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1 REPEAL OF THE “REPEAL” OF THE ESTATE TAX UNDER THE 2001 ACT BY THE 2010 ACT AND THE PROPOSED COORDINATION OF THE GRANTOR TRUST RULES AND THE TRANSFER TAX RULES – PLANNING IN 2012 Seattle Estate Planning Council Dinner September 19, 2012 The Rainier Club Seattle, WA 5:30 pm Lawrence Brody, Esq.Bryan Cave LLP Copyright 2012. Lawrence Brody. All Rights Reserved.

2 2 The Economic Growth and Tax Relief Reconciliation Act of 2001 (the “2001 Act”) had been widely reported to “repeal” the federal estate tax. However, all of the provisions of the Act (including repeal of the estate tax) were temporary and would have expired (would have “sunsetted”), unless Congress provided otherwise prior to December 31, 2010. Accordingly, under the 2001 Act, after 2010, absent congressional action, the estate, gift and generation-skipping taxes were to be reinstated under prior law, so that the estate tax and the GST tax were repealed for only the twelve months of calendar year 2010 (and the gift tax wasn’t repealed even for 2010). 3931897

3 3 The Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 (the “2010 Act”), enacted on 12/17/10, postponed that sunset for two years, until December 31, 2012, and introduced a number of new helpful (but not totally clear) transfer tax concepts.

4 4 Attached Comparison Grid The attached grid summarizes the major transfer tax provisions of pre-2001 Act law, the 2001 Act, and the 2010 Act.

5 5 Estate, Gift and Generation-Skipping Tax Provisions Comparison Among re-2001 Act Law, the 2001 Act, and the 2010 Act PROVISIONPRE-2001 ACT LAW2001 ACT2010 ACT Estate tax ratesGraduated rates ranging from 18 to 55 percent. Repealed rates in excess of 50 percent in 2002; 2003 through 2006, reduced rate by one percentage point per year; in 2007 through 2009, 45 percent maximum estate tax rate; tax repealed on January 1, 2010; pre- 2001 Act rates reinstated in 2011. Maximum rate of 35% Postpones reinstatement of pre-2001 Act rates until 2013 Five-percent surtax5-percent surtax on transfers in excess of $10,000,000 but not exceeding $17,184,000. Repealed the 5% surtax; effective for decedents dying after December 31, 2001; 5% surtax reinstated in 2011. Postpones reinstatement until 2013 Applicable Exclusion Amount (Unified Credit) Unified credit equivalent amount in 2002 and 2003, $700,000; in 2004, $850,000; in 2005, $950,000; in 2006 and thereafter $1,000,000. Increased Applicable Exclusion Amount in 2002 and 2003, to $1 million; in 2004 and 2005, to $1.5 million; in 2006 through 2008, to $2 million; in 2009, to $3.5 million; dropped to $1 million in 2011. Exemption of $5 million per person/$10 million per couple; indexed for inflation to $5,120,000 in 2012. Postpones reinstatement of pre- 2001 Act exemption until 2013 Provisions affecting small and family-owned business and farms Special use valuation (reduced market value by $750,000); family- owned business and farm deduction (allowed an additional $675,000 deduction); and allowed installment payments at reduced interest rates. Repealed family-owned business and farm provisions in 2004 (retained special use valuation and installment payment provisions).

6 6 Estate, Gift and Generation-Skipping Tax Provisions Comparison Among re-2001 Act Law, the 2001 Act, and the 2010 Act (cont’d) PROVISIONPRE-2001 ACT LAW2001 ACT2010 ACT Basis of property acquired from a decedent Non-I.R.D. property passing from a decedent’s estate generally took a stepped-up basis, meaning fair market value. Effective January 1, 2010: property passing from a decedent’s estate took carryover basis; estate may elect to step-up basis in $1.3 million of non-IRD assets; an additional $3 million of property transferred to (or in some trusts for) a surviving spouse may receive stepped up basis; basis step-up is reinstated in 2011. Allow estates of decedents who died in 2010 to elect out of estate tax/stepped-up basis regime into no estate tax/modified carry-over basis regime. Gift tax provisionsAnnual exclusion of $10,000 to each donee during the taxable year; exclusion of $20,000 if spouse consents to split the gift with donor spouse; unified credit may be used during life to shelter transfers from gift tax. Effective January 1, 2002, retained gift tax provisions, including annual exclusions, with reduction in the rates; credit increased to $1 million for lifetime gifts effective January 1, 2002 and thereafter, including after 2009; as of January 1, 2010, rates set at highest individual income tax rate. Gift exemption for 2010 remains at $1 million; increases to $5 million thereafter; indexed for inflation to $5,120,000 in 2012; maximum rate 35%. Postpones reinstatement of pre-2001 Act exemption until 2013.

7 7 Estate, Gift and Generation-Skipping Tax Provisions Comparison Among re-2001 Act Law, the 2001 Act, and the 2010 Act (cont’d) PROVISIONPRE-2001 ACT LAW2001 ACT2010 ACT Generation skipping transfer taxes Imposed a 55-percent transfer tax on amounts in excess of $1 million exemption for transfers to or for the benefit of a beneficiary one or more generation below that of the transferor. Effective January 1, 2002, coordinated rates with the maximum estate tax rates; effective January 1, 2004, coordinated GST Exemption with deathtime Applicable Exclusion Amount; repealed tax after December 31, 2009; current rates and exemption reinstated in 2011. GST exemption increased to $5 million per transferor; indexed for inflation to $5,120,000 in 2012; GST rate for 2010 is 0%; thereafter is 35%. Postpones reinstatement of pre-2001 Act exemption (adjusted for inflation) until 2013 Portability of Estate Tax Exemption No provision. Allows surviving spouse to use unused estate tax (but not GST tax) exemption of last prior deceased spouse, if deceased spouse’s estate elects; this exemption is not indexed.

8 8 Planning During 2012 Under the 2010 Act 1.Planning with the increased gift exemption(s). Clients who have not used any part of their lifetime gift exemptions could make gifts of up to $5,120,000 in 2012; clients who have used their full $1 million gift exemption (or have even exceeded their gift exemption and paid gift tax) could make an additional $4,120,000 gift in 2012. Even with the increased gift exemption, clients should continue to make full annual exclusion gifts as well as gifts for education and medical expenses to or for all of their donees.

9 9 Based on the way the instructions to the Form 706 indicate adjusted taxable gifts are calculated in completing a decedent’s estate tax return, for a decedent dying after 2012, if the estate exemption were to go back to $1 million or $3.5 million, technically the gift exemption used in 2011 or 2012 which exceeds the estate tax exemption available at death would be added back to adjusted taxable gifts in determining the decedent’s estate tax. This is what has become known as “clawback” of the excess gift exemption. The use of the increased gift exemption should, accordingly, only be used to gift assets which have great appreciation potential and/or which generate substantial income (or, in a perfect world, both).

10 10 Although the creation of QPRTs (especially in an era of low interest rates) isn’t particularly leveraged, the decline in home values and the increase in gift exemption may increase interest in QPRTs. As discussed below, the increased gift exemption(s) could be used to give economic substance to a proposed sale of assets or a loan to a trust, perhaps eliminating the need for, or reducing the level of, beneficiary guarantees. Use of the increased gift exemption(s) should likely be made to grantor trusts, to increase the transfer tax leverage of the transaction – allowing the grantor to pay the income tax on trust income and gains without a gift, increasing the value of the trust and decreasing his or her remaining estate taking advantage of what has been called the “tax burn” of grantor trust planning.

11 11 The 2010 Act did not change the rules with respect to discount planning or short-term GRATs, both of which are still viable planning options (although the President’s Budget proposes changing both). Using the increased gift exemption of the wealthier spouse to create a lifetime non-marital trust for the less wealthy spouse could move the increased exemption plus appreciation and undistributed income out of both spouse’s estates and give the spouse/beneficiary broad access to the trust assets (and the donor spouse indirect access to them, through the donee spouse).

12 12 A pattern of distributions to the donee spouse which were given back to the donor spouse (or put in a joint account) would raise an implied retention issue for estate tax purposes for the donor spouse. If one spouse were wealthy enough not to need an interest in a trust created by the other spouse, a safer strategy would be for the wealthier spouse to create a non-marital trust for the less wealthy spouse and for that spouse to create a trust for the children, perhaps using funds gifted from the wealthier spouse, using both of their increased gift exemptions. Using the increased gift exemption to create a non-zeroed out charitable remainder or lead trust could combine the increased exemption with a donor’s charitable goals.

13 13 2. Planning with increased lifetime GST exemption(s). As noted above, unlike the use of the increased gift exemption, use of the increased lifetime GST exemption cannot be subject to clawback. As also noted above, to further increase the transfer tax leverage of using the increased gift exemption during 2012, clients should consider making gifts of the increased gift and GST exemptions into long-term, inter-generational “dynasty” trusts.

14 14 In addition to keeping the property out of the transfer tax system for an extended period of time (perhaps forever), keeping the gifts in trust will provide creditor and spousal claim protection – protection from creditors and predators – as well as investment management and protection for the beneficiaries, for the trust’s extended term. If loans, rather than gifts, were made in 2010 to GST trusts (because until the 2010 Act, there was no GST exemption to allocate to those gifts), a gift of the increased exemptions could allow the trust to partially or fully repay them.

15 15 3. Reviewing existing estate planning documents because of the increased estate and GST exemption(s). Because the increase in the estate and GST exemption(s) are only in effect for two years, absent further Congressional action, not all client estate plans will need to be reviewed and amended to reflect those higher exemptions. However, there are some situations where existing documents will need to be reviewed and likely amended, especially those where the increased exemption(s) will likely distort the client’s plan, such as:

16 16 a.Formula-driven plans for a married couple involving a credit shelter trust and a marital gift where, if one client were to die in 2012, funding a credit shelter trust with $5,120,000 might leave the surviving spouse less outright than he or she would be comfortable with. b.Formula-driven plans where gifts to grandchildren or trusts for their benefit will be over-funded, reducing the amount going to a surviving spouse or to children. c.Formula-driven plans for a married couple, such as in second marriage situations, where the credit shelter trust was for the benefit of children by a prior marriage, which could disinherit the surviving spouse. d.Formula specific bequests of the estate or GST exemption to other than descendants.

17 17 Wills or trusts which leave everything to the surviving spouse or which use disclaimer plans – under which everything is left to the surviving spouse but allow him or her to disclaim any or all of the gift into a credit shelter trust for his or her benefit – would seem not to require review because of the increased exemption(s). Similarly, a bequest to a “one lung” trust which would qualify as a QTIP (if a total or partial QTIP election were made for it) could add flexibility to the plan, without requiring an outright bequest to the surviving spouse.

18 18 4. Planning for the possible use of portability of the estate tax exemption. While portability has been touted as one of the attractive benefits of the 2010 Act, there are a number of reasons why it may prove not to be helpful in many situations. The sunset provision of TRA provides that portability will disappear after 2012, and the costs of portability may not be sustainable (although the President’s Budget proposes that it would be permanent, as does the Middle Class Tax Cut Bill, described above). The inability to preserve the first spouse’s unused GST exemption favors the use of credit shelter trust planning for wealthy decedents (applying the decedent spouse’s GST exemption to that trust, assuming that it benefits skip persons).

19 19 The portability concept strongly encourages the filing of federal estate tax returns for all married decedents dying in 2011 or 2012, in order to preserve the availability of the portable exemption; could it be malpractice not to at least recommend the filing of a return to elect portability, even if the odds of the second death in 2012 are small? In fact, there appears to be no reason (other than costs) not to do so, even if the surviving spouse is less wealthy – they might win the lottery or remarry well. On the other hand, while portability might not be planned for, where both spouses die in 2011 or 2012, and the first spouse to die left everything to the survivor, it may be useful for a number of reasons.

20 20 5. Planning with the increased lifetime exemption(s) to “fix” existing gifts, sales, loans, etc. One possible use of gifting the increased gift and GST exemptions may be to “fix” existing broken insurance or estate planning transactions. Where split-dollar or private premium financing arrangements were created without a “exit strategy” to allow the advances or loans to be repaid during the insured’s lifetime, use of increased gift and GST exemptions could create side-funds as the exit strategy.

21 21 Even if the split-dollar or premium financing arrangement or the installment sale is not under-water, having the lender or seller forgive all or part of the loan, advance, or note would simplify the transaction (although, under the split-dollar regulations, the forgiveness of interest due in premium financing would be a gift of that interest and would be subject to a penalty). As noted above, if an installment sale relied on guarantees to give the transaction substance, a gift of the increased exemption to the purchasing trust may allow the guarantees to be released or at least reduced.

22 22 6. Insurance planning with the increased lifetime exemption(s). Being able to transfer the increased gift and GST exemptions into an irrevocable life insurance trust could eliminate the need for more complex transactions, such as split-dollar or private premium financing, to fund large premiums – increasing the simplicity of funding premiums for large policies.

23 23 Transferring the increased exemptions into an ILIT in 2012 would allow the trustee to either purchase a single premium policy (which would create an inflexible modified endowment contract) or to invest the gift and pay premiums as they became due out of the trust’s investment account (with the grantor paying the tax on the account’s income). As noted above, the increased gift and GST exemptions may be useful in “fixing” old insurance transactions that have gone upside down, by allowing notes or split-dollar arrangements to be paid off early.

24 24 As noted above, the increased gift and GST exemptions could be used to create a side fund in an insurance trust which had entered into a loan or split-dollar arrangement, which wasn’t created originally, to allow an earlier, lifetime “rollout” of the transaction from non-policy values. If termination of a pre-Final Regulation split-dollar arrangement involving an ILIT would be treated, under Notices 2002-8 and 2007-34, as a transfer, for transfer tax purposes, of any policy values remaining after repaying the premiums advanced, the increased gift and GST exemption, could be used to protect these transfers; in fact, because of those increased exemptions, clients who were hesitant to terminate pre-Final Regulation arrangements, because of the potential transfer tax consequences, may decide to do so this year.

25 25 Effect of the Scheduled Sunset of the 2001 Act in 2013 1.Under the “as if it never enacted” rule of the 2001 Act, all of the provisions enacted as part of EGTRRA would be repealed retroactively (as if never enacted) after 2012, because the 2010 Act merely postponed the repeal of these provisions for two years.

26 26 2.Treating EGTRRA as if it had never been enacted beginning in 2013 means that all of its helpful GST provisions described above, (which clients and practitioners have relied on since 2001) will disappear, retroactively, as if they had never existed. What do/what should/what can practitioners do thereafter for trusts that had been severed under those rules, trusts that had relied on automatic allocation of GST exemption (either intentionally or inadvertently), or trusts that had been severed or granted Section 9100 relief?

27 27 3.But, treating EGTRRA as if it had never been enacted beginning in 2013 is the best argument against clawback of the use of increased gift exemption, if the estate tax exemption at death is smaller.

28 28 Coordination of the Grantor Trust Rules and the Transfer Tax Rules 1.One of the most interesting transfer tax proposals made in the President’s 2013 Budget is the one described as designed to “coordinate certain income and transfer tax rules applicable to grantor trusts”. This proposal is new (although the rationale for having different income tax and transfer tax sensitive powers has been discussed for some time); the proposal addressing the subject of beneficiary grantor trusts (BDITs) is not only new, it is a surprising recognition by Treasury of their use.

29 29 2.The proposal indicates that the reason for the change is that the lack of coordination between the income and transfer tax rules that apply to a grantor trust creates opportunities that result in a “transfer of significant wealth... without transfer tax consequences”.

30 30 3.The proposal provides that: “To the extent that” the income tax rules treat a settlor of a trust as the owner of the trust for income tax purposes: The assets of the trust would be includable in the gross estate of the settlor for estate tax purposes; Any distribution from the trust to a beneficiary during the settlor’s life would be subject to gift tax; and Any trust assets when the trust ceases being a grantor trust during the settlor’s life would be treated as having then been transferred to the trust.

31 31 4.If a non-settlor is treated as the owner of a trust (as in a BDIT transaction), if that beneficiary engages in a sale or exchange with the trust that would have been subject to capital gains tax, but for the grantor trust status of the trust from the beneficiary’s point of view, the proposal would subject the value of the trust, net of the consideration received by the beneficiary, to estate tax at the beneficiary’s death; that tax would be paid by the trust.

32 32 5.The proposal would not change the treatment of any trust which is a grantor trust and which “is already includable” in the grantor’s gross estate (presumably meaning “could be includable”, because of the grantor’s death during the term), such as GRATs and QPRTs. 6.The proposal would be effective for trusts created on or after date of enactment and, subject to the transition relief described below, also to any portion of a pre-enactment trust attributable to a contribution made after date of enactment, including, presumably, those resulting from an undervalued sale transaction – that portion of the sale would have to be segregated, under the terms of the trust, from the pre-adoption gift.

33 33 7.Finally, regulatory authority would be granted to create transition relief for “certain types of automatic, periodic contributions to existing grantor trusts” (presumably referring to irrevocable life insurance trusts which are grantor trusts and which require on-going contributions); but query as to what the word “automatic” means here – are recurring gifts to pay premiums automatic in any sense? 8.As noted, the proposal on traditional grantor trusts seems to convert any irrevocable grantor trust (other than trusts like GRATs or QPRTs) into an incomplete gift trust (much like an irrevocable trust in which the grantor retains a power of appointment) – includable in the grantor’s estate for estate tax purposes, with any distributions to anyone other than the grantor treated as gifts for gift tax purposes, and (unlike traditional incomplete gift trusts) termination of grantor trust status during the settlor’s life treated as completing the gift.

34 34 9.The proposal regarding BDITs obviously undoes any benefit of doing a sale to a BDIT by the beneficiary, since any increase in value of and any income generated by the BDIT would be includable in the beneficiary’s estate. However, it apparently would not apply to income tax disregarded loans to the BDIT by the beneficiary, to allow it to acquire assets from third parties in taxable transactions. 10.Because the proposal is only effective for trust created or added to after enactment (again, with a regulatory exception for what it calls automatic, periodic contributions to pre-existing trusts, whatever that means), clients who are considering either installment sales or loans to traditional grantor trusts or sales to BDITs probably should be encouraged to enter into those transactions now.

35 35 11.Some initial planning thoughts on grantor trusts, if the proposal were to be enacted: Every grantor trust, not just those created as intentional (intentionally defective) grantor trusts would be effected by this proposal. Subject to the possible meaning of, adoption and application of the regulatory exception discussed in the proposal, especially its use of the word “automatic”, pre- existing irrevocable life insurance trusts which were grantor trusts (because of the ubiquitous power to use income to pay premiums, without the consent of an adverse party) would become partially subject to the new rules as new gifts were made to pay premiums – perhaps those premium payments would have to be loaned to the trust, to avoid partial inclusion.

36 36 Presumably, clients will want the ability to create irrevocable trusts which will not be includable in their estate for estate tax purposes, and therefore would be willing to forego grantor trust treatment. Creating a grantor trust and funding it with the increased estate and GST exemptions prior to adoption of this proposal may be attractive to many clients. In order to be sure to create a non-grantor irrevocable life insurance trust, the power to use income to pay premiums would have to be discretionary and would have to require the consent of an adverse party (a trust beneficiary), and that consent would have to be obtained in order to do so.

37 37 Although the proposal is focused on the interplay between the income tax grantor trust rules and the gift tax and the estate tax, some aspects of the proposal will have GST implications in many cases, as well, since many irrevocable grantor trusts are designed as multi-generational (dynasty) trusts. What does the phrase “to the extent that” the trust is treated as a grantor trust mean? If only a portion of the trust is treated as a grantor trust, would only that portion be subject to the proposal? What if only the ordinary income portion were so treated, as is arguably the case where the provision creating grantor trust status is the power to use income to pay premiums? Note that grantor trust status of some trusts “comes and goes” – a domestic trust becomes a foreign trust, an insurance trust surrenders or sells its policies, the grantor’s spouse is added or deleted as a trust beneficiary, etc.

38 38 Having the estate tax inclusion or exclusion of the trust from the settlor’s estate depend on those changes and the resultant grantor or non-grantor status of the trust at death seems unworkable. In addition, if the trust began as a grantor trust, termination of that status during the settlor’s life would treat the assets as having then been transferred to the trust for gift (and potentially GST) purposes; if grantor trust status re-started and then ended again, would their be a second transfer of the then value of those same assets? This proposal would also appear to apply to lifetime charitable lead trusts which are created as grantor trusts, to allow the grantor to obtain an income tax deduction for the actuarial value of he charity’s lead interest (at the tax cost of being taxed each year during he charity’s lead interest on the trust’s income).

39 39 Some similar thoughts on BDITs: Although the IRS has issued some 50 or so private letter rulings on the grantor trust status of BDITs from the beneficiary’s point of view (without much analysis of how that is so), including BDITs in this proposal must be an indication of the frequency with which the IRS is seeing them in audits and PLR requests. This proposal may lead to the creation, before its adoption, if what have been called “protective BDITs”, created now and funded with an initial $5,000 seed gift (by a third party), to be able to be used to enter into purchase or loan transactions with the beneficiary at some later date – grandfathered from these new rules because never added to after adoption. Note again that any inadvertent gift resulting from an undervalued sale would, under the terms of the trust, have to be segregated from the initial gift to the trust and from the balance of the sale transaction.


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