The presidential election is now behind us. What do the results mean for estate-planning professionals? We asked three leading estate-planning experts—Michael O. Hartz (MOH), Thomas G. Opferman (TGO) and Charles A. Redd (CAR)—to answer the following four questions on how the election will affect estate planning:
1. What impact do you think President Obama’s victory will have on the U.S. estate, gift and generation-skipping transfer (GST) tax?
2. Have you changed the advice you give to your high-net-worth clients based on the election results? If so, how?
3. How do you think the election results will impact your clients’ charitable giving, if at all?
4. For those clients with family businesses, what’s the impact of the election results on those family businesses?
Based on their answers, we can see that even though we know the election results, what happens next is still difficult to predict. But, our experts have insightful advice as to what clients should do, given the uncertainty. Please note that our experts’ answers are all based on the facts in place as of the end of November 2012, when this article was written.
Estate, Gift and GST Taxes
Our experts seem to agree that tax increases are likely. Beyond that, there are a lot of proposals out there that will affect estate planning, and it’s difficult to predict what will happen.
MOH: Any discussion of estate tax repeal has been relegated to the dustbin. It appears, in line with President Obama’s 2013 budget proposal, that estate, gift and GST tax rates will be higher than in 2012 and that estate, gift and GST tax exemptions will be lower than in 2012, and it doesn’t seem that the Republican control of the House will be enough to maintain the 2012 rates and exemption levels.
The foregoing forecast doesn’t take much of a crystal ball, but what will require one is determining whether a lame-duck session of Congress will provide practitioners any guidance prior to the end-of-the year. Stranger things have happened, especially in light of the lame-duck legislation enacted in December 2010, which, among other changes, gave us portability and reunified gift and estate tax exemptions (and a GST tax exemption) of $5 million (indexed for inflation). Who knows what surprises may be in store.
While many practitioners seem resigned to a $3.5 million estate and GST tax exemption and a 45 percent income tax rate, the real question is whether the gift tax exemption will remain unified with the estate tax exemption. Also, while portability will likely remain permanent, other Obama administration proposals (for example, 10-year minimum term for grantor retained annuity trusts (GRATs), 90-year limitation for GST/dynasty trusts and estate inclusion of irrevocable grantor trusts) may have an uphill battle.
However, anything is possible. Who would have guessed that 2010 would pass by with no estate tax?
TGO: Many observers expect retroactive tax legislation in 2013 if none is passed in 2012, perhaps preceded by another short-term patch to avert a temporary return to pre-2001 transfer tax rules. If Congress ultimately adopts the president’s key proposals, transfer tax rates will increase from 35 percent to 45 percent and exemption equivalents will drop from $5.12 million to $1 million for gift taxes and $3.5 million for estate and GST taxes. In addition, GST tax-exempt dynasty trusts, which now may last indefinitely in states that have eliminated the rule against perpetuities, would be limited to 90-year terms. Distributions from a grantor trust during the grantor’s lifetime would be subject to gift tax and, at the grantor’s death, trust assets would be included in the grantor’s estate. GRATs would be subject to a 10-year minimum term, and remainders would be required to have some value for gift tax purposes. The proposed new grantor rules, essentially, would end the use of grantor trusts, eliminate installment sales to intentionally defective grantor trusts and significantly reduce the use of GRATs, especially for clients wary of a 10-year mortality risk. President Obama also favors consistent valuations for reporting gain or loss for income tax purposes, so that a recipient of property would be required to report the same basis as the transferor of the property.
While many of the president’s proposals would increase overall transfer taxes, certain proposals would benefit some clients. For example, the president and many members of Congress support portability and would make it permanent. Portability is especially useful for married couples with large individual retirement accounts, a house in joint tenancy, little or no state estate tax exposure, no children from a prior marriage and no interest in creditor protection or trust management expertise. In addition, by supporting repeal of the Defense of Marriage Act, the president and many in Congress effectively support extension of the marital deduction to same-sex couples.
If exemption equivalents change, as is expected, clients, especially those with children from a prior marriage, should be mindful of formula clauses used to allocate distributions between a marital share and a family share. In addition, some commentators believe a reduced gift tax exemption could expose certain clients to gift tax clawback; however, many clients haven’t hesitated to take advantage of the relatively generous gift tax exemption currently in effect.
CAR: As of the time of this writing (the last week of November 2012), the impact of President Obama’s election triumph is difficult to predict. One thing that can be said with a high degree of confidence, however, is that the estate, gift and GST tax system won’t be repealed in the foreseeable future. Candidate Romney and the Republican platform voiced support for repeal, but Romney is now out of the picture, and Republican influence inside the Beltway, while by no means eliminated, has been diminished.
It seems equally unlikely that we’ll see a permanent or long-term return to a $1 million transfer tax exemption (indexed for GST tax purposes) and a 55 percent marginal transfer tax rate. Although Representative Jim McDermott (D-Wash.) continues to run up the flagpole his “Sensible Estate Tax Act of [you name the year]” (last introduced on Nov. 17, 2011),1 which, if enacted, would provide for, among other things, a $1 million exemption (indexed for all purposes) and a 55 percent rate, it appears there are few in Congress who agree with his characterization of that approach as “sensible.”
President Obama’s wish list of changes to the 2012 transfer tax rules is found in the Administration’s Budget Proposal contained in the General Explanations of the Administration’s Fiscal Year 2013 Revenue Proposals (the Green Book), released on Feb. 13, 2012. It includes many components, perhaps the most prominent of which is a return to the 2009 standard of a $3.5 million estate tax applicable exclusion amount and GST exemption, a $1 million gift tax applicable exclusion amount and a 45 percent top transfer tax rate. In addition, as set forth in the Green Book, the president would, among other things: (1) make portability permanent; (2) effectively kill estate planning based on being able to exclude from a grantor’s gross estate the value of property composing irrevocable grantor trusts; (3) severely curtail the implementation of valuation discounts in estate planning; and (4) terminate the effect of GST exemption after 90 years from the date it was allocated.
Momentum seems to be building (although the source of this momentum seems shrouded in mystery) for retention of the 2012 transfer tax template: (1) a $5 million applicable exclusion amount (indexed) for all purposes; and (2) a 35 percent rate. Perhaps this (or some as yet unknown transfer tax concoction) will be a part of a “grand bargain” that will be legislated to avoid falling over the so-called “fiscal cliff” on Jan. 1.2
We’re still operating within almost exactly the same divided government context to which I alluded in my “Gridlock Reigns Supreme” article3 in the May 2012 issue of this magazine.
This could easily cause, and I continue to believe it will cause, deferral of changes to the estate, gift and GST tax regime until after Dec. 31. Accordingly, when this article is being read, I expect that we’ll have reverted to $1 million and 55 percent. I think that, at some point this year, legislation will be enacted, with a retroactive effective date of Jan. 1, that will incorporate, temporarily or long-term, a $5 million applicable exclusion amount (indexed) for all purposes and a 35 percent rate—perhaps along with a few features of the president’s wish list. For acceding to $5 million and 35 percent, instead of his preferred $3.5 million and 45 percent, the president will have a bit more leverage to obtain revenue enhancements on the income tax side.
Advice to Clients
For the most part, our experts continue to give the same general advice to clients after the election as they had before.
MOH: Given that high-net-worth clients are generally focused on wealth shifting, the election results most likely caused an uptick in last minute gifting by those clients who, for whatever reason, had remained on the fence. Possibly, those clients were waiting for the election results to make a more informed decision.
While some clients were more motivated to implement one or more wealth transfer strategies, the big picture advice I would give to clients remains consistent, both before and after the election. Planning should be a part of an integrated, well-thought-out strategic plan, and the client’s goals and objectives should remain the guidelines for advice that’s given. Whether the exemption is $1 million or $5.12 million, or whether the estate, gift or GST tax rate is 55 percent or 35 percent, shouldn’t have a material impact on the long-term view of the client’s estate-planning program. Surely, taking advantage of planning opportunities shouldn’t be ignored; however, the key is to integrate those opportunities into the client’s long-term planning objectives.
TGO: The election result didn’t change our advice to our clients. We’ve been recommending that high-net-worth clients take advantage of the current, relatively favorable, transfer tax exemptions and rates before year-end, and most clients already did so. Like many other estate-planning practitioners, we also anticipate continued tax uncertainty and, although the election is behind us, we won’t have the benefit of reliable, predictable tax planning rules until Congress enacts reasonably permanent tax legislation, the president signs it into law and the Internal Revenue Service provides guidance with respect to any ambiguities.
To fully use 2012 exemptions and rates before their scheduled expiration at midnight, Dec. 31, 2012, many high-net-worth clients made leveraged gifts of appreciating assets to GST-exempt dynasty trusts. In addition, clients took advantage of available opportunities to create short-term zeroed-out GRATs and installment sales to intentionally defective grantor trusts. Non-grantor charitable lead trusts are popular with some clients because of the historically low interest rate environment. Clients should also re-examine insurance and liquidity needs in light of potentially higher overall estate tax liabilities.
Since the election wasn’t, by itself, expected to provide tax clarity, many clients are choosing flexible strategies that will permit beneficiaries or trustees to make adjustments in the future. For example, disclaimer trusts and limited powers of appointment may give beneficiaries the opportunity to take a second look at an estate plan and bring it into line with new tax, economic or family circumstances. In addition, trustees, who often are independent, may be given broad discretion over distributing income and principal and making tax elections. Some clients also are comfortable giving trustees broad investment powers and express authorization to add or remove beneficiaries, change the situs of the trust and decant the trust—even into a new trust with different beneficiaries. The potential benefits of flexibility, however, should be balanced against a client’s desire for greater certainty with regard to how and for whom a trust is ultimately administered and distributed.
CAR: I haven’t made significant structural changes in such advice based on the election results, but I’ve refined my advice in some respects and have sought to bring a greater sense of urgency to client discussions. Had President Obama been defeated in his re-election bid, the Green Book would have been largely, if not completely, forgotten—at least for the next four years. Given the president’s success on Nov. 6, however, the Green Book has achieved enhanced stature. It’s quite possible that one or more of the proposals outlined in the Green Book that would affect estate planning will soon find their way into new tax legislation. These initiatives include: (1) causing inclusion in a settlor’s gross estate of the value of property of an irrevocable trust for the sole reason that it’s a grantor trust for income tax purposes; (2) substantially constricting the use of valuation discounts when transferring interests in a family-controlled entity by tightening the definition of an “applicable restriction” under Internal Revenue Code Section 2704(b); (3) limiting the duration of GST exemption allocation to 90 years; and (4) with respect to any GRAT, imposing minimum and maximum terms, requiring the present value of the remainder interest to be greater than zero and prohibiting any annuity decrease during the term.
Accordingly, while I continue to extol the benefits of estate planning using irrevocable grantor trusts, I now must advise clients there’s at least some possibility that the value of the assets of such trusts will, solely because of grantor trust status, be includible in the client’s gross estate. Furthermore, if such a trust is to be designed as a dynastic, generation-skipping vehicle, or if the trust is to be funded with assets that would seem to generate valuation discounts, I must apprise clients of the severe constraints to the use of the GST exemption and valuation discounts that may shortly be imposed by new tax laws. Thus, there’s more incentive than ever to establish and fund irrevocable perpetual grantor trusts sooner rather than later. At the same time, there’s the specter of a possible retroactive effective date applicable to one or more changes in the tax law that could reach back far enough to impact even transactions that occurred in 2012.4 Articulating a message to clients that they had best proceed very quickly, but perhaps not at all, can be like hurtling toward a traffic signal that has just turned yellow. As always, I am striving fully to explain all possible advantageous and disadvantageous consequences and then allowing the client to make an informed decision regarding whether to proceed.
Similarly, although, again, I must be certain the client understands and appreciates the risk of a new tax law with a retroactive effective date, I’m advising those for whom a GRAT may be a desirable estate-planning technique that, if we are to move forward with a GRAT, we should do so as soon as possible to maximize the likelihood that it won’t be subject to the restrictions laid out in the Green Book. It also makes sense for those who are interested in GRATs or any leverage strategies based on low interest rates to consider implementing those promptly, due to still prevailing historically low applicable federal rates.
Some of the proposals being considered (reducing the charitable deduction) may result in a decrease in charitable giving, according to our experts. But, depending on what happens, there are certain charitable giving strategies that may prove effective.
MOH: Time will tell, but I fear that a significant reduction in the benefit of the income tax charitable deduction will have a materially adverse impact on the future of significant charitable giving. Few of us are wholly altruistic, and if the income tax benefit for charitable gifting is greatly reduced, I doubt there will be an increase in altruism.
Alternatively, so long as the estate tax charitable deduction remains in place, especially in light of potentially higher estate tax rates, there could be a greater emphasis on testamentary charitable planning. From that perspective, charitable giving may increase.
TGO: Some clients will support charitable causes no matter who occupies the White House and irrespective of the tax laws in effect. Others adapt the amount and timing of their philanthropy to changing tax policies and economic forecasts, both of which are likely to be impacted by the election.
The president favors limiting itemized deductions for higher income taxpayers to 28 percent, while increasing their tax rates from 35 percent to up to 39.6 percent. If enacted into law, the president’s proposals would reduce the value of charitable deductions for high-earning clients, while potentially leaving fewer after-tax funds available for philanthropy. Although only the wealthiest taxpayers would be impacted by these changes, their donations disproportionately fund the large gifts on which many universities, hospitals and other charities rely. According to the Center for Philanthropy at the University of Indiana (the Center), the wealthiest 3 percent of American households contribute half of the $210 billion donated by individuals annually. In addition, between 2009 and 2011, a period of recession, high-net-worth households reduced their charitable contributions by 7 percent and made fewer charitable gifts spontaneously, according to the Center. Its study, conducted prior to the election, also found that most high-net-worth individuals didn’t plan further reductions in their charitable giving over the next three to five years. Respondents also planned to increase their use of private foundations and donor-advised funds (DAFs).5 With bipartisan support for reinstatement of individual retirement account charitable rollovers, clients who are at least 70½ years old may, once again, be able to give up to $100,000 from their IRAs directly to public charities. For those clients, IRA charitable rollovers would represent a valuable opportunity to support important causes, while avoiding income tax on an IRA required minimum distribution (RMD). Under the charitable rollover rules that expired in 2011, contributions: 1) qualified as RMDs, 2) were excluded from taxable income, and 3) weren’t limited to 50 percent of the taxpayer’s adjusted gross income (AGI). Several important restrictions applied, however. Funds were required to pass directly from an IRA to charity without intermediate possession by the taxpayer. In addition, an IRA charitable rollover wasn’t permitted for gifts to a DAF, a supporting organization or a private foundation.
CAR: The election results are likely to have some impact on my clients’ charitable giving, but I wouldn’t describe such impact as huge. Among the factors high-income taxpayers will consider is the likelihood that federal income tax rates applicable to them will increase as a result of either legislative compromise (with President Obama having some leverage to negotiate income tax increases) or our stepping off the fiscal cliff.6 Were that the only consideration, it would have been an easy choice for such taxpayers to defer charitable gifts into this year or beyond. Of course, the amorphous probability of income tax hikes isn’t the sole consideration. As proposed in the Green Book, income tax rate increases would apply to married taxpayers filing joint income tax returns having AGI of $250,000 or more and single taxpayers having AGI of $200,000 or more, and such increases were to have taken effect as of Jan. 1, 2013. As of this writing, it’s by no means clear, however, who would be impacted by income tax rate increases or when those increases would occur.7 It’s certainly possible that negotiations between the Administration and Congress could result in new tax legislation containing higher AGI thresholds and/or a delay of the effective date. In addition, the time value of money will be relevant to some taxpayers. A deduction today against income taxed at a lower rate may be worth more to a given taxpayer than the same deduction tomorrow against income taxed at a higher rate. Moreover, as was very often the case even before the election, unique situational characteristics must be taken into account, such as unusual known or expected spikes or drop-offs in AGI and the particular needs (immediate vs. longer term) of the intended donee charity.
Additionally, charitable remainder trusts (CRTs), which have waned in popularity in the past several years, largely as a result of low interest rates, may make a comeback if and when a capital gains tax rate increase and the 3.8 percent Medicare surtax on net investment income take effect with respect to high-income taxpayers. A CRT, as an income tax-exempt entity,8 will continue not to be subject to capital gains tax, but will be subject to the new 3.8 percent Medicare surtax.
The consensus among our experts is that family businesses will be affected by the election results based on a variety of factors, including increases in capital gains taxes and possible changes to valuation discount rules.
MOH: From a business perspective, added burdensome government regulations, higher tax rates and added costs to implement Obamacare, combined with a sluggish economy, don’t bode well for family businesses. Given the uncertainty of the Tax Code, family businesses (as well as publicly traded companies) have found it difficult to develop sound strategic business plans when there’s uncertainty as to the tax impact of those decisions.
From an estate-planning perspective, the election results should cause family businesses to focus more closely on transferring more of the ownership of the family business, especially in light of the current ability to achieve valuation discounts due to minority interest and lack of marketability. The new Congress may seriously entertain alternatives that could effectively reduce the availability of valuation discounts. Curtailing (or possibly eliminating) valuation discounts will make it that much more difficult to transition a family business to the next generation. Also, curtailing (or eliminating) valuation discounts, in effect, results in an increase in the transfer tax that would be paid by family business owners when transferring interests in the family business. This added tax burden will make it that much more difficult to successfully transition the family business to the next generation of family owners.
TGO: President Obama favors increasing the tax on long-term capital gains from 15 percent to 20 percent and increasing the tax rate on dividends to 39.6 percent. The Affordable Care Act (ACA) mandates an additional 3.8 percent tax on investment income for higher earning taxpayers. Accordingly, many clients with family businesses accelerated compensation and dividends in 2012, using a combination of cash and notes that locked in current historically low interest rates. Compensation often is preferred over dividends, since “reasonable” compensation is deductible and dividends aren’t; however, clients shouldn’t be too aggressive, lest “excessive” compensation be recharacterized as dividends. In addition, some clients are considering stock redemptions as a means of distributing cash at lower capital gains rates. This strategy was less useful while capital gains and dividends were taxed at the same rates.
The election also clarified the status of the ACA, and companies with 50 or more employees are preparing for compliance. Some businesses are planning to hire more employees on a part-time basis to minimize exposure to the ACA. The Administration, however, has proposed an expanded health insurance tax credit for small businesses.
Clients who own family businesses also are re-evaluating their life insurance to determine whether they have sufficient liquidity for payment of higher estate taxes. Clients are also re-examining buy-sell agreements. Meanwhile, practitioners hope that Congress will make permanent the rules governing qualification for installment payment of estate tax under IRC Section 6166, since without Congressional action, more restrictive pre-Economic Growth and Tax Relief Reconciliation Act (EGTRRA) rules will come into effect. For example, Section 6166 only would apply if a family business has up to 15 partners or shareholders—down from 45 under current law. In addition, a reversion to pre-EGTRRA tax rules could result in acceleration of the balance of estate taxes due if a family business lawfully elected installment payments under Section 6166 post-EGTRRA, but wouldn’t have qualified to do so under Section 6166 pre-EGTRRA.
The family business owner also may wish to note that the president’s proposals would limit valuation discounts based on lack of control. Proposed rules would disregard any limit on an owner’s right to liquidate his interests or be admitted as a full partner. Potentially favorable tax proposals include increased deductions for start-ups and the ability to expense up to $1 million in investments.
CAR: The vast majority of family businesses are pass-through entities for income tax purposes, that is, subchapter S corporations, partnerships and limited liability companies. Since the owners of a family business are, therefore, the alter ego of the business from an income tax point of view, many family businesses are, in practical effect, almost certainly staring down the barrel of impending income tax increases—whether as a result of new tax legislation or the fiscal cliff. Depending on the provisions ultimately included in such new tax legislation (to whom and/or when income tax hikes would apply) or whether the fiscal cliff is the culprit, such increases could be material to a family business. Thus, I think many family businesses will, at least in the immediate future, conduct operations in a very fiscally conservative manner. Family business decision makers will move cautiously in deciding whether to hire additional employees, make investments in equipment, infrastructure, research, development, and so on.
Family business succession is also likely to be impacted by the election results. Among those tax law changes promulgated in the Green Book is a provision that, by changing the definition of an “applicable restriction” under IRC Section 2704(b), would substantially limit employing valuation discounts in transferring equity in a family-controlled entity. Under IRC Section 2704(b), an applicable restriction is to be ignored when determining the value of a transferred interest in a corporation or partnership controlled by members of the transferor’s family. An applicable restriction is a restriction on such a corporation or partnership’s liquidation ability that, as a result of or following the transfer of an interest in such entity, lapses in whole or in part or may be removed by the transferor or any member of the transferor’s family. One of the exceptions to the “applicable restriction” definition paraphrased in the preceding sentence is that the term “applicable restriction” doesn’t include any restriction imposed by state law. Thus, if state law provides a default rule governing the circumstances under which liquidation may be permitted, that rule, regardless of how restrictive, won’t be ignored in determining value.
The Administration views as potentially subject to abuse, a federal tax statute whose structure allows the laws of individual states to set the standard by which a key component of value determination is or isn’t to be considered. Accordingly, the Green Book’s proposal to amend IRC Section 2704(b) would introduce a new category of “disregarded restrictions” that would be ignored in the same circumstances in which “applicable restrictions” are now ignored and in additional circumstances as well. The litmus test for a disregarded restriction would be whether it has certain characteristics to be outlined in regulations.
This proposed Section 2704(b) change has the potential to be extremely harsh. It takes little imagination to see how the IRS, by regulation, could effectively sweep away several decades’ worth of jurisprudence sanctioning the use of valuation discounts in connection with transferring family business interests. It’s within this context that many owners of family business interests are proactively exploring the implementation of strategies for transferring such interests to the next generation—in many cases sooner that they had otherwise intended.
1. H.R. 3467.
2. Although any sequestration resulting from diving off the fiscal cliff could be unwound retroactively by post-Dec. 31, 2012 legislation, a growing number in Washington seem to want to avoid sending a signal to the nation that governmental gridlock continues unabated.
3. See Charles A. Redd, “Gridlock Reigns Supreme,” Trusts & Estates (May 2012) at p. 22.
4. The Administration’s Budget Proposal contained in the General Explanations of the Administration’s Fiscal Year 2013 Revenue Proposals (the Green Book) provides, generally, that changes in the grantor trust, GST exemption and valuation discount rules would apply to transactions occurring on and after the date of enactment, but the Green Book isn’t cast in stone, and the estate planner relies on Green Book details, such as effective date provisions, at his peril. Moreover, enactment could occur with little advance notice. Who can forget Dec. 17, 2010?
5. “The 2012 Bank of America Study of High Net Worth Philanthropy” (November 2012), http://newsroom.bankofamerica.com/.../2012_BAC_Study_of_High_Net_Worth_Philanthropy_0.pdf.
6. Note that if it’s the plummeting from the fiscal cliff that causes income tax rate increases, such increases will apply across the board—not only to high-income taxpayers.
7. Remember, though, that the new 3.8 percent Medicare surtax is already on the books (Internal Revenue Code Section 1411) and is applicable beginning Jan. 1, 2013, regardless of whether we’ve gone over the fiscal cliff.
8. IRC Section 664(c)(1).