- No advisers believed estate tax repeal would occur in
2010, but it has. Few if any advisers believe that the $1 million exclusion
and 55% rate scheduled to become law in 2011 will remain, but they may.
Well, maybe... The tremendous uncertainty makes planning difficult, but not
taking any action may prove to be the worst option for many high net worth
- The fullowing discussion is based on questions posed
to panels at several different seminars and meetings at which advisers
endeavor to grapple with the issues.
- Recommending estate planning steps amid such
uncertainty is difficult,
- The ancillary implications of planning can make the
decision and implementation process even more complex.
i. The matrimonial
planning implications of these circumstances and possible planning steps could
have unintended, and potentially significantly adverse matrimonial
investment location (independent of investment allocation) is far more
difficult in light of the uncertainty (e.g., will a particular trust be GST
exempt or not). For example, there is some uncertainty as to
whether a trust that was created during the years 2001 through 2009, to which
GST tax exemption was deemed allocated [IRC Section 2632(c)], will the trust
continue to remain exempt from the GST tax after 2010? The issue is that the
manner in which the law is written provides that after 2010 Code Section
2632(c) will be treated as if it "had ever been enacted."
- Continued economic uncertainly clouds the
- Should your clients revise their wills to Address
- Most clients never update their wills frequently
enough in any event, so updates are generally long overdue.
- So let's say clients do update their will, should it
have separate provisions for 2010 and 2011? Absulutely.
- Estate tax repeal is real for 2010 and documents need
to address the basis step up and other issues.
- Practitioners should consider documenting what
clients have been advised. Whatever decisions a client makes regarding 2010
planning (to do or not to do). Confirm and document that advice to plan was
given. Some practitioners have actually requested that clients sign a
document confirming they made the call as to what was done in 2010. But
what are the potential adverse implications to client relationships by
asking for this? It is questionable whether this level of confirmation is
really necessary. Most practitioners find that clients simply won't even
come in for a meeting!
- Should your clients revise their wills to
Address State Tax Legislation (or Lack
- Many states have enacted laws to fill the gap in the
formula clauses that don't work because of repeal. Example, your state law
may say to use the 2009 exemption amount to determine how much should go
into a bypass trust. But for many, perhaps most, clients that is just a
rough fix that isn't what they intended. So for most, even that decision
should be revisited.
- New York assembly bill A09857 is typical of the
approach taken by a number of states. Many practitioners and clients may
rely on these types of "fixes" to resulve the interpretation of formula
clauses under wills, but these are a rough stop gap at best, the
legislation in many cases is preferable to no legislation, but it may be
substantially different than the client's true objectives. Reviewing and
perhaps revising the will is the only appropriate course of action. It is
dangerously incorrect to assume that a client would want the $3.5 million
figure to apply as this type of legislation if the client executed his or
her will when the exclusion was $1 million, for example. Further, in light
of the substantial economic upheaval over the past few years, any
assumption as to how assets should be divided without a reconsideration of
the client's actual balance sheet, title to assets, etc. is at best only
i. "The bill amends
the Estates, Powers and Trusts Law to provide that a formula in a will, trust
or beneficiary form executed or created prior to January 1, 2010 providing, in
sum and substance, for a bequest of the maximum amount of property that can be
sheltered from Federal estate tax by reason of credits against such tax, shall
be construed under the Internal Revenue Code of 1986 as in effect for decedents
dying on December 31, 2009, in the case of a decedent who is survived by a
spouse, and who dies at a time when the Federal estate tax is repealed. The
federal estate tax is not deemed repealed if it is legally reinstated
retroactively to the time of the decedent's death Similarly, if a will, trust
or beneficiary designation executed or created prior to January 1, 2010
contains a bequest which is in sum and substance equal to the decedent's unused
exemption from the federal generation skipping transfer tax, then such bequest
shall be construed under the Internal Revenue Code of 1986 in effect on
December 31, 2009, in the case of a decedent who dies when the federal
generation skipping transfer tax is not_ in effect. Again, the federal
generation skipping transfer tax is considered to be in effect if legally
reinstated retroactively to the date of decedent's death."
i. Maryland Senate Bill 337;
Legislative Bill 1047, Approved by the Governor April 12, 2010.
- Will the Service respect the impact of retroactive
state legislation governing the interpretation of will formula clauses for
the purposes of the application of the federal tax laws? While it would
appear that the Service should, especially in light of the fact that the
interpretation of will provisions is a matter of state law, and the Service
is certainly aware of the hardships that the unanticipated estate tax
repeal created, this result is not assured. Hopefully future legislation
will clarify and resulve any uncertainty.
- Should your clients revise their wills to
Address 2011 Anticipated Tax Law?
- The unknowns of 2011 should be dealt with as well.
Everyone learned the lesson of not addressing enough "what if" scenarios in
2010, that same mistake should not be repeated for 2011. The law for 2011
is a $1 million exemption and 55% rate. Many advisors believe that a $3.5
million exclusion and 45% rate might become law. Both scenarios, as well as
the possibility of an exemption that inflation adjusts or changes over
time, should all be addressed.
- There is no standard one-size-fits-all approach that
could feasibly suffice for all plans or documentation. Every plan really
needs to be tailored to the clients specific scenario and objectives. For
many clients, the real issues is whether they will incur the cost, time and
thought required to tailor documents and planning to meet their
- Many attorneys draft for disclaimers to provide
flexibility in light of uncertainty. Too often surviving spouse's never
- Formula clauses in wills and trusts (e.g. fund a
bypass trust with the largest amount that won't create a federal estate
tax) can be modified to address the uncertainty of the estate tax by
incorporating into their design caps and floors. For example: no more than
some maximum or cap of perhaps $3.5 million, and no less than some minimum
or floor amount of say $1 million, will be transferred to a particular
trust. Practitioners can also include qualitative statements of what the
client's intent is so that if a court has to interpret it they can.
- Should Clients Make Large Gifts This Year?
- Taxable gifts (above the $13,000 annual exclusion and
$1 million lifetime exclusion) are only taxed at a bargain rate of 35% in
2010. The rate increases to 55% in 2011. If the If gift tax is paid
pertaining to transfers made within three years of death, the gift tax is
included in the decedent's gross estate. IRC Sec. 2035. This may still
provide leverage depending in how the gift tax credit is calculated. If it
is calculated as if the gift tax were paid at the 55% rate, the payment of
gift tax at the 35% rate will provide in itself a tax benefit. One possible
interpretation is that the estate will receive a credit for gift tax paid
as if the gift had been made in 2011. IRC Sec. 2001(b). If the
client survives for 3 years, the gift tax paid is entirely excluded from
the decedent donor's estate.
- If a client has used up his or her entire gift
exclusion makes a $1 million taxable gift in 2010 a gift tax of $350,000 at
the 2010 35% gift tax rate will be incurred. If that amount is invested at
some assumed rate of return over the client's remaining life expectancy,
compare that net amount to what the client can bequeath if $1.35 million
were instead invested at the same rate of return but then subjected to a
55% marginal estate tax rate at the end of the client's life
- The bargain gift rate could be a substantial economic
benefit to heirs, but there remain many uncertainties that make it
impossible to really determine if based purely on the rate gifts should be
made. What are the pros and cons of making a gift which will require the
out-of-pocket payment of a gift tax? If a client is in their late 80s or
ill, might incurring a gift tax might prove a huge tax savings, effectively
permitting them to pay tax at 35% instead of 55%. But a host of questions
affect the benefits of this planning. What will the marginal estate tax
rate be when the client in fact dies? If the balance of power shifts in
Washington what might be the state of the estate tax? What if the client
does not survives 3 years? If the client dies in less than 3 years their
estate will receive a credit for the gift credit tax that would have been
paid if the gift was made in 2011? That could mean that the tax paid in
2010 would be 35% but the estate would get a 55% credit. This issue will
have to be addressed by future legislation.
- Before committing confirm whether there is a state
gift tax. For clients willing to incur a tax today to save
estate tax tomorrow, compare the possible gift tax scenarios to the client
electing to convert their regular IRA to a Roth IRA and paying the income
tax to remove those dullars from their estate. The dullars paid in income
tax will be removed from the estate regardless of when the client
- Could the guise of estate tax planning be used to
deplete the matrimonial estate prior to a divorce action being started?
Spouses considering this type of planning should assure that they have
adequate resources after the gifts being made and if there is any
uncertainty re-evaluate the planning if the gifts are substantially larger
than the traditional annual gifts they had been comfortable with in the
past. One of the issues that might arise is whether the non-donor spouse
consented to the gifts. If gift tax returns are filed by both spouses, or
joint gift letters are used confirming the intent to make a gift, it may be
difficult to later deny that the impact of the gift was not
- Should gifts be made to Grandchildren or Grandchildren
- If your client is planning a gift, should the gift be
a generation-skipping ("GST") to grandchildren or a trust for
grandchildren? Gifts to grandchildren (or other "skip persons") that won't
be subject to a GST tax since none exists in 2010. The issues with making
gifts to generation-skipping trusts for grandchildren this year is much
more uncertain. The GST tax is scheduled to be law in 2011. So what will be
the transfer tax consequences when distributions are eventually made to the
grandchildren in 2011 and later years? Most experts worry these will be
subject to GST tax.
- If your client establishes and funds a trust in 2010
how will later distributions from the trust to grandchildren (skip persons)
after 2010 be treated for GST tax purposes? Will the deemed allocation
rules of section 2632(c) apply to transfers made in 2010 even though there
is no GST tax exemption to allocate in 2010? These rules in pre-2010 years
automatically allocated a client's GST exemption to exempt transfers to
trusts that were characterized as "GST trusts." But how can
that occur in 2010 when there is no GST tax?
- So what's a planner to do? If gifts are going to be
made to a GST exempt trust, perhaps the trust should include sub-trusts,
one GST exempt and one not. A formula clause would allocate the amount that
is not GST exempt (if that is what the law ultimately is clarified to
provide) to a non-GST exempt sub-trust and what is GST exempt to a GST
exempt sub-trust. The trust and the allocation clauses should make clear
what the client's intent is.
- Whatever is done concerning GST allocation in January
2011 all 2010 potential GST transfers should be evaluated to determine if a
late allocation of GST exemption should be made.
i. That would
entail allocating GST to the transfer in January based on the valuation of the
assets in January.
ii. If the
allocation of GST exemption to a transfer is required to be made on a gift tax
return and the gift tax return is not timely filed, the value of the property
for purposes of a late allocation of the GST tax exemption is the value on the
date the gift tax return is actually filed. IRC Sec. 2642(b)(3).
iii. Even this may
not be simple. If the asset was valued in 2010 when discounts were permitted,
and if the law applicable to 2011 eliminates discounts or restricts them
effective January 1, 2011 how will that affect the valuation and amount of GST
exemption necessary to allocate?
- There are a number of implications to consider. The
incentive for large out right transfers to grandchildren is substantial,
but issues abound. Will the outright transfers be so large as to be
damaging on a personal level to the donees? Is the consummation of large
gifts outside of the protective structure of trusts so against the donor's
personal planning objectives as to outweigh any potential tax benefit?
- Matrimonial counsel should endeavor to confirm that
the gifts are intended by the non-donor spouse, or in other circumstances
protect the non-donor spouse from these large gifts being pursued in
advance of a divorce filing. If a large gift is made and the intent is that
both spouses allocate GST exemption in 2011 when the GST again becomes law,
consideration should be given to executing an agreement to do so to avoid
the need for exemption allocation being used as leverage in a divorce
- Taxpayers cannot use an UGMA instead of an outright
gift or distribution because the GST regulations treat UGMA as a "trust
- Should trustees make Distributions to Grandchildren from Trusts
- If your client has a trust should or must the trustee
make distributions to grandchildren in 2010 when no GST applies? The
potential tax benefit is that the trust might be able to make a
distribution to a grandchild (or other skip person) without any GST tax.
That could be a substantial benefit but there are a host of hurdles to
consider. When might this occur?
- Example: A bypass trust was formed when
your client's spouse died, that names your client as the surviving spouse,
children, and future descendants as beneficiaries. However, no GST
exemption was allocated. If distributions are made to grandchildren they
could avoid the GST tax (taxable distribution).
- Example: Your client and his/her spouse
established a trust for their children and transferred substantial assets
to it over the years and the value of those assets has grown. The trust,
while primarily to benefit children, named grandchildren and later
descendants as beneficiaries as well. However, no GST
exemption was allocated to the trust because it was anticipated that other
than distributions for medical or tuition expenses which qualify for the
GST annual exclusion no distributions would be made to grandchildren. In
2010 because of the anomaly of the one year repeal of the GST tax it might
be feasible to make distributions of the entire trust to the grandchildren
and avoid any further GST tax. In 2010 distributions to grandchildren trust
beneficiaries could avoid the GST tax (taxable distribution).
- But for these types of distributions to occur a host
of requirements must be met:
i. The governing
trust document has to permit the distributions.
ii. The trust
should not have had GST allocation previously made. If the entire trust remains
GST exempt as a result of pre-2010 exemption allocations there is no GST tax
benefit to the distribution.
iii. The trustee
has to have the authority to make the distribution under the trust instrument.
If the instrument is not clear it is uncertain whether a court could reform the
instrument to accomplish this. Some trusts instruments give broad discretion to
trust protectors or distribution committees that may provide sufficient
flexibility to reinterpret provisions.
iv. There cannot be
an objection by non-grandchildren beneficiaries with respect to the proposed
distributions. Any significant distributions to obtain a one-time
GST tax benefit could have significant negative economic affect on other trust
beneficiaries. Are they agreeable to the distributions? Should they consent in
a written agreement to the distribution and have independent counsel?
v. If the trustee
makes a distribution to achieve a possible tax benefit (the future still
remains uncertain as to what the law will be), that may be a viulation of the
fiduciary's duty to be impartial, etc. What if the future legislation makes the
distribution taxable or eliminates the benefit of the distribution?
- Should client's establish GRATs now ?
- There are numerous proposed bills to restrict GRATs.
For example, the House of Representatives passed the Small Business and
Infrastructure Jobs Tax Act of 2010 on March 24 (H.R. 4849) that, if
enacted, will make three changes to the GRAT technique. While these are
less severe than a repeal of GRATs, they really can take a lot of the
planning benefits out of the GRAT technique. The new GRAT
restrictions will be effective for gifts and transfers made after the date
of enactment. So if your clients could benefit from a short term GRATs,
they should act while it is still feasible.
- Clients need to be aware that even if they begin the
process the law may prevent its implementation. But is it worth that risk?
Probably. GRATs seem almost assuredly pegged for restriction or
elimination. Interest rates are at historic lows. Most expect the estate
tax to be law again next year.
- Some of the issues to consider in planning last
i. With interest
rates still at historic lows should the GRAT be for a longer than the typical
two year term to lock in the low hurdle rate?
ii. If it is
believed that GRAT restrictions or elimination is likely should the GRAT term
be longer since the rulling GRAT technique will unlikely be viable?
- Should clients establish CLAT now?
- Charitable lead annuity trusts are a great toul to
benefit charities, all of which are in considerable financial need in the
current environment. Interest rates are at historic lows so that this type
of planning, like GRATs is opportune.
- In 2010 there is currently no incentive to create
testamentary CLT so long as estate tax repeal remains in force, since no
estate tax savings is feasible. Should wills be revised to provide for
testamentary GRATs if and only if the estate tax is law?
- For 2011, if the estate tax rules anticipated become
law, use of CLTs in planning will again be opportune. What if you want to
benefit charity and also prevent the IRS from questioning the value of
closely held business interests included in the estate? Using CLT reduces
incentive if audit adjustment won't increase tax revenue but rather
increase the amount going to charity using a defined value clause. If the
discounts on non-contrulling interests are restricted or eliminated the
impact of this on the percentage and dullar values of business and other
assets passing to heirs should be considered.
- Should Clients Establish CRTs Now?
- CRTs are effective when income tax rates are high and
clients have substantial capital appreciation in assets. Fullowing the run
up in the markets from the lows of a year or two ago, capital appreciation
exists. If the estate tax becomes law again in 2011 with a $1 million
exclusion and high 55% rate, combining a CRT with an insurance trust (often
referred to as a wealth replacement trust) may provide a valuable planning
- One issue remains with respect to CRT planning. While
perhaps unintended, the effect must be considered. IRC Sec. 2511(c) creates
some uncertainty. Notice 2010-19, 2010-7 I.R.B. 404, provided some guidance
but indicated that a transfer in 2010 to a trust that is not a whully
grantor trust will be considered a transfer by gift "of the entire interest
in the property." Given this statement, it is unclear how section 2511(c)
will be applied to a transfer to an inter vivos CRT.
- 2010 Tax Filings for
- A tax filing for the estate of a 2010 decedent will
be required in order to allocate basis under the carry over basis/estate
tax repeal regime. The tax form to complete this filing has not yet been
issued by the Service so that the estate will have to await further
guidance to proceed. Waiting for guidance, however, should not delay the
tedious steps that at this point may be inevitable to complete the return
when it is issued. The information report the personal
representative will likely have to file will probably be comprehensive and
as complex as the current estate tax return. To address the implementation
of the carryover basis requirements, IRC Sec. 6018 requires a report be
filed for any estate with $1.3 million of assets other than cash. This is
more onerous than the law as it existed in 2009. The filing will be
required to be completed by the income tax due date of decedent April 15,
- In determining whether a filing is required the
issues as to how to define "cash" must be addressed. Is a money market
mutual fund that could decline below $1/share cash?
- This required report is very detailed and will
require the executor to describe all assets, hulding period, basis, fair
market value ("FMV") of assets, etc. This is all the information that had
heretofore been reported on an estate tax return.
- One of the most burdensome projects for some 2010
estates will be to identify the historical cost basis of securities and
other assets that may have been held for decades or longer.
- The personal representative will have to advise
the IRS of:
i.The name and tax identification number (e.g.,
Social Security number for an individual) of each beneficiary
ii.An accurate description of the property
invulved. For publicly traded stock this will be quite simple.
Likely, more complex requirements and details will be required of a closely
held business or other harder to value assets.
iii.The adjusted income tax basis of the property
to the decedent. This requirement was not relevant under prior law when most
assets (except IRD, etc., an IRA account as an example) received a step up in
tax basis to the fair value at death (or at the alternate valuation date six
months fullowing death).
iv.The fair market value of each asset to the
decedent. This is similar to the current law. Although the new law post 2009 is
based on a carry over basis concept, the existence of the "modified" carry over
basis approach actually adapted (i.e., which permits you to adjust basis for
the $1.3 million general and the $3 million spousal amounts) requires both tax
basis and fair market value data. When this is compounded by the issue of how
to allocate these adjustments, the complexity is truly remarkable.
v.The decedent's hulding period for the
property. As explained above, the time the decedent held the property, which is
necessary for determining the capital gains consequences on the sale of
property, carries from the decedent to the heirs.
vi.Any information necessary to determine if any
of the gain an heir would realize on the sale of the property would be taxed as
ordinary income (i.e., at the maximum individual income tax rates) rather than
as capital gain income (potentially taxed at the lower capital gains tax rates)
must be provided. This could include information as to dealer
status. For example, if the decedent purchased land, subdivided, and suld many
lots as inventory, any remaining lots could generate ordinary income and not
capital gains to the heirs. Similarly, depreciation deductions claimed on a
property could cause the recharacterization of some portion of the gain as
ordinary income instead of more favorable capital gains.
vii.If carry over basis remains law, which is
unlikely, but hey, who knows, the IRS will define the phrase "sufficient
information" which your executor will have to provide, in a broad, complex and
difficult to comply with manner. But when they do, forgive them, for it was
Congress that came up with this mess. The IRS will only be trying to implement
viii.Any other information that the IRS may require
in regulations. Hey, if they are requiring all "sufficient" information in the
preceding paragraph, what else might they want?
- Once the personal representative makes the
determinations above, he or she will then have to report to the estate's
heirs the information necessary for them to determine their tax basis,
hulding period,, etc. in the property. Specifically, the new law will
require that for decedent's dying after 2009 the fullowing information will
have to be provided to heirs:
i.Name, address, telephone number of the person
filing the return. This will generally, but not always, be your
ii.All of the information required to be
furnished to the IRS, as explained in the preceding section, for the assets
bequeathed to the particular heir.
- Section 6018 requires an executor to file a return
with respect to large transfers at death and transfers of certain gifts
received by the decedent within three years of death. This is generally
appreciated property which the decedent received by gift within three years
of death the transfer of which should have been reported on a gift tax
return. No mystery here as to the purpose, identify potentially large
transfers of appreciated assets pre-death so that they can benefit from the
limited basis step up under the carryover basis regime. The requirement is
new and guidance in the form of the return to be filed and instructions to
the return would be helpful.
- State estate tax and inheritance tax returns might
warrant extending if feasible while all the issues are sorted out.
Similarly, the estate's income tax return, Form 1041 should probably be
extended while issues are sorted out.
- How can the basis allocation be
- What guidance is there to make the decisions? For
many estates the $1.3 million adjustment (basis increase) will more than
exceed the appreciation in the estate. But if it doesn't the complexity and
issues could be monumental.
- If different beneficiaries will be affected
differently some fiduciaries may find sufficient comfort in an agreement of
the beneficiaries acknowledging the allocations decided upon. However, if
the beneficiaries are not represented by independent counsel what benefit
will such an agreement really provide to the fiduciary? Will a court
approval of the settlement be advisable?
- Until the basis allocation issues are resulved what
steps can the personal representative take? Should assets be suld or held
until this is resulved? If an asset is suld prior to the filing of the new
required estate carry over basis filing requirement how will basis
allocation to the suld asset be determined? The fact that the modified
carryover basis regime is instituted for only one year creates considerable
confusion. What are the income tax consequence of a sale of
the decedent's assets in 2011 or thereafter? Will the basis step
up/allocation be recognized if the carry over basis regime is repealed from
- What factors should the personal representative
consider in endeavoring to address the allocation of the $1.3 million
dullar basis adjustment?
i. Possible future
ordinary income tax rates.
ii. What will the
capital gains tax rates be?
iii. General tax
incentives that could minimize or defer the income tax consequences on selling
intent that a particular asset be held for a short or long time period.
v. Any wishes as
testator may have expressed to such Executor.
vi. What is the
expected hulding period for the property? If property, such as a family
cottage, is intended to remain for generations in the family it is less in need
of an allocation to increase basis than are other assets which are more likely
to be suld.
vii. Are other
avenues to avoid, defer or minimize the potential future capital gains tax
available and how does their availability compare to other assets in the estate
if the maximum basis adjustment has to be rationed to the various assets?
viii. If the estate
hulds raw land that is likely to be donated to the local church for an
expansion project the basis adjustment is less important as compared to other
assets if a charitable remainder trust could be used.
ix. If the estate
owns a shopping center and rather than sell it a tax deferred Code Section 1031
exchange is a likely possibility, then the allocation of basis to the shopping
center may be less advantageous than an allocation to other assets.
x. If highly
appreciated securities could be contributed to an exchange fund to diversify
without incurring capital gains then these assets would be less in need of an
xi. If the
decedent's principal residence can be suld and exclude gain under the home sale
exclusion rules then to the extent that that exclusion will avoid taxable gain,
basis adjustment should not favor the residence.
xii. What will the
tax bracket and status of the beneficiaries receiving the property be?
- What are the State Tax Consequences of a 2010
- State estate and income tax issues can create
- Many states continue to impose a state level estate
tax even during the 2010 repeal. Is there a disconnect for those dying in
2010 in a state with a state estate tax between the federal basis
adjustment and a state basis adjustment? If there is no federal income tax
basis adjustment for a particular asset, will the state that assesses an
estate tax in 2010 permit a special state level basis adjustment to avoid
both a state estate tax and later capital gains tax on the unadjusted basis
of those assets? It would appear that this will at most affect a very
limited number of decedents who die in 2010 in states with estate taxes and
who have appreciation in the estates greater than the $1.3 million/$3
million spousal basis adjustments.
- However, if the state law references federal law
prior to the 2010 basis adjustment than the estates and heirs of all
decedents dying in those states in 2010 will face a potential for double
taxation (state estate tax and future state capital gains tax on the
unadjusted carryover basis in those assets).
- This potential unfairness could be addressed if the
state legislation that has been enacted that provides that 2009 federal law
applies to interpret formula clauses also applied 2009 law for basis
purposes if a state estate tax has been paid.
- New York has considered such legislation, but it is
not clear what the outcome will be or whether other states will fullow
- If a client died in 2010 How Do You Plans To
Raising Cash Requirements by The Estate?
- Loans can be used to appease beneficiaries in need of
distributions while these issues are sorted out. Other steps should be
taken to better diversify the portfulio pending resulution. For example,
loss positions can be suld out since they won't be affected by the
allocation and the cash proceeds reinvested in a manner that better
balances the estate's investment portfulio.
- For situations which will require on going advances a
type of revulving loan agreement might be useful.
- What about Code Section 303 Treatment? What has
Happened to this Planning Toul?
- IRC Sec. 303 provides that when stock in a closely
held corporation comprises a significant component of the decedent's
estate's IRC Sec. 303 can provide a valuable toul to address liquidity
issues. The mechanism is for the corporation to redeem shares of stock from
the deceased sharehulder's estate. This can be done without requiring a
forced sale of the business, without triggering ordinary income tax
treatment that would accompany a dividend to the deceased sharehulder's
estate, and it can be used to infuse cash for the estate to pay the estate
taxes and other expenses. This technique has not received significant
attention as a result of the shift to limited liability companies as the
most common form of entity structure for closely held businesses.
Nevertheless, there are millions of closely held businesses that remain
organized in corporate sulution and with pending tax changes there has for
the first time in many years actually been talk of reconsidering the use of
C corporations as the tax environment evulves. Also, under current and
prior law dividends have been taxed at such a low rate this approach has
not been of significant benefit. That too may change.
- The essence of the IRC Sec. 303 technique is that the
payments made to redeem a portion or all of the deceased sharehulder's
stock is characterized as payments for stock taxed at what historically had
been more favorable rates, rather than as dividends which historically had
been taxed at higher ordinary income tax rates. Also, as a payment for
stock the gain recognition is reduced by the tax basis in the stock, a
benefit obviously not available if a distribution were taxed as a dividend.
Here too the complexities of estate tax repeal in 2010 weak havoc to
traditional planning concepts. Under pre-2010 law assets received a step-up
in tax basis on death. IRC Sec. 1014(a). On death the tax basis of the
decedent's stock interest would be stepped up to the fair market value as
of the date of death (or the alternate valuation date). The result would be
that the only capital gains income likely triggered by application of an
IRC Section 303 redemption would be post-death appreciation.
- However, under the carry over basis regime in 2010
whether or not there is a step up in tax basis, and if there is to what
extent that step up will eliminate only some or all of the pre-death
appreciation will depend on whether and how much of the $1.3 million
general, or $3 million spousal basis adjustments the executor allocates to
the business interests invulved. IRC Sec. 1022. So it is possible that in
2010 a redemption could trigger as much gain under IRC Sec. 303 as a
dividend! The entire intent of the statute is undermined.
- In some instances a IRC Sec. 303 redemption can
provide a valuable one time opportunity to remove cash from a closely held
business in a tax advantaged manner, even if the cash provided is not
essential to meet estate expenses.
- Will Section 303 redemption proceeds be subject to
the increased Medicare taxes? If you earn a salary from an active business
the Medicare tax will apply without limit. If you receive a dividend from a
passive business the Medicare tax (once the threshuld is passed) will apply
without limit. But what about the new Medicate taxes? Starting in 2013 an
additional .9% Medicare tax will be imposed on wages and self-employment
income over $200,000 for singles and $250,000 for married couples. IRC Sec.
3101(b)(2). That makes the marginal tax rate 2.35% for employees.
Self-employed persons will face a 3.8% rate on earnings over the above
amounts. Also starting in 2013 a 3.8% Medicare tax will apply to net
investment income if your adjusted gross income (AGI) is over the $200,000
(single) or $250,000 (joint) threshuld amounts. IRC Sec. 1411.
More specifically, the greater of net investment income or the excess of
your modified adjusted gross income (MAGI) over the threshuld, will be
subject to this new tax. Will Sec. 303 redemption proceeds avoid these
- Why was this special Sec. 303 rule historically
necessary? Absent the IRC Sec. 303 redemption provision the only means an
estate would have to minimize the income tax consequence of a redemption
would be would be the Code Section 302 provisions which are far less
- Whatever approach is used, if an estate tax exists
and has been deferred, consideration should be given to the impact of any
distribution or redemption on an election under IRC Sec. 6166 to defer
estate tax if one had been made. Generally, a redemption under IRC Sec. 303
should not accelerate payments under IRC Sec. 6166 estate tax deferral. IRC
- The potentially favorable rules for a redemption
under IRC Sec. 303 to any class of stock: common, preferred, voting, or
non-voting. Treas. Reg. 1.303-2(c)(1).
- What requirements must be met for the IRC Sec. 303
redemption rules to apply:
i. The stock
invulved must be included in the decedent's gross estate for federal estate tax
purposes. IRC Sec. 303(a). In 2010 with estate tax repealed, is this
requirement possible to meet? If this hurdle is surmounted, which presumably it
will be in 2011 if and when the estate tax is again law, there is some
flexibility in the ownership of the stock. If the actual stock to qualify for
the IRC Sec. 303 redemption is changes as a result of a post-death
reorganization or similar transaction the successor stock may still qualify.
Treas. Reg. 1.303-2(d). For example, the stock may be recapitalized to preserve
relative voting contrul of different sharehulders and post-recapitalization
non-voting stock may be redeemed. If the stock is distributed to heirs it may
still qualify. However, if the stock is suld to an heir, or received by the
heir in satisfaction of a pecuniary bequest, it will not qualify for IRC Sec.
303 treatment. Treas. Reg. 1.303-2(f); Rev. Rul. 87-132.
ii. The value of
the stock, of any class in the corporation, included in the decedent's estate
must generally exceed 35% of the excess of decedent's gross estate reduced by
deductions and expenses under IRC Sec. 2053 and 2054. IRC Sec. 303(b)(2)(A).
Stock in different corporations can be aggregated for purposes of this test if
the decedent owned at least 20% of each corporation. Stock transferred within
three years of death can be counted in certain instances for purposes of
meeting the 35% test.
iii. The corporate
distribution in redemption of the stock which qualifies for this treatment is
limited to the sum of the amount of taxes the estate pays and funeral and
- How Has Repeal Affected Code Section 754 Basis
Adjustments and What Might 2011 Bring?
- Under Carryover Basis. Partnership agreements and
limited liability company operating agreements frequently include
provisions governing a basis adjustment under partnership tax law section
754 of the Internal Revenue Code. If the estate tax is in fact repealed and
a carry over basis in place the implementation of a Code Section 754
election may change. The basis of an LLC or partnership interest may not be
the same as under prior law.
- The executor making the allocation of the basis
adjustment under the new carry over basis regime, in contrast to prior law,
might be held liable for allocating basis adjustment to a partnership or
LLC if the general partner, manager, or members have to approve the
adjustment. In the past, since the step up in basis was automatic, there
was no issue for the executor other than pursuing the adjustment, However,
under the new paradigm, since the basis adjustment is limited, if an
executor allocates the limited $1.3 or $3 million basis adjustment to a
partnership interest and the 754 election is not automatic, the executor
might be sued by the beneficiaries for wasting the limited benefit of the
basis adjustment. On the other hand, if the partnership or LLC interest is
highly appreciated, and the executor does not allocate basis adjustment to
this interest, the executor could be held liable for not maximizing the tax
- General Rules. The basis of partnership property may
be adjusted as the result of a transfer of an interest in the partnership
by sale or exchange or on the death of a partner if the election provided
by IRC §754 is in effect with respect to such partnership.
This result is the same for basis of property held in an LLC,
provided the LLC is taxed as a partnership. This provision is not effective
for S corporation assets.
- If the election is in effect, the new owner of the
partnership or LLC interests may obtain depreciation deductions based on
the stepped up basis. IRC §754. A sharehulder in an S corporation is
limited to his/her pro-rata share of the S corporation's depreciation
- The partnership agreement and the LLC operating
agreements must be reviewed in order to determine whether the agreements
address the 754 election.
- The election to adjust the LLC's or partnership's tax
basis is made by filing a written statement with the LLC's or partnership's
tax return, Form 1065, for the year in which the transfer occurs, e.g., for
the tax year in which a member or partner, dies.
- A valid IRC Sec. 754 election must:
i. Be included in a
return filed on time, including extensions.
ii. Include a
statement with the fullowing data:
iii. The name and
address of the LLC or partnership
iv. The signature
of one of the Members or Partners. It should, however, be signed in a manner
permitted under the Operating Agreement for the LLC, e.g. by the manager or the
v. State that the
LLC, as a partnership for federal income tax purposes, or the partnership makes
an election to adjust tax basis under Code Section 743(b). Treas. Reg.
- The adjustment, in the case of a distribution of
property by the partnership will be made under IRC §734.
- The adjustment, in the case of a transfer of
partnership interests, will be made under IRC §743.
- The adjusted basis of the partnership property will
be increased by the excess of the basis to the transferee partner of his
interest in the partnership over his proportionate share of the adjusted
basis of the partnership property. The adjusted basis of the partnership
property will be decreased by the excess of the transferee partner's
proportionate share of the adjusted basis of the partnership property over
the basis of the interest in the partnership.