Tax Law Changes Affecting Estate Planning, November 2008
RE: TAX LAW CHANGES AFFECTING ESTATE PLANNING
We will probably continue to have a federal estate tax. However, with proper planning, clients can reduce or eliminate this tax. Federal interest rates are currently low, and the economic recession has lowered asset values. These two items increase planning opportunities to make tax-free transfers of businesses, real estate and other investments to children and grandchildren.
1. WHAT ARE THE LIKELY FUTURE CHANGES TO THE ESTATE TAX LAWS?
With the new President and Congress, the following are the likely potential changes to the federal estate and gift tax laws:
1.1. Changes to the Federal Estate Tax Rates and to the Estate and Gift Tax Exemptions. Under current law, during the 2008 taxable year, the federal estate tax exemption is $2,000,000 per person, while the gift tax exemption is $1,000,000 per person. This estate tax exemption increases to $3,500,000 in 2009. Under current law, in 2010 the estate tax is scheduled to be repealed, with reinstatement of this tax in 2011 with only a $1,000,000 exemption and a top tax rate of 55%.
Based upon the candidates’ political statements during the election, the federal estate tax exemption is likely to remain at a minimum of $3,500,000, and the top estate and gift tax rate will be in the 35% to 45% range.1 There has also been discussion to unify the gift and estate tax exemption to one amount.
1.2. Portability of the Federal Estate Tax Exemption Between Spouses. Both Democrats and Republicans in the past have proposed to have a “portability” between spouses of the federal estate tax exemption. If enacted into law, “portability” means that one spouse could transfer their $3,500,000 federal estate tax exemption to the other spouse. In other words, the estate tax exemption of the deceased spouse could be used by the surviving spouse without having to utilize a Bypass trust. “Portability” would thus allow both spouses, in the aggregate, to leave a total of $7,000,000 estate tax-free (assuming a $3,500,000 estate tax exemption) to their family upon both spouses’ death.
1.3. Adjustment to Assets’ Income Tax Basis At Death. Under current law, an asset’s income tax basis is adjusted at death to its fair market value (which means an asset’s basis could increase or decrease from its adjusted cost basis depending on the asset’s date of death value). This income tax rule, however, expires in 2010 (along with the expiration of the estate tax), and is reinstated in 2011. Proposed tax law changes have included preserving the current adjustment to an asset’s income tax basis at death (the so-called “step-up” in basis tax rule).
1.4. Does California Intend to Enact a New Estate Tax or Inheritance Tax? No legislative proposals have been made to reintroduce such a tax in California. Additionally, there is no proposal pending at the federal level to reenact the federal state death tax credit.
2. RECENT DEVELOPMENTS WITH VALUATION DISCOUNTS.
Grantor retained annuity trusts (“GRATs”), family limited partnerships (“FLPs”), transfers of closely held corporate stock and intentionally defective income trusts (”IDTs”) all depend upon valuation discounts to transfer assets tax-free to family members. Valuation discounts include discounts for minority and lack of marketability, along with discounts for built-in corporate income tax liabilities. In the past, Congress has discussed tax legislation which would repeal valuation discounts for assets owned by family members. Although it is unclear if any such legislation will be enacted in the near future, Congress may consider enacting such legislation to offset lost federal revenues from an increased estate tax exclusion and lower estate tax rates.
2.1. Current Status of Valuation Discounts. For properly structured FLPs, the IRS on recent audits has allowed marketability discounts in the 20 – 25% range (depending on the type of assets such as real estate or marketable securities), plus minority or lack of control discounts in the 15 – 25% range. Therefore, total blended valuation discounts in the 32% to 44% range are currently being allowed on audits by the IRS. A FLP may even own marketable securities and the FLP’s limited partnership interests may still receive a valuation discount.2
2.2. How to Preserve Valuation Discounts for FLPs. Recent cases and IRS audit positions indicate that valuation discounts for FLP interests3 are respected only where partnership formalities are observed. Past IRS attacks on FLPs have included assertions that the decedent retained a prohibited enjoyment of the FLP’s assets under §2036. To avoid an IRS attack on a FLP, the following items should be followed: (i) The FLP should be funded first with its assets, followed by gifts to family members of that FLP’s partnership interest. (ii) Do not pay personal expenses from a FLP, commingle the FLP’s assets with personal assets or take personal loans from the FLP. (iii) FLP distributions should be made proportionately among the partners based upon their partnership percentage ownership and should be made on a regular basis. (iv) Estate taxes should be avoided being paid from the FLP. If there are not enough liquid assets in the estate to pay such taxes, then consider borrowing monies from a third party bank or from another family member in order to pay these taxes, and secure that loan by the FLP’s partnership interests. (v) Clients forming FLPs should keep outside of the FLP enough liquid assets to maintain their personal lifestyles. (vi) Finally, if possible, the FLP should be formed well in advance of death.
It is also helpful if the FLP’s formation has a business purpose as was shown in the LLC case of Estate of Anna Mirowski4. Additionally, in the Mirowski case, the fiduciary duties of the LLC manager towards the other LLC members were preserved in the LLC’s operating agreement.
2.3. Increasing Valuation Discounts by Creating Multi-Level Entities. Multi-level valuation discounts were allowed by the Tax Court in the recent case of Jane Z. Astleford5. In Astleford, the taxpayer owned a FLP interest, which FLP in turn owned an interest in a general partnership. The taxpayer/donor of the FLP’s limited partnership interest was allowed a 16% minority interest and a 21% lack of marketability valuation discount for their FLP limited partnership interest, plus the underlying general partnership interest owned by the FLP was valued using a 30% blended valuation discount for minority interest and lack of marketability. Accordingly, a total combined valuation discount of 54.5% was produced (30% discount of the underlying general partnership interest plus a 35% combined valuation discount of the FLP limited partnership interest). In addition to these valuation discounts, the Court allowed a “market absorption” valuation discount to the general partnership for its land holdings, since the general partnership’s sale of a large amount of its land would cause a reduced sales price for that land.
Multi-level valuation discounts have been allowed in other Tax Court cases6. Multi-level valuation discounts for partnerships owning other partnerships (or even fractional interests in real estate) are a powerful tax planning tool to produce substantial valuation discounts. When setting up multi-layered owned entities to achieve greater valuation discounts, it is helpful to show a business purpose for the establishment of each entity layer. For example, a second-tiered partnership entity may need to be established in order to have other family members or outside third parties invest in that second-tiered partnership.
2.4. No Indirect Gift to FLP. Holman and Bianca Gross7 held that valuation discounts were respected for a gift of limited partnership interests where the FLP’s assets were contributed to the FLP shortly before the FLP limited partnership interests were gifted to the children. The Tax Court held that there was no indirect gift of these contributed assets, and that the FLP was recognized along with the gifts of FLP interests.
2.5. Stock Valuation Discounts for the Built-in Corporate Tax. Valuation discounts for corporate income tax liability on a hypothetical sale of that corporation’s assets can produce significantly lower stock values for lifetime gifts and for transfers at the death of a shareholder. In Estate of Frazier Jelke8, the amount of this discount for income tax liabilities was allowed by the Eleventh Circuit to be the actual full dollar amount of this hypothetical income tax (without any liability reduction for the fact that such asset sale may occur many years in the future). The Jelke decision is consistent with the Fifth Circuit’s decision in Estate of Dunn9. However, the Tax Court has not yet agreed with the Courts of Appeal in the Jelke and Estate of Dunn decisions. Thus, it remains unclear here in the Ninth Circuit if the Jelke decision will apply.
3. ANNUAL GIFT TAX EXCLUSION INCREASES FOR 2009.
In 2008, each person is permitted to gift tax-free each year the annual gift tax exclusion amount of $12,000 per donee. This annual gift tax exclusion increases to $13,000 per donee for the 2009 calendar year (thus, a total of $26,000 for husband and wife).10
4. CAN FORMULA VALUATION CLAUSES BE UTILIZED TO MAKE GIFTS?
Yes, in certain circumstances formula clauses can be used to avoid a gift tax should the IRS later revalue that gift, as in the Fifth Circuit’s decision in Charles T. McCord, Jr.11 In Estate of Christiansen12, the beneficiary of an estate made a disclaimer on terms which stated that if the IRS changed its valuation, an additional amount would go to a private foundation controlled by the decedent’s family. Taxpayers under McCord can make defined value gifts, and if there is a later IRS revaluation of that gifted asset, then the increased value of that asset can go to a charity (instead of generating a gift tax).
5. IRS ISSUED A FAVORABLE PUBLISHED REVENUE RULING FOR INTENTIONALLY DEFECTIVE INCOME TRUSTS.
Intentionally defective income trusts (known as IDTs) can shift significant amounts of assets tax-free to children and grandchildren. Under an IDT, the grantor remains taxed on all of the trust’s income, but the trust’s assets are not included in the grantor’s estate for federal estate tax purposes. To shift asset values to family members, the IDT purchases assets from the grantor in exchange for an installment promissory note. Because the IDT is deemed owned by the grantor for income tax purposes, no gain is recognized on this grantor’s sale of assets to the IDT (including no interest income on the promissory note). The goal is to have the IDT’s purchased assets appreciate faster than the interest rate paid back to the grantor under the promissory note. With current low AFR interest rates, IDTs are an attractive estate planning tool. The key to making this IDT work is to include a trust provision which makes the IDT taxable to the grantor for income tax purposes, while not causing the IDT’s assets to be included in the grantor’s estate for federal estate tax purposes. The IRS held in Rev. Rul. 2008-2213 that an IDT provision which permitted the grantor to remove assets out of the IDT, and then replace such assets with substituted assets of equivalent value, will create a “grantor trust” for income tax purposes, and such a power of substitution will not cause the IDT assets to be included in the grantor’s estate for estate tax purposes under §§2036 or 2038.
6. LOWER FEDERAL INTEREST RATES ENABLE CLIENTS TO NOW GIFT A GREATER AMOUNT OF ASSETS TO FAMILY MEMBERS TAX-FREE.
Clients’ ability to make gifts using GRATs or to transfer assets to their children using an IDT is directly dependent upon federal interest rates. Where federal interest rates are low, increased tax-free gifts can be made using GRATs and IDTs. For November, 2008, the §7520 interest rate for determining the present value of a GRAT annuity is a low 3.6%.14 Interest rates which can be utilized for IDTs are even lower. For example, the November, 2008 midterm AFR interest rate for quarterly promissory note payments is a low 2.94%. With the current recessionary economy, these low federal interest rates are likely to continue into 2009, giving clients tax planning opportunities to transfer assets to younger generation family members.
This Newsletter is not tax or legal advice for any client. Each client’s estate plan and tax situation contains unique facts. Thus, clients should consult their own tax and legal advisors as to their own estate plan.
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.
2 See Tax Court cases of Estate of Anna Mirowski, T.C. Memo 2008-74; and Thomas H. Holman, 130 T.C. No. 12 (2008).
3 These same types of FLP valuation discounts also apply to family owned limited liability companies.
4 T.C. Memo 2008-74.
5 T.C. Memo 2008-128.
6 See, for example, the following Tax Court cases: Estate of Piper, 72 T.C. 1062 (1979); Janda, T.C. Memo 2001-24; Gow, T.C. Memo 2000-93; and Gallun, T.C. Memo 1974-284.
7 T.C. Memo 2008-221.
8 100 AFTR2d 2007-6694 (11th Cir. 2007), cert. den. U.S. Sup. Ct. (2008).
9 90 AFTR2d 2002-5527 (5th Cir. 2002).
10 See Rev. Proc. 2008-66 which modified the exclusion amount under Section 2503.
11 98 AFTR2d 2006-6147.
12 130 T.C. No. 1 (2008).
13 In order to avoid an IRS §2036 or §2038 claim, the IDT should preserve the fiduciary duties of the trustee to insure that the assets which the grantor substitutes in the IDT have the equivalent value of the assets which the grantor withdrew from the trust. Also, the IDT trust documents should specify that this asset substitution power cannot be used in a manner which would shift the benefits among the trust beneficiaries.
14 See Rev. Rul. 2008-50.