Clients who take advantage of the current tax environment can achieve thunderous results
I hesitate to write an article containing hyperbole. Whenever I read something that contains terms such as “amazing,” “unprecedented,” “unheard of,” “spectacular” or “unbelievable,” my immediate, admittedly cynical, reaction is to doubt the assertions and question the author's credibility.
That said, I now ask you to give me the benefit of the doubt when I tell you that we are right smack in the middle of the most dynamic and exciting period for estate planners in the history of the republic. The combination of opportunities that currently exists to enable our clients to move substantial wealth to or for the benefit of their children, grandchildren and more remote descendants, has never been seen before. We're in the eye of the perfect storm of estate planning.
High Applicable Exclusion Amount
Perhaps the most obvious and powerful tool that estate planners have at their disposal is the estate and gift tax applicable exclusion amount and generation-skipping transfer (GST) exemption of $5.12 million which, under current law, will remain in effect through the end of 2012. Never have the applicable estate and gift tax exclusion amount and the GST exemption been so high. An individual can transfer up to $5.12 million, and a married couple can pass up to $10.24 million to or for the benefit of anyone they choose and not pay any estate, gift or GST tax.1 When combined with one or more sophisticated estate-planning strategies, it's possible to transmit even more underlying value than is ostensibly sheltered from transfer tax by the dollar amount of the exemption.
However, the $5.12 million estate and gift tax applicable exclusion amount and GST exemption will evaporate at the stroke of midnight on Dec. 31, 2012, and a $1 million applicable exclusion amount and GST exemption will take effect.2 Alternatively, it's possible that current law will be changed and the baseline estate and gift tax assumptions outlined in the Obama Administration's Budget Proposal contained in the General Explanations of the Administration's Fiscal Year 2012 Revenue Proposals (the Green Book), released on Feb. 14, 2011, will prevail. Should that occur, we would see, among other features, a $3.5 million estate tax applicable exclusion amount beginning Jan. 1, 2013. The Green Book contains no assumptions concerning the gift tax applicable exclusion amount or the amount of the GST exemption.
Low Marginal Rate
Coupled with the historically high applicable estate and gift tax exclusion amount and the GST exemption is the remarkably low estate, gift and GST tax rate of 35 percent. Marginal estate and gift tax rates haven't been lower in many decades, and the marginal GST tax rate has never been lower. While it's hard to imagine counseling a client to embark on a strategy that involves intentional payment of GST tax, there's never been a more advantageous time for certain very wealthy clients to consider making taxable gifts large enough to require payment of gift tax. Those of us (a large majority, I think) who expect never to see the highest estate and gift tax rate lower than 35 percent, consider 35 percent a cheap toll for transferring wealth. The toll is even cheaper (25.9 percent) on an estate tax equivalent basis, if the donor lives for at least three years after having made a gift, because the gift tax paid is excluded from the donor's eventual estate tax base.
However, under current law, the 35 percent estate, gift and GST tax rate will disintegrate at midnight on Dec. 31, 2012, and a marginal rate of 55 percent for all three transfer taxes will be resurrected.3 Another possibility is that the baseline estate and gift tax assumptions set forth in the Green Book will be enacted, in which case we would see a 45 percent flat estate tax rate. The Green Book doesn't indicate what the gift or GST tax rate would be.
Extremely Low AFRs
Beyond high transfer tax exemptions and low rates, we're in the midst of historically low applicable federal rates (AFRs), which enable the making of leveraged sales and gifts (for example, using intentionally defective trusts, grantor retained annuity trusts (GRATs) and charitable lead annuity trusts) that have vastly more potential for shifting wealth to or for the benefit of children, grandchildren and more remote descendants than has been seen in several decades. AFRs are based on the average market yield on outstanding marketable obligations of the United States,4 so, as long as the economy is weak, AFRs are likely to remain low. AFRs change monthly though, so estate planners can't consider very low AFRs to be a permanent tool. Bear in mind, also, that the Green Book contains proposals to require that a GRAT, to pass muster under Internal Revenue Code Section 2702, have a term no shorter than 10 years and a remainder with a present value at creation greater than zero. These proposals would also prohibit any decrease in the amount of the annuity from one year to the next.
Depressed Asset Values
The values of many of our clients' assets are, largely as a result of the flagging economy, lower than they could have imagined as recently as five years ago. Most of our clients undoubtedly consider these asset values to be artificially low — a reflection of an unusually bad economy. When the economy improves, asset values are expected to escalate. What better time than now for our clients to give or sell these assets, at amazingly low values, to or in trust for their children, grandchildren and more remote descendants?
Defined Value Clauses
The value of certain property can be difficult to ascertain. Now's the optimum time to provide charitably inclined clients holding difficult-to-value property with the opportunity to make gifts and sales of such property — allocating a stated dollar amount in value of the property to or in trust for their descendants and allocating the remainder to charity. This strategy of transferring assets, often referred to as planning with defined value clauses, can be enormously powerful because part of the strategy's effect is to deprive the Internal Revenue Service of any incentive it would otherwise have to audit the gift tax return in which the subject transfer is reported. This is because any increase in value of the property transferred passes, under the defined value clause, to charity. So, due to the gift tax charitable deduction, the IRS can't possibly collect additional gift tax revenue. The IRS has challenged the use of defined value clauses several times over the past few years, but no court has sustained the government's position.5 Defined value clauses remain alive, well and readily available for use by clients. However, in the last reported case addressing the validity of defined value clauses, the U.S. Court of Appeals for the Ninth Circuit expressly invited the IRS to amend its regulations if troubled by the consequences of the court's decision.6 Thus, now's the time — before the IRS promulgates a regulation to eviscerate this excellent technique — to transfer difficult-to-value assets using defined value clauses.
Despite the government's many litigation successes over the past 15 years involving taxpayers claiming valuation discounts with respect to transferred interests in family limited partnerships (FLPs) and limited liability companies (LLCs),7 it nevertheless remains clear that a properly documented, formed and administered FLP or LLC, created with the appropriate, provable motivation, can still generate significant transfer tax discounts that will withstand IRS scrutiny. For a taxpayer to succeed, it's critically important that the client painstakingly follow all formalities associated with the entity's establishment and operation. Equally important is for the client to have a “legitimate and significant non-tax reason” for setting up the entity.8
However, the Green Book contains a proposal that would severely limit the use of valuation discounts in estate planning regardless of the client's reasons for engaging in such planning and how carefully the client implemented such planning. That proposal would create a new category of “disregarded restrictions,” which would apply when valuing an interest in a family-controlled entity that was transferred to a member of the family. A restriction would be ignored if, after the transfer, it would lapse or could be removed by the transferor or a member of the family.
Very Long-Term Trusts
It's legally permissible in many states to establish trusts that are designed to exist longer than permitted under the common law rule against perpetuities. Indeed, the laws of several states allow the creation of trusts with the theoretical potential to last forever. Whether statutes that enable creation of such perpetual trusts are a positive development in the law may be questionable, but it's beyond debate that perpetual trusts are an incredibly powerful tool in the estate planner's arsenal. A client can make a large gift to his children in a transfer tax-advantageous manner, but the value of the gifted property (other than what's consumed by the children) will be included in the children's respective taxable estates (or among the children's aggregate lifetime taxable gifts). By contrast, that client could instead make a large gift to an irrevocable perpetual trust in a transfer tax-advantageous manner and allocate his GST exemption to the gift. Except to the extent of judicious distributions out of the trust, the value of the property in the trust will never be included in anyone's taxable estate. Put another way, instead of having a transfer tax potentially assessed at every generation level, a perpetual trust enables the client to avoid paying transfer taxes at the generation levels of all current and future trust beneficiaries.
It's possible, however, that this estate-planning benefit may not be available indefinitely. The Green Book contains a provision that would limit the effective duration of an allocated GST exemption to 90 years. Additionally, at its 2010 annual meeting, the American Law Institute adopted the Restatement (Third) of the Law, Property (Wills and Other Donative Transfers), which, among other things, sets out a rule against perpetuities that would effectively limit the duration of trusts to the lives of beneficiaries no more than two generations removed from the settlor.
Through a quirk in the tax law,9 it's possible for an individual (the “grantor” in fiduciary income tax lingo) to establish and fund an irrevocable trust that's treated as owned by him for income tax purposes but not for estate tax purposes. The result of creating such a trust is that, while the value of the trust property, regardless of how large it may grow, won't be subject to estate tax at the grantor's death, all items of income, deduction and credit will, for income tax purposes, belong to the grantor. Thus, to the extent the trust property produces taxable income, the grantor will be legally obligated to pay, out of his own funds, the federal income tax (and, in most states, state income tax) on such income. The trust property, to the extent not distributed to beneficiaries, may therefore grow unimpeded by income taxes, and the grantor's eventual taxable estate will be reduced by the income taxes the grantor pays on income generated by the trust. To add even more power to the trust, it might be established and administered in, or, at the grantor's death, be moved to, a state that doesn't impose income tax on trusts.
Combining some or even all of the elements of what's now possible has the potential to produce truly breathtaking benefits. A client and his spouse could make a combined gift of up to $10.24 million to an irrevocable, perpetual trust that's a grantor trust for income tax purposes. The trust could have its situs in a state that imposes no fiduciary income tax. The property used to fund the trust could be property that, in the current economic environment, is artificially depressed in value, and that property, before it's transferred to the trust, might be conveyed to an FLP or LLC with respect to which significant valuation discounts could be available. The trust could be funded by a part-gift, part-sale. The sale could be in exchange for a very low interest promissory note with interest only payable during the term of the note. The documents by which the gift and sale are implemented could contain defined value clauses. In sum, the perfect storm of estate planning is roiling.
This perfect storm may, however, be on the threshold of subsiding.10 As explained above, much of what we can accomplish for our clients in the current economic and tax environment may be available for a limited time only. Estate planners should meet with their clients and explore the currently available, unprecedented opportunities as soon as possible.
- Beware, however, the possibility of “clawback,” which refers to inclusion in a donor's taxable estate of the amount by which the donor's aggregate lifetime taxable gifts exceeds the estate tax applicable exclusion amount available to the donor's estate. Literally following the instructions to line 7 of Form 706 (“United States Estate (and Generation-Skipping Transfer) Tax Return”) may result in clawback. Clawback could be a particular issue for the estate of a donor who dies when the estate tax applicable exclusion amount has declined below the gift tax applicable exclusion amount in effect when the donor made the maximum possible lifetime taxable gifts that wouldn't result in gift tax being payable. Even if clawback does apply, making such maximum possible lifetime taxable gifts can still be a benefit because all post-gift total return on the gifted assets would be removed from the donor's transfer tax base, and transfer tax would be deferred, on an interest-free basis, until the donor's death. Most commentators believe Congress will enact legislation to prevent clawback, but such action isn't certain. Clients need to be fully apprised concerning clawback.
- The $1 million GST exemption will be adjusted for inflation from 1998. Internal Revenue Code Section 2631(c) prior to amendment by Section 521(c)(2) of the Economic Growth and Tax Relief Reconciliation Act of 2001 (P.L. 107-16).
- An additional 5 percent surtax will apply to estates and aggregate lifetime taxable gifts exceeding $10 million.
- IRC Section 1274(d).
- Estate of Petter v. Commissioner, T.C. Memo. 2009-280, aff'd 2011-2 U.S.T.C. par. 60,623 (9th Cir. 2011); Hendrix v. Comm'r, T.C. Memo. 2011-133; Estate of Christiansen v. Comm'r, 130 T.C. 1 (2008), aff'd 586 F.3d 1061 (8th Cir. 2009); Succession of McCord v. Comm'r, 120 T.C. 358 (2003), aff'd 461 F.3d 614 (5th Cir. 2006).
- Estate of Petter, ibid.
- See, e.g., Estate of Liljestrand v. Comm'r, T.C. Memo. 2011-259; Estate of Turner v. Comm'r, T.C. Memo. 2011-209.
- See, e.g., Estate of Bongard v. Comm'r, 124 T.C. No. 95 (2005).
- See Revenue Ruling 85-13, 1985-1 C.B 184, which was issued in response to Rothstein v. United States, 735 F.2d 704 (2d Cir. 1984). The sharply progressive federal individual income tax rates in effect at the time made the position enunciated in Rev. Rul. 85-13 advantageous to the government.
- I know there are those who are certain that a reversion to the $1 million applicable exclusion amount and GST exemption amount and 55 percent marginal transfer tax rate of the 2001 Tax Act will never happen. I imagine those are many of the same folks who were equally certain that the one-year repeal of the federal estate tax would never see the light of day.
Charles A. Redd is a partner at Stinson Morrison Hecker LLP in St. Louis
Deep Blue “An Exhilarating Run: The Gaff-rigged Yawl ‘Duet’ Off the Fastnet Rock” (24 in. by 30 in.) by Jenny Morgan, sold for $968 at Christie's Maritime Art Sale in London on Nov. 24, 2011. Launched in 1912 as “Gaviotta,” this 72 footer was bought in the 1930s by explorer Augustine Cortauld, who renamed her “Duet.” She's currently owned by Rev. Christopher Cortauld, founder of The Ocean Youth Club.