The Los Angeles County Bar Blog

NEW ESTATE TAX LAW PUTS VIABILITY OF MOST EXISTING ESTATE PLANS IN DOUBT

On December 16, 2010, Congress passed and sent to the president the "Middle Class Tax Relief Act of 2010."  The law contains the most sweeping change in the taxation of estates in 29 years.  It also contains a ticking time bomb that might explode in the faces of the beneficiaries of many trusts.  As a result of the new law, many existing estate plans no longer work, and many others will cause actual harm.  Every married couple's existing estate plan should at least be reviewed, if not scrapped.

Here are the major estate tax changes:

            · The exclusion from estate tax for citizens and residents is increased to $5 million.  If a person dies with an estate under valued at under $5 million, his or her estate pays no estate tax.  The $5 million exclusion will increase based on cost-of-living adjustments.  The exclusion was $3.5 million in 2009.

            · If a decedent's estate exceeds $5 million, the rate of tax on the excess is reduced to 35%.  The highest rate was 45% in 2009.

            · A married couple can shield $10 million from estate taxes.  If the first to die of a married couple (the "deceased spouse") does not use his or her $5 million exclusion, the administrator of the deceased spouse may elect to give the unused exclusion to the surviving spouse.

It is this last change, the "portability" of unused estate tax exclusions, that will cause many estate planners--and their clients--to question the viability of their existing estate plans. 

In order to understand the problem, we must focus on a basic estate tax concept, the "unlimited marital deduction" (UMD).  With a couple of minor exceptions, if a person dies and leaves his or her estate to his or her surviving spouse, the UMD says that there are no estate taxes on the first death, regardless of the size of the estate.  No fancy estate planning is required in order to qualify for the UMD.  For example, were Bill Gates to write a one-sentence will on the back of an envelope saying "I give everything to my wife when I die," the UMD would kick in, resulting in his widow receiving the entire estate free of estate taxes.  The theory behind the UMD is that married couples should be treated as a unit, with estate tax coming due only on the death of the surviving spouse.

The interplay of the exclusion and the UMD resulted in married couples losing one estate tax exclusion.  Let's assume Mr. and Mrs. Jones, a married couple with a $7 million estate.  If Mr. Jones had died in 2009, when the exclusion was $3.5 million, leaving everything to Mrs. Jones, the UMD results in no estate taxes on Mr. Jones's death.  If Mrs. Jones had also died in 2009, the IRS would have allowed a $3.5 million exclusion to Mrs. Jones's estate and would have taxed everything above $3.5 million, resulting in a estate tax of $1,455,800.  If Mr. and Mrs. Jones had never met and never married, and each had died in 2009 with a $3.5 million estate, the combined estate tax would have been zero!

For many years, the IRS has allowed married couples to avoid this result by means of a trust that, unlike Bill Gates's hypothetical one-sentence will, does require some fairly sophisticated estate planning.  The planning device is an “A-B” trust, and it operates as follows:  Let's assume that Mr. and Mrs. Jones's estate is valued at $7.1 million, and that Mr. Jones died in 2009, when the exclusion was $3.5 million.  Upon his death, the estate divides into two subtrusts, a "Marital Deduction Trust," (the "A" trust) and a "Credit Shelter Trust" (the "B" Trust.)  The "B" Trust is allocated an amount equal to the exemption in effect in the year of the deceased spouse's death ($3.5 million).  The "A" Trust is allocated the balance, i.e. $3,600,000.  On Mr. Jones's death, the Marital Deduction Trust is not subject to estate tax because it qualifies for the UMD.  The "B" Trust is subject to estate tax, but the assets allocated to it equal Mr. Jones's exemption, resulting in no tax.  So far, we have not done anything to avoid estate taxes for Mr. Jones or Mrs. Jones; a one-sentence will leaving everything to Mrs. Jones would have sufficed to completely avoid estate taxes on Mr. Jones's death. 

The magic that is the A-B trust becomes apparent on the second death.  Let's assume Mrs. Jones also died in 2009.  The $3.6 million in the "A" trust is subject to tax, Mrs. Jones gets her $3.5 million exemption, and only $100,000 is subject to tax.  None of the assets in the "B" trust are subject to tax. 

In order for the A-B technique to work, the "B" Trust must restrict Mrs. Jones's use of the property. She may not have a "general power of appointment" over the property, i.e. the unfettered right to dispose of the property.  Usually, her power to invade the trust is limited to Mrs. Jones' "health, education, support and maintenance" needs, which shouldn’t cramp her style, but is less than the complete discretion she has over the "A" Trust.  Not having a general power of appointment over the assets means that she is deemed not to own the assets, and if she is deemed not to own them, her estate is not taxed on them.

All this will be unnecessary on January 1, 2011.  Starting then, Mr. Jones's executor will be able to give Mr. Jones's unused $5 million exemption to Mrs. Jones, even with a one-sentence will written on the back of an envelope.  The potential problem lies in those A-B trusts that pre-date the new law, and the problem is not an estate tax issue; it's an income tax issue.

One of the biggest benefits of the Internal Revenue Code is the "step-up" in basis when a person dies.  For example, had Mr. Jones bought Ford Motor Company stock for $10 per share, and sold it during his lifetime for $100 per share, he would have realized a $90 capital gain.  But if Mrs. Jones had inherited the stock from Mr. Jones, she would have obtained a $100 date-of-death basis in the stock, and all of the gain inherent in the stock would have been forgiven.  Had she later sold the stock for $101, her capital gain would have been $1, not $91.  But in order to obtain a step-up, the asset must be included in a decedent's estate, and none of the assets in the "B" trust are included in the decedent's estate.  In our example, if the Ford stock had increased in value from $100 to $300 following Mr. Jones's death, their children would receive a $100 basis in the stock, not $300.

In prior years, we weren't much troubled by this result.  We were willing to forego the step-up in basis in order to avoid the estate tax, because estate tax rates were always higher (45%) than capital gains rates (15%).  But with a married couple now able to shield a $10 million estate from estate taxes without an A-B trust, any married couple with an estate small enough so as to likely not incur an estate tax will now find that their "B" trust is an income tax albatross.  These married couples will lose the basis step-up, with all of the resulting capital gains taxes, without any corresponding estate tax savings.

In addition to the tax detriment that is inherent in the A-B trust, there is a non-tax reason that many existing A-B trusts may now no longer meet their creators' needs.  In order to qualify for the estate tax benefits of the A-B trust, the tax code instructed us how to write those trusts.  Specifically, following the first spouse's death, the surviving spouse may freely alter or amend the "A" trust, the "B" trust becomes irrevocable following the first spouse’s death.  Many people were willing to suffer this consequence if it meant a substantial reduction--or elimination--of estate taxes.  But for married couples with an estate that is not likely to reach $10 million, this consequence may no longer be acceptable.

There are some circumstances when a "B" trust may be desirable for nontax reasons, and those still remain intact.  For example, the first-to-die spouse may want some assets to be placed in an irrevocable trust to make certain that the children receive those assets, and not the survivor's new love interest.

Bottom line: Any married couple with an A-B trust should, at the very least, have it reviewed.  Depending on the size of the estate and the nature of the assets, many married couples will wish to amend or revoke their existing estate plans. 

Nevada Introduces Restricted LLCs

On May 29 the Governor of Nevada approved Nevada Senate Bill 350, which creates a new type of limited liability companies. These new LLCs are called "restricted," and the enabling legislation can be found in the newly enacted NRS 86.161. A restricted LLC is an ordinary Nevada LLC that elects to be "restricted" by checking off the appropriate box in its articles of organization.

The restricted LLC statute imposes restrictions on the LLC's ability to make distributions. The statute provides, in part, that unless otherwise provided in the articles of organization, a restricted LLC shall not make any distributions to its members with respect to their membership interests until 10 years after the date of formation of the LLC (or amendment of the articles of an existing LLC to become a restricted LLC), so long as the LLC has remained a restricted LLC.

Why would one want to set up an LLC that may not make any distributions to members for 10 years? Internal Revenue Code Section 2704(b) provides that when valuing an interest in an entity for gift tax purposes, the liquidation restrictions contained within the LLC operating agreement have to be disregarded by the appraiser if the LLC is owned by family members both before and after the transfer. Code Section 2704(b)(3)(B) provides, however, that a restriction that is imposed by state law cannot be ignored.

Nevada has always been a business friendly state, and it hopes that with these new restricted LLCs, it will attract the business of estate planning attorneys seeking greater valuation discounts for transfers of interests in business entities between family members. Given that the restriction can be lifted fairly simply (by amending the LLC's articles of organization), it is a flexible concept that should grow in popularity.

Obama Administration's Estate Tax Proposals

The so-called Green Book (available on the Treasury website), titled "General Explanations of the Administration's Fiscal Year 2010 Revenue Proposals," contains interesting material.

First, there has long been a "step-up in basis" at death.  The meaning of this can be explained with an example. Your mom bought a house for $100,000. At her death the house was worth $1,000,000. You sell it shortly after her death for $1,000,000. Your taxable gain is zero, because your basis is not her $100,000 basis but the $1,000,000 fair market value at her death. The Obama administration is proposing that the executor file a report with the IRS as to the fair market value of the property. That will allow the IRS to match the value reported for estate tax purposes with the basis used by the heirs. A similar obligation will be imposed on donor's as to inherited property (a donee must use the donor's basis). Happily the administration is not proposing to do away with the step-up in basis on these facts. 

Second, the administration proposes to eliminate some of the valuation discounts currently available for interests in family-controlled entities. This is similar to a proposal made in January by a member of the House of Representatives.

Third, the administration would impose a minimum 10-year term on grantor retained annuity trusts (GRATs). GRATs are typically used to transfer interests in S corporation stock, in family limited partnerships, and in publicly traded securities to heirs. A GRAT is only successful in transferring the assets if the donor survives the term. For that reason, most GRATs use terms of less than 10 years to minimize the risk of the donor's death. This proposal will not eliminate GRATs. Instead, it will increase the pressure on the parent to buy life insurance to handle the situations in which the parent dies prematurely.

No one knows what proposals will pass. Some of these will almost certainly be viewed as anti-family business. The three of them are projected to raise $736,000,000 in 2010 and $1.6 billion in 2011, amounts that are barely rounding errors in a $3 trillion budget.

Estate Tax Planning for $41 Trillion

The 1999 report titled Millionaires and the Millennium: New Estimates of the Forthcoming Wealth Transfer and the Prospects for a Golden Age of Philanthropy by the Social Welfare Research Institute at Boston College predicted that over the 55-year period from 1998 to 2052, a minimum of $41,000,000,000,000 will pass from one generation to the next. Does that prediction still make sense given the current once-in-a-generation recession?

In the January 27, 2003, issue of the Planned Giving Design Center, LLC, newsletter, the authors of the study issued an updated report confirming that estimate. It has now been 6 years since their update, and the market has gone up and down since then.

Currently, in February 2009, four factors have come together to make this a once-in-a-generation opportunity to do estate tax planning, whether that $41 trillion estimate is high or low. The window on this opportunity will close sometime in the next year or two. Here are the four factors:

(1) The lowest interest rates since the IRS started requiring interest rates for transfers among family members;

(2) Low asset values, whether for closely held businesses, investment real estate, or publicly traded securities;

(3) High valuation discounts (the discounts for lack of control and lack of marketability are inversely related to the stock market); and

(4) Introduction of a bill—H.R. 436—on January 9, 2009, that would eliminate valuation discounts on transfers of passive assets among family members and eliminate the lack of control discount for transfers of interests in closely held entities among family members.

Advisers should put on their Elmer Gantry hats and preach the true religion to their clients to take advantage of this opportunity to transfer wealth now, and recognize that the same structures used to reduce the value of assets for estate tax purposes also have creditor protection benefits.

Leaving IRA Proceeds to Charity Can Be Dangerous to Your Heirs

A father has a trust benefitting his children and several charities. He names the trust as the beneficiary of his IRA. On his death the IRA is paid to the trust, and the trustee uses the IRA proceeds to satisfy the bequest to the charities. The only remaining beneficiaries of the trust are the children. What went wrong?

In IRS Chief Counsel Memorandum ILM 200848020 (December 1, 2008) the IRS ruled that the trust had taxable income due to the IRA proceeds; however, it had no offsetting charitable income tax deduction. As a result, the children had taxable income without cash because the trust did not require the IRA to be used to pay the charity.

The safest approach is to have the IRA name the charities directly as the beneficiaries. This way the taxable income is never received by the children, so they do not need to search for an offsetting charitable income tax deduction. Retirement plan assets are an increasingly large proportion of taxable estates. Mixing retirement plan assets, charities, income taxes, and estate taxes is a complex witches' brew.

Tax Court again Accepts Estate Tax Discount for Built-In Gain

Often in estate tax planning, one spouse—who may be called Dad—dies leaving no estate tax because Dad's estate was divided into two trusts: the exemption (or bypass) trust, which held the amount that can pass free of estate tax in all events (that amount is $3,500,000 in 2009), and the marital trust. Now the surviving spouse—Mom—dies. Her estate includes 50 percent of a closely held corporation. Were an independent third party to buy the stock of the corporation, that buyer would liquidate the corporation and sell the assets. In doing so, that buyer would incur a large tax. Should the value be reduced by that tax? The taxpayers want the answer to be yes. The IRS wants the answer to be no.

For example, say a $10,000,000 C corporation was owned by Dad and Mom.  After Dad dies, his $5,000,000 half of the estate is allocated as follows; $3,500,000 to the exemption trust; and $1,500,000 to the marital trust.  Mom later dies owning $5,000,000 of stock. What is the value of the stock in Mom's estate? Mom's estate includes the $1,500,000 from the marital trust plus the $5,000,000 from the survivor's trust. Is her estate $6,500,000? If so, then subtract her $3,500,000 exclusion and the taxable estate is $3,000,000.

However, if the corporation is full of zero basis assets, then a buyer knows that upon the sale of those assets there would be a massive corporate level tax. Since corporations do not have a capital gain tax rate, that tax might be $3,500,000. If it is that high, then the portion included in Mom's estate—65 percent—is not worth $6,500,000 but ($10,000,000—$3,500,000 capital gain tax = $6,500,000 times the 65 percent of Mom's share = $4,225,000).  Then, if we subtract Mom's $3,500,000 lifetime exclusion, the taxable estate is only $725,000. That is a significant reduction from the first calculation.

The U.S. Fifth Circuit Court of Appeals, in Estate of Dunn, 301 F. 3d 339 (2002), held that the value must be reduced by 100 percent of the potential tax in valuing a 64 percent interest in a closely held business. The U.S. 11th Circuit Court of Appeals agreed in Estate of Jelke, 507 F. 3d 1317 (2007) when valuing a 6.44 percent interest in a closely held corporation.  Other commentators, including the dissent in Jelke, have suggested that discounting by the entire potential tax is inappropriate and that, instead, a discount by the present value of the tax is more appropriate. In Estate of Marjorie deGreeff Litchfield v. Commissioner, T.C. Memo 2009-21 (January 29, 2009), the Tax Court followed the Jelke dissent and accepted a discount for the present value of the tax liability.  Although not as big of a discount as 100 percent of the tax liability, this is still a large victory for taxpayers as it represents a large reduction in the gift or estate tax value of an asset. 

Advisers must check appraisals to be sure that this large factor (discount for future tax liability) has been considered in estate and gift tax planning and reporting. 

Estate Tax Planning Is a Growth Industry

When President Bush took office in 2001 the cumulative Federal deficit was $5 trillion, and there was a great deal of impetus to repeal the estate tax.  Opponents labelled it the "death tax."  Public Law 107-16--the Economic Growth And Tax Relief Reconciliation Act of 2001--was signed into law by President Bush on June 7, 2001. It increased the lifetime transfer tax (estate and gift tax) exclusion from $1,000,000 to $1,500,000 (2004-2005), $2,000,000 (2006-2008) and $3,500,000 (2009) before complete repeal (!!!) of the estate tax in 2010. However, the law returns to prior law starting in 2011. The expectation at the time was that there would be enough of a legislative majority to "continue" the repeal sometime before 2010.

Now with Barack Obama about to take office the cumulative federal deficit is likely to be $15 trillion, and there is little, if any, impetus to repeal the estate tax.  A good guess is that a law will be passed within the next year to maintain the estate tax rate and exclusion at their 2009 levels (45% $3,5000,000). 

Twenty years from now the Baby Boomers will be in their late 70s and early 80s. Those are the ages at which estate tax planning starts becoming a major goal. Will Congress have applied a cost of living adjustment to the $3,500,000 lifetime transfer tax exclusion? Probably not.  Our clients who are today worth $30,000,000 to $300,000,000 will, in 20 years (at 5%), be worth $80,000,000 to $800,000,000.  Estate tax planning seems likely to have a long term future.

Lobbying against Estate Tax Repeal

A December 3, 2008, press release by Citizens For Tax Justice (ctj.org) warns that only 0.9% of deaths in 2005 and 0.7% of deaths in 2006 resulted in the payment of estate tax. The press release makes the following points: (i) the estate tax does not threaten family farms; and (ii) a fair tax system is impossible without an estate tax. 

In 2007 a total of 17,416 estates were filed showing an estate tax liability, of which 3,637 were in California.  That suggests a ratio in California of 1 estate tax lawyer per taxable estate tax return.  (Humor intended.)

By contrast, in Governor Palin's state the comparative percentages were 0.0% in 2005 and 0.0% in 2006. 

Family Entities: Why a Small Gift Yields Disproportionate Savings

Family limited partnerships (FLPs) and family limited liability companies (FLLCs) are excellent structures. When properly formed, funded, and operated, they can help with asset protection planning and estate tax planning. They can be used as a more convenient way to manage family business and investment assets, and to introduce the next generation to the investment and management of family assets. 

The two primary estate tax planning benefits can be illustrated with this example:

Mom and dad own $10,000,000 of investment real estate. They give an undivided 3% interest to an irrevocable trust for their children. The children's trust contributes 2% (two thirds of the 3%) to a corporation. Mom and dad, the children's trust, and the corporation contribute their interests in the real estate (97%, 1%, and 2%, respectively) to the limited partnership in exchange for a 97% limited partner (LP) interest, and 1% LP interest and a 2% general partner interest, respectively. 

After the limited partnership has been capitalized, Mom and Dad give a 10% LP interest to the children. 

What is the value of that 10% LP interest? Is it 10% X $10,000,000 (the value of the underlying real estate) = $1,000,000? No. 

Mom and dad hire a business appraiser who opines that the discounts for (i) lack of marketability and (ii) lack of control related to an LP interest are 30%. Therefore, the value of the gift is 10% X $10,000,000 X 70% = $700,000. That is the first of the two primary benefits: a discount on gifts of LP interests while one or both parents are alive.

Rich Rush Estate Tax Planning By 12/31/08

Wealthy families are rushing to complete estate tax planning motivated transactions by December 31, 2008.  These transactions are designed to "lock in" current asset values so that future appreciation will shift to their children and later generations. 

There are four separate reasons causing the year-end planning frenzy. 

First, valuation discounts available for interests in family business entities are higher when the stock market is lower.  For example, a gift of limited partnership interests, in a partnership which consists primarily of investment real estate, might have —in 2006—been discounted by 30% due to (i) lack of control and (ii) lack of marketability. However, in the current environment, where the stock market has dropped 40% in a year, the combined discounts are getting closer to 45%.

Example #1: Parents have $10,000,000 of commercial real estate in a family limited partnership (FLP). In 2006 they make a gift of a 10% limited partnership ("LP") interest to an irrevocable trust for their children. The business appraiser determines that an LP interest in this FLP is subject to a (i) 15% discount for lack of control and (ii) 20% discount for lack of marketability. As a result, the 10% LP interest is worth $10,000,000 X 10% X (85% X 80%) = $680,000.  That is a combined discount of 32%.

Example #2: In November, 2008, Parents make a gift of another 10% LP interest to the irrevocable trust for their children. The business appraiser determines than an LP interest is subject to a (i) 15% discount for lack of control and (ii) 35% discount for lack of marketability.  As a result, the 10% LP interest is worth $10,000,000 X 10% X (85% X 65%) = $552,500.  That is a combined discount of 44.75%.

Second, the asset values to be transferred by parents to their heirs are lower, reflecting depressed real estate and equity markets, including the difficulty in securing credit. Commercial and industrial real estate is not as depressed as residential real estate; however, they are not at the peaks enjoyed two years ago.

Third, Congress will be desperate to raise revenue due to a large (i) current budget deficit (estimated at nearly $500 billion in the next fiscal year) and (ii) accumulated U.S. deficit (nearly $11 trillion dollars).  Therefore, Congress may return to prior proposals to raise estate taxes on the wealthy, e.g., an extra 10% on estates over $20,000,000.  That would make the rate 55% instead of the current 45% maximum bracket.  After all, if the rate is only increased on estates over $20,000,000, it will not impact the "middle class."

Fourth, another element of potential legislation designed to raise revenue, discussed in the past, would be to eliminate valuation discounts for interests in family entities. Return to examples 1 and 2 above. The discounts of 32% and 44.75% would be unavailable.

Conclusion: prudence suggests that now is the time for the wealthy to seriously examine transferring value to their heirs (better: irrevocable trusts for their heirs). The structures used can be simple sales; self-canceling installment notes; private annuities; grantor retained annuity trusts; etc.  However, the opportunity to at least consider transfers at this time should not be overlooked.