they quickly extract the funds needed to satisfy the bill to the IRS? Will they be forced to sell a portion or all of the business at a “fire sale” price in order to come up with the cash needed?

Lifetime Gifting Considerations

Recent increases in the estate tax exemption ($11.7 million per person, indexed for inflation) have allowed many estates to avoid federal estate transfer taxes. Nonetheless, executing gifts during one’s lifetime is still a wise and effective method for transferring ownership of one’s bounty to other individuals or entities. The logic here is for someone to give away property while living and, in doing so, reduce their taxable estate. There can also be non-monetary reasons for gifting, such as the donor reaping the pleasure of seeing the recipient enjoy the gift, and providing for the support, education and welfare of a donee. In addition, planning for change can also be prudent, as the estate tax regime in this country has always been a “political football”. It has been frequently changed at the whims of the politicians in power and the Biden administration has already made several proposals to lower the exemption amount. Even without legislative action, the current threshold is slated to “sunset” in 2026 back to the $5 million (adjusted for inflation) amount that was in effect prior to 2018. Because of this uncertainty, knowledge of the rules related to lifetime gifts can be beneficial.

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Income Taxes and Estate Planning

The financial press generates numerous articles about federal estate transfer taxes, often detailing the misadventures regarding the estates of the rich and famous. However, only 1% of estates generate any estate transfer taxes. A working knowledge of the rules applying to possible income taxes, however, is more relevant to many more estates. Parents who are desiring to treat multiple children or heirs equally are sometimes surprised to learn that bequeathing equal dollar amounts will not be equitable after Uncle Sam’s claims are considered.

What is “the Unholy Trinity”

The “unholy trinity” is an insurance industry euphemism that describes a problematic circumstance with a life insurance contract. In addition to the insurance company, there are three named parties in the insurance contract. Party #1 is the owner of the insurance policy and this person has numerous rights. They are: (1) the right to name or change the beneficiary, (2) the right to cash in, surrender or cancel a policy, (3) the right to receive policy dividends, if any, (4) the right to borrow against policy cash value, (5) the right to pledge the policy as collateral for a loan, and (6) the right to assign any rights and/or the policy itself and the right to revoke such assignments. Party #2 is the person whose life is being insured and Party #3 is the beneficiary (ies) who receives the death benefit upon the passing of Party #2.

Qualified Disclaimers

Believe it or not, some people may not desire to receive an inheritance. Reasons for this could be many. Perhaps an inheritor is doing very well financially but wants to benefit a less wealthy sibling that may need the assistance. Or, the inheritor may already be in a very high income tax bracket and the required distributions from an inherited IRA will simply amplify their existing tax bill. This later situation may become more commonplace due to the Secure Act’s (see blog posting dated January 20, 2021) elimination of the “stretch IRA strategy” for non-spousal beneficiaries. Beneficiaries could have been designated decades ago and never updated. Yet, the passage of time can certainly affect the financial circumstances of these heirs.

Per Capita vs Per Stirpes

People who are preparing estate planning documents should be aware that these instruments might remain in effect for a lengthy period of time. We live in a dynamic world and circumstances can change over these years. Descendants might be born, pass away or develop cognitive impairments. Due to the possibility of these changes, estate planners often incorporate specific legal terms in drafting wills and other documents. Two of these terms are per stirpes and per capita. Having a good understanding of these two legal concepts can be very helpful in assuring that one’s property is distributed in a manner consistent with one’s wishes.