The Economic Growth and Tax Reconciliation Act of 20012 (the "2001 Act") has simplified federal transfer tax planning for unmarried individuals and couples who do not expect their estates to exceed one million dollars. Such individuals are no longer subject to federal estate and gift taxation and in nearly all instances need not be concerned with the generation skipping transfer ("GST") tax. While such individuals comprise most of the population, most estate planning clients anticipate having estates in excess of one million dollars. Nearly everyone in this category now needs "sophisticated" planning for the increasing exemptions between now and 2009, the repeal of the estate and GST taxes (but not the gift tax) in 2010 along with major limitations on the traditional step up in basis on death, and the reversion to the old system in 2011. Estate planning must also deal with the virtual certainly that the Byzantine plan of existing law will be substantially changed.
This outline summarizes some of the more significant provisions of the 2001 Act, offers some possibilities for dealing with a dynamic transfer tax and considers some of the traditional "sophisticated" estate planning techniques in light of the new law.
I. Changes made by the 2001 Act
A. Exemptions and Rates
The estate tax exemption will
change so that increasing amounts may be passed free of federal estate tax. The
GST exemption will increase in a similar way. The gift tax exemption remains
constant from 2002 through 2010 at one million dollars. The top estate, gift and
GST brackets are eliminated over time. In 2010 the estate and GST, but not the
gift tax are eliminated. In 2011 the old law will be restored. These are
summarized in the following table:
| Calendar Year | Estate and GST exemption | Gift Tax Exemption | Maximum Transfer Tax Rate |
| 2002 | $1,000,0003 | $1,000,000 | 50% |
| 2003 | $1,000,000 | $1,000,000 | 49% |
| 2004 | $1,500,000 | $1,000,000 | 48% |
| 2005 | $1,500,000 | $1,000,000 | 47% |
| 2006 | $2,000,000 | $1,000,000 | 46% |
| 2007 | $2,000,000 | $1,000,000 | 45% |
| 2008 | $2,000,000 | $1,000,000 | 45% |
| 2009 | $3,500,000 | $1,000,000 | 45% |
| 2010 | N/A | $1,000,000 | 04% |
| 2011 | $1,000,0005 | $1,000,000 | 55% |
B. Credit for State Death Taxes
Former law provided a
credit against federal estate tax for state death taxes of up to 16% of federal
estate taxes. In 2002 only 75% of the credit is available. Fifty percent is
available to those dying in 2003 and 25% is available in 2004. Beginning in 2005
a deduction, but not a credit is allowed. Many states, including Utah impose a
"pick-up" tax equal to the maximum available federal estate tax
credit.6 On its face this provision is merely a revenue transfer from
such states to the federal government. However, faced with losing revenue,
states may enact new inheritance taxes. Some states7 will continue to
impose death taxes notwithstanding the lost credit. Thus state death taxes may
become an increasingly important issue.
C. Basis Step-Up
In 2010, the year of the estate tax
repeal, the step-up in basis will be limited. The general rule is that a step-up
of up to $1,300,000 is allowed. The rational seems to be that if a husband and
wife both died in 1999 they could have passed on $1,300,000 to their heirs
without estate tax (assuming a well planned estate) and with a basis step up. A
person acquiring property from a decedent spouse (in a form qualifying for the
current marital deduction) may receive an additional $3,000,000 step up. Further
step-ups are allowed for unused capital and net operating losses and unrealized
losses that would have been deductible had they been realized prior to death.
Otherwise, an asset will have the same basis in the hands of the heir as the
decedent had. Typical Utah clients can aspire to a full step-up in 2009, but
planning will be essential.
D. Non-resident alien spouses
Under previous law,
property passing to a non-citizen spouse qualified for a marital deduction only
if it was held in a "qualified domestic trust."8 Tax is imposed on
distributions from such a trust to a surviving spouse. The 2001 Act imposes tax
on such payments until 2021. Note however, that this provision, like most other
provisions of the 2001 Act is repealed after 2010.
E. Technical changes to GST
Six technical changes are
made to the GST. Automatic GST exemption allocations are changed. The rule is
complex, and the best solution is for the planner to determine and implement the
correct allocation. It will be easier to create separate trusts. Relief from
late elections is broadened. "Substantial compliance" is sufficient for
allocation of GST exemption. Some relief is available if a person to whom
exemption has been granted predeceases the transferor. The time for valuing
assets transferred under the exemption is the time the value is finally
determined for gift tax purposes. These provisions are of considerable
assistance in GST planning.
F. Exemption for qualified conservation easement
Under
prior law, 40% of the value of land subject to a qualified conservation easement
could be excluded from the gross estate, subject to several conditions, one of
which required that the land be located either near a city (to make green belt)
or a national park or wilderness area. This requirement has been repealed.
G. Other changes
The qualified family owned business
interest rule, which provided relief from taxation of such interests valued at
up to $1,300,000 is repealed in 2003 when the general exemption rises to
$1,500,000. The extension of time to pay estate taxes in closely held businesses
is extended to qualified lending and finance companies, but the deferral period
for such interests is 4 years, not 14.
II. Lifetime Gifts
Lifetime gifts always have the advantage that the sooner the property is removed from the potential estate of the donor, the more of the future appreciation is excluded from the estate. Further, some opportunities, such as the annual exclusion are "use it or lose it" in nature. Hence a current gift-giving program is probably the first order of business for any "sophisticated" estate plan.
A. Annual exclusions
Ten thousand dollars, adjusted for
inflation after 1998, per donor per donee per year may be transferred without
gift tax9 or GST tax10 consequences, thereby reducing the
potential taxable estate. Spouses can join together to give $20,000 to a single
person.11 Payments to prepaid tuition programs qualified under
Section 529 may take advantage of five years of the annual
exclusion.12 Thus a donor may give each child or grandchild $50,000
through such a program; a couple may give $100,000. A donor may pay tuition or
medical care expenses (that qualify under the Code) without limit.13
Transfers using the annual exclusion may be made in trust for minors if the
trust terminates at age 21,14 or to a trust granting the beneficiary
the right to withdraw the amount for a period of time and if adequate notice of
such right is given.15 In view of the uncertainty of transfer tax
planning, the opportunity provided by annual exclusions should not be
ignored.
B. Lifetime Exclusion
The lifetime exclusion for gifts
was increased from $675,000 to $1,000,000 effective January 1, 2002. Because the
value of any transfer is greater the earlier it is given, consideration should
be given to using any unused portion of the exclusion. However, because of the
progressive transfer tax rates, the $325,000 increase in the exemption may not
permit an additional transfer of that amount tax-free. For example, suppose a
donor previously transferred $1,000,000 (perhaps in connection with GST tax
planning). If the transfer occurred in 2001 a tax of $125,250
($345,800-$220,550) would have been paid. If $325,000 were transferred this year
an additional $9,500 ($134,750 + $345,800 -$345,800 -$125,250) would be due.
This reflects a 6% rate differential on $75,000 and a 2% differential on
$250,000. The maximum tax-free gift would have been $302,906.98.
C. Taxable Lifetime Gifts
The use of taxable lifetime
gifts has been made more complex by the new law. Though many taxpayers think
otherwise, there is no advantage in deferring a one-time transfer tax. The
growth in value of the transferred asset exactly offsets the time value of the
accelerated tax, assuming a uniform tax rate and a uniform rate of return on
investments.16 (The step-up in basis on death, however, adds another
dimension for income tax planning.)
All things being equal, the gift tax rate (a so-called "tax exclusive rate") is lower than the same estate tax rate a "tax inclusive rate"). Consider a taxpayer in a 40% transfer tax bracket with $1,000,000 to pass to his issue. If he makes a gift of $714,286, the gift tax (40%) is $285,714, exactly equaling the $1,000,000. On the other hand, if the asset is held until death, the estate tax (40%) will be $400,000 leaving only $600,000 for the heirs. The heirs get 19% more, in this case, with a lifetime gift. In general, if "e" is the estate tax rate, the comparable gift tax rate "g" = e/(1+e), so if e = 40%, g =28.67%.17 This analysis is irrelevant if there are gift taxes (as there will continue to be under the 2001 Act) but no estate tax. The law on the books says there will be no estate tax for those dying in 2010, but otherwise there will be estate tax. Planners tend to think that most clients WILL be subject to estate death, but clients tend to avoid gift tax in these circumstances.
This has a major impact on "sophisticated estate planning" because many of the techniques are premised on the client being willing to incur some gift tax. Some of these are discussed below.
III. The Estate Tax Marital Deduction
A. The Problem
1. Under-funding: Formulas to Eliminate Estate Tax on First
Death
Since 1981, the typical estate plan for a married
couple(particularly if it is the only marriage of each spouse) is to provide
that the maximum amount that can pass free of federal estate tax will be placed
in a trust (the by-pass or family trust) in which the surviving spouse may have
some interest, but not enough to cause the trust to be taxed in her estate, with
the remainder going either directly to the surviving spouse or to a Qualified
Terminable Interest Property ("QTIP") trust which is usually taxable in the
survivor's estate.. Alternately the QTIP Trust is funded with the minimum amount
necessary to eliminate federal income tax, with the balance going to the family
trust. In either case there is no federal estate tax liability on the first
spousal death.
2. The Widow's Election under Utah Probate Law
The
dramatic increase in the exemption amount may result in the QTIP trust being
under-funded. If a person dies in 2010, nothing would go to the QTIP trust. The
Utah Probate Code permits the surviving spouse to elect a share of her spouse's
estate equal to the value of 1/3 of the "augmented estate."18 Aside
from the complexity of the computation, Utah courts have yet to construe this
section as applied to a QTIP trust. One possible construction is that NO
property in a QTIP trust satisfies the requirements of Utah law and the
surviving spouse may break the trust.19 A more likely outcome is that
Utah courts would allow the then present value of the spouse's life interest in
the QTIP trust to satisfy, pro tanto, the requirement.20 However,
this is a moving target. The older the spouse, the less is the value. Some
states (e.g. Florida) have a formula for determining such value, but Utah has
not adopted such a rule. While this problem existed before, the under-funding
resulting from the 2001 Act may give rise to more "widow's election"
controversies.
3. Under-Funding: Equal Shares
Since the time of payment
of the estate tax does not affect its burden, large estates are sometimes set-up
so that half (or some adjustment to half) of the couple's estate is taxed on
each spouse's death. This takes maximum advantage of the lower rates available
under the progressive tax. Under the new law, if a couple had a four million
dollar estate and one spouse died in 2002, it would probably be a mistake to
subject half the estate to taxation ($2,000,000, less $1,000,000 exemption
leaves $1,000,000 subject of taxation with a projected tax of $435,000) when
there may be little or no tax if the survivor lives to 2009.
4. Over-Funding
An equal share formula will not be
necessary if a person dies in a year when there is no estate tax (2010). The
client may prefer that a smaller share go to his spouse in that case,
particularly when there is a subsequent marriage late in life.
5. Drafting Issue
Apart from substance, a formula
containing language such as "optimum marital deduction" or "reducing federal
estate taxes to their minimum" or "one-half of my gross estate for federal
estate tax purposes" does not make sense if there is no federal estate tax.
Courts can probably determine the testator's intent, and even the technical
terms may continue to be defined.21 However, at least on a going
forward basis, drafters should consider including language in their documents
for dealing with a time when the estate tax is not in effect.
6. When the Problem Arises
Aside from probate and
drafting issues, under-funding may not be a major issue when the surviving
spouse is the parent of the decedent's children. In Utah, medium estates often
provide the surviving spouse with the income from the family trust with a right
to principal in case of need.22 As a practical matter the survivor
may see little difference between the two trusts. However providing family trust
income to the survivor is inefficient from an estate tax standpoint and is often
inefficient from an income tax standpoint. In larger estates an independent
trustee may be given a sprinkling power.23 If the beneficiaries of
the family trust are not family of the spouse (as in a second marriage)
under-funding is likely to create controversy.
B. Solutions
1. Executor or Trustee Discretion
The executor or
personal representative, or in the case of a revocable inter vivos trust, the
trustee, may be given discretion to allocate the residue of the estate between
the marital bequest and the family trust. If the surviving spouse is the
executor and all children are products of the marriage, this may work well since
the terms of the two trusts will be similar. However the power is most critical
in a large estate where the income from the family trust is not intended for the
spouse. Here, the trustee will not wish to exercise such power unless the
"step-mother" and the children are able to agree. This poses practical
problems.
2. Disclaimers
In some situations the entire residue
could be left in a QTIP Trust, with the spouse having the ability to disclaim
into a family trust. Because the gift tax is not repealed, it is critical that
the disclaimer be qualified under Code § 2518. The disclaimer must be in
writing, must be made before the person accepts any benefits and must generally
be made within nine months of the decedent's death.
Disclaimers have two disadvantages as compared to an executor's power. First, there is no fiduciary duty applicable to the potential disclaimer. The survivor need not exercise the power pursuant to the decedent's wishes. Secondly, the executor is not subject to the nine-month time limit. Although the executor should not postpone making an election indefinitely, it is less likely her power will be inadvertently lost due to the passage of time.
Conversely, the estate could be left to non-spousal beneficiaries, who would have the power to disclaim to the spouse. This might be used if there are adult children of a prior marriage. However this technique has two further drawbacks. Where the person disclaiming is not the spouse, the property cannot be allowed to return to that person. Thus the family member could not retain a remainder interest in the QTIP trust.24 Further there are often multiple beneficiaries of the family trust, including minor children and unborn issue. This will greatly complicate the disclaimer process.
3. QTIP elections
The executor could choose to not elect
to treat a QTIP trust interest as qualifying for the marital
deduction.25 The executor may make this election in whole or in
part.26 The portion of the trust to which the election does not apply
will be included in the decedent's estate and if the trust does not give the
spouse a general power of appointment or contain other defects, the assets will
not be included in the survivor's estate. Thus all of the estate could be left
to the QTIP trust and the executor would have the power to determine, in effect,
which estate the property will be taxed in. This has none of the drawbacks of
the disclaimer and the executor is under a fiduciary duty. However, while the
tax effects can be changed, there is no change in the disposition as a result of
this technique. For example, in many cases the client would want the surviving
spouse to have a general power of appointment over the QTIP trust. Such a power
would negate this strategy. However, there is a possible solution.
4. "Clayton QTIPS"
Following litigation the Treasury
adopted regulations that say, in effect, a will or trust can be drafted so that
to the extent an election is made to qualify property for the marital deduction,
the property will go to a QTIP trust, and otherwise it may pass to others, as to
a family trust.27 This tool would probably not be available if there
is no estate tax.
5. Conclusion
While disclaimers and QTIP elections are
often provided in existing documents, they often only work if the marital
deduction is over-funded. Since the new law will often result in the marital
deduction being under-funded amendment of many estate plans is appropriate.
IV. Planning for 2010
The year 2010 is so far away, and the likelihood of the law changing before that time so great, that few clients will want to plan for that contingency. However the planner should at least be aware of some potential problems.
A. Excess Bequests to Spouse
If H dies in 2010 and leaves
everything to W, but W dies in 2011, all but $1,000,000 of the combined estate
will be taxed. At a minimum those contemplating spousal bequests that may be
effected in 2010 should consider a by-pass trust. For example a total of
$1,000,000 might go to the surviving spouse outright or in trust, with the
remainder in a trust that might provide the spouse income and a limited power of
appointment.
B. Basis Step-Up: Minimum Funding
Those taking property
from a decedent dying in 2010 will get a step-up in basis to the extent of $1.3
million, unrealized losses and carryover capital losses and net operating
losses. In a large estate in may be appropriate to take advantage of the
unlimited marital gift tax deduction to provide that each spouse has at least
$1.3 million of unrealized gains at death. Additional planning is difficult,
since the planner will not ordinarily know which spouse, if either, will die in
2010. Further, unrealized gains and losses are moving targets.
It is NOT clear that property included in the decedent's trust because held in a QTIP trust will qualify for the step-up. Thus the transfer must be outright, carrying the usual disadvantages (creditors claims, successor spouses, investment management) or the assets could be put in a QTIP trust28 under which an independent trustee has the power to pay out assets in 2010 if it seems appropriate. Also property transferred to the decedent within three years of death will not get a basis step-up unless the transferor was the spouse.29
C. Basis Step-Up: QTIP Funding
In addition to the
foregoing basis step-up, $3,000,000 of gain can be eliminated if the decedent
spouse leaves property either outright to the surviving spouse or in a QTIP like
arrangement. The outright bequest seems unwise; the estate tax is scheduled to
return in 2011. A QTIP like arrangement means that the spouse has at least a
life interest in income and no one else has a power of appointment to a person
other than the spouse. There need be no election to include the property in the
survivor's estate should the estate tax return.30
V. Planning for the State Death Tax
If the client owns property in a state that imposes a death tax in excess of the allowable credit (thus any such tax after 2004) further planning is appropriate. Perhaps those assets should be owned through a single member LLC organized in a jurisdiction that imposes no state death tax. The planner should check to see that such an arrangement is respected for purposes of that state's death tax.
New York imposes a death tax not limited to the federal credit. Presumably New York will not impose a death tax on shares of corporations organized in New York if the decedent is not domiciled in New York. However these issues should be considered.
If the client is domiciled in a state where a non-creditable death tax is imposed (or if Utah imposes one) consideration should be given to changing domicile. Florida has adopted a constitutional amendment forbidding death taxes, presumably to encourage retirees to relocate. For the truly mobile client the United States Virgin Islands offers incentives that could reduce United States income tax liability as well as eliminate state death taxes. Finally, if the client is going to be subject to state death taxes, the state marital deduction should be considered. If the surviving spouse may leave the state, this may suggest increasing the marital bequest.
VI. Generation-Skipping Transfer Tax
Clients interested in passing assets to their grandchildren, or later generations must consider the generation-skipping transfer tax. The current exemption is $1,060,000 but will rise with the estate tax exemption. This simplifies GST planning.
Formerly the estate tax exemption was less than the GST exemption. To avoid estate tax, all but, say $675,000 would pass to the surviving spouse as QTIP property. There would not be enough left in the decedent's estate to take full advantage of the $1,000,000 GST exemption. A "reverse QTIP" election31 was provided to use QTIP property to fund the GST exemption. In most cases it will no longer be necessary to deal with this problem.
The changes to GST under the 2001 Act should also make it easier to deal with GST exemption planning. Drafting issues are similar to those with the estate tax. If the client provides that grandchildren are to receive an amount equal to "the maximum GST exemption" this might pass too much if the exemption is $3.5 million and raise the question in 2010 whether the amount is all (because the entire estate can pass without GST tax) or nothing (because there is no GST tax and hence no GST exemption). Probably neither will reflect the wish of the client.
VII. Gifts to Charity
A comprehensive analysis of charitable giving is beyond the scope of this program. Some important techniques to consider are suggested below.
A. Simple Gifts
Gifts of full interests to charities
qualified under Code § 501(c)(3) are deductible for gift, estate and income tax
purposes.32 It is advisable to either check the IRS list of qualified
charities33 or obtain a copy of the organization's IRS 501(c)(3)
determination (most charities, other than churches are required to obtain a
determination34). Deductibility will be affected by whether the
recipient is a public charity or private foundation.35
Many individuals choose to make charitable bequests at death. If the individual is subject to federal income tax, it is always better to make the contribution prior to death. Suppose an individual in a 30% income tax bracket and 40% federal estate tax bracket provides for a charitable gift of $100,000 on death. The $100,000 will not be taxed in the estate, but there will be no income tax benefit. If the gift is made prior to death there will be a $30,000 income tax benefit. This will increase estate taxes by $12,000. Never the less the heirs will be $18,000 ahead. This illustrates that the estate-planning goal is not to minimize estate tax (this technique may actually increase estate tax), but to maximize after tax value passing to heirs.
While there is no authority on this point, it does not seem likely that the IRS would challenge deathbed gifts. Therefore permitting holders of durable powers of attorney to make such gifts for the dying while complying with provisions for ademption by satisfaction36 should be considered.37
B. Appreciated Property
In many cases the donor is
allowed a deduction of the fair market value of appreciated property for income
tax purposes. Under current law the basis of appreciated property38
for death or near death gifts may make no difference, as all property gets a
step-up on death. However if the individual might die when there is a limited
step-up in basis (all of us are in that category) the incentive to use low basis
property for charitable giving increases.
C. Charitable Lead Trusts
A gift or bequest to charity in
the form of an annual sum certain or a fixed percentage of annually determined
fair market value to charity for a period of years, followed by a remainder to
family members qualifies both for the estate and the gift tax charitable
deductions. Generally no income tax deduction is allowed.40 There are
many technical requirements that must be carefully followed.
The advantages of this technique may be illustrated by an example. T regularly contributes ten percent of his adjusted gross income as shown on his federal tax return to his church. He has an income producing property that needs little management that produces annually a sum of $10,000. He transfers the property to his children, but provides that $10,000 must be paid to his church for life. The charitable interest is valued based on 120% of the prevailing mid-term federal interest rate41 and life expectancies found in Table S.42 Let's suppose the value of the property is $120,000 and the value of the charity's interest is $50,000. Thus the gift tax value of the transfer to the children is $70,000.
Note that even though there is no income tax deduction, T's adjusted gross income is reduced by $10,000 per year (the income that would have been received from the property) by the transfer. Thus T may come out whole for income tax purposes. (However, T may also lose depreciation deductions, so further study is required.) The $10,000 partially satisfies his tithing. Possibly his tithing requirement is reduced, because his adjusted gross income is reduced. Suppose that had the value of the property on T's death is $200,000. T has reduced his potential taxable estate by $130,000 at NO cost to himself.
Under current law, the calculation will become more complicated, if the annual exclusion is not available for the $70,000 gift. If T waits until death, the estate tax might be repealed. Even better, he might die while the step-up in basis is in effect transfer the property to his surviving spouse, who would take a basis step-up. She might then die there was no estate tax. Then again, the results could be quite different depending on year of death and changes in law. The pros and cons must be weighed.
D. Charitable Remainder Trusts
Income, gift and estate
tax deductions are available when a fixed amount or fraction based on current
assets is reserved or transferred to children with the remainder to
charity.43 Qualifying Charitable Remainder Trusts are not subject to
income tax.44 Hence CRTs are often used to permit a tax-free sale of
an appreciated asset which provides an increased income stream to the
grantor.
A CRT must reserve a payment of between 5% and 50% of value, and the term may not exceed a single life or twenty years.45 The value of the charitable remainder must be at least 10% of the net fair market value of the property at time of transfer.46
In an estate-planning context, the value of the gift or bequest of the life interest is computed as with a charitable lead trust. A charitable deduction is available to the donor computed by subtracting the value of the interest transferred to non-charities from the total value.
If the recipient of the income is in a lower tax bracket than the donor there are further income tax savings. Overall CRTs are of more interest in an income tax planning context than an estate tax planning context.
E. Private Foundations; Consult and Advise Funds
Clients
often wish to make current gifts to charity, by way of endowment, retaining
power both as to future use of income and the investment of principal. The
wealthy client may wish to establish a private foundation. These entities are
subject to many restrictions.47 Unrealized appreciation is generally
not deductible when a private foundation is a recipient unless the asset is
stock for which quotations are readily available.48 The total annual
charitable deduction may be limited to 20% of adjusted gross income (compared to
30% for appreciated property generally and 50% for cash contributions to public
charities).49 There are exceptions and special rules.
Mutual fund advisors now sponsor vehicles that achieve many of the advantages of private foundations with less expense and restriction. These go under the name "consult and advise," "donor advised", "charitable endowment" and the like. In these cases the donor makes an outright gift to a charitable entity maintained by the mutual fund advisor. Generally only cash and traded securities are accepted. Since the gift is irrevocable, the full amount of the gift is generally currently deductible for income tax purposes. It is out of the future taxable estate. The donor may choose among several funds or pools of funds in which to invest the assets. The donor then "suggests" a recipient of a charitable contribution through a "grant recommendation form." Grants must be to 501(c)(3) or other qualified entities. There will usually be a minimum size and perhaps a maximum number per year (with additional fees for grants in excess of the number). Over time, annually or perhaps longer, an annual average payout of five percent is required. If the endowment is paid out too quickly the mutual fund company may assess additional fees.
There will be a minimum initial contribution, usually with lower minimums for subsequent additions. One program will accept a minimum of $25,000, but this may be spread over time, providing each contribution is at least $5,000. Fees are assessed at the mutual fund level and also for administration. It is possible to find programs assessing fees of less than 1% per year. Remember that part of the fee would be incurred anyway either as trading fees or mutual fund fees, if the donor continued to invest in securities. The donor may name a successor (e.g. a child) to make grant recommendations after his death. Under current procedures, that successor may name a successor and so on indefinitely.
Does the donor have any legally enforceable rights once the gift is made? Such rights, if they exist, might adversely affect the tax consequences. However mutual fund advisors make their money by increasing the assets under their direction. The charitable fund would have to go to a charity (albeit not necessarily the donor's charity) in any event. Thus it would seem there are strong market incentives for the large publicly recognized mutual fund advisors to honor the arrangement.
VIII. Life Insurance
While life insurance proceeds are generally not subject to income tax50 they are subject to estate tax, unless an exclusion, such as the marital deduction applies. Therefore the estate planner generally has the policies held by an irrevocable trust. For the trust to be respected the grantor must not retain any prohibited powers over the policy51 or any "incidents of ownership" over the policy or the trust.52
The most difficult problem, however, is that if the decedent transferred a life insurance policy within three years of his death, the entire proceeds will be included in his estate.53 To attempt to deal with this, several rules have evolved. First, the trust, not the grantor should be the initial owner and applicant. Second, if the grantor is to pay the premiums, make a cash contribution to the trust, giving the trustee discretion as to whether to pay the premiums.54 "Crummey Powers" discussed above may be used to take advantage of the annual exclusion. The courts have sometimes included proceeds in the grantor's estate on the theory the trustee was the grantor's agent.55 This attack depends on facts and circumstances and an independent trustee would probably not be held an agent. The best solution, of course, is to fund the policy in such a way that the grantor expects to live more than three years after paying the last premium. It is close to impossible to transfer term, particularly employer provided group term insurance, in such a manner that the proceeds are not included in the estate.
The most common reason the client adopts this arrangement is logically incorrect. The client expects to make a few premium payments, which attract little or no gift tax, and the beneficiaries of the trust receive a large inheritance. This will be true some of the time. However, if the insurer is to remain solvent, on average the value of the premiums transferred over the insured's life must be comparable to the maturity value of the policy. The premiums most also pay the insurance company for taking the risk and incurring sales and administration expenses. However, the tax-free accumulation of income earned by the invested portion of premiums works in favor of the beneficiaries. If life insurance is purchased for the income tax advantage, it is not really an estate-planning tool, but dealing with the complexities of the irrevocable life insurance trust does require sophistication.
Life insurance can be a very useful estate-planning tool when liquidity is required. A client may wish to pass his business on to his children. Life insurance provides the funds to pay the taxes without forcing a liquidation to pay death taxes. Partners may enter into a buy-out agreement effective on their respective deaths. This can be funded through life insurance. As discussed in the Retirement and the Estate Tax Section, it is desirable to leave funds in an IRA or qualified retirement plan as long as possible. Life insurance is one vehicle for paying the estate tax on retirement accounts without having to invade them. Life insurance also plays a natural role in dealing with the risks of premature death. If a client creates a charitable remainder trust, reserving an interest for his life (or the life of his spouse) life insurance protects against his premature death. Further, the premiums paid to the irrevocable life insurance trust provide the discipline necessary to make transfers to the next generation. That is, even if the client lives his full life expectancy, the life insurance trust will provide more favorable treatment than where there is no trust and the client fails to take advantage of the annual gift tax exclusions.
Life insurance also provides a measure of protection against the increased estate tax liability the client may incur if she should die before the larger exemptions become effective (or before 2010).56 Life insurance could also be used to protect the income tax savings that might be lost if the client failed to live to the required beginning date (usually age 70 ½) for distributions from qualified retirement plans. And, of course, life insurance can be used to protect against the loss of salary, other earnings, or profits to be made by the client because of premature death.
If life insurance is appropriate for any of these reasons, the irrevocable life insurance trust should be considered.
IX. Future Interests: GRATS, GRUTS, QPRTS and Defective Grantor Trusts
A. GRATS and GRUTS
If a Grantor (the client) retains a
qualified annuity or unitrust interest after placing property in trust, the
analysis is much the same as with a charitable lead trust, except, of course,
the grantor retains the income.57 One important difference is that
the grantor must outlive the interest (hence the interest must be a term of
years, not a life interest) otherwise the entire value returns to the
estate.58
Perhaps the most interesting use of GRATs and GRUTS involve property that (it is hoped) will appreciate rapidly. By reserving large amounts of income, a relatively short income interest (perhaps two years) can reduce the residual value of the property passing to something approaching zero.
While GRATs work well in theory, finding rapidly appreciating assets is easier said then done. Most GRAT planning (that ultimately saves taxes) involves paying a significant gift tax at the time of the transfer. In light of the current uncertainty about tax rates, the enthusiasm for GRATs is likely to diminish.
B. PRTs and QPRTs
The donor may use the same strategy
with his home, and continue to live in it for a period of time. The advantages
are the same as with the GRAT, except that the income interest is a right to
possession. If the donor wishes to live in the home after the expiration of the
term, the children or other successors could rent it to him. There can be no
guarantees, so this decreases the attractiveness of this device. Further, it
cannot be combined with the potential exclusion from income of up to $500,000 of
gain on sale under Code § 121.
A personal residence trust, as authorized in the Code may not sell the residence. A qualified personal residence may sell the residence but the trust instrument must contain provisions to preserve the interest. The trust must distribute income annually to the grantor. Corpus may not be distributed to anyone other than the grantor. The trust may hold only the personal residence, certain improvements, cash necessary to meet expenses, insurance proceeds and sales proceeds. If the residence is sold, the proceeds must be used to acquire another home within two years. The home may not be sold to the grantor. Additional provisions apply to define when the trust ceases to be a QPRT and how assets should be distributed in such event.
As discussed with GRATS, the uncertain state of future transfer taxation makes residence trusts less appealing.
C. The Defective Grantor Trust - Preserving Basis
Step-Up
It is often possible to attain grantor trust status while
having the transfer recognized for estate and gift tax purposes.59 In
a grantor trust transactions between the trust and the grantor are not
recognized for income tax purposes. For example, G transfers stock worth
$100,000 to a GRAT, reserving the right to $35,000 per year for three years. The
gift tax on the remainder is thus low. The trustee borrows the funds to make
payments. At the end of three years the stock is worth $500,000. G purchases the
stock for $500,000. No gain is recognized because the transaction is between a
grantor and a grantor trust. Roughly $350,000 has been transferred to the
beneficiaries of the trust without significant gift or estate tax AND the
grantor will get a step-up in basis on the stock when he dies (unless the
step-up is repealed).
Note that grantor trusts need not reserve the income to the grantor (e.g. they need not be GRATs), so they may also be used to provide income to children or other family members. The transfer of the income interest can be drafted as either a completed or incomplete gift. In the former case (the classic defective grantor trust) the advantages of the GRAT are lost. However the payment of income taxes by the grantor reduces his taxable estate. (This is usually only interesting if the grantor is in an income tax bracket lower than or equal to the recipients). The IRS has ruled privately that such tax payments are further gifts,60 but some planners argue there is no support for this position. If the transfer is treated as an incomplete interest, than for tax purposes it is as if the grantor retained the term interest. The income is then a gift to the beneficiaries as earned. However it should be a current gift qualifying for the annual exclusion.
Defective grantor trusts are also used for life insurance, permitting the grantor to take interest deductions on policy loans. Use of defective grantor trusts in connection with charitable lead interests allows the grantor to take a charitable deduction at the time the trust is funded.61 The grantor will have to recognize income over the term interest, but this may be sheltered by depreciation or other deductions.
Defective grantor trusts may used to hold stock in S corporations. Only certain types of trusts can hold stock in S corporations. An electing small business trust is flexible, but pays tax at the maximum rate.62 A qualified subchapter S trust results in tax to an individual, possibly at less than maximum relates but restricts beneficial ownership interests.63 A grantor trust may hold S corporation stock64 and may be the best alternative.
D. The Sale of Remainder Interests Lives Again,
(But
did you know it had died?)
If the grantor sells the remainder interest,
at the time the income interest is created, for adequate and full consideration
in money or money's worth, there is no gift and there will be no inclusion of
the GRAT in the grantor's estate.65 This is true even though the
grantor dies during the term. Hence it is possible to retain a life estate as
well as a term of years. Gradow vs. U.S66 diminished the
popularity of selling remainders, by holding that adequate consideration must be
paid for the entire interest, not just the remainder. However, subsequent
decisions suggest that the price will suffice if it covers the
remainder.67 So sale of remainders lives again.
As with grantor trusts, this technique is not confined to GRATs and may be coupled with the transfer of the income interest to a child or family member.
Why bother? Of course selling property that will appreciate rapidly is good estate planning, but conceptually can't be done. If you really know the property will go up in value, it currently already has a high value. If you don't know, then the gift may not appreciate as hoped. What makes the technique of interest is that IRS valuation tables tend to overstate the value of life estates. If the remainder is valued at fair market value of the property less an over-valued life estate, the remainder sale is good estate planning. However, there remains the problem of getting the child enough money to pay for the remainder. In a simple case the grantor would first give the child the money, and then allow the child to pay for the remainder. The gift tax element is still there and therefore the 2001 Act makes this less attractive than when NBI first suggested including this technique on the program.
IX. Planning for the Transfer of Interests in Closely Held Businesses
Closely held business interests will be discussed in a different segment of the program.68 The irrevocable life insurance trust, GRATs and GRUTS, and items that follow can be useful in that process. The reader may find it easier to understand the motivation behind such techniques if she keeps the closely held business interest in mind.
X. Private Annuities
In the most common case, the grantor sells an appreciated asset to a child or family member, in return receiving a life annuity calculated according to IRS tables to provide equal value. With the right values, there will be no estate or gift tax consequences, although the asset sold will have been removed from the grantor's estate. However, his estate will be augmented by the annuity payments, unless he spends or otherwise disposes of the funds. He will recover basis ratably over the anticipated life expectancy, and recognize his gain ratably as well.69 Notice how closely this resembles a GRAT (especially if the remainder is sold). The anticipated appreciation of the asset escapes estate taxation and the relatively high value of the life estate permits a lower annuity payment.
XI. Self-Canceling Installment Notes
The client may sell property, usually appreciated in return for a self-canceling installment note. The obligation would expire on death. To avoid a gift tax, the consideration would have to be more than if the note were not contingent. Both the asset and the note are excluded from the taxable estate.70
However, on death the seller's estate must recognize the balance of the gain.71 Further, the buyer has discharge of indebtedness income under general tax law72 although the matter does not seem to have been litigated. The seeming double taxation arises the exclusion of gifts and inheritances from income tax73 is lost.
While SKINs may be useful in special circumstances (the rapidly appreciating asset, preferably one that has not yet appreciated, coupled with a low bracket beneficiary), they are probably not the estate planning technique of preference.
XII. Valuation Discounts
Valuation is a subject of its own. This section treats some common methods for valuing and reducing what might otherwise be viewed as the value of interests in entities.
A. Blockage
If stock or another interest is publicly
traded so there is a "quoted" per share value, it will not be possible to attain
that value if a large enough block is sold over a short period of time. The
market price is set where supply equals demand. While some buyers will pay the
quoted price, others will not. If enough stock must be sold, some of the stock
will have to be sold to buyers who demand a lower price.74 To
establish this "blockage" discount requires significant substantiation .It is
impossible to give a rule of thumb amount, although 8% to 10% may not be
uncommon in some cases. If separate gifts of the same issue of stock are made at
the same time, each gift is valued separately (i.e. no
discount).75
B. Restricted Stock
Not all shares of a publicly traded
security may be sold over exchanges. Restrictions may apply to shares of the
original owners, or others under Rule 144 of the Securities and Exchange
Commission. A discount is permitted for the restriction.76 The
discount again depends on many factors and the liberalization of Rule 144 in
recent years would suggest a reduction in the available discount. However a 25%
discount would not be extraordinary.
C. Lack of Marketability
Closely held shares are not
readily marketable. The distinction between minority discounts and lack of
marketability discounts in this context is hard to make, and not always made by
courts. However the case law recognizes lack of marketability discounts and
discounts in the range of 35% are not uncommon. However, it would be a mistake
to assume that lack of marketability discounts can always simply be added to
minority discounts.
D. Minority Discounts
Minority discounts take into
account the lack of control over an entity's governing board, operations,
dividend and distribution policy and liquidation decisions. Courts are generally
sympathetic to such discounts and the combined marketability/minority discount
can exceed 50%. As with all discounts, a foundation based on facts and
circumstances is essential.
1. Shareholder, Parsons Behle & Latimer, Salt Lake City, Utah;
Visiting Associate Professor of Law, University of Utah College of Law,
1999-2000; Adjunct Professor 2000-
2. P.L. 107-15 signed June 7, 2001
3.
Because of inflation adjustment the GST exemption for 2002 and 2003 is actually
$1,060,000
4. The gift tax continues reaching a maximum of 35% for cumulative
transfers in excess of $500,000.
5. The gift and estate tax exemptions had
previously been scheduled to reach $1,000,000 in 2006. Thus the "sunset" rolls
back the exemption to $1,000,000 not $675,000.
6. UCA 59-11-100 et seq.
7.
Pennsylvania and New York seem likely candidates
8. Internal Revenue Code
("Code") Section 2056(d) and 2056A
9. Code 2503(b)(1)
10. Code
2612(c)(1)
11. Code Section 2513
12. Code Section 529 (c)(2)(B)
13.
Code Section 2503(e)
14. Code Section 2503(c)
15. For "Crummey" Trusts see
BNA Tax Management Portfolio 846-1st "Gifts to Minors" IV. 11
16. See the
Appendix to the materials on "Retirement and the Estate Tax" for a derivation of
this result.
17. Conversely, e = g /(1-g). A 40% gift tax rate is thus
equivalent to a 66.67% estate tax rate.
18. Utah Code annotated § § 75-2-201
through 75-2-214
19. For example, prior to 1981 nothing in a QTIP trust
(where the spouse had no power of appointment) would have qualified for the
federal estate tax marital deduction. Code § 2056(b)(3). That is for property to
treated as passing to a spouse, perhaps she must obtain the whole fee, not
merely a life estate or other "terminable interest."
20. See UCA § §
75-2-208(7)(b) and 75-2-209
21. Code § 2210, the estate tax repeal, says the
estate tax "shall not apply to decedents dying after December 31, 2009." It does
not actually strike the estate tax from the statute books.
22. Need is often
some combination of health, education, support and maintenance. See Code §
2041(b)(1)(A). Broader powers, unless subject to veto by someone with an
interest, result in including the trust value in the survivor's estate,
defeating the purpose of the family trust.
23. See Code § 678 for the income
tax disadvantages of the survivor having such power if she is a potential
beneficiary (she is taxed on the income).
24. See Treasury Regulation
25.2518-2(e)
25. Code § 2056 ((b)(7)
26. Treasury Regulation
20.2056(b)-7(b)(i)
27. Treasury Regulation 20.2056(b)-7(d)(3)(i)
28.
Qualifying under Code § 2523(e) or (f) relating to gift tax
29. Code §
1022(d)(1)(C)
30. Code § 1022
31. Code § 2652(a)(3)
32. Code § § 2522,
2055 and 170.
33. "Cumulative List of Organizations Described in Section
170(c) of the Internal Revenue Code of 1986" (Pub. 78), updated and reissued
annually
34. Code § 508(c)
35. Code § § 170(b) and 170(e)
36. Utah Code
§ 75-2-609
37. In drafting devises, bequests and legacies and deathbed
transfers, particularly when the recipient is a church and the asset is real
property, the planner should recall the common law concerning mortmain. See 17
Utah 331, 53 P. 1015 Staines v. Burton (Utah 1898) 1898 Utah Lexis 72. For
example Ohio had a statute § 2107.06 of the Ohio Revised Code of 1954
invalidating charitable devises and bequests in wills made less than one year
before death. In 1965 the period was shortened to six months and in 1985 the
statute was repealed. The amending note states that 5 states (not named)
retained mortmain statutes at the time, and mortmain statues in two other states
had been held unconstitutional.
38. Property whose basis exceeds fair market
value should usually be sold, with the proceeds going to charity, so that the
client may take advantage of the loss.
39. Code § § 2055(e)(2)(B) and
2522(c)(2)(B)
40. See Code § 170(f)(2)(B)
41. Code § 7520
42. Treasury
Regulation 20.2031-7
43. Code § § 170(f)(2) 2055(e)(2)(A) and
2522(d)(2)(A).
44. Code Section 664
45. Treasury Regulations 1.664-2 and
1.664-3
46. Code § 664(d)(1)(D)
47. Restrictions are imposed on failure to
distribute income, self-dealing, excess business holdings, scholarships and
other activities through excise taxes Code § § 4940-4948. Procedural Rules are
found in § § 507-509.
48. Code § 170(e)(5)
49. Code § 170(b)(1)(D)
50.
Code § 101(a)(1)
51. As the power to affect beneficial enjoyment Code §
2036(a)(2) or the power to revoke the trust Code § 2038
52. Code §
2042(2)
53. Code § 2035(a)(2)
54. The argument is that if the grantor pays
the premium some measure of the policy becomes his, whereas this is not true if
the trustee chooses to use trust funds to pay premiums. Hope v. U.S. 82-2
U.S.T.C. 13,504 (5th Cir.)
55. Detroit Bank and Trust Company v. U.S. 467 F
2d 964 (6th Cir. 1972)
56. In practice there is no protection than can be
purchased against the higher estate taxes may be incurred by living past
2010.
57. Code § 2702
58. Code § 2036(a)(2)
59. Code § § 671-677
provide rules for treating a trust as owned by the grantor for income tax
purposes. Some retained powers, e.g. the power to revoke, will result in the
transfer being ignored for estate and gift taxes as well. Others, e.g. an
exercised power of the grantor as trustee to make a loan (even if small) to
himself, result in the trust being respected for estate and gift tax purposes,
but not for income tax purposes.
60. PLRs 9504021, 9444033, 9416009, 9413045
and 9352004.
61. Code § 170(f)(2)
62. Code § § 641(c) and 1361(e)
63.
Code § 1361(d)
64. Code § 1361(c)(2)(A)(i)
65. Code § 2036
66. 897 F.2d
516 (Fed. Cir. 1990), aff'g 11 Cl. Ct. 808 (1989).
67. D'Ambrosio Est. v.
Comr., 101 F.3d 309(3d Cir. 1996), rev'g 105 T.C. 252(1995), cert. denied
(1997); Wheeler v. U.S., 116 F.3d 749(5th Cir. 1997), rev'g 96-1 USTC Para.60,
226 (D. Tex. 1996); Magnin Est. v. Comr., 184 F.3d 1074 (9th Cir. 1999), rev'g
T.C. Memo 1996-25.
68. Transition planning involves the corporate
reorganization provisions, Code § § 351-384, corporate distribution and
redemption provisions, and Code § § 301-318, the law governing corporations and
other entities and, depending on the nature of the business other areas of the
law.
69. See Rev. Rul 69-74 1969-1 C.B. 43
70. Moss Est. v. Comr., 74 T.C.
1239, acq. in result only, 1981-1 C.B. 2.
71. Frane Est. v. Comr., 98 T.C.
341 (1992), aff'd in part and rev'd in part, 998 F.2d 567 (8th Cir.
1993).
72. U.S. v. Kirby Lumber Co. 84 U.S. 1 (1931), rev'g 44 F.2d 885 (Ct.
Cl. 1930).
73. Code § 102(a)
74. Treasury Regulation 20.2031-2(e).
75.
Treasury Regulation 25.2512-2(e)
76. Rev, Rul 77-287 1977-2 C.B. 319. See TAM
9419001.
