Estate Planning Concepts In
an Age of Uncertainty
Scott Dondershine, CPA, Esq.
David, Brody & Dondershine, LLP
(703) 264-2220
sdondershine@dbd-law.com
12/15/09
Copyright 2009 Scott Dondershine
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Introduction
• Status of the Federal Estate Tax Laws
• Summary of Basis Estate Planning
Concepts
– Use and Purpose of RLTs
– Use and Purpose of ILITs
• Succession Planning for Businesses
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WHY DO I NEED AN
ESTATE PLAN?
• Distribute your assets in
the time & manner you
intend
• Creditor Protection
• Avoid Need for Probate
• Incapacity Planning
• Prevent IRS from
becoming the major
beneficiary of your estate
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Distributing Assets
in the Intended Manner
• How should the
assets be distributed?
– Outright to your
children in a lumpsum?
– Remain in trust until:
• Special concerns?
–
–
–
–
Special needs trust?
Education?
Creditors?
Charity?
• Children/grandchildren
reach certain age?
• Stagger distributions
• Longer period of time
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Avoid Probate
• Although the states have simplified the
procedures:
– Still time
– Still money
– Still public process
– Still a hassle
• Assets in trust avoid probate
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Creditor Protection
• Although generally does not protect
grantor from his/her creditors:
– Can protect kids from their creditors (two
slides from now)
– Divorce of a child
– Bankruptcy or other creditor
• Exception to general rule for grantors in
VA (next slide)
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VA Code Section 55-20.2
• TBE Property Protection for:
– Assets held jointly (AS TBE) and then
transferred to trusts
– Personal or real property
• May require multiple transfers to take
advantage of provision
– Intermediate transfer to TBE
– Then transfer to the trusts
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Dynasty Trusts
• Like a Tube of Toothpaste (Better off
inside)
• Problem with mandatory or staggered
distributions
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Incapacity Planning
• Easier to Manage Assets Through Trusts
• Without Trust:
– Power of Attorney (“POA”)
– Is the POA going to be recognized in the
distant future?
– Risk of revocation
• Do not have same risk with a trust and can
specify instructions
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Taxes, Taxes,Taxes
• “The art of taxation consists in so plucking
the goose as to obtain the largest possible
amount of feathers with the smallest
possible amount of hissing”
• Jean Baptiste Colbert (King Louis XIV
Finance Minister)
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Applicable Exclusion Amount
(Unified Credit)
• Shelters assets from:
– Estate taxes, or
– Gift taxes
• Important to maximize
use to minimize taxes
• Has increased as part
of 2001 Tax Act
• Increases are then
rescinded in 2011
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2001 Tax Act
• Key to understand – The Economic
Growth and Tax Relief Reconciliation Act
of 2001 (“EGTRRA”)
• Huge act but three main points for today:
– Increase in estate credit until 2010 repeal
– Phase-out of tax brackets
– Repeal of step-up in favor of modified basis
increase
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Sunset? Why?
• Sunset provision needed to comply with “Byrd
Rule”
• Byrd Rule permits Senators to raise points of
order against “extraneous” provisions such as a
budget impact beyond period covered in the
applicable reconciliation measure
• Can waive rule if have 60 votes
• Republicans did not have 60 votes
• So, Republicans choose sunset to avoid
implementation of the Byrd Rule
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Amount of Exclusion
from Estate Taxes
•
•
•
•
•
•
•
2001 - $ 675,000
2002 - $1,000,000
2003 - $1,000,000
2004 - $1,500,000
2005 - $1,500,000
2006 - $2,000,000
2007 - $2,000,000
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• 2008 - $2,000,000
• 2009 - $3,500,000
• 2010 – N/A: no estate
taxes
• 2011 & after $1,000,000*
*(this is not a typo!)
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Phase-out of Tax Rates
Highest Tax Rate:
2001- 55%
2002- 50%
2003 - 49%
2004- 48%
2005- 47%
2006- 46%
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2007-2009 – 45%
2010 – N/A
2011 – back to 2001
so 55%
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Impact on Gift Taxes
• Credit for gift taxes does not change and
is frozen at $1mm
• For 2010, the maximum gift tax rate is
35% - §2502
• After 2010, if sunset applies then back to
pre-EGRRTA rules apply (linkage to estate
tax system as a “unified system”)
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Generation Skipping Taxes
• GSTT exemption:
– 2009 - $3,500,000
– 2010 – N/A (no GST)
– 2011 - $1,060,000 per sunset
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Partial Step Up in Basis
• Before EGTRRA
– Assets subject to estate tax but basis in all
assets increased to market value on (§1014):
• Date of death; or
• Value on alternate valuation date (6 months after
death)
• EGTRRA “repeals” the estate tax laws and
for decedents dying after 12/31/09, there
is no more basis increase (§1014(f))
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Complicated Basis Rules
• Since step-up repealed, there instead is a
modified carry-over basis (§1022)
• Subject to certain conditions:
– General basis increase is an additional $1.3mm
– Assets to surviving spouse can receive a $3mm
additional basis increase
• So, need to track the allocations and it can be
very complicated series of computations
• This rule also sunsets as it is part of EGTRRA
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If Modified Rules Continue
• Estate planning documents (RLT and/or Will)
should:
– Direct representative to use discretion to allocate
basis increase to certain assets
– Prefer allocation to:
• assets that are most likely to be sold in the future
• assets, which if sold, would produce ordinary income rather
than long term capital gains
– Don’t allocate to:
• assets that will, or are likely to pass to, charitable
beneficiaries
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Lot of Confusion
• What is going on?
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How to Plan?
• How does one plan?
– Will the sunset of EGTRRA occur resulting in
a $1mm credit and full-step up in basis under
§1014?
– Will there be a full permanent repeal with the
“modified basis increase” (basically keeping
2010 in the future)?
– Will there be compromise legislation?
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Survey Says!
• Proposals:
– Before the recent budget crisis thoughts of
permanent and full repeal
– Now:
•
•
•
•
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Most seem to predict credit of $3.5 mm per person
Some predict credit of $2 mm per person
Top rate probably will be 45%
Possible portability of the credit from spouse to
spouse
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Senate/House Bills
• House passed on 12/3/09, H.R. 4154 (225 v. 200)
–
–
–
–
$3.5mm permanent exemption for estate & GSTT (not indexed)
Maintain $1mm exemption for gift taxes
Reinstatement of step-up in basis rules
45% top rate for estate and gift taxes
• Senate is considering S. 2784
–
–
–
–
$3.5mm permanent exemption with inflation index adjustment
Credit is unified – applies to estate and gift taxes
45% top rate for estate and gift taxes
Portability of unused credit
• Not exactly sure what will happen in reconciliation
• Bottom line: amendment likely will be the one with “the
smallest possible amount of hissing”
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Timing of Change
• Back in 2001 conventional wisdom was for
quick adoption
• Now, issue not priority and 2010 is
approaching
• Best guess: change before first return for
2010 is due
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Retroactive Effect
• Initial reaction is for no retroactive effect
– No ex post facto laws – Art I, Sect 9 of Cons
• However, per US Supreme Court:
– Calder v. Bull (1798) – Art 1, Sect 9 applies to criminal
laws
– U.S. v. Carlton (1994) – retroactive application of
amendment to estate tax code does not violate due
process clause of 5th amendment unless since
retroactive impact rationally related to a legitimate
legislative purpose
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Where Go From Here?
• Lots of confusion
• Plan for worst case
scenario:
– Estate taxes with
$1,000,000 credit in 2011
– A/B trust, unless both
spouses have less than
$1,000,000 “for sure”
• May want to amend plan
if estate tax repeal is
made permanent
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A/B Trust – Slide I
• Avoid Pitfalls
– Joint Ownership
– Life Insurance
– Retirement Assets
– “I Love You Will”
• Problem with above is “wasted credit of
first spouse”
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A/B Trust – Slide 2
• Goal:
• Pitfalls:
– Make sure that each
spouse can utilize
applicable exclusion
amount (unified credit)
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– If do not implement,
then may only be able
to utilize one spouse’s
unified credit
– For instance, based
upon credit in 2011 (if
complete sunset) want
to shelter $2,000,000
not just $1,000,000
– Savings: up to
$435,000
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Family Trust
• Amount up to Estate Tax Credit
• Income and principal to spouse and
children for (“HEMS”):
– Health
– Education
– Maintenance
– Support
• Spouse can be sole trustee
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Marital Trust
• Amount in excess of credit
• Income annually to spouse
• Principal for health, education, welfare of
support of the spouse (“HEMS”)
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Why Should We Worry – We Have
Less than $1,000,000 in Assets!
• Include:
–
–
–
–
–
–
–
Assets of both spouses unless A/B trust and retitling
Life insurance
Portion of jointly-owned property
IRA and other retirement plans
Household and personal effects
Collectibles
Assets in a revocable living trust
• Appreciation
• Anticipated inheritances or gifts
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What if Assets > Both Credits
• If assets exceed the credits of both
spouses then:
– Consider ILIT
– Consider CRT
– Consider GRATs
– Consider discounting & leveraged gifts
– Other vehicles beyond scope, e.g., QPRT
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ILIT - Basics
• Purpose – insurance not taxed and can
pay for taxes on remaining assets
• Watch out for three year rule
• Some flexibility in trustees but consider
“reciprocal trust doctrine”
• Can incorporate dynasty trust provisions
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ILIT – Flexibility
• Trust protector provisions
• Possible to transfer insurance to new trust
• Possible to cancel policy and have new
trust with different terms obtain new policy
• But be mindful of:
– Fiduciary duties
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Charitable Remainder Trusts
• CRATs and CRUTs
– Lifetime annuity or percentage to decedent
and/or spouse
– Remainder to charity
• Large asset and appreciation removed
from estate
• Income tax deduction
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Replace Lost Principal of CRT
- Purchase life insurance using cash
generated from tax savings (income tax
deduction)
- Own insurance in ILIT
- Best of both worlds – lot of assets out of
estate, benefit charity and replace
principal with no estate tax increase due to
ILIT
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GRATs
• Retained annuity for the grantor
• Remainder passes to beneficiary, e.g., children
• Benefits:
– Annuity stream
– Grantor taxed on income, i.e., grantor trust
– Tax structure very clear as it is a statutory vehicle
(§2702(b))
– Appreciation on trust property in excess of §7520 rate
(120% of mid-term AFR) is removed from estate if
grantor survives the term
– Can “zero out” gift tax
– Remainder removed from estate if survive term
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GRATs (Slide II)
• Disadvantages:
– If die during term, value of the property
included (so, use series of rolling GRATs)
– If survive annuity term, then annuity stops so
need to have replacement “stream” if Grantor
needs same
– Discount or “hurdle” rate is higher than used
in a private annuity or installment sale since
120% of mid-term rate not 100%
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Gifts
• Gift of assets using up estate tax credit
• Gift of assets using annual credit
• Future appreciation in the assets avoids
estate/gift taxation
• Discounts may be available through FLP
and other means
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Goals of Buy-Sell Agreements
• Provide a Market for Shares Upon Death
of a Stockholder or Termination of
Employment
• Restrict Transfer of Shares During Lifetime
• Lock in the Value of Shares for Estate Tax
Purposes
• Secure Successful Transition of Business
from One Generation to the Next
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Provide a Market for Shares
• Insurance proceeds
– Death
– Disability
– Retirement or other termination of
employment - CSV
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Restriction on Transfer of Shares
•
•
•
•
Desired sale to third party
Bankruptcy or divorce
Gift or pledge
Termination: For Cause and Not For
Cause
• Death
• Drag Along
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Lock in Value for Estate Tax
Purposes
• Section 2703 of IRC and 2031
• Avoid worst case scenario of valuation greater
than sales price per buy-sell agreement
• Minimize audit exposure and avoid worst case
scenario
• Save a lot of estate taxes and attorney fees
• A lot of agreements do not sufficiently consider
this issue
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Six Requirements for Locking in
Value (Req. 1 & 2)
•
The estate must be obligated to sell
the stock at the price set forth in the
agreement. From 2031-2(h) and case
law but not Section 2703.
• The agreement must be applicable to
transfers during life. From 2031-2(h)
and case law but not Section 2703.
(If not from §2703 then “presumption” for
non-family buy-sells does not apply)
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Requirements for Locking in Value
(Req. 3 & 4)
•
•
Agreement must either fix a price or
set forth a mechanism for its
determination and the price must be
fair and reasonable. From 2031-2(h)
but not from 2703.
Agreement must be entered into for a
valid business purpose. From 20312(h) and set forth in Section 2703.
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Requirements for Locking in Value
(Req. 5)
•
The Agreement must not be a
substitute for a testamentary devise.
From 2031-2(h) and also set forth in
Section 2703. Two Tests:
– Does the agreement serve a testamentary
purpose?
– Was formula fair at the time when the
agreement was entered into?
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Requirements for Locking in Value
(Req. 6)
•
Terms of buy-sell agreement must be
comparable to similar arrangements
entered into by persons in an arm’s
length transaction. From Section
2703.
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Business Succession
• Who will inherit?
• Who should run the business?
– Kids
– Spouse
– Creditors
– Key employees
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Cross-Purchase Type
• Cross-Purchase
– Increase in basis
– Can be complicated if have more than three
or four stockholders: Each stockholder needs
to own policy on life of every other
stockholder unless:
• Possible to use LLC (but probably need to
establish business purpose besides owning
insurance)
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Redemption Type
• Stock Redemption
– No increase in basis
– Proceeds subject to creditors of the business
– Possible AMT for non-small (§55(e)) C Corps
(ACE adjustment when paid)
– Avoid potential dividend treatment if not
buying all shares
– Probably easier to administer
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Transfer for Value Pitfall
• Recipient Generally Not Taxed On Receipt
of Proceeds
• Exception that results in tax: If swap
policies to start agreement or other
transfer occurs
• Very easy to fall into this trap - even if coown policies to reduce required number
• Potential solution if problem difficult to
otherwise avoid: Have LLC own policies
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Who Pays Premiums?
• Recognize income tax issues
• Possible use of split-dollar funding
arrangement where corporation pays
premiums but shareholder owns all or
portion of policy
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Who Owns Policy?
• If cross-purchase - shareholders need to
own policies
• If redemption - company needs to own
policies
• Possible use of split-dollar arrangement or
LLC
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What Happens to Excess
Proceeds?
• If don't pay attention – you are rolling the
dice
• Generally, excess should be retained by
owner of policy: corporation or other
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Summary – Buy-Sell
• Very important tool to consider even if
estate and gift taxes are repealed
• But, must carefully consider all issues
since there are many traps for the unwary
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Other Issues
• Powers of attorney:
– Medical
– Financial
• Living Will
• Creditor Protection
Planning
• Pour-over Will – appoint
guardians for children
• Special Needs Trusts
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The End
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