Archive for Estate Tax

IRS Form 7004 Automatic Extension of Time To File Certain Business Income Tax, Information, and Other Returns.

If your corporation, partnership or estate operates on a calendar year basis the tax return is due March 15th which is coming up! If you need additional time to file tax returns for these entities file IRS Form 7004 which is an application for Automatic Extension of Time To File Certain Business Income Tax, Information, and Other Returns.

Filing this form by March 15th gives you an additional 5 or 6 months to file your actual tax documents. Instructions for this form are essential so be sure to read them.

If you contact me (or any tax practitioner worth their salt) to hit this deadline the first thing that you will be advised to do at this late date is to get this automatic extension request filed. If anything it alleviates the stress of rushing through the tax return AND you avoid the onerous late filing penalty.

American Taxpayer Relief Act 2012

The American Taxpayer Relief Act of 2012 makes permanent many otherwise expiring tax provisions. The following is my summary of what I believe to be relevant provisions:

Ordinary income above a certain threshold is taxed at a higher rate. The thresholds are: taxable income of $400,000 (for an unmarried taxpayer), $425,000 (for a head of household), and $450,000 (for a taxpayer who is married and filing jointly).

The current maximum 15% tax rate on long-term capital gains and qualified dividends is extended for individuals who have taxable income up to $400,000 (for a unmarried taxpayer), $425,000 (for a head of household), and $450,000 (for a taxpayer who is married and filing jointly). For capital gain and dividend income above the applicable threshold, the rate increases to 20%. With the new 3.8% Medicare surtax for unmarried and head of household taxpayers with modified adjusted gross income (“MAGI”) over $200,000 and married taxpayers with MAGI over $250,000, the capital gain and qualified dividend rate has become more complex.

The 3.8% “Medicare surtax” effective January 1, 2013, under the health care reform law passed in 2010 is still being deployed. This new tax applies to certain types of investment income for unmarried taxpayers with MAGI above $200,000 and married couples above $250,000. The tax applies to the lesser of the individual’s net investment income or MAGI in excess of the threshold amounts. In addition, high-income earners will be subject to an additional payroll tax of 0.9% on wages received in excess of those threshold amounts.

The $5 million estate, gift and generation-skipping transfer (GST) tax exemptions are now permanent and adjusted for inflation from 2011. It also makes permanent the “portability” provision between spouses, which allows a surviving spouse to use a deceased spouse’s unused exemption on lifetime gifts and/or transfers at death. GST exemption, however, is not portable.  For 2013, the exemption amount is projected to be $5.25 million. The Act sets the rate for all transfers in excess of the exemption amount (for all three taxes) at 40%. The federal credit for state death taxes is now permanently repealed. However, an estate may continue to deduct state estate or inheritance taxes for purposes of computing the federal estate tax.  A variety of beneficial GST tax provisions that were scheduled to expire have been made permanent, including the automatic allocation of a taxpayer’s GST exemption to certain transfers, provisions permitting the “qualified severance” of a trust into two trusts, one of which is exempt from the GST tax and one of which is not; and relief for a late allocation of GST exemption.

The alternative minimum tax (AMT) patch, which historically had been passed each year by Congress to lessen the burden of AMT on millions of middle-income households is now permanent and will be adjusted for inflation. Under the Act, the AMT exemption amount for 2012 is $50,600 for unmarried taxpayers and heads of household, $78,750 for taxpayers who are married and filing jointly, and it is indexed for inflation going forward. The 2013 exemption amounts are projected to be $51,900 for unmarried taxpayers and heads of household, and $80,750 for married taxpayers filing jointly.

The personal exemption phase-out (“PEP”) provision, which had been suspended under prior law, returns. It phases out the personal exemption for taxpayers with adjusted gross income (“AGI”) over $250,000 (for an unmarried taxpayer), $275,000 (for a head of household), and $300,000 (for a taxpayer who is married and filing jointly).

A past law often referred to as the “Pease provision” which limited itemized deductions for high-income taxpayers is reinstated. The Pease provision was suspended for 2010 through 2012 allowing taxpayers to deduct 100% of their itemized deductions regardless of their income subject to other applicable restrictions. The Pease provision applies to AGI above the following thresholds: $250,000 (for an unmarried taxpayer), $275,000 (for a head of household), and $300,000 (for a taxpayer who is married and filing jointly). The Pease provision phases out itemized deductions by the lesser of (i) 3% of the excess of AGI over the threshold or (ii) 80% of the otherwise allowable deductions. While the Act did not directly address the mortgage interest or charitable deductions, the Pease provision has the effect of limiting the amount of these deductions that a taxpayer may take if his or her income exceeds the applicable threshold.

The payroll tax “holiday” enacted in 2010 expired. Under the payroll tax holiday, the 6.2% social security tax paid by all wage earners was temporarily cut to 4.2%. The expiration of the holiday will cause wage earners to pay 2% more in social security taxes on all wages up to $113,700.

The ability to exclude from income gain on the sale of certain qualified small business stock (QSBS) is extended, as long as the stock was held for more than five years before sale. The exclusion is generally 50%, but was increased to 75% for QSBS acquired after February 17, 2009, and before September 28, 2010; and to 100% for QSBS acquired after September 27, 2010, and before January 1, 2012. The Act extends the 100% gain exclusion to QSBS acquired after September 27, 2010 and before January 1, 2014. Note that the QSBS exclusions are generally limited to the greater of (i) $10 million of gain or (ii) ten times the taxpayer’s cost basis in the stock sold in that year. In addition, gain subject to the 100% exclusion rule is not a preference item for alternative minimum tax purposes.

The ability of a taxpayer age 70½ or older to exclude up to $100,000 from gross income for distributions made directly from a traditional or Roth IRA to a qualified charity is extended. This provision expired after 2011; it is now extended for 2012 and 2013. The Act contains two time-sensitive provisions giving taxpayers flexibility with respect to the 2012 tax year. First, if a taxpayer took a required minimum distribution (“RMD”) in December of 2012, he or she can elect to treat some or all of that RMD as a qualified charitable contribution to the extent that the distribution (up to $100,000) is transferred in cash to a qualifying charitable organization before February 1, 2013, and meets the other charitable rollover requirements. Second, a qualified charitable contribution made in January of 2013 may be treated as having been made on December 31, 2012.

A deduction for a charitable gift of long-term capital gain property is generally limited to 30% of the donor’s adjusted gross income (AGI). However, for the years 2006 through 2011, a special provision allowed a deduction of up to 50% of the donor’s AGI for contributions of “qualified conservation property.” The Act extends this provision through December 31, 2013.

There are various other individual and business tax provisions that were set to expire including: earned income credit; adoption credit and assistance; child and dependent care credit; mortgage debt cancellation relief; mortgage insurance premiums deduction; marriage penalty relief; and bonus depreciation.

The ‘Fiscal Cliff’ and Your Tax Obligations

Our esteemed President has proven to me to be extraordinarily disingenuous with his statements about the middle class and their purported tax obligations as pretty much everyone’s taxes will go up in 2013 as a direct result of the cumulative efforts of our ‘elected officials’ over the last few days.  Please don’t get me wrong as I find the man’s leadership in most regards to be much more stoic than any other President in my life time.

What I find particularly galling however is that everyone it seems from pundits to established economists speak about the need to create jobs in America as the best way to reduce the deficit. I believe as a matter of principal that the best way to create jobs from a policy or legislative perspective is to drastically reduce employment tax and to completely eliminate self employment tax as these are some of the biggest costs and risks associated with being an employer or job creator.

Either way if you would like to read the actual legislation a pdf version can be found here at the US Government Printing Office and summaries can be found here at the Library of Congress.  The following are some highlights of what to expect:

Starting in 2013, there will be a new 39.6% rate placed on these thresholds:

  • Married Filing Jointly: $450,000 of taxable income

  • Qualifying Widow(er):  $450,000 of taxable income

  • Head of Household: $425,000 of taxable income

  • Single: $400,000 of taxable income

  • Married Filing Separately: $225,000 of taxable income

Starting in 2013 the tax rates on long-term gains would be:

  • 0% if income falls below the 25% tax bracket

  • 15% if income falls at or above the 25% tax bracket but below the new 39.6% rate

  • 20% if income falls in the 39.6% tax bracket

The Senate proposes the following AMT exemption amounts for 2012 indexed for inflation starting after 2012:

  • Married Filing Jointly: $78,750

  • Qualifying Widow(er): $78,750

  • Single: $50,600

  • Head of Household: $50,600

  • Married Filing Separately: $39,375

The proposed threshold amounts at which itemized deductions would start to be limited are:

  • Married Filing Jointly: $300,000 of AGI

  • Qualifying Widow(er): $300,000 of AGI

  • Head of Household: $275,000 of AGI

  • Single: $250,000 of AGI

  • Married Filing Separately: $150,000 of AGI

The Senate proposes to re-instate the personal exemption phase-out starting in 2013. Taxpayers would see their total personal exemptions reduced by two percent for each $2,500 by which adjusted gross income exceeds the threshold. The proposed threshold amounts for 2013:

  • Married Filing Jointly: $300,000 of AGI

  • Qualifying Widow(er): $300,000 of AGI

  • Head of Household: $275,000 of AGI

  • Single: $250,000 of AGI

  • Married Filing Separately: $150,000 of AGI

The Senate proposes that the following tax provisions be extended through the end of the year 2017:

  • American Opportunity Credit

  • Child Tax Credit at $1,000 maximum and partially refundable

  • Earned Income Credit for 3 or more dependents

The following provisions would be extended through 2013:

  • Educator expenses deduction

  • Exclusion for cancellation of debt on primary residences

  • Mass transit and parking benefits excluded from income set at maximum of $175 per month.

  • Mortgage insurance premium deduction

  • Deduction for state and local sales taxes

  • Charitable deduction for donating real property for conservation purposes

  • Tuition and fees deduction

  • Exclusion for charitable distributions from individual retirement accounts

Gift Tax on Transferred Real Estate

The person or entity transferring a property has a capital gain to the extent that the amount realized exceeds the adjusted basis of the property. However according to Reg § 1.1001-1(eno loss is allowed on a transfer that is part sale and part gift, if the amount received is less than the adjusted basis.

For example if you gift a $600,000 property to your grand daughter the excess of the Fair Market Value (FMV) of ($600,000) over the amount of money received in exchange or realized ($0) is considered a gift for tax purposes reported on IRS Form 709, United States Gift (and Generation-Skipping Transfer) Tax Return.  It is also eligible for the annual gift tax exclusion as well as the limits on the life time exclusion.

Tax Treatment of Charitably Donated Artwork

Please refer to IRC 170 as well as Publication 526, Charitable Contributions (PDF), Publication 561, Determining the Value of Donated Property (PDF), and Publication 1771, Charitable Contributions Substantiation and Disclosure Requirements (PDF) for detailed information on charitable contributions. This is what I’ve learned about issues involving charitable contributions of artwork that tax examiners focus on:

1. The charitable contribution deduction for artwork by Art Galleries, Dealers or the Artist who created the artwork is generally limited to the smaller of fair market value on the date of contribution or its adjusted cost basis taking into consideration cost of goods sold to prevent a double deduction.

2. A charitable contribution deduction is generally based upon the fair market value of the property at the time of the contribution. If a sale of donated property would have generated ordinary income or a short term capital gain, the amount otherwise deductible is reduced by the amount of ordinary income or short term capital gain that would have been recognized.

3. As stated in IRC § 1.170A-4(b)(1): “The term ‘ordinary income property’ means property any portion of the gain on which would not have been long term capital gain if the property had been sold by the donor at its fair market value at the time of its contribution to the charitable organization. Such term includes, for example, property held by the donor primarily for sale to customers in the ordinary course of his trade or business, a work of art created by the donor *** ”. IRC § 1221(a)(3)(A) excludes from treatment as a capital asset property in the possession of the person who created it. In other words art created by an artist and sold by the artist is treated as ordinary income.

4. Artwork donated to a charitable organization by an Art Gallery owner or a Dealer in artwork creates a consideration as to whether the artwork being donated is actually held as an investment or is inventory of the owner. The difference being that a charitable contribution deduction for the long-term capital gain property is generally its fair market value, while the deduction for a contribution of inventory is limited to the lower of cost or fair market value.

5. The deduction for artwork that was gifted by the artist who created it to the investor is generally limited to the smaller of the gift basis or the fair market value on the date of the charitable contribution.

6. Appraisals and Valuations

  • All taxpayer cases selected for audit that contain artwork with a claimed value of $50,000 or more per item must be referred to the IRS’ Art Appraisal Services for review by the Commissioner’s Art Advisory Panel. IRM 4.48.2 provides this mandate and the procedures and information needed to make the referral can be found in IRS Rev. Proc. 96-15. Generally the best course of action is to request a review of art valuations for income, estate, and gift returns and subsequently obtain a Statement of Value from the IRS prior to filing the return. Even if the value is under $50,000, the Art Appraisal Services will assist the examiner upon request.

  • A written acknowledgment from the person making the donation is required for donations of $250 or more. For claimed charitable contributions over $500, IRS Form 8283 must be attached to the return and the taxpayer must maintain certain records.

  • For a charitable donation of property in excess of $5,000 the donor has an additional requirement of obtaining a “qualified appraisal”. IRS Form 8283 requires that the appraisal for donated art valued at $20,000 or more must be attached to the return. For property valued at more than $5,000, an appraisal summary must be attached to the return. Appraisals in the entirety for art valued in excess of $500,000 must be attached to the return. The specifics of “qualified appraisal” requirements as well as “appraisal summary” and other related requirements can be found in IRS Notice 2006-96 and 2006-45 IRB 902.

  • A charitable donee is required to file IRS Form 8282 if it sells, exchanges, or otherwise disposes of (with or without consideration) charitable deduction property (or any portion) within 3 years after the date the original donee received the property. The form is filed with the IRS and provided to the donor of the property. A third party contact should be considered to determine if the form 8282 was required and not provided.

  • In order for a taxpayer to claim a deduction for the full fair market value of tangible property donated to charity the property must be used by the charitable organization in a way that is related to its charitable purpose. For example art is generally treated as ‘use property’ for an art museum, and perhaps a school, but probably not necessarily for a rescue organization.

  • It is possible to claim a deduction for a donation of a fractional interest in art, but immediately before the donation the property must be wholly owned by the donor or shared by the donor and the charity. Special valuation rules apply to subsequent fractional gifts. The deduction may be recaptured if the gift is not completed within the earlier of 10 years after the initial fractional gift or the date of the donor’s death.

  • Section 6695A imposes penalties on appraisers in certain circumstances. Section 6662 provides accuracy related penalties on the donor.

7. Examiners consider whether corporate officers are unreasonably compensation for the duties performed when large artwork transactions are reported by corporations.

8. Examiners investigate as to whether travel is not personal in nature as travel is usually a significant item in the art and art gallery industry. Gallery owners and artists alike tend to travel to buy, sell, and track art. Only the owner’s travel expenses are deductible, NOT the expenses of family members. Trips to vacation locations such as Hawaii, California, Florida, or Colorado have the potential to be personal in nature, and are usually disallowed.

IRS Statistics of Sole Proprietor Income

Approximately 22.7 million individual income tax returns reported non-farm sole proprietorship profits of $244.8 billion for tax year 2009 according to the recently released Statistics of Income Quarterly Report.  Check it out here -> Summer 2011

Some other points worth noting in my opinion include:

1. For tax year 2008, almost 67,000 foreign-controlled domestic corporations reported combined profits of $21.8 billion.

2. 6,675 corporations claimed a total foreign tax credit of $86.5 billion against their U.S. income tax liability in tax year 2007.

3. Nearly 37,000 estate tax returns were filed for decedents who died in 2007 with total gross estates of $2 million or more, the filing threshold for that year reporting a combined total of $224.8 billion in assets.

Surviving Spouse Estate & Gift Tax Exclusion

IRS Notice 2011-82 makes available the ability for taxpayers to pass along their unused estate & gift tax exclusion amounts to their surviving spouse if an estate tax return is filed. This new portability election allows estates of married taxpayers to pass along the unused part of their exclusion amount ($5 million cap in 2011) to their surviving spouse,which in theory should eliminate the need to do silly things like re-title property etc.

It is expected that most estates of people who are married will want to make the portability election, including people who are not required to file an estate tax return for some other reason. The only way to make the election is by properly and timely filing an estate tax return on Form 706. As bizarre as this seems, there are no special boxes to check or statements needed to make the election. The estate tax return is due nine months after the date of death. Estates unable to meet this deadline can request an automatic six-month filing extension by filing Form 4768. Estates of those who died before 2011 are not eligible to make this election. Stay tuned in further regulation on the matter.

Simple Trusts – Basic Observations

For tax purposes a Simple Trust requires that all income generated by the trust be distributed each year to the trust’s beneficiaries.  Even if a trust distributes all its income every year this alone does not necessarily make it a simple trust though. Understanding the trust document is important.  If all income is not distributed the trust is essentially a complex trust, any net income after expenses is taxed in the trust at the trust’s tax rate. If distributed, the beneficiaries’ share of taxable income after expenses is reported on a K-1 and taxed on the beneficiaries respective returns at their respective tax rates.

A trust treated as a simple trust in year 1 can become a complex trust in future years if it doesn’t violate the trust agreement.  I’ve seen this happen when the trust wishes to make charitable donations. A Simple Trust is prohibited from allowing its funds to be used for charitable purposes.

If the income is not distributed out of a simple trust annually, the Trustee has problems.  That is where tax problems happen and I get called in.  What I have learned is that ultimately the beneficiary may be taxed on the income whether it is distributed or not particularly when a simple trust becomes a complex trust without the beneficiaries grasping the tax realities of the change.

Sale Leaseback

From a tax perspective the fundamental issue is whether a legitimate business purpose exists for the formation of a distinct entity to do a sale leaseback. If one exists and this is pursued all elements of the transaction should meet an arms length standard and be at fair market value.

For a sale-leaseback, the business owner will set up a new LLC and then under an arms length transaction, sell the asset to the LLC and immediately enter into a lease for this property from the LLC. If the primary purpose of this strategy is to raise more capital, then it is necessary to find the investor who will be putting the cash into the LLC. The primary disadvantage in considering this strategy is the small business owner is giving up some of the profits in the business via the lease payments.

The primary caution in considering this strategy is you must understand the transaction must be an “arms-length” transaction for both the sale to the LLC and the leaseback of the asset from the LLC. A secondary issue is whether the lease qualifies as an operating lease or a capital lease. The third issue, which may be the most critical to many small businesses, is have you given up your primary asset that may be critical for your use as collateral for your overall debt structure? Most likely, the business owner will have to pay taxes at the time of the sale.

If the motivation is to transfer ownership in assets to other family members or employees, this transaction may be structured more along the lines of a gift-leaseback. In order to determine the value of the gift into the LLC, you must obtain an appraisal of the fair market value of the equipment. This strategy would normally only be considered by a business that would conclude that it is “asset rich.” As with the sale-leaseback, it is important that the lease be at fair market value.

This strategy could afford the business owner to 1) potentially reduce the size of their taxable estate and 2) potentially shift some income and cash flow to either family members or key employees.

For any gifting, be sure to familiarize yourself with the gift tax and estate tax implications. A major factor in evaluating this strategy is whether the assets transferred will be appreciating in value. Another factor as discussed above, is whether the business owner will need the assets for collateral in the future. And, the business owner needs to make a long-term estimate of the cash flow impact on the business.

Take care to determine if a gift tax return must be filed or in the case of employees, if the transfer constitutes taxable compensation. Also don’t overlook the new LLC’s ability to take depreciation on the assets.

The final aspect of considering this topic is control. In these transactions, the business owner may be giving up control over assets that are key to the business. An extension of this question is to consider if future asset purchases will be made by the newly created LLC or inside the business.

If the concern is legal liability, then this is a discussion to be had with their legal counsel and not their CPA/financial planner. The fundamental question to be raised with their attorney is if you have the assets in another LLC will it limit any of your liability exposures.

Estate Tax Planning Tips for 2011

The 2010 Tax Act extends to December 31, 2012, the income, estate, gift and generation-skipping tax provisions enacted during the administration of President George W. Bush (“EGTRRA”). For the two-year period beginning January 1, 2011, it reinstates the unified federal estate, gift and GST exemption, sets the exemption at $5 million and sets the tax rate on amounts over the exemption at 35%. It also includes, for those 2 years only, a new “portability” provision that allows the executor of the first spouse to die to transfer any unused gift and estate tax exemption to the surviving spouse. It also changes the estate tax law and provides an option for estates of those who died in 2010. And it presents more uncertainty, as this tax “relief” is only for two years and has built-in uncertainties. Plus, just like under EGTRRA, if Congress does not act before the sunset date, the EGTRRA provisions and the 2010 Tax Act provisions will disappear and the tax laws will revert to how they read in 2000.  These changes, and the uncertainty that comes with them, present some unique planning opportunities and challenges for estate planning. 

Opting Out of the Estate Tax for Those Who Died in 2010
The 2010 Tax Act made a retroactive reinstatement of the estate tax, setting the exemption for 2010 at $5,000,000 (without portability), and repealed the carryover basis provisions that were unique to 2010. However, the executor for a decedent who died in 2010 may elect to opt out of the new law and therefore have the modified basis rules (unlimited step-down for loss assets and a limited step-up of $1.3 million ($60,000 for non-resident non-citizens), plus $3 million for assets passing to a surviving spouse) and no estate tax apply.

The executor of a 2010 decedent has until September 19, 2011, to make the election; file estate tax, GSTT and basis allocation returns; pay estate tax; and make disclaimers.

Planning Tip: In almost all cases for 2010 estates that are less than $5 million (the applicable exclusion amount), the election to opt out should not be made. These estates almost always come out better with the $5 million exemption and fair market value step-up in basis. For larger estates, an evaluation will need to be made before assuming the carryover basis would be better.

Considerations for Determining Whether to Opt Out of the Estate Tax for 2010 Decedents

  • Calculating how much would be paid in estate taxes now vs. capital gain tax on the future sale of assets.

  • Anticipating dates of sales of assets. If no sale is expected, there is no need to take the election.

  • Considering ability to allocate basis adjustments up to the fair market value at the date of death for assets that will likely be sold in the near future.

  • Anticipating future capital gains rates and ordinary income rates for ordinary income property.

  • Weighing present value of anticipated income tax costs against current estate tax amount.

  • Considering how to resolve potential disputes among heirs regarding the $1.3 million limited basis increase. (The surviving spouse will always get the $3 million step-up.)

Example #1: John dies in 2010, leaving $6.3 million estate with $5 million basis to Child. 

Estate tax calculation: $6.3 million estate minus $5 million exemption equals $1.3 million taxable estate. Tax rate of 35% produces $455,000 due in estate taxes.

Income tax calculation: $6.3 million in assets minus $5 million basis equals $1.3 million gain. Apply the $1.3 Special Basis Allocation so Child’s basis is now $6.3 million, generating complete step-up in basis.

Result: Carryover basis option is the easy choice.

Example #2: John dies in 2010, leaving $8 million estate with basis of $2 million to wife Olivia.

Estate tax calculation: $8 million estate using unlimited marital deduction equals zero taxable estate with zero estate tax. Complete step-up in basis provided under Section 1014. If left in QTIP, can make partial QTIP election to preserve $5 million exemption amount or possible disclaimer to remainder beneficiaries. On Olivia’s death (assuming no asset growth and permanency of new tax law), estate tax is 35% of $3 million = $1,050,000.

Income tax calculation: $8 million in assets minus $2 million basis equals $6 million built-in gain. Only $4.3 million of basis adjustment available (special basis allocation of $1.3 million plus spousal basis adjustment of $3 million). Capital gains tax = 15% x $1.7 million = $255,000.

Result: Adjusted basis of $6.3 million vs. $8 million basis with estate tax. Also leaves $1.7 million subject to capital gains in the future.

Planning Tip: Estate taxes are payable currently. Capital gains taxes are only payable when the assets are sold. If they are not sold and the beneficiary dies with the assets in his estate, they would receive a full step-up in basis at his death (assuming current law).

Generation-Skipping Transfer Tax Planning
With the extension of EGTRRA, concerns for the GSTT in 2010 have been resolved. The GSTT exemption for 2010 was $5 million and the tax rate for 2010 only was 0%. While the sunset provision of EGTRRA still exists, the $5 million GSTT exemption and 35% tax rate will allow for some interesting planning opportunities over the next two years.

The goal of GSTT planning is to transfer wealth to generations beyond one’s children tax free. The 2010 Tax Act opens a window of opportunity that makes this easier. When the GST exemption was $1 million, it was a very limited resource; sometimes it could be difficult to decide how to best use and leverage it over multi-generational gifting trusts, ILITs and IDGTs. With the larger GST exemption, choices are less limited and easier to implement. The $5 million exemption makes it easy to create much larger dynasty trusts that will be exempt from estate taxes and provide asset protection for as long as the applicable Rule against Perpetuities will allow.

Planning Tip: Design multi-generational trusts so that gifts to the trust are completed gifts to avoid inclusion in the grantor’s estate. Avoid estate tax in the beneficiaries’ estates by making sure that no beneficiary has a general power of appointment. Benefit multiple generations by using cascading trusts. Allocate sufficient GSTT exemption to always have an inclusion ratio of zero.

Planning Tip: In the past, even if you could find enough Crummey beneficiaries to cover the annual premium for a multi-generational ILIT for gift tax purposes, allocating GSTT exemption to cover all of the premium payments was often the sticking point. A $5 million GSTT and gift tax exemption until December 31, 2012, makes trust funding for future premiums and single pay policies attractive options.

Planning Tip: Clients must be proactive with these dynasty trusts. Automatic GSTT allocation cannot be trusted because of the sunset provision. File a gift tax return to ensure and document the GSTT exemption allocation.

Portability of Deceased Spouse’s Unused Exclusion Amount (DSUEA)
For those dying in 2011 and 2012, the executor of the estate may transfer any unused estate tax exemption to the surviving spouse. It must be done on a timely filed Form 706 Estate Tax Return. Only the most recent deceased spouse’s unused exemption may be used by the surviving spouse so a remarriage jeopardizes the original DSUEA. The DSUEA can be used to exempt gifts by the surviving spouse. There is no portability of the GST exemption and, unless Congress acts, DSUEA not used by December 31, 2012, will be lost.

Example: Jack and Jill are married and neither has made any taxable gifts. Jack dies in 2011 and leaves his entire $3 million estate to a bypass trust. His executor elects to permit Jill to use Jack’s unused exclusion amount. Jill now has an applicable exclusion amount of $7 million (her $5 million basic exclusion amount plus $2 million DSUEA from her deceased husband, Jack).

Chapter 2: After Jack died, Jill married Jerry. Jerry died in 2012, and left his entire $4 million estate to his children. The $2 million DSUEA Jill previously received from Jack is wiped out by Jerry’s subsequent death. If Jerry’s executor makes the election to permit Jill to use Jerry’s DSUEA, her applicable exclusion amount is $6 million ($1 million less than she had prior to Jerry dying). If Jerry’s executor does not make such an election Jill’s applicable exclusion amount is just her own $5 million ($2 million less than she had prior to Jerry dying).

Alternate ending: Same scenario, but Jill dies in 2012 instead of Jerry. Jill left her entire $3 million estate to a bypass trust; therefore her DSUEA is $4 million (Jill’s $7 million applicable exclusion amount minus the $3 million left to the bypass trust). If Jill’s executor makes the election, Jerry can use Jill’s unused exclusion amount, so his applicable exclusion amount will be $9 million (Jerry’s basic exclusion amount of $5 million plus Jill’s $4 million DSUEA).

Concerns: Open questions under the 2010 Tax Act are, what exemption is applied to gifts by one holding a DSUEA, and how? Is the DSUEA used first or one’s own exemption? If there is an election, how will it be made?

Planning Tip: With the new portability option, clients may think they do not need to include a bypass trust in their planning.  However there are still many benefits and reasons to use a bypass trust, including:

  • Asset protection;

  • Certainty and control for the first spouse to die over how his/her share of the assets will be managed and distributed;

  • Protection of the assets in event of a remarriage;

  • Maximize and preserve GST exemption (portability only applies to gift/estate tax exemption);

  • Increase in value post death;

  • State estate taxes (portability is a federal provision and is not applicable to state laws);

  • Income shifting down to other beneficiaries who might be in a lower tax bracket;

  • A DSUEA is not indexed for inflation; and

  • Portability may end and any unused DSUEA lost on December 31, 2012.

Bottom line: bypass trust planning is proven, advantageous and reliable. DSUEA reliance is none of those plus compels filing an estate tax return even for non-taxable estates. 

Charitable Donations from IRAs
Previously, those who wanted to make a contribution from their IRA to charity would have a check issued to them, make the donation to the charity, then pay income tax on the distribution and take the charitable deduction. For 2011, those over age 70 1/2 may make tax-free distributions up to $100,000 ($200,000 if married) directly from their IRA accounts to charity and counted against their Required Minimum Distribution (RMD) for 2011. (No tax paid, no deduction.) Donations made in January 2011 may also be counted as having been made in 2010 and applied to any unmet 2010 RMD obligation.

Dealing with the Uncertainty
Over the next two years, we can expect that the estate tax will remain a political football; the House Democrats have already complained that the estate tax exemption is too generous, President Obama suggested increased taxes for the wealthy in his State of the Union Address, and major tax reform hearings are already planned for 2011 in both the House Ways and Means and the Senate Finance Committees. Possibilities during this time include:

  • Present legislation, with the $5 million exemption and 35% tax rate, will be made permanent.

  • EGTRRA’s 2009 regime, with a $3.5 million exemption and 45% tax rate, will be extended permanently. (This has already been proposed by the House Democrats.)

  • Congress may do nothing, in which case 2013 will bring a $1 million exemption and 55% top tax rate. (This should be incorporated as a possibility in planning.)

  • There could even be “permanent” repeal of the estate, gift, and GST taxes. With the $5 million exemptions and 35% tax rate, little revenue will be coming in from them, making them less painful to eliminate.

Practical planning applications can include:

  • Increased use of trust protectors with amendment power to deal with tax changes coupled with a grantor’s statement of intent (to minimize estate taxes, maximize benefits to spouse, etc.);

  • Decanting provisions, coordinate drafting with state law;

  • Authorizing the trust protector power to grant a beneficiary a general power of appointment (with higher exemption amounts, it may be advantageous to include property in beneficiary’s estate to receive step-up in basis);

  • Including formula testamentary general powers of appointment;

  • In decoupled states, funding the marital share with sufficient property to reduce both federal estate tax and state death taxes to lower amount (can divide marital share into two QTIPs);

  • Having a contingency plan built in for possible repeal: all to a QTIP, all to a bypass trust, percentage division into marital and non-marital shares, etc.

With the gift, estate and GSTT exemption so high for the next two years, there is a concern that the public will think there is no need to do any estate planning.  In order to use, preserve, protect and transfer wealth responsibly, in order to provide for yourselves and your children, and to perpetuate their goals, dreams and values for future generations, you have done the right thing by getting to the end of this position paper.  Now be sure to follow through.  This post was created by Frank J. Evans and is presented to you with his permission.  Edited by John R. Dundon.