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  1. 2012 Advanced Sales Forum Sponsored by: Presented by: Julius H. Giarmarco, J.D., LL.M. Giarmarco, Mullins & Horton, P.C. 101 W. Big Beaver Road, 10th Floor Troy, Michigan 48084 (248) 457-7200 jhg@disinherit-irs.com www.disinherit-irs.com

  2. Estate, Gift, and GST Taxes • 1 The Tax Relief Act of 2010: • For individuals who died in 2010: • Tax the decedent’s assets at 35%, after estate tax exemption of $5 million and receive a “stepped up” income tax basis equal to fair market value at death. • Alternatively, elect out of the estate tax regime, no estate tax is assessed and modified carryover basis rules apply in determining recipients’ income tax basis in the assets. • 2 For 2011 and 2012, portability of the estate tax exemption between married couples (Note: Not applicable to GST tax exemption). • 3 Estate, GST, and gift tax exemptions are indexed for inflation in 2012. • 4 Indexed for inflation ($1.4M estimate).

  3. Wealth Transfer Strategies Over Lifetime Annually Transfer of wealthexcluded fromany gift tax Transfer of wealththrough GST, estate,and gift tax exemptions Transfer of wealth utilizing discount strategies Transfer of wealth utilizing freeze strategies(appreciation-only gifts) Transfer of wealththroughtaxable gifts • $13,000 per individual ($26,000 gift splitting with spouse) per donee • Direct payments to educational institutions and health care providers1 • Irrevocable life insurance trusts (ILIT)2 • Gift tax exemption of up to $5M per individual • GST and estate tax exemptions of $5M per individual3 • Generation-skipping transfer trust (GST) • Family limited partnership (FLP) • Family limited liability company (FLLC) • Non-voting shares in family corporation (C or S corporation) • Grantor retained annuity trust (GRAT) • Intentionally defective grantor trust (IDGT) • Qualified personal residence trust (QPRT) • Intra-family loan • Statutory freeze partnership (FLP or FLLC)4 • Pay gift tax now rather than paying estate tax later • Converting traditional IRA to Roth IRA5 Charitable planning: CRTs and CLTs. 1 To qualify for exclusion, gifts of tuition and medical expenses must be made directly to the provider. 2 Often can be structured to use annual exclusion gifting. 3 In 2012, an estate is taxed at a top rate of 35% with a $5.12 million estate tax exemption and a $5.12 million GST tax exemption. 4 Can serve to both utilize discount and transfer wealth utilizing freeze strategies. 5 Paying the income tax in converting a traditional IRA to a Roth IRA is essentially a tax-free gift.

  4. 2012: A Perfect Storm for Gifting • Low property values. • Historically low AFRs and Section 7520 rates. • $5.12M gift/GST tax exemptions are expiring. • President Obama’s proposals are looming.

  5. President Obama’s 2013 Budget Proposal • Reduce the estate and GST exemptions to $3.5 million and the gift tax exemption to $1 million and provide a top rate of 45% for those taxes. • Portability of a deceased spouse’s unused estate and gift tax exemption would continue.

  6. President Obama’s 2013 Budget Proposal • Eliminate a trust’s GST exemption on the trust’s 90th anniversary. • Eliminate valuation discounts on family-controlled entities. • Require a minimum 10-year term for GRATs.

  7. President Obama’s 2013 Budget Proposal • Modify the treatment of “grantor trusts” so that: • Trust assets would be subject to estate tax. • Distributions to a beneficiary during the grantor’s lifetime would be subject to a gift tax. • Trust assets would be subject to gift tax if the trust ceases to be a grantor trust during the grantor’s lifetime.

  8. President Obama’s 2013 Budget Proposal • Caution: Most ILITs are grantor trusts! • The power to use trust income to benefit the grantor’s spouse (IRC 677(a)(1)); • The power to use income to pay premiums on policies insuring the grantor (IRC 677(a)(3)); or • The grantor’s non-fiduciary power to substitute trust assets for assets of an equivalent value (IRC 675(4)(C) and Rev. Rul. 2011-28).

  9. Advantages of Lifetime Gifting • Removes appreciation and income from the donor’s estate. • Gifts to an intentionally-defective grantor trust (“IDGT”) remove the taxes on trust income from the grantor’s estate.

  10. Advantages of Lifetime Gifting • Shifts income to lower tax brackets of donees (except where Kiddie Tax applies), unless IDGT is used. • Leverages GST exemption. For example, ILITs.

  11. Advantages of Lifetime Gifting • Removes the gift tax from the donor’s estate. • Gift tax is exclusive; estate tax is inclusive. • IRC Sec. 2035(b) adds back to the estate any gift taxes paid within three (3) years of death. • Possible phase out of valuation discounts. • Possible return to lower gift tax exemption and higher tax rate in 2013.

  12. Disadvantages of Lifetime Gifting • Loss of control, but this can be mitigated by: • Using an FLP or FLLC with the grantor acting as the general partner or manager. • Voting and non-voting shares. • Ability to remove and replace trustees (with someone not related or subordinate to the grantor).

  13. Disadvantages of Lifetime Gifting • Loss of stepped-up basis. • Loss of income. • Possible Clawback.

  14. Is Clawback Really a Problem? • Arguments Against Clawback • Congress did not intend clawback, and this intent should override any contrary statutory interpretations. • The sunset provisions of EGTRRA treat the $5 million unified credit amount as having never existed, once 2013 rolls around.

  15. Is Clawback Really a Problem? • Arguments Against Clawback • Clawback is inconsistent with the entire unified gift and estate tax regime – to tax prior gifts at death that were exempt from tax at the time of the gift. • Code §2001(B)(2) provides that the use of tax rates in effect at the decedent’s death applies to the constructive gift tax computation – thus, unified credit amounts at death should likewise apply.

  16. Is Clawback Really a Problem? • But even if clawback becomes reality, the potential to pass appreciation on the transferred assets tax free is a powerful impetus for gifting now.

  17. Simple Gifts • Forgive loans. • Pay off children’s mortgages. • Equalize custodial gifts and Section 529 plans. • Pay off split-dollar and premium financing arrangements. • Outright gifts of non-voting interests in family business.

  18. Sophisticated Gifts • ILITs. • Dynasty Trusts. • Formula Gifts – Wandry. • Spousal Lifetime Access Trusts. • Intentionally-Defective Grantor Trusts. • Grantor Retained Annuity Trusts • Beneficiary-Defective Inheritor’s Trusts. • Qualified Personal Residence Trusts. • Private Split-Dollar - Loan Regime.

  19. GRAT Irrevocable Life Insurance Trusts

  20. ILITs Crummey Gifts Premium Payments Grantor/ Insured Dynasty/ ILIT Insurance Company Allocate GST Exemption Death Benefit Net Proceeds Children and More Remote Descendants

  21. Switching ILITs • Sale of policy from old ILIT to new ILIT for cash or promissory note. • If purchase price is at fair market value, then three-year rule of IRC Sec. 2503 does not apply. • No transfer-for-value if new ILIT is grantor trust. Rev. Rul. 2007-13. • No gain on sale if old ILIT is a grantor trust (or if no gain in policy).

  22. GRAT Dynasty Trusts

  23. Dynasty Trust – Overview of Technique Dynasty Trust Grantor No transfer tax paid. Discretionary Distributions to Children for Life • Advantages • Creditor protection • Divorce protection • Estate tax protection • Dispositive plan protection • Spendthrift protection • Consolidation of capital No transfer tax paid. Discretionary Distributions to Grandchildren for Life No transfer tax paid. Discretionary Distributions to Great-Grandchildren for Life Gift should take advantage of any remaining lifetime gift exclusion and lifetime GST exclusion No transfer tax paid. Future Generations

  24. Dynasty Trust vs.35% Estate Tax Every 30 Years

  25. GRAT Formula Gifts

  26. Wandry v Comm’r, TC Memo 2012-88 • Say this: I hereby transfer a fixed dollar amount of my FLP interests worth $5.12 million. • Not this: I hereby transfer 25% of my FLP interests.

  27. Wandry v Comm’r, TC Memo 2012-88 • The Tax Court in Wandry took note that other federal courts validated formula clauses, citing Christiansen (180 T.C. 1, aff’d 586 F. 3d 1061); Petter (T.C. Memo 2009-280, aff’d 653 F. 3d 1012; and McCord (461 F. 3d 614).

  28. Wandry v Comm’r, TC Memo 2012-88 • In those three cases, and in Hendrix (T.C. Memo 2011-133), the formula clauses reallocated any “excess” transfers to charities (thereby qualifying for a charitable gift tax deduction) – not back to the donor. • The Courts were comforted by the fact that, presumably, the charities would assure the values used represented FMV.

  29. Wandry v Comm’r, TC Memo 2012-88 • The Tax Court stated that it is inconsequential that the adjustment clause reallocated membership units among petitioners and the donees, rather than to a charitable organization. • The Tax Court explicitly stated that the lack of charitable component in formula value clauses does not result in a “severe and immediate” public policy concern.

  30. Wandry v Comm’r, TC Memo 2012-88 • Possible drawback with formula clauses: • How to allocate income and losses during “open” period? • If the transferee is a grantor trust, all income and losses are includible on the grantor’s income tax return during the open years. • As such, no amended tax returns will be necessary.

  31. GRAT Spousal Lifetime Access Trusts

  32. SLATs Grantor SLAT Assets Spouse is trustee; and spouse and children have access to income and principal; spouse is primary beneficiary Spouse and children At spouse’s death Remainder to children and more remote descendants

  33. Reciprocal SLATs • If Husband and Wife set up trusts for each other that are similar, then the two trusts may be “uncrossed” and treated for estate tax purposes as if each spouse had created a trust for himself / herself. United States v Grace, 395 US 316 1969. • Gift splitting is generally unavailable with SLATs.

  34. Avoiding the Reciprocal Trust Doctrine • Use different distribution standards (i.e., an ascertainable standard in one SLAT, and a fully-discretionary trust in the other SLAT). • Use different trustees. For example, wife can be sole trustee and beneficiary of one trust; and husband can be a co-trustee (with an independent third party) and beneficiary of other trust.

  35. Avoiding the Reciprocal Trust Doctrine • Give one spouse a 5% / $5,000 power, but not the other. • Give one spouse a limited power of appointment, but not the other. • Give one spouse the broadest possible limited power of appointment, and the other spouse a power of appointment limited to the grantor’s descendants.

  36. Avoiding the Reciprocal Trust Doctrine • Give one spouse a limited power of appointment – both during lifetime and at death; and give the other spouse only a testamentary limited power of appointment. • In an ILIT, include a marital deduction savings clause in one trust; but not the other.

  37. Avoiding the Reciprocal Trust Doctrine • Fund one trust with liquid assets and the other with illiquid assets (i.e., closely-held business interests). • Create the trusts at different times.

  38. Avoiding the Reciprocal Trust Doctrine • If the richer spouse transfers assets to the poorer spouse so that the poorer spouse can establish a SLAT, this might trigger the step-transaction doctrine. • In Holman, 130 T.C. No. 12 and Gross, T.C. Memo 2008-21 2008, gifts of partnership interests 6 days and 11 days, respectively, after the formation of the partnership were ruled not to be step transactions.

  39. GRAT Grantor Retained Annuity Trusts

  40. GRATs Grantor (Age 70) GRAT ______________________ End of Year 1 ______________________ End of Year 2 ______________________ GRAT Remainder $137,915 $1 million of Securities $510,517 of Securities $510,517 of Securities Actual Asset Transfer $1,000,000Annuity Payments (Projected) $1,021,033Remainder (Projected) $137,915 Taxable Gift $0.08 Assumed 10% growth with a 1.4% §7520* *January 2011 §7520 Rate $137,915 of Securities Beneficiaries

  41. GRAT Intentionally-Defective Grantor Trusts

  42. IDGT Authorities • Sale to a grantor trust is disregarded for income tax purposes. Rev. Rul. 85-13. • Grantor’s payment of trust’s income taxes is not a gift. Rev. Rul. 2004-64. • Power of substitution does not result in adverse estate tax consequences. IRC Sec. 675(4)(c) and Rev. Rul. 2008-22. • Power of substitution over life insurance not an incident of ownership. Rev. Rul. 2011-28.

  43. Installment Sale to IDIT 5. Excess Cash Flow/Premiums 1. Gifts $1M Grantor/Insured IDGT Life InsuranceCompany 2. Loans $9M 6. Death Proceeds (Income and Estate Tax Free/Leverages GST Exemption) 3. $9M Note to Grantor Balloon Payment in 9 Years 4. $105,300 annual interest (Interest Rate 1.17%) • Advantages: • Value of loan proceeds frozen at 1.17% for nine years (assumed mid-term AFR). • Grantor’s estate further reduced by the income taxes paid on behalf of the trust. • The trust property escapes estate taxation for as long as permitted under state law. • Possible valuation discounts for promissory note in Grantor’s estate.

  44. Grantor Trust vs. Non-Grantor Trust

  45. IDGT vs. GRAT • With IDGT: • No mortality risk. • Can allocate GST exemption to seed gift. • Mid-term AFR is less than Section 7520 rate. • Back-loading (i.e., interest only with balloon payment vs. level annuity payment). • Not a statutory technique. • Possibility of unintended gift tax, which may be mitigated by using a “defined value” clause.

  46. GRAT Beneficiary-Defective Inheritor’s Trusts

  47. Beneficiary-Defective Inheritor’s Trust • A grantor cannot establish a trust for his/her benefit and protect the trust assets from creditors or estate taxes (except in the “self-settled” states). • But, a third party (i.e., parent) can establish a trust for a child / grandchild’s benefit and protect the trust assets from the beneficiary’s creditors and estate taxes – provided the beneficiary does not make gifts to the trust.

  48. Parent/Grantor Funds BDIT with $5,000 BDIT fbo Child • Beneficiary has a Crummey withdrawal power which makes the beneficiary the owner of the Trust for income tax purposes. IRC Sec. 678(a). • Grantor can have no grantor trust powers. • Grantor allocates his/her GST exemption to the gift.

  49. Parent/Grantor Funds BDIT with $5,000 BDIT fbo Child • Beneficiary is co-trustee with a third party and has the right to remove and replace trustees with someone who is not related or subordinate. IRC Section 672(c). • Trustees can use trust income and principal for the beneficiary’s health, education, maintenance and support. • Beneficiary has a testamentary limited power of appointment (except over any life insurance on the beneficiary’s life) to “re-write” the trust.

  50. Parent/Grantor Funds BDIT with $5,000 Installment Sale IRS • Beneficiary sells non-voting interests of a start-up business to BDIT. Beneficiary continues to control the business entity. Possible valuation discounts. • No gain on the sale. Rev. Rul. 85-13. • Beneficiary’s payment of BDIT’s income taxes is a tax-free gift to the BDIT. Rev. Rul. 2004-64. Beneficiary BDIT fbo Child Interest Payments(at mid-term AFR) /Balloon (in 9 years) Pays Income Taxes