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Which Dragon Do We Slay? Tax Issues in Estate and Gift Plans

Which Dragon Do We Slay? Tax Issues in Estate and Gift Plans. The Current Tax Landscape. Estate Tax Rate = 40% Estate and Gift Tax Exemption Amount = $5.49MM, inflation adjusted from $5MM in 2011 Estate Tax Exemption Now Portable To Surviving Spouse. The Current Tax Landscape.

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Which Dragon Do We Slay? Tax Issues in Estate and Gift Plans

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  1. Which Dragon Do We Slay?Tax Issues in Estateand Gift Plans

  2. The Current Tax Landscape • Estate Tax Rate = 40% • Estate and Gift Tax Exemption Amount = $5.49MM, inflation adjusted from $5MM in 2011 • Estate Tax Exemption Now Portable To Surviving Spouse

  3. The Current Tax Landscape • Historical Estate Tax Exemptions • Estate and gift tax exemptions also were unified in 2011 • 108,000 estate tax returns filed in 2001 • Just over 15,000 estate tax returns filed in 2010

  4. The Current Tax Landscape • What’s next for transfer taxes?

  5. The Current Tax Landscape • Income tax changes starting in 2012 • Ordinary income tax rate = 39.6% on $400,000 for single taxpayers or $450,000 for taxpayers married filing jointly • Personal exemption phased out when adjusted gross income over $250,000 for single taxpayers and $300,000 for taxpayers married filing jointly • “Pease” limitation on itemized deductions for adjusted gross income over $250,000 for single taxpayers and $300,000 for taxpayers married filing jointly • Top long-term capital gain tax rates 20% for taxpayers in the 39.6% ordinary income tax bracket

  6. The Current Tax Landscape • The Takeaway: • For high net worth clients, the balance between estate taxes and income taxes is less lopsided toward estate taxes than it historically has been. • For most every other client, estate taxes currently are not an issue, but income taxes certainly might be.

  7. Which Dragon Do We Slay? • Built-in capital gains generally are eliminated at the owner’s death under IRC § 1014(a) if the appreciated assets are included in the owner’s taxable estate. • Estate tax planning tools often remove appreciated assets from the owner’s estate or discount the value of the assets, resulting in no income tax basis step-up or a decreased basis step-up. • Should the taxpayer hold assets until death, obtaining an income tax basis step-up but paying estate tax? • Or should the taxpayer “freeze” or discount the estate, reducing estate taxes but missing out on the income tax basis step-up?

  8. Pre-2010 Estate Plan Issues Traditional Tax-Planned Estates Can Have Unintended Consequences

  9. Pre-2010 Estate Plan Issues • The traditional tax-planned estate includes, at least, a credit shelter trust, a GST exempt QTIP (marital) trust, and a GST nonexempt QTIP trust • Under the current $5.49MM estate tax exemption, individuals with estates less than $5.49MM will often partially fund a credit shelter trust and no QTIP trust • Typically, there is no income tax basis step-up on the assets of the credit shelter trust at the surviving spouse’s death

  10. Pre-2010 Estate Plan Issues Hypothetical scenario: • Ozzie and Harriet were happily married for 30 years when Ozzie died last year. Ozzie last executed estate planning documents in 2002, when the estate tax exemption was $1MM and Ozzie’s estate was $2MM. At his death, Ozzie’s estate was $3.5MM but it has appreciated to $4MM. Under Ozzie’s documents, all of his estate passed to a credit shelter trust. Harriet’s current estate is $1.5MM. • The built-in gain in the trust will remain beyond Harriet’s death because the trust assets are not includible in Harriet’s estate.

  11. Pre-2010 Estate Plan Issues • Possible solutions where the pre-2010 estate plan has “matured” • Grant a general power of appointment to the surviving spouse • Decanting -- Va. Code § 64.2-779.16.C • Non-judicial settlement agreement • Distribute the credit-shelter trust assets outright • Uneconomic Trust under $100,000 -- Va. Code § 64.2-732 • Non-judicial settlement agreement • Non-judicial settlement agreement is valid to the extent it does not violate a material purpose of the trust and could be approved by the court. Va. Code §64.-709 • Consider whether remainder beneficiaries have any gift concerns when consenting to a non-judicial settlement agreement

  12. Pre-2010 Estate Plan Issues • What about cases with more difficult facts? • Suppose that Ozzie died in 2011 when the exemption was $5MM. The credit shelter trust left by Ozzie now is $4.5MM with $3MM of basis, while Harriet’s estate is $2MM. Would it be prudent to give Harriet a general power of appointment?

  13. Pre-2010 Estate Plan Issues • What will the transaction costs be to give Harriet the GPOA? • Will income tax be recognized all at once or over time? • Will tax exemptions or rates change significantly before Harriet’s death? • Is GST planning a significant concern for Harriet? In real cases, it may be difficult to determine what the best course of action will be, except perhaps where the risk of causing estate tax is negligible.

  14. Pre-2010 Estate Plan Issues • Continuing Non-Tax Reasons for Using Trusts • Probate avoidance with funded Revocable Trusts • Asset protection for the surviving spouse or children • Controlling disposition of the assets beyond the surviving spouse’s death

  15. Pre-2010 Estate Plan Issues Hypothetical scenario: • Ozzie and Harriet are happily married and have two grown children. Their combined estate is $4MM. At the death of the first spouse to die, they intend for all to pass to the survivor, and at the survivor’s death, to their children equally. • Ozzie has concerns that Harriet is showing early signs of dementia. If Ozzie were to die first, he would be concerned that Harriet would be preyed upon by the pool boy. • Harriet is concerned that if she dies first, Ozzie would succumb to an aggressive paramour in the nursing home. • In this instance, trusts can address Ozzie’s and Harriet’s concerns.

  16. Pre-2010 Estate Plan Issues • Ozzie and Harriet can leave trusts for one another to prevent the surviving spouse from squandering assets or being the victim of undue (or unwelcome) influence. • Consider appointing an Independent Trustee or Co-Trustee. • Limit “stretching” of the distribution standard. • But consider the cost and potential emotional and administrative complications of involving an unrelated trustee. • Keep in mind the surviving spouse’s elective share right. • The elective share right can be satisfied by assets passing in trust only under certain circumstances. Va. Code § 64.2-308.9.2.

  17. Boosting Basis, Not Estate Tax Can I slay both dragons? (Can I slay my dragon and eat it too?)

  18. Boosting Basis, Not Estate Tax • Potential tools for boosting basis: • Transfers that don’t use gift and estate tax exemption • General powers of appointment • Unlimited marital deduction and portability • Grantor trust asset substitutions • Community property double basis step-up • Delaware Tax Trap • Retain § 2036 estate inclusion strings • Gift and bequest back

  19. Transfers that Preserve Exemption • Transfers that freeze or diminish the estate but don’t use gift and estate tax exemption • Sales to grantor trusts • Grantor Retained Annuity Trusts (GRATs) • Charitable Lead Annuity Trusts (CLATs) • By preserving exemption, the transferor is able to shield more of the transferor’s estate from estate tax while receiving a basis step-up on the assets included in the estate. • However, in estates of significant value where the estate tax concern clearly outweighs income tax concerns, gifts can significantly reduce potential estate tax by removing future appreciation from the estate and eliminating the tax-on-tax problem of the estate tax. Consequently, it is generally more tax-efficient to make a gift where transfer taxes are the primary concern. Paying gift tax also can increase basis. IRC § 1015(d).

  20. Transfers that Preserve Exemption • Sales to grantor trusts (intentionally defective grantor trust/IDGT) • A grantor trust is a trust that is inseparable from the Grantor for income tax purposes. • Transactions between the Grantor and the trust are not recognized for income tax purposes. • Typically, the Grantor sells an appreciating asset to the trust in exchange for a fixed-yield, non-appreciating note. • There is no gift on the sale. Therefore, no exemption is used. • Grantor’s payment of trust’s income taxes is not an additional gift to the trust. Rev. Rul. 2004-64.

  21. Transfers that Preserve Exemption • Sales to grantor trusts • Various powers, rights, or roles retained by a Grantor or granted to a third party can cause the trust to be a grantor trust • Rules governing grantor trusts are found in IRC §§ 671-679 • Common methods of intentionally triggering grantor trust status: • Selecting related trustees and granting broad distribution authority • Retaining right to reacquire trust assets • Granting a power to add beneficiaries • Granting a power to loan funds to grantor without adequate security

  22. Transfers that Preserve Exemption • Grantor Trust • Client treated as owner of assets for income tax purposes • Sale often involves a discounted asset • Trust should own property to support legitimacy of leveraged purchase • Assets excluded from estate for estate tax purposes, including appreciation above interest rate • No step-up in basis at Client’s death Stock/LLC/LP Unit Sales to grantor trusts - simple example Client Sale Promissory Note Mid-Term AFR @ 1.89% • No Capital Gain on Sale to Grantor Trust • No Gift on Sale Because Fair Value is Exchanged Spouse, Children, or Other Beneficiaries

  23. Transfers that Preserve Exemption • Grantor Retained Annuity Trusts (GRATs) • Basic Description: Grantor transfers property into a trust, usually for a term of years (most often 2 or 3 years). The trust pays an annuity that is determined using the “7520 rate” to the grantor annually. At the end of the trust’s term, the remaining assets pass to the next generation. • July 2017 7520 rate is 2.2%. • The taxable gift is the value of the contributed assets less the present value of the retained annuities. IRC § 2702(a), (b). • Walton v. Comm’r, 115 T.C. No. 41 (2000) permits “zeroed-out” GRATs, where annuity value offsets contribution completely. • Excess income and appreciation over the 7520 hurdle rate pass without gift or estate tax if grantor lives until end of GRAT term.

  24. Transfers that Preserve Exemption • Grantor Retained Annuity Trust • Funded with $1 Million • Two Year Term • Assume 2.2% Section 7520 Rate • Assume Assets Grow 7% Annually (pre-tax growth, as Client pays income tax for grantor trust GRAT) • Taxable Gift of $0.10 • No Exemption Used! Year 1 Annuity Payment $470,057 GRAT – simple example Client Year 2 Annuity Payment $564,069 Distribution to Children $77,870

  25. Transfers that Preserve Exemption • Grantor Retained Annuity Trusts (GRATs) • “Rolling” GRATs created each year can isolate periods of appreciation, increasing the odds of successfully transferring wealth to the next generation. • This can be a very effective method of managing the amount of a client’s estate so that it remains at an acceptable level. • GRATs are grantor trusts. • Remainder beneficiaries also can be grantor trusts, reducing the estate further through income tax payments and allowing for additional income tax basis planning opportunities.

  26. Transfers that Preserve Exemption • Charitable Lead Annuity Trust • 20 Year Term • Initially funded with $1,000,000 asset • Taxable gift of $0 to Children • $1,000,000 Gift to Charity • Assume 7% Annual Growth • Assume 2.2% Section 7520 Rate • Annuity increases by 20%/year Charity $1,396,421 Annual Annuity Payments Charitable Lead Annuity Trusts (CLATs) 20 Years Client’s Children $1,886,461 End of 20 Year Term

  27. General Powers of Appointment • Use General Powers of Appointment to Cause Estate Tax Inclusion to Obtain Stepped-Up Basis • GPOA is power to appoint to self, estate, or creditors of either. • Prearrange a potential GPOA for the surviving spouse over the Credit Shelter Trust. • Could possibly be granted by a Trust Advisor • Could be exercisable only with the consent of a non-adverse party • Could be limited to built-in gain assets only (so as not to get a stepped-down basis) • A GPOA also could be useful in a generation-skipping trust that otherwise wouldn’t be included in a descendant’s estate.

  28. General Powers of Appointment Hypothetical scenario: • Ozzie has died and left Harriet a credit shelter trust valued at $3MM and basis of $2MM. Harriet’s own estate is $2MM. Harriet is now living with the pool boy. • If Ozzie had the foresight to grant a Trust Advisor the power to give Harriet a general power of appointment over the credit shelter trust, exercisable only with the consent of a third, non-adverse party, the credit shelter trust could be made taxable in Harriet’s estate, wiping out the built-in gain without causing estate tax, and without significant concern that Harriet could appoint to the pool boy.

  29. Portability • Using Portability with the Unlimited Marital Deduction • A deceased spouse’s unused exemption (DSUE) can be transferred, or “ported,” to the surviving spouse. • A bequest to a spouse no longer wastes the decedent spouse’s exemption like it did before 2011. • Rev. Proc. 2016-49 has authorized a QTIP deduction where an estate tax return is filed to elect portability. • A bequest to the spouse or to a QTIP trust results in estate tax inclusion, and basis step-up, at the first spouse’s death and at the second spouse’s death (if the assets are still owned at the second spouse’s death, of course).

  30. Portability • Drawbacks to relying on Portability to Avoid Estate Tax • The DSUE amount the survivor takes is not inflation-adjusted. • GST exemption cannot be ported. • The first spouse could, however, allocate his/her GST exemption to a QTIP trust through a reverse QTIP election. • This is less optimal than GST planning with a credit shelter trust, as the QTIP trust necessarily “leaks” income. • The QTIP trust also might cause tax in the survivor’s estate, which would be payable first by the QTIP trust under IRC § 2207A. • Risk of estate tax law changes prior to the second spouse’s death.

  31. Grantor Trust Asset Swaps • Swapping Assets in a Grantor Trust • Transactions between the Grantor and the trust are not recognized for income tax purposes. • Perhaps the most common “grantor trust power” is the “power to reacquire the trust corpus by substituting other property of an equivalent value.” IRC § 675(4)(C). • The swap might be done by an unrecognized sale or by an asset substitution. • Consider the terms of the trust regarding asset substitution. • Consider any state law effects of a sale versus asset substitution (e.g., real estate transfer taxes).

  32. Grantor Trust Asset Swaps Hypothetical scenario: • Ozzie is the grantor of a grantor trust for the benefit of his children, which will not be taxed in his estate. The trust currently holds real estate valued at $1MM with basis of $500K. Ozzie has $2MM of relatively liquid, high-basis assets. • Prior to his death, Ozzie can substitute $1MM of his high-basis assets for the trust’s real estate. The basis of the real estate then will be stepped-up at Ozzie’s death.

  33. Community Property • Take Advantage of Community Property Benefits • When a spouse dies owning community property, the decedent spouse’s half of the community is subject to estate tax, but both halves of the community (i.e., even the surviving spouse’s one-half interest) receive a stepped-up basis. IRC § 1014(b)(6). • Community property might be titled in the name of one spouse. • Virginia recognizes community property upon the death of a married person. See Va. Code § 64.2-315 et seq. and Commonwealth v. Terjen, 197 Va. 596 (Va. 1956). • Practice Pointer: Track community property if it is material by amount or percentage of the estate.

  34. Community Property Hypothetical scenario: • Ozzie and Harriet have lived their married lives together in California. During their marriage, they’ve amassed an estate of $6MM, $4MM of which is titled in the name of Harriet alone, $1MM is in the name of Ozzie alone, and $1MM is in their names jointly. Ozzie and Harriet now are retired and recently moved to Virginia to live close to their son. Sadly, Harriet dies not long after moving to Virginia. • Under Virginia’s Uniform Disposition of Community Property Rights at Death Act, Harriet’s estate should be $3MM (one-half of each asset). • All $6MM of assets receive stepped-up basis. • Pop quiz: What if the titling of the assets were reversed--$4MM in Ozzie’s name, $1MM in Harriet’s name, and $1MM jointly-titled?

  35. Delaware Tax Trap • Delaware Tax Trap • A limited power of appointment will be treated as a general power of appointment if it is exercised to create another power of appointment that can be validly exercised “to postpone the vesting of any estate or interest in such property, or suspend the absolute ownership or power of alienation of such property, for a period ascertainable without regard to the date of the creation of the first power.” IRC § 2041(a)(3). • This means that exercising a limited power of appointment to create a new power of appointment with a longer rule against perpetuities period causes the assets subject to the original exercise to be included in the powerholder’s estate.

  36. Delaware Tax Trap Hypothetical scenario: • Ozzie’s father created a trust for Ozzie in 1972, prior to the GST tax and prior to the births of Ozzie’s children. Nothing about the trust will cause it to be included in Ozzie’s estate. The trust has $3MM of value, with $2MM of basis. Ozzie’s estate is $2MM. • If Ozzie has a limited power of appointment over the trust, he might be able to exercise the power in favor of trusts for his children that will extend beyond the original rule against perpetuities and trigger the Delaware Tax Trap. • At Ozzie’s death, the trust assets are included in Ozzie’s estate and receive stepped-up basis. No additional estate tax is due because the combined value of assets is below the exemption amount.

  37. Delaware Tax Trap • Why would it ever be necessary for a beneficiary to trigger the Delaware Tax Trap rather than using other means (e.g., decanting) to give Ozzie a general power of appointment? • The Trustee might not be willing to exercise discretion in a way that requires a complicated analysis of the estate and income tax effects, particularly considering the constant changes in the laws. • It would seem that Ozzie must invoke Va. Code § 55-12.4.A.8 in the trust for his children to waive Va. Code § 55‑12.1, Virginia’s Delaware Tax Trap savings clause.

  38. IRC § 2036 • Retain IRC § 2036 Strings • A decedent’s gross estate includes the value of property transferred by the decedent during life where the decedent retained, for life, “(1) the possession or enjoyment of, or the right to the income from, the property or (2) the right, either alone or in conjunction with any person, to designate the persons who shall possess or enjoy the property or the income therefrom.” IRC § 2036(a). • Bona fide sales for adequate and full consideration are excepted. • Depending on the circumstances and the property transferred, it might be arguable that the decedent enjoyed the income or controlled its distribution until death.

  39. IRC § 2036 Hypothetical scenarios: • Ozzie created a partnership, funded it with investment assets, then sold partnership interests to his children. Ozzie continues to draw on the investment assets when desired. • Harriet titled her beach house over to her children, but she continues to use the beach house regularly until the time of her death. • Rex gives Exxon shares to his children, with the understanding that the dividends from the shares will continue to be used to pay his retirement home expenses. • In each instance, it might be argued that the asset is brought back into the taxable estate of the donor. The asset’s basis is stepped-up, which isn’t a bad result if estate tax isn’t increased.

  40. Gift and Bequest Back • Why not just give something to someone on their deathbed so they can bequeath it back? • Appreciated property acquired by a decedent by gift within one year of death that then passes back to the original donor takes carry-over basis. IRC § 1014(e). • The IRS has issued rulings indicating that it takes the position that IRC § 1014(e) applies where assets return to the original donor directly or indirectly. PLRs 200210051, 200101021, 9026036 and TAM 9308002.

  41. QUESTIONS?

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