Dedon on Estate Planning

Life Insurance

Many clients rely on life insurance as part of their estate plan.  Indeed, for clients with taxable estates, it is difficult to plan without using life insurance to pay estate taxes.  Life insurance is particularly important if the assets are illiquid, such as real estate or a closely held business, and the estate tax needs to be paid within nine months of death.

Life insurance can be purchased so that the entire amount of the death benefit is received by the beneficiaries estate tax free. For example, under current law, if a husband and wife have assets worth $7 million exclusive of life insurance, and they have a $3 million life insurance policy in an irrevocable trust, the children receive $10 million estate tax free.  This assumes the assets are positioned properly to take advantage of each spouse's $3.5 million exemption and the irrevocable trust is the original owner of the policy.

When creating an irrevocable trust, several complicated issues arise that are the Trustee's responsibility.  If the Trustee is a family member unfamiliar with the legalities of irrevocable trusts, professional guidance is necessary.  Issues relevant to the Trustee include (1) is a Trust account opened by the Trustee to receive premium payments; (2) assuming the grantor pays the premium, is the payment protected by the annual exclusion; (3) the answer to (2) above often depends on whether "Crummey letters" have been prepared, qualifying the premium payment for the annual exclusion.

The Trustee also is responsible for making sure the policy is performing properly, e.g., are the policy assumptions pertaining to interest and mortality rates appropriate?  Also, the Trustee must determine if the insurance carrier is still a strong company.

Using an Irrevocable Trust to own life insurance provides significant advantages.  However, the advantages come with some complication; namely, choosing the right Trustee.  If the Trustee is not an institution or professional, the Trustee must know where to turn for help in dealing with a myriad of issues.

Estate Tax Legislation

Inquiring minds want to know:  what is the latest in Congress on estate tax? All tax legislation must come from the House Ways and Means Committee, and two news items came out of Ways and Means last week.

First, Chairman Charles Rangel, despite his own problems and contrary to earlier statements, said he is drafting a bill to make the $3.5 million exemption permanent. In the past, Rangel said he favored extending the $3.5 exemption amount one year and addressing it again in 2010.

Second, two other Ways and Means Committee members introduced legislation to increase the exemption to $5 million over the next 10 years, plus index the amount for inflation. This bill would also lower the estate tax rate from 45% to 35%.

As you know from reading this Blog and other publications, if the estate tax law is not addressed the exemption amount will fall to $1 million with a maximum 55% tax rate in 2011. The estate tax would disappear entirely for one year, 2010. Hence, the estate tax system is a Congressional priority, notwithstanding all the other issues Congress is now facing.

Besides dealing with the exemption amount and the tax rate, there are other important estate issues before Congress. For example:

• the issue of "portability," i.e., the ability of a married couple to protect $7 million without having to carefully arrange asset titling and beneficiary designations prior to their deaths.

• whether Congress should curtail certain advanced estate planning tools, such as being able to discount for tax purposes the value of intra-family gifts and the use of 2-year GRATS.

(I have written in prior posts on portability, discounting and GRATS.) As of now, it is anticipated that none of these subjects will be addressed this year.

Settling Tax Issues with the IRS

The IRS is gearing up its tax compliance efforts after a few years of reduced activity. One indication of these increased efforts is the recent hiring of 400 new IRS Appeals Division employees. The IRS now has roughly the same number of Appeals Officers that existed a decade ago. As professionals who deal with the IRS know, the Appeals Division is the second layer of IRS review for taxpayers whose estate and income tax returns are audited.

The first level is the audit level, where the agent is likely to view issues from the IRS perspective. If matters cannot be settled at the audit level, the next step is typically the Appeals Division. The Appeals Officer is supposed to consider the "hazards of litigation," meaning rather than take a biased IRS view, the Appeals Officer should consider the legal issues supporting each side and strive to reach a reasonable settlement. As Kurt Meier, deputy chief of the Internal Revenue Service's Appeals division recently said at an American Bar Association luncheon, Appeals must provide an "impartial, fresh look." It has been my experience that most Appeals Officers subscribe to this view.

Therefore, often taxpayers who settle their tax problems with the IRS will do so at the Appeal level, not at the audit level with an agent. Settling at the Appeals level avoids the added cost and time involved in Tax Court litigation. For this reason, having adequate Appeals Officers on board is not bad news.

Charitable Contribution Deductions

Many donors are confused whether they can claim a charitable income tax deduction for gifts directly to individuals. Even if the donee is poor and in need, a contribution directly to that individual does not necessarily result in a charitable contribution deduction.

Some background: Generally only contributions to charities are tax deductible. The IRS determines whether an organization is a qualified charity. Charitable organizations are generally two kinds: (1) public charities, such as universities, churches, relief organizations such as the Red Cross and the United Way, and most hospitals, or (2) private foundations. While public charities receive much of their support from many donors, private foundations are typically created by individuals and receive support from a limited number of people, such as from one family. So if Mom and Dad create a charity and they are the sole contributors that charity will be private foundation.

Although contributions to both public charities and private foundations are tax deductible, public charities enjoy more advantages. For example, a private foundation must distribute 5% of its assets annually. If 5% of its assets are not distributed, then taxes are imposed.

So back to my earlier point: if Mom and Dad create their own private foundation and it is approved by the IRS, that foundation cannot make distributions directly to individuals unless the foundation receives IRS approval for such specific grants. Thus, it is not sufficient to receive IRS approval for the foundation; the IRS also must bless the contributions directly to the donee-individuals. Mom and Dad must tell the IRS they intend to offer scholarships or grants directly to individuals. Mom and Dad must tell the IRS the criteria for selection, the potential grantees, who will do the selection, and other information. The IRS wants to make sure the donees are not, for example, Mom and Dad’s family. On the other hand, if Mom and Dad’s IRS approved private foundation distributes directly to a public charity, no prior IRS approval is required for the distribution.

In sum, when you donate to your church or your university and don’t receive anything in return, you obtain a charitable contribution deduction. However, if you create your own charity you need to obtain IRS approval as a private foundation and additional IRS approval if your private foundation intends to give directly to individuals. No contribution deduction is allowed for contributions directly to individuals that do not flow through qualified charities.

Estate Tax Legislation?

Is this the week Congress establishes certainty in the estate tax law? Probably not but talks are ongoing.

According to House Ways and Means Committee Chairman Charles Rangel, Committee members this week are continuing to discuss how to avoid the one-year elimination of the estate tax. Under current law, there would be no estate tax in 2010 but in 2011 the estate tax would return and cover estates exceeding $1 million at maximum tax rates of 55%. Currently, there is a $3.5 million exemption amount. For married taxpayers who do the proper planning, they can double the exemption amounts ($2 million in 2011 and $7 million in 2009).

It is difficult to plan not knowing whether the estate tax exemption will be extended at the $3.5 million level; whether it goes away temporarily or permanently; whether the exemption is reduced to $1 million; or an entirely unknown alternative. Rangel was quoted last week by the Publisher, BNA, that he favors a one-year extension of the $3.5 million amount rather than a "permanent" solution. President Obama has said he believes $3.5 million is the appropriate amount. On the other hand, Republicans still believe that a greater exemption amount and a lower estate tax rate is appropriate.

My prediction is that Congress will, as Rangel said, extend the $3.5 million exemption for one year, meaning we will have the same uncertainty for at least one more year. The problem would then again have to be addressed 2010. We will know soon. 

GIFT TAX RULES

When it comes to transferring assets for gift and estate tax purposes, there is much confusion regarding the federal rules. What is an annual exclusion gift? How much can I protect from estate tax when I die? Can I give it away before I die? There are many more questions. Let’s consider these rules: (I am assuming U.S. citizens because the rules may be different for non-citizens.)

1. Upon your death, you can protect $3.5 million from estate tax. Although this amount changes on January 1, 2010, virtually everybody knowledgeable in this area expects Congress and the President to extend the $3.5 million amount (or increase it) into 2010 and beyond.

2. Prior to you death, you can give away $1 million without paying any gift tax. However, if you do give away $1 million during your life, the amount of the gift is deducted from what you can protect at your death (unless it is an annual exclusion gift – see 3).

3. In addition to the $1 million, you can give away $13,000 per year to any beneficiary. This "annual exclusion" amount does not have to be to a family member.

4. You can pay education and medical expenses in addition to the $13,000 and the $1 million exemption amount

5. If you are the beneficiary of an inheritance under 1) above, or a gift under 2), 3) or 4) above, you do not pay federal tax on receipt of the gift. If there is a tax consequence, it applies to the person dieing or making the gift.

How do these rules apply? Here are some examples:

Ex 1: Mom and Dad have three children. They can each give $13,000 ($26,000) to each of the three children ($78,000). Mom and Dad can make these same gifts each year without any income or gift tax consequence.

Ex 2: Two of the children are married. There are 4 grandchildren. Mom and Dad also have a favorite niece. They can gift on an annual basis another $182,000 without any income or gift tax consequence (7 x $26,000).

Under Ex 1 and 2, Mom and Dad gave away $260,000, saving $117,000 in estate tax upon their deaths ($260,000 x 45% estate tax).

Ex 3: Mom and Dad are really wealthy and desire to give away more than the annual exclusion amounts in Examples 1 and 2. Thus, they gift $2 million to their three children. Now upon their deaths, they will only be able to protect $5 million between them ($3.5 million each x 2 = $7 million - $2 million gifts).

Ex 4: For all the gifts above, the assets come from Mom’s separate brokerage account. Notwithstanding, Dad can join in the gifts even thought he does not own the assets because of "gift splitting." The "gift split" would be reflected by Mom and Dad filing a gift tax return each year of the gift, which provides information to the IRS but does not cause any gift tax.

Why gift now? There are several answers to this question. For example, asset values are low, thus allowing you to remove more from your taxable estate. Also, all appreciation in the assets will be removed from your taxable estate. Further, there are various gift strategies that allow you to discount the value of the transferred assets for gift tax purposes. IRS interest rates that may apply to some of these strategies are also low now, allowing for more to be removed from the taxable estate.

Obviously there is more to gift and estate tax planning, but these are a few of the basic rules.

Fundamental Estate Planning

This summer may be remembered for the unusually large number of high profile deaths. These deaths cause us to face our own mortality and, for estate planning lawyers, result in more phone calls. It is always surprising how many individuals don't have any planning, such as Wills, Powers of Attorney and Medical Directives. Even fewer people have the appropriate planning, such as Revocable Trusts for probate avoidance or correct beneficiary designations on assets and proper asset titling.

With this in mind, by clicking Download Fundamental Estate Pl Presentation 8-31-09 blog.PPT you can follow a PowerPoint Presentation I will be giving this fall to prospective clients and professionals covering the need for fundamental estate planning, the necessary planning tools to utilize, and the critical importance of examining the ownership of the assets and beneficiary designations. The Case Study in the PowerPoint highlights this latter point.

Family Partnerships and Estate Planning

A recent Tax Court Memorandum Opinion, Estate of Miller v. Commissioner, T.C. Memo 2009-119 (May 27, 2009), adds to the long line of cases involving taxpayers who claim valuation discounts for transfers of assets to family members. The intended result is that, because the asset values are reduced for tax purposes, significant estate tax saving result. As in Estate of Miller, the preferred entity to obtain discounts is often a Family Limited Partnership (FLP). Limited Liability Companies are also often used.

For purposes of highlighting the importance of Estate of Miller, I am eliminating details of the facts. Simply assume the taxpayer transferred marketable securities into an FLP and then gifted limited partnership interests to her children. The gifts occurred over a two year period. The taxpayer claimed a 35% discount from the asset value of the publicly traded securities inside the FLP because the gifts consisted of limited partnership interests. That is, although the marketable securities were in Merrill Lynch and Fidelity accounts, because they had first been transferred into the FLP, and then limited partnership interests were transferred not the public securities, discounts for lack of market and control should apply.

The Tax Court agreed with the taxpayer in concept and allowed discounts for the gifts made in Year One but not Year Two. In broad terms, the importance of the Tax Court’s decision is the following:

Taxpayers can obtain discounts for gifts of limited partnership interests even when the FLP holds marketable securities.

• A 35% discount may be reasonable. Indeed, the IRS did not challenge the amount of the discount. Thus, in theory a discount more or less may be appropriate, depending on the facts.

There must be a business purpose for the creation of the FLP. A "business purpose" means, in essence, a non-tax reason. The Tax Court concluded actively managing marketable securities is a valid "business purpose." Thus, taxpayers do not need to operate a "business" in the sense of a car dealership or government contracting business to rise to the level of a valid business purpose.

So, what did the Tax Court determine was the distinguishing factor between Year One when the gift (and 35% discount) was allowed and the second year when the Court said there was not a legitimate gift? It comes back to business purpose and the non-tax reason for creating the FLP and making the gifts. (The relevant Internal Revenue Code Section is 2036.) The Tax Court stated there was a legitimate non-tax reason to create the FLP. Here, it was primarily the need for an entity to allow a child to continue the active investment philosophy of his parents. The child worked full-time in this activity. Perhaps other factors were important, such as asset protection, succession planning for the family and centralized management. The court also noted the taxpayer had other assets to live on beyond those gifted to her children. Thus, the Year One gift was legitimate.

However, in Year Two when the second round of gifts was disallowed, the taxpayer was not in good health. The Court concluded the gifts were motivated by death bed planning. Also, after this round of gifts, the taxpayer did not have other assets in her own name sufficient to pay her bills. Thus, the Court held the gifts in Year Two were motivated by the taxpayer’s desire to reduce estate tax.

In general, Estate of Miller v. Commissioner is a pro-taxpayer case because it illustrates that FLP’s and LLC’s remain viable gift and estate tax planning tools if set up for valid reasons. However, if thrown together at the last minute as part of death bed planning or without any credible non-tax reason, they will be subject to challenge. The IRS will also challenge the discounts if the formality of the structure is not observed, e.g., commingling assets, failure to make pro rata distributions, opening appropriate accounts, etc.

As I have written about in the past, whether Congress renders these cases moot through legislation that would curb or eliminate discounting in family settings remains an open question.

Estate Tax Legislation

President Obama hoped Congress would pass health care reform before the August recess. However, it will now be considered in the fall. Does this portend a similar delay in estate tax legislation?

Much has been written about the need for estate tax legislation to add "permanence" to the law, which now affects primarily decedents with estates exceeding $3.5 million. Current law provides that, in 2010, there is no estate tax and in 2011 forward only $1 million of assets can be protected from estate tax. These two extreme differences add to the uncertainty in estate planning. Most agree that Congress will at least extend the $3.5 million exemption for one year to avoid the elimination of the estate tax in 2010. Obama is on record supporting a $3.5 million exemption. (By the way, there are also proposals for other estate tax changes that I have previously written about. These pertain to GRATs and family discounting.)

However, what if legislative proposals deemed more important (e.g., health care) bogs down in Congress and estate tax reform is pushed aside? Commentators do not expect this calamity to result but one tax lobbyist has told me he would not be surprised if no estate tax law is passed. In the absence of legislation, 2010 becomes the year to die for estate tax purposes. Stay tuned.

Gift/Sale To Intentionally Defective Trusts

Virginia Business Magazine published online my recent article on gift/sales to Intentionally Defective Trusts. It is an estate planning strategy business owners should consider.  You can access it by going to:  www.virginiabusiness.com, or it is reprinted below.

Transferring business interest to an intentionally defective trust

June 30, 2009 10:33 AM
John Dedon

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Lifetime gifts of closely held stock and real estate from business owners to children are a valuable way to shift assets to the next generation while minimizing estate taxes. There are several ways to implement a lifetime transfer. Sometimes an outright gift, although simple and straightforward, is not the most effective transfer technique.

 

For example, when the proposed transfer exceeds the annual federal gift exclusion limits (currently $13,000 per donee per year); when a parent would rather use the annual gift exclusion for other purposes; or when the proposed transfer exceeds the $1 million lifetime gift exemption (or it has already been used), other techniques must be considered.

 

One common method is a gift and sale of assets to an intentionally defective grantor trust (IDGT). The IDGT beneficiaries are the children and often future generations. Because the IDGT may be designed as a dynasty trust, future estate tax is avoided.

 

IDGTs are beneficial because: assets transferred (and future appreciation) to the IDGT are removed from the business owner’s estate; income tax to the grantor may be avoided on the sale of the assets; income on the assets inside the IDGT is paid by the grantor, thereby resulting in greater tax-free gifts; and the assets inside the IDGT are protected for future generations from creditors and failed marriages.

Why is an IDGT important?

 

It may be disconcerting to employ a trust called “defective,” but the term merely refers to creating an irrevocable trust, where assets are transferred to the trust so they are removed for estate tax purposes but the income on such assets continues to be taxed to the transferor. Such a trust is called a “grantor trust.”

 

The ability to work the income and estate tax consequences to the business owner’s benefit arises because the income tax rules and estate tax rules do not dovetail perfectly. Because of this inconsistency, a trust can be drafted to give the business owner certain benefits or powers while avoiding others. In an IDGT, assets will be excluded from the business owner’s estate for estate tax purposes, but the assets’ income will be taxed for income tax purposes.

 

In effect, the business owner intentionally violates the rules designed to avoid the trust income from being taxed to him.  Transfers to such a trust are said to be “effective” for estate tax purposes, but “defective” for income tax purposes.  This creates great opportunity for both income and estate tax planning.

 

Mechanics of an IDGT

 

To implement an IDGT, where the trust assets will not be included in the business owner’s taxable estate, take the following steps:

 

(1)  Fund the trust by making a “seed gift” to the IDGT.  As a rule of thumb, it is often recommended that the value of this seed gift be at least 10 percent of the value of the sale transaction described in step 2 below.  The seed gift can be cash, marketable securities, or a percent of the asset to be purchased.  When the gift is made, the business owner would use some of his lifetime gift exemption to avoid paying gift taxes (or pay gift tax if the gift exceeds his lifetime gift exemption).

 

(2)  Sell an asset, such as company stock, LLC interests, or real estate, to the IDGT in exchange for an installment note for the purchase price.  The note would bear interest equal to the IRS rate that is published each month (the “Applicable Federal Rate” or “AFR”).  This interest rate is locked in for the life of the loan.  The AFR rate for a 9-year note in June 2009 was 2.25 percent.  Because the IDGT is a grantor trust for income tax purposes, the sale of the asset would not result in any taxable gain to the business owner (for income tax purposes, the business owner is considered to be selling an asset to himself).

 

Assuming the business owner gifted company stock, dividends from the stock would pay for the purchase of additional stock.  That is why it is important that the corporation is an S corporation. 

 

An example

 

Below is an example of how the sale of stock worth $10 million by a business owner to an IDGT would work:

 

Step 1: Gift of $1 million in stock. The gift should be at least 10 percent of the total value of the sale.

 

Step 2: Sale of $9 million in stock to IDGT. The promissory note includes an interest ate of 2.25 percent, interest-only annual interest payments and a 9-year term balloon payment.

 

The $10 million of transferred stock will earn dividends which will pay the annual interest payments. The balance, if any, may be accumulated and reinvested by the IDGT; used to pay down principal; or disbursed to the IDGT beneficiaries.

 

-Assume the trust earns 7 percent income each year:
$10 million trust assets x 7% income = $700,000 annual income

 

-Annual interest payments:
$9 Million principal x 2.25% AFR interest rate = $202,500 annual interest

 

John P. Dedon is a principal in the firm with the Trust, Estate & Tax Planning practice group of Odin, Feldman & Pittleman. Dedon blogs about estate planning issues for Virginians and U.S. citizens at dedononestateplanning.typepad.com.

 

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