CHANGES TO LAWS REGARDING ESTATE PLANNING
Law Offices of Robert A. Briskin, a Professional Corporation
1901 Avenue of the Stars, Suite 1700, Los Angeles, California 90067
|Certified Specialist – Taxation Law
The State Bar of California
Board of Legal Specialization
CHANGES TO LAWS REGARDING ESTATE PLANNING
The following highlights certain recent developments and changes to California laws and Federal tax laws affecting estate planning.
1. Increase in 2006 of the Gift Tax Annual Exclusion. Beginning in 2006 each person’s annual gift tax exclusion increased to $12,000 per year per donee (from its former $11,000 amount). 1 This $12,000 per donee annual gift tax exclusion is in addition to the gift and estate tax exemption discussed below, and is also in addition to the unlimited gifts that a person can pay directly for a child’s educational tuition or medical expenses. Donors can even prepay educational tuition for children’s education to avoid gift and estate taxes and not have such payments applied against their annual gift tax exclusions. 2
2. Increase in 2006 of the Estate Tax and Generation-Skipping Tax Exemption. Beginning in 2006 the estate tax and generation-skipping transfer tax exemption increased to $2 million (from its former $1.5 million amount). The maximum transfer tax rate for gift, estate and generation-skipping transfer taxes is 46% in 2006. The gift tax lifetime exemption remains at $1 million. Any portion of the gift tax exemption utilized by clients for lifetime gifts reduces this $2 million estate and generation-skipping tax exemption.
3. Future Changes to Estate and Gift Tax Law. Under current tax law 3 the estate and generation-skipping exemption increases in 2009 to $3.5 million (with the gift tax exemption remaining at $1 million). The estate tax is to be repealed in 2010 (with the top gift tax rate becoming 35% in 2010) and in 2010 there is to be a carryover income tax basis of the decedent’s assets. In 2011 the entire transfer tax system is restored to a $1 million unified gift and estate tax exemption (and a maximum 55% tax rate).
In 2005 there was proposed legislation in Congress to permanently increase the gift, estate and generation-skipping tax exemptions, and also proposed legislation to permanently repeal the estate tax. Senator William Frisk recently announced that he intends to introduce to the Senate new estate and gift tax legislation in May 2006. However, in the current political climate of budget deficits, many Washington observers feel that it will be difficult for Congress to permanently reduce estate and gift taxes in 2006.
4. Increase of the 2% Interest Portion for Paying Estate Taxes in Installments on Closely Held Businesses. Beginning in 2006 the lower interest rate portion of the estate tax installment payment provisions of ‘6166 (which is subject to the lower 2% interest rate) increased to $1.2 million (up from its former $1,170,000 amount).
5. Changes in the Family Limited Partnership Area. Family limited partnerships (“FLPs”) remain a viable estate planning technique. FLPs, if prepared and utilized correctly, can still be used with grantor retained annuity trusts (known as “GRATs”) and defective income trusts. Recently the IRS has issued a taxpayer friendly private letter ruling on the tax consequences of defective income trusts. 4
However, because of recent IRS attacks on FLPs and IRS successes in court cases during 2005, proper and careful planning and documentation must be implemented to form and operate a FLP. During 2005 the IRS prevailed in attacking FLPs in the Fifth Circuit Court of Appeals case of Strangi 5 and in the Korby 6 cases under ‘2036 theories. The IRS has been successful in attacking FLPs in other tax cases where the FLP has not been properly formed or operated, or lacked a business purpose. 7 However, the taxpayer prevailed in the recent FLP case of Estate of Kelley . 8 In Estate of Kelley the Tax Court allowed the limited partnership interests to receive a 12% minority discount and a 23% marketability discount (for a blended 32.24% combined discount) for a FLP owning only liquid passive investments (in the form of cash and certificates of deposit).
6. California Domestic Partnership Law. California permits same sex couples sharing a common residence (and different sex couples sharing a common residence where one partner is at least 62 years of age and qualifies for certain benefits under the Social Security Act), to become Registered Domestic Partners by filing a Declaration of Domestic Partnership with the California Secretary of State. These Registered Domestic Partner rules are significant in estate planning since California community property laws will apply from the time that the parties became Registered Domestic Partners. Additionally, court procedures for dissolving marriages will apply to the termination of Registered Domestic Partnerships.
Registered Domestic Partners are not, however, treated the same as married couples under income and estate tax laws. For example, Registered Domestic Partners cannot file joint California or federal income tax returns nor can they take advantage of the federal estate tax marital deduction. However, there is property tax relief commencing in 2006 to permit Registered Domestic Partners to transfer real property between themselves so that the recipient Domestic Partner can then retain the property’s property tax basis under Proposition 13 (without there being a change of ownership occurring). 9
7. Planning for Clients Who Own Assets in Other States. Although California no longer has a state estate or inheritance tax, other states continue to have such taxes. 10 Clients with assets located in these other taxing states, such as clients who own out-of-state real estate, should keep in mind that even though they are California residents, their out-of-state assets may be subject to these 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 property can, in some cases, be shifted by first transferring the out-of-state real properties to a limited liability company or partnership which is formed outside of the taxing state. The ability to effectuate such tax planning will depend on the applicable state tax laws.
8. California Now Allows the Use of Unitrusts. Trust accounting issues are important where the trust income beneficiary (in the QTIP Trust it is the surviving spouse) receives all of the income and the trust’s remainder beneficiaries receive the trust assets at the income beneficiary’s death. These trusts can produce family tensions where the income beneficiary (such as the surviving spouse) desires large income distributions and may, thus, encourage the trust to invest in high yield bonds or other fixed income assets, while the remainder beneficiaries (e.g., the children) desire instead for the trust to invest only in appreciating assets (such as stocks with low dividends or appreciating real estate with little rental income).
A unitrust can solve this family trust investment dilemma. Commencing in 2006, California allows a trust to convert to a “unitrust”. 11 A unitrust is a trust that annually distributes to the income beneficiary a stated fixed percentage of the annual value of the trust assets. In a unitrust, the trust assets are appraised each year and the income beneficiary then receives each year a fixed percentage of those assets’ values (fixed between 3% and 5% of the fair market value of the trust’s assets). The unitrust payout can satisfy both the objectives of the income spouse beneficiary and the remainder children beneficiaries. For example, the unitrust assets can be invested in growth stocks, but the surviving spouse still receives the fixed annual annuity payment (i.e., between 3% and 5%) of the value of the trust assets that year.
To ensure compliance with requirements imposed by IRS Circular 230, we hereby inform you that the U.S. Federal tax advice contained in this Newsletter is not intended to be used nor has this Newsletter been written to be used, and it cannot be used, by any taxpayer for the purpose: (i) avoiding penalties under the Internal Revenue Code, or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein. No tax advice is being given by this Newsletter for any specific transaction. If you desire advice about any particular transaction, then please telephone Robert A. Briskin at 310-201-0507.
1 See Rev. Proc. 2005-70 2005-47 IRB 1 which sets forth the Internal Revenue Code’s inflation adjustment for tax items in 2006.
2 See PLR 200602002 where the IRS approved the grandparent’s prepayment of grandchildren’s educational tuition as an exclusion from gift taxes under ‘2503(e).
3 The current transfer tax exemptions and rates, along with the sunset provisions were enacted as part of the Economic Growth and Tax Reconciliation Act of 2001.
4 See PLR 200606006 released February 13, 2006.
5 89 AFTR2d 2002-2977 (5th Cir. 2005).
6 Estate of Austin Korby, TC Memo 2005-103; and Estate of Edna Korby, TC Memo 2005-102.
7 See Estate of Bongard, 124 TC No. 8 (2005) where the Tax Court said the exception to ‘2036 for “bona fide sale for adequate and full consideration” only applies where there is a “legitimate and significant non-tax reason to create the FLP.”
8 TC Memo 2005-235.
9 This property tax relief begins with lien date for 2006-07 property tax fiscal year pursuant to California Rev. and Tax. Code ’62(p). These exempt transfers include lifetime and death transfers and transfers in trust.
10 States still with some form of an estate or inheritance tax are: Alabama, Connecticut, Illinois, Indiana, Iowa, Kansas, Kentucky, Maine, Louisiana, 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.
11 See amended Probate Code ‘16328. The IRS issued Regulations under ‘643 permitting beneficiaries entitled to trust “net income,” to have that net income determined through exercise of the power to adjust, and permits a trust to switch the method for determining net income without producing adverse tax consequences.