ESTATE PLANNING AFTER ESTATE TAX REPEAL By EDWARD L. PERKINS, JD, LLM (Tax), CPA I.
Overview of the New Estate Planning Reality A.
The ATRA of 2012
The American Taxpayer Relief Act of 2012 (the”ATRA”), signed into law on January 2, 2013. The ATRA reset the maximum estate tax rate at 40%, increased the federal estate tax exemption amount (termed the “Basic Exclusion Amount”) to $5,120,000 per individual, and made permanent the concept of “portability”. These changes effectively repealed the Federal Estate tax for over 98% of Americans, and fundamentally changed the nature of estate planning. This program will examine in detail how those changes have created a new estate planning reality, and what that means for the client and the estate planner. B.
Changes in the Unified Transfer Tax
The Federal Estate Tax
The ATRA established the maximum estate tax rate at 40%, and increased the federal estate tax exemption amount (termed the “Basic Exclusion Amount”) to $5,120,000 per individual. Indexed for inflation the Basic Exclusion Amount now stands at $5,450,000 per individual for 2016. 2.
The Federal Gift Tax
The gift tax exemption reunified with the estate tax exemption. This means that a $5,450,000 Basic Exclusion Amount is also available for gifts made in 2016 and $5,450,000 is available for gifts made in 2016. The highest marginal gift tax rate is the same as the highest estate tax, i.e. – 40%. 3.
The Generation Skipping Tax
The ATRA also impacted the generation-skipping transfer tax or “GST”. The GST exemption has now also risen to $5,450,000 for 2016. The GST tax rate for transfers made in 2016 will, like the estate and gift tax, is also 40%. 4.
An interesting change made permanent by the ATRA which significantly impacts on federal estate tax planning is the concept of “portability”. Portability basically allows the Basic Exclusion Amount which is unused by the estate of the first of a married couple to die to be carried over and used, with an interesting twist, by the surviving spouse’s estate. II.
The Old Estate Planning Reality A.
Estate Planning Pre -ATRA
Prior to the ATRA if the potential combined taxable estate of a husband and wife exceeded the Basic Exclusion Amount, the following planning steps were considered basic: 1. Adopting estate planning documents which included a marital deduction gift, and a Credit Shelter Trust; 2. Making sure each spouse owned sufficient assets in their name alone in order to fund the CST; 3.
Transferring ownership of life insurance to an irrevocable insurance trust;
Gifting assets during lifetime;
and These planning steps resulted in estate planning documents that were essentially driven by federal estate tax planning, resulting in dispositional choices that some considered unnecessarily complex. B.
The Credit Shelter Plan
If a married couple owned assets with a value large enough to be exposed to the federal estate tax, i.e., if the value of the gross estate exceeded the single federal estate tax exemption, a competent estate planner would certainly recommend documents designed to dispose of the estate assets in the following way: 1. Upon the death of the first spouse an amount equal to the federal estate tax exemption not utilized by the deceased spouse during their life time would pass to a trust sometimes termed a “Credit Shelter Trust” or “By Pass Trust”. The assets held by this trust although held for the benefit of the surviving spouse during his or her lifetime, would, if the trust was properly drafted, not be taxable in the surviving spouse’s estate for Federal Estate Tax purposes. 2. If the estate of the first of the married couple to die was large enough the value of the estate over the value passing to the Credit Shelter Trust would pass to the surviving spouse in a way which would qualify for the federal estate tax marital deduction. This so-called “marital deduction” gift could either be outright or also in trust. 3. Upon the death of the surviving the aggregate estate would pass to the couples then surviving heirs. The primary estate tax advantage realized by implementing a Credit Shelter Trust was to allow a married couple the opportunity to shelter an amount equal to twice the federal estate tax exemption from Federal Estate Tax, as the estate passed through both estates by taking advantage of both spouse’s Basic Exclusion Amount when transferring assets to their heirs. If this plan was implemented assets with a value up the level of the Basic Exclusion Amount could pass without estate tax to the Credit Shelter Trust upon the death of the first spouse, and if the Trust was properly structured, without estate tax again on the death of the survivor as well In order to 2
illustrate how this planning worked and appreciate the benefit of the Credit Shelter Plan consider the following two examples: Example One: Assume your clients are a married couple, Bill and Ruth. They have two children. Bill and Ruth have a probate estate valued at $6,000,000, and the federal exemption amount is $3,500,000. $4,500,000, of the couple’s assets are owned by Bill outright in his name alone and $1,500,000, is owned by Ruth outright in her name alone. Lets assume further that Bill and Ruth rather than implementing a Credit Shelter plan have an Estate Plan providing that on the death of the first of them to die everything passes to the survivor and then upon the death of the survivor to the children, in equal shares. Assume that Bill dies first. In this case Ruth would inherit Bill’s assets without federal estate tax. This is because his estate passes to a surviving spouse, and by reason of the federal estate tax marital deduction, the property in his estate is not taxed. On Ruth’s death, the entire estate of $6,000,000, i.e., $4,500,000 received from Bill, and the $1,500,000, she owns in her own name is fully taxable, and a federal estate tax of $1,225,000, is incurred. The problem with this approach is that while the couple incurred no estate tax upon Bill’s death, they missed the opportunity to fund a Credit Shelter Trust which would not be taxed in Ruth’s estate, i.e., they wasted Bill’s federal estate tax exemption. As noted, under the Credit Shelter Plan, instead of providing that the entire estate passes outright to the surviving spouse, the estate planning documents provide that an amount equal to the remaining federal estate tax exemption pass to the Credit Shelter Trust. Assets valued in excess of that amount will pass under this plan would pass to the surviving spouse either outright or in trust. Example Two: In Example One, above, we assumed that upon Bill's death, his entire estate of $4,500,000 would pass to Ruth outright, but under the Credit Shelter Plan,$3,500,000 of his estate (an amount equal to the federal estate tax exemption), would instead pass to the Credit Shelter Trust to be held for Ruth's benefit. The balance of Bill's assets (now valued at only $1,000,000) would pass to Ruth outside of the Credit Shelter Trust. When Ruth dies, the tax advantage of the Credit Shelter Trust becomes apparent. In Example One, when Ruth died, the entire aggregate estate was subject to the Federal Estate Tax. In Example Two, under the Credit Shelter Trust, only the $2,500,000 dollars that she owns outside of the trust was taxable. Therefore, the Federal Estate Tax of $1,225,000 in Example One was reduced to $0 through the use of the Credit Shelter Trust. The effectiveness of the Credit Shelter Trust in reducing the estate tax liability of a married couple was limited by several factors. First, the maximum amount that could be pass to the Credit Shelter Trust under the estate tax code on the death of the first spouse without incurring federal estate was limited to an amount equal to that spouse’s federal estate tax exemption amount. Second, the documents creating the Credit Shelter Trust had to be in place prior to the death of the first spouse. Since it was not in most cases possible to determine with certainty which spouse would die first, both the husband and the wife had to have the proper documents.
Another potentially limiting factor, was the amount of property owned outright by the first of a married couple to die. Even though the Credit Shelter Trust could shelter an amount equal to the federal estate tax exemption the funding occur from assets in the estate of the first spouse to die. Therefore each spouse had to have sufficient assets in their name alone to fund the Credit Shelter Trust, in case that spouse died first. There was a simple rule of thumb: if the estate has an aggregate value of twice the estate tax exemption or more, then each spouse should own assets with a value of at least the exemption amount. If the value of the estate is less than that amount, then each spouse should own one half of the combined estate in their name alone. Example Three: Assume the same fact as in Example One except that none of the couple’s assets are owned by Bill, and the entire estate of $6,000,000, is owned by Ruth outright in her name alone. Let’s assume that Bill and Ruth have implemented a Credit Shelter plan. Again, assume that Bill dies first. Since Bill owns no assets nothing will be subject to tax on his death. However upon Ruth’s death, the entire estate of $6,000,000, is fully taxable, and a federal estate tax of $1,225,000, is incurred. This because even with the Credit Shelter plan in place no assets passed into the Credit Shelter Trust on the death of the first spouse. C.
The Irrevocable Insurance Trust
The irrevocable insurance trust or “ILIT” can prove a valuable estate planning tool. If properly structured, the ILIT can effectively remove life insurance from an insured’s taxable estate with very little or no gift tax consequence. From a gift tax point of view, the transfer of the policy is generally a taxable gift, but its value is based on the cash surrender value of the policy and not is face value. On the other hand, if an individual dies owning the incidents of ownership on a life insurance policy, the face value of the policy is fully includable in their federal gross estate. As an alternative to naming one or more individuals or the insured's estate as the beneficiary of the life insurance policy, consideration should be given to having the policy owned by an irrevocable life insurance trust. An individual who already owns a life insurance policy may transfer that policy to an inter vivos trust or, if an individual has not already acquired a policy, he or she could create a trust and have the trustee acquire one or more policies on his or her life. Under either scenario, the life insurance policy will be the property of the trust. The trust will be both the owner of the life insurance policy and the beneficiary of the proceeds, and therefore it will not be taxed as part of the insured person’s estate. In the case of an existing policy, this does require that the transferor survives for three years after the transfer. The trust instrument then designates the intended beneficiaries of the policy and the nature and extent of their interests in the proceeds. This allows the insured to control the use and enjoyment of the funds through the trust. D.
In situations when the aggregate value of the estate exceeded the level at which the basic estate planning reviewed above could eliminate the anticipated federal estate tax (generally twice 4
the federal estate tax exemption), lifetime gift planning was often recommended. The case for making inter vivos gift transfers of interests in property lay in the opportunity to reduce the value that was ultimately subject to transfer tax. Lifetime transfers can achieve a meaningful and permanent reduction of that value in several ways. First, if the property is appreciating property, a lifetime transfer will remove any post transfer appreciation from the taxable estate. In addition, if the property is income producing property, the post transfer income will also be removed. Another aspect of the gift tax that is often not considered is the fact that the tax paid on inter vivos gifts is effectively removed from the tax base, while in the case of the estate tax, the tax is included and taxed in the tax base. Finally, there is the ability to discount the taxable value transferred by taking advantage of the annual exclusion and certain discounting techniques. III.
The New Estate Planning Basics A.
After the enactment of the AFTRA, the question of whether the Credit Shelter Trust is still a necessary part of a married couple’s estate plan comes into question because of two important changes made to the federal estate tax: (1) the addition of “portability”, and (2) the increased level of the Basic Exclusion Amount. The increased level of the Basic Exclusion Amount coupled with the addition of portability to the planning equation, brings into question whether traditional estate planning already in place should be abandoned in favor of simpler plans and what form estate planning should take going forward. Finally, the question of when lifetime gifts should be made must be addressed. These questions will be the subject of this section of this program. B.
In Light of Portability Does a Spousal Trust Still Work?
What exactly is “portability”? After the ATRA the Basic Exclusion Amount that is not utilized when the first of a married couple passes away may now be available or “portable” to reduce the federal estate tax of the surviving spouse. Specifically, the American Taxpayer Relief Act provides that, in the case of the estate of the surviving spouse, the Basic Exclusion Amount is equal to what is termed the “Applicable Exclusion Amount”. That amount is equal to the sum of (1) the “Basic Exclusion Amount” (i.e., currently $ $5,450,000 indexed for inflation) and (2) the “Deceased Spouse’s Unused Exclusion Amount”. The “Deceased Spousal Unused Exclusion Amount” is defined as the “Unused Exclusion Amount” of the “last deceased spouse” - in other words the Basic Exclusion Amount still available to the estate of the individual who was the last husband or wife of the surviving spouse before they died. This definition makes it irrelevant how much property the surviving spouse actually inherited from their husband or wife, or whether the surviving spouse inherited any property from that spouse at all. The only question is how much of the Basic Exclusion Amount was utilized by the deceased spouse’s estate when they died. Example Four: Assume that Bill dies first in 2016 and leaves his entire estate to Ruth outright. Ruth would inherit Bill’s assets without federal estate tax by reason of the marital deduction. The property in his estate is not taxed. As a result Bill’s Basic Exclusion Amount is not used and the Deceased Spousal Unused Exclusion 5
Amount is $5,450,000. Provided Ruth does not remarry, upon Ruth’s death the Applicable Exclusion Amount available to her estate is $10,900,000 (i.e., the sum of the Deceased Spouses’ Unused Exclusion Amount of $5,450,000, and the Basic Exclusion Amount of $5,450,000 available to her estate). 2.
Why the Credit Shelter Trust is still the Better Option
One of the primary objectives of both the Credit Shelter Trust and portability is to ensure that both spouses can take advantage of their Basic Exclusion Amounts of $5,450,000. The Credit Shelter Trust achieves this objective by funding the trust from the estate of the first spouse to die. As illustrated above portability allows the estates of married couples to utilize the Basic Exclusion Amount available to each spouse’s estate without the need of implementing a Credit Shelter Trust or other sophisticated planning as part of their estate plan. Does this make Credit Shelter Trust Planning obsolete? Let’s compare the two. b.
The Credit Shelter Trust - In order for a Credit Shelter Trust to accomplish the objective of allowing both spouses’ estates to each take full advantage of the Basic Exclusion Amount, several things must be done properly. First, the proper documents implementing the Credit Shelter Trust must be in place prior to the death of the first of the married couple to die, and second, the first spouse to die must have sufficient assets in their name alone to fund the trust in an amount up to the Basic Exclusion Amount. Obviously, if a Credit Shelter Trust is not adopted by the first spouse to die it cannot achieve the intended result. However, even when a Credit Shelter Trust has been adopted, if the first spouse to pass away does not own sufficient assets to fund the trust to the level of the Basic Exclusion Amount, the full advantage to be realized by adoption of the Credit Shelter Trust will be lost. Portability - As alluded to above one problem with portability is that amount of the Unused Exclusion Amount available to the surviving spouse’s estate is dependent upon the Unused Exclusion Amount of the “last deceased spouse”. The planning issues with this requirement are obvious. Consider this example: Assume the same facts as the immediately preceding Example above. Example Five: Assume that Ruth remarries after Bill’s death to Harry. Harry has his own children to whom he wishes to leave his entire estate. Harry predeceases Ruth and in his will leaves his entire estate of $5,450,000, to his surviving children. His executor claims Harry’s entire Basic Exclusion Amount of $5,450,000. In this case Ruth’s Applicable Exclusion Amount is only $5,450,000, her own Basic Exclusion Amount of $5,450,000, limited to her own Basic Exclusion Amount. Because of the fact that Harry utilized his entire Basic Exclusion Amount upon his death the “Deceased Spouse’s 6
Unused Exclusion Amount” is zero (-0-). She gets no benefit from Bill’s Unused Exclusion Amount of $5,000,000. A second issue with portability is that in order to claim the Unused Exclusion Amount, the executor of the estate of the deceased spouse must have filed an estate tax return which computes the Unused Exclusion Amount and make an election that such amount shall be taken into account. The amount of the exclusion considered “unused” will be dependent upon the values stated on that return. The statute requires that this return be timely filed and the statute of limitations to audit the return is suspended. This raises the question of whether all estates no matter what their size should file a federal estate tax return or risk not having the Unused Exclusion Amount of the first spouse to die being available to the surviving spouse’s estate. Suppose for example at the time of Bill’s death the combined estate was only $4,000,000, and no estate tax return was filed when Bill died. By the time Ruth dies the estate is now worth $6,000,000. Can her estate still claim Bill’s Unused Exclusion Amount to shelter estate tax? The answer seems to be no – since as stated by the statute a timely filed estate tax return is required. c.
Shelters Appreciation from Estate Tax
The Credit Shelter Trust - The Credit Shelter Trust can only be funded on the death of the first spouse with an amount equal to the Basic Exclusion Amount without incurring the federal estate tax. However on the death of the survivor it is not only that value but also the appreciation realized on that value that will pass estate tax free. Portability - The Basic Exclusion Amount of the survivor is indexed for inflation. However the value of the Deceased Spouse’s Unused Exclusion Amount is not indexed. As a result that amount will be fixed at the time of his or her death. As a result the appreciation on that causes assets inherited from the first spouse to exceed the Deceased Spouse’s Unused Exclusion Amount will not be sheltered from estate tax. d.
The Credit Shelter Trust - Since the assets passing to the Credit Shelter Trust are held by a trust, they will be administered by the Trustee. Depending on the identity and expertise of the Trustee this may allow the surviving spouse to take advantage of that management expertise. Portability - Since assets held by the surviving spouse will be held by that spouse outright no management of the assets will be available. e.
The Credit Shelter Trust - Assets passing to the Credit Shelter Trust will be disposed of according to the terms of the trust as determined by the settlor spouse. Portability - If assets pass to the surviving spouse that spouse will control their ultimate disposition. f.
The Credit Shelter Trust - The assets held by the Credit Shelter Trust cannot be attached by the creditors of the trust beneficiary if the trust contains a valid spendthrift clause.
Portability - Assets passing to a surviving spouse outright will be subject to the debts and liabilities of the survivor. Therefore, no asset protection will be available. g.
The Credit Shelter Trust – In the past many estate plans have employed a strategy designed to ensure that generation transfer tax exemption of the first of a married couple to die is not wasted. This strategy involved creating a sub trust to the credit shelter trust plan which would be fully exempt from GST Tax. Since the decedent would be considered the “transferor” of the share of the estate passing to this sub trust of the Credit Shelter Trust, the decedent’s GST Exemption would be allocable to this share. In addition a second sub trust could be created within the marital trust share if necessary, and by a “reverse QTIP election”, the decedent would be considered the “transferor” of this share as well. Since, the generation skipping tax exemption is not portable this type of GST planning is only possible if a Credit Shelter Trust is part of the estate plan. Portability - If the estate plan relies on portability to shelter the estate from estate tax, the estate runs the risk that avoidable GST could be incurred. h.
Availability of Step Up in Basis.
The Credit Shelter Trust - Assets passing into a Credit Shelter Trust will qualify for a step up in basis equal to fair market value on the first spouse’s death but not upon the death of the surviving spouse. Portability - If the entire aggregate estate of the married couple is held outright by the surviving spouse at the time of his or her death, then the entire aggregate estate will qualify for a step up in basis upon the surviving spouse’s death. i.
Both the Credit Shelter Trust and portability allow the estates of both the husband and wife the opportunity to take full advantage of the Basic Exclusion Amount in each of their estates. One advantage of portability over the Credit Shelter Trust planning lies in the fact that it also allows the entire aggregate estate to receive a basis step up at the survivor’s death. However, the Credit Shelter Trust affords other distinct planning advantages over portability which may make it a better planning alternative. Therefore, in most cases, the adoption of a Credit Shelter Trust as part of the estate plan is still recommended. Essentially portability should only be relied upon to correct problems which result from under funding the Credit Shelter Trust upon the death of the first spouse – either because no Credit Shelter Trust was never implemented or because the estate of the first spouse to die did not have sufficient assets in their name alone at death to fund the Credit Shelter Trust. Another planning area in which Portability can serve useful is the disposition of IRAs and qualified retirement plans. In the past if the client owned significant IRAs and/ or qualified retirement plan balances the estate planner was often faced with a choice: Use the IRA or qualified 8
plan to fund the Credit Shelter Trust, and possibly incur greater income tax liability, or make the plans payable to the surviving spouse and incur potentially higher estate tax. With Portability payment of the retirement plan proceeds directly to the surviving spouse can be made without exposing the proceeds to greater estate tax liability. IV.
Estate Planning After Tax Repeal A.
If Credit Shelter Trust is still recommended the following questions must be addressed: •
For which estates?
What is the form of the document?
Are there any additional provisions to consider?
In addition other issues involving the estate plan such as when to recommend the Irrevocable Life Insurance Trust and when to recommend aggressive gift planning should also be address. B.
The Form of the Estate Planning Documents
If Credit Shelter Trust is still recommended the following questions must be addressed: •
For which estates?
What is the form of the document?
Are there any additional provisions to consider?
In addition, other issues involving the estate plan such as when to recommend the Irrevocable Life Insurance Trust and when to recommend aggressive gift planning should also be addressed. The old adage in estate planning was that if the potential combined taxable estate of a husband and wife exceeded the Basic Exclusion Amount, a Credit Shelter Trust planning was appropriate. The reasoning being that if the entire estate passed outright to the surviving spouse their sole Basic Exclusion Amount would not be sufficient to shelter the estate from the federal estate tax. Therefore, Credit Shelter Trust planning was required to ensure that the Basic Exclusion Amount was utilized to shelter the combined estate from the federal estate tax. Therefore, assuming that a Credit Shelter Trust is for many estates the favored estate plan the question becomes “What form should it take?” 2.
Prior to 2013, if Credit Shelter Trust was part of the estate plan of a married couple it was often structured to reduce or avoid the federal estate tax by taking advantage of the estate tax marital deduction and the Basic Exclusion Amount in the most efficient way possible. The proper allocation between the Credit Shelter Trust and the marital deduction share was normally created by formula, generally either a formula that defined the marital deduction gift and the amount allocated to the Credit Shelter Trust in terms 9
of the marital deduction gift (a “minimum marital deduction formula”), or a formula that defined the marital deduction gift and the Credit Shelter Trust in terms of the Basic Exclusion Amount (a “credit shelter formula”). In either case the result was much the same, an amount up to the Basic Exclusion Amount passed to the Credit Shelter Trust and the excess passed pursuant to the marital deduction gift. If the surviving spouse is, as is the case in many estate plans, the sole beneficiary of both shares then the amount at which the Basic Exclusion Amount is set, whether $5,450,000 or some other figure, should not present any concerns. However if the Credit Shelter Trust benefits individuals in addition to or other than the surviving spouse, allocation between the two shares created by the new higher level Basic Exclusion Amount remains consistent with the planning objectives of the testator. This may involve a formula clause which caps the share passing to the Credit Shelter Trust to a certain amount or percentage of the estate, or perhaps divides the shares on a percentage basis, rather than based on the Basic Exclusion Amount. 3.
The QTIP Trust
One way to build flexibility into the plan is to utilize a single QTIP Trust. Under this alternative, the plan would involve disposition of the residual estate to a single trust which qualifies as a QTIP trust. Upon death of the first of the married couple to die the residual estate of that spouse would pass to that trust. The executor could then decide by election the portion of the trust that would qualify for the estate tax marital deduction and the credit shelter share, based upon the level of the Basic Exclusion Amount at that time. 4.
The Disclaimer Trust
Another way to build flexibility into the plan is to implement a so-called “Disclaimer Trust”. Under this plan the disposition of the residual estate is made to the surviving spouse outright, with the right to disclaim any or all of the residual estate in favor of the Credit Shelter Trust. This arrangement would allow the surviving spouse to determine the proper allocation between the marital (i.e., the share passing outright), and the Credit Shelter Share. 5.
Provisions Designed to Obtain Basis Step Up
The primary disadvantage of the Credit Shelter Trust as compared to portability is that assets held by the Credit Shelter Trust are not stepped up on the death of the second of a married couple to die. In situations where the surviving spouse’s Applicable Exclusion Amount exceeds the value of that spouse’s estate transferring low basis property from the Credit Shelter Trust to the surviving spouse in order to allow for a basis step up in their hands may be advantageous. In order to allow for this possibility, the document could contain one or more of the following provisions. The document could contain a liberal distribution provision which allows the trustee to distribute appreciated property to the surviving spouse in the trustee’s discretion unlimited by an 10
ascertainable standard. A more drastic version of this power might allow complete termination of the trust. Of course only a trustee independent from the trust beneficiary should hold such a power. In both cases the distribution or termination will remove the property from the trust and place it in the hands of the surviving spouse. Another alternative that could avoid this result is simply allowing the third party to grant the surviving spouse a general power of attorney over the trust. The granting of the power will allow for the property in the trust to be taxable in the surviving spouse’s estate and obtain a basis step up. If the power is unexercised the property would remain in the trust subject to disposition under the trust terms. b.
Simultaneous Death Provisions
Under the concept of portability, the “Deceased Spousal Unused Exclusion Amount” is defined as the “Unused Exclusion Amount” of the “last deceased spouse” - in other words the Basic Exclusion Amount still available to the estate of the individual who was the last husband or wife of the surviving spouse before they died. Under the Uniform Simultaneous Death Act in situations where husbands and wives die in a common occurrence, in probating their respective estates each is presumed to have survived the other – therefore no portability. Care should be taken that a clause be included in the documents reversing this presumption and designating one of the spouse’s as the survivor in the event of death in a common occurrence. Here is a sample clause: “If my spouse and I shall die under such circumstances that the order of our deaths cannot be readily ascertained, my spouse shall be deemed to have predeceased me. No person, other than my spouse, shall be deemed to have survived me if such person dies within 30 days after my death. This article modifies all provisions of this will accordingly”. C.
Must pre 2013 Documents be amended?
The question of whether pre-2013 documents should be amended may depend upon whether the documents contain one or more of the provisions discussed in this section. Certainly, formula allocation clauses should at the very least be examined to determine if they still fit a client’s disposition plan, and if not should be amended. V.
When Are Gifts Recommended? A.
The question of whether a gift giving program should be adopted as a part of the estate plan is addressed in this section. The case for making inter vivos gift transfers of interests in property lies in the opportunity to reduce the value that is ultimately subject to transfer tax. Lifetime transfers can achieve a meaningful and permanent reduction of that value in several ways. First, is the availability of the $14,000, per donee per year (the "annual exclusion") for gifts of “present interests. Second, if the property is appreciating property, a lifetime transfer will remove any post transfer appreciation from the taxable estate. In addition, if the property is income producing property, the post transfer income will also be removed. Another aspect of the gift tax that is often not considered is the fact that the tax paid on inter vivos gifts is 11
effectively removed from the tax base, while in the case of the estate tax, the tax is included and taxed in the tax base. Finally, there is the ability to discount the taxable value transferred by taking advantage of the annual exclusion and certain discounting techniques, discussed below. The primary disadvantage in making lifetime gifts to be considered is the loss of the step up in basis to fair market value that occurs when assets are retained in the taxable estate until death. The donee of property gifted during the donor's life takes a carryover of basis from the donor, increased by any gift tax attributable to the amount by which the fair market value of the gifted property exceeds basis at the time of the gift. In situations where the estate tax incurred is less than the tax benefit of a step up in basis, an inter vivos transfer may not be advisable. The ATRA, combined with the Affordable Care Act of 2010, have dramatically increased the potential impact of capital gains on estate planning, particularly gift giving strategies. The 2012 Act increased the maximum federal capital gain rate beginning in 2013 from 15% to 20% for higher bracket taxpayers (i.e., taxable income above $400,000 for single filers and $450,000 for joint filers). The Affordable Care Act had previously added a 3.8% surtax beginning in 2013 on net investment income for higher income taxpayers (i.e., modified adjusted gross income above $200,000 for single filers and $250,000 for joint filers). This results in a combined federal capital gain rate of 23.8% for higher bracket taxpayers, an increase of 8.8% over the maximum rate that applied prior to 1/1/13. (This represents almost a 60% increase in the combined federal taxes imposed on capital gains.) B.
Step Up in Basis
The basis of property acquired from a decedent by inheritance, bequest, devise, etc., that hasn't been sold, exchanged, or otherwise disposed of before the decedent's death, is generally equal to its fair market value (â€œFMVâ€?) at the date of the decedent's death. However, if: (1) The fiduciary elects for estate tax purposes to value the decedent's gross estate at the alternate valuation date, the basis of the property is its FMV at that date; (2) The fiduciary elects for estate tax purposes the special use valuation method of valuing farm or other closely held business real property included in the decedent's gross estate, the basis of the real property is its value determined for purposes of the special use valuation election (rather than its FMV); (3) Land acquired at death is subject to a qualified conservation easement, it is excluded from the decedent's gross estate (an executor may elect (on Form 706, Schedule U) to exclude from the gross estate up to 40% of the value of land subject to a qualified conservation easement meeting certain requirements and subject to a dollar cap of $500,000, and its basis (to the extent that it's subject to the easement) is the basis in the hands of the decedent. Fair market value on the date of the decedent's death (or the alternate valuation date, if applicable) doesn't apply to determine the basis of property: 12
(1) That's appreciated property acquired by the decedent by gift in the 1-year period ending on his death, and that is reacquired by the donor (or the donor's spouse) from the decedent, (2) Included in the decedent's estate but disposed of by the taxpayer before the decedent's death, (3) That's stock in a domestic international sales corporation (DISC) or former DISC, or of certain foreign entities; or. (4)
That is a right to receive income in respect of a decedent.
The fair market value (FMV) of property at the decedent's death or at the alternate valuation date is the FMV as determined by an appraisal for federal estate tax purposes. If no federal estate tax return is required to be filed, the FMV of the property appraised as of the date of death for purposes of state inheritance or other transmission taxes (e.g., legacy taxes) is used to determine FMV. However, if no federal estate tax return is filed, the alternate valuation date cannot be used to determine FMV The executor can elect (irrevocably, on Form 706) to use an alternate valuation date rather than the decedent's date of death to value the property included in the gross estate. This alternate date is generally six months after decedent's death or earlier date of sale or distribution. The alternate valuation can be elected only if its use decreases both the value of the gross estate and the combined estate and GST tax liability. C.
Basis Adjustment for Gifted Property
The donee's basis for property acquired by gift or transfer in trust is usually the same as the donor's adjusted basis at the time of the gift plus all or part of the gift tax paid on the gift. Property acquired by gift has a single or uniform basis although more than one person may acquire an interest in the property. If property was acquired by inter vivos gift (i.e., by reason other than the death of the donor), whether the gift was made outright or in trust, the basis in the hands of the recipient-donee, at the date of the gift, may be the same basis as it would be in the hands of the donor or it may be the fair market value of the property at the time of the gift. Which basis applies depends on the purpose for which it is determined, namely: . . . for determining gain, and for depreciation, depletion, or amortization, the donee's basis is the same as the donor's adjusted basis, for loss purposes the donee's basis is the lower of the donor's basis or the fair market value, when the gift was made. The donee's basis for property acquired by gift is increased by all or a portion of the federal gift tax paid on the gift. Any basis increase for gift tax paid is treated as an adjustment to the basis of the property. Thus, the gift tax paid can increase the donee's basis for determining depreciation, depletion, or amortization, as well as for determining gain or loss. The amount of the increase in basis for gift tax paid is the amount of the gift tax attributable to the net appreciation in value of the gift. The tax attributable to the net appreciation is determined by multiplying the gift tax paid with respect to the gift by the net appreciation in value of the gift and dividing the result by the amount of the gift. Net appreciation in value is the amount by which the fair market value of the gift exceeds the donor's adjusted basis immediately before the gift. For purpose of the above computation, the â€œamount of the giftâ€? is the value of the gift as finally determined for purposes of the gift tax. This means that in making the above computation the value of the gift is to be 13
reduced by any portion excluded or deducted under the applicable: (a) annual exclusion of Code Sec. 2503(b); (b) charitable deduction of Code Sec. 2522; and (c) marital deduction of Code Sec. 2523. D.
This makes the essential question â€œAre the estate tax savings resulting from making a gift greater than the value of a basis step up?â€? It is an over simplification to assume that since gifts result in loss of the opportunity to realize a basis step up to fair market value, that lifetime gifts should never be recommended. Rather a careful analysis should be made in order to determine the relative benefit of making the gift in terms of transfer tax savings as compared to the benefit of basis step up. In making this analysis I would suggest an approach illustrated by the following hypothetical: Assume Ms. A is single and has estate valued at $10,430,000, consisting of just two assets classes, cash of $5,000,000, and $5,450,000 in marketable securities with a basis in her hands of $1,000,000. Sale of the marketable securities will result in long term capital gain if sold. Also assume that Ms. A has not utilized any of her Basic Exclusion Amount of $5,450,000, up to this point in her life. In order to determine whether Ms. A should gift the marketable securities, determine the net after tax value available to her heirs by assuming first that she gifted the marketable securities during her lifetime retaining the remaining assets in her estate: (1) First, determine the gift tax consequences of the gift. In this case there will be no actual tax due as the result of the transfer, but Ms. A will have utilized her full Basic Exclusion Amount. (2) Second, in order to determine the value of the loss of the basis step up, determine the net after income tax proceeds assuming the marketable securities were immediately sold by the donee: Gross Sales Price Adjusted Basis
$5,450,000 - 1,000,000
Long term capital gain $4,430,000 Rate .238 Income Tax
This would leave net after income tax value of $4,375,660. (3) Next determine the net after estate tax value of the remaining assets in her estate, assuming Ms. A then died. Since Ms. A utilized her full Basic Exclusion Amount, the remaining 14
$5,000,000, in her estate would be subject to federal estate tax at the forty (40%) percent rate; resulting in a $2,000,000, federal estate tax. This would leave net after estate tax value of $3,375,660 (4) Add the two amounts determined in (1), and (2) above. The total net after tax value resulting from making the lifetime gift is $7,375,000. Next, assume Ms. A retained the marketable securities in her estate and then died. Assume again that her heirs sold the marketable securities immediately upon receipt. (1) First, determine the net after estate tax value of the remaining assets in her estate, assuming Ms. A then died. Again the $5,000,000 in estate value, over and above the Basic Exclusion Amount, would be subject to the federal estate tax resulting in a tax of $2,000,000, and net after estate tax value of $3,000,000. (2) Next, determine the net after tax income proceeds assuming the marketable securities were immediately sold by the done. Since the adjusted basis of the marketable securities would be step up to fair market value at the date of death there would be no gain on the hypothetical sale of these assets leaving a net after income tax proceeds of $5,450,000. (3) Adding the two amounts determined in (1), and (2) above, results in total net after tax value resulting from retaining the assets in the estate of $8,430,000. Not surprisingly, the difference between the two alternatives, i.e., $1,054,340, is the value of basis step up. All things being equal because the Unified Transfer Tax system makes it a tax neutral choice as to whether an individual makes lifetime gifts or retains assets in their estate, it would seem that the loss of step up in basis inherent in making a lifetime gifts, would make it never the proper planning choice to make a lifetime gift. However, again it is a drastic over simplification to assume, that lifetime gifts should never be recommended. Here are some of the considerations which should be taken into account in making this decision: 2.
Differences in Taxable Value
One of the advantages of making lifetime gifts is that the value subject to the gift tax can be significantly less than the value ultimately subject to the estate tax. This can be for any one or more of the reasons reviewed below: a.
Appreciation and Income
By making a gift of a property interest the taxable value of the transferred interest is limited to the value of that interest at the time of the transfer. Any post transfer appreciation is removed from the taxable estate. Under the right circumstances an inter vivos gift may remove significant value from the taxable estate. Also, often overlooked is that fact that the income, realized by the transferred property, such as dividends, interest, and rental income, is also removed from the taxable estate. b.
The Annual Exclusion
The Internal Revenue Code allows for an exclusion from gifts of $14,000,1 per donee per year (this is called the "annual exclusion") for gifts of “present interests.”2 As a result, a single transferor may deduct $14,000 from the taxable transfers made to each transferee each year. The value that qualifies for the annual gift tax exclusion is never taxed. Over time, following a plan of annual gift giving can remove significant value from the taxable estate by taking advantage of the annual exclusion. In order to qualify for the annual exclusion, the property interest transferred must constitute a gift of a "present interest." A present interest must grant the donee the immediate right to use, possess, and enjoy the gifted property. An outright gift will constitute a gift of a present interest, but a transfer of property in trust may or may not constitute a gift of a present interest, depending on the terms of the trust. c.
A valuation “discount” is a reduction in the otherwise determined value of an equity interest in an ownership interest in an entity, such as a corporation, partnership or limited liability company. One significant advantage of making a lifetime transfer of property which involves an interest in business or income producing property is the ability to utilize valuation discounts which are often difficult to obtain through a testamentary transfer. Some of the more significant discounting techniques which are available to the planner include utilizing family limited partnerships, and gifts of minority interests in business assets. d.
Preferential Gifting Techniques
There are several ways that an inter vivos transfer can be made other than a straight gift of the property. These alternative methods may result in transfer tax savings. Four of those options are discussed in this section: (i) the grantor retained annuity trust (“GRAT”), (ii) the sale to an intentionally defective grantor trust in exchange for a private annuity, (iii) the sale to an intentionally defective grantor trust in exchange for a Self-Canceling Installment Note, and (iv) the qualified personal residence trust. It should be kept in mind when analyzing the tax advantage realized by these techniques that with the exception of the personal residence trust, require an “add back” to the estate. Pursuant to a GRAT, an owner transfers his or her ownership interest in the property to an irrevocable trust retaining a current income interest in the trust for a specified term (anticipated to be shorter than the grantor's life expectancy). The sale to an intentionally defective grantor trust is in exchange for a private annuity. The private annuity must be set at a sufficient level that it is equal in value to the interest transferred. In the case of the Self-Canceling Installment Note, the transaction is the same as that described in regard to the private annuity except that instead of a private annuity the transferor receives an installment note in the exchange that cancels by its terms at the time of the transferor’s death. These “add backs” will reduce the valuation advantage of making the lifetime transfer. 1 2
This figure is adjusted for inflation. A “present interest” is an interest that the donee has the present right to enjoy the ownership of the transferred property.
Removal of Tax Paid from the Tax Base
An aspect of the gift tax that is often not considered is the fact that the tax paid on inter vivos gifts is effectively removed from the tax base while in the case of the estate tax the tax is included and taxed in the tax base, provided the gift takes place within three years of the death of the transferor. Hereâ€™s an example: Example: Mr. E has an estate of $20,000,000. If he makes a lifetime gift of $10,000,000 â€“ the resulting gift tax of $1,706,250 is removed from his taxable estate. On his subsequent death only the $8,293,750, remaining in his estate will be taxed resulting in an estate tax and additional transfer tax of $2,902,812. This would leave net $15,390,937 for the heirs .If on other hand he made no lifetime transfers the entire $20,000,000 will be subject to the estate tax on his death, the estate tax would be $5,206,250, leaving the heirs with $14,793,750, after tax. 3.
The Type of Asset to be Transferred
Also to be considered is the type of property to be transferred. a.
Highly Appreciated Assets
Obviously, assets with a low basis relative to fair market value will benefit to a greater degree from a basis step up at death as compared to assets with a higher basis relative to fair market value. Also to be considered is the chance that he asset will appreciate post transfer. Asset such as cash, and debt securities would not be in this category, but marketable securities and undeveloped real estate, for example, may be. b.
Tax Rate Differences
The value of a basis step up in depends in large part on the income tax rate that would apply in the event of the sale or exchange of the particular property. The rates can vary from a 0% tax to 39.6% depending on the type of asset. The top marginal rate for ordinary income and short term capital gain being 39.6%, and for long term capital gain 20%. (1)
Capital assets include all assets except the following: (a) Stock in trade of the taxpayer or other property of a kind that would properly be included in the inventory of the taxpayer if on hand at the close of the tax year.(b) Property held by the taxpayer primarily for sale to customers in the ordinary course of his trade or business.(c) Accounts or notes receivable acquired in the ordinary course of a trade or business for services rendered or from the sale of any properties described in (a) or (b), above.(d) Depreciable property, amortizable Code Sec. 197 intangibles, and real property used in the taxpayer's trade or business.(e) Certain copyrights, literary, artistic, or musical works (unless, for musical works or copyrights in them, and certain letters, memoranda, or similar property, (f) U.S. government publications (e.g., Congressional Record) received from the government without charge or below the price sold to the public, in the hands of the recipient and carryover-basis transferees.(g) Commodities derivative financial instruments held by a commodities derivatives dealer (except for certain instruments not connected to the dealing activity).(h) Any hedging transaction (e.g., to manage risk of price changes or currency fluctuations) 17
clearly identified as such before the close of the day on which it was acquired, originated, or entered.(i) Supplies of a type regularly used or consumed by the taxpayer in the ordinary course of the taxpayer's trade or business. Holding a capital asset for the short-term holding period (one year or less) results in shortterm capital gain or loss on the sale or exchange of that asset. Holding a capital asset for the longterm holding period (more than one year) results in long-term capital gain or loss on the sale or exchange of that asset. The holding period for property acquired by gift includes the donor's holding period if the property has the same basis for gain or loss (see ¶ 2463 et seq.) in whole or in part in the hands of the donee as it would have in the donor's hands. But if the property is sold by the donee at a loss based on its market value on the date of the gift (and not the donor's basis), the holding period starts from the date of the gift. The holding period of property acquired from a decedent starts with the date of death. However, property acquired from a decedent which is sold within the short-term capital gain holding period after the decedent's death is considered to be held for the long-term capital gain holding period if the person selling the property has a basis that is determined under Code Sec. 1014 (by reference to the property's fair market value on the date of death or alternate valuation date). The long-term holding period is also met where special use valuation property is acquired by a “qualified heir” from the decedent's estate, and is sold within the short-term holding period to another “qualified heir.” (2)
Ordinary Income Property
Gain realized on the disposition of property which does not constitute a capital asset in the hands of the taxpayer is taxed at regular income tax rates. Generally this would include inventory and other property held primarily for the sale to customers in the ordinary course of business. (3)
Surtax on Investment Property
In addition a tax is imposed, in addition to income tax, on an capital gains that constitute “investment income”. The tax is 3.8% of the lesser of (a) the estate's undistributed net investment income or (b) the excess of the estate's AGI over the dollar amount at which the highest estate income tax bracket begins. (4)
Property Subject to Depreciation Recapture
A gain on the disposition of Section 1245 property is treated as ordinary income to the extent of depreciation or amortization allowed or allowable on the property. The following deductions are treated as amortization for purposes of the Section 1245 recapture rules: the expense deduction under Code Sec. 179; the deductions under Code Sec. 179B and Code Sec. 179C (for property generally placed in service before 2010) for certain refining costs; the deduction for the cost of energy efficient commercial buildings under Code Sec. 179D; the deduction for the costs incurred before 2010 of qualified film and TV productions under Code Sec. 181; qualified 18
architectural and transportation barrier removal expenses under Code Sec. 190; and reforestation expenses under Code Sec. 194. Part or all of the gain on the sale or other disposition of Section 1250 property may be treated as ordinary income. But where property was held more than one year, there's no depreciation recapture if it was depreciated via straight line. Thus, Section 1250 recapture doesn't apply to residential rental or nonresidential real property depreciated under MACRS. For Section 1250 property held more than one year, the amount of gain treated as ordinary income is the lower of (1) the “applicable percentage” of the part of the “additional depreciation” (see below) attributable to periods after '75, or (2) in the case of a sale, exchange or involuntary conversion, the excess of the amount realized over the adjusted basis, or in the case of any other disposition, the fair market value of the property over its adjusted basis. (5)
Unrecaptured Section 1250 Property
Unrecaptured section 1250 gain, taxed at a maximum rate of 25%, is the excess (if any) of: (1) the amount of long-term capital gain which is not otherwise treated as ordinary income, and which would be treated as ordinary income if Code Sec. 1250(b)(1) recapture applied to all depreciation (rather than only to depreciation in excess of straight line), and the applicable percentage under Code Sec. 1250(a) were 100%, over (2) the excess (if any) of the amount of losses taken into account in computing 28% rate gain over the amount of gains taken into account in computing 28% rate gain. (6)
Intellectual property, including copyrights, artwork, patents, and trademarks, which provide an extraordinary tax planning opportunity has a zero basis in the hands of the creator. In addition, income realized upon the sale or exchange of intellectual property will be treated as ordinary income. Making gifts of intellectual property should not be recommended. The donee will be considered to hold an ordinary income asset with a carryover basis of zero, and a basis for the property determined in whole or in part by reference to the basis in the hands of that donor. Conversely, a testamentary transfer of the property would result in a step up in basis as well as converting the property to a capital asset. (7)
The taxation of artwork in the hands of the artist is the same as it would be for the creator of a copyright, as discussed above. c.
IRAs and Qualified Retirement Assets
IRA and qualified retirement assets are not transferable during the lifetime of the owner, so the assets are never candidates for lifetime gifts unless the owner is willing to incur a taxable distribution of the assets. A distribution from a decedent's IRA to a surviving spouse may be “rolled over” to another qualified retirement plan or IRA, thereby deferring the recognition of income. In addition, if the surviving spouse is the beneficiary of all or a portion of the decedent's IRA, the surviving spouse may also elect to treat the decedent's IRA as his or her own IRA. In both of the foregoing cases, the IRD problem discussed is deferred until after the death of the surviving spouse (unless the surviving spouse remarries). d.
Loss Property 19
A capital loss sustained by a decedent during his lifetime is deductible only on the final return filed on his behalf. No part of the capital loss can be carried to later years. Since the adjusted basis of the loss property will be reset to fair market value at the date of death, the ability to realize the loss by the estate beneficiaries will be lost if the property remains in the estate. A lifetime gift of the property will result for loss purposes in a donee's basis equal to the lower of the donor's basis or the fair market value, when the gift was made. Therefore the recommended approach is for the owner to realize the loss during lifetime and then either gift or retain the proceeds. e.
Section 1244 (“Small Business Corporation”) Stock.
Loss on the sale, exchange or worthlessness of Section 1244 stock is deductible, within limits, as an ordinary loss, even though gain on the stock is capital gain. This ordinary deduction is available only to an individual to whom the stock was issued by a small business corporation, or an individual who was a partner in a partnership at the time the stock was issued to a partnership by a small business corporation. Transferees of these original purchasers don't qualify. Therefore again the recommended approach if feasible is for the owner to realize the loss during lifetime and then either gift or retain the proceeds. f.
Mortgaged real estate in which the amount of the mortgage exceeds the property's adjusted basis, is sometimes referred to as “negative basis” property as well as negative capital. The difference between the amount of unpaid mortgage and the property's basis is referred to as the minimum gain amount. The sale of such property will trigger gain to the extent that the unpaid mortgage balance exceeds the property’s adjusted basis even if no other consideration is realized upon the sale or exchange of the property. As a result a lifetime gift of such property treated as a part gift/part sale may trigger taxable income in the amount of such excess. On the other hand, death of the owner will not trigger this phantom income, and the step up in basis will either reduce gain on the sale of the property or increase the beneficiary's depreciation deduction. g.
Upon the death of a partner, the transfer of a decedent's interest in the partnership does not result in gain or loss, even if the deceased partner's share of liabilities exceeds outside basis. The basis of a partnership interest acquired from a decedent is the fair market value of the interest at the date of his death or at the alternate valuation date, increased by his estate's or other successor's share of partnership liabilities, if any, on that date, and reduced to the extent that such value is attributable to items constituting income in respect of a decedent. If a Section 754 election applies, an adjustment is made to the tax basis of the partnership property as a result of the partner's death. 4.
Time Value of Money
The present value of an amount of expense or receipt is always less than or equal to the future value because money has interest-earning potential, a characteristic referred to as the time 20
value of money, except during times of negative interest rates, when the present value will be greater than the future value. Time value can be described with the simplified phrase, “A dollar today has a greater worth than a dollar tomorrow”, a dollar today is worth more than a dollar tomorrow because the dollar can be invested and earn a day's worth of interest, making the total accumulate to a value more than a dollar by tomorrow. Interest can be compared to rent. On the other hand a dollar of expense paid today is more expensive than a dollar of expense realized in the future. The old adage “Defer tax and accelerate deductions” should be kept in mind in making disposition decisions. In this context, this translates into out of pocket gift tax realized today may prove more expensive than later incurred estate tax even if the amounts are equal. Likewise, the value of a step up in basis in regard to an asset is retained by the estate beneficiaries may be a lesser value or no value. 5.
State and Local Income Tax and State Inheritance Tax
In performing an analysis of whether an asset should be gifted during lifetime or retained in the estate, don’t overlook the impact of state and local income tax, and state inheritance tax on your calculations. VI.
Techniques to Increase Basis A.
Transfer Property to the Dying Spouse
A donor (or the spouse of the donor) of “appreciated property” may reacquire the property from the donee if the donee later dies. If the conditions described below are met, the basis of the reacquired property to the donor (or spouse) is the adjusted basis of the property to the donee-decedent immediately before the death of the donee-decedent. This “adjusted basis rule”—rather than the “stepped-up basis” rules —applies only if: (1) the property was acquired by the donee-decedent by gift and the donee dies within one year of the gift; and (2) the property is acquired from the donee-decedent by—or passes from the donee-decedent to—the donor (or the donor's spouse). If these conditions do not apply the transfer of property to the first of a married couple to pass away can achieve basis step up without by reason of the marital deduction incurring additional federal estate tax. B.
The Estate Tax has historically included certain “string provisions” which bring back into the gross estate of a transferor, property transferred by lifetime gift but pursuant to which the transferor retained an interest or control over the property until death. In the current environment of a significantly increased Basic Exclusion Amount, these provisions can be used in situations where the client wishes to make a lifetime gift of property, and at the same time realize a step up in basis at death. 1.
a. Overview. Sec. 2036 requires that property once owned by the decedent and gifted during lifetime be included in the decedent's gross estate if the decedent retained a life interest in the property. b. The Elements of Sec. 2036. Sec. 2036 provides that a decedent's gross estate includes value of any interest in property transferred by the decedent whether in trust or otherwise if the following elements of sec. 2036 are present: 21
(1) Transfer Requirement. The decedent must have made a transfer of property during lifetime for less than adequate return consideration in money or money's worth. (2) Retention Requirement. The decedent must have retained either: (i) the right to the income, (ii) the right to use or enjoy the property transferred, or (iii) the right to control the income, use or enjoyment of the property. (3) The Period Requirement. The retention of the right or control must be either: (i) for the decedent's lifetime, (ii) a period which does not end before the decedent's death, or (iii) for a period which cannot be ascertained without reference to the decedent's death. c. Retention of Voting Rights. Sec. 2036(b) provides that a retention of voting rights in the shares of stock of a "controlled corporation" transferred after June 22, 1976, will cause the stock to be included in the decedent's gross estate if: (1) The voting rights are retained for the decedent's life or for a period that cannot be ascertained without reference to the decedent's death or for any period that does not in fact end before the decedent's death. (2) A "controlled corporation" is defined as one in which the decedent and his or her relatives owned at least 20 percent of the total combined voting power of all classes of stock at any time after the transfer of the property or within three years of the decedent's death. d.
(1) W transfers $100,000 into trust retaining the right to the income from the property for life. W's retention of the income from the transferred property for life requires inclusion of the full value of the property transferred in W's gross estate under sec. 2036. (2) Z transfers ownership of his house to R, but retains the right to live in the house for ten years. Z dies within 5 years of the transfer. Z's retention of the enjoyment from the transferred property for a period, which did, not in fact end prior to Z's death requires inclusion of the full value of the property transferred in his gross estate under sec. 2036. (3) Q transfers $100,000 in trust retaining the right to allocate the income between R and S, until death. Q's retention of control over the income from the transferred property for life requires inclusion of the property transferred in her gross estate under sec. 2036. 2.
a. Overview. Sec. 2038 requires inclusion of the property or property interest when the decedent has made a gratuitous lifetime transfer but retained the right to revoke the transfer or alter the nature of the transfer until death. b.
The Elements of Sec. 2038. In order for sec. 2038 to apply the following elements must be
present: (1) Transfer Requirement. The decedent made a transfer of property for less than adequate consideration in money or money's worth. 22
(2) transfer. (3)
Right to Alter or Revoke. The decedent retained the right to revoke or alter the Power Exists at Death. Such power must exist at the time of death.
c. Example: E transfers property into trust for the benefit of F, but retains the right to revoke the trust for life. Sec. 2038 will require inclusion of the trust property in E's estate, whether or not the property would be returned to E or E's estate upon revocation. d. Nature of the Power to Alter or Revoke. The key to the applicability of sec. 2038 is whether the enjoyment of an interest in property transferred by the decedent during his or her lifetime is subject to "any change" prior to his or her death by reason of a power retained by the decedent over the property. Almost any authority retained by the decedent to tamper with the enjoyment of interest transferred during lifetime will constitute a power to "alter or amend, revoke or terminate". (1) Power to Revoke. The broadest power that the decedent might hold is the power to revoke the transfer. A power to terminate a trust is expressly described in sec. 2038. (2) Power to Alter or Amend. It is long recognized that sec. 2038 is not limited to powers that can be exercised to the benefit of the decedent. (a) Power over Beneficial Interests. The power to alter or amend under sec. 2038 encompasses a power generally to name new beneficiaries of a trust and the power to change beneficial interest among a limited group of beneficiaries. For example, if D transfers property and trust income to A for life or remainder to B or B's estate, but reserves the right to invade corpus for the benefit of either A or B, invasion for the benefit of either will affect the enjoyment of the interest of the other and so both interests are subject to change within the meaning of the section. (b) Power over the Time or Manner of Enjoyment. The IRS's position is that if the "time or manner" of enjoyment of an interest may be altered, the interest is subject to sec. 2038. Thus, the retained right to accelerate a property interest is within sec. 2038. For example, F transfers property in trust for the benefit of G. The trust is to last until G attains age 30, at which time the trust will terminate and be distributed to G. F retains the right to terminate the trust and distribute the trust property to G prior to age 30. The property is subject to sec. 2038. (c) Administrative Powers. It is probably now a settled principal that holding a mere administrative or managerial power over trust assets does not constitute powers to alter beneficial interest within sec. 2038. On the other hand, an unrestrained power to make investments of trust property is within sec. 2038. (d) Gift to Minors. As discussed above in regard to sec. 2036, a transferor who acts as custodian of property transferred to a Uniform Transfers to Minors Account or
Uniform Gift to Minors Account has retained the power to "alter" the gift, and sec. 2038 will apply. e.
Power in Whatever Capacity.
Sec. 2038 applies to a power, whatever capacity; i.e., whether as a trustee or
(2) Powers held by a third party will not be ascribed to the transferor. However, if the decedent holds the unrestricted power to remove or discharge a trustee at any time and appoint himself trustee, the decedent is considered to have all the powers of the trustee. f.
Powers Restricted by Standard.
(1) A power to "alter or amend" restrained by an ascertainable standard such as "health, education, support, or maintenance", will preclude the application of sec. 2038 to the transfer. (2) For example, assume L transfers property to a trust, reserving the discretion as trustee to make distributions of income to his son, M, or accumulate income in the trust. If the discretion of the trustee can only be exercised if a need for "health, education, or maintenance" of the child is present, then sec. 2038 does not apply. (3) On the other hand, if the discretion can be exercised by the trustee without restraint, then sec. 2038 will apply. g. Source of Power. Sec. 2038 provides that it makes no difference, whatever, whenever or from whatever source the power the decedent acquired the prescribed power. h. Whether Held Alone or With Another. The fact that the power to "alter or amend" the gift is held in conjunction with another is not considered in determining whether sec. 2038 will apply to a particular transfer of property. i. When Power must Exist. The power must exist at the time of the decedent's death. A release, unless it occurs within three years of death, precludes inclusion. j. Amount to be Included. Sec. 2038 includes in the gross estate, the value of any interest in property transferred by the decedent, which was subject on the date of the decedent's death to being changed through one of the prescribed powers. The value of the estate includes only the value of the property subject to change. For example, if the decedent had the power to change only an income interest, sec. 2038 requires that there be included in the estate only the value of that interest. 3.
a. Overview. Sec. 2041 requires property to be included in the decedent's gross estate if the decedent held a "general power of appointment" over the property at the time of death. b.
The Elements of Sec. 2041.
(1) General Rule. Sec. 2041 provides that all property over which a decedent possessed a "general power of appointment" at his or her death is includible in his or her gross estate. (2) Possession of the Power at Death. It is the possession of the general power of appointment by the decedent, not its exercise, which triggers inclusion under sec. 2041. (a) A general power created after October 21, 1942 and held by the donee will result in taxability of the subject property in his or her estate if he or she merely holds the power until his or her death. (b) Also, it is not required that the decedent ever actually own the property which is the subject of the power, for inclusion to result. (3) Only "General Powers of Appointment" Covered. Only powers defined as "general powers of appointment" can result in includibility under sec. 2041. (a) A "general power of appointment" is one which can be exercised by the person to whom it was given in favor of himself, his or her estate, or the creditors of himself or his or her estate (b) The term includes all powers, which are substance and effect powers of appointment regardless of the nomenclature used in creating the power. The power to consume or appropriate trust principal exercisable without restriction in favor of the person holding the power is a general power of appointment. (c) A power exercisable for the purpose of discharging a legal obligation of the decedent or for his pecuniary benefit is considered a power exercisable in favor of the decedent or his or her creditors and is therefore considered a taxable general power of appointment. C.
Defective Grantor Trust
If many cases clients have made gift transfers or perhaps private annuity sales to IDGT. A common power used to achieve grantor trust status is the power retained by the grantor, in a non-fiduciary capacity, to reacquire the trust corpus by substituting other property of an equivalent value. For income tax purposes, transactions between the grantor and the IDGT will be disregarded.17 As such, grantors may exercise the power to swap high-basis assets for low-basis assets without jeopardizing the estate tax includibility of the assets and without having a taxable transaction for income tax purposes. To maximize the benefits of the swap power, it must be exercised as assets appreciate or are sold over time. When exercised properly, this can ensure that only those assets that benefit the most from the step-up will be subject to estate inclusion. D.
Discounts and Premiums
Generally, there are two discounts which may be appropriate when valuing an equity interest in a closely-held business entity, the discount for “lack of marketability” and the “minority interest” discount. The “lack of marketability” discount is based on the premise that equity in any closely-held business cannot be 25
readily sold on an established market. The lack of marketability discount is generally available whether the interest is transferred at death or by inter vivos gift. The “minority interest” discount is a discount in the value of an interest in a closely held business representing a lack of control in terms of vote. The “minority discount” is based on the premise that a non-controlling or “minority” interest has less value than an interest representing an otherwise equal interest that has the ability to vote. If a client’s estate plan has designed to take advantage of minority discounts by retaining n0ncontrolling interest in the estate, you might consider either transferrin, or creating a controlling interest back to the client, reversing the effect of the minority discount. In addition interest in the client’s estate will qualify for a control premium, further increasing the value of the interest and the step up in basis.
Prepared by Gibson & Perkins, PC attorney Edward L. Perkins Media, PA www.gibperk.com 484-326-8285