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

The Internal Revenue Code currently provides a tax break for individuals age 70 ½ or over to make distributions of up to $100,000 from an IRA to a charity and exclude the distributions from taxable income.  This generally results in tax savings compared to either (1) the taxpayer making charitable gifts using other, after-tax assets, or (2) the taxpayer taking a distribution from his or her IRA and then contributing the distributed funds to a charity.  Because the amount distributed from the IRA to charity is not included in taxable income, it is not subject to the 50%/30%/20% of AGI limitations on charitable deductions.

This provision is set to expire on December 31, 2011.  Taxpayers who are planning year-end charitable contributions should consider whether the contribution may be completed using IRA assets.
 

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Estate planners frequently prepare both life insurance trusts and family limited partnerships.  These planning tools are similar in that the client has ongoing administrative and management jobs after the legal work has been completed.  With life insurance trusts, clients typically have to manage a new bank account for the trust, prepare and send proper Crummey notices, keep trust records, etc.  With family limited partnerships, clients have to make investment and distribution decisions, and manage the partnership as a legitimate business.  Lawyers always are concerned about whether a client will properly administer the planning after the legal work has been completed.

In Estate of Turner, a recent Tax Court case (TC Memo 2011-209), the IRS asserted two arguments – (1) that the decedent had not managed his family limited partnership as a legitimate business, and therefore all of the partnership assets were includible in his estate under Code §2036, and (2) that the decedent’s faulty annual exclusion gifts to his insurance trust failed to qualify for the $13,000 per person per year annual exclusion. 

The court found for the IRS on the Code §2036 claim, finding that there was no bargaining among the family members in creating the family partnership, that the decedent commingled personal and partnership funds when he used partnership funds to make gifts, pay premiums on life insurance policies and pay legal fees, that the partnership was not funded for at least eight months following the formation of the entity, and that the decedent treated the partnership as his own at-will investment account. 

However, the court found for the estate on the issue of annual exclusion gifts.  Even though the decedent had paid the insurance premiums from his own funds rather than gifting funds to the trust (which the trustee could then use to pay premiums), and even though no Crummey notices had been sent to the trust beneficiaries, the court found that the premium payments were indirect gifts that qualified as “present interest” gifts for purposes of the annual gift tax exclusion. 

Clients who have struggled to follow the administrative requirements of an insurance trust to the letter (and their advisors who have explained it to them) can take heart from the second part of the Tax Court’s opinion in this case.  Like the Crummey and Cristofani cases before it, Turner represents another taxpayer victory on the issue of present interest gifts to insurance trusts.
 

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The IRS recently released the Applicable Federal Rate, or “AFR,” for October, 2011.  The AFR is a key interest rate used in connection with a number of the more sophisticated estate planning techniques, such as grantor retained annuity trusts (“GRATs”), sales to intentionally defective grantor trusts, and qualified personal residence interest trusts (“QPRITs”).

The mid-term AFR for October is 1.4%, which is historically low.  This means that GRATs, sales to grantor trusts, and intra-family loans are even more attractive in October because the amount that is required to be paid back to the donor under these techniques is relatively lower due to the extremely low interest rate. 

On the other hand, techniques in which the value of the gift is dependent upon the value of the income interest retained by the grantor, such as QPRITs or charitable remainder annuity trusts (“CRATs”), are not as attractive.  For these techniques, the low interest rate leads to a lower value for the retained interest and a higher value for the remainder interest, thereby resulting in a larger taxable gift when the technique is implemented.

With the increased lifetime gift exclusion ($5 million in 2011 and 2012) and the possibility that the use of GRATs may be restricted in the future, now may be the time to explore some of the estate planning approaches that have been enhanced by historically low interest rates.

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We recently posted a blog article on the choice between gifting to a 529 Plan or a Minor’s Gifting Trust.  There is a third option – transferring assets to a custodial account for the benefit of a minor.  In New Jersey and New York, these gifts would be made under the Uniform Transfers to Minors Act (“UTMA”).

A donor can create an UTMA account for the benefit of a minor beneficiary, and can gift annual exclusion gifts (or larger amounts which would then utilize a portion of the donor’s lifetime applicable exclusion amount).  The account is owned by the minor and as a result the minor is the taxpayer.  While the beneficiary is a minor, the designated custodian is in control of the account and makes all investment and distribution decisions.  Unlike a 529 Plan, the growth inside the UTMA account is subject to income tax and distributions are not limited to higher education.  Interestingly, if the custodian has a legal obligation to support the beneficiary, and the custodian dies while the beneficiary is a minor, the custodial account will be included in the custodian’s taxable estate.

The major disadvantage of gifting to an UTMA account is the minor beneficiary becomes entitled to the account upon attaining age 21.  Under most circumstances, it is not advisable for a 21 year old to be the recipient of a sizeable sum of money at the time when maturity, life experience and knowledge all are just beginning to develop.  The much better alternative is a Gifting Trust that can prescribe restricted but flexible terms for the beneficiary to receive assets.

Prior to 1987, one of the advantages of transfers to UTMA accounts was that, by transferring assets to these accounts, the assets were then taxed at the child’s generally lower income tax rate, rather than the parents’ tax rate.  Congress adopted the “Kiddie Tax” in 1986 which eliminated this tax benefit.  The Kiddie Tax today provides that for investment income for children under age 18 (and dependent children under age 24 who are full time students), amounts in excess of $1,900 will be taxed at the parents’ tax rate.  The age was originally 14 but Congress changed the age to 18 in 2006.

Thus, the income tax advantage of the UTMA account has largely been eliminated.  As a result, gifting to Gifting Trusts and/or 529 Plans (for gifting for higher education expenses) is generally preferable.

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Gifting is an integral part of estate planning and the incredible rise of education costs has made gifting to fund educational expenses an important consideration for many families.

One common technique implementing this planning is the creation of a 529 Plan for a benefit of a child or grandchild.  After-tax dollars are contributed to these accounts which then grow federal income tax free for the benefit of the beneficiary of the account.  The funds must be used for college tuition and related expenses.  If the beneficiary does not use all the funds, the beneficiary can be changed to another child.  To the extent funds are used for non-educational purposes, they are subject to income tax and a 10% penalty on the earnings of the account.  The penalty can be avoided if the beneficiary dies, becomes disabled or receives a scholarship.

529 Plans are limited in that they only can provide for higher education expenses.  An alternative to a 529 Plan is the creation of an irrevocable gifting trust to be the recipient of gifts for your beneficiaries.  The gifting trust can permit the trustee to make distributions to the beneficiary (i.e. a child or grandchild) not only for college, but for other educational needs, health, maintenance, support or any other legitimate reasons, such as a down payment on a house or to start a business.  The trust could extend out for a term of years (i.e., until the beneficiary attains age 35), or can even be for the lifetime of the beneficiary.  While the trust is irrevocable so that it is not included in the donor’s estate, it can be drafted in a very flexible manner to permit distributions over a longer period of time.  In this way, the donor (through the trustee) maintains control over the distribution of the assets

The major disadvantage to the gifting trust when compared to the 529 Plan is that the funds in the trust do not grow income tax free.  Each year, to the extent income is not distributed, the trust will be required to pay income tax on its earnings.  

Lastly, it is also important to note that a donor can pay for a child or grandchild’s educational expenses directly as a tax-free gift, which is in addition to (and not limited by) the $13,000 per donee per year gift tax annual exclusion.

When considering gifts to minors and other beneficiaries for educational purposes, it is important to consider 529 Plans and their tax benefits and compare this to the advantages of a gifting trust and its flexibility to make a wider range of distributions to make an informed decision as to which approach is more appropriate.

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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.

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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.

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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
 

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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.

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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.
 

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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.

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