Tax, Trusts & Estates Law Monitor : Estate Planning Lawyer & Attorney : Cole Schotz Meisel Forman & Leonard Law Firm : NJ, Mid-Atlantic Gift Tax & Trust Issues

After meeting with a lawyer who advised him about divesting himself of assets so that he one day would be able to qualify for Medicaid, Peter Muscle, age 88, made a gift to his girlfriend of PSE&G stock having a value just over $1 million.  He died six months later. 

As most readers know, New Jersey has both an estate tax and an inheritance tax.  The estate tax is triggered on a decedent’s assets that exceed $675,000.  The inheritance tax is imposed on assets that do not pass to a spouse or lineal descendants.  Since New Jersey does not have a gift tax, gifting assets away during lifetime under some circumstances can have the effect of saving New Jersey transfer taxes.

However, the inheritance tax law (but not the estate tax law) also contains a rule that gifts made in contemplation of death are pulled back into the decedent’s estate and subject to inheritance tax.  See NJSA 54:34-1(c).  Furthermore, if the decedent makes a transfer without adequate consideration of a material portion of the decedent’s estate within three years of death, then the burden of proof switches to the estate to prove that the gift was not in contemplation of death.   

In this relatively straightforward case, the court did not believe the estate’s explanation that the gift was made in celebration of marriage, and held that the estate failed to carry its burden of proof.  The gift was therefore made in contemplation of death and was subject to New Jersey inheritance tax. 

Gifts are an effective planning technique to reduce state level estate tax exposure, but advisors need to be aware of this risk in New Jersey inheritance tax cases.

• Email This
• Print
• Comments
• Trackbacks
• Share Link

Sometimes a client owns life insurance and borrows against the policy in order to pay premiums.  After many years of this, it is not unusual for the loans against the policy to exceed the owner’s basis in the policy.  If the policy is then terminated (ie, the client surrenders the policy or just stops paying the premiums), the client often is surprised to learn that the termination triggers income tax on the difference between the amount of the outstanding loan and the basis in the policy.
 
The seminal case on this issue is Atwood v Comm’r (TC Memo 1999-61).  In Atwood, the Tax Court found that when the policy is disposed of (surrender, lapse or life settlement), the relief of the outstanding liability is tantamount to a cash distribution and is therefore taxable to the extent it exceeds basis. 

In a recent appellate level decision, the 10th Circuit affirmed a Tax Court decision on the same issue.  McGowen v Comm’r, 108 AFTR 2d 2011-6063 (10th Cir 2011), aff’g TC Memo 2009-285.  In this case, the taxpayer purchased a single premium life insurance policy in 1986.  By 2004, the loan on the policy exceeded its cash value.  The insurance company notified the taxpayer that she needed to make a minimum payment on the loan in order to keep the policy in force.  The taxpayer failed to make any payment, and the insurance company cancelled the policy and sent a 1099 reflecting over $500,000 of taxable income.  The taxpayer claimed that the income was cancellation of indebtedness (“COD”) income and excludible because she was insolvent at the time.  But the Tax Court disagreed, finding that the debt was not discharged but rather was repaid in effect by transferring an appreciated asset (the built-up cash value of the policy).  The 10th Circuit affirmed, finding that the taxpayer was not insolvent at the time the policy was terminated.

These cases usually involve inadvertent terminations of the life insurance policy, and this was the case in McGowen where the taxpayer likely ignored the insurance company’s notices about the consequences of a policy termination.  If a client is aware of this issue, there may be viable alternatives to prevent such an adverse result, such as keeping the policy in force until death but significantly reducing the death benefit so that the premiums are significantly reduced. 

• Email This
• Print
• Comments
• Trackbacks
• Share Link

One of the most basic reasons to have a Will is to name an executor.  The executor gathers and manages assets, administers the estate, pays bills, pays taxes, and ultimately distributes the estate assets to the decedent’s beneficiaries.  The “paying taxes” part of the job can be difficult.  People don’t like to pay taxes.  Also, if there are substantial non-probate assets, or different beneficiaries sharing disproportionately in the estate, the allocation of taxes among the beneficiaries can be a very significant issue.  The executor also is responsible for dealing with tax authorities, not always a desirable job.

These types of issues came to a head in the recent Tax Court case of Gudie v Comm’r.  Decedent, a California resident, held her assets in a living trust (ie, non-probate asset) with her two nieces as successor co-trustees.  During her lifetime, decedent entered into an unusual private annuity transaction, selling her assets to her nieces in exchange for their promise to pay her an annuity.  Although no payments related to the transaction ever were made, decedent’s estate tax return reported that the decedent’s $8 million liability from the private annuity transaction exceeded the decedent’s $7 million in assets, so no estate tax was due.  Perhaps not surprisingly, the IRS challenged this position, and sent a deficiency notice to one of the nieces.

The niece raised the “wrong taxpayer” defense, arguing that, even though she had signed the estate tax return, she was only a co-trustee and had never been formally appointed as the executor of the decedent’s probate estate, so she was not the proper party to be notified of the deficiency.  Again unsurprisingly, the Tax Court rejected this argument, and denied the niece’s motion to dismiss the case.  The court found that the niece was a “statutory executor” under the tax rules and was the proper person to receive the deficiency notice. 

This case highlights some of the risks faced by fiduciaries of trusts or estates.  The successor trustee in this case attempted a weak argument to try to avoid the alleged tax deficiency, and lost.  The estate administration process is often complicated and needs to be attended to carefully.

• Email This
• Print
• Comments
• Trackbacks
• Share Link

On September 13, 2011, the IRS announced that large estates of individuals who died in 2010 will have until early next year to file various required returns and pay any estate taxes due.  In addition, the IRS is providing penalty relief to certain beneficiaries of these estates on their 2010 federal income tax returns.

This relief is designed to give large estates, normally those over $5 million, more time to comply with the tax law changes enacted late last year.  The IRS is providing the following relief:

1. Large estates, opting out of the estate tax, now will have until Tuesday, January 17, 2012, to file Form 8939.  This carryover basis form, required of estates making this choice, was previously due on November 15, 2011.  Because this is a change in the specified due date rather than an extension, no statement or form needs to be filed with the IRS to have this new due date apply.

2. 2010 estates that request an extension of time to file on Form 4768 will have until March 2012 to file their estate tax returns and pay any estate tax due.   Normally, a six-month filing extension is automatically granted to estates filing this form, but extensions of time to pay are granted only for good cause.  As a result, most 2010 estates that timely file Form 4768 will have until Monday, March 19, 2012 to file.   For estates of those dying late in 2010 (after Dec. 16, 2010 and before Jan. 1, 2011), the due date is 15 months after the date of death.  No late-filing or late-payment penalties will be due, though interest still will be charged on any estate tax paid after the original due date.

3. Special penalty relief is provided to many individuals, estates and trusts that already filed a 2010 federal income tax return, or obtained an extension and plan to file by the October 17, 2011 extended due date.  Late-payment and negligence penalty relief applies to persons inheriting property from a decedent dying in 2010, who then sells the property in 2010 but improperly reports gain or loss because they did not know whether the estate made the carryover basis election.  Further details are provided in Notice 2011-76 posted on IRS.gov.

• Email This
• Print
• Comments
• Trackbacks
• Share Link

On September 6, 2011, the Christie Administration announced that the New Jersey Division of Taxation will extend tax payment and filing deadlines for individuals and businesses whose operations were disrupted by Hurricane Irene.  Taxpayers who are not able to make normal deadlines for any tax filings (including estate and inheritance tax returns) that were due on or after August 27, 2011 have been extended until October 31, 2011.  All 21 New Jersey counties have been declared federal disaster areas and would qualify for this relief.

In New York, deadlines for tax returns due on or after August 26, 2011 and before October 31, 2011 have also been postponed until October 31, 2011.  This applies to taxpayers directly affected by the storm in the counties of Albany, Clinton, Delaware, Dutchess, Essex, Greene, Montgomery, Nassau, Orange, Otsego, Rensselaer, Rockland, Saratoga, Schenectady, Schoharie, Sullivan, Suffolk, Ulster, Warren and Westchester. This does not affect New York, Kings, Bronx or Queens Counties.

Also, the Internal Revenue Service is giving affected taxpayers until October 31, 2011 to file most tax returns (including estate, gift or GST tax returns), or to make tax payments that have either an original or extended due date occurring on or after August 27, 2011, and on or before October 31, 2011.

We will keep you apprised of the developments regarding this relief.

• Email This
• Print
• Comments
• Trackbacks
• Share Link

On March 30, 2011, a few members of the House Ways and Means Committee (Kevin Brady, R-Texas, joined by Mike Ross, D-Arkansas, Kristi Noem, D-South Dakota, Dan Boren, D-Oklahoma and Devin Nunes, R-California) introduced legislation, HR1259, to repeal the estate and generation-skipping transfer tax, effective on date of enactment.  The legislation does not repeal the gift tax; it is maintained with a $5 million exemption and a 35% gift tax rate.  In lieu of estate and GST taxes, the legislation provides that there would be no step up in basis for assets at death and in its place, the carryover basis regime that was part of the 2010 estate tax repeal would be utilized.  It is not imminent that this legislation will be enacted, nor do we expect it to go far, but we nevertheless will keep an eye on it.

• Email This
• Print
• Comments
• Trackbacks
• Share Link

For those people who thought there would be a lull in proposed estate/gift tax legislation as a result of the sweeping 2010 tax law, that is not the case. President Obama’s 2012 budget proposal released last week contains numerous important estate and gift tax proposals, which are as follows:

1. Returning the estate/gift tax to 2009 levels, meaning a $3.5 million estate tax exemption amount, a 45% estate/gift tax rate and a $1 million lifetime gift tax exemption.
2. Making permanent the new portability rules with respect to enabling the surviving spouse to use the deceased spouse’s unused exclusion amount.
3. Adding another category of restrictions for family controlled entities that would be required to be disregarded for valuation purposes. A key component of planning involves the use of leverage and valuation discounts to reduce (i) the value of lifetime gifts if assets are transferred during life and (ii) the value of a decedent’s assets at death. This proposal potentially could limit the utility of family owned investment partnerships and limited liability companies.
4. Limiting the use of GRATs to a minimum term of 10 years and requiring the remainder interest to have a value greater than zero. This proposal has been floating around for some time now, and is another attempt to have the usefulness of GRATs minimized.
5. Limiting the duration of generation-skipping transfers in trust to ninety (90) years from the creation of the trust. With many states eliminating rules related to the duration of trusts, this proposal is aimed at recapturing revenue lost with the permitted perpetuity of trusts.

As these proposals are debated, we will keep you apprised of any developments.
 

• Email This
• Print
• Comments
• Trackbacks
• Share Link

We were alerted by one of our blog readers last week to a Wall Street Journal editorial published on February 8 stating that, from an estate tax perspective, New Jersey is the worst state in which to die. The article explains that up to 54% of a New Jersey decedent’s wealth could be lost to estate taxes in 2011 (New York decedents would lose 45.4%). While we disagree with some of the factual assertions set forth in the article (including that the state death tax deduction is new in 2011 – it is not and has been in place since 2005), we agree with the larger point that state estate taxes should be a significant concern for New Jersey (and New York) taxpayers.

With the federal estate tax exemption at $5 million per person in 2011 and 2012, the margin between the New Jersey exemption ($675,000) and the New York exemption ($1 million) has widened appreciably. The consequence is that for married taxpayers who want to take advantage of the first spouse to die’s full federal exemption and pass $5 million to their beneficiaries (for example, to an exemption trust for the benefit of the surviving spouse and/or children), then without special planning, a New Jersey/New York estate tax of approximately $391,600 would be due. Parties must consider whether it is worthwhile to pay some state level estate tax in the first spouse to die’s estate, especially in light of the fact that beginning in 2011, a married decedent’s federal estate tax exemption is portable, meaning the surviving spouse can use the first spouse to die’s unused estate tax exemption amount.

A number of variables factor into the decision, including: (1) the size of the surviving spouse’s estate; (2) all appreciation of the assets owned in the exemption trust will pass free of federal and state estate taxes in the future; (3) the current law is in place for two years, and as a result, the federal exemption amount could be reduced and estate tax rates (currently 35%) could be increased; (4) the age of surviving spouse; and (5) future plans of the surviving spouse, who possibly could move to a state with no estate tax (ie, Florida).

All of these decisions lead to another point. Estate plans need to be drafted in a very flexible manner to enable different decisions to be made depending on each taxpayer’s individual circumstances. It is not appropriate in this tax environment to have an inflexible plan.
 

• Email This
• Print
• Comments
• Trackbacks
• Share Link

Under the Tax Relief Act of 2010, an individual has a lifetime exemption equal to $5 million for 2011 and 2012.  This exemption can be used to not pay estate and gift taxes or both.  In 2013, this exemption is scheduled to go back to $1 million unless there is further legislation enacted to have the exemption be different.  There is a legitimate concern that it will be important to utilize this exemption over the next 2 years to avoid the potential risk that it may go down to a lesser amount in the future.  There needs to be careful analysis as to whether one should gift.  A key concern is the income tax basis that the recipient will receive. If one inherits an asset, the basis is the date of death value.  Alternatively, if one receives a gift, the basis is the lesser of the grantor's basis and the fair market value of the property at the time of gift.  This can have a great impact on a subsequent sale of the asset and/or depreciation deductions available for a depreciable asset.  For example, assume that dad bought a rental property for $100,000 and it is now worth $5 million.  Dad wants to transfer the property to his child. If dad gifts the property, then the child's basis will be $100,000. If the child then sells the property for $5 million, he/she will have a capital gain of $4.9 million which at an approximate combined federal and state income tax rate of 25% would result in taxes of $1,225,000.  Alternatively, if Dad died owning the property, the child's basis would be $5 million and a subsequent sale would result in no capital gain.  If the child did not sell the inherited property, he/she would be able to take much higher depreciation deductions based on the substantially increased basis to reduce taxable rent payments thereby substantially reducing income taxes.  Therefore, any gift plan analysis must take into account the benefits to be derived by gifting such as federal and New Jersey/New York estate tax savings versus any potential lost income tax benefits.

• Email This
• Print
• Comments
• Trackbacks
• Share Link

The following letter was recently distributed to clients and friends of Cole Schotz:

Dear Clients and Friends:

On December 17, 2010, President Obama signed into law sweeping new tax legislation that makes significant changes to estate, gift and generation-skipping transfer (“GST”) taxes. Not only may the new law have a dramatic impact on your existing estate plan, which we now strongly encourage you to review, it may also provide an excellent opportunity to implement additional planning that could benefit several generations of descendants.

In this regard, it is important to note that the new law is temporary – the favorable tax provisions sunset at the end of 2012, at which time Congress will either pass new legislation or allow the provisions of the 2001 tax law to take effect ($1 million exemption and a top estate and gift tax rate of 55%). Thus, it is critical for you to review your estate plan during this two year period to ensure you are maximizing your tax saving opportunities.

This letter contains a brief overview of the major changes to the federal estate, gift and GST tax system, all of which are effective January 1, 2011:

• The estate, gift and GST exemptions are $5 million per taxpayer and the tax rate is 35%. Prior to the suspension of estate and GST taxes in 2010, the estate and GST exemptions were capped at $3.5 million, the gift tax exemption was capped at $1 million and the top tax rate was 45%. The exemption amounts will be adjusted for inflation after 2011.
• The estate tax exemption for a deceased spouse is now “portable,” meaning the surviving spouse can use the unused estate tax exemption of the “last deceased spouse.” Thus, for example, if the first deceased spouse’s exemption is left fully intact, the surviving spouse will be able to transfer during his or her lifetime or at death $10 million gift and estate tax free. Use of the last deceased spouse’s exemption is not automatic – an election will need to be made on the last deceased spouse’s federal estate tax return. In addition, the deceased spouse’s GST exemption is not portable. What this all means is that portability planning is not simple, and proper thought and consideration needs to be given to this issue to ensure it is being handled correctly.
• The lifetime gift tax exemption increases from $1 million to $5 million (and $10 million per couple) so that the gift tax exemption is now unified with the estate tax exemption. This presents many planning opportunities for taxpayers to transfer significantly more wealth during their lifetimes without paying gift tax. For those taxpayers who have previously utilized their full $1 million lifetime gift exemptions, the new tax law permits an additional $4 million of lifetime gifting gift tax-free. The annual gift exclusion remains at $13,000 in 2011, or $26,000 per couple.
• There was concern that the new legislation would include restrictions on the use of (i) valuation discounts when transferring ownership interests in family entities as a part of a gift giving program and (ii) short term grantor retained annuity trusts (“GRATs”), a very effective technique to transfer assets without the imposition of gift tax. The new tax law does not contain either restriction. Thus, family entity planning, short term GRATs and sale transactions to trusts should be seriously considered, especially in light of the increased exemption amounts, and the current low valuation and interest rate environment.
• If, unfortunately, someone died in 2010, the new legislation has provided two different approaches to utilize in administering 2010 estates. The default rule is that the estate tax regime applies at a 35% rate and a $5 million estate tax exemption. The executor can opt out of the estate tax regime and instead choose the carryover basis regime, meaning there will be no federal estate tax but the decedent’s beneficiaries will not get a stepped-up basis in the assets inherited (subject to a limited right to increase the basis by $1.3 million for any beneficiaries and an additional $3.0 million for spouses).
• While significant changes were made to the federal transfer tax system, as discussed above, state estate taxes remain unchanged. Due to the greater disparity between the federal exemption amount ($5 million) and state exemption amounts (New Jersey –$675,000 and New York -$1 million), a larger (and potentially) unnecessary state estate would be triggered if your existing estate plan maximizes the federal estate tax exemption. While the federal exemption is now portable, state exemptions are not, so it will be even more important for estate plans to provide flexibility to enable the appropriate decisions to be made to maximize tax savings. Finally, for those taxpayers who travel to Florida and can make it their home, the new law magnifies even further the importance of reviewing the possibility of changing one’s domicile from New Jersey or New York to Florida to avoid the imposition of state estate taxes.
• As mentioned above, the new tax is not permanent – it sunsets at the end of 2012. Due to the temporary nature of the new law, it may be prudent for taxpayers to take advantage of the additional $4 million of tax-free gifting that is available for the next two years. Not only will additional gifting take advantage of the larger lifetime gift exclusion amount, it will remove the future appreciation of the gifted asset out of the taxpayer’s estate and potentially shift income to beneficiaries in lower income tax brackets.

We strongly recommend that you contact a member of our Tax, Trusts and Estate Department to review the effect of this change in law on your estate plan, whether or not we drafted your estate planning documents. Together, we can determine what steps, if any, need to be taken to achieve your estate planning objectives and to maximize the amount of wealth that will pass to younger generations. A list of the members of this department is attached to this letter.

Best wishes for a happy and healthy New Year.

Very truly yours,

COLE, SCHOTZ, MEISEL, FORMAN & LEONARD, P.A.
TAX, TRUSTS & ESTATES DEPARTMENT
 

• Email This
• Print
• Comments
• Trackbacks
• Share Link

It is official. President Obama signed into law Friday the “Tax Relief, Unemployment Insurance Authorization, and Job Creation Act of 2010.” The law removes (for now) a good deal of the uncertainty that existed with the repeal of the estate tax in 2010 and a return in 2011 to the estate and gift tax exemptions and rates of 2001.

The major gift, estate and generation-skipping tax provisions of the Act are as follows:

• Beginning January 1, 2011, the estate, gift and generation-skipping tax exemption is $5 million per taxpayer ($10 million per couple) and the tax rate is 35% (beginning in 2010).
• The estate tax exemption for a deceased spouse is portable, meaning the surviving spouse can use the unused estate tax exemption of the “last deceased spouse.”
• The lifetime gift tax exemption increases from $1 million to $5 million, meaning the gift tax exemption is unified with the estate tax exemption. This presents many planning opportunities for taxpayers to transfer significantly more wealth during their lifetimes without paying gift tax.
• Two year GRATs are still permitted.
• For decedents dying in 2010, executors have a choice. The default rule is that the estate tax regime applies at a 35% rate and a $5 million estate tax exemption. The executor can opt out of the estate tax regime and opt for the carry-over basis regime. The due date for the estate tax return and/or the return reporting carry-over basis is now nine months following date of the enactment of the Act (September 17, 2011), and not nine months from the date of death.
• The rates and exemptions are temporary and apply only in 2011 and 2012, at which time the law will need to be revisited again.
   

• Email This
• Print
• Comments
• Trackbacks
• Share Link

There has been a flurry of activity in the estate tax arena in the past few days and we wanted to keep readers updated. The first item was Senator Baucus’s (D-Montana) new estate tax proposal introduced on December 2, which, in summary, would have reinstated the estate tax at 2009 levels, meaning a $3.5 million exemption amount ($7 million per couple) and a 45% estate tax rate. This piece of his proposed legislation provided for an effective date of January 1, 2010, but would have allowed 2010 estates to elect to choose the no estate tax and modified carry-over basis regime that is currently in place for 2010. Other interesting items from Senator Baucus’s proposal included the lifetime gift exemption increasing to $3.5 million (effective on the date of the introduction of his bill, or December 2, 2010) and a minimum 10 year term for GRATs, with the GRAT remainder interest required to have a value greater than zero (effective on the date of enactment of the legislation). This legislation was voted down in the Senate on December 4.

Senator Baucus’s proposal was overshadowed on Monday by President Obama announcing his compromise with Republicans on the extension of the Bush tax cuts. Along with an agreement to keep the top income tax rate at 35% for all taxpayers for an additional two years, with regard to the estate tax, President Obama announced for two years, beginning in 2011, the estate tax rate would be 35% and the exemption per taxpayer would be $5 million.

Yesterday, House Democrats voted not to introduce President Obama’s tax plan for debate, in a move to negotiate some of the components of his plan. Thus, at this time, it is unclear what the components of new tax legislation (if any) will be. If no law is enacted, beginning January 1, 2011, the estate tax rate would be 55% with a $1 million exemption per taxpayer.

We will keep you updated as developments occur.
 

• Email This
• Print
• Comments
• Trackbacks
• Share Link

Two quick updates as we head into December and the last month of the 2010 Estate Tax Repeal:

1. 2011 Annual Gift Tax Exclusion to Remain the Same at $13,000. In 2010, the annual gift tax exclusion permits a taxpayer to gift $13,000 to any beneficiary, annually, even if the taxpayer has used up his or her $1 million lifetime gift exclusion. The 1997 Tax Reform Act tied the annual exclusion amount to increases in the CPI Index, and as a result, the annual exclusion has increased from $10,000 in 1997 to $13,000 currently. Due to a lack of significant inflation in 2010, the maximum gift tax annual exclusion in 2011 will remain at $13,000. This should also serve as a reminder that there is approximately one month left to take advantage of your 2010 annual exclusion gifts.
2. December AFRs even lower than historically low November AFRs. The December Applicable Federal Rates were just released, with the “7520 rate” falling to 1.8% from 2% in November. With such low rates, techniques such as GRATs and Sales to Grantor Trusts are even more attractive due to the low amount of interest that needs to be paid back to the taxpayer as a result of the transfers made by the taxpayer.

• Email This
• Print
• Comments
• Trackbacks
• Share Link

One of the lesser known components of the 2010 estate tax repeal is that the gift tax rate in 2010 is 35%, as opposed to the 45% gift and estate tax rate that was in place in 2009. This presents a planning opportunity for a taxpayer to reduce his taxable estate and save a significant amount of taxes if the taxpayer believes that his estate will be subject to an estate tax in the future.

Absent new legislation, the 2010 estate tax repeal will sunset in 2011, with the estate tax reinstituted at rates as high as 55% and an exclusion amount equal to $1 million (adjusted for inflation). Gifts in excess of $1 million also will be subject to gift tax at rates as high as 55%. Thus, gifting assets in 2010 at a lower rate will ultimately transfer significantly more wealth to a taxpayer’s beneficiaries.

Assume that a taxpayer desires to gift $10 million to his children and has used his lifetime gift exclusion. In 2010, the gift tax on this gift, payable at a 35% rate, would be $3.5 million. Taxpayer would pay the gift tax so the total outlay for the taxpayer to get $10 million to his beneficiaries would be equal to $13.5 million. Assuming that the taxpayer survives three years from the date of the gift, the amount of the gift tax paid will not be included in taxpayer’s estate.

Now assume that the same taxpayer does not make the gift in 2010, and dies with $13.5 million in his estate in a year where the maximum estate tax rate is 55% (and said taxpayer also has used his full exclusion amount). The amount of estate tax due on the $13.5 million included in the taxpayer’s estate would be approximately $7.5 million, leaving approximately $6 million to pass to the taxpayer’s beneficiaries. On these facts, the 2010 gift of $10 million increases the net amount passing to taxpayer’s beneficiaries by almost $4 million.

The lower gift tax rate combined with the fact that the gift tax paid is not subject to estate tax (assuming taxpayer survives three years from the date of the gift) can produce dramatic savings for taxpayers inclined to make gifts in 2010 and pay gift tax.

Even more dramatic savings can be achieved in 2010 if the taxpayer’s beneficiaries are grandchildren. Due to the fact that the generation-skipping transfer (“GST”) tax is repealed in 2010, a gift in 2010 to grandchildren will not trigger a GST tax. If the same taxpayer dies in future years leaving these assets to grandchildren, the assets will be subject to both estate tax and a significant GST tax (up to 55%), further diminishing the amount ultimately passing to grandchildren.

There are less than three months remaining (assuming no retroactive application of new gift and estate tax laws) to implement this planning.

• Email This
• Print
• Comments
• Trackbacks
• Share Link

Estate of Stewart is a new Second Circuit opinion addressing the application of Code §2036 to a situation where a decedent transferred a principal residence but continued to live in it.

In Stewart, the decedent owned a Manhattan brownstone. She and her adult son occupied the first two floors and leased the top three floors to a commercial tenant. In late 1999, the decedent was diagnosed with pancreatic cancer and saw an estate planning attorney. In May, 2000, she gifted a 49% interest in the Manhattan brownstone to her son. The decedent died in November, 2000, and the estate reported a 51% interest in the brownstone on the 706.

The IRS issued a notice of deficiency, claiming that 100% of the property was includible under Code §2036 because the decedent had continued to use and enjoy the property until her death. Code §2036 causes estate inclusion for any property to the extent of any interest of which the decedent made a transfer but retained for his or her life, the possession or enjoyment of, or the right to the income from, the property.

The Tax Court agreed with the IRS and found that the decedent and her son had an implied agreement as to her continued use and enjoyment of the property, making it 100% includible in her estate. However, the Second Circuit disagreed. As to the residential portion of the property, the Second Circuit held that the decedent did not retain the exclusive use of the residence, nor did she withhold possession from the donee. Therefore, the gift should be respected. As to the commercial portion of the property, the Second Circuit remanded the case for the Tax Court to determine specifically to what extent the decedent retained an interest. Under the facts of the case and the holding of Revenue Ruling 79-109, the Tax Court could find a specific portion of the property (eg, half of the 49% gifted) to be includible.

What are the lessons of this case for estate planners and their clients?

1. If a donor makes a gift of a residence to children or others but continues to live in the residence, pay all expenses or does not change his or her relationship to the property in any way, the gift almost certainly will not be respected for tax purposes and the full value of the property will be includible in the donor’s estate.
2. When the donee is a co-tenant with the donor, as was the case in Stewart, the chances are better that the gift will be respected for tax purposes. The legal and financial arrangement between the parties should be fully documented.
3. It is interesting to note that the parties in this case stipulated to a 42.5% discount for lack of control and lack of marketability.
    

• Email This
• Print
• Comments
• Trackbacks
• Share Link

Attached is an article from Tuesday’s New York Times, which details the story of Dan L. Duncan, a Texas billionaire, who died in March 2010, and as a result of the 2010 federal estate tax repeal, will be able to pass his multi-billion dollar fortune to his family estate and generation-skipping tax free. This is the type of story that may trigger a strong reaction from Congress to not only finally move on estate tax legislation, but potentially retroactively apply it.

• Email This
• Print
• Comments
• Trackbacks
• Share Link

As many of us know, the Qualified Personal Residence Interest Trust, or “QPRT,” is a common estate planning tool. An individual contributes his or her residence to a trust, but retains the right to live in the residence for a term of years (e.g., 10 or 20 years). The contribution of the residence to the trust is a gift, but the gift is reduced by the value of the individual’s retained interest, so the gift is much less than the actual fair market value of the residence.

The creation of the remainder interest typically constitutes a taxable gift by the grantor of the trust. This can limit the utility of a QPRT if a client already has used his or her $1 million lifetime gift tax exemption, or if the value of the remainder interest would exceed $1 million. For example, a $10 million New York City apartment will generally create a remainder interest of greater than $1 million if transferred to a QPRT (the calculation depends, of course, on the QPRT term of years, the discount rate in effect, the client’s age, etc.). This client may not be able to create a traditional QPRT without triggering a gift tax.

One planning technique that a client at this level might wish to consider is a “zeroed-out QPRT.” With a zeroed-out QPRT, the individual retains certain rights (ie, a limited power of appointment) over the remainder interest so that the initial transfer of the property to the trust is not a gift at all.  In other words, the actuarial value of the remainder interest is not gifted away and remains in the grantor’s estate. But if the individual survives the term of the QPRT, the future appreciation in value of the residence will be removed from the individual’s estate. Only the actuarial value of the remainder interest at the beginning of the trust term should be includible.

Let us return to the above example of a $10 million New York City apartment and assume the client is 65 years old and creates a 15 year QPRT to own the property. The remainder interest is allocated to its own trust, and the client retains a limited power of appointment over it. Based on the current actuarial tables, the grantor’s retained interest will be worth approximately $6 million and the remainder interest will be worth approximately $4 million. There should be no gift at the time of transfer due to the grantor’s limited power of appointment over the remainder.

Now let us assume that the client survives the term, and when the client dies at 81, the property has a value of $17 million. On these numbers, the amount includible in the client’s estate should be only the original $4 million remainder. All of the appreciation in the property has occurred outside of the client’s estate.

One downside to this technique is that the donees will receive the property with a carryover basis and not receive a step-up (assuming the step-up rules apply). Since the estate tax is greater than the capital gains tax, this generally does not present an issue, though it is worth noting that the scheduled increase in capital gains rates will worsen the income tax effects of a sale of the property.

The zeroed-out QPRT is an interesting application that may be a worthwhile consideration for certain clients. Please contact us if you would like to discuss this technique.

• Email This
• Print
• Comments
• Trackbacks
• Share Link

We wanted to continue to update you on new developments over the past few months in matters related to the estate tax.

• Despite reports stating that an estate tax deal was imminent, on May 18, Senate negotiators said that an agreement regarding estate taxes was on the verge of collapse after a majority of the Democratic caucus expressed concerns about voting for an expensive tax cut for wealthy families. Senate Finance Commissioner Max Baucus (D-Mont.) said “there is no agreement on the estate tax in either substance or process. None whatsoever.” Lobbyists said they believed the deal would have resulted in a top tax rate of 35 percent with a $5 million exemption level for individuals ($10 million for couples), with both figures indexed for inflation. They also believed it would have eliminated the chances of a retroactive estate tax increase.

• We previously wrote about bills being filed in both the Florida House and Senate in February, 2010 to impose a Florida estate tax on non-residents who own real or personal property in Florida and who reside in states that tax Florida residents who own property in those states. If enacted, the law would have been effective July 1, 2010. Both bills died in committee on April 30.

• In New York, an amended version of a bill was recently introduced to amend the estates, powers and trusts law to deal with certain formula clauses in Wills and trusts for estates of decedents dying in 2010. The amended bill provides, in essence, that for decedents dying in 2010, a formula clause in a dispositive instrument providing for a bequest of the maximum amount that can pass free of federal estate or GST taxes, shall be construed with respect to the law in effect for decedents dying on December 31, 2009. While we encourage all clients to review their planning documents in light of repeal, this bill could serve as a backstop for those clients who have documents drafted with formula clauses that are not applicable as a result of the estate tax repeal.

• A similar bill was introduced in the New Jersey Senate on May 20 to clarify the interpretation of certain formula clauses in Wills and trusts executed before 2010.
   

• Email This
• Print
• Comments
• Trackbacks
• Share Link

There have been a number of new developments related to federal and state level estate taxes over the past few months.

• House passes 10 year minimum term for GRATs. On March 24, 2010, the House passed the Small Business and Infrastructure Jobs Tax Act of 2010 which contains a provision instituting a 10 year minimum term for GRATs and a requirement that the remainder interest for GRATs be greater than zero. As we have detailed in prior blog posts, short term GRATs are an effective estate planning tool to transfer significant wealth to younger generations estate and gift tax free. If enacted into law, the use of GRATs will be severely limited. The bill now goes to the Senate for consideration. If you have been considering implementing a GRAT, you should move forward quickly before it is too late.
• NJ estate tax extended to non-residents? A bill was introduced on February 8, 2010 in New Jersey seeking to extend the New Jersey estate tax to non-residents who own real or tangible property in New Jersey. Currently, the New Jersey estate tax only applies to New Jersey residents.
• Florida estate tax on non-residents? Bills were filed in both the Florida House and Senate in February, 2010 to impose a Florida estate tax on non-residents who own real or personal property in Florida and who reside in states that tax Florida residents who own property in those states. If enacted, the law would be effective July 1, 2010.
• Federal estate tax repeal. We are three months into the one year estate tax repeal and there are no new significant developments. It remains pure speculation at this point whether the repeal will be replaced with a new estate tax law and if so, will the new law be retroactively applied so that the repeal is treated as if it never existed, or whether the repeal will run its course for 2010 and 2011 will bring a reinstated estate tax with much lower exemption amounts ($1 million federal exemption and generation-skipping transfer tax amounts).

We of course will be following all of these developments closely and will post updates if and when the status of the above matters change.
 

• Email This
• Print
• Comments
• Trackbacks
• Share Link

It is fairly common for foreigners to invest in US real estate. Before doing so, however, they should consider the income, gift and estate tax implications of such investments and possible tax structuring (entities, trusts, etc.) to minimize exposure.

A foreigner may purchase US situs real estate directly and own the property or properties in his or her individual name, though this creates income tax reporting and withholding issues. In addition, if the foreign owner then dies, his or her US situs real estate is subject to US estate tax, often an unpleasant surprise for the surviving family members. This tax result is exacerbated because, generally speaking, foreigners do not get the benefit of a unified credit.

Example: Charles, a Japanese citizen, buys a New York City rental apartment valued at $2 million. He dies 10 years later when the property is worth $4 million. Absent other circumstances, Charles’ US situs property is subject to US estate tax. Assuming a 45% tax rate and no exemption, federal estate tax of $1.8 million will be due nine months from Charles’ date of death. New York estate tax would be additional. (Note that the federal estate tax is currently repealed, so these figures in this example apply only if/when the federal estate tax is re-enacted).

There are a number of steps that foreigners and their families should consider if faced with the situation of a foreign decedent owning US property, including:

Treaty relief.  If the US has an estate tax treaty with the decedent’s home country, the decedent may be entitled to a greater unified credit. A common treaty provision gives a nonresident alien decedent a unified credit equal to a fraction of the unified credit available to US persons. The fraction is equal to the percentage of the decedent’s US situs property over the decedent’s worldwide property. The greater unified credit permitted under a treaty can mitigate the estate tax exposure.

Post mortem QDOT.  A surviving spouse (often an nonresident alien too) can create a qualified domestic trust (“QDOT”) and transfer to it inherited US situs real estate. With a proper structure and a QDOT election in place, property passing to a nonresident alien spouse will qualify for the estate tax marital deduction. The effect of this is to defer the estate tax until the death of the surviving spouse, though it does not avoid the estate tax altogether.

Pre-death planning. There are any number of steps that could be taken prior to death to avoid US estate tax. Some common considerations include (1) annual exclusion gifts of interests in the property which will qualify for the gift tax annual exclusion, (2) transferring the real estate to a foreign corporation, since the shares of a foreign corporation generally are not subject to US estate tax in a nonresident alien’s estate, or (3) transferring the real estate to another entity, the ownership of which will not be subject to US estate tax. Before taking any of these steps, the property owner should look into the income tax considerations (including FIRPTA), gift tax considerations, and reporting requirements that can be quite onerous. These approaches also should be considered for a surviving spouse’s portion of jointly owned property.

Conclusion. When a foreigner dies owning US situs real estate, the executor or surviving family members can consider a number of steps to reduce the US estate tax exposure.
 

• Email This
• Print
• Comments
• Trackbacks
• Share Link

For the first time in almost 100 years, a federal estate tax does not exist.  On January 1, the federal estate and generation skipping transfer taxes were eliminated, but only for one year.  Click here to read about the current legislative uncertainty.

• Email This
• Print
• Comments
• Trackbacks
• Share Link

The following letter was recently distributed to clients and friends of Cole Schotz:

Dear Clients and Friends:

Due to Congressional inaction in the final weeks of 2009, the Federal estate tax has been repealed for individuals dying in 2010 and the generation-skipping transfer (“GST”) tax has been repealed for generation-skipping transfers made in 2010. However, current law provides that the estate tax and GST tax will be restored as of January 1, 2011 with only a $1 million applicable exclusion and a $1 million GST exemption, indexed since 1998 for inflation, as compared to the $3.5 million applicable exclusion and GST tax exemption that had been in effect in 2009. The Federal gift tax remains in place (though at a lower tax rate) with a $1 million exemption and will not change except as to certain specialized trusts.

It was widely anticipated in the tax and estate planning community at large that Congress would take action before the end of 2009 to prevent this result. Therefore, virtually all tax professionals determined that it was unnecessary for clients to undertake a review of their estate planning documents prior to the end of 2009. Since Congress did not act, however, it is important for you to be aware of this situation which will likely be resolved in one of the following ways:

1. Congress could pass legislation which reinstates the estate tax and GST tax with specified exemption amounts that would be retroactive to January 1, 2010;
2. Congress could pass such legislation that would be effective as of a later date; or
3. Legislation will not be passed in 2010, in which case, there would be no estate or GST tax in effect until January 1, 2011, when those taxes would be reinstated with a top estate and GST tax rate of 55%, an applicable exclusion amount of $1 million and a GST exemption of $1 million, indexed since 1998 for inflation.

Of course, other scenarios are always possible as Congress’ action or inaction is impossible to predict. We will closely follow all discussions in Congress, review all proposed bills, and advise you when legislation has been enacted. We also will post updates to our tax blog (www.taxtrustsandestateslawmonitor.com) on these matters as they break.

While the prevailing view is that Congress will address these issues and retroactively restore the estate and GST taxes effective as of January 1, 2010, there is no guarantee that this will occur. Therefore, it is important that you are aware that the current state of the law, with repeal in place, could create unintended results as to how your assets will pass at the time of your death and could result in adverse tax consequences. Whether your particular situation is impacted and, if so, in what manner, depends on the particular wording in your Wills, Trusts and other estate planning documents and on your family and financial circumstances.

Examples of only a few of the situations that could produce unintended results include (i) an allocation of assets between the children of a current or prior marriage and a surviving spouse and (ii) an allocation of assets between children and grandchildren, where such allocations are based on tax concepts that were in effect when your Wills were executed but are no longer in effect under current law. In both of these cases, assets may be distributed in a way that you did not intend. The potential tax consequences that could result if the repeal stays in effect are literally too numerous to mention here, and must be explored on an individual basis.

Another change that applies only in 2010 relates to the tax basis of inherited assets. Under the law in effect prior to 2010 and again in 2011, the tax basis of inherited assets generally changes to the value of those assets on the date of the decedent’s death. Under the law now in effect, however, the basis in inherited assets remains the same with two limited exceptions: (i) up to a $1.3 million increase in basis will apply to assets passing to beneficiaries on a decedent’s death and (ii) up to an additional $3 million increase in basis will apply to assets passing to a surviving spouse.

Given that the potential tax and distribution impact could be significant, we suggest that you contact a member of our Tax, Trusts and Estate Department to review the effect of this change in law on your estate plan, whether or not we drafted your estate planning documents.

Best wishes for a happy and healthy new year.

Very truly yours,

Cole, Schotz, Meisel, Forman & Leonard, P.A.

• Email This
• Print
• Comments
• Trackbacks
• Share Link

To the surprise of most estate planning practitioners, the arrival of January 1, 2010 brought with it a federal estate tax repeal. Congress was unable to compromise prior to year end on legislation that would have either maintained the status quo ($3.5 million applicable exclusion amount and a 45% estate tax rate) or implemented new exclusion amounts and/or tax rates.

As a result, the following rules apply in 2010:

• There is no federal estate tax;
• There is no generation-skipping-transfer (“GST”) tax;
• While the gift tax exclusion amount remains fixed at $1 million, the gift tax rate drops to 35%; and
• The basis step-up for inherited assets is eliminated. In its place, beneficiaries will inherit assets with the basis of the decedent (assuming the asset has appreciated). There are two exceptions: (i) there will be a $1.3 million increase in basis to assets passing to beneficiaries on a decedent’s death and (ii) there will be an additional $3 million increase in the basis of assets passing to the decedent’s surviving spouse.

The prevailing belief among estate planners is that Congress will act soon to re-institute the estate tax and make it retroactive to January 1, 2010. If Congress fails to act in 2010, the federal estate tax will be reinstated by law on January 1, 2011 with a $1 million applicable exclusion amount and a $1.2 million GST exclusion.

This is a brief summary of the major estate tax changes as a result of the repeal. We will be blogging frequently on this topic as developments unfold. Please also look for a letter we are mailing out to our clients and friends explaining some of our concerns regarding the repeal, a copy of which will be posted to the blog shortly.

• Email This
• Print
• Comments
• Trackbacks
• Share Link

On December 3, the House of Representatives by a vote of 225 to 200 passed an estate tax bill which makes the $3.5 million applicable exclusion amount and the 45% estate tax rate permanent. Every Republican, along with 26 Democrats, voted no on the bill. If a law is not passed by December 31, the estate tax will be repealed for one year, and in 2011, the estate tax will return with a $1 million exemption (subject to inflation) and a top estate tax rate of 55%. The Senate is not expected to adopt this bill; it is more likely to pass a one year extension of the current law. We will keep you posted on all developments as they unfold.

• Email This
• Print
• Comments
• Trackbacks
• Share Link

Although Congress has been focused on health care and two wars, virtually everyone agrees that there will be estate tax legislation in the final 30 days of 2009, and the repeal scheduled for January 1, 2010, is not going to happen.

House Majority Leader Steny Hoyer is expected to bring a bill to the floor this week that would make permanent the 2009 estate tax levels ($3.5 million exemption, 45% rate), though a one-year patch also remains a possibility. This bill does not include other features like reunification, portability and indexing for inflation, due to concerns that these features increase the “cost” of the bill and make it less likely to pass given the limited time for consideration.

The Senate will take up the legislation toward the middle of December. Several lobbying groups feel that there is greater support in the Senate for reunification, portability and indexing.

If some or all of these features are included in the Senate bill, but not the House bill, they will get resolved in conference. Lobbying groups predict it will be down to the wire, with any agreement occurring between December 23 and December 30.
 

• Email This
• Print
• Comments
• Trackbacks
• Share Link

As of January 1, 2010, new rules take effect, permitting taxpayers to convert their traditional IRAs to Roth IRAs without any income limitations.  Click here for an overview of Roth IRAs and a summary of the new conversion rules.

• Email This
• Print
• Comments
• Trackbacks
• Share Link

The imminent federal estate tax legislation is on everyone’s minds, and it appears increasingly likely that the legislation this year will be a one-year patch, or a one-year freeze of the 2009 rules (a 45% estate tax rate and a $3.5 million exemption).

According to the Association for Advanced Life Underwriting (“AALU”), an important trade and public affairs group, permanent reform is less likely this year and enactment of a one-year patch is the most likely outcome.

Some of the important considerations in the estate tax legislation debate include:

• Cost. According to congressional analysis, permanent enactment of the 45% estate tax rate and a $3.5 million exemption will “cost” the government $233 billion over 11 years (that is, compared to the 2001 rules which could return in 2011). Given large federal deficits, lawmakers may focus on the estate tax as one area to recover revenues lost through AMT reform, the R&D credit or other law changes.
• Reunification, portability and indexing. Some of the more thought-provoking issues in the estate tax debate include (1) reunification of the gift and estate tax exemptions, (2) the portability of unused exemption amounts between spouses, and (3) indexing the exemption amounts to inflation.
• Limitations on lack of control and lack of marketability discounts. Restrictions on the use of discounts are included in the “Pomeroy” bill, currently the leading bill in the House. It is of course unknown at this time whether this provision will be enacted.

The AALU predicts that the Senate debate on the estate tax will extend to mid or late December. We will continue to post updates as new issues arise regarding this legislation.
 

• Email This
• Print
• Comments
• Trackbacks
• Share Link

The IRS has released the AFR interest rate for October, reducing the September AFR rate from 3.4% to 3.2%. While this is above the historically low 2% AFR rate in February, it still represents a very low interest rate, making GRATs a very attractive estate planning device to transfer significant wealth to your family members gift and estate tax free. In this environment where there are some proposals in Congress designed to curtail the use of GRATs, it again highlights that now is the time to seriously consider implementing a GRAT if you have a large taxable estate.

• Email This
• Print
• Comments
• Trackbacks
• Share Link

The IRS has issued the Applicable Federal Rate (“AFR”) for September, keeping the AFR rate under Code §7520 unchanged from August at 3.4%. What this means is that GRATs are still very attractive estate planning devices for taxpayers. The AFR rate is the interest rate the IRS requires taxpayers to apply to the amount gifted to the GRAT to value the gift at zero. If the gifted assets appreciate at an amount greater than 3.4%, then notwithstanding any valuation discounts attributable to the gifted assets, the appreciation in excess of 3.4% would pass gift tax-free to the GRAT’s beneficiaries. Thus, the lower the AFR rate, the more attractive GRATs are to taxpayers.

In light of proposed legislation in Congress requiring only long term GRATs and limiting valuation discounts, now may be the time to implement a GRAT.
 

• Email This
• Print
• Comments
• Trackbacks
• Share Link

2009 has been an interesting year for estate planners. The arrival of 2009 brought an increase in the applicable exclusion amount to $3.5 million (from $2 million in 2008), meaning taxpayers with proper planning could shield this amount from the imposition of federal estate taxes. 2009 also brought the scheduled estate tax repeal for a one year period beginning on January 1, 2010 that much closer.

Notwithstanding the fact that we are now less than seven months away from a temporary estate tax repeal, there is a prevailing belief among estate planners that Congress will change the law before 2010 preserving some form of the estate tax, especially in light of the economic meltdown and the federal deficit.

In fact, numerous bills have already been introduced in Congress detailing estate tax parameters for 2010 and beyond. With respect to the applicable exclusion amount, three separate House bills have been introduced with exclusion amounts equal to $2 million, $3.5 million and $5 million, respectively.

For the most part, the estate tax rates in these bills are set at the current 45% estate tax rate, and some impose surtaxes on estates in excess of $10 to $25 million.

Other important items are addressed in these bills as well. For example, there is a mention of unifying the gift and estate exemptions, meaning if this were part of the new law (we believe unlikely at this point), the $1 million lifetime gift exclusion amount would be increased to equal the estate tax exclusion amount. This certainly would expand the ability of a taxpayer to implement more lifetime transfer planning.

Some of the bills include the concept of making the estate tax exclusion portable for couples, meaning for example if a husband does not utilize his full exclusion, his wife could utilize not only her exclusion, but his as well.

Finally, there is language in one bill which would restrict the use of valuation discounts typically applied to the ownership of closely held non-business family entities. These discounts are an integral part in transferring wealth to the next generation.

We will be keeping a close eye on estate tax legislation throughout the year and will report to you the new estate tax law as soon as it is passed.
 

• Email This
• Print
• Comments
• Trackbacks
• Share Link