Proposal to Limit Dynasty Trusts, from WSJ

It’s official: A type of trust used by the wealthy to shelter assets from estate taxes for hundreds of years, or even forever, is under fire.

The proposal, which first appeared a few weeks ago on a hit list of estate provisions in President Obama’s 2012 budget, would limit tax-free “dynasty trusts” to 90 years.

The chances of passage are practically zero this year, say experts. But taxpayers should know that the idea is in play—and act accordingly. As proposed, the change would apply to new trusts or additions of money to existing ones, but not to those already funded.

Bottom line: If you are considering setting up a dynasty trust, move swiftly. “This proposal reinforces the other reasons for doing so,” says Julie Kwon, a partner at McDermott, Will & Emery in Silicon Valley. Among them: the current generous terms of the estate and gift tax—a $5 million individual exemption and a top 35% rate, both of which are set to expire at the end of 2012.

“We’re encouraging people who want these trusts to set them up now,” Ms. Kwon says.

Dynasty trusts have gathered steam since the 1986 tax overhaul installed the current version of the “generation-skipping tax.” This levy imposes taxes that would be avoided if taxpayers left assets to heirs who are more than one generation below.

Example: Robert, a widower, has a net worth of $15 million and his heirs include children, grandchildren and great-grandchildren. If he leaves everything to his children and they in turn leave everything to theirs and so on, there could be an estate tax toll with each generation.

Robert would like to put his entire estate into a trust and skip layers of tax. But if he does, the generation-skipping tax kicks in and replaces the lost taxes—except for an exempted amount, which is currently $5 million per individual or $10 million per married couple. That $5 million can be pumped up using discounts, life insurance and other leveraging techniques.

Dynasty trusts push that generation-skipping tax exemption to the max, putting the exempted amount beyond the reach of estate taxes for the life of the trust. That, in turn, means the heirs don’t have to “spend” their own exemptions on those assets. These trusts are now allowed in 23 states and the District of Columbia (see table), to the delight of companies that charge fees to manage them. Taxpayers don’t have to live in a state to put a trust there.

To enable these trusts, most of the states allowing them had to get rid of an old common-law principle called the “rule against perpetuities,” which allowed trusts to exist only for about 90 years. The Obama administration proposal would reinstate this old principle in a way by removing the federal tax exemption after 90 years. So the trust can go on indefinitely, but the exemption can’t. (The pass applies to taxes on wealth transfers, of course; annual income taxes are always due.)

According to Ms. Kwon, “more than half” her clients choose to set up these trusts when presented with the option.

Opponents of dynasty trusts often object to them on policy grounds. Prof. Ray Madoff of Boston College Law School fears they will help create a new aristocracy with access to tax-free, creditor-proof wealth. She also worries they benefit bankers as much as families: “Bankers are using these trusts as a decoy to line their own pockets.”

Attorney Beth Kaufman of Caplin & Drysdale in Washington raises a practical issue: “Most of my clients like to know something about the people they are leaving money to.” According to a 2010 report written by University of Michigan law professor Larry Waggoner for the American Law Institute, which endorsed the restriction on dynasty trusts, the average person can expect to have 450 descendants 150 years after a trust is established. And a parent’s genetic relationship to a child can be 50%, while the one with an heir six generations removed is no more than 1.6%.

Attorney Howard Zaritsky, a consultant to other estate lawyers, believes the main benefit of long-lived trusts is that they protect family assets from being dispersed by creditor claims and divorce. For most trusts, he suspects, 90 years will be long enough.

For those opting into dynasty trusts, all the experts urge care in drafting because the distant future is full of unknowns. In particular, it should allow for the removal of the institution handling the trust so heirs won’t be captive to high fees or poor performance. Says Mr. Zaritsky: “Between the trustee and beneficiaries, there needs to be a balance of powers worthy of James Madison.”

Some Observations Worth Noting from the Will Doctor

Tax Rates: For decoupled states like NY and NJ, (not Fla), the estate tax rates are higher.  In NY, after a deduction for state estate taxes paid (highest NY bracket is 16%), the net NY tax rate is 10.4%, so:
For New Yorkers, estate taxes are now 35% plus 10.4%=45.4%.

Of course, in NY, estate taxes are paid on the inheritance over $1 million in value.  The tax on the $4 million difference between what the IRS allows each spouse, and NY allows, is $391,600.  This state estate tax must be considered in decisions about how to use our newly enhanced tax benefits to avoid the unnecessary payment of this tax.

NY has no gift tax, so gift taxes in excess of 1) the annual tax free $13,000 per donee, and 2) the lifetime federal exemption of $5 million are taxed at the 35% federal rate only.

Because of the different ways that gift taxes and estate taxes are calculated, it STILL pays to make lifetime gifts to reduce potential estate taxes. The effective rate of taxes on gifts at a 35% estate/gift tax rate is now 25.926%. For New Yorkers, this is more significant, since the difference is from 45.4% to 25.926%.

Another point to make when considering lifetime gifts vs. waiting for the estate tax, is that for purposes of NY estate tax, previous (“adjusted”) taxable gifts are not included in the computation of the NY estate tax.

ABA Posts TRA 2010 Tax Summary

The Trust & Estate Section of the American Bar Association has released an explanation of the new legislation which runs forty pages, but if you are interested, here it is:

www.abanet.org/rpte/eCLE/programs/2011/RP1TUT/ABA_TRA_2010_summary.pdf

We have been attending webinars and telephone lectures (five so far), and have some useful thoughts to put these in context, and should get to these soon.  The Will Doctor

Law Summary, Letter to Clients

More than you want to know, but thanks alot to the people at Wealth Strategies Journal for this piece:

On December 17, 2010 President Obama signed the Tax Relief, Unemployment Insurance Reauthorization and Job Creation Act of 2010 (the “Act”).  The Act significantly changes the federal estate tax, which impacts estate planning for many of our clients, and presents significant estate planning opportunities.  This memorandum summarizes the Act’s key changes and provides you with our observations about the Act’s impact from an estate planning perspective.  Please note that there are several important changes made by the Act that this memorandum does not summarize.

SUMMARY OF KEY ESTATE AND GIFT TAX PROVISIONS OF THE ACT

Estate Tax
Before the Act, the federal estate tax was gradually reduced over several years and then eliminated for decedents dying in 2010. Prior law provided that the estate tax, with a maximum tax rate of 55 percent and a $1 million applicable exclusion amount, would be reinstated after 2010. Additional changes scheduled for years after 2010 affected the gift and generation- skipping transfer (“GST”) taxes.
The Act reinstates the estate tax for decedents dying during 2010, but at a significantly higher applicable exclusion amount of $5 million, and a lower maximum tax rate of 35 percent, than under prior law. This estate tax regime continues for decedents dying in 2011 and 2012. Unfortunately, this new regime is itself temporary and will sunset on December 31, 2012 and the prior estate tax regime, with a 55 percent maximum estate tax rate and a $1 million applicable exclusion amount, is reinstated at that time.
The Act also eliminates the modified carryover basis rules for 2010 and replaces them with the stepped-up basis rules that had applied before 2010. Property with a stepped-up basis generally receives a basis equal to the property’s fair market value on the date of the decedent’s death. Under the modified carryover basis rules that applied during 2010 before the Act, executors could increase the basis of estate property only by a total of $1.3 million (plus an additional $3 million for assets passing to a surviving spouse, for a total increase of $4.3 million), with other estate property taking a carryover basis equal to the lesser of the decedent’s basis or the property’s fair market value on the decedent’s death.
The Act gives estates of decedents dying during 2010 the option to apply (1) the estate tax based on the new 35 percent top rate and $5 million applicable exclusion amount, with stepped-up basis, or (2) no estate tax and modified carryover basis rules under prior law.
The Act also provides for “portability” between spouses of the estate tax applicable exclusion amount for estates of decedents dying in 2011 and 2012 if both spouses die before 2013. Generally, portability allows surviving spouses to elect to take advantage of the unused portion of the estate tax applicable exclusion amount (but not any unused GST tax exemption) of their predeceased spouses, thereby providing surviving spouses with a larger exclusion amount. Special limits apply to decedents with multiple predeceased spouses.
To preserve the first deceased spouse’s unused applicable exclusion amount, the executor for such spouse must file an estate tax return and make an election on such return, even if such an estate tax return would otherwise not be required.

Gift Taxes
For gifts made in 2010, the maximum gift tax rate is 35 percent and the applicable exclusion amount is $1 million. For gifts made in 2011 and 2012, the Act limits the maximum gift tax rate to 35 percent and increases the applicable exclusion amount to $5 million. As discussed below, this change provides an opportunity to move significant amounts of wealth free of estate and gift taxes.
Donors continue to be able to use the annual gift tax exclusion before having to use any part of their applicable exclusion amount. For 2010 and 2011, the annual exclusion amount is $13,000 per donee (married couples may continue to “split” their gift and may make combined gifts of $26,000 to each donee).
Generation Skipping Transfer (“GST”) Tax
The Act provides a $5 million GST exemption amount for 2010 (equal to the applicable exclusion amount for estate tax purposes) with a GST tax rate of zero percent for 2010. For transfers made after 2010, the GST tax rate would be equal to the highest estate and gift tax rate in effect for the year (35 percent for 2011 and 2012). The Act also extends certain technical provisions under prior law affecting the GST tax.

OBSERVATIONS REGARDING THE ACT
Generally, the estate and gift tax provisions of the Act are very favorable to taxpayers because of the substantial increase in the applicable exclusion amount, to $5 million, and the lower maximum estate and gift tax rate of 35 percent. The Act also addresses several technical estate, gift and GST tax issues in a manner that is favorable to taxpayers (e.g., the impact of the lapse of the estate tax, including the application of basis rules, on decedents passing away during 2010).

Temporary Fix
The Act is a temporary fix, which sunsets on December 31, 2012, immediately after the next election cycle. It is impossible to predict whether it will be extended in either its current or some modified form, especially given the fact that it is a hot button issue with both major political parties. If Congress fails to act, the Act will lapse and the estate tax will revert to what it would have been under prior law (i.e., $1 million applicable exclusion amount and 55 percent maximum estate and gift tax rate).

Increased Gift Tax Applicable Exclusion Amount
From 2001-2010, the applicable exclusion amount for gift tax purposes has been $1 million. The Act increases this to $5 million, or $10 million per married couple. This change provides an unprecedented opportunity to move substantial amounts of wealth out of individuals’ estates. There are several techniques that individuals can use to leverage this $5 million applicable exclusion amount, to move substantially more wealth out of their estates.
To illustrate, individuals can now make gifts of $5 million to trusts governed by the laws of certain states, such Delaware and Alaska, move all growth in such wealth out of their estates, provide a significant amount of asset protection for such assets, and the transferor may continue to be a discretionary beneficiary of such trusts, without any gift tax cost.
In addition, the increased gift tax applicable exclusion amount increases the amount of assets that individuals can transfer via an installment sale to a dynasty/grantor trust. Under this estate planning technique, individuals can now make an initial gift of as much as $5 million ($10 million per married couple) to a dynasty trust, and then transfer as much as $45 million ($90 million for a married couple) to such dynasty trust in exchange for an installment note. This technique works especially well for family businesses that are expected to grow significantly in value over time.
Given the fact that the Act will sunset without further Congressional action in 2012, we are advising clients that it would be prudent to implement estate planning techniques utilizing lifetime gifts before the December 31, 2012 sunset date.

State Estate Taxes
Many states have separate estate tax regimes with lower applicable exclusion amounts than the federal applicable exclusion amount. These include the District of Columbia, Maryland, New Jersey, and New York, among others. It is critical that the estate plans of individuals living in or owning property located in such states address such estate tax exposure.

Portability
One of the more notable provisions contained within the Act is the “portability” provision, which provides in general terms that if one spouse does not fully utilize his/her entire $5 million applicable exclusion amount, the unused portion can be used by the surviving spouse’s estate. This provision is intended to avoid the need for credit shelter trusts in estate planning documents. Unfortunately, both spouses must die before 2013 in order to benefit from the portability provision.
In addition, credit shelter trusts continue to provide significant additional benefits beyond just the use of each spouse’s applicable exclusion amounts. These include the following:
· Ensuring that assets contained in the credit shelter trust pass to children of the couple and not to any new spouse of the surviving spouse.
· Ensuring that appreciation on the assets contained within the credit shelter trust, which may exceed the applicable exclusion amount at the surviving spouse’s death, are not subject to estate tax at that time.
· Protection of assets in the credit shelter trust from creditors of the surviving spouse, including any marital claims of future spouses.
Given the fact that the portability provision will sunset in 2012, as well as for the reasons stated above, we are advising clients to continue to use estate plans that incorporate credit shelter trusts.

Things Not In the Act
There are two key provisions that many commentators feared would be in the Act, but which were not included in it. Specifically, there have been several proposals to place limits on Grantor Retained Annuity Trusts (“GRATs”), which allow individuals to transfer wealth out of their estates with as little as a zero estate or gift tax cost that would have made GRATs less valuable from an estate planning perspective. There have also been several proposals to limit valuation discounts in connection with certain estate planning techniques such as family limited partnerships. There were no such provisions included in the Act. Therefore, these techniques continue to be available to move wealth to lower generations.

Temporary Relief Does Not Extend to Non-US Citizens Who Are Not Resident for Estate Tax Purposes
The Act reinstates federal estate taxes on United States-situs property of non-US citizens who are not residents. The increased applicable exclusion amount to $5 million per person does not apply to non-US citizens who are not residents. US situs property exceeding $60,000 in value is again currently subject to US estate taxes beginning at graduated marginal rates beginning at 18 percent. Accordingly, particular vigilance needs to be exercised in structuring the acquisition of US assets such as real property, so as to avoid imposition of US estate taxes at pre-2010 levels.

SUMMARY
To summarize, the Act makes significant estate and gift tax changes. The key points discussed above include the following:
· The estate tax exclusion amount increases to $5 million per person for 2010 through 2012.
· The maximum estate and gift tax rate is reduced from the 55 percent maximum rate under prior law to a maximum estate and gift tax rate of 35 percent for 2011 and 2012.
· A “portability” provision is included, which allows surviving spouses to use any applicable exclusion amount that is not used by the first spouse to pass away.
· The GST exemption amount is increased to $5 million for 2010 through 2012.
· The Act sunsets at the end of 2012, thus making the foregoing changes temporary in nature.
As always, we recommend that clients review their estate plans periodically and/or whenever a significant life event occurs (e.g., birth of a child, death of a spouse, purchase of new home, etc.).
For clients with substantial amounts of wealth and with closely held businesses, we highly recommend that such clients consider using lifetime gifts to take advantage of the current $5 million lifetime gift tax applicable exclusion amount, which will expire absent further Congressional action at the end of 2012.
Please do not hesitate to contact us with any questions that you might have or if you would like to discuss your estate plan in light of the Act.

Link to Brief NY Times Analysis

Just a few points, but worth perusing:

http://www.nytimes.com/2010/12/18/your-money/taxes/18wealth.html?ref=business

A Reference for Professionals

Please use the following link for an excellent source of basic data on the new law.

http://www.taxpolicycenter.org/taxtopics/Compromise_Agreement_Taxes.cfm

Thursday Night, Midnight, Congress Passes Obama Tax Deal

We will have alot to discuss in coming months as we digest the new law, and its temporary nature. For now, its enough to point out that our descendants will be able to (we hope) enjoy more of our hard earned wealth.

Deal Includes Unification of Exemptions for Gifts, and Estates

Assuming the details in the final bill currently under negotiation are not changed,  (the discussions surround the amount of the Exemption, and the tax Rate), the unification of Exemptions for lifetime gifts and estates at death opens up great opportunities for our clients.

Under the law before 2010, the exemption for estates increased each year up to the final $3.5 million in 2009-but the amount of lifetime gifts you could make (in excess of annual exclusion gifts of $13,000 per donee) never went above $1 million.  The original amount of your death-time Estate Tax Exemption is always (in the past and under proposed law for the next two years) reduced by the amount of the Lifetime Gift Tax Exemption used through lifetime gifts.  Don’t forget that all of the Exemptions are available for each parent who takes advantage of them, and one parent can use the others’ gift tax Exemptions and Exclusions if a gift tax return is filed.

Lets illustrate this with an example, assuming a $5 million Exemption.   Now our clients can EACH gift, without tax, during life, up to $5 million (or one spouse can gift up to $10 million and use both, as noted above).  If they did gift the full Exemption during life, there would be no estate tax Exemption remaining for use on the estate tax return.   If one parent gifted $2 million during life, on death their estate would not be taxable until after the first $3 million.

Coupled with the expected continuation of favored estate planning techniques such as Grantor Retained Annuity Trusts (GRATs), and the use of minority interest and marketability discounts on the value of our property subject to estate and gift taxes, this represents a HUGE opportunity to reduce future estate taxes for families whose wealth exceeds the Exemption thresholds.

Previously, the Gift Tax Lifetime Exemption remained lower than the Estate Tax Exemption for a reason: The Congress/IRS didn’t want taxpayers to gift large amounts of wealth to other family members who would pay the taxes on the income produced by the gifted property at lower tax rates-it was to prevent bracket shifting on income tax returns.  That strategy has, it seems, been abandoned, and with it, additional tax savings can be generated with thoughtful planning.  Interestingly, the Will Doctor points out that the use of Grantor Trusts (where the donor pays income taxes on gifted property) has increased dramatically in recent years, as a better alternative than bracket shifting.

Portability of Estate Tax Exemptions, between spouses is another bonus in the proposed law which will help make sure that parents who are not careful about their estate planning dont loose the ability to use their estate tax Exemptions.

One more point, for now: The ability to make annual tax free gifts of $13,000 per donee continues under the proposed law.  This was already indexed for inflation (and will not change in 2011).  The unified estate and gift tax exemptions, finally, as proposed, will also be indexed starting next year.

Latest from the House-Tax Deal Defeated

Latest this afternoon is that House Democrats voted down the proposed tax deal. This was to be expected, as maneuvering towards serious negotiations to water down the Obama/Republican estate tax proposal.

Estate and Gift Taxes in 2010, Looks Good

Wall Street Journal today reports that the proposed tax legislation is being prepared to include a provision for deaths occurring in 2010, giving the option to choose the law existing in 2010 (repeal, with its loss of step up in basis), or the new law in 2011 (and we fully expect a return of basis step up with the tax exemptions and rates previously discussed).

This is good news for those smaller estates for decedents who passed away in 2010 which would not have paid estate taxes under 2009 or 20011 laws, but who lost the step up in basis. This effectively represented an unintended income tax penalty for smaller estates, which may now be rectified.