• Congress passes American Taxpayer Relief Act—Congress passed the American Taxpayer Relief Act (the Act) on Jan. 1, 2013, technically after the nation had already gone over the “fiscal cliff.” The Act repeals the sunset provisions of the 2001 and 2010 Tax Acts and, therefore, makes permanent, with some modifications, many of the estate tax provisions that have been in effect for the last decade. The Act didn’t address other estate-planning hot topics like the duration of grantor retained annuity trusts, limiting the duration of dynasty trusts exempt from the generation-skipping transfer (GST) tax, limiting valuation discounts applicable to gifts of interests in family limited partnerships or other entities or changing the rules surrounding grantor trusts.
Estate, gift and GST tax. As noted above, most of the law applicable in 2012 has been kept intact. The Act keeps the gift, estate and GST tax exemptions unified at $5 million. Indexed for inflation, this results in a unified exemption of $5.25 million for 2013. However, the Act also permanently increases the top estate and gift tax rate from 35 percent to 40 percent. Since the GST tax rate is the highest marginal estate tax rate, the GST tax rate also increases to 40 percent. The Act continues portability, or the ability of the estate of the first spouse to die to transfer his unused exclusion amount to his surviving spouse. All changes are effective for individuals dying and gifts made after 2012. Note that over time, the exemption will increase significantly. For example, in 20 years, the unified exemption per individual will be $7.65 million based on a 2 percent inflation rate or $11.06 million at a 4 percent inflation rate.
Charitable rollover. The Act extends the ability for taxpayers over age 70½ to donate up to $100,000 directly from their individual retirement accounts to charity and exclude the distribution from their taxable income. However, since the extension occurred after the end of the year, the Act deems the following as occurring on Dec. 31, 2012: (1) rollover distributions made directly to charity before Feb. 1, 2013, and (2) distributions already received by a taxpayer between Nov. 30, 2012 and Jan. 1, 2013, which are then transferred to charity before Feb. 1, 2013.
Income tax rates. For tax years beginning after 2012, the income tax rates for individuals generally will remain at 10 percent, 15 percent, 25 percent, 28 percent, 33 percent and 35 percent. If the current law had been allowed to sunset, the income tax rates would have increased to 15 percent, 28 percent, 31 percent, 36 percent and 39.6 percent, respectively. However, the Act applies a 39.6 percent tax rate for incomes above a threshold of $450,000 for married taxpayers filing jointly, $425,000 for heads of household; $400,000 for single filers; and $225,000 for married taxpayers filing separately. These threshold amounts will be adjusted for inflation after 2013.
Phase-out of personal exemption and itemized deductions. Starting in 2013, the phase-out of the personal exemption is reinstated for those whose income is above certain thresholds: $300,000 for joint filers; $275,000 for heads of household; $250,000 for single filers; and $150,000 for married taxpayers filing separately. The exemption of a taxpayer whose income is above these thresholds is reduced by 2 percent for each $2,500 (or portion thereof) by which the taxpayer’s adjusted gross income (AGI) exceeds the applicable threshold. In addition, for these taxpayers, the total amount of their itemized deductions is reduced by 3 percent of the amount by which their AGI exceeds the threshold amount. However, there’s a cap: The reduction can’t exceed 80 percent of the otherwise allowable itemized deductions. The threshold amounts will be adjusted for inflation for tax years after 2013.
Capital gains and qualified dividend rates. If current law had been allowed to sunset, the long-term capital gains rate would have increased from 0 percent to 10 percent for those taxpayers below the 25 percent income tax bracket and from 15 percent to 20 percent for those taxpayers subject to an income tax bracket of at least 25 percent. Under the Act, for income otherwise taxed at rates below 25 percent, the capital gains and qualified dividends rate will be 0 percent permanently. The capital gains and qualified dividends rate for income otherwise subject to at least the 25 percent income tax rate, but less than the 39.6 percent rate, will continue to be 15 percent. However, beginning in 2013, the top rate for capital gains and qualified dividends will permanently rise to 20 percent (up from 15 percent) for income that would otherwise be taxable at 39.6 percent. In addition, a 3.8 percent surtax (under Internal Revenue Code Section 1411) on investment-type income and gains for tax years beginning after 2012 may apply to increase the effective capital gains tax rates to
18.8 percent and 23.8 percent respectively.
Permanent alternative minimum tax (AMT) relief. The Act provides permanent increases to the AMT exemption amounts, raising them from $45,000 for married taxpayers filing jointly, $33,750 for unmarried taxpayers and $22,500 for married persons filing separately to $78,750, $50,600 and $39,375, respectively, for 2012. These exemption amounts will be indexed for inflation.
• Regulations regarding 3.8 percent Medicare surtax—The Treasury and Internal Revenue Service have proposed regulations interpreting IRC Section 1411, which imposes a 3.8 percent tax on the net investment income of an individual, estate or trust beginning in 2013. Generally, under Proposed Regulations Section 1.1411-3, the tax on an estate or trust is 3.8 percent of the lesser of: (1) the taxpayer’s undistributed net investment income, or (2) the excess (if any) of its adjusted gross income over the threshold for the highest tax bracket under IRC Section 1(e), which is $11,650 for 2012. The surcharge doesn’t apply to certain trusts, including grantor trusts (because the trust income is taxable to the grantor), wholly charitable trusts and business trusts. Regarding electing small business trusts, the S portion and non-S portion each computes its respective undistributed net investment income, which is then combined, and the trust is then treated as a single trust for purposes of calculating its AGI. There are also special rules for charitable remainder trusts (CRTs) that apportion the net investment income among the trust beneficiaries.
• Gift of portion of annuity interest in CRT qualified for income tax deduction—In Private Letter Ruling 201249002 (Dec. 7, 2012), the IRS approved a charitable income tax deduction for a gift of a partial interest in a CRT. The taxpayer and his spouse had established a charitable remainder unitrust, which paid them (jointly or to their survivor) a certain percentage of the value of the trust property on the first day of each calendar year. The trust was irrevocable and couldn’t be amended, but the taxpayer and his spouse retained the right to designate the charities to receive the remainder.
The taxpayer’s spouse had died; therefore, he was the sole beneficiary of the trust. He proposed to give a certain undivided percentage interest of the unitrust entitlement to a charity and to irrevocably designate the same charity as the beneficiary of the same undivided percentage interest in the remainder of the trust. The charity gave no consideration to the taxpayer for the gift or the designation. In the proposal, the taxpayer and the charity planned to consent to a partial termination of the trust in their respective capacities as settlor and beneficiary. The trustee of the trust (who was the taxpayer) would then distribute the designated percentage of the trust’s corpus outright to the charity and continue to hold the balance of the trust in accordance with the terms of the trust agreement.
The IRS ruled that the taxpayer was entitled to deduct the charitable contribution for income tax purposes. The amount of the deduction would be equal to the present value of the right to receive the annual unitrust payments from the percentage of the trust that was gifted.
For gift tax purposes, Treasury Regulations Section 25.2522(c)-3(c)(1)(i) provides that if a gift of a partial interest is made to a charity, and the donor or another private individual retains or receives an interest in the same property, no deduction is allowed unless the charitable interest meets the requirements of Treas. Regs. Section 25.2522(c)-3(c)(2). That section provides that a gift of an undivided portion, not in trust, of the donor’s entire interest in property is deductible. Therefore, since the taxpayer’s gift was of an undivided interest in the trust, it qualified as a deductible gift for gift tax purposes.
• Release of income interest in trust by non-citizen, non-resident not a gift—In PLR 201250001 (Dec. 14, 2012), a non-citizen, non-resident was the sole current income beneficiary of several trusts established by her father. The trusts were grandfathered for purposes of the GST tax because they became irrevocable on her father’s death, which was prior to Sept. 25, 1985. The trusts were to terminate on the later of the taxpayer’s and the taxpayer’s brother’s deaths, at which time the remaining trust property was to be paid to her children.
The taxpayer wished to release her income interest in the various trusts and sought rulings that the release wouldn’t be subject to U.S. gift tax or be considered a constructive addition for GST tax purposes.
The IRS looked to IRC Section 2501(a)(2), which provides that no gift tax is imposed on a transfer of intangible property by a non-citizen, non-resident and confirmed that the income interest in the trust constituted intangible property. Therefore, the release wasn’t subject to gift tax.
In addition, because the release of the income interest wasn’t a taxable transfer, it wouldn’t be a constructive addition for GST tax purposes. Under Treas. Regs. Section 26.2601-1(b)(1)(v)(A), a release, exercise or lapse of a power of appointment that’s treated to any extent as a taxable transfer is treated as an addition to the trust. Further, Treas. Regs. Section 26.2663-2 provides that a transfer by a non-citizen, non-resident is only a direct skip subject to GST tax if the transfer is a taxable transfer subject to estate or gift tax. Since her release wasn’t a taxable transfer for gift tax purposes, the IRS held it wouldn’t be a constructive addition for GST purposes either.