Source: https://btalawoffices.com/estate-tax-law-changes/
Timestamp: 2020-01-29 04:43:51
Document Index: 378637509

Matched Legal Cases: ['§64', '§64', '§64', '§64', '§64', '§64']

Estate Tax Law Changes - BT Arnett Law
(202) 587-2726
Under the 2018 tax changes, Congress enacted the Tax Cuts and Jobs Act of 2017 (the "TCJA"). The exemption amount was increased to roughly $11,200,000, indexed annually for inflation. This means that you can leave up to $11,200,000 without incurring federal estate tax liability between now and 2025. In 2025, the exemption amount will decrease to pre-2018 levels, which will be $5,490,000. The marginal estate tax rate remained at 40%. Looking solely at the favorable tax climate and making no plans to avoid or minimize taxes for the future may be a mistake.
In 2012, Congress and the President agreed to permanent estate transfer tax exemption revision that set the unified credit equivalent exemption at $5.25 million. In 2013, Congress indexed the exemption amount for inflation and set the maximum estate rate at 40%. The estate tax had been in flux since 2001 with provisions which were set to sunset at the end of 2012 unless Congress acted. The Estate tax has been settled, with the exception of the inflation indexing; however there may be upcoming changes in the tax law, including the Obamacare taxes, with President Trump's Inauguration.
On New Year's Day of 2012, Congress approved a permanent set of estate, gift, and generation-skipping transfer (GST) tax rates and exemptions. Despite speculation, the law now made permanent by Congress is identical to 2012 law, except that the compromise rate is forty (40) percent, an increase from the 2013 tax rate previously set at thirty-five (35) percent.
At the end of 2012, the American Taxpayer Relief Act (ATRA) updated GST legislation, and the IRS clarified trust implications with the Estate Tax exemption amounts and portability, issuing private letter ruling PLR-107217-13. As a result, the GST, estate and gift tax exemption amounts are now unified at $5.49 million for 2017. However, the GST exemption (an exemption for gifts from grandparents to grandchildren skipping the generation in between, i.e., the grandparent's children ) is not portable as further explained herein below. Thus, Estates should elect to use the GST election on the first to die rather than wait until the second to die and lose half of the exemption amount.
The new forty (40) percent rate is up from the thirty-five (35) percent rate of 2010 through 2012, but less than the projections in 2009.
The estate exemption was $5 million, indexed for inflation since 2011, which places it at $5.25 million for gifts made and for estates of decedents dying in 2016 the exemption is $5.45 million. Under the 2018 tax changes, Congress enacted the Tax Cuts and Jobs Act of 2017 (the "TCJA"). The exemption amount was increased to roughly $11,200,000, indexed annually for inflation.
Although the gift tax exemption was lower than the estate tax exemption from 2004 through 2010 and many viewed its "reunification" with the estate tax exemption in 2011 and 2012 as very fragile, Congress has chosen to keep the two exemptions the same, as well as the GST exemption, which is also $5.25 million for 2013. Thus, the exemptions may be used during lifetime to make tax-free gifts or at death to shield bequests from the estate tax. EGTRRA "decoupled" the estate and gift taxes systems, AFTA-2012 reunited them.
With unified estate and gifts tax exemptions maintained at their 2011 and 2012 levels, we now know that the rush to make large gifts at the end of 2012 may not have been necessary. But there was no way to know that until a few hours after it was too late, when Congress finally acted. As a result the government will be receiving the gift taxes on those large gifts as of December 31, 2012. And if the timing of some of the gifts was dictated by the January 1 "sunset" that was on the books when 2012 ended, our sense is that those year-end gifts generally reflected serious thinking about estate planning priorities, responsibly provided younger generations with access to family wealth, and removed any future appreciation in transferred assets from the reach of the gift and estate taxes. Despite the permanence of this law, Congress will likely make more changes.
The December 2010 legislation introduced the "portability" of the exemption for gift and estate tax purposes (there is further discussion on portability herein below), whereby the exemption not used by the first spouse to die would be available for use by the surviving spouse for gift tax purposes and the surviving spouse's executor for estate tax purposes (but not for GST tax purposes). Treasury Regulations published in June 2012 provided considerable clarity and welcome guidance regarding portability.Congress has now made portability permanent.Once you have read this section, please check out the Heckerling Institute Updates page for additional current development in the estates and trust laws.
Estate Tax Law - Recent History Along with 2016 Rates and Exemptions
Congress ended its 2009 session without extending the Economic Growth and Tax Relief Reconciliation Act of 2001 for estates and generation-skipping transfer ("GST") taxes, resulting in the repeal of both taxes as of December 31, 2009. While this sounds like a good thing, it is actually bad because this means that in 2010, the Federal Estate and GST taxes was repealed. With the repeal of these Federal taxes, the $3.5 million Estate and GST Exemptions were eliminated along with the 45% estate and GST tax rates.
Also, eliminated in 2010 is the adjustment of basis to fair market value at death. This adjustment is often referred to as a "step-up" in basis rule. This rule allowed a heir to step-up the basis of an asset to the date of death value so that less gain was recognized upon the sale of an asset. There were, however, minimal exemption amounts of step-up of up to $1.3 Million for non-spousal heir (if timely elected) and for property left to a husband or wife, there was allowed an additional $3 Million step-up allowed. Thus, for the spouse there was a total step-up allowed of $4.3 Million. These step-up in basis rules required cumbersome cost basis tracing before increase in tax basis was permitted to an inherited asset.
Cost of inherited assets:
Amount of property exempt from Tax
Basis of inherited property used to calculate capital gains tax
2000-2001 $675,000/55% Full step-up in basis
2002 and 2003 $1 million/49-50% Full step-up in basis
2004 and 2005 $1.5 million/47-48% Full step-up in basis
2012 $2 million/45-46%
$5,120,000/35% If you elect out of the old rules, then modified carry-over basis for estate assets, with additional step-up basis of up to $1.3 million for non-spousal heirs; property left to husband or wife allowed additional $3 million step-up (total basis of $4.3 million). Under the none-carry over rules, there was full step-up in basis. The same applies for later years.
2013 $5,250,000/40% Full step-up in basis
2014 $5,340,000/40% Full step-up in basis
2015 $5,430,000/40% Full step-up in basis
2016 $5,450,000/40% Full step-up in basis
2017 $5,490,000/40% Full step-up in basis
2018 11.18 million/40% Full step-up in basis
On December 17, 2010 President Obama signed into law the Tax Relief, Unemployment Insurance Authorization, and Job Creation Act of 2010, Pub. L. No. 111-312 (the "Act"). The Act made significant changes to the estate, gift, and generation-skipping transfer ("GST") taxes. This article highlights some of those changes.
1. Estate Tax.
Under the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act default rule for 2010 is that a federal estate tax exists for all of 2010 estates with a credit equivalent to a $5 million exemption and a maximum marginal rate of 35%. Thus, there was no estate tax repeal for 2010. However, for estates of decedents dying at any time during 2010, including after enactment, executors may elect to have the modified carryover basis rules apply rather than be subject to the estate tax. The timing and manner of making the election on the part of the executor is unclear. The Internal Revenue Service is expected to provide needed guidance concerning the election. The due date for the estate tax return and the payment of estate taxes has been extended by the Act to no earlier than nine months after the date of enactment. This extended due date applies to those decedents dying on or after January 1, 2010, and before the date of enactment. The date of enactment was December 17, 2010. Thus, the extended due date is September 17, 2011, which falls on a Saturday. Accordingly, the extended due date for the filing of the estate tax return and the payment of estate taxes for these estates will be no earlier than September 19, 2011.
2. Carryover Basis.
Interestingly enough, the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act did not extend the due date for the carryover basis report for those estates electing to be subject to carryover basis. The carryover basis report was due Monday, April 18, 2011. Informal remarks of government officials indicate that taxpayers will be granted an administrative extension of time to file Form 8939 until at least October 15,2011. This deadline was extended because of Hurricane Irene. The Service had released a draft Form 8939 on December 16, 2010, but there were no instructions to accompany that form. The IRS has now issued a Revenue Procedure 2011-41 and Notice 2011-66 with further instructions. The form, however, is still not available on the IRS Web site. Because this form was released prior to the date of enactment of the Act, it did not contain an election into the modified carryover basis regime but has been updated now. The IRS issues an IR-2011-83, Aug. 5, 2011 stating that 2010 Form 8939 is due Nov. 15, 2011; Reporting Option Applies to Many Large Estates.
3. Elect or Not To Elect out of the Estate Tax and into the Modified Carryover Basis Regime,
For large estates far in excess of the $5 million, we expect that the executor would make the election to opt out of the estate tax and into the modified carryover basis regime. Likewise, for estates falling within the $5 million exemption amount the executors should do nothing and permit the regular "step-up in basis" rules of section 1014 to be applied to the decedent's estate. If there are uncertainties concerning hard-to-value assets, the executor may wish to file Form 706, United States Estate (and Generation-Skipping Transfer) Tax Return, to commence the running of the statute of limitations on any valuation issues. In the case of other estates falling outside these two ranges, however, the executor should analyze the tax issues and the nontax issues associated with the election. Some of the factors to consider include:
a. The amount of the estate tax payable currently as compared to future capital gains taxes that otherwise would have been avoided, but for the modified carryover basis;
b. Lost depreciation or amortization expenses from the modified carryover basis regime;
c. The timing of future sales and resulting capital gains;
d. The impact of possible increases in income tax rates;
e. The impact of the $1.3 million basis adjustment (if electing out of estate tax rules of the new legistlation) along with the other basis adjustments for assets passing to a spouse or as qualified terminable interest property, or Qualified Terminable Interest Property (QTIP) trust; and
f. Nontax impact of funding bequests if the executor opts out of the estate tax in 2010.
4. Impact of Federal Estate Tax Changes on State Estate Tax Rules and Other Issues.
Many decedents who died during 2010 with estates of significant value had done estate planning based on the expectation that the estate tax would apply on their deaths. Accordingly, these estate planning activities resulted in the inclusion of provisions in the relevant legal documents to cause the funding of certain trusts based upon certain estate tax ramifications. The existence or nonexistence of an estate tax could significantly affect how those trusts are funded. Thus, the decision of the executor to opt out of the estate tax or to remain subject to the estate tax could significantly affect how the trusts are funded.
For example, the proper interpretation of a will might be that all the assets of the decedent would pass into a credit-shelter trust if there is no estate tax, because that is the amount that can pass estate tax-free. A number of states passed laws during 2010 that affect the "tax-free" bequests under such formula provisions. Those states are Delaware, the District of Columbia, Georgia, Idaho, Indiana, Maryland, Minnesota, Michigan, Nebraska, New York, North Carolina, Pennsylvania, South Dakota, Tennessee, Utah, Virginia, Washington, and Wisconsin. In these states, the executor is required to fund the trusts assuming that 2009 estate tax rule applied with its $3.5 million exemption amount. Now that the exemption amount has been increased to $5 million for all of 2010, will these states "fix" the amount that will pass to the credit shelter to $5 million? How are wills and revocable trusts in states other than the listed states to be interpreted in light of the retroactive enactment of the estate tax during 2010? Florida and South Carolina passed statutes during 2010 allowing courts to consider evidence as to the intent of the testator or testatrix. In most cases, it would appear that the executor is well advised to obtain court approval or at least a beneficiary agreement as to the proper interpretation of the will or revocable trust given all the issues. On March 26, 2011, Governor McDonnell has signed into law emergency legislation that addresses uncertainty about the meaning of estate and generation-skipping transfer tax terms in the estate plans of persons who died in 2010. The legislation is effective immediately and is retroactive to January 1, 2010. The new law makes changes Virginia Code section §64.1-62.4 to provide, as a default rule, that a provision of a will, trust, or other instrument of a person dying in 2010 that is based on the federal estate and generation-skipping transfer (GST) tax laws will be deemed to refer to the law applicable in 2010 under the 2010 Tax Act, regardless of whether the decedent's personal representative or other fiduciary makes the election provided under the 2010 Act out of the federal estate tax and into an income tax regime. The law also provides for judicial or private relief in the event the default rule does not carry out the decedent's intent. Virginia is the first state to enact legislation in response to these issues created by the 2010 Tax Act. The 2010 Tax Act renewed the uncertainty about formula clauses in the estate plans of 2010 Virginia decedents, and in particular: (1) whether the $5 million estate and GST exemptions apply to formula clauses; and (2) whether the exemptions continue to apply where the executor opts out of the federal estate tax and into modified carryover basis. The changes to Virginia Code §64.1-62.4 attempt to resolve these concerns for 2010 decedents by the following provisions: If the document is otherwise silent, the statute provides a default rule of construction that applies the 2010 Tax Act $5 million estate and GST exemptions for the purpose of determining who receives assets. Va. Code §64.1-62.4(A). The statute clarifies that the 2010 Tax Act estate and GST exemptions continue to apply for the purpose of determining who receives assets even where the executor opts out of the federal estate tax. Va. Code §64.1-62.4(A). A personal representative, trustee, other fiduciary, or any beneficiary may seek judicial relief if the default rule does not carry out the testator's intent. So that the judicial relief provision operates properly, suits must be brought before January 1, 2012, extrinsic evidence is allowed, and the petitioner has the burden of proof by clear and convincing evidence. Va. Code §64.1-62.4(B). Consistent with the Virginia Uniform Trust Code, the statute also provides that all interested persons may enter into an agreement to depart from the default rule if the default rule does not carry out the testator's intent, and permits the parties to seek court approval of the agreement. Va. Code §64.1-62.4(C). These changes are intended to protect the intent of most testators, reduce litigation, and reduce risks for fiduciaries by replacing chaos with certainty and also allowing remedies if the default rule does not fit the situation.
Unlike, Maryland and DC, Virginia took a completely opposite response to the changes in the federal estate tax rules in 2006 when it abolished its estate tax for decedents dying on or after July 1, 2007.
In 2006, Maryland and the District of Columbia imposed a state Estate tax on estates valued at more than $1 million. Maryland and the District of Columbia were among a hand-full of jurisdictions that broke off from the Federal estate tax rules in 2006. Maryland also instituted a Maryland Only QTIP election in 2006.
In 2014, the Maryland legislature voted to increase the estate tax exemption gradually on an annual basis from the current $1,000,000 exemption until it matches the federal estate tax exemption in 2019 as follows:
Deaths between January 1, 2015 and December 31, 2015: $1,500,000 exemption
Deaths between January 1, 2016 and December 31, 2016: $2,000,000 exemption
Deaths between January 1, 2017 and December 31, 2017: $3,000,000 exemption
Deaths between January 1, 2018 and December 31, 2018: $4,000,000 exemption
Deaths on or after January 1, 2019: Maryland exemption will match federal exemption, estimated to be $5,900,000 in 2019 (more on that below)
With regard to state estate taxes, however, currently only Hawaii offers portability at the state level, but Maryland will begin offering portability of its state estate tax exemption beginning in 2019.
With all the recent tax law changes at the federal and state levels, it is advisable to review their documents for regarding the credit shelter trust funding.
The District of Columbia is working on similar legislation to increase its jurisdictions exemption amount annually.
The time for making any disclaimer for property that passed by reason of the death of the decedent during 2010 prior to the date of enactment (December 17, 2010) has been extended to nine months after the date of enactment of the Act. Thus, the extended due date for disclaimers of this nature would be September 17, 2011. The two major issues that will be associated with such disclaimers will be first, whether the beneficiary has accepted the benefits of the property, and second, whether the period for such disclaimer has expired under state-law requirements. The federal law appears to allow an assignment of the interest in lieu of the state-law disclaimer, but in that case the disclaimer must be of the entire interest in the property that is disclaimed by the beneficiary. Note that this particular extension of the disclaimer period only applies with respect to decedents' estates, it does not apply to gifts.
6. Generation-Skipping Transfer (GST) Tax.
The generation-skipping transfer tax was retroactively enacted to January 1, 2010, and is effective for all of 2010, but with a zero GST tax rate. The generation-skipping transfer tax exemption-equivalent amount was likewise increased, similar to the estate tax exemption-equivalent amount, to $5 million. The decision to opt into the modified carryover basis regime will not affect the GST tax exemption amount for generation-skipping transfers during 2010. By reenacting the GST tax retroactive to January 1, 2010, Congress "fixed" many of the issues planners had encountered concerning the ability to allocate the GST exemption to an irrevocable trust that had been funded during 2010. Not only can taxpayers allocate the GST exemption as they would have in prior years, but the exemption amount has increased to $5 million.
Furthermore, direct skips, taxable distributions, and taxable terminations are technically generation-skipping transfers during 2010, but the tax is imposed on such transfers at a 0% rate. Because such transfers are technically taxable events, those transfers should be reported on an appropriate timely-filed return. For direct skips, the required return would be a gift tax return or an estate tax return. For taxable terminations, the required return would be Form 706-GS(T), Generation-Skipping Transfer Tax Return for Terminations. For taxable distributions, the required return would be Form 706-GS(D), Generation Skipping Transfer Tax Return for Distributions. Some might argue that, because the penalty for failure to file these returns is based on the amount of tax due, no return is required to be filed. Generally, filing the return would commence the running of the statute limitations on the transactions reported and thus would appear to be the preferred approach. Because a direct skip during lifetime has always attracted an automatic allocation of the GST exemption, it will be necessary to opt out of this automatic allocation for 2010 direct skips assuming such election satisfies the client's objectives. However, the client may not want to opt out where the client made a contribution to an irrevocable trust solely for the benefit of skip persons and the trust is designed as a dynasty trust so that subsequent generations will also benefit from the trust. In that case, even though there would be no tax imposed upon funding, GST taxes will be due in the future because of the subsequent taxable distributions or possible termination of interests. In addition to the issue concerning the ability to allocate the GST exemption during 2010, there had also been concerns about whether making direct skips to irrevocable trusts or even transfers to grandchildren's accounts established under the Uniform Transfers to Minors Act might result in future GST-taxable transactions when distributions were made to skip persons in subsequent years. Again, because the GST tax was retroactively enacted, the so- called "move-down rule" should apply to such transfers so that subsequent distributions to the skip persons will not result in GST tax. The effect of the move- down rule was that the transferor was assigned to one generation above the highest generation of any person who had an interest in the trust immediately after the transfer.
The exemption-equivalent amount for taxable gifts during 2010 remained at $1 million. Commencing in 2011, however, the gift tax and estate tax became unified again with the same $5 million exemption-equivalent amount for both the gift tax and the estate tax. The maximum gift tax rate for 2010 through 2012 is 35%. Some taxpayers may have made taxable gifts in 2010 in anticipation of the tax rate returning to a maximum 55% rate. With the exemption-equivalent amount increasing to $5 million for 2011 and 2012, these clients may be very disappointed that they made the gifts during 2010. Affected clients may wish to discuss with their attorney the possibility of using disclaimers and/or rescissions to reverse otherwise taxable gifts made during 2010.
With the new exclusions set at the federal level at $5 Million for tax-free gifts, the states may want to impose a state gift tax. Generally, the gift taxes set by the federal government are the only gift taxes that apply to monetary gifts and estate gifts. However, there are certain states that have imposed regulations regarding their own set of gift taxes for the same situations in which gifts are taxed federally. Seven states impose their own gift tax requirements, namely: Wisconsin, Delaware, New York, Louisiana, North Carolina, South Carolina, and Tennessee. Each of these states has their own rates at which they tax valuable gifts from one person to another. With these states, there are certain situations in which there are exemptions to the gift taxes. These exemptions must be researched for each state individually.
Gift taxes, at either the federal or state level, are not assessed for every single financial gift. The rates for gift taxes usually only triggered after a set amount of money has been given, and these rates are set at an amount high enough so that most people don’t have to worry about them for routine financial gifts. For example, in most states, other than the seven states enumerated above, adopt the law that any gift under the maximum value of $13,000 (so-called "annual gift tax exemption amount") is considered exempt from any sort of gift tax, both federal and state. These values are subject to change, however, so it might be wise to look into the current tax year's rates. Neither the District of Columiba, Maryland or Virginia has a state gift tax.
Further, there may also be exemptions to the gift tax if qualified medical or educational expenses are paid directly to a medical care provider or to a educational institution. It is wise to consult with an experienced tax attorney to help determine whether or not a financial gift is subject to tax.
8. Recapture or "Clawback" of Increased Exemption Amount.
The Act is designed so that, absent further congressional action, the relevant tax laws in place prior to 2001 will again become effective beginning January 1, 2013. For estate and gift tax purposes, this would result in a $1 million exemption-equivalent amount with a 55% maximum marginal tax rate. If a client takes advantage of the $5 million exemption-equivalent amount and makes a $5 million gift during 2011 or 2012, it is unclear what will happen if the client dies after 2012 and the estate-tax exemption- equivalent amount has returned to $1 million. The exemption-equivalent amount has never decreased in this fashion and the Internal Revenue Code is unclear as to what results should be obtained under a unified transfer-tax system in these circumstances. Based on the existing Form 706 instructions, a recapture of the tax would occur, i.e., the tax payable with the Form 706 could effectively include additional gift tax based on a reduced exemption-equivalent amount. Given that the current instructions were drafted without this issue in mind, it is difficult to know with certainty how the Service would apply the rules in this context. Generally, absent a decline in value of the assets transferred before death, the client will be no worse off should there be a subsequent recapture of the transfer tax. Using a depreciating asset to make a taxable gift has always been a bad planning idea. Thus, as a practical matter, planners should warn clients of the possible recapture, or so-called "clawback," but generally clients should proceed with taxable gifts to take advantage of the increased exemption-equivalent amount. The future income on such property as well as the future appreciation in value of such property will not be included in the donor's gross estate. Furthermore, often such taxable gifts carry valuation discounts, thus further leveraging the taxable gift. If the client does proceed with making taxable gifts that use the increased exemption-equivalent amount, the client may wish to consider the following:
a. Marital and Charitable Deductions. If the decedent's estate is subject to the recapture tax and the entire estate is passing to charity and/or the surviving spouse or trusts for the surviving spouse eligible for the marital deduction, the additional recapture tax will be paid from the assets used to fund the charity and/or spousal bequest, causing a reduction in the deduction. This results in an interrelated calculation because the reduced deduction results in an increase in estate taxes which likewise must also decrease the size of the deduction, and so on.
b. Inequitable Distributions Among Beneficiaries. If the taxable gifts are made to one set of beneficiaries who are different from the beneficiaries under the will and/or revocable living trust, the recapture tax paid by the estate in effect causes the testamentary beneficiaries to bear the burden of the wealth transfer tax for the gifts made during lifetime. If the recipients of the taxable gifts are also beneficiaries of the estate, it should be possible for the will and/or revocable trust to cause an apportionment of the additional recapture tax to such beneficiaries. If the recipients of the taxable gifts are not beneficiaries, the donor could have the recipients enter into an agreement to pay the recapture tax.
9. “Portability” of Exemption Amount (DSUEA).
Effective in 2011, the executor of a deceased spouse's estate may elect to transfer any unused estate tax exemption-equivalent amount to the surviving spouse. Portability does not exist with respect to any decedent dying during 2010. For the surviving spouse to obtain the additional "deceased spousal unused exclusion amount," the executor of the deceased spouse's estate must make an election on a timely-filed estate tax return. Thus, generally, even though an estate tax return is not required to be filed, an executor would normally want to file the return so in order to make this election. Only the most recent deceased spouse's unused exemption may be used by the surviving spouse. Thus, if the surviving spouse remarries after acquiring an increased exemption amount from the first spouse, the exemption amount could be lost and/or reduced if the new spouse also predeceases the original surviving spouse with a reduced exemption amount or no exemption amount. On the other hand, should the new spouse be the surviving spouse, the new spouse cannot acquire any of the increased exemption amounts from the very first spouse to die. For example, assume Sid dies and Wilma acquires Sid's unused exemption amount in addition to her own basic exemption amount. Wilma marries Thomas. If Wilma dies first, then Thomas may obtain Wilma's basic unused exemption amount, but may not utilize any of Sid's unused exclusion amount.
The increased exclusion amount may be used to apply against both gift and subsequent estate taxes. For gift tax purposes, the applicable exemption amount is determined based on the applicable exemption amount available for estate tax purposes as if the donor had died as of the end of the year. Thus, it appears that the surviving spouse can take advantage of the increased exemption amount even if the taxable gifts during the calendar year predated the death of the deceased spouse. It is important to note that portability does not apply to the GST tax exemption. Generally, for planning purposes most estate planners will still highly recommend the use of the credit-shelter or bypass trust as a technique to take advantage of the exemption amount of the first spouse to die. Although portability prevents the loss of the exemption, the increased exemption amount acquired from the first spouse to die will not increase with inflation. Assets held in the credit-shelter trust generally are protected from the creditors of the beneficiary. Likewise, assets held in a credit- shelter trust may be better protected in the case of a divorce action against the beneficiary. Furthermore, the future appreciation of the assets held in the credit-shelter trust will pass estate tax-free to the remainderman. If a GST tax exemption is allocated to the credit-shelter trust, the GST tax exemption of the first spouse to die will be preserved at least to the extent of the assets placed in the credit-shelter trust or the available exemption amount. An in-depth discussion of all the issues surrounding portability is beyond the scope of this Tax Bulletin.
The tax planning wills and revocable trusts for a married couple provides the most tax benefits. Married couples need to contemplate the future uncertainties surrounding the estate tax. The exemption amount could remain at $5 million or could be reduced to $1 million in 2013. There may continue to be legislative proposals to repeal the estate tax in light of the relatively small amount of revenue it generates. Regardless of any potential repeal, the drafting of wills or revocable trusts must contemplate these possibilities. In light of the uncertainty, it may be preferential to use Qualified Terminable Interest Property (QTIP) trusts or disclaimer funding provisions into credit-shelter trusts. Assuming a $5 million exemption-equivalent amount in 2013, many estates will no longer be exposed to federal estate taxes, in which case the wills and/or revocable trusts should be drafted with a bent toward any state death taxes and other non-tax aspects, such as management of assets and asset protection.
With the increase of the exemption-equivalent amount to $5 million for gift, estate, and GST tax purposes, clients with larger estates should contemplate estate planning techniques to utilize the increased exemption-equivalent amounts. Some techniques to consider include the following:
a. Outright gifts at lower than normal rates;
b. Gifts to qualified personal residence trusts (QPRTs);
c. Gifts to irrevocable dynasty-type trusts with an allocation of a GST tax exemption;
d. Sale of assets to an irrevocable dynasty-type trust designed to be an intentional grantor ( deemed owner) trust;
e. Gifts to self-settled trusts taking advantage of the law of those states that permit the assets of such trusts to be exempt from the creditors of the settlor; and
f. Gifts to life insurance trusts (ILITs) to provide adequate funds to make future premium payments on life insurance held by the trust.
The tax law changes established by the new Act will all expire at the end of 2012. Thus, all the concerns and issues that existed in 2010 will be resurrected, once again, in 2012 and possibly 2013. Congressional Super-Committee was unable to reach agreement on extending the current exemption amounts; thus, it is likely that Congress will reduce the Five Million ($5M) exemption down to the One Millioni ($1M) exemption amount before the end of 2012.
The discussions at the Annual Heckerling Institute on Estate Planning, held in January each year in Orlando, Fla., are extensive. In spite of this, we have included some of the key points presented on a number of topics they discussed :
1. Can non-working spouse survive comfortably? A frequent problem in a closely held or family business is how to provide cash flow to the non-involved spouse if the working spouse dies. This issue will be compounded as more closely held business interests are transferred to irrevocable trusts this year. Consider implementing a salary continuation agreement while the working spouse is alive and well. The business corporation can enter into an agreement with the working spouse, which assures that as a component of current compensation, payments will continue to the surviving spouse.
2. Pre-death business planning. If the value of the family business is approximately one-third of the estate, it won't satisfy the 35 percent of gross estate requirement to qualify for estate tax deferral under Internal Revenue Code Section 6166. As a result, the ability to defer for 14 years the payment of the estate tax will be lost. If an investment is made in the business, it will increase the value of the business as a percentage of the overall estate. This could transform otherwise non-qualifying cash into qualifying business interests and push the entire business value over the threshold. Alternatively, use the $5.12 million gift tax exemption to make a gift of non-business assets to change the percentages, thereby increasing the relative value of business interests in the estate. Remember that in "decoupled" states, the use of the deferral payment isn't available, as it's a federal benefit only.
3. Step transactions. The Internal Revenue Service has used the step-transaction doctrine to attack a range of estate plans. The typical sequence of planning events can add to the exposure to this type of challenge. Assume a client discussed with his advisors making gifts before the $5.12 million exemption changes. The client might also have discussed creating an irrevocable trust to which the gifts would be made. Thereafter, the client formed a limited liability company (LLC) and transferred assets to the LLC. Once the LLC was formed and funded, the client then consummated a gift of LLC interests to "seed" the trust. Finally, the client sells LLC interests to the trust. If the IRS can demonstrate that this was all part of one integrated plan, and each step is dependent on the other, then it will treat these steps as if they all happened at one time. If this occurs, any discount on the LLC interests your client gifts and sells to the trust won't be realized. Real intervening economic events may break the "chain." For example, declaring a dividend if a corporation is involved in the planning might change values. If the entity for which interests will be given is a real estate holding company, you may break the sequence from an economic perspective by entering into a new lease after the property was transferred into the LLC, but before the gift/sale to the trust, after a gift to a spouse who will fund the trust or between a gift to the trust but before a sale to the trust.
1. Gifts of interests that could cause estate inclusion. Too often, gift planning is focused on large and obvious assets. For some clients, carefully identifying less obvious but very nettlesome assets to gift may have a beneficial impact. The client's interests or rights may cause estate tax inclusion at death. These rights might include: a retained life estate, the retained power to vote stock in a closely held company, the power to remove and replace a trustee and incidence of ownership in life insurance. Now's an ideal time to review existing estate-planning documents, especially older trusts that haven't been given attention in years. Identify possible powers or rights that might taint trust assets as includible in the client's estate and gift or terminate them now. While the exemption can shelter the possible gift, don't forget to disclose these gifts on a 2012 gift tax return.
2. Gift equalization. Equalizing gifts have always been a concern for many clients seeking to maintain some sense of equality among the family lines of various children (or other heirs). If clients have made annual exclusion gifts to children, spouses and grandchildren over time, the different family lines may have become quite unequal. Some clients would like to equalize this imbalance, but many haven't addressed it. The $5.12 million exemption affords a great opportunity to effectuate an equalization plan. If the exemption drops to $1 million in 2013, as the law presently provides, this opportunity may disappear.
3. Gifting in trust? Make it a grantor trust. While practitioners are well aware of the potential advantages of a grantor trust, with the attention being given in 2012 to large gifts to use the $5.12 million exemption before it expires, you should remind clients of the substantial advantages of making large gifts to trusts that are intentionally structured as grantor trusts. The estate-planning advantages are hard Heckernng family businesses gift planning to overlook. First, someone has to pay the income tax with respect to the income earned on the assets transferred to the trust. With a grantor trust, the grantor pays it, thereby further depleting the estate-and retaining in full the assets of the trust. While it might appear that the tax payment constitutes a taxable gift, after all, the grantor is assuming the tax with respect to assets owned by the trust, Revenue Ruling 2004-64 holds that the grantor's payment of the tax is an obligation and therefore not a gift. What if the income tax cost becomes too expensive for the grantor's comfort? Some might consider a tax reimbursement provision, although this has to be handled properly to avoid an estate inclusion issue. Another approach is to turn off grantor trust status, which may be feasible in some trust structures.
Other advantages of the grantor trust, while obvious to practitioners, elude many clients. While sales of appreciated assets to the defective or grantor trust would ordinarily cause income tax to the grantor, Rev. Rul. 85-13 assures that transactions between the grantor and his grantor trust aren't recognized for income tax purposes. Similarly, the interest income earned by the grantor with respect to the note used in connection with the sale also isn't taxable.
4. Gifting may save state estate taxes. Many states impose estate taxes based upon the application of the now non-existent state death tax credit and don't have a gift tax (two states do, but most don't, for example, New Jersey). The state death tax credit was calculated based on the decedent's net taxable estate. However, it didn't account for adjusted taxable gifts. Therefore, gifts generally aren't taxed when made, nor when added back into the calculation of the state estate tax upon death. For example, assume a client has a $5.12 million estate and dies in 2012 in a state that imposes tax in the manner stated above. The client's estate will pay no federal estate tax (assuming no prior adjusted taxable gifts), but will pay a state estate tax equal to $405,200. Suppose instead the client consummates a gift in 2012 of the entire $5.12 million prior to death. No federal gift tax is incurred, there will be no state gift tax (excluding two states) and since the state death tax credit is calculated without adding back adjusted taxable gifts, there's nothing left in the net taxable estate and, accordingly, no state estate tax in most decoupled states. The result is a $J05.200,,savings with a pre-death transfer in lieu of a transfer on death.
5. Gifting may save estate taxes but cost more in income taxes. Gifting, whether to save state estate taxes or eliminate post-transfer appreciation from the estate can be productive in many cases. With the advent of the $5.12 million exemption, there's a tendency to want to take advantage of Congress' recent generosity. However, gifts carry with them a potentially costly income tax problem. An asset that's gifted retains the donor's basis; there's no step-up in income tax basis. With substantially appreciated assets, the income tax cost to the donee on the eventual sale of the asset may be greater than the estate tax savings. Take the case of a client with a $5 million estate-all of which is stock with a basis of $1 million. If the client gifts the stock to a child immediately prior to death, the estate will save $391,600 in state estate taxes. However, when the child later sells the stock for $5 million, the child will realize a $4 million capital gain, a $600,000 federal income tax (at current rates) and perhaps a state income tax as an add-on as well. Worse, if the Buffet tax (that is, a minimum 30 percent tax rate on incomes exceeding $1 million) or something akin to it is enacted, the child may face a much greater tax of perhaps $1.2 million, with little or no ability to plan around it.
6. IRS gift scrutiny. If a client made an "informal" gift of a vacation home or other property to his children, but didn't report it, a current IRS audit initiative may be quite a surprise. The IRS has been scrutinizing local property tax records. It has now investigated property transfer records in 15 states and, presumably, will examine records in more states in the future. The IRS has found that 60 percent to 90 percent of gratuitous non-spousal real estate transfers weren't reported on gift tax returns. If clients have such unreported gifts, it may behoove them to take the lead and file the missing gift tax returns. For most transfers made in 2011 and 2012, there's not likely to be a gift tax issue because of the $5 million and $5.12 million exemptions, respectively. However, for prior transfers made when the gift exemption was $1 million (or less in earlier years), there may be an issue. Clients may assume that the only implication of the failure to report is the gift tax return, but this issue can extend further than the one return. If the client makes future taxable gifts and has to file a gift tax return to report those gifts, those future returns must disclose prior gifts. This means all future gift tax returns would also be incorrect, because the figure for prior taxable gifts would be incorrect. If the client's executor becomes aware of an unreported gift and files an estate tax return, that too would be an incorrect return. This is a potentially substantial risk awaiting many unsuspecting taxpayers.
7. Gift tax liability exposure. Clients are likely to view exposure for unpaid gift tax as a non-issue because of the large current exemption. But, there's a potential risk that many clients wouldn't suspect. The law is clear that the donor should pay any applicable gift tax. But if the donor doesn't pay, then the donee of the gift is personally liable for the gift tax. This rule has a much broader reach than many would imagine. A donee can be responsible for a tax even if it's not his gift that triggered the gift tax. For example, say a client made a large a gift to his new spouse, which qualifies for gift tax marital deduction, so that there was no gift tax attributable to that gift. The client also made a separate large taxable gift to another donee, perhaps a child from his prior marriage. The donor then fell into financial difficulties and didn't pay the gift tax. While the child/donee would then be liable for the gift tax, the spouse is also subject to liability for that tax. Even though the client's new spouse received a gift that didn't trigger any gift tax, she's liable for the entirety of the gift tax on the gift made to the child under IRe Section 6324. These rules could create even more havoc in some circumstances. For example, say a son is named agent under his father's power of attorney. His father used up his $5 million gift exemption, then fell ill. Any new gifts will be taxable. The son makes gifts to his siblings of $2 million and to his father's new wife of $1 million, but doesn't pay the gift tax from his father's funds as agent or from his own funds. The new wife can be held liable for $700,000 (35 percent), representing the gift tax on the $2 million gifts to the father's children from a prior marriage.
8. Gifting with the ultimate security blanket using a self-settled trust. As 2012 moves forward, an increasing number of clients should evaluate the benefits of making large taxable gifts prior to 2013. A significant impediment for many "mid-wealth" clients is the concern that they'll need the funds that, for tax purposes, might make sense to gift. Using a domestic asset protection trust (DAFT), also known as a self-settled trust, may provide the wherewithal for an independent trustee to distribute assets back to the grantor if needed. This could present the ultimate" do over" if the trustee determines that the grantor needs the funds. The problem with a DAPT permitting distributions back to the grantor is that the transfer is to a self-settled trust, which in most states subjects the assets of the trust to creditors. As such, the right of creditors to attach trust assets renders the assets of the trust includible in the grantor's estate pursuant to IRC Section 2036, thereby undoing the desired planning. Several states allow self-settled trusts without subjecting the trust to creditors. Without such creditor attachment, Section 2036 doesn't apply, and the assets of the trust shouldn't be included in the grantor's estate. Note that the IRS will apply Section 2036 if there's an implied understanding that the assets will be made available to the grantor. Trustees should use great care to minimize the use of the power. The IRS has focused attention on the course of conduct of the trustee and grantor to determine if there was an implied understanding. The trustee should exhibit great care in following an independent discretionary standard, uninfluenced by the grantor.
Congress may have unintentionally provided for "clawback" of pre-2013 gifts in excess of the donor’s estate tax exemption after 2012. For example, suppose a donor gives away $5,000,000 in 2012; the estate tax exemption reverts to $1,000,000 in 2013; and then the donor dies. Clawback would mean that the $5,000,000 gift would be subject to estate taxation using only the $1,000,000 exemption. Under current (i.e., 2012) law, there should be no clawback, because Internal Revenue Code section 2011 provides a credit for the gift tax that would have been paid on lifetime gifts, and the credit is based on the rates in effect when the gift was made, rather than the rates in effect on the date of death. Unfortunately, the provisions in Code section 2011 that allow this favorable credit expire on December 31, 2012. Thus, unless Congress extends the favorable credit, clawback may result by default.
The $5,490,000 gift tax exemption ($5,000,000 indexed for inflation) in effect for the rest of 2076 makes large gifts attractive, especially in light of the possibility that the estate and gift tax exemptions could revert to lower amounts in the future considering the large federal deficits. There are many ways to take advantage of the large gift tax exemption, including discounted gifts using entities (which are no longer available starting in 2016), grantor retained annuity trusts ("GRATs") that are not zeroed-out for gift tax purposes, and grantor trusts for the benefit of a donor’s spouse and descendants.
Children who have more assets than their parents should consider making gifts to their parents. The gifts could be annual exclusion gifts or zeroed-out GRATs, in order to minimize the use of the child’s gift and estate tax exemptions. The parents then could structure their estate planning so that the gifted assets would not pass back to the donor child upon the death of the parents.
Reliance upon portability of the federal estate tax exemption is generally less effective than traditional bypass trust planning, due to the creditor protection benefits of a bypass trust, the ability of a bypass trust to shelter appreciation of assets, the fact that the portable exemption is not indexed for inflation after the first spouse’s death, and the possibility that portability will be eliminated in the future. On the other hand, portability may be extremely useful for retirement benefits, which might suffer adverse income tax implications if used to fund a bypass trust.
If a qualified terminable interest property ("QTIP") election is not necessary in order to reduce federal estate tax, then an estate may not elect QTIP treatment for the purpose of permitting a step up in basis for the QTIP trust assets remaining at the surviving spouse’s death. Rev. Proc. 2001-38; PLR 201112001. In order to achieve a step up in basis, the surviving spouse could be granted a general power of appointment (for example, a power of appointment in favor of the creditors of the surviving spouse’s estate).
A surviving spouse who has received a required minimum distribution ("RMD") from an individual retirement account ("IRA") may not disclaim the RMD or the income attributable to it, but may disclaim all or a portion of the balance of the IRA. Rev. Rul. 2005-36; PLR 201125009.
In an era of historically low interest rates, extremely long term GRATs may be an effective strategy for reducing federal estate tax. For example, a grantor could create a 99-year GRAT, knowing that the grantor will die during the GRAT term, causing inclusion in the grantor’s estate. The amount includable is the amount required to produce the annuity using the Code section 7520 rate in effect at the grantor’s death. If interest rates rise significantly between the creation of the GRAT and the grantor’s death, then the amount required to produce the annuity (and thus the amount included in the grantor’s estate) could decline substantially.
The death of a shareholder does not terminate an S election, but distribution of S corporation stock from a decedent’s estate to an ineligible shareholder does terminate the S election. For the year of an S corporation shareholder’s death, S corporation income, losses, deductions, credits, etc. are reported pro rata on the decedent’s final income tax return and on the estate’s first fiduciary income tax return.
Generally, there is no income in respect of a decedent ("IRD"), because the decedent has reported his or her share of the S corporation income. Nevertheless, if the S corporation (at the date of death) had a right to an item that would have been IRD if held by the decedent directly, then the decedent’s share of that item would be IRD to the recipient of the decedent’s stock. The portion of the value of the stock that is attributable to IRD is not entitled to a step up in basis.
When an S corporation shareholder dies, the corporation may elect (with the consent of all shareholders) to treat the current tax year as if it consisted of two separate tax years, the first of which ends on the date of death.
There is no restriction in the Internal Revenue Code on how long an estate may own S corporation stock. Nevertheless, state law may require that the estate distribute assets within a reasonable amount of time. Because the estate itself is the S corporation owner while the estate is administered, S corporation income potentially could flow through an estate to a beneficiary who otherwise would be ineligible to own S corporation stock.
Certain trusts are eligible S corporation shareholders, including grantor trusts, a trust that was a grantor trust prior to the grantor’s death (but only for two years after the date of death), a testamentary trust (but only for two years after the transfer of assets to the trust), a qualified Subchapter S trust ("QSST"), and an electing small business trust ("ESBT").
A QSST must distribute (or be required to distribute) all of its income to one U.S. citizen or resident beneficiary and may not distribute principal other than to the income beneficiary. The income beneficiary’s interest must terminate at the earlier of the income beneficiary’s death or when the trust terminates. If the trust terminates during the income beneficiary’s life, then the trust assets must be distributed to the income beneficiary. The income beneficiary must elect to be treated as owner of the portion of the trust consisting of S corporation stock. Generally, the election must be made within two months and sixteen days after the S corporation stock is transferred to the trust.
An ESBT is more flexible than a QSST, because an ESBT may (1) have more than one beneficiary; (2) accumulate income; and (3) sprinkle income and principal among beneficiaries. Nevertheless, there is a cost for this flexibility. The portion of the trust that consists of the S corporation stock is treated as a separate trust for income tax purposes, and the trust is taxed on the S corporation income at the highest income tax rate for trusts. An ESBT election is made by the trustee.
A QTIP trust cannot be an eligible S corporation shareholder unless it also qualifies as either a QSST or an ESBT. A qualified domestic trust ("QDOT") cannot be an eligible S corporation shareholder unless the spouse becomes as U.S. citizen. A section 2503(c) trust can qualify as a QSST as long as the trustee distributes or is required to distribute the income at least annually to the benefi ciary. A charitable remainder annuity trust ("CRAT") or a charitable remainder unitrust ("CRUT") cannot qualify as a QSST.
In a trust that gives the trustee discretion to distribute income or principal, a trustee must act, rather than remain passive. A trustee breaches its fiduciary duty to the benefi ciary if the trustee refuses to make a determination whether or not to make a distribution. The trustee must be reasonably informed regarding the terms of the governing document and the circumstances surrounding a beneficiary’s request for a distribution. A trustee must act impartially and in good faith regarding distributions to beneficiaries. A grantor might create discretionary distribution powers in order to give beneficiaries incentives (for example, to obtain an education, embark upon a career, pursue charitable goals, or raise a family). Internal Revenue Code section 2041(b)(1)(A) provides that a discretionary distribution provision that is limited to an "ascertainable standard" related to "health, education, support, or maintenance" does not constitute a general power of appointment. Accordingly, discretionary distribution powers often contain the so-called "HEMS" standard or similar language. Under Treasury Regulations section 20.2041-1, the term "comfort" does not constitute an ascertainable standard when it is used alone, but it can form an ascertainable standard when it is used in conjunction with one of the other "HEMS" magic words. According to the regulations, the terms "welfare" and "happiness" do not constitute ascertainable standards. The regulations provide that the term "health" includes "medical, dental, hospital and nursing expenses and expenses of invalidism." The regulations also specify that "education" includes college and professional education. Under the Restatement (Third) of Trusts, section 50 (2003), the term "education" also includes living expenses, fees, and other costs of attending an institution of higher education. The regulations treat "support" and "maintenance" as synonymous. According to the Restatement, these terms extend beyond bare necessities to a beneficiary’s accustomed standard of living. The regulations state that it is "immaterial" whether a beneficiary must exhaust his or her own income in order to receive a discretionary distribution from a trust.
The seminar materials contain an extensive discussion of the "prudent investor" rule, under which a trustee has a duty to "invest and manage trust assets as a prudent investor would." The prudent investor rule draws heavily upon the concept of "modern portfolio theory," including an emphasis on diversity and total return (both income, and capital appreciation) from assets. The prudent investor rule is embodied in the Uniform Prudent Investor Act, and the Restatement (Third) of Trusts, section 90 (2003)). Note that under Maryland Annotated Code, Estates & Trusts Article, Section 15 114, the prudent investor rule applies to some trustees automatically, and to other trustees only if they elect to have the prudent investor rule apply to them.
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