A Grantor Trust is a Trust that is ignored for tax purposes. Back when Federal Income Tax Rates were much higher, wealthy individuals would establish many trusts for their descendants to push income in to the lower brackets. The trusts were designed to give the Grantor lots of power over the various trusts. Congress decided to maintain the integrity of the Federal Income Tax System by implementing the Grantor Trust Rules. If a Grantor retains certain powers over a trust, then the trust is ignored for income tax purposes. This, in effect, keeps all of the income of the various trusts that "violate" the Grantor Trust rules combined back on the Grantor's income tax returns at the Grantor's marginal bracket.
Back when income tax rates were much higher, the Grantor Trust rules limited the usefulness of trusts. In fact, a trust that violated the Grantor Trust rules was said to be a defective trust. A trust that did not work. If designed for income tax planning, that is correct, the trusts would no longer meet those goals.
Today, Income Tax Rates are lower. Additionally, to further limit the utility of trusts to dilute the income tax base, the tax brackets for trusts are greatly compressed. That is, a trust hits the highest income tax bracket at only around $11,000 of taxable income. This compression of the brackets makes using trusts to manipulate income tax rates unattractive. The Grantor Trust rules are actually no longer needed, but they remain in the law.
The Grantor Trust rules provide a distinct tax advantage from a gift and estate tax point of view. If a gift is made to a properly drafted trust, that trust will keep the assets of the trust out of the Grantor's taxable estate. At the same time, the trust will be ignored for income tax purposes.
This dual tax status trust is essentially a vehicle to allow you to make a gift to your spouse, children or other beneficiaries that can grow income tax free. Income tax-free compounding is a powerful tool for the transfer of wealth.
Remember the estate tax is scheduled to return on 01/01/11 with a $1 million exemption and a 55% highest rate. The assets in a properly structured Grantor Trust not only grow income tax free during the grantor's life, but also will not be subject to an estate tax hit.
Grantor trusts is one more tool to help you Disinherit Uncle Sam.
Patrick
Showing posts with label Estate Tax. Show all posts
Showing posts with label Estate Tax. Show all posts
Wednesday, November 24, 2010
Tuesday, October 19, 2010
Inheritance Trust to Protect an Inheritance from Creditors
Many of my clients are deeply concerned about how litigious our society has become and fear that their assets may one day be taken by creditors. As a result, they desire to legally protect their assets from creditors, including the possibility of divorce. If you share these concerns, I want you to be aware of an important technique that can asset protect an inheritance and provide an important piece of your estate plan.
The traditional estate planning process focuses exclusively on passing assets downstream to beneficiaries (i.e., to children and grandchildren), often ignoring a potential inheritance from parents or other family members. However, Americans are living longer and longer and trillions of dollars will change hands in the coming decades. Most of these assets will be transferred in a manner that is not protected from the claims of creditors or former spouses.
The laws of most states, including North Carolina, prohibit so-called "self-settled trusts" - an irrevocable trust you establish for your benefit, yet which purports to protect the trust assets from creditors. Therefore, once you receive an inheritance, it is too late to asset protect it. For potential inheritances, we can, by creating an Inheritance Trust to be the recipient of the inheritance, protect these assets. An Inheritance Trust legally protects the inherited assets yet allows you to access them as necessary. It also may remove a substantial portion of the assets from your potential taxable estate, thereby saving estate taxes at your death.
If you want to know more, please contact me.
Patrick
The traditional estate planning process focuses exclusively on passing assets downstream to beneficiaries (i.e., to children and grandchildren), often ignoring a potential inheritance from parents or other family members. However, Americans are living longer and longer and trillions of dollars will change hands in the coming decades. Most of these assets will be transferred in a manner that is not protected from the claims of creditors or former spouses.
The laws of most states, including North Carolina, prohibit so-called "self-settled trusts" - an irrevocable trust you establish for your benefit, yet which purports to protect the trust assets from creditors. Therefore, once you receive an inheritance, it is too late to asset protect it. For potential inheritances, we can, by creating an Inheritance Trust to be the recipient of the inheritance, protect these assets. An Inheritance Trust legally protects the inherited assets yet allows you to access them as necessary. It also may remove a substantial portion of the assets from your potential taxable estate, thereby saving estate taxes at your death.
If you want to know more, please contact me.
Patrick
Wednesday, September 1, 2010
Transferring Business Interests to Family Members: Sale of Non-Voting Stock Interests to Grantor Dynasty Trusts
Most of us have at least one client who has a family-owned or closely held business interest as a major part of their estate. Typically, that client has done nothing to plan for the succession of the business. That kind of planning can be challenging because of the complex tax issues and the human element (egos, relationships, etc.) involved. On the other hand, it can be most rewarding, and it offers excellent opportunities to create a deeper relationship with an existing client and build a relationship with the next generation. It also offers the opportunity to create ongoing professional relationships with other key advisors, as we must work together to achieve the best results for our mutual client.
Below, we will examine a case study of how clients can benefit from selling non-voting stock in a closely held business to a specific type of "grantor" dynasty trust.
Our Case Study
The Facts: Harry the husband, age 62, is married to Wilma the wife, age 58. This is a second marriage for both of them. They have no prenuptial agreement and no estate plan. Steve, who is Harry's son, is actively involved in Harry's business. Wilma's daughter Dottie is unemployed and not involved in Harry's business, which Wilma and Dottie resent. Harry and Wilma have one joint child, Mark, who is a minor and is also not involved in Harry's business. Neither Harry nor Wilma has used any of their $1,000,000 lifetime gift tax exemption.
Harry owns 100% of a business that is an S-corporation. It is very successful and has a current fair market value of $10 million. It also has significant cash flow and high growth potential. Harry's desire (which Steve shares) is for Steve to own and continue the business after Harry retires or dies.
There are significant other assets in the estate, including their home and other investments. Some are owned jointly by Harry and Wilma, and some are owned solely by Harry.
Under the probate laws of the state in which they live, if Harry dies intestate Wilma will receive half interest in each of Harry's assets and Steve and Mark will each receive a one quarter interest in each of them. As a result, Wilma, as Mark's guardian, will end up controlling 75% of the business while Steve will only control 25%. In addition, assuming Harry does not die in 2010, there will be a potentially huge estate tax liability. This is not what Harry wants to happen.
Harry's Goals and Objectives: After meeting with his team of advisors, Harry has defined his goals and objectives as:
To meet Harry's goals and objectives, here is the plan his advisors recommend and why:
Phase 1: Reorganize and Recapitalize the S-Corporation
In a tax-free reorganization, convert the S-corporation to a limited liability company taxed as an S-corporation with voting and non-voting common units.
Harry owns all of the 1,000 outstanding shares of the company. They are all voting shares. After the reorganization and issue of voting and non-voting membership units, Harry still owns 100% of the business, only now it is 10 LLC membership units (1%) that are voting and 990 (99%) that are non-voting. Why reorganization of the S-corporation into an LLC is part of the plan will be explained later.
Phase 2: Create Dynasty Trusts
Establish an irrevocable trust for each child that is designed so that its income is taxable to Harry and make initial contributions to the trust.
Harry creates three irrevocable grantor trusts, one for each child, in a jurisdiction that permits perpetual private trusts. The trusts are all "grantor" trusts for income tax purposes, but not for estate and gift tax purposes. These are known as Irrevocable Deemed Owned Trusts (IDOTs). Some call them Intentionally Defective Grantor Trusts (IDGTs).
Planning Tip: It is possible (and an excellent idea) to design the IDOTs so that their income being taxed to Harry can be stopped if that becomes desirable later.
Harry makes a $600,000 cash gift to the trust established for Steve. This is a taxable gift that must be reported on a Federal gift tax return (IRS Form 709). However, no gift tax will be due because $600,000 of Harry's $1 million lifetime gift tax exclusion will be used to shelter the gift from taxation.
Harry will also allocate $600,000 of his generation skipping transfer tax exclusion to Steve's trust. Steve's trust will therefore have a zero inclusion ratio (i.e., have a 0% tax rate) for generation skipping transfer tax purposes.
Planning Tip: In 2010, because the generation skipping transfer tax is suspended, this allocation cannot be made. Therefore, consider making late GST exemption allocations in 2011 when the GST returns, if Congress amends the tax code to permit doing so. Alternatively, delay implementing Phase 2 until 2011.
When Harry and Wilma make gifts to the trusts for Dottie and Mark, they do the same kind of allocations.
This trust structure provides a huge benefit to their descendants because the trusts' assets will never be included in their descendants' estates for estate tax purposes.
Phase 3: Sell Non-Voting Membership Units to Steve's Trust for an Installment Note
To give Steve ultimate ownership of Harry's business, start by selling all of the non-voting membership units to the dynasty trust for Steve.
To make a private sale or gift between family members of something valuable that does not have a known value, the IRS requires that a qualified valuation expert determine its fair market value. When what is sold or given away is an interest in a business, there are two steps to the valuation. First, the balance sheet assets owned by the business (real estate, specialized equipment, inventory, etc.) are valued. Then a business evaluation is performed to determine whether and to what extent the value of the assets underlying an interest in the business needs to be adjusted for lack of control over the business and lack of marketability of the membership interests.
The reason that the S-corporation was reorganized into an LLC taxed as an S-corporation is that limitations on the transferability of a business interest are disregarded in the valuation if they are greater than the default provisions of the state law that govern the business. The default provision for corporations is that there is no limitation on transferability. On the other hand, some states' default provision on LLC membership transfer is that all members must consent.
When the adjustments for lack of control and lack of liquidity are made to non-voting interests in an LLC, it is not uncommon that their cumulative effect is to depress the fair market value by a significant amount. In this case, we assume that the non-voting units' value will be depressed 40% because of lack of control and lack of marketability. Thus, the non-voting units will have a value of $6,000 per unit, making the total value of the 990 non-voting units $5,940,000.
Voting units will have a premium value to reflect the control value. In this example, the voting units have an appraised value of $12,000 per unit, making the total value of the 10 voting units equal to $120,000.
The fair market value of the entire company, sold as a unit, is still $10 million, but the value of the parts does not add up to $10 million! That it is only $5,940,000 + $120,000 = $6,060,000.
In this phase, Harry sells his 990 non-voting units to the dynasty trust for Steve using a 20-year installment note, payable annually. The note is for $5,940,000 (the fair market value of the 990 non-voting units) and is at a rate of 4.26% (which is slightly above the current long-term AFR rate). Based on the value and terms of the note, the trust will pay Harry $447,197 every year for 20 years. This is a legitimate arms-length business transaction because Steve's dynasty trust is a creditworthy borrower since its assets ($600,000 initial gift + $5,940,000 in LLC units) exceed the value of what it has bought by more than 10%.
Planning Tip: There is no "bright line" test for what is a commercially reasonable loan-to-value ratio. Many practitioners use 10%, but some are more comfortable at 20%.
Planning Tip: Make sure the installment note is handled just like an installment sale to a non-family member or to a bank. Have a signed pledge or security agreement, pay any tax required, do any filings required. Make sure you have a documented paper trail.
The Outcome
Company Ownership and Control
After Phase 3 is completed, Harry owns 10 voting units, which gives him 100% control of the business and 1% of the equity. The dynasty trust for Steve owns 990 non-voting units, which gives it no control over the business and 99% of the equity. The dynasty trust also has $600,000 in cash that Harry gifted to it as seed capital.
Income Tax Reporting
Harry is deemed to be the "owner" of the dynasty trust for Steve for purposes of reporting its income. As long as that is so, the dynasty trust for Steve does not have to file a Form 1041 fiduciary income tax return. Instead, an information return is filed, with the dynasty trust income tax information reported to Harry as the trust's deemed owner, for reporting on his personal Form 1040 income tax return.
Income Tax Effect of Sale of Membership Units
Harry's sale of LLC units to the dynasty trust for Steve is a "non-recognition" event. Because Harry is the deemed owner of the trust for income tax purposes, it is treated as a sale by Harry to himself. Thus no gain is recognized on the sale of the stock and no interest income is recognized on the installment note payments. Of course, the trust does not receive a deduction for interest payments made either.
"Pass Through" Dynasty Trust Income
Income from the LLC will be allocated to the unit holders based on their unit ownership percentages. Let's assume the business has $500,000 in net income. Harry owns 10 voting units, which is equal to 1% of the equity. Therefore, Harry will be allocated $5,000 in K-1 income. The dynasty trust for Steve owns 990 non-voting units, which is equal to 99% of the equity. Therefore it will be allocated $495,000 in K-1 income.
Because the dynasty trusts are structured as grantor trusts for income tax purposes, Harry must pay the income tax attributable to all of their income, including the S-corporation income that is allocated to the trust for Steve. But that is what he was doing before the sale of his non-voting units to Steve's trust, so he is paying the same income tax before and after the sale of the units. Harry's payment of the trusts' income tax is not an additional gift to the trusts, which means that every year Harry is transferring, gift tax free, additional estate assets to the trusts for the children.
How the Dynasty Trust Makes the Required Note Payments
We assume for this case study that the LLC will have $500,000 per year of cash flow to distribute to its unit holders. That will provide Steve's dynasty a cash distribution of $495,000 ($500,000 x 99% = $495,000). Thus at the end of year one it will have $1,095,000 in cash ($495,000 from the LLC and the $600,000 that was gifted to it as seed capital). The trustee can thus easily make the $447,197 note payment to Harry.
Planning Tip: If the company does not generate enough income to pay the note, take the same approach as if a borrower can't repay a bank loan. Options would include deferring payment until such time as the business recovers or renegotiating the term or interest rate of the note.
Results After Year One
At the end of the first year, the note has been reduced to $5,745,847 and the dynasty trust has a cash balance of $647,803. The trustee of the dynasty trust could use this cash to:
Planning Tip: A higher income tax rate would mean less income, but there may be other sources of income. For example, Harry is still in control of his company, and he may receive a salary as well as compensation as a Director on its Board.
Planning Tip: Harry may be able to reduce his salary from the LLC if he does not need the cash flow. This would save payroll tax and would give the business more cash flow. However, make sure he receives enough in salary to continue to qualify for group health insurance coverage.
When Harry Dies
If Harry has either consumed or gifted the net after the tax note payments that he receives from Steve's dynasty trust, only the unpaid balance of the note will be included in his taxable estate; there is no asset "build-up" inside his estate as the company grows.
The dynasty trust for Steve is GST "exempt" so that following Harry's death its assets will never be subject to estate, gift or GST taxation (unless the Congress changes the rules).
So are the dynasty trusts established for Dottie and Mark, so the life insurance proceeds received by them on Harry's death are also GST "exempt," providing a legacy for them and their descendants.
Harry could leave the 10 voting units (1%) to Steve in trust, too.
This arrangement would leave Steve's trusts owning 100% of the business and the other children's GST exempt trust shares owning cash.
Harry's wife Wilma will continue to receive the remaining note payments for her support.
Estate Tax Results
Using this technique, all of Harry's goals and objectives were met. His son Steve would receive the business without having to buy him out, yet Harry could control the timing of the business transfer. He was able to provide for his other children and his wife. In addition, Harry saved substantial estate taxes.
This technique also presents excellent opportunities for strengthening professional relationships, as it requires a team of advisors to work together to achieve these goals. Remember to collaborate as needed. Also remember to present the information to your clients and their advisors in a way that is easily understood and therefore less threatening. In order for your clients to be motivated to act, they must understand what you are recommending and the benefits to them.
Below, we will examine a case study of how clients can benefit from selling non-voting stock in a closely held business to a specific type of "grantor" dynasty trust.
Our Case Study
The Facts: Harry the husband, age 62, is married to Wilma the wife, age 58. This is a second marriage for both of them. They have no prenuptial agreement and no estate plan. Steve, who is Harry's son, is actively involved in Harry's business. Wilma's daughter Dottie is unemployed and not involved in Harry's business, which Wilma and Dottie resent. Harry and Wilma have one joint child, Mark, who is a minor and is also not involved in Harry's business. Neither Harry nor Wilma has used any of their $1,000,000 lifetime gift tax exemption.
Harry owns 100% of a business that is an S-corporation. It is very successful and has a current fair market value of $10 million. It also has significant cash flow and high growth potential. Harry's desire (which Steve shares) is for Steve to own and continue the business after Harry retires or dies.
There are significant other assets in the estate, including their home and other investments. Some are owned jointly by Harry and Wilma, and some are owned solely by Harry.
Under the probate laws of the state in which they live, if Harry dies intestate Wilma will receive half interest in each of Harry's assets and Steve and Mark will each receive a one quarter interest in each of them. As a result, Wilma, as Mark's guardian, will end up controlling 75% of the business while Steve will only control 25%. In addition, assuming Harry does not die in 2010, there will be a potentially huge estate tax liability. This is not what Harry wants to happen.
Harry's Goals and Objectives: After meeting with his team of advisors, Harry has defined his goals and objectives as:
- To have a comprehensive plan that will ensure ownership of the business will pass to his son Steve. (Steve also wants the security of knowing the business will one day become his.)
- To be in control of the timing of the transfer of the business.
- To treat his stepdaughter and his younger son fairly.
- To have enough cash flow for now and to provide for Wilma if he dies first.
- To save estate taxes.
To meet Harry's goals and objectives, here is the plan his advisors recommend and why:
Phase 1: Reorganize and Recapitalize the S-Corporation
In a tax-free reorganization, convert the S-corporation to a limited liability company taxed as an S-corporation with voting and non-voting common units.
Harry owns all of the 1,000 outstanding shares of the company. They are all voting shares. After the reorganization and issue of voting and non-voting membership units, Harry still owns 100% of the business, only now it is 10 LLC membership units (1%) that are voting and 990 (99%) that are non-voting. Why reorganization of the S-corporation into an LLC is part of the plan will be explained later.
Phase 2: Create Dynasty Trusts
Establish an irrevocable trust for each child that is designed so that its income is taxable to Harry and make initial contributions to the trust.
Harry creates three irrevocable grantor trusts, one for each child, in a jurisdiction that permits perpetual private trusts. The trusts are all "grantor" trusts for income tax purposes, but not for estate and gift tax purposes. These are known as Irrevocable Deemed Owned Trusts (IDOTs). Some call them Intentionally Defective Grantor Trusts (IDGTs).
Planning Tip: It is possible (and an excellent idea) to design the IDOTs so that their income being taxed to Harry can be stopped if that becomes desirable later.
Harry makes a $600,000 cash gift to the trust established for Steve. This is a taxable gift that must be reported on a Federal gift tax return (IRS Form 709). However, no gift tax will be due because $600,000 of Harry's $1 million lifetime gift tax exclusion will be used to shelter the gift from taxation.
Harry will also allocate $600,000 of his generation skipping transfer tax exclusion to Steve's trust. Steve's trust will therefore have a zero inclusion ratio (i.e., have a 0% tax rate) for generation skipping transfer tax purposes.
Planning Tip: In 2010, because the generation skipping transfer tax is suspended, this allocation cannot be made. Therefore, consider making late GST exemption allocations in 2011 when the GST returns, if Congress amends the tax code to permit doing so. Alternatively, delay implementing Phase 2 until 2011.
When Harry and Wilma make gifts to the trusts for Dottie and Mark, they do the same kind of allocations.
This trust structure provides a huge benefit to their descendants because the trusts' assets will never be included in their descendants' estates for estate tax purposes.
Phase 3: Sell Non-Voting Membership Units to Steve's Trust for an Installment Note
To give Steve ultimate ownership of Harry's business, start by selling all of the non-voting membership units to the dynasty trust for Steve.
To make a private sale or gift between family members of something valuable that does not have a known value, the IRS requires that a qualified valuation expert determine its fair market value. When what is sold or given away is an interest in a business, there are two steps to the valuation. First, the balance sheet assets owned by the business (real estate, specialized equipment, inventory, etc.) are valued. Then a business evaluation is performed to determine whether and to what extent the value of the assets underlying an interest in the business needs to be adjusted for lack of control over the business and lack of marketability of the membership interests.
The reason that the S-corporation was reorganized into an LLC taxed as an S-corporation is that limitations on the transferability of a business interest are disregarded in the valuation if they are greater than the default provisions of the state law that govern the business. The default provision for corporations is that there is no limitation on transferability. On the other hand, some states' default provision on LLC membership transfer is that all members must consent.
When the adjustments for lack of control and lack of liquidity are made to non-voting interests in an LLC, it is not uncommon that their cumulative effect is to depress the fair market value by a significant amount. In this case, we assume that the non-voting units' value will be depressed 40% because of lack of control and lack of marketability. Thus, the non-voting units will have a value of $6,000 per unit, making the total value of the 990 non-voting units $5,940,000.
Voting units will have a premium value to reflect the control value. In this example, the voting units have an appraised value of $12,000 per unit, making the total value of the 10 voting units equal to $120,000.
The fair market value of the entire company, sold as a unit, is still $10 million, but the value of the parts does not add up to $10 million! That it is only $5,940,000 + $120,000 = $6,060,000.
In this phase, Harry sells his 990 non-voting units to the dynasty trust for Steve using a 20-year installment note, payable annually. The note is for $5,940,000 (the fair market value of the 990 non-voting units) and is at a rate of 4.26% (which is slightly above the current long-term AFR rate). Based on the value and terms of the note, the trust will pay Harry $447,197 every year for 20 years. This is a legitimate arms-length business transaction because Steve's dynasty trust is a creditworthy borrower since its assets ($600,000 initial gift + $5,940,000 in LLC units) exceed the value of what it has bought by more than 10%.
Planning Tip: There is no "bright line" test for what is a commercially reasonable loan-to-value ratio. Many practitioners use 10%, but some are more comfortable at 20%.
Planning Tip: Make sure the installment note is handled just like an installment sale to a non-family member or to a bank. Have a signed pledge or security agreement, pay any tax required, do any filings required. Make sure you have a documented paper trail.
The Outcome
Company Ownership and Control
After Phase 3 is completed, Harry owns 10 voting units, which gives him 100% control of the business and 1% of the equity. The dynasty trust for Steve owns 990 non-voting units, which gives it no control over the business and 99% of the equity. The dynasty trust also has $600,000 in cash that Harry gifted to it as seed capital.
Income Tax Reporting
Harry is deemed to be the "owner" of the dynasty trust for Steve for purposes of reporting its income. As long as that is so, the dynasty trust for Steve does not have to file a Form 1041 fiduciary income tax return. Instead, an information return is filed, with the dynasty trust income tax information reported to Harry as the trust's deemed owner, for reporting on his personal Form 1040 income tax return.
Income Tax Effect of Sale of Membership Units
Harry's sale of LLC units to the dynasty trust for Steve is a "non-recognition" event. Because Harry is the deemed owner of the trust for income tax purposes, it is treated as a sale by Harry to himself. Thus no gain is recognized on the sale of the stock and no interest income is recognized on the installment note payments. Of course, the trust does not receive a deduction for interest payments made either.
"Pass Through" Dynasty Trust Income
Income from the LLC will be allocated to the unit holders based on their unit ownership percentages. Let's assume the business has $500,000 in net income. Harry owns 10 voting units, which is equal to 1% of the equity. Therefore, Harry will be allocated $5,000 in K-1 income. The dynasty trust for Steve owns 990 non-voting units, which is equal to 99% of the equity. Therefore it will be allocated $495,000 in K-1 income.
Because the dynasty trusts are structured as grantor trusts for income tax purposes, Harry must pay the income tax attributable to all of their income, including the S-corporation income that is allocated to the trust for Steve. But that is what he was doing before the sale of his non-voting units to Steve's trust, so he is paying the same income tax before and after the sale of the units. Harry's payment of the trusts' income tax is not an additional gift to the trusts, which means that every year Harry is transferring, gift tax free, additional estate assets to the trusts for the children.
How the Dynasty Trust Makes the Required Note Payments
We assume for this case study that the LLC will have $500,000 per year of cash flow to distribute to its unit holders. That will provide Steve's dynasty a cash distribution of $495,000 ($500,000 x 99% = $495,000). Thus at the end of year one it will have $1,095,000 in cash ($495,000 from the LLC and the $600,000 that was gifted to it as seed capital). The trustee can thus easily make the $447,197 note payment to Harry.
Planning Tip: If the company does not generate enough income to pay the note, take the same approach as if a borrower can't repay a bank loan. Options would include deferring payment until such time as the business recovers or renegotiating the term or interest rate of the note.
Results After Year One
At the end of the first year, the note has been reduced to $5,745,847 and the dynasty trust has a cash balance of $647,803. The trustee of the dynasty trust could use this cash to:
- Invest and save. (Income taxes on the earnings would be taxed to Harry.)
- Make distributions to the trust beneficiaries. (Distributions would be gift tax-free.)
- Buy life insurance on Harry's life.
Planning Tip: A higher income tax rate would mean less income, but there may be other sources of income. For example, Harry is still in control of his company, and he may receive a salary as well as compensation as a Director on its Board.
Planning Tip: Harry may be able to reduce his salary from the LLC if he does not need the cash flow. This would save payroll tax and would give the business more cash flow. However, make sure he receives enough in salary to continue to qualify for group health insurance coverage.
When Harry Dies
If Harry has either consumed or gifted the net after the tax note payments that he receives from Steve's dynasty trust, only the unpaid balance of the note will be included in his taxable estate; there is no asset "build-up" inside his estate as the company grows.
The dynasty trust for Steve is GST "exempt" so that following Harry's death its assets will never be subject to estate, gift or GST taxation (unless the Congress changes the rules).
So are the dynasty trusts established for Dottie and Mark, so the life insurance proceeds received by them on Harry's death are also GST "exempt," providing a legacy for them and their descendants.
Harry could leave the 10 voting units (1%) to Steve in trust, too.
This arrangement would leave Steve's trusts owning 100% of the business and the other children's GST exempt trust shares owning cash.
Harry's wife Wilma will continue to receive the remaining note payments for her support.
Estate Tax Results
- Harry has removed $10,600,000 of appreciating assets from his gross estate that, at his death, would be subject to estate tax. Unless the Congress acts quickly, the top rate after the catch-up tax will be 55% in 2011.
- Harry has received an asset (the self-amortizing note) that is based on a discounted asset value, frozen (will not appreciate in value) and depreciating (the note principal will decrease over the 20-year note amortization term).
- If Harry does not accumulate the note payments, then at the end of the note term (20 years), he will have totally removed the $10,600,000 (plus all future appreciation on this amount) from his gross estate without making a taxable gift other than the initial $600,000 seed capital gift.
- The trust assets are in a generation skipping tax-exempt trusts that can include asset protection features. These trust assets are not included in the children's or grandchildren's gross estates at their deaths.
Using this technique, all of Harry's goals and objectives were met. His son Steve would receive the business without having to buy him out, yet Harry could control the timing of the business transfer. He was able to provide for his other children and his wife. In addition, Harry saved substantial estate taxes.
This technique also presents excellent opportunities for strengthening professional relationships, as it requires a team of advisors to work together to achieve these goals. Remember to collaborate as needed. Also remember to present the information to your clients and their advisors in a way that is easily understood and therefore less threatening. In order for your clients to be motivated to act, they must understand what you are recommending and the benefits to them.
Friday, July 9, 2010
Retirement Accounts
No matter the amount of your retirement assets, proactive planning is critical because of the sometimes confiscatory taxes these assets are subject to – up to 70% or more in certain circumstances. As you may know, traditional retirement assets are not subject to income tax until withdrawal – and because the withdrawals consitute income, the larger the withdrawal, the higher the tax rate. If you’re like many of our clients, you want these assets to grow to the maximum extent possible, since assets not taxed until withdrawal grow much faster than assets that are taxed every year.
There are several strategies that can help you defer and perhaps eliminate the tax liability of these hard-earned assets, while at the same time legally protecting them from the creditors of your loved ones. These strategies can also help you coordinate your retirement plans with your overall estate and financial planning objectives to ensure that those objectives are met.
Retirement Plan Trust Planning can hep ensure maximum stretchouts but must be done carefully to avoid a requirement of early distributions.
There are several strategies that can help you defer and perhaps eliminate the tax liability of these hard-earned assets, while at the same time legally protecting them from the creditors of your loved ones. These strategies can also help you coordinate your retirement plans with your overall estate and financial planning objectives to ensure that those objectives are met.
Retirement Plan Trust Planning can hep ensure maximum stretchouts but must be done carefully to avoid a requirement of early distributions.
Thursday, July 8, 2010
Tax on Life Insurance
Few people realize that, even though they may have a modest estate, their families may owe hundreds of thousands of dollars in estate taxes because they own a life insurance policy with a substantial death benefit. This is so because life insurance proceeds, while not subject to federal income tax, are considered part of your taxable estate and are subject to federal estate tax.
The solution to this problem is to create an irrevocable life insurance trust that will own the policy and receive the policy proceeds on your death. A properly drafted life insurance trust keeps the insurance proceeds from being taxed in your estate as well as in the estate of your surviving spouse. It also protects the trust beneficiaries from their own “excesses”, against their creditors, and in the event of divorce. Moreover, the trust also provides reliable management for the trust assets. Here's how the irrevocable life insurance trust works.
You create an irrevocable life insurance trust to be the owner and beneficiary of one or more life insurance policies on your life. You contribute cash to the trust to be used by the trustee to make premium payments on the life insurance policies. If the trust is properly drafted, the contributions you make to the trust for premium payments will qualify for the annual gift tax exclusion, so you won't have to pay gift tax on the contributions.
The life insurance trust typically provides that, during your lifetime, principal and income, in the trustee's discretion, may be paid or applied to or for the benefit of your spouse and descendants. This allows indirect access to the cash surrender value of the life insurance policies owned by the trust, and permits the trust to be terminated if desired despite its being irrevocable. On your death, the trust continues for the benefit of your spouse during his or her lifetime. Your spouse is given certain beneficial interests in the trust, such as the right to income, limited invasion rights, and eligibility to receive principal. On the death of your spouse, the trust assets are paid outright to, or held in further trust for the benefit of, your descendants.
If you own a life insurance policy with a significant death benefit, an irrevocable life insurance trust may be of substantial benefit to you. Contact me you would like your situation assessed to see how you could benefit from an Irrevocable Life Insurance Trust.
The solution to this problem is to create an irrevocable life insurance trust that will own the policy and receive the policy proceeds on your death. A properly drafted life insurance trust keeps the insurance proceeds from being taxed in your estate as well as in the estate of your surviving spouse. It also protects the trust beneficiaries from their own “excesses”, against their creditors, and in the event of divorce. Moreover, the trust also provides reliable management for the trust assets. Here's how the irrevocable life insurance trust works.
You create an irrevocable life insurance trust to be the owner and beneficiary of one or more life insurance policies on your life. You contribute cash to the trust to be used by the trustee to make premium payments on the life insurance policies. If the trust is properly drafted, the contributions you make to the trust for premium payments will qualify for the annual gift tax exclusion, so you won't have to pay gift tax on the contributions.
The life insurance trust typically provides that, during your lifetime, principal and income, in the trustee's discretion, may be paid or applied to or for the benefit of your spouse and descendants. This allows indirect access to the cash surrender value of the life insurance policies owned by the trust, and permits the trust to be terminated if desired despite its being irrevocable. On your death, the trust continues for the benefit of your spouse during his or her lifetime. Your spouse is given certain beneficial interests in the trust, such as the right to income, limited invasion rights, and eligibility to receive principal. On the death of your spouse, the trust assets are paid outright to, or held in further trust for the benefit of, your descendants.
If you own a life insurance policy with a significant death benefit, an irrevocable life insurance trust may be of substantial benefit to you. Contact me you would like your situation assessed to see how you could benefit from an Irrevocable Life Insurance Trust.
Wednesday, May 26, 2010
Limited Partnerships and LLCs – Do you want to pass business assets to your family in a structured way?
The IRS continues to attack the discounted valuation of limited partnerships and LLCs, but taxpayers have had some recent court victories. These cases are very fact-specific but have some common elements. To note a few, the discounted valuation of an entity is more likely to be respected if: there were legitimate non-tax purposes for forming the entity; there is an ability to document active management of the entity’s assets; the client refrains from the use of an entity as a “pocketbook” for personal expenses; and sufficient assets are maintained outside the entity to provide for the client’s support and the payment of estate taxes on the client’s death. Clients with limited partnerships or LLCs in existence should ensure, in consultation with counsel and other advisors, that all necessary legal formalities (e.g., tax filings, periodic meetings, etc.) are being observed.
Wednesday, May 12, 2010
The Mysteriously Disappearing Federal Estate Tax
From Strauss & Associates, P.A. May 2010 Newsletter:
The old saying goes that nothing in this world is certain but death and taxes — but the disappearing federal estate tax proves the proverb wrong. The future of federal estate tax is all but certain.
Since 1914 the federal government has had some form of estate tax that applied to larger estates when their property passed to beneficiaries. In very basic terms, wealthy families paid significant taxes on the transfer of their fortunes from generation to generation. This reliable source of tax revenue helped to stabilize U.S treasury levels over the years.
Under strange circumstances, the federal estate tax was repealed for the first time in almost a century for the estates of those dying in calendar year 2010. However, some of these estates will still be subject to the estate or inheritance taxes imposed by particular states.
The current situation has its roots in from a 2001 federal law passed by the Republican-controlled Congress and signed by the second President George Bush — the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA). Dubbed the Death Tax by its opponents, the estate tax became subject to a curious 10-year reduction scheme, culminating in its one-year repeal in 2010 and a return to pre-EGTRRA levels in 2011. The unusual 10-year plan was blamed by some on complex congressional rules of procedure and budgeting.
For estate-tax relief, EGTRRA provides this graduated schedule of exemptions along with slowly decreasing tax rates from 50 percent in 2002 to 45 percent in 2009:
As 2010 approached, it was widely assumed by estate planning lawyers that the one-year estate tax lapse would be repealed by Congress and would never happen. Indeed, various proposals were introduced, but in a year dominated by the health care debate, 2010 dawned with the EGTRRA provisions intact and the estate tax unexpectedly lapsed.
A huge problem immediately became apparent. Wealthier people use a variety of complex estate planning tools to minimize the financial impact of the estate tax, such as bypass or marital trusts. While such arrangements make sense within the traditional estate tax structure, these provisions could be interpreted in 2010 when no estate tax is imposed to actually disinherit a surviving husband or wife, clearly contrary to the decedent's wishes.
Such potential problems make it imperative that people consult their estate planning attorneys as soon as possible to inquire whether they should make amendments to their plans, especially people who are ill and anticipate that their possible deaths in 2010 could set into motion legal consequences for the distribution of their estates they did not intend.
In addition, it is a good idea to get sound estate planning advice from a knowledgeable lawyer because it is unclear whether Congress will change the estate tax in some way after 2010. While some feel the repeal should be permanent, many think Congress may instead try to enact a retroactive estate tax for 2010, which would probably be challenged constitutionally. And what might happen after that is anybody's guess. In this uncertain time, get solid legal advice about how to protect your estate, especially if your assets are substantial enough to possibly be subject to a future estate tax.
The old saying goes that nothing in this world is certain but death and taxes — but the disappearing federal estate tax proves the proverb wrong. The future of federal estate tax is all but certain.
Since 1914 the federal government has had some form of estate tax that applied to larger estates when their property passed to beneficiaries. In very basic terms, wealthy families paid significant taxes on the transfer of their fortunes from generation to generation. This reliable source of tax revenue helped to stabilize U.S treasury levels over the years.
Under strange circumstances, the federal estate tax was repealed for the first time in almost a century for the estates of those dying in calendar year 2010. However, some of these estates will still be subject to the estate or inheritance taxes imposed by particular states.
The current situation has its roots in from a 2001 federal law passed by the Republican-controlled Congress and signed by the second President George Bush — the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA). Dubbed the Death Tax by its opponents, the estate tax became subject to a curious 10-year reduction scheme, culminating in its one-year repeal in 2010 and a return to pre-EGTRRA levels in 2011. The unusual 10-year plan was blamed by some on complex congressional rules of procedure and budgeting.
For estate-tax relief, EGTRRA provides this graduated schedule of exemptions along with slowly decreasing tax rates from 50 percent in 2002 to 45 percent in 2009:
- For a death in 2002 through 2003, $1 million of the estate exempt from tax
- For a death in 2004 through 2005, $1.5 million of the estate exempt from tax
- For a death in 2006 through 2008, $2 million of the estate exempt from tax
- For a death in 2009, $3.5 million of the estate exempt from tax
- For a death in 2010, no estate tax
As 2010 approached, it was widely assumed by estate planning lawyers that the one-year estate tax lapse would be repealed by Congress and would never happen. Indeed, various proposals were introduced, but in a year dominated by the health care debate, 2010 dawned with the EGTRRA provisions intact and the estate tax unexpectedly lapsed.
A huge problem immediately became apparent. Wealthier people use a variety of complex estate planning tools to minimize the financial impact of the estate tax, such as bypass or marital trusts. While such arrangements make sense within the traditional estate tax structure, these provisions could be interpreted in 2010 when no estate tax is imposed to actually disinherit a surviving husband or wife, clearly contrary to the decedent's wishes.
Such potential problems make it imperative that people consult their estate planning attorneys as soon as possible to inquire whether they should make amendments to their plans, especially people who are ill and anticipate that their possible deaths in 2010 could set into motion legal consequences for the distribution of their estates they did not intend.
In addition, it is a good idea to get sound estate planning advice from a knowledgeable lawyer because it is unclear whether Congress will change the estate tax in some way after 2010. While some feel the repeal should be permanent, many think Congress may instead try to enact a retroactive estate tax for 2010, which would probably be challenged constitutionally. And what might happen after that is anybody's guess. In this uncertain time, get solid legal advice about how to protect your estate, especially if your assets are substantial enough to possibly be subject to a future estate tax.
Saturday, May 8, 2010
Don’t both spouses automatically receive the $1,000,000 applicable exclusion amount for a total exemption of $2.0 million in 2011 without doing anything?
No! In order for married couples to fully utilize both spouse’s applicable exclusion amount of $1,000,000 in 2011 (assuming no new estate tax legislation), a plan must be in place. Unless they want to give assets to someone other than each other, their estate planning documents, whether in a will or a trust, must plan for the creation of a credit shelter trust at the first spouse’s death. Because clients do not know which spouse will be the first to die, both spouse’s plans should provide for the utilization of such tax credit shelter trusts. Many spouses believe that such credits would be given automatically, sheltering $2.0 million assets in 2011.
In reality, when one spouse provides in a will or trust to leave everything to the surviving spouse outright, then the first spouse to die does not use their $1,000,000 exemption, but instead places everything in the potential taxable estate of the surviving spouse. There is no tax at the first death due to the unlimited marital deduction. However, at the second death there will only be $1,000,000 that can pass without tax. The amount of assets above the exemption will be taxed at a rate of up to 55%. In order for both spouses to provide for each other and receive their own $1,000,000 exemption, they must plan to do so in a will or trust.
In reality, when one spouse provides in a will or trust to leave everything to the surviving spouse outright, then the first spouse to die does not use their $1,000,000 exemption, but instead places everything in the potential taxable estate of the surviving spouse. There is no tax at the first death due to the unlimited marital deduction. However, at the second death there will only be $1,000,000 that can pass without tax. The amount of assets above the exemption will be taxed at a rate of up to 55%. In order for both spouses to provide for each other and receive their own $1,000,000 exemption, they must plan to do so in a will or trust.
Wednesday, March 3, 2010
What is Gift-Splitting?
Oddly enough, married individuals can combine their annual exclusions and this is called “gift splitting”. For example, if you are married and have 3 children, you and your spouse can jointly give each child up to $26,000 each year. It doesn’t matter from whose assets the gift is made. If you give one child money or property that exceeds your individual annual exclusion of $13,000 and your spouse consents to the split, on the federal gift tax return, then both your spouse’s annual exclusion and yours can be applied and no gift tax will be due.
Thursday, February 18, 2010
Estate tax viewed as big Ag issue in ’10
It is no surprise that the Estate Tax will be a big issue for farmers and ranchers in 2010. They have a lot to lose if we go back to a $1 million estate tax exemption.
Go to Article.
Patrick
Go to Article.
Patrick
My Personal Thoughts on the Estate Tax
I have said for years that I thought we would actually have repeal in 2010. I have also thought that the estate tax exemption will go back to $1 million in 2011. Well we are more than 6 weeks into 2010, and we have repeal.
If Congress were to change the estate tax laws in any way during calendar year 2010, then they would essentially be legislating a tax increase. I understand that politicians do not particlularly like to vote for a tax increase, as it can impact re-election. If Congress waits until January 2011 to change the estate tax laws, then they would legislating a tax cut! Tax cuts are good for re-elections.
Anyways, I still think it will go back to $1 Million in 2011.
Take care, Patrick
If Congress were to change the estate tax laws in any way during calendar year 2010, then they would essentially be legislating a tax increase. I understand that politicians do not particlularly like to vote for a tax increase, as it can impact re-election. If Congress waits until January 2011 to change the estate tax laws, then they would legislating a tax cut! Tax cuts are good for re-elections.
Anyways, I still think it will go back to $1 Million in 2011.
Take care, Patrick
Thursday, February 4, 2010
Saturday, January 23, 2010
Tuesday, January 12, 2010
Estate Tax Debate: Choosing Children Over Charity? - Financial Planning
Estate Tax Debate: Choosing Children Over Charity? - Financial Planning
When Congress allowed the estate tax to expire at the end of 2009 it may not have realized that it was setting up a social experiment that could test the values of high-net-worth individuals.
When Congress allowed the estate tax to expire at the end of 2009 it may not have realized that it was setting up a social experiment that could test the values of high-net-worth individuals.
Friday, January 8, 2010
On the Money: Don't count on an estate tax repeal
On the Money: Don't count on an estate tax repeal. By Richard Behrendt , for BizTimes.
“To the dismay of most observers, Congress has ended its 2009 session without resolving the frustrating uncertainty surrounding federal estate tax rules. Efforts in the Senate to extend the 2009 estate tax rules, which included a $3.5 million exemption and a 45 percent tax rate, stalled just before the Christmas holiday.
Read More
“To the dismay of most observers, Congress has ended its 2009 session without resolving the frustrating uncertainty surrounding federal estate tax rules. Efforts in the Senate to extend the 2009 estate tax rules, which included a $3.5 million exemption and a 45 percent tax rate, stalled just before the Christmas holiday.
Read More
Estate Tax: What You Need to Know for 2010
Estate Tax: What You Need to Know for 2010:
At first glance, the failure of Congress to plug the 2010 estate tax loophole appears to be good news for children of ailing rich parents — and of little consequence to everyone else. But in fact, by letting the tax lapse, Congress has created a bunch of unintended consequences and increased the chances that you will owe taxes on an inheritance. Yes, the perverse result of the disappearing estate tax is that some people of lesser means may owe capital gains taxes on inherited assets. What’s more, since many wills and trusts are written on the assumption that the estate tax exists, a will that made sense last year (or any other year, for that matter) could result in your surviving spouse getting shut of your estate. Read More
At first glance, the failure of Congress to plug the 2010 estate tax loophole appears to be good news for children of ailing rich parents — and of little consequence to everyone else. But in fact, by letting the tax lapse, Congress has created a bunch of unintended consequences and increased the chances that you will owe taxes on an inheritance. Yes, the perverse result of the disappearing estate tax is that some people of lesser means may owe capital gains taxes on inherited assets. What’s more, since many wills and trusts are written on the assumption that the estate tax exists, a will that made sense last year (or any other year, for that matter) could result in your surviving spouse getting shut of your estate. Read More
Tuesday, January 5, 2010
Planning After “Repeal” of the Federal Estate Tax
From its inception, the 2001 tax act was scheduled to repeal the federal estate tax and generation skipping transfer tax (GSTT) for one year beginning January 1, 2010. This should come as no surprise. What is surprising, however, is the fact that the 2001 tax act has now played out and repeal, at least temporarily - and unless reinstated retroactively - is upon us. This article explores how we got here (which may be instructive as to what will happen in the future) as well as some of the planning implications of no federal estate tax or GSTT for at least some part of 2010.
How Did We Get Here?
On June 7, 2001, President George W. Bush signed into law the much-heralded Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA), designed to provide significant tax relief, including “permanent” relief from the federal estate tax (with its then $675,000 exemption and maximum 55% tax rate).
As we know, EGTRRA steadily lowered the maximum estate tax and GSTT rate to 45%, while increasing the exemption amounts to $3.5 million in 2009 and eliminating federal estate tax and GSTT altogether in 2010. However, as a result of a Senate rule that limits laws with a negative fiscal impact to 10 years (the so-called Byrd Rule), from inception EGTRRA contained a “sunset” provision. Under this provision, as of January 1, 2011, the law is scheduled to revert back to pre-EGTRRA law as if EGTRRA never existed. In other words, the federal estate tax and GSTT exemption will become $1 million (it was scheduled to increase under prior law) with a maximum rate of 55%.
Planning Tip: As a result of the Byrd Rule, practitioners should accept with caution EGTRRA interpretations that offer tax savings beyond 2010.
Planning Tip: In 2010 the estate tax and GSTT are replaced by a modified carryover basis system. The impact of modified carryover basis is discussed more fully below.
What Will Congress Do Now?
No one knows with certainty what Congress will do to remedy this situation but several key Congressmen have stated publicly that they will attempt to pass estate tax legislation early in 2010. One of them, Senator Max Baucus, Chairman of the Senate Finance Committee, has said that swift action is necessary to prevent “massive, massive confusion.”
Furthermore, many in Congress have expressed the desire to make such legislation retroactive to January 1, 2010. If Congress purports to make these tax charges retroactive to January 1, there are sure to be numerous lawsuits over the constitutionality of such retroactivity and, in all likelihood, these challenges would not be resolved until after years of litigation culminating in a Supreme Court decision. Where would that leave clients who die in the interim?
Planning Tip: It is not a foregone conclusion that Congress can make the estate tax legislation retroactive to January 1, 2010. Chief Tax Counsel to the House Ways and Means Committee, John Buckley, has opined publicly that reinstituting the estate tax retroactive to January 1, 2010, would be unconstitutional.
Cynics, however, note that these same Congressmen were unable to pass a one-year patch that would have eliminated the confusion in the first place. They also suggest that it is in the best interest of both Democrats and Republicans to do nothing and let EGTRRA sunset - and their argument has gained traction recently.
The argument is as follows: Democrats have incentive to do nothing because this law was passed by a Republican Congress and signed by a Republican President - they have no responsibility for the insanity caused by the sunset. Republicans, alternatively, are incentivized to do nothing because they have steadfastly argued for total repeal of the “death tax,” and this cry - at least in 2001 - resonated with the American people. Their argument is that Democrats had the opportunity to permanently end the “death tax” and chose not to. In what potentially will be a significant mid-term election, many in Congress will likely use their position on the “death tax” in an attempt to ensure reelection.
Planning Tip: Given the above factors, the most likely outcome for the estate tax will depend upon the other pressing priorities on Capitol Hill.
Modified Carryover Basis
Under our current estate tax system, subject to some exceptions, assets owned at death receive a basis “step-up” to their fair market value at the time of death. Therefore, if your client dies owning Walmart stock that he or she bought for $10,000 many years ago, for example, the beneficiaries could sell the stock at its fair market value of, say, $10 million, and pay little or no income tax. The only tax the beneficiaries would have to pay would be on the difference between the sale price and the fair market value at death. (Of course, the stock would also be subject to estate tax at the client's death.)
Under EGTRRA, along with repeal of the estate tax and GSTT in 2010, a beneficiary receives property with an adjusted basis equal to the lesser of the decedent's basis or the asset's fair market value on the decedent's date of death. Thus, EGTRRA eliminates the automatic “step-up” to the date of death value but retains the “step-down” for depreciating assets.
Planning Tip: Modified carryover basis will impact far more decedents than those who would have been impacted by the estate tax, 70,000 versus 6,000 according to some estimates.
To offset this loss of the step-up in basis, EGTRRA provides that the executor (or other person responsible for the decedent's property) may allocate a $1.3 million “aggregate basis increase” on an asset-by-asset basis up to the particular asset's fair market value at the date of the decedent's death. Assets left to a spouse may receive an additional $3 million “spousal property basis increase,” also asset-by-asset, up to the particular asset's fair market value at the date of the decedent's death.
Planning Tip: Unless one can affirmatively prove the basis of an asset, the IRS presumes that the asset has a basis of the property's approximate fair market value on the date it was acquired by its last owner. Therefore, it is absolutely critical that clients keep adequate records for all assets.
Planning Tip: It is worth noting that Congress instituted modified carryover basis one other time in history and repealed it retroactively because of the difficulty in administration.
Lifetime Powers of Appointment
Under current law, for purposes of the basis step-up, a surviving spouse owns property in a marital trust over which that spouse has a lifetime or testamentary power of appointment. However, for purposes of the $3 million spousal property basis increase, only a QTIP trust is eligible and EGTRRA treats property in a QTIP trust over which the surviving spouse has a lifetime power of appointment as not owned by that spouse. Thus, if the surviving spouse has a lifetime power of appointment over the QTIP trust the executor (or other person responsible for the decedent's property) cannot allocate the spousal basis increase to marital trust property. Alternatively, the executor can allocate the spousal property basis increase to QTIP property over which the surviving spouse has only a testamentary power of appointment.
Planning Tip: The planning team should review clients' marital trusts carefully to ensure availability of the spousal property basis increase.
The Impact on Existing Estate Plans
Residuary Marital Trust Formula Funding Clauses
Under a typical living trust or will, the document creates at least two trusts, a credit shelter (aka bypass or Family) trust and a marital trust. Often, the living trust or will language divides the decedent's property into the two trusts through what is known as a residuary marital trust formula funding clause, as follows: the amount of the decedent's property that will pass to the credit shelter trust equals the “maximum amount that can pass free of federal estate tax;” the balance of the decedent's assets pass to the marital trust.
If the client created this estate plan when the federal exemption was significantly lower, and in particular if the client dies in 2010, this common estate planning language will cause the unintentional over-funding of the family trust and under-funding of the marital trust. Where the family and marital trusts contain identical beneficiaries and dispositive provisions, this over-funding of the family trust and under-funding of the marital trust will have no significance. However, if the family and marital trusts contain different beneficiaries and/or different dispositive provisions, this may cause unintended and undesirable consequences to the client.
Planning Tip: The planning team should review all estate plans created more than five or so years ago to ensure that each plan meets the client's current planning objectives. The planning team should also review every estate plan created before 2001 to review the formula-funding clause.
For example, with second or subsequent marriages, and in particular where there are children from a prior marriage, the client often limits the surviving spouse's rights to the income from the marital trust, while the children from the prior marriage are often the beneficiaries of the credit shelter trust. If the client dies in 2010, all of the client's assets will pass to the credit-shelter trust, and the marital trust - i.e., the surviving spouse - will receive nothing! This is certainly not what the client wanted and it will not provide the state's statutory minimum to the surviving spouse. With few or no assets left to the surviving spouse, he or she may resort to a lawsuit against the trust or estate for the statutory minimum, thereby increasing legal fees and wreaking havoc with the estate plan.
Planning Tip: The planning team can help clients prevent this problem by working with the attorney team member to modify the will or trust language to ensure that assets are available for the surviving spouse.
Conclusion
Since most estate planners did not anticipate EGTRRA playing out into 2010, many clients' estate plans fail to take into consideration the lack of estate tax and its replacement, modified carryover basis. As the above discussion demonstrates, the key is flexibility and ensuring that clients' estate plans contain enough flexibility to accomplish their goals under changing circumstances.
How Did We Get Here?
On June 7, 2001, President George W. Bush signed into law the much-heralded Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA), designed to provide significant tax relief, including “permanent” relief from the federal estate tax (with its then $675,000 exemption and maximum 55% tax rate).
As we know, EGTRRA steadily lowered the maximum estate tax and GSTT rate to 45%, while increasing the exemption amounts to $3.5 million in 2009 and eliminating federal estate tax and GSTT altogether in 2010. However, as a result of a Senate rule that limits laws with a negative fiscal impact to 10 years (the so-called Byrd Rule), from inception EGTRRA contained a “sunset” provision. Under this provision, as of January 1, 2011, the law is scheduled to revert back to pre-EGTRRA law as if EGTRRA never existed. In other words, the federal estate tax and GSTT exemption will become $1 million (it was scheduled to increase under prior law) with a maximum rate of 55%.
Planning Tip: As a result of the Byrd Rule, practitioners should accept with caution EGTRRA interpretations that offer tax savings beyond 2010.
Planning Tip: In 2010 the estate tax and GSTT are replaced by a modified carryover basis system. The impact of modified carryover basis is discussed more fully below.
What Will Congress Do Now?
No one knows with certainty what Congress will do to remedy this situation but several key Congressmen have stated publicly that they will attempt to pass estate tax legislation early in 2010. One of them, Senator Max Baucus, Chairman of the Senate Finance Committee, has said that swift action is necessary to prevent “massive, massive confusion.”
Furthermore, many in Congress have expressed the desire to make such legislation retroactive to January 1, 2010. If Congress purports to make these tax charges retroactive to January 1, there are sure to be numerous lawsuits over the constitutionality of such retroactivity and, in all likelihood, these challenges would not be resolved until after years of litigation culminating in a Supreme Court decision. Where would that leave clients who die in the interim?
Planning Tip: It is not a foregone conclusion that Congress can make the estate tax legislation retroactive to January 1, 2010. Chief Tax Counsel to the House Ways and Means Committee, John Buckley, has opined publicly that reinstituting the estate tax retroactive to January 1, 2010, would be unconstitutional.
Cynics, however, note that these same Congressmen were unable to pass a one-year patch that would have eliminated the confusion in the first place. They also suggest that it is in the best interest of both Democrats and Republicans to do nothing and let EGTRRA sunset - and their argument has gained traction recently.
The argument is as follows: Democrats have incentive to do nothing because this law was passed by a Republican Congress and signed by a Republican President - they have no responsibility for the insanity caused by the sunset. Republicans, alternatively, are incentivized to do nothing because they have steadfastly argued for total repeal of the “death tax,” and this cry - at least in 2001 - resonated with the American people. Their argument is that Democrats had the opportunity to permanently end the “death tax” and chose not to. In what potentially will be a significant mid-term election, many in Congress will likely use their position on the “death tax” in an attempt to ensure reelection.
Planning Tip: Given the above factors, the most likely outcome for the estate tax will depend upon the other pressing priorities on Capitol Hill.
Modified Carryover Basis
Under our current estate tax system, subject to some exceptions, assets owned at death receive a basis “step-up” to their fair market value at the time of death. Therefore, if your client dies owning Walmart stock that he or she bought for $10,000 many years ago, for example, the beneficiaries could sell the stock at its fair market value of, say, $10 million, and pay little or no income tax. The only tax the beneficiaries would have to pay would be on the difference between the sale price and the fair market value at death. (Of course, the stock would also be subject to estate tax at the client's death.)
Under EGTRRA, along with repeal of the estate tax and GSTT in 2010, a beneficiary receives property with an adjusted basis equal to the lesser of the decedent's basis or the asset's fair market value on the decedent's date of death. Thus, EGTRRA eliminates the automatic “step-up” to the date of death value but retains the “step-down” for depreciating assets.
Planning Tip: Modified carryover basis will impact far more decedents than those who would have been impacted by the estate tax, 70,000 versus 6,000 according to some estimates.
To offset this loss of the step-up in basis, EGTRRA provides that the executor (or other person responsible for the decedent's property) may allocate a $1.3 million “aggregate basis increase” on an asset-by-asset basis up to the particular asset's fair market value at the date of the decedent's death. Assets left to a spouse may receive an additional $3 million “spousal property basis increase,” also asset-by-asset, up to the particular asset's fair market value at the date of the decedent's death.
Planning Tip: Unless one can affirmatively prove the basis of an asset, the IRS presumes that the asset has a basis of the property's approximate fair market value on the date it was acquired by its last owner. Therefore, it is absolutely critical that clients keep adequate records for all assets.
Planning Tip: It is worth noting that Congress instituted modified carryover basis one other time in history and repealed it retroactively because of the difficulty in administration.
Lifetime Powers of Appointment
Under current law, for purposes of the basis step-up, a surviving spouse owns property in a marital trust over which that spouse has a lifetime or testamentary power of appointment. However, for purposes of the $3 million spousal property basis increase, only a QTIP trust is eligible and EGTRRA treats property in a QTIP trust over which the surviving spouse has a lifetime power of appointment as not owned by that spouse. Thus, if the surviving spouse has a lifetime power of appointment over the QTIP trust the executor (or other person responsible for the decedent's property) cannot allocate the spousal basis increase to marital trust property. Alternatively, the executor can allocate the spousal property basis increase to QTIP property over which the surviving spouse has only a testamentary power of appointment.
Planning Tip: The planning team should review clients' marital trusts carefully to ensure availability of the spousal property basis increase.
The Impact on Existing Estate Plans
Residuary Marital Trust Formula Funding Clauses
Under a typical living trust or will, the document creates at least two trusts, a credit shelter (aka bypass or Family) trust and a marital trust. Often, the living trust or will language divides the decedent's property into the two trusts through what is known as a residuary marital trust formula funding clause, as follows: the amount of the decedent's property that will pass to the credit shelter trust equals the “maximum amount that can pass free of federal estate tax;” the balance of the decedent's assets pass to the marital trust.
If the client created this estate plan when the federal exemption was significantly lower, and in particular if the client dies in 2010, this common estate planning language will cause the unintentional over-funding of the family trust and under-funding of the marital trust. Where the family and marital trusts contain identical beneficiaries and dispositive provisions, this over-funding of the family trust and under-funding of the marital trust will have no significance. However, if the family and marital trusts contain different beneficiaries and/or different dispositive provisions, this may cause unintended and undesirable consequences to the client.
Planning Tip: The planning team should review all estate plans created more than five or so years ago to ensure that each plan meets the client's current planning objectives. The planning team should also review every estate plan created before 2001 to review the formula-funding clause.
For example, with second or subsequent marriages, and in particular where there are children from a prior marriage, the client often limits the surviving spouse's rights to the income from the marital trust, while the children from the prior marriage are often the beneficiaries of the credit shelter trust. If the client dies in 2010, all of the client's assets will pass to the credit-shelter trust, and the marital trust - i.e., the surviving spouse - will receive nothing! This is certainly not what the client wanted and it will not provide the state's statutory minimum to the surviving spouse. With few or no assets left to the surviving spouse, he or she may resort to a lawsuit against the trust or estate for the statutory minimum, thereby increasing legal fees and wreaking havoc with the estate plan.
Planning Tip: The planning team can help clients prevent this problem by working with the attorney team member to modify the will or trust language to ensure that assets are available for the surviving spouse.
Conclusion
Since most estate planners did not anticipate EGTRRA playing out into 2010, many clients' estate plans fail to take into consideration the lack of estate tax and its replacement, modified carryover basis. As the above discussion demonstrates, the key is flexibility and ensuring that clients' estate plans contain enough flexibility to accomplish their goals under changing circumstances.
Monday, January 4, 2010
Estate-Tax Repeal Means Some Spouses Are Left Out
Estate-Tax Repeal Means Some Spouses Are Left Out
WASHINGTON—Spouses of those wealthy who die this year might find themselves with nothing if the family will isn't revised—a major wrinkle that could follow Friday's repeal of the federal estate tax.
WASHINGTON—Spouses of those wealthy who die this year might find themselves with nothing if the family will isn't revised—a major wrinkle that could follow Friday's repeal of the federal estate tax.
Estate planning for business owners includes planning for transitions
Estate planning for business owners includes planning for transitions:
If you are an owner of or partner in a business, you may have an additional layer of estate planning to consider, especially since the business may be your family's largest asset.
If you are an owner of or partner in a business, you may have an additional layer of estate planning to consider, especially since the business may be your family's largest asset.
Don't let estate tax limbo be an excuse to do nothing
http://www.salisburypost.com/Opinion/010310-insight-walser-estate-tax
Don't let estate tax limbo be an excuse to do nothing
Don't let estate tax limbo be an excuse to do nothing
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