2012 Gift and Other Estate Planning
By: Martin M. Shenkman, CPA, MBA, AEP, PFS, JD
2012 gift planning is the topic of the moment for estate planners, tax practitioners and their clients. But the sound bites the media has disseminated (current 2012 $5.12 million exemption; 35% rates could become $1 million; and, a 55% rate in 2013) masks a myriad of essential details, complexities and planning nuances that both practitioners and clients need to consider on a rather urgent basis. The following article addresses many of these issues and endeavors to do so in a broad and comprehensive manner to frame the issues, rather than in a detailed analysis of any particular issue. While this article was originally written for advisors to assist them in guiding their clients, we are forwarding it to taxpayers who may wish to consider the many issues that surround gift and other estate planning in 2012.
1. Types of Clients Who May Benefit from 2012 Gift Planning.
2. Impediments to 2012 Planning.
- Introduction. Many people assume, even some practitioners, that unless you are dealing with ultra-ultra-ultra-wealthy or high-net-worth (however one defines that) clients, this stuff doesn't apply. It's not true. It's more than just the ultra-wealthy that need to jump on this planning opportunity. There are a number of types of clients that should consider 2012 planning.
- Elderly or Terminally Ill Clients. These clients, if they don't implement planning now, their age or health may not afford the time in the future to plan, regardless of what happens with the potential changes in the estate tax law. If this type of client survives 2012 and dies in 2013, and the exemption is, in fact, allowed to decline to $1 million, the estate tax cost could be substantial.
- Residents of Decoupled States. Any client living in a decoupled state, because you may be able to make a significant impact on state estate tax.
- Clients Worried About Lawsuits. Physicians, and any client concerned about asset protection. Doctors are just the most commonly thought of client when you worry about asset protection planning, but that affects every client.
- Non-Married Same-Sex Couples. About 12% of the couples in our country are non-married couples. This is a lot of clients. Without a marital deduction, for the vast majority, $5.12 million is enough money to shift assets between them however they want. You miss the opportunity, it's gone.
- High Net Worth Clients. And then obviously, wealthy clients should certainly jump on this. But too many people that view themselves as not wealthy really are wealthy because of the $5 million exemption this year, but it's only $1 million next year, how do you define wealthy? Clients really need to think about it. And one of the things that I know we've seen constantly, many clients absolutely do not understand how wealthy they really are. They bought a house for $30 grand that's now worth $500 grand. They invested something in a closely held business that's now worth ten times what they think it's worth. Often, the clients that should be doing this planning simply don't get it. So, to summarize types of clients who may benefit from 2012 planning, it's lots more than just the mega-wealthy.
- Introduction. There are a number of impediments to clients moving forward with 2012 gift planning. Overcoming these impediments is the biggest challenge practitioner’s face. It's not that practitioners can't plan, it is guiding clients over their hurdles to implementing planning. Consider the following issues.
- Complexity. To properly undertake any major 2012 gift planning in a reasonable or correct fashion almost invariably means a trust, not an outright gift. That already creates some degree of complexity. Grantor trust status, perpetual GST allocation, locking in discounts, and so forth, all add additional layers of complexity. Planning late in 2012 further exacerbates the complexity. Simply put, clients cannot move millions of dollars without significant complexity. The oft stated client goal of “simplicity” will almost invariably undermine appropriate 2012 planning.
- Cost. There will be attorney and other professional fees to implement 2012 transfers to trusts. Appraisal fees can be quite costly if entity interests will be involved. There is clearly a significant cost to optimally implementing planning. Many clients undoubtedly reply "I'm not going to spend $20,000++ to do all this planning." But many of these clients are potentially garnering millions of dollars of future transfer tax savings, significant asset protection, and other benefits. Many clients simply respond to disbelief as to what the law changes might mean. Often clients do not understand the potential impact of discounts being eliminated, grantor trusts, GRATs and GST allocations being restricted, and other nuances beyond the much simpler change in exemption amount.
- Uncertainty. Clients are loath to commit to costly and complex planning while they remain very uncertain as to the future of the tax law. Advisors, to best help their clients, must “unlock” the keys to motivate clients to move forward in spite of the uncertainty. No one seems to feel, at this juncture, that the tax system, as it will apply to the wealthy, will ever be more favorable than it is presently.
- Clawback. Clawback is the technical tax calculation specter that, if applicable, could seemingly unravel much of the 2012 planning benefits. However, it seems that, whether or not it really occurs, not planning because of it will prove a costly mistake. The issue is, what happens if a client consummates a large 2012 gift and in 2013 and later years the exemption amount in fact declines to $1 million and the client dies? Will that prior gift be brought back into the client’s estate for purposes of calculating the actual estate tax due? Why do we care? The concept of clawback is that the manner in which the calculation of the estate tax works, according to some practitioners, is that if you make a gift in 2012 of $5 million and the exemption next year in 2013 is $1 million and death occurs, then the $4 million prior taxable gift, in effect, comes back. Your client’s net estate on death in 2013 is whatever assets it includes. You must then add back prior taxable gifts of $4 million, then subtract the reduced $1 million exemption. In effect, your client loses the benefit of what planning was done. Many, perhaps most, other practitioners are adamant that it's absolutely never going to happen, and it's not what was intended. But, the reality is that there is no absolute assurance of what might occur. But, even in the worst case scenario of clawback, should planning stop? No. If your client consummates a large gift in 2012, all the benefits of that gift -- discounts, grantor trust status, perpetual GST allocation, etc. – may be realized, and those benefits may accrue, regardless of clawback. Appreciation will be removed from the client’s estate. So make the gift today, as even in the worst-case scenario, your client appears to still be better off. In spite of this, practitioners might consider, as a routine, including in every memo they give clients on 2012 planning, a brief caution about clawback so that the client (or perhaps more correctly, the client’s heirs) cannot later come back to challenge the practitioner if, in fact, clawback becomes a reality.
- “Income” is Too Low.
i.Many clients are loath to make any significant gift in 2012, regardless of the planning benefits, because they believe they need the “income” from the assets involved in order to pay living expenses. While the optimal planning approach is to have a budget and financial plan prepared to confirm the appropriateness and magnitude of a large 2012 gift, this is often not feasible. As the time remaining to make 2012 gifts becomes more compressed, it will become impossible. In most cases, where it appears that gifting may be appropriate, an educational process is in order. Clients used to living off “income” need to understand the distinction between “income” and “cash flow,” and that the latter is really the correct concept. Further, many clients viewing the “income” from their investments as all they can live on, often do not understand modern portfolio theory and the concepts of a unitrust payment structure from an investment portfolio. Often, explaining these concepts will be a prerequisite to helping the client gain the appropriate comfort level to consummate 2012 transfers that, by all calculations, are advisable.
ii.Although perhaps unconventional for some wealth managers, having a conversation about options for how assets remaining in the client’s name can be invested, whether or not those options are actually pursued, can afford some greater comfort to a client exploring a new financial paradigm in order to undertake 2012 gifts. For example, some clients might find comfort in a portion of their retained portfolio being structured as a laddered bond portfolio, so that not only interest, but annually maturing bonds, will, in the aggregate, provide a cash flow to fund living expenses for many years to come. While an anathema to many financial planners, a discussion of available annuity products for a portion of the retained portfolio may offer some peace of mind to clients previously wedded to CDs and tax exempt municipal bonds as their sole investments. At least exploring including some component of annuities in the portfolio, to assure that certain expenses are covered, might provide comfort. Some annuity products may afford a sufficiently higher “return” to the client than the client’s previous investments, and some modicum of a guarantee to the client’s family members that, if the client dies prematurely, some payment will inure to the family, that some annuity component might be the key to unlocking the client to planning.
Insufficient Wealth: Many clients spend as if their net worth is a multiple of reality. Many clients estate plan as if their net worth is a fraction of reality. These are simple truths of the psychology of many clients. Thus, to motivate some clients to seriously undertake 2012 transfer planning, practitioners may have to help the client really understand the magnitude of the client’s wealth.
3. Common 2012 Planning Mistakes.
- Introduction. There are a host of common mistakes that clients and/or practitioners undertaking 2012 transfer planning may fall prey to. Clients often have dangerous misconceptions about 2012 planning issues, especially if the primary source of their knowledge is what was gleaned on the 4th hole. Practitioners who have not previously been involved in large wealth transfer planning, should be extremely cautious jumping in to the 2012 planning fray without adequate assistance. There is no shame in informing a client that you will assist with the planning, but require a specialist (in whatever field the practitioner works) for the particular 2012 transaction. No doubt, many practitioners dabbling for the first time will get their fingers burned. Another means to address planning complexity that any practitioner may be unfamiliar with, to backstop the practitioner and the process, is to assure that the weaknesses that any particular practitioner has are backed up by strengths of other members of the planning team. Few 2012 plans will be properly implemented without the close coordination of an estate planning attorney, CPA, insurance consultant, wealth manager and often other disciplines as well. If, for example, the estate planner is weak in certain tax areas, but the CPA firm is a large practice with specialists in those disciplines, that may be sufficient to fill any gaps. Lone wolf planning by any one practitioner on the estate and financial planning team will prove particularly dangerous in 2012.
- Outright Gifts are a Mistake. The simple outright gift, like writing a check or transferring interests in a family business, is, in fact, the most common approach that many practitioners and clients are taking for 2012 planning. Big mistake for the client, and potentially a big mistake for the practitioner. If your client gifts $1 million to a child to save future estate tax, does that really accomplish the client’s goal? There's a 50% divorce rate. What did your client just do? Step out of the proverbial frying pan into the fire? The outright gift can be a significant mistake because there is no protection from creditors' claims or divorce for the donee. The gift, if not spent or wasted by an imprudent donee, will be exposed to the next generation’s estate tax. That may be at a future date when GRATs, discounts, grantor trusts and other techniques are no longer available for planning. Consider the example of gifts in nontraditional, same sex families. If a client gifts his or her partner $5 million outright, then when he or she subsequently dies, the partner’s estate will pay an estate tax on that amount. If the deceased donee partner bequeaths the assets back to the surviving donor partner, an estate tax will be due on transferring the wealth back to where it was prior to the 2012 gift. If instead the assets were given in trust, something akin to an inter-vivos credit shelter trust, it can pass to the donor partner, other future heirs or next generations without incurring an estate tax.
- Local Trust. Many practitioners unfamiliar with more sophisticated estate planning will form trusts in their state, the state of the client’s domicile. Many clients seeking to minimize costs, and, in particular, to avoid an annual institutional trustee fee, will demand that their professionals create a plan based on a local trust. But when a trust is established in whatever state in which the client resides, instead of using a state which has more favorable laws, significant disadvantage can occur. While a growing number of states have enacted favorable trust legislation, the four states of: Alaska, Delaware, South Dakota, and Nevada, have really become the premier states for sophisticated trust planning. Other states may not afford the same degree of creditor protection and may have unfavorable state income tax laws (which may be academic while the trust is a grantor trust, but which will not be academic following the future cessation of grantor trust status, such as on the death of the grantor). Additionally, state law may have a more limiting perpetuities clause, less favorable trust laws, and a much less robust selection of institutional trustees, and so forth. If a client establishes a trust for a 2012 gift in a state with an unfavorable rule against perpetuities, and in the future President Obama’s proposal to limit the number of years for which GST allocation may be made is enacted, future generations could lose out in a dramatic way.
- Non-DAPT. As noted above, the core of determining the magnitude of appropriate 2012 transfers is a budget and financial plan. But, in many cases (perhaps most), even with sophisticated Monte Carlo simulations, many clients remain uncomfortable making large transfers out of their reach. This is particularly true for clients at wealth strata for which the gift contemplated is a large percentage of their overall assets. While it should be less true at higher wealth levels, in many cases the client’s worries remain. Thus, in many instances a Domestic Asset Protection Trust (“DAPT”) which permits the client to remain a discretionary beneficiary of an independent trustee, is the preferable approach. PLR 200944002. However, many practitioners are unfamiliar or uncomfortable with this type of planning. When a practitioner gives in to client pressure to avoid institutional trustee fees and forms a trust for 2012, planning in the client’s home state, which does not permit self-settled trusts, the fiscal consequences to the client could be negative. An important psychological, or even actual, safety net could be forfeited. Thus, for many of clients who are not ultra-wealthy, they will not, or should not, give away significant wealth if they cannot be a beneficiary.
- Ignoring Gift Splitting Issues.
i.In their zeal to avoid the reciprocal trust doctrine and/or the step-transaction doctrine (see below), or for the client to minimize trustee fees and other costs, the plan might become a single transfer of $10.24 million to one trust for the benefit of the client’s spouse, children and future descendants. Since the gift is double the donor/client’s exemption, the non-donor spouse will have to elect to gift-split, so that both $5.12 million exemptions can be allocated to avoid tax on the gift.
ii. Gift splitting, however, is not available on a gift to a trust for which the spouse electing gift splitting is a beneficiary. IRC Sec. 2513(a); Rev. Rul. 56-439. The law requires that the gift be to a person other than the spouse for gift splitting to be available. If the spouse is a beneficiary of the trust, even a discretionary beneficiary in the discretion of an independent trustee, the IRS position may be that the gift is not to someone other than the spouse.
iii. If neither spouse is to be included as a beneficiary of such a trust, while gift splitting will then be available, practitioners should take additional precautions to assure that the clients understand the economic consequences of the transfer. If there is a divorce, business set back, significant negative health problem, will the retained resources really be adequate?
Ignoring the Step Transaction Doctrine.
i.The Step Transaction Doctrine, which is another issue that has always been on the tax practitioner’s planning radar screen, has potentially unusual significance to 2012 planning, especially as 2012 winds towards conclusion. Greater vigilance than usual is in order. There are many potential applications of this doctrine to 2012 planning, several of which are illustrated below.
ii.One potential step transaction risk to 2012 planning can be illustrated as follows. Assume that the husband had all the family assets in his name (or at least the assets that the family considers appropriate to gift as part of their 2012 planning efforts). Husband gifts $5.12 million (or whatever number under that amount) to Wife. Wife then establishes an irrevocable trust and transfers by gift those same assets into that trust. Absent the gift from Husband to Wife, Wife would not have adequate assets to use her exemption. Gift splitting is not an option if a spouse will be a beneficiary of the trust. As the time between Husband’s gift to Wife, and Wife’s transfer to her trust, is compressed, the risk of the IRS asserting the step transaction doctrine grows. As the time remaining before the end of the 2012 year wanes, these risks grow as it becomes more limiting how much time can be inserted between the different legs of the various transfers. While time is certainly not the only factor, the ability to insert economic change or risk into each phase of the transaction necessarily becomes more limited.
iii.When one spouse shifts assets to the other spouse and then gifts them into a trust, the IRS position might be that Wife in the above example did not really fund that trust. Rather, Husband put $5 million into his own trust, and thereafter Husband put $5 million into Wife's trust, using the wife as a mere conduit in the transfer. So if, for example, Husband had a $10 million brokerage account and transferred $5 million into Wife's name, and the next day Wife transfers those same securities to her trust, what have the clients really achieved? Obviously, some time should be allowed to pass between transfers. Certainly, at a minimum, endeavor to retain the securities in the Wife’s account for a month or more, at least a sufficient amount of time so that the securities are reflected on her brokerage statement. Perhaps, look to cases like Holman to ascertain the minimum period of time that assets must be retained in the Wife’s name prior to transfer for there to have been meaningful economic risk. While the context of Holman is different, the concepts might be applied to the reciprocal trust doctrine analysis.
iv. A better approach would be to, in addition to whatever time period occurs, actually create meaningful economic change to the assets. For example, if your client can actually have their wealth manager create a new investment policy statement and a new asset allocation model, that might provide some break to the step-transaction. If there is a means to change the fundamental nature of the assets, do something substantive, perhaps create an LLC or FLP to hold all of the Wife’s assets (those being transferred to her trust and a portion of those retained, perhaps even in conjunction with other family members). If real estate is involved, perhaps a new lease or management agreement can be negotiated.
Not Using an Institutional Trustee.
i.Practitioners should consider advising every client to at least consider the use of an institutional trustee. The client may not be able to secure nexus and situs in one of the favorable jurisdictions, like Alaska, without the use of an institutional trustee in that state. Many of the 2012 donee trusts will be complex trusts that a family member or friend of the client will not have the sophistication to manage properly.
ii.Inexperienced family trustees can undermine the best trust planning.
iii.Use of an institutional trustee can also avoid many pitfalls by assuring an independent trustee in the mix of fiduciaries.
Not Using a Directed Trust.
i.If the client will transfer assets that include interests in a family business, or even a family investment FLP or LLC, the institutional trustee (and even many individual trustees) will not be comfortable with the investment risk, and issues as to lack of diversification as may be required under the applicable Prudent Investor Act. The solution to this dilemma is for the practitioner to structure the trust as what is referred to as a “directed trust.” This type of trust, if permitted under applicable state law (potentially another critical reason to have the trust formed in an appropriate state), can designate an “investment adviser” or “investment trustee.” This person can assume responsibility for investment decisions for the trust, e.g. to continue to hold family business interests, while the general or other trustees will have no responsibility for that decision.
ii.If a named family member can serve in such capacity, it is often feasible for the trust to include an institutional administrative trustee who may then charge a relatively modest flat annual fee since they will not have any investment risk associated with the trust’s investment decisions.
Not Considering Impact on Basis.
i.There is much uncertainty in estate planning, but estate planning cannot be viewed in isolation of income tax consequences of the planning. As practitioners are all aware, and even most clients, assets given by gift retain the donor’s tax basis. Instead, if assets are retained in the client’s name and, hence, estate, they should qualify for a step up in income tax basis at death to the then fair market value of the assets.
ii.If the gifted assets are later sold by the trust, and the assets have appreciated substantially (which is why they are typically transferred to the trust in the first instance), there will be a gain for income tax purposes. If, instead, the grantor retained the asset until death, there may have been an increase or step-up in basis. This interconnection or coordination between the income tax and the transfer tax system should not be ignored in planning. Practitioners should endeavor to weigh the potential capital gains tax versus estate tax exposure. This analysis, however, is quite impossible to perform given the uncertainty over the estate tax system, capital gains rates and more. Nevertheless, it should be discussed. If the client’s net worth will be below the $5 million exemption, if that is extended, and certainly if it is likely to be less than President Obama's proposed a $3.5 million exemption, then there may be no future estate tax cost savings to offset the increased capital gains tax cost of a current gift plan. If the client lives in a decoupled state, e.g., New York or New Jersey, then the future savings might be in state estate tax in that decoupled state. In such instances, practitioners can evaluate the arbitrage between potential capital gains and the state estate tax savings. In many cases, that arbitrage will be negative because the state estate tax savings may prove to be at a rate that is lower than the future federal capital gains rate.
iii.In some instances, practitioners can help clients identify assets with less current appreciation for gift transfers. However, that, too, may prove suboptimal in that the goal of asset transfers is to remove future appreciation from the client’s estate.
Not Considering Negative Basis. If the assets to be transferred, such as depreciated real estate, have a negative basis, the impact of the transfer must be carefully considered.
i.Any client making a significant gift in 2012, even well under the $5.12 million maximum exemption amount (even a $1 million gift, depending on the size of the client’s estate) could have a significant and adverse impact on the client’s future financial security. Members of the client’s planning team should be involved in pre-planning for the gift. This should ideally include completing a budget and financial projections for that client. Ideally, this should be done as a Monte Carlo simulation, to address and endeavor how to quantify a broad range of possible outcomes.
ii.For many clients, making a large gift for the first time raises a host of emotional issues and in particular, insecurities. If, for example, the client has a $5 million estate and lives in a decoupled state where there is only a $1 million exemption, if the client gives away $1 million, they could save perhaps $150,000 of state estate tax. While this might prove advantageous to making the gift, a financial projection for the client showing what they may need in terms of dollars to cover future living costs is the backstop to give the client some peace of mind and assist them in determining how much to give.
iii.So practitioners should advise almost every client that, while they should evaluate the benefits of making gifts, they should first have their accountant and/or wealth manager complete a projection,
iv.From an estate tax and asset protection perspective, if practitioners can document that the client can reasonably make the gift and not need those resources, that will help support an argument against an IRS attack of an implied agreement with the trustee that they were going to pay money back to the client/donor. So, get involved proactively and do projections for this type of planning.
Not Planning for the Reciprocal Trust Doctrine.
i.Another tax doctrine that most practitioners have been aware of, but which, until the 2011-2012 planning years received scant attention, is the “reciprocal trust doctrine.” This tax doctrine should be given careful consideration in 2012 planning scenarios. The issue most commonly will arise when both spouses wish to make gifts to an irrevocable trust. Practitioners, however, should be mindful that the doctrine can apply in a much broader context than just transfers to trusts, or just transfers with spouses involved.
ii.The application of the reciprocal trust doctrine can be illustrated as follows. Husband and Wife each wish to make gifts of $5.12 million to trusts to take advantage of their $5.12 million exemption. Husband creates a trust and transfers his gift into that trust. Husband’s trust benefits the wife for her life and all their descendants. The Wife creates a similar trust, and transfers her gift into that trust. Wife’s trust benefits Husband for his life and all their descendants. The types of trusts that are involved could be similar to the bypass trust that would commonly appear in a will, although more sophisticated trusts might prove preferable. Does this plan work?
iii.A key issue in setting up trusts in the above manner is that if Husband sets up a trust for wife and descendants, a bypass-like trust, and Wife sets up a trust for husband and descendants, they may have almost mirror-image trusts. The reciprocal trust doctrine could be evoked by the IRS or the courts to uncross or unravel those trusts. The concept is that the basic deal was you set up a trust for me, you scratched my back, and I scratched your back. It's as if nothing really happened of economic significance. Both Husband and Wife are effectively in the same economic position before and after the trusts were established.
iv.The reciprocal trust doctrine could haunt many of the plans that are being established in 2012.
v.Practitioners should endeavor to craft the trusts to be different enough so that the doctrine will not apply. One problem is, if you read the tax cases and some of the PLRs on the reciprocal trust doctrine, it is clear that there is no safe-harbor or cookbook step that assures the doctrine’s inapplicability. Some practitioners are comfortable that if the draftsperson simply differentiates the powers of appointment used in each of the trusts that will be sufficient to negate a reciprocal trust challenge. While that may be so, given the dollars involved in many such trust plans, more differences might be warranted.
vi.Practitioners should bear in mind that there has never been a year in the history of the transfer tax where so many people have had such an incentive to shift so much wealth as in 2012. The corollary is that there has never been a year in the history of the transfer tax where the IRS has had such an incentive to audit gift tax returns.
Why Gift Now?
- Introduction. Practitioners are well aware of the significant incentives for clients to consummate large 2012 gifts, and other transfers. The following review of potential benefits, however, may nevertheless prove helpful in guiding and encouraging clients to move forward with planning.
- Save Federal Estate Tax. While practitioners and clients are well aware of the potential federal estate tax savings of gifts, it bears repeating, given the potential significance. If a client makes a gift of $5.12 million in 2012, dies in 2013, and the exemption, in fact, drops to $1 million, having made the gift will have removed (so long as clawback does not occur) $4.12 million from the client’s estate, along with any income tax paid on trust income that is reported on the donor/client’s income tax return as a result of grantor trust status, plus any appreciation in the value of the gifted assets. The savings can be substantial. While clients’ might fret at the cost of the 2012 planning, if this potential scenario does in fact occur, the savings could easily exceed several millions of dollars. Uncertainty aside, not a bad investment payoff.
- Save State Estate Tax. While practitioners in decoupled states are well aware of the tax impact of decoupling, many clients are predominantly or solely focused on the federal estate tax. The fact that a client does not face an estate tax on a federal level does not mean that the client cannot save hundreds of thousands of dollars in state estate tax with some basic gift planning. But this type of planning could be curtailed by a 2013 decline in the gift exemption to $1 million. Importantly, while most practitioners seem to believe that the “exemption” will never be permitted to drop as low as $1 million, and even President Obama’s proposal was for a $3.5 million exemption, that does not mean that the gift exemption may not revert to its pre-2010 Tax Act level of $1 million. So, under current law, a client with a $5 million estate, domiciled in a decoupled state with a $1 million exemption, could gift $4 million and potentially avoid all (or almost all depending on the calculation) state estate tax. However, if the gift exemption reverts to $1 million, that gift will no longer be practical.
- Grandfather for GST Purposes. President Obama has proposed limiting the number of years for which GST exemption can be allocated to gifts made to a trust. If the trust is formed in 2012, and the gifts made to it are consummated in 2012, that amount may be grandfathered for GST purposes without regards to such a restriction if enacted in the future. The difference may have no impact on the clients, but could have a dramatic impact on the future transfer taxes of the client’s descendants. Also, if the assets are paid out of the trust when the GST allocation ends, it will undermine the asset protection planning that the trust affords the future generations as well.
- Grandfather for Grantor Trust Purposes. Grantor trust status is a keystone of much of modern estate and trust planning and drafting. A trust’s status as “grantor”, for income tax purposes permits the much coveted estate tax burn in the client’s estate. Highly appreciated assets can be sold to a grantor trust without triggering income taxes. Insurance transfers to and from a grantor trust can avoid income tax issues. President Obama’s Greenbook proposal, if enacted, would undermine this critical component to planning by providing that assets, in a grantor trust, will be included in the client’s estate. Distributions out of grantor trusts will be taxed in the future as completed gifts at that time. If a trust is created and funded in 2012, it may be grandfathered, at least as to transfers completed prior to any law change. This can have a tremendous planning benefit. Practitioners might consider drafting express language permitting trustees to create subtrusts for pre and post grantor trust law changes so that the trust can be bifurcated as to any future non-grantor component.
- Lock in Discounts. There have been a host of proposals over recent years to restrict or eliminate valuation discounts on various assets. If a gift is consummated before law change, the valuation discounts that are currently permitted should be locked in. Once the law changes, the leverage discounts afforded may be lost.
- Remove Appreciation from the Estate. If assets are transferred to a trust in 2012, all post transfer appreciation will be held in the trust and outside the client/transferor’s estate.
- Minimize Future State Income Tax. If a client shifts assets into what is characterized as a grantor trust today, there will be no state estate tax savings if the income is all taxed to the grantor. However, following the grantor’s death, grantor trust status ends and, since the trust is an irrevocable trust, the heirs residing in high tax states may defer any state income tax by deferring distributions. If the trust is established in one of the trust friendly states discussed above, there likely will be no state income tax on trust earnings retained in the trust for out of state beneficiaries.
- Save Future Generations' Estate Tax. If all the bad things from a tax planning perspective discussed throughout this article go through, if we don't do the planning today for the parents' generation in perpetual trusts, the kids are going to come back in 20 years with a million-dollar exemption, no discounts, no GST -- perpetual GST planning, no grantor trusts. All the fun tools are gone, and we're going to be hard-pressed to do the right planning for the kids. Do it today.
- Incur Gift Tax at Low 35% Rates. It may prove beneficial for elderly high net worth clients to make taxable gifts in 2012 and incur a gift tax at the current lower 35% rate, than to, instead, hold assets that may be subject to a 55% estate tax rate in 2013 (and potentially a 5% surcharge). There is obvious risk with this type of planning in that the rate may not rise in the future and the hoped for arbitrage may never be realized.
- Gift Tax is Exclusive. The different manner in which the gift tax (exclusive) and the estate tax (inclusive) are calculated favors the net impact of incurring a gift tax over an estate tax.
i.Gifting assets to a self-settled trust today may protect those assets from a future lawsuit.
ii.With a $5.12 million exemption, the client may simply be able to gift assets to a self-settled or DAPT and obtain meaningful asset protection. However, if the gift exemption declines to $1 million, this type of planning could become more complex and costly. The client could then have to fund a family limited partnership, obtain a discount appraisal, gift non-FLP assets then consummate a note sale for additional assets. If grantor trust status is eliminated, or discounts eliminated, even that planning may be less productive, or impractical.
Better than a Prenuptial. Clients contemplating marriage may benefit by gifting and/or selling asset to a self-settled or other trust before the marriage. If the assets are not owned by the client when the wedding occurs, they may be safer than even a well-crafted prenuptial agreement can assure.
Better than a Postnuptial. Gifting assets to a self-settled trust today may protect those assets from a future marriage ending in divorce. If the client is presently married, and a parent creates a Beneficiary Defective Irrevocable Trust (“BDIT”), the child can sell assets to the BDIT, arguably without dissipating marital assets. The sale can then permit a family business, or other asset, to grow outside the estate and safeguard that interest from the potential ravages of a future divorce.
Techniques to Consider.
- Introduction. There are a host of techniques which practitioners should consider in planning and structuring 2012 gift transactions. Some of these are listed below.
- Net Gifts. The net gift is a technique that might be useful for some 2012 gifts. This technique can be illustrated as follows. Parent gives Child money, and then the Child pays the gift tax, instead of the Parent. The amount of gift tax Child has to pay is calculated using a formula: [Fair market value of the gift x 35% gift tax rate] divided by [1 + the 35% gift tax rate]. A net gift approach can be used where the donor seeks to limit the amount of the gift. If the IRS were to succeed in challenging the value of the gift, the net gift approach would reduce that amount for tax purposes.
- Valuation Adjustment Clause.
i.A growing number of court cases have upheld a technique that can provide important insulation to gift transfers and sales of hard to value assets. Wandry v. Commissioner. This is especially important as many clients are pushing their gift transfers close to the $5.12 million available exemption in an effort to take advantage of it before the law might change. If the transfer documents define the amount given in terms of a dollar figure transferred, and make a good faith effort to properly value the assets involved, some commentators believe that these types of adjustment clauses should be respected. In Wandry, the transfer documents gifted a "sufficient number of units" in the family business LLC to equal specified dollar amounts. The Wandry gift documents included the following adjustment clause language:
ii.“Although the number of Units gifted is fixed on the date of the gift, that number is based on the fair market value of the gifted Units, which cannot be known on the date of the gift but must be determined after such dates based on all relevant information as of that date. Furthermore, the value determined is subject to challenge by the Internal Revenue Service (“IRS”). I intend to have a good-faith determination of such value made by an independent third-party professional experienced in such matters and appropriately qualified to make such a determination. Nevertheless, if, after the number of gifted Units is determined based on such valuation, the IRS challenges such valuation and a final determination of a different value is made by the IRS or a court of law, the number of gifted Units shall be adjusted accordingly so that the value of the number of Units gifted to each person equals the amount set forth above, in the same manner as a federal estate tax formula marital deduction amount would be adjusted for a valuation redetermination by the IRS and/or a court of law.”
iii.Given the very favorable position the Wandry court took, and the many substantial transfers being made in 2012, practitioners should consider the use of a valuation adjustment clause in more transactions than in prior years. It appears that many commentators are not suggesting the use of valuation adjustment clauses as the default approach, unless there is a reason not to use one.
i.For clients seeking to transfer more than the $5.12 million, or $10.24 million for a married couple, a sale has to be combined with the gift transfer in order to freeze larger asset values and shift the growth of those assets outside the client’s estate.
ii.While the legal basis for a trust purchasing assets to be required to have any specified “capital” is quite unclear, many commentators have echoed the concept that there should be either a 10:1 or 9:1 ratio of assets in the trust (e.g., received by the trust as a gift) relative to assets purchased by the trust for a note. Whether there is any merit or not to this position, so many commentators have voiced this concept that practitioners should be careful structuring transactions without this amount of assets in the trust. In the alternative, many practitioners will structure transactions with guarantees in lieu of capital. If the transaction is greater than a 9:1 or 10:1 ratio, support guarantees will be needed, according to many.
iii.The incentives to consummate these transactions in 2012 are substantial. Valuations remain low for many types of assets. Interest rates are at historic lows, so the interest rate that has to be charged on the loan/note used for the trust to purchase assets is quite low. If the negative proposed changes to grantor trust rules are enacted, it is not fully clear how a sale transaction after the date of enactment would be treated. While it is possible that a note sale for fair value to a grandfathered grantor trust will still be viable, if the transaction can be consummated before such a change occurs, it might prove more secure.
Guarantee. As discussed in the preceding paragraph, if a sale of assets to a trust occurs and the trust has insufficient “capital” or seed gifts held, many practitioners recommend that some amount of the note issued by the trust to the seller be guaranteed by another party (e.g., a family entity or another family member). When a guarantee is used, a separate guarantee document should be created by counsel. Ideally, the guarantor should be represented by independent counsel. There are divergent views among practitioners as to whether a fee should be paid by the trust which is benefiting from the guarantee, to the guarantor providing it.
Standby BDIT. With 2013 potentially bringing whopping estate tax increases, bolstered by President Obama’s proposals to eliminate or restrict grantor trusts and GST dynastic planning, wealthy clients can take additional steps to protect their children’s future estate plans. Set up a beneficiary defective irrevocable trust (“BDIT”) today for each child and gift $5,000 to it. Use the least costly trustee you can identify in Alaska, Delaware, Nevada or South Dakota. That will create for the child a trust, the Standby-BDIT that will hopefully grandfather grantor trust status, GST/dynastic tax benefits, and more.
Split-Dollar DAPT. While the wealthy family may benefit from the Standby BDIT described above, ultra-high net worth families may benefit from much more aggressive and significant planning. A wealthy child desirous of funding his or her own $5.12 million DAPT may not have resources to do so. Nevertheless, having such a grandfathered trust with a significant asset base may prove the keystone of all future planning. The child’s parents probably cannot make a $5.12 million gift since they’ve likely used up their $5.12 million exemptions on dynasty trusts or DAPTs they have already established. So, how can the heir of an ultra-high net worth family take advantage of his or her $5.12 million exemption and grandfather all the great benefits of the Standby BDIT technique above? The parent could loan the child a large amount of money, say $6 million. The child could use $5.12 million of that loan to make a gift to a DAPT established by the child. But that loan won’t be respected, because the child’s assets are inadequate (or the child could have simply made his or her own gift). The IRS would likely challenge the purported loan as a taxable gift. However, if the child purchases a significant permanent life insurance policy, perhaps $10 million, the loan can be structured as a split-dollar loan with the appropriate elections filed as required by the split-dollar insurance Regulations. The IRS would have to recognize the transfer as a loan because the Regulations say it has to. This aggregation of split dollar life insurance loan and the child funding a gift of $5.12 million to his or her own DAPT can provide the key to a wealthy heir locking in 2012 benefits. Years from now the DAPT, as a grantor trust, could buy the insurance from the Child if advisable. This technique will provide the child a fully funded $5.12 million grantor, dynastic trust that hopefully will be grandfathered, if the laws are all changed. This will be the keystone for all of the child’s future planning.
QPRTs Used Correctly.
i.The Qualified Personal Residence Trust (“QPRT”) is a useful technique, in the right circumstances, to leverage a gift of the value of a principal residence or vacation home out of the client’s estate.
ii.For many wealthy clients, the use of a QPRT that utilizes any gift exemption may prove counterproductive, as that valuable gift exemption may be better utilized on transfers of family business interests or other assets with greater discounting and appreciation potential. Furthermore, the grantor trust tax can burn, so many clients should lock in before changes in the law occur or it will not be accomplished with the use of a QPRT.
iii.However, for some clients, the use of a QPRT, while the gift exemption remains at the historically high $5.12 million, may be a unique planning opportunity that should not be permitted to lapse unused. If a client has adequate or excess exemption after planning for other assets that deserve priority in the planning hierarchy, and their home or vacation home is quite valuable, locking in a transfer of their home or vacation home may only be feasible in 2012. If the gift exemption declines to the $1 million level it had been at for many years, these opportunities will be forever lost. Further, under current law, if a husband and wife each transfer ½ of a tenants-in-common interest in a home into a separate QPRT, a discount on the valuation of each of those partial interests may be permitted. If the proposed changes in discounts are enacted, this further component of leverage for QPRTs will be lost.
iv.When evaluating this type of planning, a number of factors should be weighed:
GRATs Used Correctly.
- Interest rates are at historic lows. In contrast to GRATs and other techniques, QPRTs are less beneficial in low interest rate environments.
- If the QPRT has a grantor trust as the remainder beneficiary, will that trust be grandfathered if the QPRT is executed and funded before a change in the law, or will possible restrictions on grantor trust apply to such a trust as that remainder trust may not receive the house as an asset until after the law change occurs?
- Will the home appreciate in value? This analysis could vary significantly depending on which part of the country the home is located in.
i.Grantor Retained Annuity Trust (“GRAT”) is a grantor trust established by the client. The client retains a fixed rate, a fixed payment typically expressed as a percentage of the value of the assets and selected to reduce the gift tax value of the transfer to the GRAT to zero, or, as some practitioners prefer, a small dollar amount. The client funds the GRAT with assets likely to appreciate (e.g., a family business interest) or, marketable securities are used. The hope that, over the typical two year term of the GRAT, the property dramatically appreciates, and your client also hopes that he or she outlives the term. At the end of the two years, the client’s family members will receive the remainder of the GRAT. Often, this can be structured as a further grantor trust. Any future appreciation after the creation and funding of the GRAT is not included in the client’s estate, if the client outlives the GRAT term.
ii.GRATs are an outstanding vehicle to remove appreciation above the federal mandated rate, or hurdle rate, from the client’s estate. GRATs thrive in low interest rate environments because the hurdle rate (or leakage back into the client’s estate via annuity payments) is much lower. President Obama’s Greenbook has proposed significant restrictions on the use of GRATs. As a result, many practitioners are urging clients to set up GRATs now before the proposed unfavorable changes are enacted. For many clients, that may prove a mistake.
iii.GRATs do not shift or utilize significant amounts of the client’s exemption, so if you have a client with wealth that you're trying to get gifts out of their estate this year, GRATs are not going to accomplish this goal. For many clients, especially given a client’s limited willingness for professional fees and complexity, dynastic and other more valuable planning may be advisable to pursue first. Once all exemption planning has been utilized, then it might be more sensible for GRATs to be considered for additional wealth transfers. This will be especially valuable for ultra-high net worth clients that have used most of their exemption on gift transfers, since GRATs are typically zeroed out or nearly zeroed out for gift tax purposes.
iv.There is another application of GRATs that has particular advantage in 2012. If you have a client in their late 60s, or early 70s, that could establish a ten-year GRAT. If the client may be uncomfortable making an outright gift, they have a $3 million estate, so it's under President Obama's proposed $3.5 million exemption, but with the inflation; their estate later will likely be taxable and their estate may already face state estate tax in a decoupled state. Using the GRAT as a way they can continue to receive a cash flow stream (in the form of the GRAT annuity payment) for some agreed number of future years locked in. This will create something akin to a freeze of that portion of assets in their estate with a cash flow return to them, and not grow the assets in their estate. So for a client reluctant to make any additional large gift transfers, GRATs could be a very clever opportunity to still effectuate some estate planning benefits.
ILITs Used Correctly.
i.Irrevocable Life Insurance Trusts (“ILITs”) present a number of planning opportunities for 2012. Consider the following.
ii.Many clients have old ILITs, many of which have never been maintained or monitored properly. 2012 is an ideal time to review those old trusts since if a “fix” is necessary, the $5.12 million exemption may make the fix relatively painless for most clients that are not ultra-high net worth. If new gifts or other transfers should be made, the large current exemption may provide the opportunity.
iii.Unwind old split-dollar insurance arrangements by making a gift to the appropriate trust to repay the loan.
iv.Consider gifting large current amounts to the trust to avoid the need for annual gifts and Crummey powers for years to come.
Restructure Old Deals. Restructure old deals in 2012 while the large exemption may make it feasible to do so. For example, if a client sold stock in a family business to a grantor dynasty trust and took back a note from the trust, review that transaction. It may be possible to restructure the loan with a lower interest rate to permit more cash flow to be retained in the trust, or just to ease cash flow burdens. It may be possible to make a cash gift to the trust and have the trust pay off the note thereby unwinding much of the complexity of the transaction.
Timing Issues as Year End Approaches.
- Standby Trusts. Clients that are still fence sitting about 2012 gifts, or have decided to gift, but are still determining what or how much, should consider completing trusts now so that the trusts are established. As the calendar approaches the end of the year, it will become more difficult to complete trusts on time.
- Gift to Existing Trusts. Near year end, when it might be impossible to complete an irrevocable trust, gifts by necessity may have to be made to existing trusts. Those trusts might not be ideal, but may still be preferable to an outright gift with no protection. These trusts can be reviewed to ascertain whether there is any flexibility in terms of dividing into subtrusts or other steps to provide some flexibility for the new gifts. It may be possible at a later date to decant the old trust into a better trust.
- Gift Entity Interests. If there are no viable trusts to hold near year end gifts, it may be preferable to transfer assets into an entity and gift interests in the entity to at least provide some measure of control over, and protection for the donee. Discounts may be jeopardized if the transfers are made and followed too shortly thereafter by gifts of entity interests.
- Living Trust Updates. For elderly or infirm, client planning should be done in a manner that considers the potential for the client losing the ability to consummate future transfers. One approach that might be useful is to fund all of the clients assets that are appropriate (e.g., not IRAs) into a revocable living trust and grant an independent person the right to revoke the grantor/client’s rights, in whole or part, to the trust. That revocation arguably consummates instantaneously a completed gift of those interests.