http://www.supremecourt.gov/opinions/11pdf/11-139.pdf

If you need help dealing with the IRS, give us a call at (404) 255-7400.

Here are the facts:

1. Currently, there is a $5 million lifetime exemption for gift and estate tax. But if Congress and the President fail to act, the $5 million exemption is reduced to $1 million on January 1, 2013. The President’s budget proposed a $3.5 million estate tax exemption and a $1 million gift tax exemption going forward. So the $5 million exemption offers a unique estate planning opportunity that might disappear at the end of the year.

2. Distressed sales are pulling down the market for real estate creating historically low property values.  In addition, appraisals now can use historical data from the recession to reduce business appraisals. With a slowly improving economy, these historically low values might not be around for much longer.

3. The IRS approved interest rates for related party transactions as low as .25% for short term obligations of 3 years or less, 1.15% for obligations between 3 and 9 years, 2.7% for obligations of 9 years or more. These historically low interest rates allow clients to freeze the value of their estate through sales and loans to Defective Grantor Trusts, with any future appreciation (excepting the small amount of interest paid) accruing outside of the client’s taxable estate.

4. Today, discounts for lack of marketability and lack of control can be used to value ownership interests in family owned entities. Simply fractionalizing assets and/or placing them in family owned entities can reduce the value of an estate by substantial amounts (25-40%). The IRS does not like these discounts and is looking to the President and Congress to eliminate their use for family owned entities. The President’s recent budget proposal would eliminate these discounts on family owned entities. If the President and Congress fail to eliminate these discounts, it is likely the IRS will, itself, act to reduce the estate tax advantage of these discounts through regulation. Therefore, time is of the essence to take advantage of these discounts.

5. Today, Defective Grantor Trusts can be used to reduce estate tax exposure. Defective Grantor Trusts are recognized for estate tax purposes but disregarded for income tax purposes. This allows us to transfer assets to the Defective Grantor Trust without income tax consequences. The President’s 2012 budget would cause grantor trusts to be disregarded for estate tax purposes (like they are for income tax purposes), thus eliminating their use for reducing estate tax exposure. While the President’s budget won’t pass this year, it is an indication of what future legislation might hold as the President and Congress look to increase revenues.

The next 7 months present an exceptional window of opportunity for individuals to make wealth transfers and decrease the size of their taxable estate.  Unless the President, the Senate, and the House of Representatives all agree otherwise, income and estate taxes will increase dramatically on January 1, 2013. Those who understand will take full advantage of this estate planning opportunity before it’s too late.

If you need help with your estate plan or would like to learn more, please do not hesitate to contact us at (404) 255-7400.

The IRS has long contested the use of defined value clauses as against public policy because they reduce the IRS’ incentive to contest asset valuations.  In the case of Joanne M. Wandry, et al. v. Commissioner, T.C. Memo 2012-88 (March 26, 2012), the Tax Court took the defined value gift issue head on and found the IRS arguments unpersuasive.

Mr. and Mrs. Wandry owned LLC units of Norseman Capital, LLC.  An independent appraiser determined that the  value of a 1% interest in the LLC was worth $109,000.  Mr. and Mrs. Norseman desired to gift to their children and grandchildren defined value amounts of the LLC as follows:

 The Wandrys executed assignments to their children and grandchildren with defined value amounts and containing the following adjustment clause in case the IRS later found that the LLC was improperly valued by the appraiser:  “the number of gifted [LLC] 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 years following the gifts, the Wandrys’ gift tax returns and the LLC income tax returns reported the children and grandchildren as an owner of a percentage of the LLC.  So each child reportedly owned a 2.39% ($261,000/$109,000) and each grandchild reportedly owned a .1% ($11,000/$109,000) interest.  

Years later, the IRS audited the gift tax return and found that a 1% LLC interest was, at the time of the gift, actually worth $150,000.   The IRS disregarded the defined value clause in the assignment, arguing that it is against public policy because it’s enforcement would virtually eliminate the incentive for the IRS to audit valuations of gifted property.  The IRS concluded that because the tax returns reported that the children owned a 2.39% interest, that must be the amount gifted to them.  And if a 2.39% LLC interest was gifted, then the value must be $385,500 (2.39% x $150,000) rather than $261,000.   The result of the audit was a taxable gift in excess of the Wandrys remaining lifetime gift tax exemption.

Mr. and Mrs. Wandry and the IRS eventually stipulated that a 1% interest in Norseman was worth $132,000, but the issues of whether the defined value formula clause and the adjustment clause were enforceable went before the Tax Court.  The IRS argued that the gift tax returns and the income tax returns were admissions of the transfer of fixed percentages.  It also argued the adjustment clause was void for federal tax purposes as against public policy on the grounds that it was a condition subsequent to completed gifts.  The taxpayers argued that the assignments only transferred defined value amounts (not percentages) and that public policy concerns regarding the adjustment clause did not apply because the value was set on the date of the gift.  

The Court found that the taxpayers’ intent and actions proved that only the dollar amounts of gifts were intended and that the public policy arguments regarding the adjustment clause were without merit.   As such, the Tax Court validated use of defined value formula gifts as an estate planning technique for reducing exposure to later valuation adjustments by the IRS.  This case was a big win for the Wandrys and for taxpayers and estate planners around the country.

If you need help with your estate plan or would like to learn more, please do not hesitate to contact us at (404) 255-7400.

This article will focus on one estate planning tool, the Self Canceling Installment Note (“SCIN”) whose benefit is magnified under 2012’s low interest rate environment. 

What is a SCIN?

SCINs are a planning technique used in a sale of an asset to either a trust or directly from an older family member to members of a younger generation.  Basically, the older generation sells the asset in exchange for an installment note with a term shorter than the seller’s life expectancy.  Life expectancies are found in IRS tables.   The installment note contains a provision by which the remaining balance is completely canceled upon the seller’s death.

What is the benefit of the SCIN?

What makes a SCIN a valuable tool is the fact that if the seller dies before the term of the note, the remaining balance is completely canceled and this canceled amount is not included in the seller’s taxable estate.   

The SCIN is especially beneficial if only annual interest payments are made until the end of the term, when a balloon principal payment is due.  By deferring the principal payment until the end of the term, the amount cancelled upon death can include the entire principal amount of the promissory note.

To illustrate, assume a client sells a small business worth $10 million to a trust for her children in return for a promissory note with annual interest payments and a balloon payment at the end of the term.  This simple sale would itself be beneficial for estate tax purposes.  If the business  appreciated to $20 million before client’s death, all $10 million of appreciation would be outside the client’s taxable estate, perhaps saving $3.5 million in estate taxes.    However, $10 million remaining principal balance on the note would remain in the taxpayer’s taxable estate, subject to a 35% tax rate.  If the client had used a SCIN rather than a simple promissory note,   the $10 million principal payment would cancel, leaving the trust with a windfall.  For estate tax purposes, this means that the entire $20 million asset escapes estate tax.

Is there any downside to a SCIN?

The IRS would not allow this transaction unless it is equivalent to an arms-length transaction between unrelated parties.   So in return for the self cancelling feature of the note,  a “mortality risk premium” is charged to the payor – typically an increased interest rate.  The older the seller is, the greater the mortality risk premium will be.    

This mortality risk premium is the downside of the SCIN transaction.  If the seller outlives the term of the SCIN, the trust will have paid the mortality risk premium interest rate to the seller for absolutely no benefit.[1] 

What makes 2012 an unusually good time to use a SCIN?

What makes the SCIN extremely attractive now is the historically low interest rate environment.  The SCIN interest rate is the base AFR rate which the IRS requires for all promissory notes, plus the mortality risk premium.  

Today, both the AFR rates and mortality risk premiums are very low.   Long term AFR rates for 2012 have hovered around 2.75%.  The largest the mortality rate premium has been for a 55-year-old male since January 2010 was only .58 percent.  The SCIN rate for a 70 year old in March 2012 was only 3.07 percent.    Thus, a 55 year old can do a SCIN at an interest rate of around 3.47%.  A 70 year old can do a SCIN for a rate of around 5.96%.  In both cases, the SCIN interest rates are below historical average prime rate of interest for third party loans.    Under these circumstances the downside risk of a SCIN is very small when compared to the huge estate tax benefit that could result. 

If you need help with your estate plan or want additional information, please contact us at (404) 255-7400.

Once a client has their estate planning documents in place, especially wills and trusts, they often think they are done.  However, as the laws change and personal situations evolve, estate planning documents often need a bit of modification.  Modifications can even be used to correct errors in elections or drafting or to impact tax consequences.  There are three areas in which modification may be discussed:  (1) retroactive modification; (2) prospective modifications; and (3) special considerations with respect to litigation settlements.

Retroactive Modifications.  Changes to documents after formation may be accomplished in a few ways.  First, reformation proceedings are available for a court to construe or reform a will or a trust and are often involved with charitable gifts, GST gifts, qualified domestic trusts and QTIPs.  However, the court held in Bosch that a determination by the state’s highest court must be obtained first in order for a reformation to be respected by the IRS.  Construction proceedings are an alternative; that is, a court is merely construing the terms of the document instead of reforming it.  As a general rule, the IRS is more likely to respect a construction determination than a reformation determination, especially without Bosch’s highest state court ruling.

In addition, where a client fails to timely make an election in regard to their trust documents with the IRS, Treasury Regulation §301.9100-3 grants an extension of the time to make an election permitted by the regulations or the statutes as long as the client-taxpayer acted reasonably and in good faith and the relief will not prejudice the interests of the government.  Although this relief is generally available for botched elections, it has met with mixed success in the case of QTIP elections.

Qualified disclaimers are another type of retroactive modification.  These were originally designed to permit someone not to accept a gift without incurring gift tax consequences, but they have often been used to correct errors.  Non-qualified disclaimers may also be used to correct errors. 

Finally, retroactive modifications are often accomplished as a result of probate contests, elective share contests, or contests involving conflicting agreements (such as separation agreements, prenuptial agreements, shareholder/partnership agreements, and the like).  In terrorem clauses can also result in reformation, in that provisions in wills carry a risk of forfeiture.

Prospective Modification.  In order to plan for the future with a completed document, decanting is one of the most powerful tools available.  Decanting allows the trustee to distribute property form one trust to another trust.   The following is a short list of reasons for decanting:

 (a)                update or modify trust provisions;

(b)               improve trust administration or management;

(c)                correct drafting errors;

(d)               address changed circumstances;

(e)                remove unworkable restrictions;

(f)                change provisions relating to trusts powers and succession;

(g)               achieve tax savings;

(h)               change trust situs;

(i)                 combine or divide trusts; and

(j)                 GST planning.

 See the article entitled “The Powers of Decanting and Appointment” for further discussion of decanting assets to another trust. 

Litigation Settlements.  As an initial matter, note that a marital deduction under Section 2056 and a charitable deduction under Section 2055 require that an interest must “pass from” the decedent under state law.  This qualifies an inheritance, as well as gifts to pass income tax free to the recipient under Section 102(a) of the Code.  However, where compensation is received in the form of damages in a lawsuit or other amounts received for services, the funds are included in the recipient’s taxable income.  In addition, fiduciary fees are generally deductible by an estate or trust, but beneficiary fees are not deductible, except in probate contests or construction proceedings. 

In the event a client is to receive a large settlement payment or other payment for services, there are several strategies for modifying an estate plan’s governing instruments to achieve the most tax efficient result.  There are a number of tax advantaged trusts which may be used, such as Credit Shelter Trusts, Marital Trusts, and GST Exempt Trusts.  The Trusts protect the assets from creditors and also allow the settlement payment or other cash assets to pass outside of one’s estate – saving estate taxes. 

 *IRS regulations require that we inform you as follows:  Any U.S. federal tax advice contained in this communication is not intended to be used and cannot be used for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or tax-related matters.

 We represent many closely held entities.  These businesses are operating as S corporations, C corporations, family limited partnerships (FLP) and family limited liability companies (FLLC).  For estate planning and gifting purposes, the entities face unique tax situations.  In representing these entities, we often rely on valuation discounts and freezing techniques when implementing estate planning.  The IRS scrutinizes the gifting and valuation discounts applied to these closely held entities, particularly in regard to the following concepts:   gift on formation/indirect gift, step transaction, annual exclusion challenges, Section 2036, valuation, and formula clauses.

 The IRS argument for gift on formation/indirect gift is that where funding of an FLP or FLLC occurs simultaneously or closely with the transfer of LP or membership interests, the gift is measured by value of assets transferred to the partnership limited liability company with no discount.  The taxpayer must prove that the funding occurred before the LP or membership interests were transferred by gift and/or sale.  See Senda.  The taxpayer has the burden of proof to show that capital was contributed and that market risk of ownership was transferred from the taxpayer to the closely held entity for a period of time.  There is no bright line test for how long taxpayers need to wait before gifting LP interests, and one may have to wait longer for non-volatile assets.  For instance, in Holman, 8 days was allowed because the assets contributed to the partnership were Dell stock, and the Dell stock has constant market risk.  The IRS had argued step transaction and indirect gift, but there was significant time (8 days) between funding and the transfer of the LP interests, so there was no gift on formation.

 Similarly, in Gross, 11 days was allowed with marketable securities.  In the Linton and Heckerman cases, bad facts produced bad results.  Simultaneous funding and transfer of an LP interest was not enough time.  Therefore, do not do things simultaneously anymore.  Even though state law says it is permissible, the IRS assertion of gift or formation/indirect gift is an easy argument to avoid and it is advisable to wait 30 to 90 days when possible. 

 In Pierre v. Commissioner, T.C. Memo 2010-106 (May 13, 2010), the IRS argued step transaction.  The issue was basically when a gift and sale of LP or LLC interests occur on the same day, whether the interests transferred should be aggregated for valuation purposes.  In Pierre, some closely held business interest was gifted as a seed gift and the rest sold on the same day.  The Court held that when two transfers occur on the same day, no time elapses, other than the time it took to sign the documents, and nothing of tax-independent significance occurs in the moments between gift and sale transactions, then the transfers should be aggregated.  This could have significant implications on valuation and Sec. 2036 considerations for adequate and full consideration determinations.  Again, there is no bright line for how long to wait. 

 One commentator agrees that the installment sale to a defective grantor trust (DGT) is one of the best estate planning techniques, but he suggests that the seed gift be made in cash (then there is nothing to aggregate), or waiting 60 days between the seed gift and the sale and be aware of property rights in what is being transferred.  In Pierre, the taxpayer still got discounts, but you have to be careful because aggregation could give rights to liquidate, and if that’s the case, then no discounts.

 Fisher and Price have thrown into question whether a gift of an LP interest is a present interest gift that qualifies for the annual exclusion.  The Court has held a number of times that donees do not have immediate substantial economic benefit from the LP interest, and therefore, no annual exclusions are permitted.  The Court argues that where there are transfer restrictions, the donees are assignees and not limited partners, and donees have no right to withdraw capital, as well as the fact that profits are distributed at the discretion of the general partner, donees do not have any right to the immediate use, possession or employment of the LP interest or income.  For planning purposes, consider adding a put right similar to a Crummey withdrawal provision.  In sum, we are generally skeptical about using FLP or LLC interests for annual exclusion gifts, primarily because of the appraisal costs and the IRS’ risks.

 Client communication is of utmost importance here.  The attorney and the client should carefully discuss planning techniques, and correspondence should layout pro-taxpayer intent, non-tax considerations, and timing matters.  For instance, it is advisable to document these items during the planning phase in order to put the client in the best position if one has to testify as to the non-tax reasons for the formation of the closely held entity. 

 Section 2036 is the most litigated issue currently.  This section provides that, as a general rule, the value of the gross estate shall include the value of all property to the extent of any interest therein of which the decedent has, at any time, made a transfer (except in the case of a bona fide sale for adequate and full consideration in money or money’s worth), by trust or otherwise, under which he has retained…(1) the possession or enjoyment of, or the right to the income from, the property, or (2) the right, either alone or in conjunction with any person, to designate the persons who shall possess or enjoy the property or the income therefrom.  There have been 28 cases since 1995.  Sixty-five percent of these cases have held for the IRS, and 35% have held for the taxpayer.  Generally, if the IRS is successful, all assets of the closely-held entity might be brought back into the estate, even if the interest in the partnerships had been transferred during life.  See Harper and Korby.

 The bona fide sale for adequate and full consideration exception is a two part test.  The adequate and full consideration means that interest must be proportionate and value of contributed property is properly credited to capital accounts.  It is pretty hard to screw this up.  The bona fide sale test requires a “significant and legitimate non-tax reason” for creating the entity.  Stone, Kimbell, Mirowski and Black all used centralized asset management as a significant and legitimate non-tax reason for forming the FLP.  Stone, Mirowski and Murphy cited involving the next generation in management, and educating the next generation of family members.  Kimbell, Black, Murphy and Shurtz cited protection from creditors and failed marriages.  Schutt, Murphy and Miller argued preservation of investment philosophy.  Church, Kimbell and Murphy cited avoiding fractionalization of assets.  Murphy and Black argued the avoidance of imprudent expenditures by future generations and protecting against bad spending habits of certain descendants.  Courts look at how an entity was actually operated after formation. 

 As for §2036(a)(1), there are a litany of cases with bad facts that found a retained right to possess or enjoy.  These include non-pro-rata distributions, personal expenditures with partnership funds, personal use of assets in the partnership, payment of estate tax and expense when assets transferred to the partnership close to death, accurate books and records not kept, and insufficient assets outside the partnership.

 To avoid Section 2036(a)(1) challenges:   (1) document non-tax reasons; (2) respect the partnership agreement; (3) maintain accurate books and records; (4) no personal use assets in the partnership; (5) pro-rata distributions; (6) avoid distributing all income; and (7) avoid “as needed” distributions and set up a distribution policy. 

 Even the most skilled tax planners and estate planners may get audited.  So it is important to prepare for an IRS audit at the planning stage.  When the IRS decides to audit, they issue broad requests. Your files can be subpoenaed, including emails. You might have to testify about reasons for creating the entity.  As stated earlier, the best evidence of non-tax reasons come from contemporaneous correspondence.  It is certainly permissible to discuss tax attributes, but talk about the non-tax attributes and reasons too. 

 Finally, using formula clauses to get around Proctor has been successful in a number of cases.  In Proctor, the tax court held the formula value clause was contrary to public policy since any attempt to collect the tax would defeat the gift.  However, in Christiansen and Petter, defined value clauses based on values “as finally determined for estate-gift tax purposes” were successful.  McCord and Hendrix were decided for the taxpayer, but in the context that the taxpayer agreed to be bound by what the donee parties confirmed and agreed was their appropriate and respective interest in the property.  All four cases involved the use of charities, and seemed to support the notion that a public policy for charity overrides the Proctor public policy.  It does seem significant that there is an independent trustee of the spill-over charitable entity.  Technically, none of these cases would really apply to our formula gifts, etc. since we very seldom use spill-over charitable donees.

 The litany of the legislative challenges to the valuation discounts in the recent past leaves one with the sense that they might not be around for very much longer.  Therefore, use them, and use them wisely, the sooner the better.

 If Section 2704(b) is expanded or interpreted to remove the impact of valuation discounts with our sophisticated estate planning techniques, we still have GRATs (although there have been proposals to eliminate the short-term and zeroed-out GRAT techniques).  We still have gifts and sales to grantor trusts (although Obama’s 2013 proposed Budget would basically eliminate DGTs), we still have intra-family loans, which is too often ignored and is a very simple technique.  It may become of increased importance if discounts are eliminated, it is generally considered a “sleeper” technique because it is not as “sexy” as a gift/sale to a DGT or a GRAT, but it can be an effective freeze technique because it limits the lender’s upside to the AFR rate (currently about 1.4%) and allows the borrower to invest the principal at hopefully higher rates of return. 

 In addition, fractional interest discounts for tenant-in-common interests in real estate have typically been viewed favorably by the Courts.  Planning options do not necessarily require a 50/50 division.  Any fractional amount should receive some discount.  Co-ownership agreements should be considered for the general management of the property. 

 Fractional interest discounts are available by making an inter-vivos transfer or special bequest to a QTIP trust of one-half the property.   Chenowith allows that there is no aggregation between the amount of property in the surviving spouse’s marital trust and the 50% that is owned outright or in another trust.  A fractional interest discount can also be available to a single person making an inter-vivos transfer of a portion of property and a specific bequest of the remaining property at death.  And, when using QPRTs, consider the husband having a QPRT and wife having a QPRT for their respective interests in the home, or separate QPRTs for each child, again, introducing fractional discounts for valuation purposes and preventing aggregation. 

 It remains an open issue whether fractional interests discounting is available for fractional interests in tangible property, such as artwork, collectibles, etc.  It is generally perceived that discounting, other than the potential costs of partitioning the artwork, is not allowed.  For now, authority permitting fractional interest discounts is limited to real estate; however, if Congress or the IRS attempts to eliminate other valuation discounts, we may see how far the limits can be pushed in other areas.

 *IRS regulations require that we inform you as follows:  Any U.S. federal tax advice contained in this communication is not intended to be used and cannot be used for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or tax-related matters.

             With the estate tax exclusion for 2012 of $5,120,000, many taxpayers with smaller estates ask why they need estate planning at all.  In fact, there are a number of reasons to make sure your estate plan is in good order: 

1. It is extremely likely this high exclusion will not remain after 2012.  (It may even go as low as $1,000,000!)
2. A good estate plan accounts for any number of contingencies in your personal and financial situations.
3. Estate planning eases the probate process at death and assures your assets go where and how you wish upon your death.
4. A proper estate plan puts control of your assets with the proper responsible person.
5. Certain strategies may be implemented to save income taxes.
6. You can protect your assets from creditors.
7. You may preserve your assets within your family and protect them from divorce. 
8. A business succession plan may be enacted to assist with the governance of the business and the business’ assets upon your death.
9. Estate planning can help you plan for retirement.
10. If you are charitably inclined, there are numerous ways in which estate planning can assist you in achieving those goals.                           

The exclusion referenced above means no estate tax is due on the first $5,120,000 of one’s estate in 2012.  The IRS currently allows the surviving spouse to carryover any unused portion of the deceased spouse’s exemption at his or her death.  This concept is known as portability, and it can be a very useful tool when used properly.  For estates under $1 million, disclaimer wills should be viewed as a good alternative to portability, but where there are creditor concerns, the situation should be viewed to see if Medicaid planning was appropriate.  For estates between $1 million and $5 million, that is between $2 million and $10 million for married couples, several categories of issues warrant attention, including preserving the generation skipping exemption, asset protection, outright versus credit shelter trust planning, state inheritance or estate taxes and freezing the estate. 

 Several general observations are worth noting.  It always seems to be a good idea to get life insurance out of estates now.  It may also be prudent to prepay premiums.  Also, Roth conversions should be considered pre-mortem as a technique to get taxes out of the taxable estate, in a situation that would otherwise involve income in respect of decedent (IRD). 

 In order to illustrate estate planning tactics, take this Example Problem 1.  Our answers to their situation appear below.

 A married couple has $2 million worth of assets.  They are in their mid-70′s, and were at one time considered wealthy, but they suffered from the effects of Madoff and now find themselves with a modest net worth consisting of their brokerage account of $1.5 million and their home worth about one-half million (in tenancy by the entirety).  They reside in New York, have 2 children and 4 grandchildren.  They have old wills which provide that all the assets of the first to die go to the surviving spouse (simple or sweetheart wills).  Fifteen years ago, they established a QPRT for their vacation home, which is now worth $1 million with a cost basis of $100,000.  The QPRT’s initial term has expired and the home continues to remain in the grantor trust.  Your clients can no longer afford to pay the rent.  The husband has been diagnosed with Alzheimer’s disease and the wife is concerned about their finances should the husband need a nursing home. 

 So, what would be the proper advice for an estate plan?

 They should redo the wills with credit shelter trust and marital trust planning.  They should not rely on portability.  It is unfavorable to rely on portability and unfavorable to rely on disclaimer wills.  Both leave assets exposed to creditors in most jurisdictions.  Further, usually one cannot disclaim under state law if you are insolvent. 

 For the vacation home, it is still in a grantor trust, so under Rev. Ruling 85-13, it is still considered owned by the grantor for federal income tax purposes.  The children could forego the rent, and arguably Sec. 2036 could cause inclusion in the taxpayers’ estate and a basis step-up, but the string does not exist at the time of the transfer to the QPRT, so this is not clear.  Prior to 1996, the taxpayers could buy back the house in order to get the low basis asset in their estate for step-up basis purposes.  Such a technique was prohibited prospectively by the IRS in 1996. 

 The vacation home is not exempt for Medicaid purposes; therefore, there is further planning that needs to be done.  What can be done to protect their assets if the husband has to go into a nursing home? 

 The investments should be moved to the wife.  Her Will can create a testamentary special needs trust if she happens to predecease her husband.  Both clients need current advance health care directives.  The clients need long term care insurance.  This may not be possible but the kids should be considering this.  The sweet spot to acquire long term care insurance seems to be when a couple is in their 50′s. 

 The couple should consider a lifetime QTIP.  This would combine state inheritance or estate tax planning with Medicaid planning by making specific provisions for the wife which do not interfere with Medicaid benefits nor allow for Medicaid inclusion.   A Medicaid IIOT (irrevocable income only trust) could be established to start the 5 year look back rule.  A closer examination of the client’s needs and assets is warranted to determine which or both of the trusts should be used. 

 In Florida, the inter-vivos QTIP is not as popular for personal residences since the home is already protected from creditor claims, etc. because of tenancy by the entirety.  This is not the case in New York and other states, so these issues should be looked at carefully.  Once the husband is moved to a nursing home, more planning can be done for the wife. 

 In some states, you could put all the assets in the wife’s name and the wife can refuse to care for the husband.  In other states, the state may have a cause of action against the wife for a duty of care to a spouse. 

Example Problem 2:   

 A husband and a wife have 2 sons, one who recently developed a new software product for which he anticipates significant revenues, the other son appears to be in a rocky marriage.  They have 3 grandchildren, one of which has special needs.  They live in a $3 million home in Naples, Florida, have a $2 million summer home in Nantucket, and have $3 million in liquid assets, including a $1 million IRA. 

 What estate freeze technique should they consider?  We would advise a defective grantor trust (DGT) and a qualified personal residence trust (QPRT).  The DGT can have discretionary tax reimbursement language that does not expose the DGT assets to creditors.  See PLR 2004-64 and PLR 200900402.  The QPRT offers the opportunity to remove a personal residence from one’s taxable estate, at an extreme discounted valuation, depending on the anticipated term of the trust.  There is however, a mortality risk that the grantor could die during the term of the QPRT, causing estate inclusion and loss of the tax benefits.  Another technique call the Remainder Purchase Marital Trust should be considered, which could effectively eliminate any mortality risk.

 How can they utilize their estate exemptions?  (1) they may need the assets so consider a self-settled trust in Nevada or Alaska; (2) consider non-reciprocal trusts; and (3) super credit shelter trusts for the wife and a QTIP for the husband.  

 What about the son’s software product?   Consider an Inheritors Trust or Beneficiary Defective Grantor Trust funded by the husband with $5,000.  Lapsing of $5,000 Crummey withdrawal power makes the trust a grantor trust vis-à-vis the beneficiary trust could be set up in an asset protection and tax haven state, such as Nevada.  Alternatives would be a self-settled trust, an inter-vivos QTIP, or life-time trusts for the son’s descendants.  When creating a self-settled trust or Inheritors Trust, consider giving a third party the power to add beneficiaries, so a surviving spouse can be added upon the grantor’s or beneficiary’s death.  Additionally, they need to consider how to protect the intellectual property related to the software, and the son may want to consider a limited liability company. 

 What other asset protection strategies are recommended?  Self-settled trusts, inter-vivos QTIP’s and life-time trusts for descendants may also be considered.  The family could place the Nantucket home in a trust – either a QPRT or a RPMT discussed above – to remove the home from probate. 

 Any other concerns?  Consider a third party special needs trust for the grandchild.  Be careful about giving Crummey powers to a special needs child.  There are plenty of other concerns that this family would want to address in order to fully protect their assets and pay the least amount of estate taxes. 

 –

Certainly, the above situations are just examples of possible estate planning techniques that we employ everyday depending on the particular situation of the client.  Every client, no matter how large or small their estate, needs estate planning. 

*IRS regulations require that we inform you as follows:  Any U.S. federal tax advice contained in this communication is not intended to be used and cannot be used for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or tax-related matters.

 A Beneficiary Flexible Trusts (also often called an Inheritor’s Trust or Beneficiary Defective Grantor Trust) is a trust set up by a third party (i.e. parents) for the benefit of the beneficiary (i.e. a child).  Both the trust principal and the income generated by the trust are available to the beneficiary for his/her health, education, maintenance and support.    The beneficiary also has the right to withdraw the greater of $5,000.00 or 5% of the value of the trust assets each year, and the beneficiary has the broadest lifetime and testamentary non-general powers of appointment.  With such great flexibility, this type of trust can be very valuable for our clients. 

 A few notes on the structure of these trusts:  generally, the grantor (ex. Dad) initially funds the trust with $5,000.00.  During the first year, the beneficiary has the power to withdraw $5,000.00 or 5% of the value of the trust.  When that withdrawal power lapses, the beneficiary becomes the grantor of the trust, i.e., a grantor trust under Section 678 of the Code.  Therefore, for income tax purposes, it is the beneficiary who is treated as the grantor of a grantor trust, not Dad, thus income taxes are paid by the beneficiary, sometimes at a much lower tax rate.  Although, these trusts are extremely effective for children who are investing and accumulating wealth.  This Section 678 “wrinkle” for the Beneficiary Flexible Trust is a bit different than the old fashioned Inheritor=s Trust that we have created in the past.  However, we want to be under grantor trust status whenever possible, according to Rev. Ruling 85-13, so this “wrinkle” is extremely advantageous to that notion. 

While we often advise that the beneficiary be the trustee of his or her own trust at a certain age, it is advisable to name an independent trustee as co-trustee with the beneficiary for these types of trusts  We will generally set up in jurisdictions that have attractive trust law, asset protection and tax law, such as Nevada, we suggest having a co-trustee in Nevada, and have an arrangement with an estate planning firm in Las Vegas like ours that specializes in estate planning, with both CPA’s and attorneys on board, which provides our clients agents and trustees where appropriate.  However, the trust should explicitly provide that no beneficiary or spouse of a beneficiary may receive any compensation as trustee.  (See, Rev. Ruling 66-167.)

 These Beneficiary Flexible Trusts can help ensure assets received in inheritance are not subject to creditors and minimize estate taxes at death.  

*IRS regulations require that we inform you as follows:  Any U.S. federal tax advice contained in this communication is not intended to be used and cannot be used for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or tax-related matters.

THE POWERS OF DECANTING AND APPOINTMENT

 Decanting can be a powerful modern estate planning tool and may be used to provide great flexibility in a trust arrangement.  In short, the power to decant stems from the power of appointment and refers to the distribution of trust property to another trust pursuant to the trustee=s discretionary authority to make distributions to, or for the benefit of, one or more beneficiaries. 

 The first discussion and application by an American court of decanting was Phipps v. Palm Beach Trust Co., 142 Fla. 782, 196 So. 299  (1940).  The Supreme Court of Florida held that a trustee could invade trust property and pay it over to another trust for the same beneficiary.  No court has since held to the contrary, that no fiduciary power exists under common law.  New York was the first state to enact rather comprehensive decanting legislation.  Alaska, Arizona, Delaware, Florida, Indiana, Missouri, Nevada, New Hampshire, North Carolina, South Dakota and Tennessee have followed suit and also passed decanting statutes.  In non-statutory jurisdictions, the practitioner must rely on Phipps or change the situs of the trust to a state which allows favorable decanting.  Georgia has no statute or precedent.  Therefore, our practice relies on Phipps when decanting our life insurance and family trusts. 

 As for the tax consequences of decanting, Private Letter Ruling 200736002 suggests that if the entire trust property is decanted into another trust, the new trust will be treated the same for income tax purposes as the old one from which the property originated.  This would be true for purposes of distributable net income (DNI), GST tax exemption allocation, and rule against perpetuities calculations, etc.  In addition, when the originating trust has negative basis assets, it may be advisable to leave such assets in the old trust in order to avoid the Crane gain.  Crane v. United States, 331 U.S. 1, 35 Aftr. 776 (1947).  There are other income tax consequences to consider as well:  the potential beneficiary gain attributable to DNI, Cottage Savings gain, and exceptions for the conversion of income interest into unitrust interests (See, Regulation 1.643(B-1), Private Letter Ruling 200810019) and qualified severances (Regulation Section 26.2642-6, 26.2654-1(b) and 1.1001-1(h)).  Finally, where a beneficiary of a trust has special powers of appointment, generally any gift is thus incomplete for gift tax purposes.  See Rev. Ruling 84-125.   Therefore, any perceived gift by a beneficiary of a decanted trust would also be incomplete and not subject to gift tax.

 In trust law, practitioners often refer to the King Lear effect; that is, the next best thing to owning wealth is controlling it.  A power of appointment provides that control to the donee, so such a power should be carefully considered in estate planning documents.   If properly drafted, these powers of appointment may allow wealth to pass to multiple generations and avoid transfer taxes. 

 If your trust documents do not provide for these powerful tools, or if you are just not sure, give us a call for more information. 

*IRS regulations require that we inform you as follows:  Any U.S. federal tax advice contained in this communication is not intended to be used and cannot be used for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or tax-related matters.

AND

OTHER ESTATE PLANNING MUSINGS

                 For 2012, the estate tax exclusion and gift tax exclusion is $5,120,000.  That means your estate will be tax free as long as it is valued below this amount.  The likelihood that this high exclusion amount will change at the end of 2012 is substantial.  We are looking at a reduced exclusion amount of $3,500,000 or even $1,000,000 and a possible estate tax rate of 45% beginning in 2013. 

             For much of the last decade, we witnessed the estate tax exemption increase ratably from $1,000,000, while the gift tax exemption remained frozen at $1,000,000.  Suddenly that changed in 2011, and the fear is that the exemption will change back to $1,000,000 just as quickly (on January 1, 2013, in a few short months from now).

             In order to ensure a client’s estate pays the minimum amount of estate tax, we strongly advise our clients to go through a life-style needs analysis.  They should look at the family considerations, strategically select assets, consider income needs, appreciation potential, fractional or joint ownership, and special use assets.   Then, these assets may be used for gifting, transfers, trusts, discounting, etc. to reduce the value of the estate.

               For instance, a closely-held business is often a good asset to transfer due to the benefits of keeping the business in the family, motivating the younger generation, using valuation discounts, using S-Corporation distributions to fund a purchase, and shifting appreciation and income to younger family members.  The benefits of gifting include (1) removing appreciation and income from our taxpayer/clients; (2) removing gift tax from estates; (3) the tax inclusive vs. tax exclusive nature of our transfer tax system; (4) state in heritance estate tax avoidance (not so much in Georgia); (5) lower income tax rates; (6) no GST recapture; (7) legislative concerns; and (8) possible phase-out of valuation discounts.  There certainly are disadvantages of gifting as well, including that the value of the gifted assets could go down, the loss of step-up in basis, loss of income, loss of control and possible recapture (i.e., clawback).  Life insurance on the donor’s life can be used to address potential recapture tax issues, at least until Congress clarifies whether and how recapture applies. 

             The new exemption amount ($5,120,000 or $10,240,000 for many married couples) can be used to “clean-up” gifts.  These would include (1) forgiving loans; (2) paying off children’s mortgages; and (3) equalizing family lines.  A complete review of a client’s assets and estate planning documents may reveal assets, interests, or powers that should be released or transferred in order to avoid inclusion of the asset or trust in a decedent’s estate.  These could be powers such as the power to vote stock in a controlled corporation that is held in a trust, the power to control the beneficial enjoyment of assets, or incidents of ownership of life insurance that could also cause inclusion of significant assets in a decedent’s gross estate.  Releases and non-qualified disclaimers can often be used even if the disclaimant is beyond any time restriction for a qualified disclaimer.  Another wise use of increased gift tax exclusion is to transfer any remaining general partnership interest held by the older generation in a Family Limited Partnership, or voting interests in LLCs and S-Corps.  Many split dollar arrangements and other loans regarding life insurance trusts can also be cleaned up with gifting.

             Multiple factors must be weighed in determining which strategies to employ for a client’s estate planning.  An economic analysis of various estate planning strategies can help focus the client and the estate planner on the components of the plan that will give the client the biggest bang for the buck. 

             Ann B. Burns of Gray, Plant, Mooty in Minneapolis, Minnesota presented a paper on a graduated approach to gifting, stating, “[a] graduated approach to gifting begins with a first step of making the gift, and then moves through the embellishments of adding grantor trust features, gift of discounted assets, allocation of GST exemption, and finally, an installment sale to a grantor trust.”   Each enhancement provides additional tax savings and net benefits to the family.   Ms. Burns continued, “the $20,000,000 client may become comfortable with only 1 or 2 steps.  The $200,000,000 client may employ them all…whether the gift is made outright or in trust…taking that step in 2012 is critical.”

             Using the high exclusion and gifting techniques are just parts of an estate plan.  The possibilities are nearly endless when you consider the attributes of family trusts, including pre-funding of the Credit Shelter Trust (the so-called Supercharged CST), giving the spouse more flexibility with the 5 and 5 power, a judicious use of power of appointments, and complementary trusts.  Note, the IRS prohibits reciprocal trusts, so, ideally, trusts created by spouses to benefit one another should be created at different times, with different assets, and with materially different terms.   

             Powers of appointment are also valuable tools that a spouse could exercise, i.e., a testamentary power of appointment over the trust to distribute trust assets to a trust for the benefit of the donor in the event that the beneficiary spouse predeceased the donor at a time when the donor needed additional resources. 

             Self-settled spendthrift trusts are another hot button topic.  In particular, the Alaska Trust Act and the impact of bankruptcy, including the Mortensen ruling in June of 2011, where a bankruptcy court ruled that an Alaska self-settled trust was not protected under federal bankruptcy law.  The court found that Mortensen intended to defraud his creditors because after funding his trust, he had insufficient assets and solvency to support his current and future debts.  Mortensen had filed for bankruptcy after the expiration of Alaska’s four year statute of limitations for self-settled trusts, but within the ten-year federal bankruptcy look-back period.

             Grantor trusts are an oft-used estate planning tool.  More recently, drafters are relying on Sections 674 and 675 of the Code to create grantor trusts.  These sections give the grantor or a non-adverse party the power to substitute assets within the trust, the power to borrow funds without adequate security, and an expanded power to add or remove a beneficiary beyond just providing for after-born or after-adopted children.  Rev. Ruling 2011-28 confirmed the IRS’ position (pro-taxpayer) that the power to substitute assets in an irrevocable life insurance trust works to create grantor trust status and does not cause inclusion in the grantor’s estate under Section 2042 of the Internal Revenue Code.  Of course, we rely on Rev. Ruling 2004-64 for its holding that a grantor of a trust, who is treated as owner of the trust for income tax purposes, pays the trust’s income tax, the grantor is not treated as making an additional gift.  In addition, the power to substitute assets is important in order to avoid carryover basis (by grantor purchasing or swapping for low basis assets from grantor trust before grantor dies). 

             Once the grantor trust is established, an installment sale to the trust may be set up.   Such a situation is generally preferable to GRATs, as there is no survivor risk, the trust can be set up as generation-skipping trusts, but technically there are no “do-overs” if the value of the assets goes down.  We have found that sometimes the parties can get together to renegotiate the sale price or the terms of the resulting notes when economic conditions or interest rates fluctuations dictate.  Generally, the sale to the grantor trust technique is the most beneficial technique for both $20,000,000 estates and $200,000,000 estates.

             This is merely a quick summary and explanation of the “happenings” in estate law currently.  As we mentioned above, each client needs to consider their life-style needs alongside an economic evaluation of their situation.  With a good understanding of the client’s full situation, we can tailor these estate planning strategies to minimize estate taxes and provide for your family as you see fit. 

*IRS regulations require that we inform you as follows:  Any U.S. federal tax advice contained in this communication is not intended to be used and cannot be used for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or tax-related matters.