The voluminous discussions during the conferences at the 46th Annual Heckerling Institute on Estate Planning, held in January 2012 in Orlando, Fla., are a lot to digest. To make it easier, we’ve summarized in a series of articles some of the ideas culled from the many programs and organized them topically. Part 1 of this series focuses on family businesses and gift planning. We’ll be covering in future articles other topics that were discussed.
Family Businesses
1. Can non-working spouse survive comfortably? A frequent problem in a closely held or family business is how to provide cash flow to the non-involved spouse if the working spouse dies. This issue will be compounded as more closely held business interests are transferred to irrevocable trusts this year. Consider implementing a salary continuation agreement while the working spouse is alive and well. The business corporation can enter into an agreement with the working spouse, which assures that as a component of current compensation, payments will continue to the surviving spouse.
2. Pre-death business planning. If the value of the family business is approximately one-third of the estate, it won’t satisfy the 35 percent of gross estate requirement to qualify for estate tax deferral under Internal Revenue Code Section 6166. As a result, the ability to defer for 14 years the payment of the estate tax will be lost. If an investment is made in the business, it will increase the value of the business as a percentage of the overall estate. This could transform otherwise non-qualifying cash into qualifying business interests and push the entire business value over the threshold. Alternatively, use the $5.12 million gift tax exemption to make a gift of non-business assets to change the percentages, thereby increasing the relative value of business interests in the estate. Remember that in “decoupled” states, the use of the deferral payment isn’t available, as it’s a federal benefit only.
3. Step transactions. The Internal Revenue Service has used the step-transaction doctrine to attack a range of estate plans. The typical sequence of planning events can add to the exposure to this type of challenge. Assume a client discussed with his advisors making gifts before the $5.12 million exemption changes. The client might also have discussed creating an irrevocable trust to which the gifts would be made. Thereafter, the client formed a limited liability company (LLC) and transferred assets to the LLC. Once the LLC was formed and funded, the client then consummated a gift of LLC interests to “seed” the trust. Finally, the client sells LLC interests to the trust. If the IRS can demonstrate that this was all part of one integrated plan, and each step is dependent on the other, then it will treat these steps as if they all happened at one time. If this occurs, any discount on the LLC interests your client gifts and sells to the trust won’t be realized. Real intervening economic events may break the “chain.” For example, declaring a dividend if a corporation is involved in the planning might change values. If the entity for which interests will be given is a real estate holding company, you may break the sequence from an economic perspective by entering into a new lease after the property was transferred into the LLC, but before the gift/sale to the trust, after a gift to a spouse who will fund the trust or between a gift to the trust but before a sale to the trust.
Gift Planning
1. Gifts of interests that could cause estate inclusion. Too often, gift planning is focused on large and obvious assets. For some clients, carefully identifying less obvious but very nettlesome assets to gift may have a beneficial impact. The client’s interests or rights may cause estate tax inclusion at death. These rights might include: a retained life estate, the retained power to vote stock in a closely held company, the power to remove and replace a trustee and incidence of ownership in life insurance. Now’s an ideal time to review existing estate-planning documents, especially older trusts that haven’t been given attention in years. Identify possible powers or rights that might taint trust assets as includible in the client’s estate and gift or terminate them now. While the exemption can shelter the possible gift, don’t forget to disclose these gifts on a 2012 gift tax return.
2. Gift equalization. Equalizing gifts have always been a concern for many clients seeking to maintain some sense of equality among the family lines of various children (or other heirs). If clients have made annual exclusion gifts to children, spouses and grandchildren over time, the different family lines may have become quite unequal. Some clients would like to equalize this imbalance, but many haven’t addressed it. The $5.12 million exemption affords a great opportunity to effectuate an equalization plan. If the exemption drops to $1 million in 2013, as the law presently provides, this opportunity may disappear.
3. Gifting in trust? Make it a grantor trust. While practitioners are well aware of the potential advantages of a grantor trust, with the attention being given in 2012 to large gifts to use the $5.12 million exemption before it expires, you should remind clients of the substantial advantages of making large gifts to trusts that are intentionally structured as grantor trusts. The estate-planning advantages are hard to overlook. First, someone has to pay the income tax with respect to the income earned on the assets transferred to the trust. With a grantor trust, the grantor pays it, thereby further depleting the estate—and retaining in full the assets of the trust. While it might appear that the tax payment constitutes a taxable gift, after all, the grantor is assuming the tax with respect to assets owned by the trust, Revenue Ruling 2004-64 holds that the grantor’s payment of the tax is an obligation and therefore not a gift. What if the income tax cost becomes too expensive for the grantor’s comfort? Some might consider a tax reimbursement provision, although this has to be handled properly to avoid an estate inclusion issue. Another approach is to turn off grantor trust status, which may be feasible in some trust structures. Other advantages of the grantor trust, while obvious to practitioners, elude many clients. While sales of appreciated assets to the defective or grantor trust would ordinarily cause income tax to the grantor, Rev. Rul. 85-13 assures that transactions between the grantor and his grantor trust aren’t recognized for income tax purposes. Similarly, the interest income earned by the grantor with respect to the note used in connection with the sale also isn’t taxable.
4. Gifting may save state estate taxes. Many states impose estate taxes based upon the application of the now non-existent state death tax credit and don’t have a gift tax (two states do, but most don’t, for example, New Jersey). The state death tax credit was calculated based on the decedent’s net taxable estate. However, it didn’t account for adjusted taxable gifts. Therefore, gifts generally aren’t taxed when made, nor when added back into the calculation of the state estate tax upon death. For example, assume a client has a $5.12 million estate and dies in 2012 in a state that imposes tax in the manner stated above. The client’s estate will pay no federal estate tax (assuming no prior adjusted taxable gifts), but will pay a state estate tax equal to $405,200. Suppose instead the client consummates a gift in 2012 of the entire $5.12 million prior to death. No federal gift tax is incurred, there will be no state gift tax (excluding two states) and since the state death tax credit is calculated without adding back adjusted taxable gifts, there’s nothing left in the net taxable estate and, accordingly, no state estate tax in most decoupled states. The result is a $405,200 savings with a pre-death transfer in lieu of a transfer on death.
5. Gifting may save estate taxes but cost more in income taxes. Gifting, whether to save state estate taxes or eliminate post-transfer appreciation from the estate can be productive in many cases. With the advent of the $5.12 million exemption, there’s a tendency to want to take advantage of Congress’ recent generosity. However, gifts carry with them a potentially costly income tax problem. An asset that’s gifted retains the donor’s basis; there’s no step-up in income tax basis. With substantially appreciated assets, the income tax cost to the donee on the eventual sale of the asset may be greater than the estate tax savings. Take the case of a client with a $5 million estate—all of which is stock with a basis of $1 million. If the client gifts the stock to a child immediately prior to death, the estate will save $391,600 in state estate taxes. However, when the child later sells the stock for $5 million, the child will realize a $4 million capital gain, a $600,000 federal income tax (at current rates) and perhaps a state income tax as an add-on as well. Worse, if the Buffet tax (that is, a minimum 30 percent tax rate on incomes exceeding $1 million) or something akin to it is enacted, the child may face a much greater tax of perhaps $1.2 million, with little or no ability to plan around it.
6. IRS gift scrutiny. If a client made an “informal” gift of a vacation home or other property to his children, but didn’t report it, a current IRS audit initiative may be quite a surprise. The IRS has been scrutinizing local property tax records. It has now investigated property transfer records in 15 states and, presumably, will examine records in more states in the future. The IRS has found that 60 percent to 90 percent of gratuitous non-spousal real estate transfers weren’t reported on gift tax returns. If clients have such unreported gifts, it may behoove them to take the lead and file the missing gift tax returns. For most transfers made in 2011 and 2012, there’s not likely to be a gift tax issue because of the $5 million and $5.12 million exemptions, respectively. However, for prior transfers made when the gift exemption was $1 million (or less in earlier years), there may be an issue. Clients may assume that the only implication of the failure to report is the gift tax return, but this issue can extend further than the one return. If the client makes future taxable gifts and has to file a gift tax return to report those gifts, those future returns must disclose prior gifts. This means all future gift tax returns would also be incorrect, because the figure for prior taxable gifts would be incorrect. If the client’s executor becomes aware of an unreported gift and files an estate tax return, that too would be an incorrect return. This is a potentially substantial risk awaiting many unsuspecting taxpayers.
7. Gift tax liability exposure. Clients are likely to view exposure for unpaid gift tax as a non-issue because of the large current exemption. But, there’s a potential risk that many clients wouldn’t suspect. The law is clear that the donor should pay any applicable gift tax. But if the donor doesn’t pay, then the donee of the gift is personally liable for the gift tax. This rule has a much broader reach than many would imagine. A donee can be responsible for a tax even if it’s not his gift that triggered the gift tax. For example, say a client made a large a gift to his new spouse, which qualifies for gift tax marital deduction, so that there was no gift tax attributable to that gift. The client also made a separate large taxable gift to another donee, perhaps a child from his prior marriage. The donor then fell into financial difficulties and didn’t pay the gift tax. While the child/donee would then be liable for the gift tax, the spouse is also subject to liability for that tax. Even though the client’s new spouse received a gift that didn’t trigger any gift tax, she’s liable for the entirety of the gift tax on the gift made to the child under IRC Section 6324. These rules could create even more havoc in some circumstances. For example, say a son is named agent under his father’s power of attorney. His father used up his $5 million gift exemption, then fell ill. Any new gifts will be taxable. The son makes gifts to his siblings of $2 million and to his father’s new wife of $1 million, but doesn’t pay the gift tax from his father’s funds as agent or from his own funds. The new wife can be held liable for $700,000 (35 percent), representing the gift tax on the $2 million gifts to the father’s children from a prior marriage.
8. Gifting with the ultimate security blanket using a self-settled trust. As 2012 moves forward, an increasing number of clients should evaluate the benefits of making large taxable gifts prior to 2013. A significant impediment for many “mid-wealth” clients is the concern that they’ll need the funds that, for tax purposes, might make sense to gift. Using a domestic asset protection trust (DAPT), also known as a self-settled trust, may provide the wherewithal for an independent trustee to distribute assets back to the grantor if needed. This could present the ultimate “do over” if the trustee determines that the grantor needs the funds. The problem with a DAPT permitting distributions back to the grantor is that the transfer is to a self-settled trust, which in most states subjects the assets of the trust to creditors. As such, the right of creditors to attach trust assets renders the assets of the trust includible in the grantor’s estate pursuant to IRC Section 2036, thereby undoing the desired planning. Several states allow self-settled trusts without subjecting the trust to creditors. Without such creditor attachment, Section 2036 doesn’t apply, and the assets of the trust shouldn’t be included in the grantor’s estate. Note that the IRS will apply Section 2036 if there’s an implied understanding that the assets will be made available to the grantor. Trustees should use great care to minimize the use of the power. The IRS has focused attention on the course of conduct of the trustee and grantor to determine if there was an implied understanding. The trustee should exhibit great care in following an independent discretionary standard, uninfluenced by the grantor.
9. Gifting with a spouse as a beneficiary. Clients are often reluctant to engage in gifting programs because of the irreversible relinquishment of the property gifted. Another option for a married client who wants to have access to the funds transferred if there’s an economic reversal, is to make the gifts to a trust of which the spouse is a beneficiary. Clients may be less reluctant to make gifts knowing that all or a portion of the assets could be redistributed back to the client’s spouse, if needed. One mechanism available is a gift to a trust of which the grantor’s spouse is a discretionary distributee. If the funds are required, the trustee can distribute assets to the spouse, who in turn can share assets with the grantor or use the assets to cover joint expenses (for example, housing). This is effectively the lifetime funding of a credit shelter trust. Of course, the safety valve disappears if the spouse/beneficiary dies or there’s a divorce. For some client situations, life insurance on the spouse/beneficiary can adequately address the risk of premature death. The divorce scenario is much harder to address. In most instances, a transfer to such a trust won’t be eligible for gift splitting. Consider the reciprocal trust doctrine. If one spouse makes a large gift to a DAPT, the other spouse might make a gift to this type of inter vivos bypass trust. While this alone may not assure avoidance of a reciprocal trust challenge, it does represent a significant difference in economic interests between the two trusts, making a reciprocal trust challenge less likely to be successful.