"Most of our caucus is very concerned about what will happen on the estate tax, and I think there are some who would probably be with Sen. Kyl, but I think it's a small number." Sen. Bob Casey (D-PA) in May 2010

“There is no agreement on the estate tax either in substance or process. None whatsoever.” Senate Finance Committee Chairman Max Baucus in May 2010

"We no longer have an agreement, because the Democratic side has decided that unless a matter has a guaranteed majority of Democratic votes going in, they're not going to allow it on the floor, at least not voluntarily," Minority Whip, Senator Jon Kyl in May 2010

Jeff Scroggin and Charlie Douglas provide members with a comprehensive look at the many factors that can and should be evaluated when the question presented is whether clients should consider gifting before 2010 comes to a close.

John J. (“Jeff”) Scroggin has practiced as a business, tax and estate planning attorney in Atlanta for over 31 years. He holds a BSBA in accounting, J.D., and LL.M (Tax) from the University of Florida. Jeff serves as Founding Editor of the NAEPC Journal of Estate and Tax Planning and is a prior Co-Editor of Commerce Clearing House’s Journal of Practical Estate Planning. He has been a member of the Board of the National Association of Estate Planners and Councils since 2002. Mr. Scroggin is the author of over 230 published articles and columns. He has been named as a 2009 and 2010 Georgia Super-Lawyer and as a 2009 and 2010 Five Star Wealth Advisor. He is an Accredited Estate Planner™. Jeff is a nationally recognized speaker on estate, business and tax planning issues and has been quoted extensively, including in the Wall Street Journal, CNN Headline News, MSNBC, National Public Radio, Fortune Magazine, Forbes Magazine, Kiplinger’s, Money Magazine, Worth Magazine, Financial Advisor, National Underwriter, Bloomberg Wealth Management, Smart Money Magazine, Journal of Financial Services Professionals, Wall Street Magazine, BNA Estates Gifts & Trusts Journal, Financial Planning, the New York Times, the Chicago Tribune, the South China Post, the LA Times, the Miami Herald and Newsday. Jeff owns one of the largest private collections of tax memorabilia in the US. 

Charlie Douglas has practiced in the business, tax, estate and financial planning areas for over 25 years. He holds a J.D. from Case Western Reserve School of Law and possesses the Certified Financial Planner™ and an Accredited Estate Planner™ designations. He currently serves as Co-editor of the NAEPC Journal of Estate and Tax Planning and is a Senior Vice President with Wells Fargo's Private Bank, where he specializes in providing comprehensive and customized planning solutions for business owners, high net-worth individuals and their families. Charlie is a speaker and author on the subject of values-based planning and has published numerous articles and books on the topic.

The authors gratefully acknowledge the help of Michael Van Cise in reviewing and improving this article. Now, here is their commentary:

EXECUTIVE SUMMARY:

Wealth planning advisors have been impatiently waiting for years for Congress to restore clarity to the transfer tax rules. Given the recent demise of a Baucus/Kyl sponsored changes in the Senate, it appears that transfer tax reform is dead for this year.

With an effective transfer tax rate as low as 25.93% (if the donor survives the gift by three years), every affluent client needs to consider the idea of gifting in 2010. Transfer tax rates are only going up in future years.

COMMENT:

Our commentary will examine some of the gift planning opportunities that exist for the remainder of 2010. The tax issues surrounding the computation of federal gift taxes, particularly their inclusion in the computation of federal estate taxes, are quite complex. We have not attempted to show every nuance of the computations and have purposely simplified and rounded computations used in the examples.

As Howard Zaritsky noted in RIA Federal Tax Update on April 1, 2010: “Serious planning for generation skipping transfers is virtually impossible in 2010. The only thing we know is that outright generation-skipping transfers in 2010 are not taxable….” Therefore, we have not provided any significant discussion of the GST issues in gift planning for 2010.

Perspectives on Transfer Tax Rates

The Chance for Reform in 2010? While the chance for any transfer tax reform in 2010 is rapidly diminishing, it is not yet completely dead (but the pulse is pretty faint). While many articles have been written on the chances for permanent transfer tax reform (See: Scroggin,  “A Smaller Estate Exemption or a Return to 2001? A Contrarian View,” LISI Estate Planning Newsletter #1521, September 17, 2009), there are a few less-mentioned reasons why reform is probably not going to occur this year:

Is it politically feasible to concurrently grant the rich an estate tax break when their income taxes are going up significantly? Senator Bob Casey (D-PA) put it this way after the mid-May bipartisan estate tax discussions in the Senate broke down, “I think it would be a big mistake when everybody is yelling about spending and deficits to have the very wealthy people get off the hook. The idea that we’re going to give an incredible economic advantage to less than 1% of the population is really offensive to me, to understate it dramatically.” Senator Casey has indicated that 80% of the Senate Democrats are opposed to the proposal of a $5.0 million exemption and 35% estate tax rate.

Congress may actually embrace the new-found gift tax revenue from clients who decide to make significant gifts in 2010. This sounds remarkably similar to Congress offering future tax benefits to taxpayers who convert their traditional IRAs to ROTH IRAs in 2010. When the Tax Reform Act of 1976 raised the maximum gift tax rate from 57.5% to 70%, gift tax receipts quadrupled in the months between the law’s enactment and its effective date.

The Congressional Budget Office estimates a dramatic surge in gift tax receipts to more than $14 billion for 2010 - more than double the amount of gift tax receipts collected in 1976 and by far the most in our nation’s history. With the elimination of date of death fair market value basis for decedents passing in 2010, estimates are that the sale of estate assets by heirs will generate significant new tax revenue in future years – possibly more than was lost to the one year repeal of estate taxes in 2010. At least that was the expectation until the Texas oilman died on March 28th leaving a $9.0 billion estate.

The vast majority of states have reported budget deficits the last two years. Many minimized significant cut-backs last year by using federal stimulus dollars. That option will not be available in 2010 and future years. However, over half the states remain coupled to the federal state estate tax credit provided for in IRC section 2011. If the 2001 tax rules return in 2011, not only would the federal government receive a revenue boost, but the “coupled” states would also see automatic increases in revenue from their restored estate taxes, without having had to enact an unpalatable tax increase.

However much they may gripe, even Republicans recognize that new sources of federal revenue are an absolute necessity. If Republicans gain control of either side of Congress in the midterm elections, they may thank the Democrats for their 2010 inactivity: Republicans may get to claim credit for reductions in the federal deficit which are funded by higher estate taxes, while campaigning (and obtaining campaign contributions) to reduce the federal estate tax.

Consider the 2011 Rates.  In 2009 the effective gift tax rate ranged from 41-45%, once the $1.0 million gift exemption was utilized. Estate tax rates in 2009 were a flat 45%. The gift tax rate for 2010 is a flat 35% for gift amounts above the $1.0 million gift tax exemption. In 2011 the top transfer tax rate (on gifts and bequests over $3.0 million) will be 55%, with an additional 5% surtax is imposed on transfers from $10.0 million to $17,184,000. The surtax was designed to eliminate the benefit of the lower marginal tax rates and raise the effective transfer tax rate on larger wealth transfers to a 55% rate.

Higher Transfer Tax Rates in the Future? But will the maximum transfer tax rate of 60% in 2011 necessarily be the highest rate in future years? Consider that in 1977 the newly unified gift and estate tax rate maxed out at 70%.  More onerous transfer taxes are possible as a necessary source of increasing revenue. We are facing a long term public financial crisis. The U.S. is now in its 3rd consecutive year of trillion-dollar-plus annual deficits and it has tens of trillions of dollars of unfunded and off balance sheet liabilities for entitlement programs. Its debt to GDP ratio is already an alarming 96.5% and that percentage is sure to skyrocket as baby-boomers continue to strain the entitlement systems in the years to come. Transfer tax rates stand a far better chance of going up, not down, and there is historical precedent during “unprecedented times” for an increase in transfer tax rates, particularly if Congress fails to bring long term deficits under control.  It’s always easier to take money from dead taxpayers – they complain less than the live ones.

2010 Offers a Unique Opportunity.  We enter the second half of 2010 without a hint of a legislation from Congress to modify the transfer tax rules in 2010 or deal with the sun-setting of the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) in 2011. With a 71% increase in the top transfer tax rate (i.e., from 35% for gift taxes in 2010 to 60% in 2011) automatically taking effect in six months and with the additional benefits of no GST Taxes in 2010, clients need to understand the benefit of pre-paying transfer taxes before the end of 2010. It’s time to start considering the options now, even if the plans are implemented later in the year. The delay of planning until the end of 2010 could be a profound and costly mistake.

Understanding Gift Taxes

Ever since the passage of EGTRRA, most estate planners have not given significant attention to the gift tax planning opportunities available from pre-paying gift taxes. That perspective will radically change in 2010.

Tax Exclusion Planning. Since 2001, most estate planning advisors have discouraged clients from making taxable gifts because permanent higher estate exemptions might make the payment of gift taxes an unnecessary reduction of an inheritance. However, as we recognize the possibility of a long term reduction in estate exemptions and increases in estate tax rates, paying gift taxes may trump waiting to pay estate taxes, particularly in 2010 when the gift tax rate is a flat 35%. If the donor survives the gift by three years, the effective rate (compared to an estate tax) is 25.93%.

Planning Example: If the donor pays the gift tax, the donor effectively transfers $1.35 of value for each dollar gifted, but is only subject to tax on one dollar. Therefore, the true rate of the tax (if the donor survives by three years) as compared to a transfer on death where the entire $1.35 would be subject to tax is determined by the following formula: $1.35 multiplied by rate X = $0.35. By solving for “X”, you determine that the true rate of tax when one considers the full benefit to the donee of the transfer is approximately 25.93%. With a valuation discount on intra-family transfers (e.g., minority interest and lack of marketability discounts), the effective transfer tax rate is even lower.

Pre-payment of gift taxes can have a decisive advantage over the payment of estate taxes. The principal reason is that gift tax is calculated on a tax-exclusive basis (on the value of the property transferred) while the estate tax is calculated on a tax-inclusive basis (on the value of property transferred plus any amount used to pay the estate tax).  This striking difference in how these taxes are calculated allows families to preserve more of their wealth by paying gift tax on a taxable lifetime transfer instead of paying an estate tax on a bequest.

Planning Example: Assume a donor has $6,000,000 available to make a lifetime gift and pay the resulting gift tax. Assume further that the full amount of the gift is taxable and that a 55% marginal estate tax rate (i.e., assuming death occurs after 2010) and 35% gift tax rate applies. The donor can make a $4,444,444 gift and pay the resulting gift tax liability of $1,555,556 (i.e., $4,444,444 x 35%). If on the other hand, the donor bequeathed the entire $6,000,000, then the Donor could only transfer $2,700,000 (i.e., $6,000,000 less a 55% tax).  The net result is that the donor transferred an additional $1,744,444 (i.e., $4,444,444-$2,700,000) - 64% more - by making a taxable gift as opposed to a bequest.

The Gross-up Rule. One of the biggest risks of incurring a gift tax is that the gift tax can become a tax-inclusive tax if the donor/payor of the gift tax fails to survive the gift by three years. IRC section 2035(b) provides: “The amount of the gross estate... shall be increased by the amount of any tax paid under [the gift tax rules] by the decedent or his estate on any gift made by the decedent or his spouse during the 3-year period ending on the date of the decedent's death.” Note that the date of the gift, not the date of the payment of the gift tax or the filing of the gift tax return begins the running of the three year statute.

If the payor of the gift tax dies within three years of the gift, any federal gift tax the decedent paid is included in the taxable estate, even if the asset subject to the gift tax is not included in computing the decedent’s estate taxes (e.g., in gift-splitting when the other spouse was the sole donor, but the decedent paid the gift tax). IRC section 2035(b) does not include gift tax payments in the donor’s estate to the extent the gift tax was paid by the decedent’s spouse pursuant to a gift-splitting arrangement.  The relevant tax policy is that there is no incentive to restore the decedent’s estate under IRC 2035 because no amounts were removed from the estate by the gift tax payment.

Prepaying transfer taxes not only provides for a lower effective transfer tax rate, it also moves future appreciation on the asset outside the donor’s taxable estate. Part of any analysis on making taxable gifts include the expected income tax cost of a loss of fair market value basis at death (or the partial step-up permitted in 2010) and the estate taxes payable at the time of death.

Planning Example: Even if the donor is not expected to survive for three years, making a taxable gift may still make sense, particularly with a rapidly appreciating asset. For example, assume a taxpayer has an asset worth $1.0 million which grows at 25% per year. Assume further that the taxpayer is in a 55% transfer tax bracket. If taxpayer has a life expectancy of two years, the gift would remove almost $563,000 (i.e., $1,000,000 at an annual rate of 25% grows to almost $1,563,000) in appreciation from the taxable estate, saving up to $310,000 in transfer taxes. Moreover, the payment of a gift tax of $350,000 removes the increase which might have come from those assets from the taxable estate (e.g., if the $350,000 tax would have generated an after-tax 10% return, an additional $73,500 is removed from the taxable estate).

State gift taxes are not pulled back into the taxable estate. See: Revenue Ruling 81-302, 1981-2 CB 170. Even though state gift tax rates are normally low and few states impose them, there may still be some benefit from reducing the estate by paying state gift taxes and not having to be concerned about the three year rule.

Transferee Liability. The donor is primarily liable for the gift tax imposed on the gift pursuant to IRC section 6324(b) and Treasury Regulation section 25.2511-2(a). However, if the donor does not pay the tax, section 6324(b) places a lien on the gifted asset, which effectively means that the donee is liable for unpaid taxes, penalties and interest of any gift received by the donee, not to exceed the value of the gift. Thus, if the gift is determined to be larger than that reported on the gift tax return, the donee may have personal liability for the increase to the extent of the value of the gift. See also Armstrong discussed below. Generally, unless the donee has assumed primary liability (e.g., by contract pursuant to a “net gift” arrangement), the donor or the donor’s estate will still have primary liability.

IRC section 6324(a)(2) provides that donees may also be liable for the estate tax when gifts are pulled back into the taxable estate (e.g., pursuant to IRC section 2035(a) for an insurance policy transferred within three years, or pursuant to 2035(b) for a gift tax added to the taxable estate).

Basis Issues. In general, the donee of a gifted asset takes over the tax basis of the donor. IRC section 1015(a) provides: “If the property was acquired by gift ..., the basis shall be the same as it would be in the hands of the donor ... except that if such basis ... is greater than the fair market value of the property at the time of the gift, then for the purpose of determining loss the basis shall be such fair market value.” If the donor’s basis in the asset exceeds its fair market value, the rules get a little more complicated for the donee. If the donee subsequently sells the asset for a gain, the donee uses the donor’s basis in the property. If the donee sells the asset for a loss, the fair market value of the donated assets is used as the basis. Thus, if the donee sells for a price between the fair market value and the donor’s basis, neither a loss nor a gain is incurred.

Planning Example: If a low basis asset is transferred to the donee, the value of the gift is effectively reduced by the income tax or capital gain tax the donee will ultimately pay upon the sale of the asset. For example, if a zero basis stock worth $10,000 is transferred to a child, the real value of the gift may only be $8,000 (e.g., $10,000 less a 20% federal capital gains tax in 2011). Instead, consider selling the asset and gifting cash of $10,000 to the child. Not only is a higher value transferred out of the estate, but the payment of the capital gains tax reduces the donor’s estate.

IRC section 1015(d)(6) provides: ”In the case of any gift made after December 31, 1976, the increase in basis provided by this subsection with respect to any gift for the gift tax paid under chapter 12 shall be an amount (not in excess of the amount of tax so paid) which bears the same ratio to the amount of tax so paid as (i) the net appreciation in value of the gift, bears to  (ii) the amount of the gift. Net appreciation… in value of any gift is the amount by which the fair market value of the gift exceeds the donor's adjusted basis immediately before the gift.”

At least two issues should be noted in dealing with 1015(d)(6). First, only the gift tax on the net appreciation in gain is taken into account. Second, the Code would appear to differ from the regulations on what is “the amount of the gift.” Treasury Regulation section 1.1015-5(c)(2) reads: “In general, for purposes of section 1015(d)(6)(A)(ii), the amount of the gift is determined in conformance with the provisions of paragraph(b) of this section. Thus, the amount of the gift is the amount included with respect to the gift in determining (for purposes of section 2503(a)) the total amount of gifts made during the calendar year (or calendar quarter in the case of a gift made on or before December 31, 1981), reduced by the amount of any annual exclusion allowable with respect to the gift under section 2503(b) …” Although there is no similar language in IRC section 1015(d)(6), the above regulation reduces the “amount of the gift” by any applicable annual exclusions.  Bottom line: when annual exclusions are available, consider using them to both reduce the taxable gift and provide a greater basis adjustment for the donee.

Planning Example: Assume in 2010 that a married client who has previously used all of her gift exemption transfers an asset worth $1.0 million (with a basis of $300,000) to 15 heirs. Gift splitting is elected for the gift, with the result that $390,000 of the gift are excluded as annual exclusion gifts. The gift tax is $213,500 (i.e., $610,000 times 35%). What is the basis addition pursuant to IRC section 1015(d)(6)?

 

·        If the annual exclusions are not treated as a part of the “amount of the gift,” the addition to basis is $149,450 (i.e., $213,500 times the sum of appreciation of $700,000 divided by the $1.0 million gift).

 

·        But if we follow the regulations, the “amount of the gift” is reduced by $390,000 and the addition to basis in increased to $213,500 (i.e., $213,500 times the sum of the appreciation of $700,000 divided by the revised amount of the gift of $610,000, but with the basis adjustment not being in excess of the gift tax paid).

Normally, one of the major detriments to lifetime gifting is the application of the carryover basis rules provided for in IRC section 1015 in lieu of a fair market value basis if the transfer occurred at death. However, for gifts by persons who die in 2010, this detriment is reduced somewhat. In 2010, IRC section 1022 provides that the basis of assets of decedent estates will be an adjusted step-up of up to $1.3 million, with an additional step up of up to $3.0 million on certain types of spousal bequests. Additional step up is permitted for certain losses carried over from the decedent. Three limits on the step up rules in 2010 have not received much attention:

·        Section 1022(d)(2) provides that any step-up cannot exceed the fair market value of the asset. Therefore, appraisals will still be necessary.

 

·        Section 1022(d)(1)(c)(i) provides that if assets are gifted to the decedent within three years of the decedent’s death the decedent’s personal representative may not allocate basis adjustment to the gifted asset. There is an exception for certain gifts received by the decedent from a spouse.

·        Section 1022(d)(1)(B)(iii) provides that a decedent will not be treated as owning any property by reason of holding a power of appointment over the property. Therefore, even though a general power of appointment might have pulled an asset into the estate of the decedent, there is no basis adjustment permitted pursuant to section 1022. Clients should consider the tax basis benefits of exercising a power of appointment before death.

Planning Example: If a client is expected to pass in 2010 and owns assets which might be discounted in value, consider the idea of eliminating the minority ownership discount to obtain a higher basis at the time of death. For example, assume a married client owns 40% of an LLC which owns several real properties. If the estate’s total appreciated value (i.e., the difference between fair market value and the client’s basis) after the redemption is less than $4.3 million, consider (before death occurs) redeeming the client’s LLC interest for one or more of the underlying pieces of real estate. In the alternative, another LLC member (e.g., a spouse) could gift or sell an 11% LLC interest to the client, permitting the application of a control premium to the LLC value in the decedent’s estate. Obviously, there are other factors which may adversely impact such a plan (e.g., maintaining family control of the asset).

GST Taxes. The rules and issues governing gifts to GST trusts in 2010 are confused and beyond the scope of this article. With the elimination of the GST tax for 2010 and the uncertainty over the GST tax treatment of post-2010 distributions from GST trusts, clients who are considering making gifts to GST trusts should consider the benefit of making such gifts directly (as opposed to using GST trusts) to grandchildren and other skip persons. If the client wants to reduce the control of the donee, consider using manager managed FLPs and LLCs or non-voting stock. In any case, the client is well advised to have provisions allowing the company a right to repurchase the gifted interest for its fair market value (e.g., as part of a right of first refusal).

Holding Period. IRC section 1223(2) provides that the donee’s holding period is tacked to the holding period of the donor. Therefore, the donee can more easily qualify for long term capital gain treatment.

Gift Planning in the 2010 Environment.

Estate Planning in 2010. The conditions for 2010 wealth transfer planning are uniquely favorable due to a number of factors, including:

·        Historically low federal interest rates,

·        Low asset values, particularly in real estate and family businesses,

·        Significant intra-family transfer discounts could be curtailed or eliminated by Congress or the IRS in the near future,

·        As noted in this article, planning now can position clients to take advantage of bargain transfer tax rates through the end of 2010,

·        The increasing possibility of restoration of the 2001 transfer tax rules in 2011 increases the tax benefit of making gifts in 2010,

·        There is a possibility of even higher transfer tax rates in the future, and

·        The benefit of  “income shifting,” given the expectation of significant increases in state and federal income tax rates in the coming years and the resulting spread in income tax rates at the upper and lower ends of taxation.     

Timing. Except in the case of a client facing imminent death, advisors should consider putting the plan in place and then waiting to complete the gift until the end of the year, because:

 

·        If the client died before the end of 2010, not only would the gift have created an unnecessary gift tax, but the partial step up in basis provided in IRC section 1022 is lost. However, to the extent that annual exclusions and gift exemptions protect the gift from taxation, delay for this reason may be unnecessary.

 

·        Congress might still act before the end of 2010. Retroactive changes may sabotage the plan. Other legislative changes might create new and unexpected planning opportunities or traps.

 

·        Other family changes might occur before January 1, 2011 and reduce the benefit of the proposed plan (e.g., divorce of a child).

Clients could complete the appraisals, sign the documents, and then leave everything in escrow with an independent party who is directed to deliver the relevant documents to the donees before the end of the year if (1) the donor has not died, (2) Congress has not adopted legislation that negates the benefit of the 2010 gifting program and (3) no other restrictions on the release of the documents have occurred (e.g., divorce of a child).  To assure that the gifts are deemed completed gifts, the escrow should leave sufficient time for actual delivery to the donees (or their designated agents), not just a release from escrow. It might be important at year end to know where the donees may be vacationing to make sure delivery occurs.

However, timing of gifts is a critical issue in starting the three year statute of limitations running pursuant to section 2035(b). The statute is triggered by the completion of the gift, not the payment of the gift tax. Therefore, the earlier the gift can be completed, the less gift-tax-inclusion risk is absorbed by the decedent’s estate.

·        One alternative is the creation of an inter vivos QTIP trust. The donor can create the trust now, but defer the decision on electing QTIP status as long as October 15, 2011 (assuming the return is extended).  But  if the decision  creates a taxable gift (i.e., deciding not to elect QTIP status), the decision should be made by April 15, 2011 in order to avoid penalties and interest on the gift tax that was due April 15, 2011.

 

·        One concern with this approach is that even if donor does not elect to treat a part of the QTIP trust as a marital deduction trust, the only beneficiary of the trust can be the donor’s spouse. To get around this issue, the trust instrument could provide that if the spouse disclaimed all or any portion of the trust, it passes to a By-Pass type trust or designated individuals (e.g., GST “skip” persons). The spouse would have nine months after the funding of the trust to make the decision to disclaim, but should not receive any benefits from the trust during the pre-disclaimer period.  However, the use of the “Clayton regulation” for gift tax marital deduction purposes is not entirely clear. For more information on this issue, see Steve R. Akers, “Estate Planning in Light of One-Year’ Repeal’ of Estate and GST Tax in 2010,” at page 35, published by Bessemer Trust.

Transferring FLP/LLC Interests & the Step Transaction Doctrine. Delaying the funding of an FLP or LLC to the end of 2010 and making a quick transfer before year’s end could prove to be problematic if the IRS raises the step-transaction doctrine. Essentially, the step-transaction doctrine treats a series of separate steps as a single transaction if such steps are in substance integrated and focused toward a predetermined result. If the funding of the LLC or FLP and the gifts of interests were collapsed into a single transaction, the result can be a gift of the entity's underlying assets instead of a gift of the ownership interests. As a result, no valuation discounts are applicable for the ownership in the LLC or FLP (e.g., lack of marketability or minority interest). See: Heckerman v. United States., 104 AFTR 2d 2009-5551 (W.D. Wash, 2009); Pierre v. Comm’r, 133 T.C. No. 2 (2009); Pierre v. Commissioner, T.C. Memo. 2010-106 (2010);

It is critically important to document the non-tax purposes of the transaction and to put as much time as possible between the funding of the entity and the gifting of the ownership interests. Arguably, the less volatile the value of the asset (e.g., cash, bonds, real estate), the more time required to realize a real economic risk and avoid having the gift of ownership in the entity treated as an indirect gift of the underlying assets of the entity.

Hoarding Cash. One of the reasons that planning should start early is the need for many clients to start hoarding cash or obtaining liquidity to pay for the gift taxes which will be due on April 15, 2011. The amount of cash the client can accumulate by April 15, 2011 will directly determine how much can be gifted in 2010.

Planning Example: Assume an unmarried client owns a family business worth $40 million. He wants to pass 49% of the business to children working in the company.  Assume a 40% discount is applied to gift. If the client has all of his gift exemption available, he would need to hoard about $3.77 million to pay the gift taxes – the less cash he expects to be able to accumulate by April 15, 2011, the less he can gift before the end of 2010. Assuming no growth in the value of the company and 100% transferred at death, the estate tax on the 49% transfer would be over $10 million (i.e., $40 million multiplied times 49% times a 55% tax rate, with no discount applied since the decedent still owns 100% of the business). If the donor survives the gift by three years, there is a tax savings of at least $6.0 million to the family.

Annual Exclusion Gifting. In this environment, the continued funding of annual exclusion gifts should be an easy choice. The annual exclusion is one of the most effective, but most under-utilized parts of an estate plan. In 2010, the Code permits taxpayers to make gifts of $13,000 each to as many different donees as the donor desires. In looking at the more sophisticated planning ideas, do not overlook the annual exclusion, including pre-payment of section 529 plans and payment of tuition and medical costs for others pursuant to IRC section 2503(e).

Planning Example: Assume a married client with a $20 million estate is seriously ill. The estate assets have a basis of $8.0 million. Assume the dispositional documents use a standard ByPass/QTIP trust arrangement. The client has four married children, fifteen grandchildren (six of whom are married) and five great-grandchildren – a total of 34 heirs. Assume in 2010 the client made annual exclusion direct gifts (i.e., not in trust) and elected gift splitting. Total annual exclusion gifts would total $884,000.

·        If the client died in 2010, the gifting would not adversely impact the estate tax costs, or the partial step-up in basis rules (i.e., allocation  of basis to the remaining assets would use the $4.3 million partial step-up allowed in 2010).

 

·        If the client and his spouse both die after 2010, the 2010 gifts could reduce the federal estate taxes by up to $486,200 (i.e., 55% times $884,000).

Transferring FLP/LLC Interests & Annual Exclusion Gifting. The IRS has maintained that, due to the restrictions on distributions and transferability of FLP interests which are often contained in FLP agreements, the transferees of FLP interests derive no present economic benefit from the transfer. As a result transfers of FLP interests have been treated as gifts of a future interest which are not eligible for the gift tax annual exclusion. See: Walter M. Price, et ux v. Comm’r, T.C. Memo. 2010-2 (January 4, 2010); Hackl v. Comm’r, 188 T.C. 279 (2002), aff’d, 335 F. 3d 664 (7th Cir. 2003); and John W. Fisher et ux. v. United States; No. 1:08-cv-00908.

Practitioners need to consider the impact of transfer and sale restrictions in their agreements which prevent transferees from the present use and enjoyment of their interests and terms which limit distributions. For example, instead of having a restriction against transferring an interest to anyone other than existing partners without the written consent of the general partner, provide that the transferee will be subject to a right of first refusal, with reasonable limits on exercise.

Purposely Creating a Gift Tax.  As noted previously, making taxable gifts in 2010 may reduce the overall transfer tax cost of the transfer.

Planning Example: If the client gifts $1.0 million to her heirs in 2010, the heirs receive $1.0 million and the donor pays the $350,000 gift tax, further reducing the donor’s taxable estate if she survives the gift by three years. Thus, a $1.0 million gift requires $1,350,000 in assets. If the taxpayer at death wanted to transfer $1.0 million to family (and is in a 55% estate tax bracket), she would need to have $2,222,222 in assets, from which an estate tax of $1,222,222 would be taken before transferring the $1.0 million to family. The difference in tax cost is $872,222.

Net Gifts. A “net gift” is a gift in which the donor, as a condition of the gift, requires the donee to pay the gift tax. The gift’s value is reduced by the gift tax to be paid by the donee because the donee’s payment of the gift tax is considered a sale, not a gift, by the donor. The amount of the gift tax (and the reduction in the value of the gift) is determined by a formula of: the tentative gift tax divided by the sum of one plus the rate of tax. In Revenue Ruling 80-111 (1980-1 CB 208), the IRS noted that any state gift taxes which were assumed by the donee can also be taken into account to reduce the gift. See: Revenue Ruling 75-72, 1975-1 CB 310 which supercedes Revenue Ruling 71-232, 1971-1 CB 275.

Planning Example: Assume the donor makes a $10 million gift in 2010 to a donee, and the donee is obligated to pay the gift tax on the transfer. Assume further that the transfer is fully subject to gift tax at the rate of 35%.  The gift tax on the “net gift” is $2,592,593 - an effective transfer tax rate of 25.93%.

Because part of the net gift transaction is treated as a sale transaction the donor may recognize taxable income from sale portion of the transaction. What taxable income does the donor recognize from the sale? Treasury Regulation section 1.1001-1(e)(1) provides that “Where a transfer of property is part a sale and in part a gift, the transferor has gain to the extent that the amount realized by him exceeds his adjusted basis in the property.” As confirmed by the examples in the above regulation, the entire basis (not a just an amount proportionate to the sale part of the transaction) is used to compute the donor’s gain, effectively reducing the gain to zero, unless the gift taxes paid by the donee exceed the donor’s total adjusted basis in the property.

The nature of a net gift is a part sale/part gift transaction. This creates some interesting basis issues for net gifts, including:

·        Pursuant to IRC section 1015(d)(6), to the extent that gift tax is paid on the donor’s appreciated value in the gift (i.e., not the entire gift tax paid), the donee’s basis in the gifted asset is increased to a value which does not exceed the property’s fair market value. See the prior discussion. But if the donee pays the gift tax, what happens? Logically, you would think that the donee’s payment of the donor’s tax could not be taken into account because the donee’s payment is considered a sale and to permit a second basis adjustment would effectively be “double-dipping.” However, IRC section 1015(d)(6) reads: “In the case of any gift made after December 31, 1976, the increase in basis provided by this subsection with respect to any gift for the gift tax paid under chapter 12 shall be…” (emphasis added). Does this mean that the increase in basis is still permitted? Treasury Regulation section 1.1015-4 reads: “Where a transfer of property is in part a sale and in part a gift, the unadjusted basis of the property in the hands of the transferee is the sum of (1)Whichever of the following is the greater: (i) The amount paid by the transferee for the property, or (ii) The transferor's adjusted basis for the property at the time of the transfer, and (2) the amount of increase, if any, in basis authorized by section 1015(d) for gift tax paid…”

·        On the sale portion of the transaction, there is an increase in the donee’s basis to the extent the donee purchased a part of the transferred asset. Thus, the donee may obtain a higher basis then would have been obtained from a straight gift when there is an unrecognized appreciation in the asset’s value.

But what happens if the gift tax is pulled back into the donor’s taxable estate because the donor died within three years of the gift or the IRS audits the return and the gift taxes are increased and the agreement with the donee holds them liable for the tax increase? Is the donee’s basis in the transferred asset adjusted for the additional increase in the sale portion of the transaction? What if, during the period from the initial transfer to the payment of the gift tax, the donee has sold the transferred asset?

The Armstrong decisions held that both any gift tax increase from an audit and the 2035(b) inclusion were so contingent and speculative that they cannot be taken into account in determining the amount of the gift tax. (See: Armstrong, Frank Jr, Est v. U.S., 2002 WL 53914 (4th Cir 2002) , aff’g 132 F Supp 2d 421(D Va 2001); Estate of Armstrong, 119 TC 220 (2002)) Logically, if the potential additional gift taxes cannot be taken into account to adjust the value of the net gift at the time of the gift, they also cannot be taken into account to adjust the basis of the gifted asset. However, it can be argued that Armstrong was the result of a narrow fact pattern including the fact that additional gift taxes were illusory because the donor’s estate (not the donees) actually paid the applicable taxes.

The Fourth Circuit noted: “Because the donees’ obligation to pay the additional gift taxes was premised solely on undervaluation, a probability no one expected to arise, the obligation was contingent and too speculative to justify application of the net gift principles…the children’s obligation to pay additional gift taxes was illusory.” Basically, the advisors did such a good job of protecting the donees that any liability for future gift tax claims was not expected to occur and did not occur, even when the gift taxes were increased and the donor died within three years of the gift. But see: McCord v. Commissioner, 461 F3d 614 (5th Cir 2006) and Arlein & Frazier, “The Net, Net Gift,” Trusts and Estates, August 2008, where the authors rely upon the 5th Circuit opinion in McCord to argue that the 2035(b) potential inclusion may create an additional reduction in the computed gift tax if the donees assume that liability. For a detailed discussion of McCord, see “Steve Akers Revisits McCord,” LISI Estate Planning Newsletter #1016, September 5, 2006; Paul Hood, “McCord – Fifth Circuit Reverses Tax Court,” LISI Estate Planning Newsletter #1010, August 23, 2006.

There are a number of other issues with net gifts, including:

·        Many clients will object to the economic cost of pre-paying the gift tax – even if the effective gift tax rate is substantially less than the potential estate tax rate in the future. It is always easier to part with cash when you are dead.

 

·        The IRS ruled in Revenue Ruling 81-223, 1981-2 C.B. 189 that the gift tax is only due after the donor has exhausted his or her unified credit (i.e., the donor cannot elect to not use the unified credit and have the donee pay the gift tax). Moreover, if gift-splitting is used, it appears that the donor and the donor’s spouse’s unified credits are used first to the extent gift splitting applies.

·        The U.S. Supreme Court ruled in V. Diedrich v. Comm’r, 226 US 628 (1982) that the donor has taxable gain to the extent the gift tax exceeds the donor’s basis in the gifted property. The income is taxable to the donor in the year the gift tax is paid, not in the year the gift was made. See also: Estate of Weedon v. Comm’r, 685 F2d 1160 (9th Cir. 1982) and Revenue Ruling 75-72, 1975-1 CB 310. Thus, any taxable income from the net gift will ordinarily occur in the year following the gift.  This could be problematic for gifts in 2010 because of the increased ordinary income and capital gain tax rates in 2011.

·        The Eighth Circuit ruled in S. Sachs Estate, 856 F2d 1158 (8th Cir. 1988) that if the donor dies within three years of the net gift, the gift taxes paid by the donee are includable in the donor’s taxable estate.

 

·        Advisors need to make sure that the obligation of the donee to pay the gift tax is not a conditional or speculative obligation. A written net gift agreement should clearly state that the donee is obligated to pay the gift tax shown on the filed gift tax return. The larger issue is whether that indemnity should extend to higher gift taxes after an audit and/or the inclusion of gift taxes in the donor’s taxable estate pursuant to 2035(b). If Armstrong is correct (see above), there would appear to be no benefit in having the donee increase his or her liability from secondary (i.e., transferee liability behind the estate’s liability) to primary (i.e., by agreeing to be the primary obligor for such claims). But review the Arlein & Frazier article discussed above.     

 

·        Pursuant to IRC section 677(a)(1), if a trust is the donee of a net gift, any income earned by the trust from the date of contribution to the date the grantor’s gift tax liability is satisfied may be taxable to the grantor under the grantor trust rules (i.e., the trust is satisfying the legal obligation of the grantor). See Treasury Regulation 1.677(a)-1(d); Estate of Sheaffer v. Comm’r, 37 TC 99 (1961), aff’d 313 F.2d 738 (8th Cir. 1963); Revenue Ruling 57-564, 1957-2 CB 328. Income from trust assets should be minimized during this period.

Discounting Family Debt. As a consequence of estate planning and other family planning, many clients have created intra-family debt (e.g., an installment sale of a family business interest to an income defective trust). Rather than leaving the debt in the estate of the older generation, clients should consider a forgiveness of the debt on a net gift basis – effectively treating a net gift arrangement as a discounted pay-off of the note.  Here’s the basic question to ask the reluctant client: “If you could satisfy a debt for 26% of its face value, while eliminating an estate tax of up to 55% of the debt, why would you NOT act?”

Planning Example: Assume a client has completed a sale of a real estate LLC using a $10 million note to an income defective trust for his children. The client agrees to forgive the note if the trust will pay the gift tax. Assuming the client has used all of his gift exemption to fund the seed money for the transaction, the gift tax on the net gift value would be roughly $2.6 million. The trusts could borrow the funds to pay the taxes by obtaining a bank loan against the real estate before the due date of the gift tax on April 15, 2011.

But what if the trust is a GST trust? Because of the uncertainties surrounding gifts to GST trusts in 2010, the client’s advisors may not want to make a significant gift to the trust. However, the client could make the gift of the IDIT note to his children (or even grandchildren as a direct skip). The trust could obtain a loan from a commercial lender and prepay $2.6 million of the note to the donee/family members who then pay the gift tax liability of the donor. The net effect is the removal of the note from the donor’s estate on a substantially discounted basis, while providing an income stream that is payable to family members, who may be in a lower income tax bracket than the donor/client. The most interesting aspect of such a plan is that even though the $10 million dollar note has been removed from the client’s estate, the amount of debt on the trust has not increased, because the gift tax liability obligation funded by the commercial loan effectively reduced the principal of the note.

 

Caution: The gift of an installment sale note can create the immediate recognition of the taxable gain in the note. See: See IRC section 453B and Revenue Ruling 79-371, 1979-2 C.B. 294. Of course, this is a problem only to the extent there is deferred taxable gain in the unpaid balance of the note.

Discounting Gifts. The recession has reduced the value of many assets. There is an increasing chance that Congress or the IRS will constrict the discounting on intra-family gifts.  These trends should encourage clients to make gifts in 2010. The use of FLPS, LLCs, fractional interests and charitable lead trusts (among other discounting techniques) should be considered in any gift tax planning in 2010.

Financed Net Gifts Present an Attractive Alternative. Instead of effectively reducing the gift to the donee by the cost of the gift tax in a net gift transaction, the donor could loan the donee the amount for the gift taxes due using the current low AFR rates.

Life Insurance.  Many clients have created Irrevocable Life Insurance Trusts (ILIT) to hold life insurance outside the taxable estate. Many ILITs have GST provisions. As noted in this article, the rules governing the funding of GST trusts in 2010 are confused at best. To minimize the risk of creating an inadvertent GST taxable distribution or termination in future years, clients should consider either borrowing against trust assets or making loans to ILITs at the low AFR rates to fund 2010 life insurance premiums.

It is amazing how many clients still own large life insurance policies in their own name or indirectly through their business entities. Many of these policies have large cash values. With the possibility of significant increases in estate taxes in 2011 and IRC section 2035(a) that includes gratuitous transfers of life insurance in the taxable estate of the insured/donor if they die within three years of the gift, clients should consider moving the life insurance out of their taxable estate as soon as possible.  Moving large cash value policies out at a 35% gift tax rate in 2010 may make significant sense for clients who have retained ownership of policies.

2010 Transfers to a Terminally Ill Spouse. Roughly 2.3 million Americans will die this year. 2010 provides some planning opportunities for a terminally ill spouse. The healthier spouse can transfer assets to the terminally ill spouse who redrafts dispositive documents to establish a testamentary bypass and/or QTIP trust for the healthy spouse. If the ill spouse dies in 2010 no portion of the QTIP Trust will be included in the healthy spouse’s estate under IRC section 2044. Why not? Because IRC section 2044 includes the assets of a QTIP trust in the surviving spouse’s gross estate only if an election is made to obtain an estate tax marital deduction for the QTIP trust. Because of the estate tax repeal in 2010, no marital deduction is available or needed and therefore the QTIP trust avoids estate inclusion in the healthy spouse’s estate.

Use of both a bypass trust and a QTIP trust gives the advantage of allocating income from the bypass trust to more than just the surviving spouse, while taking advantage of the larger basis adjustment (i.e., $3.0 million) permitted under IRC section 1022 for transfers for the benefit of surviving spouses. However, unlike the standard “A-B” trust arrangement in which any excess over the estate exemption is solely allocated to the marital share, in this case, once the $4.3 million basis adjustment is reached, assets should again be allocated to the by-pass trust to permit more flexibility in allocating later trust distributions.

But what happens to the basis of the assets bequeathed by the spouse? For 2010, IRC section 1022(d)(1)(c)(i) provides that if assets were gifted to the decedent within three years of the decedent’s death, no basis adjustment may be allocated to the assets. However, there is an interesting exception to this rule in IRC section 1022(d)(1)(c)(ii), which reads: “Clause (i) shall not apply to property acquired by the decedent from the decedent's spouse unless, during such 3-year period, such spouse acquired the property in whole or in part by gift or by inter vivos transfer for less than adequate and full consideration in money or money's worth.” Thus, unless the asset being gifted was acquired by the gifting spouse “by gift or by inter vivos transfer for less than adequate and full consideration in money or money's worth,” the asset can still receive a partial basis adjustment pursuant to IRC section 1022. IRC section 1014(e) which eliminates a step up in basis on assets gifted within a year of demise is revoked for 2010. See IRC section 1014(f).

Planning for Gift Splitting.  As noted earlier, IRC section 2035(b) only applies if the payor of the gift tax dies within three years of the gift. This offers a planning opportunity. If one spouse is in poorer health than the other, consider making a gift splitting election and have the healthier spouse (assuming they have the available funds from their own resources) pay the total gift tax (See: PLR 9214027). This eliminates the chance that the gift tax will be included in the unhealthy spouse’s taxable estate. What if neither spouses is in great health?  Consider gift splitting and having each spouse pay half the gift tax, increasing the chance that at least one of them will survive beyond the three years.

If the couple were in a second marriage and had different beneficiaries, the unhealthy spouse could revise his or her dispositive documents and make a special bequest to the surviving spouse to compensate for the payment of gift tax – just do not tie it directly to the gift tax paid. Funds used to pay the gift tax should not originate from a donor spouse with an implicit understanding that the non-donor spouse use the funds to pay the donor spouse’s gift taxes. Where such funds have originated from the donor spouse with an implied understanding that they be used to cover donor’s taxable gifts, the IRS has applied form-over-substance principles and ruled that all of the gift tax paid was in essence paid by the donor spouse (See: Brown v. United States, 329 F 3d 664 (9th Cir 2003) and TAM 9729005) .

Gifts from Existing Marital Trusts.  Normally, deferral of transfer taxes makes sense. But 2010 has turned many of our planning perspectives on their head. What happens if a spouse has passed before 2010 and created a QTIP trust for the surviving spouse? Pursuant to IRC section 2044 the QTIP trust assets will be subject to estate tax at the death of the surviving spouse at an effective tax rate of up to 55% versus a 35% tax rate in 2010. If permitted by the trust instrument, clients who have QTIPs for their benefit should consider taking a principal distribution from the trust and then gifting the assets to heirs at the lower gift tax rate. Net gifting could increase the benefit of this planning technique.

Planning Example: A client’s deceased spouse created a QTIP which holds $10 million growing at 5% per year. The surviving spouse is comfortable and is willing to make a net gift of $6.0 million to their heirs and the trust permits discretionary principal distributions. Assuming the spouse has used her gift exemption, the net gift tax is approximately $1.5 million, making a net passage to heirs of $4.5 million. If the client dies in five years, the $6.0 million asset would have been worth approximately $7.66 million and the estate tax (at 55%) would have been up to $4.2 million – a net after-tax bequest of $3.4 million. If the client made the net gift five years earlier, after appreciation, the heirs would own an asset that has appreciated to $5.7 million – a tax savings of up to $2.3 million

Purchases or gifts of lifetime or remainder interests in the QTIP should also be considered. The merger of lifetime and remainder interests in a QTIP is normally treated as a gift transaction, generally as “net gift” transaction. See: Revenue Ruling 98-8, 1998-1 C.B. 541; Treasury Regulation sections 20.2207A-1(a)(2), 20.2207A-1(b), 25.2519-1(c)(1), 25.2519-1(C)(4), 25.2519-1(G); Lawrence M. Lipoff, “Revisiting Purchases of Remainder Interests in QTIP Trusts,” Estate Planning, March 2000.  See also: Morgens, 133 TC 17 (2010) for the result when the surviving spouse dies within three years of the deemed gift (covered by Paul Hood in LISI Estate Planning Newsletter #1599).

Gifting to Unhealthy Non-Spouses.  In considering