Submitted by Danielle Cruttenden
Merrill, Cruttenden & Collinson, P.A.
Printed in the Spring 2011 Edition of the Maryland State Bar Association's Newsletter for
the Estate & Trust Membership Section
Before a record crowd at the 45th Heckerling Institute on Estate Planning Dennis Belcher, a panelist for Recent Developments, announced that the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010, hereafter referred to as the Tax Relief Act of 2010 or "TRA 2010," was a "game changer." Sam Donaldson, another panelist, reminded us how one year earlier most of us were stunned by the sun setting of the Economic Growth and Tax Relief Reconciliation Act of 2001 ("EGTRRA") and the repeal of the federal estate and generation skipping tax. As the days and months passed in 2010, planners believed that the chance of retroactive estate and gift tax grew increasingly slim. Some of us encouraged clients to make taxable gifts with the threat of increased estate and gift tax rates. Then, to the surprise of most, after significant approval by the Senate and the House, the Tax Relief Act was signed into law on December 17, 2010 by President Abomey providing a federal and generation skipping tax exemption of $5 million and sets the maximum rate at 35%. The relief, however, is short lived as the TRA 2010 provisions apply for two years only. The new law extends the provisions of EGTRRA to sunset on December 31, 2012 instead of December 31, 2010.
The Tax Relief Act of 2010 served as the main theme of the conference. The presentations focused on understanding the new law, how it affects 2010 decedents' estates, what opportunities are presented and how planning for our clients will change. While other interesting and helpful presentations were included as part of the conference, this article will focus on what was discussed about TRA 2010.
TRA 2010 - Synopsis:
Estate and generation skipping taxes were reinstated effective as of January 1, 2010 providing a $5 million dollar exemption for both and a maximum rate of 35%. Estate, generation skipping and gift taxes were reunified, except that for 2010 the gift tax exemption remained at $1,000,000. Beginning in 2011 the gift tax exemption is also $5 million. Inflation adjustments apply in increments of $10,000 beginning in 2012. There is a 9-month automatic extension to September 19, 2011 to file estate tax returns and make disclaimers.
Estates of 2010 decedents may elect to have the carryover basis rules apply. An adjustment to basis of $1.3 million is provided for under those rules as well as an additional $3 million adjusted basis for property passing to a surviving spouse. For decedents' estates with less than $5 million, the personal representative will want the step-up in basis and will NOT elect carryover basis rules to apply. For estates exceeding $5 million, the personal representative will need to consider whether the amount of appreciation is covered by the available adjusted basis. For those estates with appreciation that exceeds the amount of available basis adjustment, the decision is much more difficult. The personal representative will need to consider many factors. . The following are some of the factors mentioned by Heckerling speaker, Steve Akers: (1) whether the election will change the amount passing under formula clauses, if so, and consents cannot be obtained from all the beneficiaries, you should seek court approval of the decision; (2) the amount of estate tax payable currently versus the gain that would be subject to income tax on future sale of assets, (3) anticipated future capital gains rates, (4) anticipated dates of sale; (5) anticipated cash needs of beneficiaries; (6) determination of which beneficiaries bear estate taxes in comparison to which persons bear income taxes due to lack of step-up in basis and (7) whether the expenses of administering the estate will be increased by making or not making the election.
The allocation of basis is to be reported on informational Form 8939, Allocation of Increase in Basis for Property Acquired from a Decedent. As of the time of the conference the time for filing Form 8939 had not been extended from the April 15, 2011. On March 31, 2011 the Treasury Department and the IRS announced that Form 8939 should not be filed with the decedent's final Form 1040 and further stated that the filing date and Form 8939 will be released at a later dated, expected to be soon after guidance is issued for the form.
TRA 2010 provides for the portability of unused exemption to a surviving spouse. The personal representative of a deceased spouse's estate may elect to transfer any unused estate exemption to the surviving spouse on a timely filed Form 706. The deceased spousal unused exclusion amount, otherwise known as "DSUEA" is effective only after 2010 and is applicable for both estate and gift tax purposes. Portability does not, however, apply to generation skipping tax "GST" exemption. Further, a spouse may not accumulate exemption through multiple marriages. A surviving spouse may only receive the unused portion of the last spouse he or she was married to. Further, there is a privity requirement so that a spouse may not use his or her spouse's DSUEA. While portability will simplify estate planning for many clients, it will still not eliminate planning for Maryland estate taxes or the need for trust drafting. Additionally, there is the risk that portability will not be extended beyond the two years of enactment.
TRA 2010 resolved most of the uncertainty that existed during the alleged period of gst repeal. Clarity came with the retroactive application of a $5 million exemption of generation skipping exemption effective January 1, 2010 and the application of a 0% tax rate for all gst transfers in 2010. All generation skipping relief provisions such as qualified severances are extended. It is now clear that transferors existed in 2010 for gst purposes; that annual gst exclusion gifts could be made in 2010 and that direct skips in trust were just as effective as direct skips not in trust. Planners generally agree that the reinstatement of the estate and gst tax as of January 1, 2010 now clarifies that estate tax inclusion periods (ETIPs) did not terminate at the beginning of 2010, even if a 2010 decedent's estate elects for a carry over basis rules to apply.
Due to the fact that $5 million may be allocated to gst transfers to trusts in 2010, it is important to remember that donors should opt out of the automatic allocation of gst for 2010 direct skips. It would be a waste of gst allocation if applied to direct skips that are subject to the 0% rate. As the time for filing disclaimers has been extended to September 19, 2011, consider whether a disclaimer can now be made that would result in a direct skip to take advantage of the 0% gst tax rate.
The mechanics for allocating gst exemption for 2010 decedents that elect for the carryover basis rules to apply remain unclear. Guidance from the Treasury Department and IRS should be forthcoming.
Whether or not we should file returns for 2010 gst distributions and terminations is debatable. As the gst tax was made retroactive for 2010 the law would require the filing of a return reporting a 2010 gst distribution or termination even though a 0% rate applies. Some planners may conclude that the filing of such returns are unnecessary on the theory that such returns are not filed to report distributions or terminations made from gst trusts with a zero inclusion ratios.
TRA 2010 also extended the election for IRA charitable rollovers. Individuals who are age 70 ½ and older may transfer up to $100,000 per year directly from an IRA to a qualified charity without the transfer being treated as a taxable and have it count toward their required minimum distribution. This is available for 2010 and 2011 only and it does not apply to donor advised funds or supporting organizations.
2010 Gifting Considerations:
The speakers were in general agreement that clients with extreme wealth should not have buyer's remorse for taxable gifts made in 2010 because of the removal of the otherwise taxable appreciation of those gifted assets from their estates. However, for those who are less likely to benefit from those taxable gifts, tax lawyers should consider whether a rescission or disclaimer of the gift is available to undo the gift. It is debatable whether a taxpayer could succeed on the argument that the gift should be undone on the basis of a mistake of fact or law. The better approach is to consider disclaimers of gifts as the time for filing disclaimers is extended to September 19, 2011. As state law needs to be followed for a disclaimer to be made, one will need to determine whether the disclaimer laws of the state of the donor or donee apply.
Drafting Thoughts:
For clients with more than $10 million, drafting will not change much. Formula clauses will credit shelter and marital trusts will likely continue to be used as the rate is more important to them than the exemption amount. The focus will be on how to help clients determine how much they can, and are willing, to gift to take advantage of the $5 million gift exemption ($10 million for married couples.) Ideas for gifting are discussed below in this article. The risk of "clawback," addressed below, will need to be explained to our clients.
For clients with less than $10 million, much consideration will need to be given to the trade off between estate tax and an opportunity to get a step-up in basis at the death of the second spouse. Drafting to lock in the marital deduction at the first death will be key. Drafting should be flexible to permit inclusion of assets in the estate of the second to die in order to achieve the step-up in basis of assets at the second death. Presenter, Bruce Stone, suggested that the credit shelter trust name an independent so that distributions can be made for the bests interests of the spouse bringing those distributed assets into the surviving spouse's taxable estate. The trust document could also be written to allow an independent trustee or third party to grant the surviving spouse a power of appointment over the trust assets thereby causing inclusion of the credit shelter trust in the second to die's estate.
Disclaimer Wills continue to provide the necessary flexibility for clients of homogeneous families with less than $10 million. QTIPs will continue to be useful for blended families. Many states, including Maryland, provide a state only qtip election. The state only qtip election which will allow the personal representative to determine which portion of the estate to defer the payment of state estate tax and which portion is to be covered by the increased federal exemption amount. In making that decision, the personal representative will want to consider reducing the amount sheltered from federal estate tax in order to achieve a step-up in basis of the assets at the death of the second spouse.
Grantor Trusts may be written to preserve the possibility of achieving a step-up in basis at the death of the grantor by giving an independent trustee or other independent party the power to grant a testamentary limited power of appointment to the grantor. As long as the power allows the possibility for shifting of benefits from one beneficiary to another, the granting of the power should cause inclusion in the grantor's estate. The document should exonerate the independent third party in its decision whether to grant the power.
Wealthier clients with blended families will need to address the clients goals in light of different tax scenarios. Bruce Stone suggests using "floors and ceilings" to direct how trusts are funded for the spouse and children. By identifying how much a client wishes to leave a spouse initially, and how much the client ultimately wants to benefit the children, an initial floor amount can be established with language in the document that makes adjustments to shift some assets away from the outright marital deduction and over to a qtip trust depending on the applicable federal and state estate tax exemptions. The following example was given: A $6 million client wants to leave a minimum of $3 million to support the surviving spouse, but also wants to ultimately to leave one-third of the residuary estate to the spouse and two-thirds to the children. If the client leaves $3 million to the spouse outright, then the children will be short $1 million. The document could give a marital gift of $3 million but then provide for the reduction of that marital gift to an amount that equals 1/3 of the residuary estate and the excess amount paid to a qtip trust. The remaining $3 million would be directed to the children, except however, that a ceiling would apply so that the gift to the children would not trigger a federal or state estate tax. That portion of the children's gift needed to result in $0 federal or state estate tax would be directed into a qtip trust. In decoupled states such as Maryland the diverted portion may need to be diverted to two separate qtip trusts, one of which is the Maryland only qtip that holds the difference between the $1 million Maryland estate tax exemption and the amount of the federal estate tax exemption.
Developing a client's statement of intent to include in the document may assist in legal proceeding in which a court must intervene or is asked to interpret the meaning of a formula clause or other funding mechanism in the document.
Planning Ideas:
The increase in the lifetime gift exemption is an opportunity for our clients. Surprisingly, TRA does not place a ten year term minimum for GRATS nor does it address discounts for partnerships, limited liability companies or fractional interests in property. Therefore, clients should consider making these gifts to obtain discounts while they are still available, after a consulting with their advisors who can help them assess the risk of such gifts.
Gift splitting for spouses allows the lifetime gift exemption of a less wealthy spouse to be used for the benefit of the descendants of the more wealthy spouse. Question: Should a marital agreement address a way to "compensate" the less wealthy spouse for the use of his or her gift exemption by the wealthier spouse?
Any discussion of gifting, however, must come with an explanation of the risk of clawback. The clawback stems from the worksheets on Form 706. Using those worksheets, if the $5 million exemption declines to $1 million in 2012, then the estate of a 2012 decedent will owe an estate tax on the gifted assets. Beth Kaufman, one of the Recent Developments panelist and former associate counsel to Treasury, points out that if you take away the worksheets and read the statute, a different conclusion is reached. It is Ms. Kaufman's opinion that a clawback is not intended by the law if the federal exemption is later reduced and that this would somehow be fixed. Nevertheless, she advises that we still disclose the risk to our clients, explain what it is, tell the client that we cannot predict what Congress will do, but that we believe it would be worked out.
Finding ways to taking advantage of the $5 million gst exemption will be a focus for wealthier clients. Planners should consider direct skips to the lowest generation possible or to trusts that will trigger the use and allocation of the gst exemption. Some planners include a provision in their trust documents that permits an independent trustee, a trust protector or someone other than the grantor to add upper level generation beneficiaries as discretionary beneficiaries to a skip person trust. This would allow the trust assets to benefit both the grantor's children and grandchildren without any gst tax being due when the trust is created. With this approach it is recommended that there be a considerable delay before adding upper level beneficiaries. The speakers proffered that even in the event of a clawback, there is no way to impose gst tax retroactively on direct skips that occurred in 2011 and 2012.
It is not clear how the inclusion ratio will be determined of a gift to a dynasty trust if the $5 million gst exemption is later reduced.
Clients will likely be interested in talking about using their increased gift exemption but may be reluctant to actually pull the trigger out of concern that may need the gifted away assets later in life. Clients will need to determine what they can afford to give away. However, here are some planning ideas that would preserve some direct or indirect access to gifted assets in the event that the client determines that a "reversal" of the gift is necessary:
Lifetime Credit Shelter Trusts for Spouses - A donor may make gifts to a lifetime credit shelter trust to benefit donor's spouse. The term "spouse" can be defined by the document to be the person to whom the donor is married at the time so that it could also be available for the benefit of a new spouse. The trust would benefit the spouse by containing terms similar to those in a standard testamentary style credit shelter trust. The spouse would be the discretionary beneficiary of the trust and can also be the trustee assuming distributions are limited to a HEMS standard. The trust could contain a limited power of appointment, exercisable at death or during life, and be written broadly enough to appoint the assets back to the donor. (To address the possibility of the donee spouse pre-deceasing the donor spouse, life insurance on the donee spouse could be payable to the donor spouse or to a trust for the donor spouse without substantially different terms to avoid the reciprocal trust doctrine.) If the donee spouse is concerned about how the donee spouse may exercise the power of appointment, the document could require the consent of a non-adverse third party, such as the donor's sibling, and the third party's consent could also be required in order to change the donee's exercise of the power.
Non-Reciprocal Lifetime Credit Shelter Trusts: The same concept above, except that each spouse creates a lifetime credit shelter trust for the benefit of the other. The terms of each trust would need to be structured substantially differently so as to avoid estate tax inclusion under the reciprocal trust doctrine.
Self Settled Discretionary Trusts: Twelve states, including Delaware, allow distributions to the settlor of a self settled trust in the discretion of an independent trustee without subjecting the trust to the claims of the settlor's creditors. These trusts can address the concern of some clients that they do not want to gift away too much money. These trusts can also be structure to include the settlor's spouse as the beneficiary as long as the settlor is married. The trusts must be established in one of the twelve states that affords such creditor protection. There is still a Section 2036 concern, for many planners who fear that the IRS will argue estate tax inclusion based upon retained enjoyment. Consider whether a power should be given to a third party to remove the settlor as a beneficiary which could be exercised shortly before the settlor's death.
Preferred Partnership: The idea behind this technique is to allow gifting to the children (either outright or in trust for them) while maintaining a comfortable stream of income to the parents which stream comes from the preferred interest of a newly created partnership. The parents would also have a common interest in the partnership from which distributions could later be made if needed from the anticipated growth in value of that interest.
Gifts and Sales to Trusts: These will still provide benefit to clients by removing the appreciation of the gifted asset from the client's taxable estate. The sale is a "leaky freeze" in that it removes the appreciation, but still permits the client to benefit from the receipt of principal and interest on the promissory note given in exchange for the asset. One interesting observation made is that in past years these sales were made difficult by the limited gift seed that could be made to the trust ($1,000,000 or the amount remaining of the client's unused gift exemption) unless the client wanted to pay a gift tax. Going forward the issue may be to make sure that the client does not gift too much seed money to the trust, especially if the asset the trust may acquire is highly volatile.
Grantor Retained Annuity Trusts (GRATs): While GRATS turn off some clients as being too complicated, they should still be considered as a way to gift, especially while interest rates remain low. Zeroed out GRATs have the advantage of transferring future appreciation of the gifted asset without the payment of gift tax or gift exemption.
More aggressive approaches, such as Turney Berry's 99 year GRAT as well as his Shark Fin CLAT, were discussed for their interesting results. These ideas are not for the faint of heart. Conservative planners are concerned that the IRS would attack both ideas as abusive. This article does not permit a detailed discussion of these methods. Both of these planning ideas were discussed by Turney Berry when he presented at Maryland's Advanced Estate Tax Institute last fall and they are both easily searchable on Google.
Undoing Transactions:
With an increase in the federal exemption amount some clients may decide that their life insurance trusts no longer serve a purpose and discontinue funding the trusts to fund those policies. Before allowing clients to allow ILITs expire they should be reminded that such trusts exclude the death benefit from state estate taxes. Clients should review their life insurance needs before allowing policies to lapse as they may be uninsurable down the road.
Clients who created qualified personal residence trusts ("QPRTS") may decide to stop paying rent to their children (or trusts for their children) in order to maintain additional cash and
to intentionally cause inclusion of the house in their estate to gain a step-up in the tax basis upon death.
The discontinuation of family limited partnerships and limited liability companies may be better for clients who get no significant tax benefit from the ongoing administration costs associated with maintaining them. Clients may wish unwind the business so that the underlying assets will be included in their taxable estate and obtain a step-up in basis on those assets at death. Alternatively, clients may see the non-tax benefit of maintaining the partnership or LLC, such as central management and asset protection, but decide to discontinue the gifting of those interests to their children allowing the parents to maintain a greater percentage of the income stream from the entity.
Clients who have created irrevocable trusts with grantor status may wish to review whether they have the ability to "toggle off" the grantor status to allow the income tax burden fall on the trust. For clients with estates less than $10 million, and who are willing to assume the risk that the exemption will not be reduced, the client/grantor should consider a repurchase of the assets in the grantor trust in order to get the step-up in basis on the assets in his or her estate.
Conclusion:
With only a two year extension and uncertainty regarding the exemptions and rates in the future, we will need to continue to be flexible in our planning. Instead of letting the exemptions dictate how trusts are funded we should spend more time learning our clients weighted objectives and design plans with those goals in mind in the most tax efficient way that we can. Income tax planning will become more of a focus. For our wealthier clients, we should find ways to take advantage of the increase in the gift tax exemption while it is available after disclosing to them the risk of clawback. State estate tax planning also continues to be a focus for many. We need to advise clients that exemptions and rates may change again in two years and that continued unpredictability in the law s really all that we can predict.
