Posted tagged ‘estate tax exemption’

Two Year Tax Planning Window of Opportunity for Large Gifts

February 9, 2011

Estate and Gift Tax Opportunity

As a result of legislation enacted by Congress in December, the current (but temporary) estate and gift tax exemption is increased to $5,000,000. The $5,000,000 exemption applies to the estates of those who die in, and to gifts made in, 2011 and 2012.

In addition, the highest estate and gift tax bracket applicable in 2011 and 2012 has been reduced to 35%.

In 2013, however, the old $1,000,000 estate and gift tax exemption is scheduled to return along with 55% as the highest estate and gift tax rate.

In light of such compelling tax facts, high net worth clients may be highly motivated to make large gifts before 2013.  If clients delay making such gifts until after 2012, and if Congress does not act to change the current law, the estate and gift tax exemption will revert to $1,000,000. The opportunity to transfer an additional $4,000,000 free of estate and gift tax will be lost.

The estate tax that may be saved as a result of making large gifts in 2011 and 2012 can be significant. For example, assume that an unmarried client has an estate with a value of $10,000,000. If he makes no gift and if he dies in 2013 when the $1,000,000 exemption and higher tax rates apply, the U.S. estate tax would be approximately $3,727,000 and the state estate tax (we are using New York tax law for this article)  would be approximately $1,068,000 for a total estate tax obligation of approximately $4,795,000.

If the client believes he needs no more than $5,000,000 for himself, however, he might be inclined to make a gift of the rest ($5,000,000) to his children (or in trust for them). If the client were to make a gift of $5,000,000 in 2012 and die in 2013, there would be no U.S. gift tax to pay and the total estate tax would be $2,750,000 (federal, $2,359,000, and state, $391,600). The estate tax saved would be more than $2,000,000.

You can find details regarding how the gift and estate tax is calculated here: No Tax Clawback Pursuant to Section 304 of TRUIRJCA.

In Connecticut, the gift of $5,000,000 in 2012 would result in a gift tax of approximately $122,000. Although the $122,000 gift tax obligation would represent an upfront cost, the overall tax benefits would still be substantial and would not be materially different. Keep in mind that in Connecticut a gift tax is incurred only when cumulative taxable gifts exceed $3,500,000.

Generation Skipping Tax Opportunity

The generation skipping tax exemption has also been temporarily increased to $5,000,000. This means that, if your gift of $5,000,000 is to a generation skipping trust, you can allocate your $5,000,000 generation skipping tax exemption to the trust and, as a result, shelter the trust assets (including all appreciation) from estate, gift and generation skipping tax for many generations.

Other Advantages

Keep in mind that the opportunity to make larger gifts of income producing property free of gift, estate and generation skipping taxes includes the opportunity to shift income, which is generated by the assets you give away, to lower-income tax bracket taxpayers.

It is also an opportunity to protect assets from the claims of creditors, whether your own future creditors or the creditors of your beneficiaries.

If you are married, the gift could be to a trust which includes your spouse (as well as children, grandchildren and even younger generations) as a beneficiary. As a result, the income need not be totally lost to your household (at least as long as your spouse is living).

You can find more information about what a trust is, and common terms included in a trust, here: The Benefits of Trusts.

What Is the Down Side?

The motivation to make large gifts now is partially the result of an expectation that the old estate tax rules may return in 2013 with a $1,000,000 exemption and a 55% estate tax rate. What if Congress makes the current, more generous rules permanent so that, if death occurs in 2013 or later, the $5,000,000 exemption will apply?

Assuming no significant appreciation in the value of the assets after the time the gift was made, there would be no estate tax cost or benefit associated with making the gift now instead of waiting to do so at the time of your death through the terms of your Will.

By making the gift now, however, your cost basis (for capital gain tax purposes) would be carried over to the donee of the gift. If the donee of the gift sells the donated asset, a capital gain tax could result based on the difference between the sale price and the carryover basis.

On the other hand, if you were to retain the assets until your death, the cost basis would be adjusted to the date of death value. As a result, the capital gain tax upon the subsequent sale of the assets by the beneficiaries who inherited the assets might be significantly reduced.

Accordingly, even though there would be little difference in the estate tax result, if a large gift is made, the opportunity to obtain a beneficial adjusted cost basis could be lost. Keep in mind, however, that careful tax planning can defer and minimize the capital gain tax to some extent. As a result, the capital gain tax risk is speculative and difficult to value.

The discussion above assumes that there is no increase in value after the gift is made. Keep in mind that, if the assets, which were the subject of the gift, increase in value, the increase would escape estate and gift taxation.

Fear of the “Tax Clawback”

Estate planners have expressed concern that, if death occurs in 2013 after a large gift has been made in 2011 or 2012, and after the U.S. estate tax exemption of $1,000,000 is reinstated, the estate tax would be calculated in a manner that, in effect, subjects the large gift made in 2011 or 2012 to an additional tax.  Commentators have referred to this as a “tax clawback.”  

The consensus among tax experts, who have looked at the issue closely, however, seems to be that the calculation which results in the tax clawback is incorrect.

Tax professionals who are reading this blog may want more details regarding the tax clawback issue. For details, go here:  No Tax Clawback Pursuant to Section 304 of TRUIRJCA.

What if there is a tax clawback? In the example above, if the Will includes a common type of tax clause, the estate, which consists of only $5,000,000 (what remains in the client’s estate after the gift is made), would bear a total estate tax burden of more than $4,135,000. If the beneficiaries under the Will are different from the donees of the gift, the beneficiaries under the Will would no doubt be extremely disappointed and would likely be looking for someone to blame for such an “unfair” result.

It is not difficult to imagine a situation where the estate tax due would actually exceed the value of the probate assets that would commonly bear the burden of the tax.

To recognize the issue is to reinforce how important it is to carefully allocate tax burdens among beneficiaries. Although we are confident that a proper interpretation of the most recent tax legislation removes the prospect of the tax clawback, until the IRS acknowledges that view, we cannot be certain that the IRS will agree.  As always, it is best to take great care in allocating tax burdens by properly crafting tax clauses in your Wills and other estate planning documents. 

Posted on 2/9/2011 by Richard S. Land, Member, and Kasey Galner, Associate, Chipman, Mazzucco, Land & Pennarola, LLC.

 

We frequently post articles relating to estate planning, estate settlement and elder law issues to this blog. We also post notices about our client seminars here. When we do, we send out notices to clients and friends of the firm. If you would like to get our notices, please join our mailing list by clicking below.

 
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Notice: To comply with U.S. Treasury Department rules and regulations, we inform you that any U.S. federal tax advice contained in this communication is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction, tax strategy or other activity.

No Tax Clawback Pursuant to Section 304 of TRUIRJCA

February 9, 2011

In our post entitled Two Year Planning Window of Opportunity for Large Gifts we invited you to come here for the legal reasoning behind the conclusion that there will be no tax clawback with respect to the estates of clients who die after 2012 and who make large gifts in 2011 or 2012.

We can take no credit for the brain work involved in reaching this conclusion. Rather, we must give credit to Dan Evans who published a newsletter on the topic via the fabulous resources of Leimberg Information Services (http://www.leimbergservices.com/blogwatch.cfm#). That conclusion has been confirmed via Paul Caron, editor of the TaxProf Blog, reporting on the opinions of tax experts participating in a BNA Tax & Accounting Webinar scheduled for February 10, 2011.

Nevertheless, we closely examined the rationale presented by Mr. Evans before being able to agree with his conclusions and the conclusions of other experts.

This is the rationale.

Section 304 of the legislation enacted in December by Congress (bearing the name of the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 (TRUIRJCA)) says:

Section 901 of the Economic Growth and Tax Relief Reconciliation Act of 2001 shall apply to amendments made by this section [sic: title].

Section 901 (Sunset of Provisions of Act) of EGTTRA says:

(a) IN GENERAL.—All provisions of, and amendments made by, this Act shall not apply—

(1) …

(2) In the case of title V, to estates of decedents dying, gifts made, or generation skipping transfers, after December 31, 2010.

(b) APPLICATION OF CERTAIN LAWS.—The Internal Revenue Code of 1986…shall be applied and administered to years, estates, gifts, and transfers described in subsection (a) as if the provisions and amendments described in subsection (a) had never been enacted.

Accordingly, after 2012 the provisions of EGTRRA do not apply and the provisions of the Internal Revenue Code must be applied as if EGTRRA were never enacted. We will refer to the law as if EGTRRA were never enacted as Pre-EGGTRA law.

Although we will describe the calculation in more detail below, keep in mind that the U.S. estate tax is computed by adding the value of the estate to the value of taxable gifts to arrive at a Tentative Tax Base. The Tentative Estate Tax is determined based on the Tentative Tax Base. To determine the U.S. estate tax, the Tentative Estate Tax is then reduced: (1) by the gift tax obligation related to the gifts that were made; (2) the unified credit against the estate tax (this is the credit that results in what we refer to as the estate tax exemption); and (3) a credit for state estate taxes paid (other credits also may be available for special situations).

At issue when discussing the possibility of an estate tax clawback is how to compute the reduction for the gift tax obligation referred to above in red.

The gift tax obligation is a function of the unified credit and the gift tax rates. The unified credit after 2012, according to Pre-EGTRRA law, is $345,800 (resulting in what is often referred to as a $1,000,000 estate and gift tax exemption). As mentioned above, the unified credit is applied against a Tentative Estate Tax (and gift tax) to arrive at the actual tax due. Under pre-EGGTRA law, the tentative gift tax on a $5,000,000 taxable gift would be $2,390,800. To arrive at the tax due, the unified credit of $345,800 (the credit which would apply if EGTRRA had not been enacted) would be applied against the tentative gift tax to arrive at the gift tax of $2,045,000. This is the tax that would have been due if the rules were applied as if EGTRRA were never enacted. Of course, if the gift is made in 2011 or 2012 there would be no actual gift tax to pay because the exemption in those years is actually $5,000,000.

In computing the estate tax on the estate of the client who dies in 2013 after making a gift of $5,000,000 in 2012, the tentative estate tax is computed on the sum of the taxable estate and the taxable gifts. In this case such sum would be $10,000,000 which is referred to as the tentative tax base.

The tentative tax on a tentative tax base of $10,000,000 is $5,140,000.

Section 2001(b)(2) of the Internal Revenue Code says that in determining the estate tax the tentative tax is reduced by “the aggregate amount of tax which would have been payable under chapter 12 [the gift tax chapter] with respect to gifts made by the decedent after December 31, 1976, if the modifications described in subsection (g) had been applicable at the time of such gifts.”

The modifications described in subsection (g) are modifications enacted as part of TRUIRJCA and would have been applicable at the time of the 2012 gift. Accordingly, for purposes of computing the reduction under 2001(b)(2), the reduction is the gift tax that would have been payable, not the gift tax actually paid.

The estate tax is being calculated in 2013 (the assumed year of the client’s death) after the provisions of TRUIRJCA have sunsetted. Because Section 304 of TRUIRJCA says that the sunset rules of Section 901 of EGTRRA apply, the pre-EGTRRA law applies to both the estate and gift tax calculations.

The final calculation therefore looks like this:

(1) The Taxable Estate of $5,000,000 and the Taxable Gift of $5,000,000 would be added together to arrive at the Tentative Tax Base of $10,000,000.

(2) The U. S. Tentative Estate Tax on a Tentative Tax Base of $10,000,000 would be $5,140,800.

(3) To arrive at the U. S. estate tax, the Tentative Estate Tax is reduced by the U.S. gift tax that would have been incurred according the law as it would be if EGTRRA were never enacted in 2001. The gift tax that would have been incurred is $2,045,000.

(4) In addition, the Tentative Estate tax is reduced by the Unified Credit available according to the law that would be if EGTRRA were never enacted. Such a Unified Credit is $345,800. The Unified Credit shelters assets having a value of $1,000,000 from U.S. estate and gift taxes according to the law that would have existed if EGTRRA were never enacted.

(5) The Tentative Estate Tax is reduced further by the Credit for N.Y. estate tax which would be $391,600.

(6) The result of the calculations described above is a U.S. Estate Tax equal to $2,358,400.

As Dan Evans points out, the result is what you would expect if gift tax policies of the past were consistently applied to the current gift tax. He explains that past policy dictated that lifetime gifts were made a part of the estate tax calculation only for the purpose of determining the estate tax brackets to be applied to the estate that remains after lifetime gifts were made. The calculation methodology was never intended to be used as a way to subject lifetime gifts to additional tax.

In the example above, if the policy is properly applied, you would expect that the estate tax on the taxable estate of $5,000,000 would be 55% or $2,750,000. This is exactly the result achieved above when the U.S. estate tax and the New York estate tax are added for a total of $2,750,000.

Posted on 2/9/2011 by Richard S. Land, Member, Chipman, Mazzucco, Land & Pennarola, LLC.

We frequently post articles relating to estate planning, estate settlement and elder law issues to this blog. We also post notices about our client seminars here. When we do, we send out notices to clients and friends of the firm. If you would like to get our notices, please join our mailing list by clicking below.

 
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Notice: To comply with U.S. Treasury Department rules and regulations, we inform you that any U.S. federal tax advice contained in this communication is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction, tax strategy or other activity.

March 10, 2011, Seminar. Is it time to review your estate plan? Maron Hotel, Danbury, Connecticut, 7:00 to 9:00 PM

January 29, 2011

Is It Time To Review Your Estate Plan?

Please  join us at the Maron Hotel, Danbury, Connecticut, on  March 10, 2011.

Call 203-744-1929 for reservations.  For more contact information, go to the end of this post.

We will be discussing whether clients should be reviewing and changing their estate plans in light of changes Congress recently made in the U.S. estate law and in light of all the other changes that may have occurred in your life and the lives of your beneficiaries and fiduciaries (Executors, Trustees and Guardians) since the last time your plan was reviewed.

For a summary of the topics we plan to cover, including a short explanation of the new U.S. estate tax rules, see the videos (Part One and Part Two) below.

For a good Wall Street Journal summary of the new U.S. estate and gift tax provisions, click here:  WSJ Article.

You can find a short written summary of the seminar topics in the text after the videos.

Estate Planning Seminar Summary Video Part One:

Estate Planning Seminar Summary Video Part Two:

Federal Estate Tax Changes: As 2010 came to an end, the U.S. Congress enacted another set of temporary estate tax changes which will apply in 2011 and 2012 with retroactive application to 2010.  Under the new set of temporary rules, the U.S. estate tax exemption is increased to $5,000,000 and the top estate tax bracket is 35%.  In 2013, however, the U.S. estate tax exemption is scheduled to be $1,000,000.  The top U.S. estate tax bracket in 2013 is scheduled to be 55%.  Under the new rules, for the first time, one spouse may give his or her unused $5,000,000 estate tax exemption to a surviving spouse.  In effect, this means married couples may take advantage of each spouse’s $5,000,000 exemption (for a total exemption of $10,000,000) without including complicated tax provisions in their Wills.

Connecticut Estate Tax: The Connecticut estate tax “exemption” is currently $3,500,000.  Because the U.S. estate tax exemption is larger than the Connecticut estate tax exemption, married clients who have wills with marital deduction formula provisions that are pegged to the U.S. estate tax exemption may incur an unnecessary Connecticut estate tax of approximately $122,000.

As we have stressed in previous seminars, the application of many types of estate tax formula provisions in Wills after exemptions have been increased could result in the disinheritance of the surviving spouse unless there has been careful planning.

In addition, many types of estate tax formula provisions in Wills may be difficult to interpret after exemptions have been increased.  This could increase the risk of litigation between beneficiaries.

For many, it may be time to use Wills that are much simpler than the complicated estate-tax-formula Wills of the past.  The temporary nature of the estate tax changes and the estate tax rules of Connecticut and other states, however, make the analysis less simple.

Our March seminar will help you determine whether you should review your estate plan to take into account the tax changes that have already been made and the changes that will be coming.

Other Reasons to Review: The other reasons for review continue to apply.

Have the circumstances of your Executor, Trustee or Guardian changed significantly?

Has the life of a beneficiary changed significantly? If a beneficiary becomes disabled, dies or is divorcing, perhaps you should change the estate plan as it relates to that beneficiary. A beneficiary’s good fortune may also be a good reason to make changes.

Have your assets changed significantly? If your assets have grown, you may now need tax planning. If your estate has decreased in size, the tax planning you did many years ago may no longer be appropriate.

If your health is failing, or if that possibility is now more real to you, you may wish to consider different approaches for dealing with incapacity.

If a substantial part of your estate consists of IRAs and similar retirement accounts (including life insurance), it may be time for you to consider specific planning strategies for such accounts.

We will cover the most common approaches for dealing with these issues and more.

SEMINAR LOCATION AND TIME

The seminar will be on March 10, 2011, at the Maron Hotel, 42 Lake Avenue Extension, Danbury, Connecticut from 7:00 p.m. to 9:00 p.m.  The doors will open at 6:30.  Refreshments will be served.

These seminars are always well attended and space is limited.  If you wish to attend, or if others you know are interested in attending, to reserve space call us (203-744-1929) or send an e-mail message to me (Richard Land at  rsl@danburylaw.com) or Kasey Galner (at ksg@danburylaw.com) or Lynn D’Ostilio (at  lsd@danburylaw.com) containing your name, number attending, telephone number and e-mail address.

Posted on 1/29/2011 by Richard S. Land, Member, Chipman, Mazzucco, Land & Pennarola, LLC

We frequently post articles relating to estate planning, estate settlement and elder law issues to this blog. We also post notices about our client seminars here. When we do, we send out notices to clients and friends of the firm. If you would like to get our notices, please join our mailing list by clicking below.

 
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The Future of Estate Planning

July 16, 2010

Half of 2010 is behind us and January 1, 2011, is around the corner. Although several proposals for estate tax exemptions from $1,000,000 to $5,000,000, and estate tax brackets from 35% to 55%, are in the Congressional pipeline, a Congressional stalemate seems just as likely as action. As a result, the unthinkable and unexpected now seem to be possible – the return of a federal estate tax system with a low $1,000,000 estate tax “exemption” and estate tax brackets that kick in at 41%. Whatever becomes the new estate planning reality, we expect there will be renewed interest in the following estate planning techniques.

(1) Credit Shelter Trusts (a/k/a “B Trusts,” “Family Trusts,” and “Bypass Trusts”). Many more clients will regard credit shelter trusts, which are established when one spouse dies for the benefit of the surviving spouse, as a real necessity instead of just possibly advantageous. For background details, see our article entitled “All Estate Plans with Marital Deduction Formula Documents Should Be Reviewed.”

(2) Gift Planning. If the “exemption” returns to $1,000,000, an estate that exceeds the “exemption,” after taking into account marital, charitable and other deductions, will be taxed at no less than 41%. Clients will be looking for gift techniques to reduce the tax exposure by reducing their estates. Simple gift techniques include small gifts ($13,000 per year per donee) which are excluded from taxable gifts and gifts to certain qualified education accounts. More complicated gift techniques include irrevocable life insurance trusts, qualified personal residence trusts, grantor retained annuity trusts, sales to certain irrevocable grantor trusts, and charitable trusts. In addition, in a high estate tax environment, many clients may wish to take advantage of depressed real estate values to make gifts of interests in real estate. Related gift planning will make the use of family limited liability companies and partnerships even more popular. The use of grantor retained annuity trusts (especially when interest rates are so low) and sales to specially designed trusts (the “intentionally defective grantor trust” or “IDGT”) will be more attractive even if proposals to limit valuation discounts are adopted.

(3) Life Insurance. Life insurance has always been a popular way to make certain that cash is available to pay estate taxes. The need for life insurance is especially compelling when large illiquid estates (for example, consisting of primarily real property, retirement plan accounts, such as IRAs and 401(k) plans, and closely held business interests) have substantial estate tax obligations. If the estate tax “exemption” is reduced and if estate tax brackets are increased, more clients will choose to acquire life insurance owned by an irrevocable life insurance trust and financed by gifts to the trust. Because estate tax obligations of U.S. citizen married couples can be deferred until the death of the surviving spouse, we expect that more married couples will be acquiring joint life (or “second to die”) life insurance policies (owned by an irrevocable trust) to finance estate tax obligations which will be due when the surviving spouse dies. Life insurance, and irrevocable life insurance trusts, can also be a useful way to deal with the mortality risk associated with grantor retained annuity trusts and similar trusts designed for gifts of a residence (the qualified personal residence trust).

There has always been a natural tendency to postpone estate planning especially when youth and good health make the risks seem remote. The uncertainty of the last ten years relating to estate tax repeal added an additional rationale for postponing the estate planning exercise. Although many of us are in denial and feel that we have preserved our youthful vigor and good health over the last ten years, the coming of January 1, 2011, and a new estate planning reality, cannot be denied.

In addition, as Congress continues to pile on new debt that will encumber the future efforts of our children and grandchildren, we face another new reality: that, for the first time in our country’s history, the next generation’s quality of life will not be better than our own. The planning steps mentioned above may minimize the estate tax burdens and maximize what is left for our children and grandchildren at a time when they may need it like no other generation before us.

Let us know what you think. Feel free to leave a comment.

Posted by Richard S. Land (rsl@danburylaw.com)

Announcement Seminar Rescheduled; March 18, 2010; 7:00 to 9:00 PM; Ethan Allen Inn, Danbury, Connecticut

February 22, 2010

Is It Time To Review Your Estate Plan?

Federal Estate Tax Repeal:  As of January 1, 2010 the U.S. estate tax has been repealed, temporarily.  The U.S. estate tax is scheduled to return in 2011 with a $1,000,000 “exemption.”  The 2009 exemption was $3,500,000.  We expect that Congress will take some action in the coming months.

Connecticut Estate Tax Changes:  Effective January 1, 2010, the Connecticut estate tax “exemption” was increased from $2,000,000 to $3,500,000 but the fate of this change is uncertain.

Our March seminar will help you determine whether you should review your estate plan to take into account the tax changes that have already been made and the changes that will be coming.  Some of the effects of repeal of the federal estate tax are explained here: January 10, 2010, article on repeal and the need for a review.

Other Reasons to Review: The other reasons for review continue to apply.

Have the circumstances of your Executor, Trustee or Guardian changed significantly?

Has the life of a beneficiary changed significantly? If a beneficiary becomes disabled, dies or is divorcing, perhaps you should change the estate plan as it relates to that beneficiary. A beneficiary’s good fortune may also be a good reason to make changes.

Have your assets changed significantly? If your assets have grown, you may now need tax planning. If your estate has decreased in size, the tax planning you did many years ago may no longer be appropriate.

If your health is failing, or if that possibility is now more real to you, you may wish to consider different approaches for dealing with incapacity.

If a substantial part of your estate consists of IRAs and similar retirement accounts (including life insurance), it may be time for you to consider specific planning strategies for such accounts.  Conversion to Roth IRAs in 2010 is especially appealing.

If you have pets, you may wish to consider recently enacted legislation relating to “pet trusts.”

We will cover the most common approaches for dealing with these issues and more.

LET US KNOW WHAT TOPICS YOU WANT US TO COVER

Contact us to let us know whether you would like us to cover a particular issue.  If we can, we will try to fit the issue into this program or a program we plan for the future.  The best way to reach us is by e-mail, but we would be pleased to receive your suggestions by regular mail or by telephone.  If you wish, call after hours and leave a voice mail message. Telephone Number: (203) 744-1929.  Or, contact me by email at rsl@danburylaw.com or Lynn D’Ostilio at lsd@danburylaw.com.

SEMINAR LOCATION AND TIME

The seminar will be on March 18, 2010, at the Ethan Allen Inn, 21 Lake Avenue Extension, Danbury, Connecticut from 7:00 p.m. to 9:00 p.m.  These seminars are always well attended and space is limited.  If you wish to attend, or if others you know are interested in attending, to reserve space call us or send us an e-mail message ( rsl@danburylaw.com or  lsd@danburylaw.com) containing your name, number attending, telephone number and e-mail address.

Posted on 2/22/2010 by Richard S. Land, Member, Chipman, Mazzucco, Land & Pennarola, LLC.

All Estate Plans with Marital Deduction Formula Documents Should be Reviewed

January 10, 2010

Making Use of Estate Tax Marital Deductions and Estate Tax Exemptions in 2010

As mentioned here, for the first time since 1915, until Congress acts to re-impose an estate tax, there will be no estate tax on estates of those who die in 2010. One of the problems created by Congress’s failure to deal effectively with this unique situation relates to the estate tax marital deduction. The purpose of this article is to alert you to problems that may exist with certain types of wills (and will substitutes such as revocable living trusts) that incorporate marital deduction planning.

Rules Applicable and Techniques Employed Before 2010

Except for the estate of a person who dies in 2010, married couples have estate planning options available to them that are not available to unmarried couples.

Under the pre-2010 federal estate tax rules (and Connecticut and New York estate tax rules), in computing the applicable estate tax, a deceased spouse’s estate is entitled to an unlimited marital deduction for certain property passing to or for the benefit of the surviving spouse if the surviving spouse is a U.S. citizen. In addition, the estate is entitled to a credit (the “unified credit”) against any federal estate tax due with respect to property not qualifying for any deduction.

In 2009, the unified credit was $1,455,800 and it sheltered $3,500,000 from the federal estate tax. In this article we use the term “exemption” as the amount that is sheltered from the estate tax as a result of the unified credit.

As this memo is being written on January 9, 2010, there is no federal estate tax. No one I know (or who I have read) believes this will be the case for long. Congress is expected to take some action early in 2010. Until Congress takes action (probably retroactively), however, for the estates of decedents who die in 2010 there is no federal estate tax. You can think of that as creating a temporary unlimited estate tax “exemption.”

In 2011 the federal estate tax is scheduled to return with a $345,800 unified credit which shelters $1,000,000 from the federal estate tax. Accordingly, under current federal estate tax law, the “exemption” is scheduled to be $1,000,000 in 2011 with tax brackets jumping back up to pre-2000 levels.

At the core of most planning for well-to-do married couples is the principle that a transfer from one spouse to a U.S. citizen spouse occurs free of any estate and gift tax. Such gifts, however, increase the estate of the donee (or surviving) spouse. As a result, if the survivor’s estate is then larger than the federal estate tax exemption, the assets given to the surviving spouse are exposed to estate taxation later at the time of the surviving spouse’s death.

At the state level, before and after 2010, the same principle applies except for the fact that state estate tax exemptions are frequently different from the federal estate tax exemption. Currently the Connecticut estate tax exemption is $3,500,000 and New York’s exemption is $1,000,000.

To make matters more complicated, as the federal tax provisions have been changed, state legislatures have responded with frequent changes to their estate tax laws. For example, Connecticut has changed its estate and gift tax provisions in significant ways more than six different times in the last five years. Within the last five years, the Connecticut General Assembly has repealed its succession tax, enacted an enhanced type of estate tax, repealed that estate tax, hastily adopted a unique new estate tax (containing obvious errors which it has chosen to perpetuate), adopted a new estate tax with a $3,500,000 exemption, and postponed the application of the $3,500,000 exemption while reinstating the $2,000,000 exemption. Governor Rell has vetoed the postponement and reinstatement. We are waiting to see whether the Connecticut lawmakers will override the Governor’s veto.  As matters currently stand (January 9, 2010), the Connecticut estate tax exemption is $3,500,000.

Although it is difficult to predict the actual amount of the federal and state estate tax exemptions that may apply at the time of your death, if an estate tax is then applicable at either a state or federal level, we can assume that an estate tax exemption in some amount will exist. If the surviving spouse receives all the property of the deceased spouse, the survivor’s estate tax could exceed the then existing exemption, thereby generating an estate tax obligation to pay.

The estate tax could be eliminated or reduced if the deceased spouse’s estate plan takes advantage of the marital deduction only to the extent necessary to minimize or eliminate the tax payable from his or her estate. This would mean that, before 2010 (and again in 2011) an amount roughly equal to the applicable exemption would pass to a trust for the benefit of the survivor (frequently called a “credit shelter trust,” “bypass trust” or “exemption trust;” for the purposes of this article, we will call it an “exemption trust”). The exemption trust would not be subjected to an estate tax when the survivor dies.

With the above in mind, estate planners often begin their analyses by asking: “Why give the surviving spouse any more as a marital deduction gift (which will be subject to tax on his or her subsequent death) than is necessary to reduce the deceased spouse’s estate tax to the lowest amount (usually zero), when the property not so given to the surviving spouse (for example, having the value of the exemption) can be placed in a trust (the exemption trust) for the benefit of the surviving spouse and escape tax entirely on his or her subsequent death?”

An Illustration: Consider the following example. Mr. Taxpayer has an estate of $1,800,000. His primary goal is the care and comfort of Mrs. Taxpayer. His secondary goal is the preservation of his estate for ultimate distribution to his descendants. Some reasonable alternatives for the disposition of his estate are:

(a) Give his total estate to Mrs. Taxpayer.

(b) Give his total estate to Mrs. Taxpayer but give her the opportunity to “disclaim” a portion of the estate. The “disclaimed property” would pass to a trust for Mrs. Taxpayer’s benefit (the “Disclaimer Trust”) and would not be subject to tax on Mrs. Taxpayer’s subsequent death. This alternative will be referred to as the “Disclaimer Plan.” [Note: A “disclaimer” is the irrevocable refusal to accept a gift of property. The general rule is that for a disclaimer to be effective for tax purposes the disclaiming party cannot have any interest in the disclaimed property following the disclaimer. There is, however, a special exception which allows a surviving spouse to disclaim property passing into a trust created under the deceased spouse’s Will for the benefit of the surviving spouse. Such a trust must, however, be narrowly drawn because the surviving spouse may not have any powers over trust principal.]

(c) Give part of his estate to Mrs. Taxpayer and the rest (equal to the exemption existing at the time of his death) to a trust (the “Exemption Trust”) for Mrs. Taxpayer’s benefit. The Exemption Trust would not be subjected to estate tax on Mrs. Taxpayer’s subsequent death. This alternative will be referred to as the “Formula Plan.”

Alternative (b), the Disclaimer Plan, is actually the same as alternative (a) but with the added flexibility which arises by giving to Mrs. Taxpayer the power to make the planning decisions, with the help of her advisors, after Mr. Taxpayer’s death. Alternative (b), the Disclaimer Plan, could produce tax results almost the equivalent of alternative (c), the Formula Plan. One important difference between the Disclaimer Plan and Formula Plan is that, under the Disclaimer Plan, tax savings will result only if the surviving spouse takes the necessary steps. The following discussion will relate only to the Disclaimer Plan and the Formula Plan.

The Disclaimer Plan: Suppose (i) Mr. Taxpayer dies in 2011 (when the federal exemption is $1,000,000) with an estate of $1,800,000, (ii) that when he drafted his Will he adopted alternative (b), the Disclaimer Plan, and (iii) that Mrs. Taxpayer’s separate assets have no value. Mr. Taxpayer’s Will provides that his total estate passes to Mrs. Taxpayer except for property she disclaims. If Mrs. Taxpayer did not disclaim, she would receive $1,800,000 (less some administration expenses) from Mr. Taxpayer’s estate, all of which would be subject to tax on her subsequent death. Because Mrs. Taxpayer’s estate, when she subsequently dies, would be approximately $1,800,000, and larger than the applicable federal estate tax exemption ($1,000,000), estate taxes would be payable from her estate. The tax would be significant. In 2011, once the taxable estate exceeds the exemption, the lowest applicable estate tax bracket would be 41%.

Mrs. Taxpayer’s estate tax liability could be significantly reduced by her use of the disclaimer shortly after Mr. Taxpayer’s death. Suppose, for example, that Mrs. Taxpayer decides that she does not need the total $1,800,000 outright from Mr. Taxpayer in order to be financially secure, or that, regardless of her financial security, the ultimate tax costs of outright ownership of the total $1,800,000 is too high. She might decide to disclaim a portion of Mr. Taxpayer’s estate having a value up to $1,000,000 (the exemption), which amount, according to Mr. Taxpayer’s Will, would pass into the Disclaimer Trust for her benefit. She might wish to pick $1,000,000 as the appropriate amount to disclaim because $1,000,000 (the 2011 federal estate tax exemption) would be the largest amount she could disclaim without generating a U.S. estate tax. The results of such a disclaimer would be as follows:

(a) Mrs. Taxpayer would receive outright from Mr. Taxpayer approximately $800,000. Her estate at the time of her subsequent death would consist of her own property (which we earlier assumed had no value) plus the $800,000 received from Mr. Taxpayer.

(b) The Disclaimer Trust receiving the disclaimed property would contain $1,000,000, less some other items (administration expenses). The Trustee would pay all income to Mrs. Taxpayer and also would have broad discretion to pay principal to Mrs. Taxpayer if she needed it. If desirable, the Trustee could be allowed to invade income and principal for the benefit of others although such provisions could make the disclaimer less attractive to Mrs. Taxpayer. The assets in the trust would not be taxed as part of Mrs. Taxpayer’s estate when she subsequently dies.

(c) Upon Mrs. Taxpayer’s subsequent death, U.S. estate taxes saved as a result of Mrs. Taxpayer’s disclaimer would probably exceed $250,000.

(d) State death taxes might also be saved by this plan because the assets in the trust (the disclaimed property) would not be subject to such taxes on Mrs. Taxpayer’s subsequent death.

The Formula Plan: Under the Formula Plan, the tax planning decisions are made in advance (at the time Mr. Taxpayer signs his Will) for Mrs. Taxpayer in favor of overall estate tax savings. The Formula Plan would be designed to bequeath to the Exemption Trust for the benefit of the whole Taxpayer family an amount equal to the estate tax exemption available at the time of Mr. Taxpayer’s death. The remainder of Mr. Taxpayer’s estate assets would pass either outright to Mrs. Taxpayer or in a trust which would qualify for the marital deduction (the “Marital Trust” or the QTIP Trust” referred to below). Although this may seem to achieve the same results as can be obtained by using the Disclaimer Plan, the most important advantage which the Exemption Trust has over the Disclaimer Trust is that the Exemption Trust can contain broad discretionary powers over principal which are exercisable by Mrs. Taxpayer, but the Disclaimer Trust cannot contain such powers.

In order to decide whether to adopt the Disclaimer Plan or the Formula Plan, Mr. Taxpayer would consider the following:

(1) Whether he believes the Formula Plan would provide his wife with sufficient benefits to make her feel comfortable and secure. One way to ask the question is: “Do I believe that, even though my wife may have control over less property, there should be placed in a trust for her benefit in all events the full amount of the exemption, knowing that to do so will lower death taxes at my wife’s subsequent death?” Of course, Mr. Taxpayer must at this point decide how he feels about trusts in light of the substantial tax savings which could result from the use of one or more trusts. If the answer to the question is “yes,” the Formula Plan is probably the one to adopt.

(2) The answer to the question posed above may depend upon the nature of the trust, and Mr. Taxpayer must decide whether the following powers, which are frequently included in the Exemption Trust under the Formula Plan (but are excluded from the Disclaimer Trust, except for the $5,000 or 5% withdrawal power), make the difference. These powers are: (i) Mrs. Taxpayer’s power during her lifetime to appoint trust principal to individuals other than herself (usually limited to descendants); (ii) Mrs. Taxpayer’s power to withdraw for her own use the greater of $5,000 or 5% of the trust principal each year, and (iii) Mrs. Taxpayer’s power upon her death to appoint trust principal to individuals (usually limited to descendants), other than herself or her estate, by appropriate provisions in her Will. On the other hand, both the Exemption Trust and the Disclaimer Trust would provide that income be paid to Mrs. Taxpayer and that the Trustee has broad discretionary powers to invade principal for Mrs. Taxpayer. As previously mentioned, the Disclaimer Trust could also include a right in Mrs. Taxpayer to withdraw the greater of $5,000 or 5% of the Disclaimer Trust principal.

(3) Mr. Taxpayer should also consider the fact that, if the Disclaimer Plan is adopted, the tax planning decisions will be left to Mrs. Taxpayer (with the help of her advisors) and must be made within nine months after his death under what could be stressful circumstances. If he believes his wife is capable of making the decision as to how much should be placed in trust so as to reduce taxes at her later death, even under such stressful circumstances, then the Disclaimer Plan would have greater appeal, even though the Disclaimer Trust is a less flexible trust. If Mr. Taxpayer believes that it would be unwise to leave this decision to Mrs. Taxpayer at a difficult time, or that the Disclaimer Trust is too inflexible, then the Formula Plan would have greater appeal.

Marital Trust Options: Both the Disclaimer Plan and the Formula Plan take advantage of the marital deduction. The different ways in which property may pass and qualify for the marital deduction can be used in either plan. If the surviving spouse is a U.S. citizen, the forms of marital deduction gifts are (i) the outright gift, (ii) the traditional Marital Trust which gives the surviving spouse the absolute power to control by Will the disposition of trust principal upon the surviving spouse’s death, and (iii) the qualified terminable interest property trust (“QTIP Trust”). Unlike the traditional Marital Trust, the QTIP Trust may irrevocably designate descendants (or any other person or class of persons) as the ultimate recipients of the marital deduction property (or prohibit the surviving spouse from appointing such property to persons other than a particular class of people). If the surviving spouse is not a U.S. citizen, the marital deduction will not be available except for property which passes to a trust known as a qualified domestic trust (“QDOT Trust”).

Considerations Relating to the Use of Trusts: The planning techniques discussed above require the creation of trusts. Factors to consider regarding the use of trusts are:

(1) Trust assets are managed by a Trustee (a person or bank) for the benefit of others. The beneficiaries, therefore, do not have control over the trust assets. A Trustee, however, must account to the beneficiaries for its actions. It is generally preferable to give a Trustee broad discretion (limited, however, by prudence) regarding investment decisions. Often, depending on circumstances, a Trustee may also be given broad discretion to decide how benefits will be divided among members of a class of beneficiaries.

(2) The most important decision regarding the use of a trust is the identity of the Trustee. The Trustee must, among other things, be meticulous about keeping separate and complete records, prudent with respect to investments, sensitive to the needs of the beneficiaries and fair in its dealings with both the trust and all beneficiaries.

(3) The management of trusts involves some expense relating to the Trustee’s compensation, court costs and legal fees.

(4) Trusts are not merely tax-saving devices. A trust may be the best way to provide a benefit for someone who is not up to managing assets. Particularly when tax considerations are not of primary concern, a trust can be drafted containing an endless variety of provisions to accomplish many different goals.

The Effects of Repeal in 2010 (Current Law as of January 9, 2010)

Federal Exemption Uncertainty: Many of you have estate planning documents which contain provisions referring to the federal estate tax exemption (the Formula Plan described above). If your death occurs in 2010 when the federal estate tax does not apply, there may be questions regarding how the documents will be interpreted. For example, documents which our firm prepared using the Formula Plan will be interpreted to maximize the value of the Exemption Trust with the result that the Marital Share might be reduced or eliminated. Such a result is not necessarily bad depending on how assets are titled and beneficiary designations for retirement accounts, life insurance and other similar assets are prepared.  To avoid surprises, however, and to assure proper coordination between the terms of the Will (or Will substitute) and beneficiary designations, it is important for you to review such plans. 

Different attorneys take different approaches to the preparation of Formula Plans. How each provision will be interpreted in light of the federal estate tax law changes will depend on the language employed by the drafting attorney. Some drafting approaches may be interpreted as maximizing the Marital Share with the result that the exemption trust would not be funded. In that case, an opportunity to use the exemption trust to shelter assets from an estate tax (that might be imposed when the surviving spouse dies) would be lost.

We suggest that everyone who has estate planning documents that use the Formula Plan ask their attorneys to review their documents and the assets comprising their estates.

State Exemption Uncertainty: As mentioned above, Connecticut’s General Assembly enacted a $3,500,000 exemption which is effective on January 1, 2010, but then postponed its effective date for two years. The postponement was vetoed, however, by Governor Rell. Unless the General Assembly overrides the veto, Connecticut will have a $3,500,000 exemption.

Other states have smaller exemptions. New York and Massachusetts, for example, have $1,000,000 exemptions. New Jersey and Rhode Island have $675,000 exemptions.

Estate plans that use the type of Formula Plan that maximizes the size of the exemption trust could result in an unexpectedly high state estate tax when the value of the property passing to the exemption trust (in 2010 this could be 100% of the estate) exceeds the value of the state exemption.

We suggest that everyone who has estate planning documents that use the Formula Plan ask their attorneys to review their documents, and the assets comprising their estates, to determine whether the size of the exemption trust should be limited to the state exemption.

Marital Deduction Uncertainty: As mentioned above, if the surviving spouse is a U.S. citizen, the forms of marital deduction gifts are (i) the outright gift, (ii) the traditional Marital Trust which gives the surviving spouse the absolute power to control by Will the disposition of trust principal upon the surviving spouse’s death, and (iii) the qualified terminable interest property trust (“QTIP Trust”). If the surviving spouse is not a U.S. citizen, the marital deduction will not be available except for property which passes to a trust known as a qualified domestic trust (“QDOT Trust”).

Many of you have estate planning documents which include a QTIP trust or a QDOT trust that is drafted like a QTIP trust. Property passing to such a trust qualifies for the estate tax marital deduction only if an election is made. In 2010, when the federal estate tax is not applicable, there is no way to make the federal QTIP and QDOT elections. Connecticut law allows a QTIP election (but is silent on the QDOT election) even when there is no federal estate tax in effect (referred to as a “state-only election”). Other states may not allow a state-only election. For example, New York, New Jersey and Vermont (among other states) do not allow a QTIP election when no federal election is made.

Accordingly, if your death occurs in 2010 when the federal estate tax does not apply, and you own property in a state which does not allow a “state-only” QTIP election (similar to New York), and if that property passes to a QTIP type trust, no estate tax marital deduction will be available under that state’s estate tax law.  As a result, estate taxes imposed by that state may by unexpectedly high.

In addition, it appears that, during 2010 (when no federal estate tax applies), no Connecticut estate tax marital deduction will be allowed for any type of transfer at death to a spouse who is not a U.S. citizen because there is no provision for making a QDOT election at the state level.  As a result, a surviving non-citizen spouse may be surprised by unexpectedly high state estate taxes.

Income Tax Basis and Capital Gains Tax Uncertainty: You might expect that the absence of the U.S. estate tax would make life simpler. Look a little under the surface, however, and you begin to understand that absence of the U.S. estate tax leaves behind certain provisions relating to capital gain taxes which will adversely affect everyone who has assets (and I literally mean everyone) while the estate tax, before repeal, adversely affected only a very small group.

Before capital gains can be taxed, the size of the gain must be computed. Generally, the gain is the difference between what you receive in exchange for the asset and your tax basis in the asset. When you purchase an asset, your tax basis in the asset is generally what you pay for it. Before 2010, when you inherited an asset from a decedent, your tax basis in the asset was adjusted to its value as of the date of the decedent’s death. Accordingly, inherited property (there are exceptions, however) usually could be sold shortly after the decedent’s death free of capital gains tax. In 2010, however, that changes. When you inherit property from someone who dies in 2010, there will not be the automatic adjustment to basis; rather, you will receive the same basis the decedent had in the property immediately before the decedent’s death (referred to as a “carry over basis”) subject to certain valuable (but limited) adjustments that must be made by your Executor.

For every decedent’s estate (whether married or single), 2010 law provides that the tax basis of inherited property may be increased to its date of death value, but the increase is limited to a total adjustment of $1,300,000. We do not yet know the mechanics of making such adjustments. Nevertheless, we expect that a very large proportion of decedent’s estates will be affected by this provision (a much larger proportion than those who are affected by the federal estate tax). Many (a vast majority?) who would not have had to file any federal estate tax return now will be required to file tax forms with the IRS to make the adjustment.

For an estate of a married decedent, an additional $3,000,000 adjustment to tax basis may be available for certain property that passes to a surviving spouse or to a qualifying trust for the benefit of the surviving spouse. Very few current estate planning documents take this $3,000,000 adjustment into account. Many exemption trusts will not qualify for this adjustment. Accordingly, unless the terms of the exemption trust are modified, an opportunity to take advantage of the $3,000,000 adjustment may be lost.

Conclusion

All estate plans with marital deduction formula documents should be reviewed. The review should include a review of all assets and beneficiary designations.

Posted on 12/30/2009 by Richard S. Land, Member, Chipman, Mazzucco, Land & Pennarola, LLC.

January, 2010, Copyright Richard S. Land

Note:  To comply with U.S. Treasury Department rules and regulations, we inform you that any U.S. federal tax advice contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction, tax strategy or other activity.


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