CHANGES TO LAWS REGARDING ESTATE PLANNING, November, 2006
Law Offices of Robert A. Briskin, a Professional Corporation
1901 Avenue of the Stars, Suite 1700, Los Angeles, California 90067
Certified Specialist – Taxation Law
CHANGES TO LAWS REGARDING ESTATE PLANNING
The following highlights recent developments and changes to California laws and Federal tax laws affecting estate planning.
1. Current Estate and Gift Tax Exemptions and Tax Rates . Congress this year again failed to make permanent Federal estate tax and gift tax exemptions and rates. Due to political disagreements, the rates and exemptions remain the same as enacted under the Economic Growth and Tax Relief Reconciliation Act of 2001. Although the House of Representatives this year passed estate tax legislation, the Senate failed to pass such legislation.
A summary of the current tax law’s estate and generation-skipping tax maximum tax rates and exemptions are as follows:
|Calendar Year||Exemption Amount||Maximum Tax Rate|
The gift tax exemption remains at $1,000,000. After 2009 the gift tax rate under current law will become the income tax rate (currently 35%). However, in 2011 the gift tax rates will revert back to the 2001 amounts 1 .
Due to the shift to a Democratic majority in Congress, some political observers predict that new estate tax legislation could be delayed until 2009. Speculation is that any new legislation will provide for a unified estate and gift tax exemption amount between $3,000,000 and $5,000,000 per person, and a maximum estate and gift tax rate between 35% and 46%.
2. IRS Announces Plans to Reduce the Number of Federal Estate Tax Auditors . Newspaper accounts confirm the IRS’s plan to cut the jobs of 157 of its 345 estate tax lawyers during 2006, along with 17 percent of its support personnel. The IRS explained that under recent tax legislation fewer people are obligated to pay Federal estate taxes, and that 10 percent of the estate tax audits produce 80 percent of the additional estate taxes 2 . The IRS also stated that it wanted to devote more of its resources to auditing income tax returns of higher income taxpayers. However, some IRS estate tax attorneys and persons outside the IRS have observed that cutting back on the number of IRS estate tax auditors may allow wealthier clients who utilize more complicated tax schemes to pay less estate taxes. 3
3. Developments in Valuation Discounts and Family Limited Partnerships . Family limited partnership (“FLPs”) continue to be a viable estate planning technique. Although the IRS has attacked FLPs in prior court cases 4 , a properly formed, documented and operated FLP will be respected by both the courts and the IRS. During 2006 the courts reiterated that minority and lack of marketability discounts apply to transfers of family corporate stock and FLP interests. For example, in Huber 5 the Tax Court approved of an appraisal which included a 50 percent valuation discount for closely held corporate stock. In Temple 6 , a gift tax refund case involving limited liability companies and partnerships owning real estate, minority and lack of marketability discounts, was upheld by the Federal District Court. The Tax Court in Dallas 7 permitted a 20 percent lack of marketability valuation discount plus a 15 to 20 percent lack of control discount for gifted family corporate stock. All of these court decisions emphasize the importance of obtaining a qualified appraisal to justify valuation discounts.
a. Using FLPs With Other Estate Planning Techniques . FLPs can be utilized in connection with grantor retained annuity trusts (known as “GRATs”) and defective income trusts 8 to transfer significant amounts of a client’s wealth tax free from the client to the client’s children and grandchildren.
b. Use FLPs Now Or Potentially Lose in the Future the Use of Valuation Discounts . Clients can create the highest percentage of valuation discounts by making lifetime gifts and lifetime sales of FLP interests, rather than waiting until the client’s death. Additionally, Congress in the past has proposed legislation to eliminate valuation discounts, which proposed legislation is likely to be reintroduced should the Democrats gain control in the future of both the Presidency and Congress.
4. Annual Gift Tax Exclusion . Clients can continue to make annual gifts under the Section 2503 gift tax exclusion, which remains in 2007 at $12,000 per donee for each donor ($24,000 for a husband and wife each year per donee). 9
Example : Assume that the clients (a husband and wife) have four children and six grandchildren (for a total of 10 potential donees). Utilizing the $24,000 per year (aggregate amount for husband and wife) per donee gift tax exclusion allows the clients each year to gift $240,000 to their children and grandchildren tax free, plus the clients can, at their deaths, each utilize their estate tax exclusion (in 2007 there is a total combined $4,000,000 of exclusions at both clients’ deaths, plus the annual exclusion gifts).
These tax-free annual gifts, plus the estate tax exclusion, can be further increased by the clients’ use of FLPs, GRATS and defective income trusts.
5. Employer-Owned Life Insurance Proceeds Are Now Subject to Income Tax, Which Will Affect Shareholders’ Agreements Structured As a Stock Redemption . New Section 101(j)(1) states that life insurance proceeds received from employer-owned life insurance policies on employees’ lives are taxed to the employer at ordinary income tax rates to the extent that these proceeds exceed the employer’s paid premiums and other payments. There is an exception to this tax rule where the insured employee was employed by the employer at any time during the 12-month period before the employee’s death, or when the life insurance policy was issued on the life of a five percent or greater owner, director or highly compensated employee. However, to qualify for this exception, before the insurance policy is issued the insured employee must receive a notice (and the employee must give the employee’s consent thereto) specifying certain terms of the insurance policy and that the employer may continue the insurance coverage after the employee’s termination of employment 10 . This new tax law means that clients should include a “notice and consent” provision in shareholders’ agreements which provide for a stock redemption using life insurance proceeds. Additionally, employers will have to be made aware of the new information return filing requirements 11 . These new tax laws apply to life insurance contracts issued after August 17, 2006.
6. IRA Distributions Can Be Made to Charities During 2006 and 2007, and the Taxable Income Excluded For Certain Taxpayers . If amounts for individual retirement accounts (“IRAs”) are distributed to charities (but not to private foundations) during 2006 or 2007, then there is an exclusion from income of the qualified charitable distributions. This exclusion is only available to taxpayers who are age 70-1/2 years or older. The maximum exclusion in each calendar year is limited to $100,000. This exclusion will be advantageous to older taxpayers who want to make charitable contributions, but who may be limited in their charitable deductions, such as those taxpayers who do not itemize their deductions, taxpayers who may have exceeded their charitable base limitation, or taxpayers who are subject to the provisions that reduce allowable itemized deductions.
7. New Limits On Making Charitable Gifts of Artwork and Other Assets . Clients sometimes make fractional gifts of artwork and other tangible personal property to charities, such as allowing charities to use the gifted property for a portion of each year. Under the new law, a donor is now required to contribute all retained interest in the gifted property by the time of the donor’s death or 10 years after the initial gift to the charity, whichever occurs first. If such provision is not satisfied, there is a recapture of the tax benefit, plus a penalty. Importantly, there is a recapture of the charitable income tax and gift tax deductions if at any time after the initial charitable gift the charity fails to exercise its possession rights or does not use the gifted property for its exempt purposes 12 .
The client’s charitable income tax deduction for donated tangible personal property is reduced to the client’s income tax basis if a charity uses such property in a manner unrelated to its exempt purposes or disposes of such property prior to the close of the tax year of the charitable gift. 13 Additionally, if the charity disposes of tangible personal property prior to the end of the third year after the donation, the excess of the charitable deduction over the client’s income tax basis in the property is recaptured and included in the client’s gross income. Based upon these new tax law provisions, it is recommended that clients donating tangible personal property to a charity obtain evidence of the charity’s use of the donated property for the charity’s tax-exempt purpose.
8. California Domestic Partners Can Now File California Joint Income Tax Returns . For tax years commencing in 2007, California registered domestic partners may now file personal income tax returns for California state income tax purposes either as married filing jointly or married filing separately. These rules do not apply to Federal income tax returns. To qualify, the domestic partners must be registered with the State of California by the end of the taxable year in which they file. 14
9. Planning For Clients Who Own Assets in Other States . Although California no longer has a state-level estate tax or inheritance tax, other states continue to have such taxes 15 . Clients with assets located in other taxing states, such as out-of-state real estate, should keep in mind that even if they are California residents, their out-of-state assets may be subject to other states’ inheritance and estate taxes. Accordingly, clients owning property located in a taxing state should consider shifting the “tax situs” of these properties to a non-taxing state. Tax situs of real estate can, in some cases, be shifted by transferring the out-of-state real estate to a limited liability company or partnership formed outside the taxing state. The ability to effectuate such tax planning will depend on the applicable state’s tax laws.
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 U.S. Internal Revenue Code, or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein.
No tax or legal advice is being given by this Newsletter for any transaction. If you desire to discuss a particular transaction, then please telephone Robert Briskin at 310-201-0507.
1 Additionally, decedents dying during 2010 will no longer have their assets receive a full step-up in income tax basis at death, with certain exceptions. However, in 2011 the tax laws will revert back to the current ‘1014 step-up in income tax basis rules.
2 In 2000 more than 120,000 estate tax returns were filed, but the projection is that only 38,000 will be filed in 2007.
3 The IRS informally indicated that it will continue to have a high percentage of audits of estates over $5,000,000.
4 See, for example, Rosen, T.C. Memo 2006-115.
5 T.C. Memo 2006-96.
6 (ED Texas, 2006), Civil Action No. 9:03-CE-165.
7 T.C. Memo 2006-212.
8 A defective income trust is an irrevocable trust taxed to the grantor for income tax purposes, but irrevocable for gift and estate tax purposes.
9 See Rev. Proc. 2006-53.
10 See ‘101(j)(4) for the required terms of this Notice and Consent.
11 See ‘6039I(c) for return filing requirements.
12 See ”170(o) and 2522(e), as modified by the Pension Protection Act of 2006.
13 See ‘170(e), as modified by the Pension Protection Act of 2006.
14 For more information on this new law, or to submit questions to the FTB, go to the FTB’s website at https://www.ftb.ca.gov/forms/.
15 States with some form of estate tax or inheritance tax are: Alabama, Connecticut, Illinois, Indiana, Iowa, Kansas, Kentucky, Louisiana, Maine, Maryland, Massachusetts, Michigan, Minnesota, Nebraska, New Hampshire, New Jersey, New York, North Carolina, Ohio, Oklahoma, Oregon, Pennsylvania, Rhode Island, Tennessee, Vermont, Virginia, Washington state, Wisconsin, and the District of Columbia. Other states such as California have a state [email protected] estate tax commencing in 2011.