JANUARY 2010

TO:     CLIENTS

RE:     ESTATE PLANNING DEVELOPMENTS

Congress’s failure to enact a new federal estate tax law has created confusion with estate taxes.  The following summarizes the current status of the estate tax law, other estate planning developments, and what you can do to take advantage of the 2010 one year estate tax repeal.

1. Status of the Federal Estate Tax Law.  The estate tax and generation-skipping tax expires for one year effective January 1, 2010.  However, the gift tax remains in effect for 2010 with a $1,000,000 exemption and the highest gift tax rate equal to the top individual income tax rate (currently 35%).  For a person dying during 2010, subject to certain exceptions , their property’s income tax basis will no longer be its estate tax value, and instead will be the lesser of:  (i) the decedent’s adjusted basis in the property; or (ii) the fair market value of that property at date of death.

Starting in 2011 the estate and generation-skipping taxes will again apply, with a much lower $1,000,000 estate tax exemption (the same as the gift tax exemption), and an increased 55% maximum estate tax rate.¹

Democratic Congressional leaders announced that during early 2010 they hope to enact legislation which will permanently change the estate tax law.  One proposal is to retroactively, from January 1, 2010, to keep in place the 2009 federal estate tax law, with an exemption of $3,500,000 per person (which would be a combined $7,000,000 exemption for you and your spouse), and to continue to allow the adjustment to a property’s income tax basis at death.

For persons dying in 2010, their estates should consider challenging the constitutionality of any retroactively enacted estate tax legislation which imposes a tax.  Because of the threat of a court constitutional challenge to a retroactive estate tax law, Congress may choose not to retroactively enact an estate tax and may instead choose to have any new estate tax only be effective from its enactment date.

In response to this confusing state of the federal estate and gift tax law, you should consider the following actions:

• You should review your estate plan’s bypass trust (sometimes known as a "Decedent’s Trust") and your estate tax exemption gifts to determine if the estate tax repeal will affect the amount of assets going to your bypass trust or cause unintended amounts to be left to certain beneficiaries.
• You could consider making gifts during 2010 to take advantage of the lower 35% gift tax rate (but remember that Congress could retroactively repeal this lower rate).
• If you or your spouse were to die during 2010, the new tax rules state that your assets’ income tax basis at your death will no longer equal their estate tax values.  There are exceptions to this rule, such as allocating up to a $1,300,000 increase to the basis of your assets, plus an additional $3,000,000 allocation of tax basis increase to your assets going to your surviving spouse.  Therefore, your estate plan documents should account for this possible lack of adjustment to your assets’ income tax basis at death during 2010.
• If you wish to transfer any of your assets to your grandchildren, you could take advantage of the repeal during 2010 of the generation-skipping tax by currently making gifts to your grandchildren, or by setting up long-term trusts to benefit your children and grandchildren.  Although not certain at this time, such long-term trusts may be "grandfathered" to be exempt from a future generation-skipping tax.  However, If you make direct gifts to your grandchildren in 2010 (or to trusts for their benefit), while the generation-skipping tax is repealed you need to remember that Congress could retroactively enact a new generation-skipping tax.

2. Current Low Federal Interest Rates Allow You to Transfer a Substantial Amount of Your Assets Tax Free to Your Family Members.  The decline in asset values has encouraged gifting.  More importantly, the federal interest rate used for grantor retained annuity trusts (known as a "GRAT") is now a low 3.0% for January 2010.  Midterm AFR rates (for promissory notes of less than a nine-year term) for January 2010 are 2.45%.  Thus, you can combine lower valued assets with these low interest rates to transfer substantial amounts of wealth tax free to your family through the use of GRATs and sales to grantor trusts (sometimes known as "defective income trusts").

3. Current Status of Valuation Discounts of your Property.  Valuation discounts remain a powerful estate planning tool to allow you to reduce and eliminate estate and gift taxes on the transfer to your children and grandchildren of the stock of your closely held corporations and your partnership interests.  In the family corporation context, valuation discounts are allowed not only for lack of control and lack of marketability, but for the corporation’s potential future income taxes on the corporation’s built-in gains.²  

         The recent Pierre³ Tax Court case confirmed that family limited partnerships can be utilized to own publicly traded securities, and still achieve lack of marketability and minority interest discounts. 
The recent family limited partnership valuation discount court cases which taxpayers have lost were those where proper legal and tax formalities were not followed on the partnership’s formation or on the partnership’s operation.  These recent court cases demonstrate that the following items should be followed in forming and operating family limited partnerships:

• The family limited partnership should be funded with assets (such as real estate or securities) prior to the gifting or sale of partnership interests to family members.  A time period should pass between the date assets are contributed to the partnership and the date on which there is the gift or sale of the partnership interests.  Otherwise, the IRS may assert that the taxpayer has effectively made a gift of the underlying assets of the partnership (thereby denying valuation discounts).
• You should not commingle your personal assets with the partnership’s assets, nor utilize the partnership’s income for your own personal expenses.  Importantly, you should retain sufficient assets outside of the partnership in order to support yourself and to pay your day-to-day living expenses without utilizing the partnership’s income or assets.
• It is helpful if a legitimate significant business purpose (apart from tax planning motives) is established for the family limited partnership’s formation.

4. District Court Permits Accelerated Interest Deductions on the Federal Estate Tax Return.  A recent Federal District Court decision allowed a decedent’s estate to borrow $114,000,000 from a related family limited partnership in order to pay federal estate taxes which the estate owed.  This estate was then allowed to currently deduct $30,000,000 of interest on this borrowing on the federal estate tax return, even though this interest was to be paid by the estate to the partnership many years in the future.⁴

 5. Annual Gift Tax Exclusion in 2010 Remains at $13,000 Per Donor.  The gift tax annual exclusion in 2010 remains at $13,000 per donor per year.  Thus, you and your spouse continue to have a combined annual $26,000 per donee exclusion.  As an example, if you and your spouse have three children and eight grandchildren, you could effectively gift $286,000 of community property per year gift tax free ($26,000 multiplied times 11).  This means that over a ten-year gifting plan, you could effectively gift $2,860,000 tax free using these annual exclusions, which is in addition to your $1,000,000 lifetime gift tax exclusion ($2,000,000 combined for you and your spouse) and the gift tax free payments you can make for your children’s and grandchildren’s educational tuition, and medical care.

6. Fixed Value Clauses Allow You to Make Tax Free Gifts to Your Family Members.  Recent court cases permit you to make gifts to your family members based upon a fixed value.  If your gifts should later be increased by the IRS to a higher value, then this additional greater value can pass tax free to a charity of your choice (including a family controlled private foundation), thus avoiding gift taxes.⁵   As an example, you could gift property to your children equal to the $1,000,000 gift tax exclusion, and state that if the IRS later revalues this gifted property to an amount greater than the gift tax exclusion, then this excess amount will pass tax free to your chosen charity (or to your family controlled private foundation).  Thus, rather than paying an additional gift tax, there is an increased amount going to your favorite charity, a much better tax result.

IRS CIRCULAR 230 DISCLOSURE:  To ensure compliance with Treasury Department regulations, we inform you that any U.S. Federal tax advice contained in this Newsletter is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties that may be imposed under the Internal Revenue Code, or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein.