Planning Before Year-End

Now’s the time to revisit those planning “Resolutions” made at the New Year

As we rang in the New Year at the beginning of 2012, the federal estate and gift tax exclusion amounts increased to a historically high level of $5.12 million dollars each (see chart below), while asset values remain low due to current economic conditions. This combination of a high exclusion amount and a depressed economy provides an opportunity to shift a greater amount of wealth at a lower cost since the tax liability on transferred assets is assessed on the fair market value at the time of the transfer. It is imperative to take advantage of the exclusion amounts before the year is out, though, because unless new legislation is enacted, both exclusion amounts are slated to decrease back down to $1 million in 2013. Some planning options you may want to consider:

Making Gifts and Allocating GST

You may want to consider making gifts, and even taxable gifts, during 2012 as the current gift tax exclusion and tax rates may not be extended. As stated above, the lifetime gift tax exclusion amount is $5,120,000 per person in 2012 ($10,240,000 million for a married couple), but is set to decrease to $1 million in 2013. Furthermore, the maximum gift tax rate during 2012 is only 35%, compared to the top rate of 55% in 2013 (see chart below). So, not only can you transfer a significant amount of assets (and any future appreciation) out of your taxable estate before incurring gift tax, but you can gift in excess of your available exemption amount and incur a much lower rate of tax.

Moreover, the generation-skipping transfer (“GST”) tax exemption amount is at an all-time high of $5,120,000 million. GST tax is assessed, in addition to any other tax, when gifts are made to an individual who is two or more generations removed from the donor. By allocating GST exemption in 2012 to gifts to grandchildren, or to a dynastic trust that will continue on for multiple generations, an individual will not only be able to transfer wealth at the lower gift tax (or possibly avoid the gift tax if gifting under the $5,120,000 lifetime exclusion amount), but will be able to avoid the additional generation-skipping tax (55% savings) and reduce his or her taxable estate.

* Starting in 1988, a five-percent surcharge was imposed between $10,000,000 and $21,040,000. After 1997, the surcharge was applied above $10,000,000 until the average rate was 55 percent.
** For Decedent’s dying in 2010, the estate can opt out of the estate tax and into a “modified carryover basis” regime.
*** Starting in 2012 to be adjusted for inflation (under 2010 Relief Tax Act, which is set to sunset December 31, 2013). Rev. Proc. 2011-52, 2011-45 IRB

Sales to Intentionally Defective Grantor Trusts (“IDGT”), Grantor Retained Annuity Trusts (“GRAT”)

Using a sale to an IDGT or a GRAT can be an effective way to reduce your taxable estate and better protect assets for future generations. 2012 may be the best year to initiate this type of planning, especially in light of the new fiscal policies being proposed by the Obama administration for fiscal year 2013 (discussed in further detail below).

In an IDGT transaction, assets (typically LLC interests) are sold to an IDGT for fair market value in exchange for an installment note. At the end of the note’s term, the assets remain in trust for the trust beneficiaries and are outside of the estate of the seller. An IDGT generally requires a “seed” gift to fund the trust of at least 10 percent of the value of the assets that will be sold to the IDGT, and this gift may be subject to gift tax.

In a GRAT transaction, assets (typically LLC interests) are gifted to a GRAT in exchange for an annuity stream payable for a term of years, otherwise known as a “retained interest”. At the end of the annuity term, the assets remain in trust for the trust beneficiaries and are outside of the estate of the donor. A GRAT may incur gift tax if the donor’s retained interest is less than the amount of the property transferred to the trust.

With the higher exemption amounts, not only can a greater amount be gifted to these types of trusts in 2012, but the gift tax on these gifts may be significantly reduced, or even eliminated.

Discount Planning with Limited Liability Companies (“LLC”)

Many individuals or families establish a limited liability company to centrally hold and manage their assets, receiving LLC interests in return for their contributions. If you have established an LLC, or are considering establishing an LLC, another tool to reduce your taxable estate is to gift LLC interests to your children, grandchildren or trusts established for their benefit. With asset values already low, LLC interests may be discounted in value even further due to lack of marketability or minority interest discounts. Gifting LLC interests rather than gifting the underlying assets may also allow an individual to maintain oversight over the underlying assets.

Qualified Personal Residence Trusts (“QPRT”)

Another technique to reduce the taxable estate is to transfer your primary residence to a QPRT. The transfer of the residence to the trust is a gift subject to gift tax. Low real estate values and the high gift tax exemption make this type of planning attractive this year.

Make it one of your New Year’s resolutions to consider these planning techniques to take advantage of historically high tax exemptions and low tax rates, and to reduce your taxable estate. Please do not hesitate to contact us so that we may tailor a particular plan that will work best for you.

Looking Ahead to 2013 – the President’s “Green Book” budget proposals and the impact on Federal Transfer Taxes

On February 13, 2012, Congress began reviewing the President’s budget proposals for fiscal year 2013 (commonly known as the “Green Book”), including a proposal that would alter the benefits of planning with intentionally defective grantor trusts (“IDGT”).

Selling assets to an IDGT is a popular way to reduce your taxable estate and it can be extremely beneficial, both from a transfer tax and an income tax perspective. An IDGT is structured so that the grantor is treated as the owner of the trust for income tax purposes, but not for transfer tax purposes. Accordingly, gain or loss on the sale of assets to the trust is not recognized, but the assets (including any appreciation) are excluded from the grantor’s estate upon death. The trust is “defective” in that it intentionally gives the grantor certain powers that cause the grantor to still be treated as the owner of the trust for income tax purposes. The grantor continues to pay the income taxes on the trust’s income, further depleting his or her estate. As discussed earlier, this planning technique can result in a significant transfer of wealth while minimizing the tax consequences.

The new proposals for 2013 seek to “coordinate income and transfer tax rules” that relate to grantor trusts, thereby completely removing the advantages of using grantor trusts, and in particular, planning with sales to IDGTs. In general, the proposal provides:

An IDGT would be treated as a grantor trust for transfer tax purposes, meaning that the assets of the IDGT would be included in the grantor’s gross estate for estate tax purposes upon death;

Any distributions from the IDGT during the grantor’s lifetime would be subject to gift tax; and

Trust assets in the IDGT would be subject to gift tax during the grantor’s lifetime if the IDGT ceases to be a grantor trust at any time.

The proposal would be effective only for those trusts established on or after the date of enactment, so the IDGT remains a powerful planning technique to consider for this year.

Other relevant proposals being advanced by the Administration include:

Returning the estate and generation-skipping transfer tax exemptions to $3.5 million, and the gift tax exemption amount to $1 million, with a top tax rate of 45%;

Making portability of unused exemption amounts between spouses permanent;

Requiring basis consistency for transfer tax and income tax purposes;

Requiring a 10-year minimum term for grantor retained annuity trusts, and a maximum term of the life expectancy of the annuitant plus ten years; and

Limiting the duration of the GST exemption to 90 years (for additions to existing trusts and trusts created after the date of enactment).

If these proposals are enacted to take effect in 2013, it may be just that more important to consider implementing planning this year before certain tax advantages are gone.

Crummey Powers May Be Valid Without Notice

If you have established an irrevocable trust (usually an insurance trust), you may have had your beneficiaries sign a “Crummey” notice every time a contribution has been made to the trust, or a premium payment has been made on a policy owned by the trust. This notice is named after the Crummey case, which provided that donors may make contributions or premium payments to a trust, and have such transfers qualify for the gift tax annual exclusion (which is currently $13,000 per year/per donee). Generally, only gifts of a present interest (an unrestricted right to the immediate use and possession of the interest) qualify for the annual exclusion. Gifts to trusts generally do not qualify as present interests since trusts are usually structured to restrict access to trust property.

However, the Crummey case provided that transfers to a trust would qualify for the annual exclusion if the trust beneficiaries were given certain withdrawal rights (known as Crummey powers) and a certain period of time within which to exercise the withdrawal right over the trust property. Although the Crummey court did not expressly address whether a grantor must give notice to the beneficiary of this right, the IRS generally requires that the grantor retain proof that notice has been given, and subsequent court decisions seem to support this practice. Accordingly, most professionals recommend that trust beneficiaries sign Crummey notices as proof that he or she did in fact receive notice of their withdrawal rights.

The IRS Issues Guidance for Grantor Retained Interests

The IRS has issued final regulations (T.D. 9555) that elaborate on the method of determining how much of a grantor retained interest should be included in the grantor’s gross estate. If the grantor has established a trust, and has retained the use of the trust property or the right to a payment interest in the trust property for a period of time that does not refer to the grantor’s death, the IRS provides calculations to determine how much of these trusts should be includible in the grantor’s estate. Previously, there had been an issue with double inclusion in the gross estate of certain grantor retained interests, and these new regulations remedy this issue.

Decanting Is Not Just For Wine – the IRS Looks Into the Tax Consequences of “Decanting” Trusts

The Internal Revenue Service (“IRS”) recently announced that it is seeking public comment on tax issues and consequences arising from trust “decanting” – “pouring” or transferring all or part of the principal of one irrevocable trust into another irrevocable trust. Decanting is a planning technique for irrevocable trusts that has become more common in recent years, and it has attracted the attention of the IRS, in part, because there is little guidance on the tax consequences of transferring the property between the trusts.

Why decant an irrevocable trust? Some irrevocable trusts, particularly older trusts, can become difficult to administer due to drafting errors, ambiguities, or changing circumstances that affect how a trust operates. Such trusts often have little or no capacity to revise the document. While most states allow for judicial modification of a trust in these circumstances, understandably this can be a costly and time-consuming process. Additionally, some states require beneficiary approval of a modification, which may cause unintended transfer tax consequences.

Decanting, on the other hand, does not require court approval or beneficiary approval, making it a cost-effective and timely way to modify a challenging trust. The provisions of the new trust can be drafted to, among other things, address changed circumstances in tax law or family dynamics, protect the tax treatment of a trust, modify administrative provisions, grant a beneficiary a power of appointment, change a trust’s governing law, or correct a drafting error. However, at times, trust decanting is also used to change the beneficial interests in a trust, such as adding or removing beneficiaries, or changing a beneficiary’s interest in the trust, essentially creating a new trust distinct from the original trust. While many estate planners have started incorporating decanting provisions into trusts, this technique has become so prevalent that 10 states have now enacted decanting statutes expressly giving trustees this power.

Generally, there are tax consequences anytime property is transferred, whether it is income, gift, estate, or generation-skipping transfer tax. But since the technique of decanting a trust is relatively new, it is unclear what tax, if any, applies when one the property of one trust is transferred to another trust. In particular, the IRS seems interested in trust decanting that results in a change of beneficial interests, such as adding or removing beneficiaries, change of a beneficiary’s interest in the income or principal of the trust, a change in the identity of the donor or transferor of a gift.

In light of the IRS’s interest in these transactions, it may be wise to exercise caution when contemplating engaging in trust decanting. Any of the attorneys at Duggan Bertsch would be happy to assist you with any questions or concerns you may have regarding your own plan.

In Summary

In five short months, the unprecedented increase in the U.S. estate tax exemption amount is scheduled to expire. This increase presents an unique opportunity to transfer significant wealth tax-free. The decision whether to take advantage of this opportunity will have far flung effects into the future and ultimately will influence how your assets will be shared between your heirs and the U.S. government.

It typically takes at least three months in complete a well thought-out wealth transfer plan once a decision has been made to transfer some of your accumulated wealth. As only five months remain within this year and three months are needed to properly implement a wealth transfer plan, the window of opportunity to consider and take advantage of this unique tax-free wealth transfer period of time is towards its end.

Jim Duggan, JD
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