New Estate Planning Pitfalls – Need for careful planning and follow-through

The Tax Relief, Unemployment Insurance Reauthorization and Job Creation Act of 2010 gives us a two year window for significant estate tax planning, ending December 31, 2012. However, this comes with some serious planning issues. Here are two:

One pitfall of the new law: The new portable credit requires a proactive election by the executor at the first death. Like the frequent failure to make proper QTIP and GST allocation elections, this is an area subject to risks. For example, if the assets are in trust, the survivors may choose not to appoint an executor, missing the opportunity to save the unused credit for the second death.

Also, the portable exemption amount only applies to the unused exemption from the last spouse. For multiple marriages, only the most recent spouse’s amount is available. In addition, an election must be made in the estate of the first spouse to die to preserve the unused exemption and allow for its use by the last deceased spouse.

Second, old trusts that had too much going to the credit portion, the beneficiaries of which are not your spouse, then he or she could be left with very little from your estate.

Please see Estate Planning Overview for definitions and tax impacts, and “to do” list.

Estate Planning – Techniques for Reducing Taxes in Large Estates

The change in the tax law from the Tax Relief, Unemployment Insurance Reauthorization and Job Creation Act of 2010 gives us a two year window for significant estate tax planning, ending December 31, 2012.

Instead of a $1 million lifetime cap, you can now gift up to $5 million. When your spouse joins in, a major amount of wealth can be transferred. This makes it important to act now, because the law could change in for 2013.

Leveraged Gifting – you can use a defective irrevocable trust (the defective grantor trust is discussed below) to fund an installment purchase of assets from you to the trust over time. The trust is “defective” so that there is no taxable transaction and no gain; it is as if you are selling to yourself. With the installment sale, a note is used and has to bear interest at the IRS mandated rates, the lowest rate of interest allowed. The goal is to repay the note using appreciated assets, where the transfer back to you is also not taxed, and complete the repayment before you die. If it is not completed, the note is an asset taxable in your estate.

Dynasty Trust – you can use the increased generation skipping transfer tax (GST) to pass more to grandchildren and future generations. Again, the new limits allow you to pass far more on to future generations.

Life Insurance Trust – an irrevocable trust that holds insurance for whatever purpose you design, while be excluded from your taxable estate. Your trustee would purchase insurance on your life. The risks of this alternative are that it is irrevocable and that the cost of the permanent insurance is very high.

Second-to-die Life Insurance – a trust that purchases second-to-die life insurance crates a source to pay estate taxes while not increasing the taxable estate.

GRAT – Another alternative is the grantor retained annuity trust (“GRAT”), which uses some portion of your unified credit as a window through which to pass assets at a discount created by the IRS tables that tell us what the asset gifted will be worth at the end of the term of the trust. You receive annuity payments during the term and the principal passes to your children at the end of the term. (This is why it must be funded with “excess” wealth – if you give the trust a term of 20 years but live many years thereafter, there will be many years during which you have foregone the benefit of the assets gifted). The expectation is that the principal will actually be worth more than the amount you gift to the trust, with such increased value escaping estate taxes. Under the new law, there are no GRAT or value limitations.

Cautions: First, the securities laws will treat you as the owner of trust assets for any restrictions on dealing with publicly traded stock. Second, if you die before the end of the term, assets revert to your estate and the structure collapses to look as if nothing was done. Last, a twist: if you stipulate that the trust will not terminate at your death, you substantially reduce the amount that gets thrown back to your estate, reducing the risk of not living through the term of the trust.

Tax inclusive and exclusive – the Sam Walton strategy can used when you want to transfer more than your unified credit alone will allow. If you make a taxable gift, it is tax exclusive (the tax comes from other assets). Thus, the tax is calculated as a percent of the gift. If you die owning the asset and it then passes to your children, it is tax inclusive as the tax is calculated as the total amount, so less of the assets pass to your children. QPRT – The qualified personal residence trust (“QPRT”) uses the unified credit and discount of a future value like the GRAT but applies it to your residence. Thus, both the benefits and risks are similar; it is the asset that differs.

“Defective” grantor trust – The “defective” grantor trust is effective for gift tax purposes and “defective” for income tax purposes so that assets are not included in your estate and yet you pay the tax on their appreciation. Paying the income taxes without any gift tax cost effectively gives away additional wealth. Again, you can leverage this with an installment sale.

Family Limited Partnership – the family limited partnership (“FLP”) is a partnership that you form, acting as the general partners and the limited partners. You transfer assets into the FLP such as any commercial real estate or your shares in your company. When this is complete, you can gift limited partnership interests to your children. Because only the general partners have any say in the management of the FLP, the IRS allows for a discount to the value of the limited partners interest. This discount is 35 to 40%, so more is passed to children without using up your unified credit. Unlike the other alternatives delineated below, when you transfer limited partner interests, your children receive the benefit now. In addition, you have the burden of tax returns for the FLP, as well as tax liability for children who may not receive distributions from the FLP to cover the taxes.

Charitable Remainder Trust – This charitable remainder trust (“CRT”) is a trust that pays a fixed annuity to you and then distributes the remaining principal to charities. You get a gift charitable deduction for the net present value of the future distribution to charities.

Charitable Lead Annuity Trust – This reverses the CRT, where a trust that pays a fixed annuity to charities selected by its trustees and then returns the remaining principal to you or to your estate. You get a gift tax deduction for the actuarial value of the annuity payments to charities or an estate tax charitable deduction.

Caution – you have an investment risk in each vehicle, where failing to generate the larger principal value in the future that you count on to use the strategy will frustrate its purposes. This is the risk of selecting assets that are expected to soar in value but instead collapse. Therefore, none of these alternatives should be considered until you are comfortable that you have “excess” wealth to pass to your children or to a charity and comfortable that you can make a commitment to do so that cannot be reversed. If you say “no” out of lack of comfort or confidence in any strategy, then you will want to stick to a basic plan for now.

What about the Future? Most observers expect the $5 million exemption to stay, along with the 35% estate tax rate. The exemption could be lower, or the rate increased. All of this is reason to review the ideas below and then update your estate plan.

Please see Estate Planning.

Estate tax update

As anticipated, Congress lifted the estate tax credit for 2011 from $1 million to $5 million, lowering the rate from 55% to 35%. Also, the date-of-death value again serves as the basis for estate assets. Also, the exemption is portable, viz. the un-used portion can be carried cover gifts by or the estate of the surviving spouse. Finally, the exemption will be indexed for inflation. (Estates can elect to use the 2010 rules for $1.3 million carry over basis for heirs).

There are some special rules: up to $1,020,000 of real property used for farming or business can get a discounted valuation; and when a closely held business comprises more than 35% of an estate, then as much as $476,000 of estate taxes can be deferred at a cost of 2% (charged by theirs).

In 2013, the exemption again falls back to $1 million and the rate goes back up to 55%, unless Congress again takes action.

For any 2010 estates, the retroactive action provides requires estates with a date-of-death valuation in excess of $1.3 million to file informational returns to report the carry over basis to the IRS and to heirs (as well as the $3 million for assets passing to a surviving spouse).

See more at Estate Planning.

(or contact us with your questions at Contact Us.)

Possible tax law changes and tax planning opportunities

From the predictions we see, Congress will be reviewing and in most cases renewing certain tax cuts. They will also pass some additional tax changes.

Here is a summary of what is expected to become law (let me know if you need more detail):

The following expired provisions are expected to be renewed: The tax free status of distributions made directly from IRAs to charity; the add-on to the standard deduction for state and local property taxes; tax breaks for state sales tax, college tuition and teachers’ school supplies; 15-year write-offs for restaurant renovations and leasehold improvements; and the R&D tax credit. The will also be a small business tax cut for hiring (let me know if you need details).

2010 is the year for Roth IRA conversion strategies, where the taxes can be paid over two years. Because of market volatility, you may want to have separate IRAs by asset classes so if one goes down, you can “un-convert”. (See prior posts on this) Note, however, that Roth conversion income can affect Medicaid premiums and taxation of Social Security benefits.

Also expected is an increase of tax rates for income and capital gains taxes for high income tax filers, where one possibility is raising the top tax rate to 39.6% on singles with taxable income above $196,000 and on married couples for taxable income over $231,000. With this could be a top capital gains rate of 20% for this group, up from 15% now. Itemized deductions could be affected as well – perhaps by capping at 28% the rate at which itemizations reduce a filer’s tax liability.

Future changes to tax rates will affect planning for 2010 – taking more income and possibly selling assets then later buying them back to up the basis for future sales.

The item still missing from the list is the fix for the estate tax (see prior posts on this). The expected change will be reviving the estate tax retroactive to January 1. However, Democrats support a $3.5-million exemption amount and a 45% rate while Republicans want $5 million and 35%. If no action is taken, 2010 will continue to have no estate tax and 2011 will have a $1 million exemption with a 60% top rate.

If you want to consider how this all applies to you, for income taxes or estate planning, let us know.

Let us know if you have questions or comments. Thanks,

Steven

Planning for Tax Law Changes – the Investment Piece

Among the anticipated changes in taxes for individuals are the increase of the long-term capital gains rate from 15% to at least 20% and the elimination of the qualified dividend rate of 15%. How do you respond? That depends on several factors.

If the investments are tax-sheltered, as in an IRA or 401(k) plan, then the change has no impact: current growth is sheltered and withdrawals are always taxed as ordinary income. If the investments are in a taxable account, then the analysis involves your long-term plans and investment style. On the long-term capital gains, if you may be selling investments soon, doing so now and buying back (subject to the wash sale rules, if applicable), would increase your basis so that less would be taxed later at a higher rate. However, if you plan to hold investments long-term, there is little reason to react now. That is, the increased tax far in the future is less, on a net present value basis, than paying a lower tax today.

The long-term capital gains tax is still likely to be less than the maximum marginal rate, so converting what would be earned income into capital gains remains attractive (e.g., the basis for exercising and holding Incentive Stock Options)

As for the dividends tax, again this depends on your investment strategy. If you believe that the proper stocks or funds include those that distribute dividends, then the tax cost is part of your analysis in selecting those investments over funds or stocks that do not pay dividends.

As with any decision regarding the tax impact on investments, it is the investment strategy that should rule the outcome.

We will report more on possible tax changes and related strategies in upcoming newsletter posts.

Let us know if you have questions or comments. Thanks,

Steven