Wealth Transfer Newsletter February 2011

Wealth Transfer Team

In this issue


Year 2010 finished with a flourish as a result of the passage of  TRA 2010, and its impact is discussed in detail in this newsletter.  The changes reflected in the 2010 legislation, including particularly the exemption from estate tax of $5M (up from $3.5M in 2009), an increase in the exemption applicable to lifetime gifts to $5M (up from $1M in 2010), the reduction in the estate and gift tax rates to 35%, and the introduction of the concept of portability of exemptions between spouses, are remarkable.  Equally notable was the fact that TRA 2010 was silent on the issues of valuation discounts applicable to interests in closely held family businesses and two-year GRATs.   The absence of provisions in TRA 2010 addressing these two techniques offers continued compelling opportunities for taxpayers to implement creative planning that could result in substantial tax savings.  As always, numerous business and other non-tax objectives can be realized in such planning, as well.

For married taxpayers with combined estates of $10M or less, a new concept of portability (which is discussed in detail in this newsletter) offers apparent simplicity by allowing a surviving spouse to utilize the unused exemption of his or her predeceased spouse, subject to a number of requirements.  However, the price of this apparent simplicity likely is the loss of substantial benefits otherwise attainable by funding a credit shelter trust at the death of the predeceasing spouse, such as asset protection, GST tax planning, and the freeze of values for appreciating assets.  Before relying on portability and drafting simple “I love you” wills, taxpayers should consider the benefits of traditional estate planning techniques. 

The window of opportunity to take advantage of the provisions of  TRA 2010 is limited, as TRA 2010 is scheduled to expire on December 31, 2012.  If Congress fails to enact further legislation, effective January 1, 2013, the exemption from federal estate and gift taxes will revert back to $1M and the estate and gift tax rates will rise to 55%.  Furthermore, President Obama’s Green Book, published in conjunction with his proposed budget for 2012, calls for the elimination of discounts for lack of marketability and lack of control for certain closely held business entities, a cap to the term of a trust that may be exempt from the GST tax to 90 years, and a minimum of a 10-year term for a GRAT.  These measures could be implemented by Congress well before the expiration of TRA 2010 in 2013.  In addition, interest rates continue to climb.  The Section 7520 rate has rocketed from 1.8% in December of 2010 to 3% in March of 2011.

The provisions of  TRA 2010 should be carefully considered, especially by clients with taxable estates.  Unique planning opportunities are available today, but their future availability is uncertain.  As always, we at Moore & Van Allen stand ready to assist you and provide prudent guidance to avoid the pitfalls and seize the opportunities that arise in this changing legislative landscape. 

Neill McBryde

Highlights of the Tax Relief Act of 2010

As mentioned in our update at the end of the year, the Tax Relief, Unemployment Insurance Authorization, and Job Creation Act of 2010 (“TRA 2010”), signed into law on December 17, 2010, significantly impact the estate, gift and generation-skipping transfer (GST) tax laws, both at the federal and state levels for 2010 through 2012.  The federal legislation provides tax relief in many cases by extending lower rates and increasing exemptions for the next two years, while also providing planning opportunities for high net worth individuals and families.  The new legislation also answers many uncertainties that existed with respect to estate, gift and GST taxes at least for the next few years, but in some cases also raises new questions particularly with respect to issues of implementation of the new legislation and its interaction with state transfer tax laws, as well as proposed revisions under President Obama’s Green Book.  Below, we will hit some of the highlights, many of which are subject to somewhat complicated caveats.

What laws applied in 2010?

  • The estate tax applied to estates of decedents dying in 2010. 
    • Highest estate tax rate is 35%.
    • Estate tax applicable exclusion amount is $5,000,000.
  • Default regime – The assets of the decedent’s estate will generally receive an income tax basis equal to the fair market value of the assets as of the date of the decedent’s death.
  • Alternate Regime - No Estate Tax/Carryover Basis.
    • The executor of an estate of a decedent dying in 2010 may elect to have the estate tax not apply to any portion of the decedent’s estate, and to have the modified basis rules under I.R.C. § 1022 apply to property acquired or passing from the decedent.
    • In general,
      • $1,300,000 of basis can be allocated to assets passing to anyone.
      • An additional $3,000,000 of basis can be allocated to assets passing to the decedent’s surviving spouse in a qualifying manner.
  • Portability (discussed below) does not apply for decedent dying in 2010.
  • Disclaimers - The deadline for making a qualified disclaimer for federal tax purposes for property received as a result of the death of a decedent has been extended in most cases nine months.
  • Gift tax rate for gifts made in 2010 is 35%.
  • Gift tax applicable exclusion in 2010 remained $1,000,000.
  • GST tax rate in 2010 was 0%.

What laws apply in 2011 to 2012?

  • The estate tax applies to estates of decedents dying in 2011 - 2012. 
    • Highest estate tax rate is 35%.
    • Estate tax applicable exclusion amount is $5,000,000 (indexed for inflation in 2012).
  • Portability is introduced to maximize use of federal exemptions between spouses.
    • The executor of a decedent may transfer the unused estate tax exemption of the decedent to his or her surviving spouse.
    • In order to effect the transfer of unused exemption to the surviving spouse, the executor must make an election on a timely filed federal estate tax return permitting the surviving spouse to use the decedent’s unused exemption. 
    • Even the executors of small estates will have to consider filing an estate tax return in order to preserve the decedent spouse’s unused exemption.
    • Advantages of Portability
      • Simplicity.
        • May avoid need for perceived “complex” estate planning documents. 
        • May also avoid need to have spouses re-title assets for purposes of ensuring that each spouse can fully utilize his or her exclusion amount.  
        • May also avoid need to fund a credit shelter trust at the death of the first spouse that would require annual trust income tax returns to be filed during the lifetime of the surviving spouse. 
        • However, the requirement that all estates that wish to use portability, regardless of size, must file an estate tax return in order to make the election to transfer the unused exemption to the surviving spouse negates somewhat, if not entirely, the other perceived benefits of simplicity offered by portability.
      • Stepped up Basis – The assets left to a surviving spouse, as opposed to a credit shelter trust, will receive a step-up in income tax basis at the death of the surviving spouse.
    • Advantages of a Credit Shelter Trust versus an outright inheritance for spouse.
      • If properly funded and administered, appreciation of assets in a Credit Shelter Trust would not be included in the estate of the surviving spouse at death.
      • No guarantee that portability is extended beyond 2012.
      • GST tax exemption amounts are not portable under TRA 2010.  As a result, a Credit Shelter Trust is a viable planning option for GST tax planning, whereas the utilization of portability of exclusion amounts is not viable for maximum GST tax planning.
      • No guarantee that states will modify their laws to match the federal laws with respect to portability.  Therefore, utilizing portability instead of a Credit Shelter Trust could have unintended state estate tax ramifications.
      • In many jurisdictions, including North Carolina, the Credit Shelter Trust can be structured to provide protection to the assets in the trust from the creditors of beneficiaries, including the creditors of the surviving spouse who may be serving as Trustee of the Trust.  Assets received by a surviving spouse with the intent of utilizing portability to shelter the assets from estate tax would be subject to the creditors of the surviving spouse, including subsequent spouses in the event of remarriage.
        • A Credit Shelter Trust offers a vehicle for making distributions to younger generations (e.g., children and/or grandchildren) without utilizing the surviving spouse’s gift tax exclusion amount during his or her lifetime.
        • A Credit Shelter Trust allows for consolidated management of assets, independent decisions regarding distributions and specified restrictions on the transfer of assets to the surviving spouse and other beneficiaries, if desired.
  • There is no alternate carryover basis regime for decedents dying after December 31, 2010.
  • Gift tax rate for gifts made in 2011 and 2012 is 35%.
  • Gift tax applicable exclusion amount is $5,000,000 (indexed for inflation in 2012).
  • GST tax rate is 35%.
  • GST Exclusion amount is $5,000,000 (indexed for inflation in 2012).

What happens in 2013?

There is an enormous amount of uncertainty regarding what the future holds for estate, gift and GST taxes.  Unless Congress acts prior to December 31, 2012, the estate tax applicable exclusion amount is scheduled to revert to $1,000,000 and the estate tax rate is scheduled to increase to 55% on January 1, 2013.  The newly introduced concept of portability is set to expire.  Gift tax rates will bounce back to at least 55% and the lifetime gift tax applicable exclusion amount will also revert to $1,000,000. 

What does all of this mean?

Based upon the level of uncertainty governing estate, gift and GST taxes in 2013, it appears that many individuals with taxable estates may have a window of opportunity for tax planning.  Other articles in this newsletter address techniques that may have a limited shelf life that maximize the increased applicable exclusion amounts and lower tax rates currently in effect.  Each situation is unique and if you have any questions, we welcome the chance to discuss your concerns and options. 


Planning Opportunities and Updates

The recently enacted Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 (“TRA 2010”) (as highlighted on page 1) provides savvy taxpayers with several new tax planning opportunities, but also requires renewed attention to one’s estate planning documents.  

500% Increase in Gift Tax Exemption

As previously noted, the lifetime federal gift tax exemption was increased an unprecedented 500% from only $1 million in 2010 to $5 million per taxpayer for years 2011 and 2012, when it was “reunifed” with the estate tax exemption.  The gift tax exemption, however, is scheduled to return to $1,000,000 in 2013, unless Congress acts to extend the current amount. 

Explanation of Gift Tax Exemption

As you may know, the lifetime gift tax exemption is the amount that a taxpayer can give during his or her lifetime without incurring gift tax.  Specifically, any gift in excess of a taxpayer’s “annual exclusion” (currently $13,000 per year per done), which does not qualify for the medical and tuition payment exception (previously discussed in our newsletters), reduces the taxpayer’s lifetime gift tax exemption.  Additionally, whatever amount is utilized during lifetime reduces the exemption available at death for estate tax purposes.  For example, if you have made no prior taxable gifts before 2011, you make a gift of $2 million to your children in 2011, and the exemption amount is $5 million at death, you would have $3 million in exemption remaining to shelter assets from estate tax.  Any amount in excess of $5 million (after taking into account lifetime gifts) would be subject to federal estate tax at a rate of 35% (scheduled to increase to 55% in 2013). 

Illustration of Potential Savings

As alluded to above, the ability to make larger lifetime gifts is an unprecedented opportunity for wealthy taxpayers to shift assets and future appreciation to descendants or trusts for descendants in a tax advantaged manner.  By making a gift now, any future appreciation is shifted from the “balance sheet” of the person making the gift to the person or trust receiving the gift.  For example, with a modest growth rate of 5%, a gift of $5,000,000 today would be worth $10,394,641 in 15 years.  Even at a 2% rate of growth, the future value of that same gift would be $6,729,342.  Obviously by extending the compounding period, the results are even more dramatic.  The future value of the gift after a 30 year period with a 5% rate of growth would be $21,609,712.  Assuming a return to a 55% estate tax rate, the savings from the elimination of the federal estate tax alone on the appreciation in the last example would be $9,135,342.

Enhancement through Use of Grantor Trust

The estate and gift tax results of the lifetime gift technique can be dramatically improved through the use of an irrevocable “grantor trust” for income tax purposes.  By making the gift to a properly structured grantor trust, the grantor (e.g., a parent) can continue paying the income taxes attributable to the assets held by the trust.  From the perspective of the beneficiaries of the trust, they are a beneficiary of assets that can grow income tax free, significantly increasing the potential value of assets in the trust.  Additionally, the income taxes that are paid further reduce the taxable estate of the grantor.  By using a grantor trust, the tax reporting is simplified by eliminating the need for a separate income tax return for the trust during the grantor’s lifetime.  An additional benefit of using a grantor trust is the increased asset protection for the trust assets (assuming a properly designed and administered trust).  For example, the assets held in trust have a much higher degree of protection from divorcing spouses and judgment creditors (e.g., from an accident or injury on a property) of trust beneficiaries.

Further Enhancement through Use of GST Exemption and Perpetuities Trusts

To enhance the gift technique even further, a parent could allocate his or her $5 million generation-skipping transfer (GST) tax exemption to the irrevocable grantor trust receiving the $5,000,000 gift, so that the assets (and any appreciation on those assets) could be held for the benefit of or distributed estate, gift and GST tax free to future generations.  A perpetual or dynasty trust that could go on for an unlimited number of generations could further enhance this gift technique.  Obviously the results of the technique are improved by a longer period for growth and by the elimination of estate and GST taxes at each generational level.

The use of “discounted” assets as discussed separately in this newsletter leverages even more the effective use of the gift tax exemption.  Of course, the Trustee of the trust should consider investing in assets that are more likely to appreciate significantly over time, thereby further increasing the effectiveness of the planning technique.

Another non-tax advantage of the gift technique is that it eliminates the unfortunate possibility of a descendant, for example, exerting undue influence over a parent or grandparent, which often becomes more prevalent later in life.  Of course, one should be hesitant to gift assets that are a part of the “core assets” needed to live comfortably and to maintain a sufficient “nest egg” for his or her life expectancy and beyond.  As a result, detailed financial analysis using modest growth projections is prudent prior to making a decision to implement the technique.

Additional Considerations

One should of course consider the possibility that gifted assets could decline in value, which could result in potentially paying higher estate taxes that would have been necessary if the assets had been retained rather than gifted.  The likelihood of that possibility of course decreases the longer the period of time between the gift and the application of the estate tax at death.   Additionally, assets that are gifted retain a “carryover” basis and are not stepped up to fair market value at death like an asset retained until death.  To reduce the impact of basis issues, higher basis assets are typically preferred for making lifetime gifts.

Proper analysis of the decision to make a lifetime gift should include consideration of income tax rates (both current and future), estate tax rates (again both current and future), one’s own needs and the needs of beneficiaries, and the projected income and appreciation from both the transferred assets and the retained assets.

Use of Large Gift Tax Exemption for Other Planning Techniques

As noted in this and other recent newsletters, a number of estate planning techniques are particularly effective in a low interest rate environment, such as grantor retained annuity trusts (GRATs) and sales to intentionally defective grantor trusts (IDGTs).  To the extent that “discounted” assets are used in these transactions, having a large gift tax exemption can act as a “buffer” in the event the IRS successfully challenges the reported value of the gifted or sold assets.  Accordingly, the risk of interest or penalties being imposed by the IRS as a result of a valuation error can be significantly reduced.

Review of Estate Planning Documents

If it has been some time since you reviewed your estate plan with one of our team’s attorneys, please contact us at your earliest convenience.  Many of our clients have experienced significant fluctuations in net worth, have been impacted by changes in their families, or have received inheritances or gifts.  In addition, many of our clients have estate planning documents that use automatically adjusting “formula” clauses that are directly impacted by the frequent and dramatic changes in the estate tax exemption from $1,000,000 in 2002 to $5,000,000 in 2011 and 2012 to $1,000,000 indexed for inflation in 2013 (unless Congress acts).  While many of these formula based plans function properly, please make sure that you have reviewed your plan with an attorney on our team to ensure your plan functions properly for you. 


Planning Opportunities available as a result of TRA 2010

In December, we outlined the dramatic changes to the estate, gift and generation-skipping (“GST”) tax landscape as a result of the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 (“TRA 2010”) that was enacted on December 17, 2010.   This newsletter separately details planning opportunities available as a result of TRA 2010.   However, some of the biggest news from TRA 2010 relates to the provisions that were missing from the TRA 2010.  Namely, TRA 2010 did not abolish short-term grantor retained annuity trusts (GRATs) or valuation discounts applicable to interests in closely held businesses.

Prior to the enactment of TRA 2010, many bills were introduced to Congress that would have raised revenues by requiring GRATs to have terms of 10 years or more and by effectively eliminating valuation discounts related to non-operating closely held businesses (e.g., family limited partnerships).  The GRAT proposals included restrictions severe enough to essentially render the technique useless.  TRA 2010 is effective for a two year period, ending on December 31, 2012.  Numerous “fixes” for various estate and gift tax issues are already floating around Capitol Hill, and with shifting political winds, a renewed desire to eliminate short-term GRATs and valuation discounts as a part of a comprehensive estate and gift tax reform is a realistic possibility.  In fact, President Obama’s Green Book released last week (see below) seeks to eliminate these techniques.  In the interim period, these great planning opportunities are still available.  By taking advantage of these opportunities now, as opposed to waiting until the end of 2012, a taxpayer can use techniques that may not be available after future legislation is enacted and can immediately begin removing any appreciation on the assets transferred out of the taxpayer’s estate.

As detailed in the article titled “Planning Opportunities in a Favorable Interest Rate Environment” in our November 2010 newsletter, we remain in a unique and unprecedented time to engage in estate planning to maximize wealth transfer due to a confluence of factors in the overall economy, including depressed asset values and low interest rates.  This makes short-term GRATs and other planning techniques using valuation discounts particularly attractive.

GRATs - As we have previously highlighted, use of a GRAT can efficiently – from a gift tax perspective – transfer wealth to the next generation.  Specifically, under the terms of a GRAT, the grantor retains the right to receive an annuity for a fixed term of years, following which the remainder will pass to specified successor beneficiaries.  Under current law, a GRAT may be structured such that at the time of funding the value of the remainder interest, which is a taxable gift, is zero (or an amount less than $1).  Additionally, there are no requirements regarding the length of the annuity term other than it must be for at least 2 years.  This short-term increases the likelihood that the grantor will survive the annuity term and thus increases the likelihood that the gift strategy will be successful. 

The amount of the annuity is determined using the Code Section 7520 interest rate.  This rate is currently near all-time lows, meaning that the annuities that must be paid to the grantor will be significantly less than in a high interest rate environment.  The 7520 rate hit its historical bottom at 1.8% in December, 2010, and has risen to 3% in March 1, 2011.   A GRAT allows a grantor to “freeze” the value of an asset in the grantor’s estate at its current and potentially depressed value, receive an annuity payment computed at a low interest rate, and transfer any appreciation on the assets in the GRAT to the next generation free of estate and gift tax.  By using a 2 year GRAT, the risk of the grantor dying during the term - and thereby negating the benefits of the GRAT - are lowered significantly.  Additionally, if the assets used in the GRAT decrease in value, the time to end the transaction can be shortened and the same assets can be used again to fund another GRAT. 

As noted, legislation has been proposed that would mandate a minimum term of 10 years and a remainder interest “greater than zero” for new GRATs.  Additionally, proposed legislation would prevent the annuity payments from being structured in such a way that the initial payments exceed the payments in subsequent years, which payment structure often is used when a realization event is anticipated with regard to the assets transferred to the GRAT.  Since the reprieve from these proposals may only last until the end of 2012, clients for whom GRATs are appropriate should strongly consider incorporating one or more GRATs in their planning. 

Valuation Discounts – TRA 2010 does not restrict the ability of taxpayers to take into account applicable valuation discounts in connection with a gift of closely held assets, including gifts of interests in real estate, family limited partnerships, S corporations, limited liability companies and other hard to value assets.  Assets subject to valuation discounts may be used in combination with previously highlighted planning techniques, such as a GRAT, a sale to an intentionally defective grantor trust, an outright gift or a gift to a dynasty trust (or some combination of the various techniques) to leverage the $5 million gift tax exemption in place through 2012. 

For gift tax purposes, the reportable fair market value of an asset, such as a limited partnership interest in a limited partnership, may be much less than the comes pending value of the underlying assets held by that limited partnership due to discounts to reflect the lack of marketability, minority interest and lack of voting control associated with the limited partnership interest.  Because these discounts (when determined by a qualified appraiser) reflect an actual consideration in the fair market value of a closely held business interest, the IRS and the courts have often accepted them in determining the value of a gift for gift tax purposes.  However, despite commercial evidence of the validity of these discounts, legislative proposals have sought aggressively to eliminate discounts in the valuation of closely held and non-operating businesses.  TRA 2010 did not impact valuation discounts, but they are clearly on the radar of lawmakers looking for revenue sources.   

TRA 2010 created a two year planning opportunity for proactive taxpayers.  Not only are new planning techniques available to certain taxpayers because of the Tax Act, but previously-used and well-established planning techniques continue to be available long after most planners assumed they would be eliminated.  The opportunities highlighted here, should be utilized, if appropriate, as soon as possible, as the 2 year window of opportunity afforded by TRA 2010 could be truncated at any time during the interim under a number of bills being flirted with by Congress.  


Team Accomplishments and Accolades

The Wealth Transfer Team welcomes Welles Campbell to our team in the Charlotte office.  Welles received her undergraduate degree from Davidson College, her J.D. from American University and her LL.M. in Taxation from New York University.   Welles is licensed to practice law in the states of South Carolina and New York and will be sitting for the North Carolina bar this summer.

Chris Jones and Brad Van Hoy recently presented a webinar for the North Carolina Bar entitled “Eye of the Storm? A Review of the Tax Relief, Unemployment Insurance Reauthorization and Job Creation Act of 2010”.

Mark Horn made the 2011 North Carolina Rising Stars list, which is included in the North Carolina Super Lawyers magazine and also spoke to the Mecklenburg County Bar on Top 10 Estate Planning Opportunities for 2011.

Brad Van Hoy spoke on current developments in North Carolina and federal estate, gift and GST tax laws at the Annual Review for the Mecklenburg County Bar.

Neill McBryde is scheduled to speak at the Estate Planners Day at Queens University this spring and at the annual meeting of the Estate Planning and Fiduciary Law Section of the North Carolina Bar with Brad Van Hoy this summer. 

Matt Kain and Wilson Loftis authored Current Developments for the Will and The Way, the official publication of the Estate Planning and Fiduciary Law Section of the North Carolina Bar.

* To comply with certain U.S. Treasury regulations, we inform you that, unless expressly stated otherwise, any U.S. Federal tax advice contained in this newsletter is not intended or written to be used, and cannot be used, by any person for the purpose of avoiding any penalties that may be imposed by the Internal Revenue Service.

** Trudy H. Robertson, Moore & Van Allen PLLC, 40 Calhoun Street, Suite 300, Charleston, SC 29401, is the lawyer in South Carolina responsible for any advertising content in this communication.



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