The Five Levels of Estate Planning is a systematic approach to explain estate planning in a way that you can easily follow. Which of the five levels you need to complete is based on your particular goals and circumstances.

Level One: The Basic Plan

The situation for level one planning is that you do not have an established will or living trust, or your existing will or living trust is out of date or inadequate. The objectives of this type of planning are:

o reduce or eliminate estate taxes;

o avoid the cost, delays and publicity associated with probate in the event of death or incapacity; and

or protect heirs from your disability, your disability, your creditors and your predators, including ex-spouses.

To accomplish these goals, you would use a vicarious will, a revocable living trust that allocates a married person’s estate between a credit protection trust and a marital trust, general powers of attorney for financial matters, and durable powers of attorney for health care and living wills.

Level Two: The Irrevocable Life Insurance Trust (ILIT)

The situation for Tier Two planning is that your estate is projected to be greater than the estate tax exemption. While there is a current lag on the inheritance transfer and generation-skip taxes, Congress is likely to reinstate both taxes (perhaps even retroactively) sometime this year. Otherwise, on January 1, 2011, the estate tax exemption (which was $3.5 million in 2009) becomes $1 million, and the top estate tax rate (which was 45% in 2009) becomes 55%. In either case, you can make cash gifts to an ILIT using your annual gift tax exclusion of $13,000/$26,000 per beneficiary.

Level Three: Family Limited Partnerships

The situation for level three planning is that you have a projected estate tax liability that exceeds the life insurance purchased in level two. If your $1 million gift tax exemption ($2 million for married couples) is used to make lifetime gifts, the gifted property and all future appreciation and income from that property are removed from your estate.

More people would be willing to give gifts to their children if they could continue to manage the gifted property. A Family Limited Partnership (FLP) or Family Limited Liability Partnership (FLLC) can play a valuable role in this situation. Typically, you would be the general partner or manager and, in that capacity, would continue to manage the assets of FLP or FLLC. You can even charge a reasonable management fee for your services as a general partner or manager. In addition, by gifting FLP or FLLC interest to an ILIT, the FLP or FLLC’s income can be used to pay premiums, thus freeing up your $13,000/$26,000 annual gift tax exclusion for other types of gifts.

Tier Four: Qualified Personal Residence Trusts and Grantor Retained Annuity Trusts

The scenario for level four planning is the additional need to reduce your estate after your $1 million/$2 million gift tax break has been used. Although paying gift taxes is less expensive than paying inheritance taxes, most people don’t want to pay gift taxes. There are several techniques for making substantial gifts to children and grandchildren without paying significant gift taxes.

One technique is a qualified personal residence trust (QPRT). A QPRT allows you to transfer a residence or vacation home to a trust for the benefit of your children, retaining the right to use the residence for a period of years. By retaining the right to occupy the home, the value of the remaining interest is reduced, along with the taxable gift.

Another technique is a grantor retained annuity (GRAT). A GRAT is similar to a QPRT. The typical GRAT is funded with income-producing assets, such as Subchapter S stock or FLP or FLLC interest. The GRAT pays you a fixed annuity for a specified term of years. Because of the retained annuity, the gift to the remaining men (their children) is substantially less than the current value of the property.

Both QPRTs and GRATs can be designed with terms long enough to reduce the value of the remaining interest that you pass on to your children to a nominal amount or even to zero. However, if you do not survive the established term, the property is included in your estate. Therefore, it is recommended that an ILIT be funded as a “cover” against your death before the end of the stated term.

Level Five: The Zero Estate Tax Plan

Level five planning is a desire to “disinherit” the IRS. The strategy combines life insurance donations with donations to charity. For example, take a married couple, both 55 years old, with a net worth of $20 million. Assume there is no growth or depletion of assets and both spouses die in a year when the estate tax exemption is $3.5 million and the top estate tax rate is 45%.

With the typical marital credit haven trust, when the first spouse dies, $3.5 million is allocated to the credit haven trust and $16.5 million to the marital trust. No federal state tax is due. However, upon the death of the surviving spouse, the estate tax due is $5.85 million. The net result is that the children inherit only $14.15 million.

Under the zero estate tax plan, the ILIT (with generation-skipping provisions) is funded by a $13 million second-to-die life insurance policy. These gifts reduce the value of the estate to $18 million. In addition, each of the couple’s living trusts leaves $3.5 million (the tax-exempt amount of the estate) to their children upon the death of the surviving spouse. The balance of his estate ($11 million) goes to a public charity or private foundation, free of estate taxes. Long story short, the zero estate tax plan gives $20 million (ie $13 million from ILIT and $7 million from living trusts) to children instead of $14.15 million; charity gets $11 million instead of nothing; and the IRS gets nothing, instead of $5.85 million.

In short, with a little advance planning, it is possible to reduce estate taxes, avoid probate, establish your wishes, and protect your heirs from creditors, ex-spouses, and estate taxes.

TO THE EXTENT THAT THIS ARTICLE CONTAINS TAX MATTERS, IT IS NOT INTENDED OR WRITTEN TO BE USED AND CANNOT BE USED BY A TAXPAYER IN ORDER TO AVOID SANCTIONS THAT MAY BE IMPOSED ON THE TAXPAYER, PURSUANT TO CIRCULAR 230.