The second half of 2012 and the first couple of days in 2013 were interesting, to say the least, for the general public and particularly so for the estate-planning community. Quality of life for estate planners in the last quarter of 2012 was essentially non-existent, with the year-end estate-planning crunch arising from the Dec. 31 gift planning deadline prompted by the threat that the gift tax exemption would return to $1 million, coupled with a 55 percent rate. Congress put those fears to rest a couple of days into the new year with the passage of the American Taxpayer Relief Act of 2012 (the Act), which President Obama signed into law on Jan. 2, 2013.1 One of the defining features of the Act is that it provides for permanent increased unified gift, estate and generation-skipping transfer (GST) tax (collectively referred to as “transfer taxes”) exemptions.
With the resolution of the fiscal cliff negotiations, and, importantly, assuming that the transfer tax exemptions made permanent in the Act in fact remain permanent and aren’t further modified in the next round of negotiations in Washington, the increased exemptions provide some new or continued opportunities to fortify and enhance estate-planning techniques that should be considered.
The increased GST tax exemption may provide an opportunity to effectively convert a GST non-exempt trust into a GST exempt trust by making a late allocation of the donor’s GST tax exemption.2 If the fair market value (FMV) of the trust assets at the time of the making of the late allocation are less than or equal to the amount of the donor’s available GST tax exemption, a late allocation could result in an inclusion ratio of zero.3 Of course, if the distribution provisions of the trust don’t provide for lifetime trusts for the benefit of the donor’s children and, instead, mandate outright distributions at certain ages, then a late allocation of GST tax exemption wouldn’t be advisable, as it would effectively waste that exemption.
In the case of larger existing GST non-exempt trusts, to which a late allocation of a grantor’s GST tax exemption wouldn’t produce an inclusion ratio of zero, but rather would result in a mixed inclusion ratio between one and zero, planners might consider splitting the non-exempt trust into two sub-trusts to make a late GST tax exemption allocation such that one trust would have an inclusion ratio of zero and the other trust would have an inclusion ratio of one.Alternatively, planners may consider doing a qualified severance after GST tax exemption has been allocated to produce the same results. While the qualified severance rules were scheduled to expire on Dec. 31, 2012, the Act made these provisions permanent.4
Another idea to consider is to allocate GST tax exemption to a grantor retained annuity trust (GRAT) or qualified personal residence trust (QPRT) upon the termination of the term interest and the estate tax inclusion period.5 If the value of the GRAT or QPRT at the end of the term interest is less than or equal to the donor’s available GST tax exemption, the allocation of GST tax exemption, either by way of automatic allocation or an affirmative allocation, could produce a trust with a zero inclusion ratio.6 Of course, this would only be advisable to the extent that there’s a trust into which the remainder of the GRAT or QPRT passes, which will exist for the lifetime of the remainder beneficiaries.
If lifetime trusts don’t exist at the end of the GRAT or QPRT, practitioners could consider first decanting the trust into a new trust that would provide for a multigenerational distribution scheme, so that the late allocation could be made to a trust that will continue for several generations.7 Any such decanted trust would be subject to the perpetuities limitation period provided for in the original trust, as well as any additional state law provisions.
Next Generation Exemption Planning
Some families took advantage of the opportunity to exponentially increase the benefits of gift planning by facilitating gifts by children and possibly grandchildren so they could use their gift tax exemptions in 2011 and 2012. Many families, however, didn’t take advantage of this opportunity beyond the current generation of the matriarch or patriarch. This is understandable, as many families didn’t focus on the advantages of planning with the increased gift tax exemption in earnest until the last half of 2012, and coordinating this planning for younger generations would have amounted to “putting the (tax) horse before the (non-tax) cart.” As the increased gift tax exemption is now permanent, families may consider more robust next-generation planning as part of an overall plan to maximize the preservation and stewardship of family wealth for multiple generations.Further, this permanence enables such planning to be done in a coordinated manner that’s consistent with the non-tax desires of the family and with the timelines desired by the various family members, rather than having an agenda driven by a purely tax-motivated deadline.
Creation of new GST exempt trusts funded by existing GST non-exempt trusts. In the case of next-generation family members who are beneficiaries of substantial existing GST non-exempt trusts, the permanent increased exemptions provide a particularly good opportunity to improve the tax efficiency of the family’s estate plan. For instance, in the case of a large existing GST non-exempt trust that will be subject to either estate tax or GST tax at the death of a beneficiary, trustees could consider making distributions to the beneficiaries (for instance, to the second or third generation beneficiaries).8 If those beneficiaries thereafter use the distributed funds to make taxable gifts, perhaps into dynastic trusts for the benefit of their descendants (and perhaps spouses), they’ve used their gift and GST tax exemptions in a manner that effectively converts “two generation” trust funds, which would otherwise be taxable at the death of these beneficiaries, into GST exempt funds, which can be preserved for multiple generations. If this planning is undertaken by the second and, perhaps, third generation, the advantages can be dramatic.
For example, consider the following: A first generation grantor created an existing GST non-exempt grantor trust that has assets with an FMV of $50 million. Further, these assets grow in value at 4 percent per year throughout the entire duration of the trust. The current beneficiaries of this trust are the grantor’s two children during their lifetimes. In our example, both children die in 50 years, at which time the trust continues for the benefit of the grantor’s grandchildren, triggering GST tax at a rate of 40 percent.9 Suppose the trustee of this existing trust distributes $10.5 million to each of the grantor’s two children in year one, and each child in turn creates a GST exempt grantor trust for the benefit of his own descendants with these funds, with each child electing to split gifts with his spouse. If no other distributions beyond those described here are made, this structure will result in overall GST tax savings of approximately $57 million over the life of the trust. If additional distributions are made from the GST non-exempt trust in years 2 through 50 of an amount of $520,000 (representing an assumed constant inflation adjustment increase of the gift tax exemption of $130,000 per year for each child, each of whom elects to split gifts with his spouse), an additional GST tax savings of $30 million will be achieved at the death of both children in 50 years. In addition to significant GST tax savings at the death of the children, the use of the inflation-adjusted increase in the gift tax exemption amount each year will have shifted over $130 million from the GST non-exempt trust to the GST exempt trust. This shift in value means that the GST tax savings at the death of the grantor’s grandchildren or further descendants would be even more compelling. The “Next Generation GST Planning” illustration, this page, is a graphical representation of the potential benefits of this planning.
Triggering the Delaware tax trap. To make use of the GST tax exemption of a family member in a lower generation, your clients may also exercise an inter vivos or testamentary power of appointment (POA) by such family member over a portion or all of the trust property in a manner that triggers the so-called “Delaware tax trap.”10 If the trust doesn’t currently provide a beneficiary with a POA, it may be possible to decant the trust into a new trust that provides these powers. The Delaware tax trap results in a gift by, or inclusion in, the gross estate of the individual exercising a POA if, under applicable local law, the power is exercised so as to postpone the vesting of property for a period ascertainable without regard to the date of the creation of the first power.11 Of course, if such a postponement is precluded under local law or if the trust instrument prohibits exercise of the POA beyond the perpetuities period set forth therein, then the Delaware tax trap can’t be intentionally triggered for these purposes. In addition, the power holder must take special care to ensure that he correctly triggers the provision. If successful, the power holder’s gift or estate tax exemption and GST tax exemption could be utilized with respect to the appointed property, creating a GST exempt trust (and possibly also retaining a GST non-exempt trust if the POA is only exercised with respect to a portion of the trust property).This technique could be useful for a beneficiary who may not have sufficient assets in his own name to make full use of the increased permanent exemptions and can also be useful in perpetuating GST exempt funds for future generations.
Non-qualified disclaimers. Beneficiaries of GST non-exempt trusts may also make use of non-qualified disclaimers to make a gift of disclaimed property and to allocate their GST tax exemption to the gift. An individual who makes a qualified disclaimer of an interest in property is treated as if the interest had never been transferred to the individual, thereby avoiding any gift tax on the disclaimer.12 However, if an individual disclaims in a non-qualified manner, for example, by disclaiming after the 9-month time limit in Internal Revenue Code Section 2518(b)(2) or after he’s accepted the benefits of the property interest, then the interest is treated as passing to the individual and then subsequently passing to the individuals who benefit from the disclaimer.13 Such a non-qualified disclaimer would, accordingly, be subject to gift tax.14 A beneficiary who makes an intentionally non-qualified disclaimer could then allocate GST tax exemption to the gift of the disclaimed property.
There are a number of ways to add leverage to next generation exemption planning.
Loans. Suppose that a client creates new GST exempt trusts as described above. To obtain additional leverage, the trustee of the larger existing GST non-exempt trust may, for example, lend additional funds to the new GST exempt trusts in exchange for promissory notes bearing adequate interest. To the extent that the value of the assets of the GST exempt trust grows at a rate above the applicable federal rate, the growth in the assets will effectively be shifted into the GST exempt trust for the benefit of future generations, rather than occurring in the GST non-exempt trust.15
Preferred partnerships. Another option to increase leverage is to use an IRC Section 2701 compliant preferred partnership, in which the newly created GST exempt trusts can own common “growth” partnership interests, and the remaining GST non-exempt trust can hold a frozen preferred interest.16 The growth in value of the frozen interest held by the GST non-exempt trust will be limited to the preferred coupon it receives and a liquidation preference, which may be beneficial if the original GST non-exempt trust will be subject to transfer taxes either in the form of estate or GST tax upon the death of the current beneficiaries. Instead, the growth interests will be owned by the new GST exempt trusts. To the extent that the preferred partnership’s assets increase in value above the preferred coupon and liquidation preference required to be paid to the original GST non-exempt trust, the growth will inure to the benefit of the new GST exempt trusts.
Many family limited partnerships (FLPs) were created at a time when the estate and gift tax exemptions were dramatically lower than they are currently and, unfortunately, at a time when many practitioners and clients didn’t have a clear understanding of what could and couldn’t be done with these vehicles. The Tax Court has provided numerous examples of the vehicles that will and won’t pass muster for estate tax and gift tax purposes, although much uncertainty still exists. If an FLP doesn’t pass muster for estate tax purposes, all of the assets initially contributed by the donor into the FLP will be fully included in the donor’s gross estate at death.
The increased gift tax exemption may provide an opportunity to effectively unwind an FLP before the negative triggering event (that is, the death of the donor) occurs. For instance, assume that an FLP exists that’s under the $5.25 million gift tax threshold. If there’s a risk that the contributed assets will be included in the grantor’s estate, perhaps the partnership could be dissolved and the assets distributed pro rata to the partners. Any assets distributed to a partner of the FLP could, thereafter, be gifted by him; depending on the value of the assets involved, the outright gift of those assets may be “covered” by the increased gift tax exemption.
For those FLPs that may trigger IRC Section 2036(a)(1) and/or (a)(2) upon the death of a grantor, the increased estate tax exemption may offer some relief. If the size of the FLP is small enough that the full inclusion of the contributed assets in the gross estate would be covered by the increased estate tax exemption, the FLP could still be maintained for the benefit of future owners and would be effectively “cleansed” from any future Section 2036 taint as to the inheritors of those interests—that is, the assets would be fully included in the estate of the creator of the FLP, but would then pass to the next generation of owners to be held as an investment and possibly used in connection with their own planning.In this scenario, Section 2036 should never apply with respect to the donee-owner of the partnership interests, as the donee never made a “transfer” of assets into the partnership; rather, the donee merely was the recipient of a partnership interest.17
Incomplete Gift Trusts
In connection with state income tax planning, some individuals residing in high income tax jurisdictions have transferred assets to incomplete gift non-grantor trusts created in jurisdictions that don’t impose state income taxes (so-called “Delaware incomplete gift non-grantor (DING) trusts”). The motivation for planning with a DING trust is often to minimize state income taxes, particularly with respect to assets that are expected to generate significant income, such as the sale of shares of a closely held business or other assets that may have a low basis. The DING trust is carefully structured to be a non-grantor trust, so that any realized income won’t be taxed to the grantor. In addition, the trust is structured so that any transfer to the trust isn’t a completed gift for gift tax purposes, for example, typically by allowing the grantor of the trust to retain a limited POA over the trust property. Properly structured, this planning allows the client to target the state income tax benefits of the DING without the use of any gift tax exemption.
Now that the inflation-adjusted gift tax exemption is permanent, clients who’ve engaged in DING planning in the past may use the assets in their DING trust to make use of their gift tax exemption. By releasing any powers that cause incomplete gift treatment of transfers to the trust, the client can cause the gift to be completed for gift tax purposes,18 triggering the use of his gift tax exemption without needing to establish a new trust or re-title assets.This may be appealing to clients who don’t have sufficient assets outside of the DING trust to make use of the increased gift tax exemption.
The “two-year gifting window” provided a limited opportunity to make significant gifts in 2011 and 2012, given the $5 million exemption in 2011 and the $5.12 million exemption in 2012. One planning idea that advisors considered during this two-year window was for the surviving spouse-income beneficiary of a qualified terminable interest property (QTIP) trust to trigger a gift under IRC Section 2519 by relinquishing his income interest.19 Section 2519 generally provides that if the beneficiary of a QTIP trust relinquishes all or a portion of his income interest, a gift is triggered equal to the FMV of the trust property, less the FMV of the beneficiary’s qualifying income interest in the trust.20 One practical issue with this technique is that the beneficiary is required to give up all or a portion of his income interest,21 which is something that a younger income beneficiary may not have been willing to do in 2011 or 2012 for the sake of tax planning.22 As the gift tax exemption is now permanent, this is an option which could be triggered in the future, perhaps when the surviving spouse is more comfortable with surrendering that income interest.
If the QTIP trust is larger than the beneficiary spouse’s remaining gift tax exemption amount, the trustees could divide the trust into two sub-trusts, one of which has assets of value equal to the spouse’s remaining gift tax exemption amount. Section 2519 would be triggered with respect to that trust only, and this trust would, therefore, no longer be subject to estate taxes upon the beneficiary spouse’s death. The other sub-trust would hold the remaining QTIP trust assets and would be subject to estate tax upon the beneficiary spouse’s death pursuant to IRC Section 2044. Further leverage could be applied with respect to these two trusts to freeze the value of the QTIP trust that will be included in the spouse’s estate through the use of loans or a preferred partnership as discussed above.This would maximize the value of the trust that isn’t includible in the beneficiary spouse’s estate, while limiting the future growth of the estate taxable trust.
For those clients who made gifts of the $5.12 million gift tax exemption in 2012, the inflation-adjusted 2013 gift tax exemption provides the opportunity to give an additional $130,000 this year and, likely, additional amounts in each subsequent year. Clients who made gifts with assets requiring a valuation appraisal may consider “topping off” their 2012 gifts with the additional $130,000 exemption.In such case, gifts made early in 2013 may be able to rely on the same or, perhaps, an updated valuation appraisal, so it may make sense to “kill two birds with one stone.”
The inflation-adjusted exemption amount may also be used to make additional gifts to trusts that have cash needs. For example, many clients made gifts in 2012 of residences or insurance policies that will be held in trust for beneficiaries. The additional inflation-adjusted exemption amount may be used to make additional contributions to the trust to support the carrying costs of a residence or to pay for renovations or improvements to the residence, or perhaps to cover large insurance premiums in which Crummey powers would be insufficient or in which such withdrawal rights don’t exist in a trust.
To the extent that a donor has existing promissory notes owed to him by a grantor trust, perhaps in connection with prior loans or sales to grantor trusts, the permanent gift tax exemption provides an ongoing opportunity to make additional gifts to the trust in the amount of the annual inflation adjustment. Those gifts can provide a means to assist the trust in making payments against the notes or, perhaps, pay them off entirely.
—The authors would like to thank Andrea Zakko, an associate in the New Haven, Conn. office of Withers Bergman, LLP, for her valuable contributions to this article.
1.H.R. 8, 112th Congress (2013). While the Act was officially passed in 2013, it’s, nonetheless, referred to as “the American Taxpayer Relief Act of 2012.”
2.Treasury Regulations Section 26.2632-1.
3.Internal Revenue Code Section 2642.
4.H.R. 8, Title 1 Section 101(a), 112th Cong. (2013); IRC Section 2642(a)(3).
5.IRC Section 2642(f).
6.IRC Section 2642.
7.Practitioners should be aware that the Internal Revenue Service requested comments regarding the tax treatment of decanting in Notice 2011-101, perhaps signaling that a change in the tax treatment of decanting may be pending.
8.IRC Sections 2612(a) and (b), 2621, 2622 and 2632, Treas. Regs. Section 26.2612-1 (rules regarding taxable terminations and taxable distributions).
9.This is a taxable termination in accordance with IRC Section 2612(a)(1).
10.See, e.g., Peter Spero, “Asset Protection: Legal Planning, Strategies and Forms,” par. 5.07B (WG&L 2012); 25 Del. Code Section 501.
11.IRC Sections 2041(a)(3) and 2514(d).
12.IRC Section 2518(a).
13.See Treas. Regs. Section 25.2518-1(b).
15.The mid-term applicable federal rate for February 2013 is 1.01 percent.
16.See N. Todd Angkatavanich and Edward A. Vergara, “Preferred Partnership Freezes,” Trusts & Estates (May 2011) at p. 20.
17.See N. Todd Angkatavanich and Rose K. Wilson, “The Dynastic Family Limited Partnership—An FLP Coupled with a Twist,” 37 BNA Tax Management Estates, Gifts and Trusts Journal 290 (September 2012). For an overview of the “marital deduction mismatch,” which may arise in this scenario, see Stephanie Loomis-Price and N. Todd Angkatavanich, “Turn(er)ing the Tables on Taxpayers,” Trusts & Estates (July 2012) at p. 18.
18.IRC Section 2514(b).
19.Treas. Regs. Section 25.2519-1(a), (f), (g) (examples 1 and 2).
20.IRC Section 2519(a), (b)(1); Treas. Regs. Section 25.2519-1(a), (c).
22.The triggering of IRC Section 2519 may potentially cause inclusion of the income interest in the surviving spouse’s gross estate under IRC Section 2036. This is especially the case when only a portion of the income interest is transferred, and the surviving spouse retains the remaining portion of this interest until death. See Read Moore, Neil Kawashima and Joy Miyasaki, “Estate Planning for QTIP Trust Assets,” 44th U. Miami Hecklering on Est. Plan. ch. 12 (2010); Richard B. Stephens, Guy B. Maxfield, Stephen A. Lind, Dennis A. Calfee and Robert B. Smith, “Section 2519 Disposition of Certain Life Estates,” par. 10.08[a], Federal Estate and Gift Taxation (WG&L 2012). See also Private Letter Ruling 200044034 (Nov. 3, 2000).