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Wealth Planning

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Excerpted from The 2013 Essential Tax and Wealth Planning Guide

Wealth transfer taxes — An overview

We take up this year’s discussion of wealth transfer taxes with a real sense of déjà vu. As was the case when this publication went to press in 2010, we are racing headlong into a statutory tax storm of monumental scope — the sunset of the so-called Bush tax cuts and the restoration of the transfer tax rate and exemption structure that existed in 2000.

Absent congressional action, with the sunset of the transfer tax provisions of the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 (the 2010 Act), estate and gift taxes in 2013 will be calculated using a common applicable exclusion amount of $1 million, a top rate of 55%, and a 5% surtax on transfers in excess of $10 million until the lower tax brackets and applicable credit amount are recaptured. States with “piggyback” estate tax laws will suddenly have estate taxes to collect again. States that "decoupled" their estate tax from the federal estate tax will have to address modifications to their laws and many taxpayers could end up with new state laws to consider. Until those adjustments are made, estates will face a patchwork of laws that may produce unexpectedly high effective estate tax rates.

There is, however, one important difference: the paralysis that plagued taxpayers and advisors alike in 2010 — when there was a real question whether Congress would act to retroactively reinstate the estate and generation-skipping transfer (GST) taxes (both had been temporarily repealed for 2010) — has been replaced with fear that time will run out before appropriate wealth transfer planning can occur before the end of 2012.

Not surprisingly, there is a race to the finish line before this unprecedented wealth transfer opportunity passes.

The 2010 Act reinstated and modified the estate and GST taxes retroactively to the beginning of 2010, and, quite unexpectedly, favorably modified the gift tax by reuniting it with the estate tax and its applicable exclusion amount of $5 million (an increase of $4 million from 2009) and a top tax rate of 35% — the same as the top income tax rate. The applicable exclusion amount is the amount of property that a person, either during life or at death, can pass tax free. Similarly, the GST exemption amount was also increased to $5 million. Additionally, for the first time in transfer tax history, the gift, estate and GST exclusions were indexed for inflation. Those limits are now set at $5,120,000 for 2012. Not surprisingly, there is a race to the finish line before this unprecedented wealth transfer opportunity passes.

Should Congress not act before 2013, other significant changes will take place in the federal estate, gift, and GST tax areas as modifications made in these areas expire.

These include:

  • The family-owned business deduction will, once again, apply to certain estates.
  • The expanded availability of the qualified conservation easement will no longer apply.
  • Current liberal estate tax installment payment rules will expire.
  • Favorable GST tax rules will expire as they are replaced with the less advantageous rules in effect before 2001 — including a GST tax exemption of $1 million indexed for inflation from 1989 (i.e., approximately $1.4 million for 2013), and a 55% tax rate.

Seeking the advice and guidance of an experienced tax professional in implementing a wealth transfer plan that reduces one’s estate, gift, and GST tax liabilities has always been a prudent course of action. Now, in these times of unprecedented wealth transfer opportunity with the GST tax exemption and estate and gift tax exclusion amounts set at $5.12 million, and the limitation of the top tax rates at 35%, it is imperative to obtain qualified advice to capitalize on what may be a rapidly shrinking window of opportunity. While the following section of our guide provides some helpful insights, you should contact your advisors to align your plan to your particular situation. And, you should do it before time runs out.

Gift tax

As a quick overview, most gratuitous transfers of property during life are subject to the federal gift tax. The gift tax is computed based on the fair market value of the property transferred. Some types of transfers are excluded in determining the total amount of gifts that are subject to tax. For example, in 2012, gifts by individuals of up to $13,000 per recipient are generally covered by the gift tax annual exclusion and are not subject to gift tax. The annual exclusion is adjusted for inflation in increments of $1,000. At the time this publication went to press, the 2013 annual exclusion amount had not yet been announced but is expected to climb to $14,000.

To qualify for the gift tax annual exclusion, gifts must be of a present interest. A present interest implies that the beneficiary has a substantial present economic benefit arising from the gift property. Such a benefit implies that the assets received can be readily converted to cash or that the assets received are income producing from the outset. As such, many outright transfers — including gifts of cash, marketable securities, and income producing real estate — qualify for the annual exclusion. Transfers under the Uniform Transfer to Minors Act and funds contributed to Section 529 educational savings plans will generally qualify for the annual exclusion. Certain gifts in trust also qualify if the trust vests an income interest in the beneficiary or allows the beneficiary a choice between withdrawing some or all of the value of the gifted property or leaving it in the trust. Consequently, not all gifts will qualify for the gift tax annual exclusion. Gifts in trust, other than mentioned above, generally do not qualify for the annual exclusion. In addition, the IRS has been successful in arguing that transfers in certain family investment entities that do not consistently distribute earnings to their owners do not qualify for the annual exclusion.

Transfers to a spouse who is a U.S. citizen are covered by the unlimited marital deduction; therefore, such transfers may be made totally free from gift tax. If a spouse is not a U.S. citizen, then the amount that can be transferred to the spouse free of gift tax in 2012 is $139,000. If either you or your spouse is not a U.S. citizen, it is imperative that you make your estate planning advisor aware of this fact. At the time this publication went to press, the 2013 annual exclusion amount for noncitizen spouses had not yet been announced.

In addition to the $13,000 annual exclusion (and the $139,000 annual exclusion for a noncitizen spouse), every individual taxpayer can transfer a certain amount of property during his or her lifetime without paying gift tax. The amount of property that can pass tax free is referred to as the applicable exclusion amount. The applicable exclusion amount is used to calculate the credit available to offset the gift tax calculated on the aggregate of all current and prior taxable gifts. The applicable exclusion amount for 2012 is $5.12 million. For 2012, the top gift tax rate is 35% (the lowest that rate has been since the Roosevelt Administration). Notably, under the law as now written, the $5.12 million exclusion amount will return to $1 million and the top rate will return to 55% from its present 35% on January 1, 2013. What cannot be overemphasized is that the failure to utilize the full $5.12 million exclusion amount prior to its lapse in 2013 may result in the unused amount being subject to estate or gift tax at higher rates at some subsequent date. Absent compelling nontax reasons, failing to avail one’s self of the current applicable exclusion amount (and, in appropriate situations, the 35% tax rate) may result in an economic detriment to the family.

For taxpayers who have previously made substantial taxable gifts, an additional credit is allowed for some or all of the gift tax actually paid in the past. The effect of this credit is to permit the taxpayer to take advantage of the additional $4.12 million increase in the exclusion amount over the $1 million applicable exclusion amount that had been in place since 2001 regardless of how generous he or she may have been in the past. This is accomplished by computing the tax on the aggregate total of all current and prior gifts using the current rate structure and subtracting from that tax calculation a hypothetical gift tax liability for the aggregate of all gifts made prior to the measuring period using the same current rate structure. The difference of these two tax computations is the tax against which the unused applicable credit amount is deducted. The applicable credit amount is the tax payable in any given year on the applicable exclusion amount — in 2012 that amount is $1,772,800.

The unused applicable credit amount is the current applicable credit amount less the amount of the credit that would have been used taking into account the historical applicable exclusion amount in effect in any given year but assuming the current rate structure had always been in place. Stated differently, for the most benevolent of donors prior to the 2010 Act, the maximum amount of unified credit “used” can never exceed the largest applicable exclusion amount in the past ($1 million in 2002 through 2009) taxed at the rate structure in place in 2012 (a maximum rate of 35% for all gifts in excess of $500,000) or $330,800. Thus, full use of the $4.12 million incremental increase in the applicable exclusion amount is assured because there will be $1,442,000 ($4,120,000 x 35%) available to offset the computed tax. But it is also this benefit which is scheduled to sunset.

What cannot be overemphasized is that the failure to utilize the full $5.12 million exclusion amount prior to its lapse in 2013 may result in the unused amount being subject to estate or gift tax at higher rates at some subsequent date.

Unlike the estate tax, discussed further later, a result of this formula is that there is no ambiguity in computing the tax liability arising for gifts made after the current rate and exclusion structure sunsets on December 31, 2012. In 2013, absent intervening legislation, the applicable credit amount will be $345,800 (the tax on $1 million under the old tax rate structure). Thus, if significant gifts were made in 2011 and 2012 well in excess of the anticipated 2013 applicable exclusion, the “used” applicable credit amount will also be $345,800, therefore permitting no additional credit offset for any gifts made after December 31, 2012. By the same token, the mechanics of the computation demonstrate that a “recapture” of the $1,427,000 difference between the applicable credit amount in 2012 and the applicable credit amount in 2013 is not possible.

As will be discussed in the estate tax section, some credibly argue that granting a credit when no tax liability was actually paid is an unlikely outcome. According to those holding this opinion, the estate tax in both scenarios would be the same — $4,795,000 — because the only credit available would be the applicable credit amount in 2013 — $345,800. To interpret the language in this manner implies that the $5.12 million exclusion amount permits only a deferral of transfer tax that will be recouped in the estate tax after 2013. Such an interpretation would conflict with the intent of the legislation. Subject to future guidance, given the legislative history, we do not share this more conservative interpretation of the rules.

Utilizing the $5.12 million applicable exclusion amount

The significantly increased $5.12 million exclusion amount projects a range of possibilities that has never been enjoyed previously. Based upon individual circumstances, we’ve organized transfer considerations around five broad themes: leveraged gifts, fine tuning, outright gifts, rainy day trusts, and blocking and tackling.

Leveraging gift transfers
If you wish to move assets in excess of the $5.12 million exclusion amount ($10.24 million per couple) through inter vivos transactions, using the increased exclusion amount as seed capital to engage in yet larger leveraged transactions remains appealing and should be strongly considered. It is important to note that, to be respected, the debt obligation must be serviced pursuant to its terms.

Tuning up prior planning
“Tuning Up” in this regard is not just dealing with prior wealth transfer transactions that may not have developed as modeled (e.g., those that might have been adversely affected by the recession); it also means effectively addressing risks that arise as tax laws change and develop.

Simple outright gifts
Consider paying gift taxes in 2012

As noted previously, the current top gift tax rate is the lowest it has been since Franklin D. Roosevelt’s first term. And as discussed below, the likelihood that the current 35% top tax rate will remain this low for any extended period of time is remote. Consequently, in the face of rising rates, after-tax family wealth ultimately is enhanced when taxed at the lowest possible rate. Although perhaps counterintuitive, this conclusion remains true even taking into account the time value of money. Additionally, keep in mind that the gift tax is less onerous than the estate tax because gift tax is assessed only on the value of the property transferred, whereas the estate tax is assessed on the aggregate value of all of the decedent’s wealth — including the funds with which the estate tax will be paid. The “tax exclusive” nature of the gift tax makes taxable gifts the most efficient method of paying transfer taxes; although federal and state governments, aware of this advantage, do require the gift taxes paid with respect to any gifts made within three years of death to be added back to the gross estate — thereby discouraging so called “death bed transfers.”

Net gifts and bargain sales

A net gift is a gift conditioned on the donee paying the related gift tax. It is called a net gift because the amount subject to tax is the net of the value of the property transferred less the amount that the donee will reimburse the donor. In the example above, under a net gift scenario, the donor would agree to transfer assets to the donee with a value of $18,458,000 on condition that the donee reimburses him for the resulting gift tax. By virtue of this agreement, the donee would be required to reimburse the donor gift taxes totaling $3,458,000 and the donee’s estate will have grown by the net amount of $15 million. The reimbursement of the tax of $3,458,000 is treated as consideration for the transfer and thus, one has a bargain sale — a sale of property having a value of $18,458,000 for $3,458,000 resulting in a taxable “net gift” of $15,000,000.

A net gift can be useful when you want to make a significant transfer, but either lack the liquidity to pay the resulting tax or are unwilling to bear the tax burden; or, in situations where the asset being transferred is illiquid and the donee is better positioned to shoulder the burden of paying the related gift tax. There is, again, a caveat. Because consideration is being received, the donor must consider whether there will be any income tax consequences arising from the transaction. To experience a taxable gain, the consideration must exceed the property’s basis.

Considerations when paying gift tax is not an option

For a great many taxpayers, the $5.12 million exclusion ($10.24 million per couple) for gifts made in 2012 is more than enough to cover their wealth transfer goals to their heirs — thus reducing the need for more complicated wealth transfer transactions. When this is true, minority interests in closely-held businesses, fractional interests in real estate, interests in entities owning distressed assets (e.g., significant real estate holdings), interests in private equity funds or other investment entities, perhaps even interests in family-owned investment entities (e.g., family limited investment partnerships or family investment LLCs), may prove the most effective candidates for gift transfers by virtue of how they are valued.

A minority interest in a closely-held enterprise is generally valued at less than its proportionate share of going concern value (for a business enterprise) or net asset value (for an investment entity) because of lack of control and/or lack of marketability discounts. This valuation outcome has been the government’s primary motivation in attacking the veracity of family owned investment entities. Thus, successful valuation outcomes depend on the determination that any closely-held entity is demonstrably motivated by reasons other than tax efficiency and that the entity is operated in a business-like manner. Still, even if the taxpayer prevails with respect to discount valuation determinations, such discounts simply lower the threshold required for a wealth transfer to be successful or, in the alternative, reduce the tax cost of the transfer if the enterprise is not ultimately successful. Notwithstanding the compelling features of transferring property that can be discounted, one must recall that the success of a gift transfer is fundamentally a function of an asset’s post-transfer growth and earnings prospects — not its current value.

Mitigating valuation risks in gift transfers

In what may be the most significant gift tax development in 50 years, the Tax Court, on March 26, 2012, released its decision in Wandry v. Commissioner, which for the first time endorsed the use of a formula clause to fix the amount of property transferred in a gift transaction. In Wandry, the taxpayer was transferring units in a limited liability company.

The IRS, as it has consistently done in every attempt made by taxpayers to mitigate valuation risk, argued that the gift was of the number of units that must, of necessity, be reflected on the gift tax return. The IRS argued that to give the required adjustment clause credence would be to nullify their ability to enforce the law by “returning” property to the grantor in an amount sufficient to eliminate in gift tax liability; consequently, such clauses were against public policy.

The Tax Court held, rather, that a formula clause drafted in the manner noted above resulted in a property transfer equal to the specified value; thus, there was no property “to be returned” to the taxpayer. It further indicated that a good faith implementation of the formula clause (i.e., a good faith appraisal and catch-up adjustments among the parties when a change in value was ultimately determined) were sufficiently significant that the “severe and immediate” frustration required to find the formula clause to be “against public policy” were not present.

The IRS has appealed the case and a ruling is expected in 2013. However, because a Tax Court opinion has national significance, it would appear that careful adherence to the Wandry model may provide a mechanism to limit gift tax exposure when transferring property that is difficult to value.

Rainy day trusts

Trusts for spouses

What are the options if you are worried about potential future “donor’s remorse” on larger transfers? Within limits, enjoying indirect access to the transferred assets is possible. For example, if you are married, you could consider transferring $5.12 million in property to a “rainy day trust” so named because it provides for income (and periodic or discretionary corpus distributions) primarily for the benefit of your spouse. Such a trust, so long as you remain married, would help preserve much of your cash flow as it existed prior to any planning. This idea, however, has certain limits. The law does not respect trusts established by each spouse for the benefit of the other spouse if the trusts’ dispositive terms are substantially identical. Where “reciprocal” trusts are important to the overall estate plan, you and your advisors must take care to differentiate the dispositive provisions of the trusts so that each trust will avoid inclusion in the donor’s gross estate.

Assuming both spouses have wealth, some might find such planning even more acceptable if each spouse could create a similar trust for the other. The law, however, does not respect identical trusts set up by each spouse for the primary benefit of the other spouse. In such situations, the assets of the trust set up by the donor will be included in his or her gross estate. However, if the trusts’ dispositive terms are not substantially identical, each trust will be respected for tax purposes and estate inclusion can be avoided. It is important to exercise care in determining the extent and nature of the differences in the dispositive terms in order to avoid estate inclusion. 

Trusteeship of trusts having the characteristics described above is ultimately a function of the amount of discretion the trustee will be required to exercise. Appointing an independent trustee, which is typically a prudent act, will be required if the exercise of trustee discretion is extensive. Trusts that limit discretion (those that impose a series of mandatory distributions or provide for distributions subject to a legal standard), however, are not compelled to utilize an independent trustee. In such cases, it may be possible to consider the spouse or children as trustees. The nature of the trust’s assets will often dictate whether more than one trustee is required and in what capacity each such trustee will serve. As a matter of principle, though, self-trusteeship of such trusts by the grantor would be strongly discouraged.

Resident asset protection trusts

An alternative to using a rainy day trust may be funding a trust in a state that permits self-settled trusts where the grantor can be a discretionary beneficiary. Because of this discretion, all such trusts must utilize independent trustees that are resident in the state whose laws will govern the trust. The key to the success of these trusts as estate planning vehicles is the denial of access to the trust’s assets by the grantor’s creditors. At this writing there are 12 states that permit such self-settled, creditor-protected trusts: Alaska, Colorado, Delaware, Missouri, Nevada, New Hampshire, Oklahoma, Rhode Island, South Dakota, Tennessee, Utah, and Wyoming. It is generally understood that these trusts will protect trust assets against the grantor/contingent beneficiary’s creditors if the grantor is a resident of one of the respective states noted above. There is considerable controversy over whether the asset protection features of such trusts extend to grantors who are nonresidents of the respective states noted above. Several bankruptcy cases have denied a discharge to grantors of a self-settled trust in a nonresident state because the laws of the grantor’s home state did not permit such trusts.

The IRS has ruled favorably that the establishment of such trusts will be regarded as a completed transfer for gift tax purposes. They have refused to rule regarding the estate inclusion of the assets of the trust in the grantor’s estate; however, since such a determination would require scrutiny of the trust’s operations. By implication, if the trust has, in fact, conveyed significant benefits to the grantor, asset inclusion may well result if such operations imply an indirect understanding between the grantor and the trustee such that the grantor effectively retained dominion and control over the trust assets.

The moral of the story — self-settled trusts are great rainy day funds, but if the fund is tapped, the risk of estate inclusion will increase dramatically.

Last resorts

Low prevailing interest rates make the use of a QPRT a disproportionately costly proposition since low interest rates act to “inflate” the value of the transferred remainder interest. Yet, because a residence —particularly a vacation residence —is both illiquid and often characterized as an heirloom asset, residences often prove easier to part with than other assets with the result that these trusts are utilized frequently. If for no other reason, QPRTs should be a gift of last resort because of the post-termination rental issue previously mentioned. Lacking better gift candidates, however, using the $5.12 million exclusion amount to move the remainder interest in a personal residence is better than letting the $5.12 million go to waste.

Basic blocking and tackling

While the unexpected introduction of the $5.12 million gift tax exclusion amount has greatly increased planning flexibility and opportunity, it need not and should not detract from the use of tried and true estate planning techniques. Quite to the contrary, they should continue to be employed in conjunction with the additional opportunities afforded under the 2010 Act.

Generation-skipping transfer (GST) tax

The GST tax is imposed on transfers during life and at death that are made to a “skip person” — a recipient who is at least two generations younger than the donor or decedent, such as a grandchild. If there were no GST tax, a gift to a grandchild would be subject to the gift or estate tax once, while a gift to a child who then gifts or bequeaths those assets to a grandchild would be subject to transfer tax twice. The GST tax is intended to tax the gift to the grandchild twice at the time it is made (through a gift tax and a GST tax), to compensate for the otherwise skipped level of tax. Furthermore, the GST tax actually paid is, itself, subject to gift tax. 

For GST tax purposes, when a gift or bequest is made within a family, the focus is on the relationship of the transferor and the transferee and not their age difference. For example, a donor may have siblings who are significantly younger than he or she and who, therefore, have children who are significantly younger than the donor and his or her children. A transfer to a nephew who is 40 years the donor’s junior is not subject to GST tax because the nephew is only one generation younger than the donor. Conversely, a transfer to a grand-nephew who is only 30 years the donor’s junior is subject to GST tax because the grand-nephew is two generations younger. Married individuals are considered to be in the same generation, regardless of the spouses’ age difference.

When the transferee is not related to the transferor, the age difference becomes important. If a donor transfers assets to a friend who is less than 12-1/2 years younger, that friend is considered to be in the donor’s generation and is not a skip person. If the friend is more than 12-1/2 years, but less than 37-1/2 years younger, that friend is considered one generation younger, and is, therefore, not a skip person. If the friend is more than 37-1/2 years younger, the friend is considered two generations younger and is, therefore, a skip person.

There is also an annual exclusion amount available for transfers subject to GST tax. The GST tax annual exclusion amount, like the gift tax annual exclusion amount, is $13,000 for transfers made in 2012. Unlike the gift tax annual exclusion, however, the GST tax annual exclusion is very limited for gifts to trusts. The GST tax exemption amount permits the transfer of a certain amount of assets free of current and subsequent GST tax. The GST tax rate is equal to the maximum federal estate tax rate for the year that the skip person receives or becomes indefeasibly vested in assets. The GST tax exemption in 2012 is $5.12 million, coinciding with the reunified estate and gift exclusion. It too, is inflation adjusted. The GST tax rate remains equal to the highest estate tax rate in effect for such year — 35% for 2012. In 2013, the law as drafted will reset the GST exemption to $1 million indexed for inflation from 1989 — an amount estimated at about $1.4 million — and the GST top tax rate will reset to 55%.

Leveraging the GST exemption — Dynasty trusts

A typical GST tax-exempt dynasty trust is used to transfer income and/or principal to multiple generations, including children, (hence the title “dynasty trust”), while paying estate or gift tax only upon the initial transfer to the trust. This is accomplished by allocating the transferor’s $5.12 million GST tax exemption to the trust in an amount equal to the value of the transferred property on the date of the transfer. The wealth accumulated in the trust thereafter avoids both estate tax and GST tax at each subsequent generation until such time as the trust terminates. Because dynasty trusts are intended to skip multiple generations, they represent the most tax efficient use of a taxpayer’s GST exemption. Although gift tax annual exclusions may be available when funding a dynasty trust, transfers to such trusts do not qualify for the GST tax annual exclusion, so the donor’s unused $5.12 million GST tax exemption will be allocated dollar for dollar when these trusts are funded.

Dynasty trusts are permitted in all states, but laws in many states limit the duration of a trust to a term from 80 to 110 years. Most states allow the trust to continue until 21 years after the death of the last surviving descendant of the trust creator who was living at the time of the trust's creation. Other states have recently amended their trust statutes to permit trusts to exist in perpetuity. An individual may create a trust in a state other than his or her state of residence; consequently, dynasty trust planning is open to everyone.
Because dynasty trusts are intended to skip multiple generations, they represent the most tax efficient use of a taxpayer’s GST exemption.

Tuning up prior GST planning

Planning tip: Given the greater GST exemption currently available, if you have existing GST trusts that have an inclusion ratio of between zero and one (that is, a trust where a distribution to a skip-person would be partially subject to GST tax), you should consider allocating the increased exemption to those

Although the law is ambiguous on how this credit should be computed after the 2013 top rate escalation and the applicable credit amount reduction, the rules governing the credit computation can be interpreted to allow a credit greater than the amount of tax actually paid for taxable gifts made in those years in which the top gift tax rates were less than 55% and/or when the applicable credit amount was greater than $345,800 (the amount of tax on the $1 million gift exclusion amount that is anticipated under the 2013 rules as they now exist).

Some credibly argue that granting a credit in excess of the applicable credit amount when no tax liability was actually paid is an unlikely outcome. However, if one were to interpret the statutory language otherwise it might imply that the $5.12 million exclusion amount permits only a deferral of tax that will be recouped in the estate tax return of anyone dying after 2012. Such an interpretation would appear contrary to the intent of the legislation.


The 2010 Act now allows portability to surviving spouses of the unused exclusion amount of decedents dying in 2011 and 2012. Thus, a surviving spouse could use his or her own base exclusion amount of $5.12 million plus the unused exclusion amount of his or her most recent deceased spouse to offset the tax on subsequent gifts or to offset his or her estate tax. The decedent’s unused exclusion amount will not be available to the surviving spouse unless the executor of the deceased spouse’s estate makes an election to convey it and computes the amount to which the surviving spouse is entitled. Relief will be extended only in extraordinary circumstances to an executor who fails to make a timely election. In enforcing the carryover, the IRS is permitted to review the deceased spouse’s prior filed gift tax returns and estate tax return to determine the proper unused exclusion amount, notwithstanding the statute of limitations with respect to those returns may have closed.

Portability represents a development that could greatly simplify the tax planning that must occur before or upon the death of the first spouse to die. No longer will it be necessary to make sure that both spouses own property equal to the prevailing applicable exclusion amount. Even where each spouse individually controls assets in excess of the applicable exclusion amount, the need to affirmatively plan for its use in the testamentary plan of the first spouse to die is removed (unless that spouse desires to affirmatively use his or her GST tax exemption, which, as is discussed below, is not portable). In fact, subject to the GST tax exception just noted (and ignoring state estate/inheritance tax considerations), there would now appear to be no tax detriment to a classic “sweetheart” disposition — leaving one’s assets fully to one’s surviving spouse either outright or in trust.

Under current law, however, the portability rules apply only if both spouses die after December 31, 2010, and before January 1, 2013. Thus, it would be ill advised to rely on portability to reduce a surviving spouse's estate tax liability unless and until portability is made permanent. Notwithstanding, should a spouse die during 2011 or 2012, prudence would require that the election be made if the decedent’s estate plan leaves any of his or her base exclusion amount unutilized. Similarly, given the possibility that portability may expire January 1, 2013, prudence would dictate that any unused applicable exclusion amount, whether “inherited” or otherwise, be used prior to that date.

As to the future of portability, it is significant that the President's FY2012 and FY2013 budget proposals included a provision to make portability permanent, but at the 2009 base exclusion amount of $3.5 million. Thus, there is reason to be cautiously optimistic, given some degree of bipartisan support.

State estate and inheritance tax considerations

On a cautionary note, many states do not now and will not hereafter conform to the federal estate tax rules. Consequently, an immediate state estate/inheritance tax may arise where the federal applicable exclusion amount is being utilized in a testamentary transfer and it exceeds the corresponding state applicable exclusion amount. Most states that have an estate tax affirmatively linked their rules to the federal code as it existed in the year 2000. In 2000 the federal (and by extension most states’) applicable exclusion amount was $1 million.

Thus, in a state that doesn’t provide for its “own” state-only marital deduction protocol, fully funding a bypass trust with the federal $5.12 million applicable exclusion amount would give rise to a state estate tax of $405,200 assuming that the state tax is equal to what the state death tax credit would have been in 2000.

If portability is made a permanent part of the tax code, the problem noted above is eliminated. Specifically, if all assets pass to the surviving spouse in a manner qualifying for the marital deduction except for enough to fund a credit shelter trust equal to the state’s exemption amount, there is no transfer subject to state estate taxation until the surviving spouse dies. However, the same analysis made above with respect to the federal tax savings associated with having the first spouse to die fund a credit shelter trust with the federal exclusion amount remains true. By paying state estate tax at the first death, all future appreciation on a federal credit shelter trust’s assets escapes state estate taxation upon the death of the surviving spouse. Whether that future savings justifies a current state estate tax liability is ultimately a function of nontax factors.

The transfer tax landscape of the future — the President’s budget proposals

The political rhetoric regarding the estate tax has quieted considerably since 2000. While bills are still introduced regularly in both houses of Congress that resolve to repeal the tax, there is general consensus that a full repeal is not a real possibility given the government’s current fiscal condition. Furthermore, as part of the President’s budget process, it is customary for the Administration to suggest tax proposals that reinforce budget provisions and reflect the Administration’s view of tax policy. Over the past four years the Obama Administration’s budget proposals have begun to flesh out what the transfer tax landscape of the future might look like — one dramatically different from what we see today.

Future tax rates and exemption amounts

The Obama Administration, in its most recent budget submission for 2013, indicated its support of a return to the rules as they existed in 2009, namely, a gift tax exclusion amount of $1 million; an estate tax exclusion amount and a GST exemption amount of $3.5 million; with a top gift, estate, and GST tax rate of 45%.

Grantor retained annuity trust (GRAT) limitations

In each of the Obama Administration’s four budgets, the Administration has consistently stated its intention to seek a 10-year minimum term for GRATs. A GRAT is a trust that names the grantor as its sole beneficiary during a set period of years during which the trust is required to make an annuity payment to the grantor. The annuity amount, as a function of prevailing interest rates, is set at a level where the net present value of the aggregate annuity payments is nearly 100% of the value of the property contributed to the trust. If the assets consistently outperform the prevailing interest rate, then the remainderman of the GRAT will succeed to that excess. Since the grantor only parts with the value of the remainder, the gift tax cost of a GRAT is nominal. However, because the trust is established fundamentally for the grantor’s benefit, should death occur during the annuity period, the full value of the trust, as a general rule, will be included in the grantor’s gross estate as if no prior planning had ever been undertaken. It is for this latter reason that a 10-year minimum term will dramatically affect the appeal of GRATs as estate planning vehicles.

Logic would dictate that GRATs would be used less frequently in 2012 given the significant increase in the gift tax applicable exclusion amount from $1 million to $5.12 million. Simply stated, a GRAT is a relatively high maintenance transaction and those that need to engage in higher complexity planning and or need to “zero out” the immediate gift tax consequences of a current transfer will simply be far fewer in number in 2012. Notwithstanding, while GRATs are likely to become relatively less important to estate planning this year, their appeal will remain high so long as:

  • Prevailing interest rates remain low (note that the prevailing rate required to be used in GRAT gift tax calculations was at an all-time low in September 2012 at 1.0%).
  • Where the assets that are likely gift candidates are value-stressed.
  • While short-term GRATs are still possible.

Requiring GRATs to have a minimum 10-year term has been endorsed by certain lawmakers also. For example, in addition to the GRAT change being included in the President’s budgets, members of both houses of Congress introduced legislation in 2010 and 2011 including similar provisions. Given the current political appetite for deficit reduction and balanced budgets, the prospects for such legislation in the future remain high. Also keep in mind that current conditions favoring the use of GRATs — potentially depressed asset values and historically low interest rates — will change with an improved economy.

Discount valuation limitations

Another Obama Administration budget proposal appearing in all four annual budgets would limit discounts applied to value transferred property. The limitation provisions pursued by the Obama Administration would act to preclude a discount for certain restrictions that appear frequently in entity operating agreements and which are specifically identified in related regulations. As such, the President’s proposal would augment existing rules that already preclude discounts for any contractual obligation that is more restrictive than underlying state law. These proposals have received somewhat less support by lawmakers, but several bills in 2009 and 2010 sponsored similar provisions.

Such limitations do not preclude any form of transfer, but rather attempt to upwardly adjust the values of transferred assets relative to the values encountered in today’s appraisals. The effect of such limitations is ultimately a function of how the appraisal industry responds to them. Many believe that recent court decisions have acted to preclude certain appraisal shortcomings that the proposed legislation seeks to address; consequently, the proposal’s impact may prove relatively modest and, were the legislation to move forward, it is not likely to prove troubling to most. Nevertheless, it would not be surprising to see valuation constraints become a more frequent topic in future proposed legislation as the prospects for deficit reduction strengthen.

Limited duration of GST tax exempt status

In its last two budgets, the Obama Administration has proposed a provision that would limit the benefit of GST dynasty trusts by requiring the trust’s inclusion ratio (the percentage of the trust that is subject to a GST tax upon certain events) to be increased to 100% upon the 90th anniversary of the creation of the trust. This proposal would apply to trusts created after enactment, and to the portion of any then existing trust attributable to additions to such trust made after the date of enactment. The primary effect of any such legislation, if enacted, would be to preclude the effectiveness of any trust not subject to a rule against perpetuities by “forcing” such trusts back into the tax base — in other words, the trust could continue, but its GST tax profile would change after 90 years. The administration of dynasty trusts subject to such a provision will become more difficult and costly since a GST tax will thereafter be due with every distribution and at the death of every beneficiary.

The estate tax treatment of grantor trusts

In the Obama Administration’s most recent budget for 2013, a new proposal was introduced that would institute what many have called a “hard to complete” rule. The rule has three facets. First, a transfer of an asset to a grantor trust would be considered incomplete. Second, any transfer out of a grantor trust to a person other than the grantor would be considered a completed gift and the value of the entire trust would be considered a completed gift upon the date that grantor trust status lapsed. Third, as a general rule, the value of the assets of any trust determined, at the date of death, to be a grantor trust relative to the decedent, would be included in the decedent’s gross estate. A grantor trust is a trust of which an individual is treated as the owner of the trust’s assets for income tax purposes.

The purpose of the proposal is to extend the disregarded entity status imposed upon grantor trusts for income tax purposes to the transfer tax provisions. If enacted, such a provision would result in much more limited use of grantor trusts than is the case today and would impose an income tax cost to several transactions that are currently quite popular, but otherwise would not inhibit the types of planning that occur today. Of concern, however, is that a trust can be both fully or partially grantor and making the determination of whether a trust is grantor or not rests upon an area of the income tax law that is extraordinarily subjective. In the form in which the budget proposal now appears, the rule would be unworkable. Notwithstanding, it is the first argument in what is likely to be a lively debate.

Beyond 2012

From the points above, you can see that the wealth transfer tax environment beyond December 31, 2012, is far from certain — and, in fact, holds the potential for change well beyond tax rates and exclusion levels. This is the type of uncertainty that has paralyzed taxpayers and their advisors before. There is an important reason to resist the planning paralysis now — the rare opportunity to employ the transfer tax provisions of the 2010 Act. This guide was intended to inform you of some of the possibilities to do just that. Once the rules sunset, it is unlikely that you will see a similar circumstance rise again. 

To reiterate: Act now to take advantage of a unique opportunity before the end of 2012 — and before you face a confluence of potential changes that may include lower exemptions, higher tax rates, and enactment of other proposals that could severely curtail current planning options. At the same time, you and your advisors should remain vigilant as the end of 2012 approaches given the possibility that, in 2013, the future of the federal estate, gift, and GST taxes may once again become unclear. Although Congress could make changes before 2013, there can only be speculation regarding the future of these taxes as the new Congress advances its agenda. Keeping informed of tax legislative developments will give you a more effective opportunity to plan ahead and react quickly as more changes transpire.

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