Estate Planning for the End of 2010 and 2011

Estate Planning for the End of 2010 and 2011

By: Martin M. Shenkman, CPA, MBA, JD


  • 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 clients.
  • 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.
  • Ancillary Implications.
  • 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 consequences.

ii. Determining 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 picture.
  • Should your clients revise their wills to Address Repeal?
  • Yes, now!
  • 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 Thereof)?
  • 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 haphazard.

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;

ii. Nebraska

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 objectives.
  • Many attorneys draft for disclaimers to provide flexibility in light of uncertainty. Too often surviving spouse's never exercise these.
  • 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 expectancy.
  • 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 dies.
  • 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 understood.
  • Should gifts be made to Grandchildren or Grandchildren trusts?
  • 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 action.
  • Taxpayers cannot use an UGMA instead of an outright gift or distribution because the GST regulations treat UGMA as a "trust equivalent."
  • Should trustees make Distributions to Grandchildren from Trusts this year?
  • 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 minute GRATs:

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 option.
  • 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 Estates.
  • 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, 2011.
  • 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 (recipient).

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 it.

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 executor.

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 made?
  • 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 2011 forward?
  • 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 assets.

iv. Testator's 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 allocation.

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 death?
  • State estate and income tax issues can create additional complications.
  • 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 suit.
  • 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 taxes?
  • 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 flexible.
  • 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 Sec. 6166(g)(1)(B).
  • 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 administrative expenses.

  • 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 benefits.
  • 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 deduction.
  • 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 Partnership Agreement.

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. §1.754-1(b)(1).

  • 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.

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