by David Pratt and Scott Andrew Bowman
For tax and estate planning attorneys, 2011 and 2012 was a whirlwind of advising clients to maximize transfer tax planning opportunities. Practitioners worked to ensure that clients took advantage of what many thought would be a once in a lifetime opportunity to transfer up to $5 million ($5.12 million in 2012) free from federal gift and generation-skipping transfer (GST) taxes. Alas, by the time the dust settled on January 1, Congress was already hard at work passing the American Taxpayer Relief Act of 2012 (ATRA).1 With President Obama’s signature the next day, it turned out that all the efforts in 2012 may have been unnecessary in many cases. So after all that, it’s 2013. Now what?
This article discusses the important provisions of ATRA as related to transfer tax and estate planning and the impact the legislation will have on planning in 2013 and beyond. It further addresses the need to look back to 2012 to ensure that all the “t’s” are crossed and “i’s” are dotted with respect to planning that took place in the whirlwind, particularly at the end of 2012 when clients and practitioners were racing to sign and fund trusts, and discusses several techniques to implement post-transfer “clean up.” Finally, it highlights “zero-gift” planning opportunities that remain attractive for clients who maxed out their applicable exclusion amount in 2012.
Transfer Tax Provisions of ATRA
• Critical Provisions — Most important among ATRA’s provisions is the continuation of the three hallmarks of the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 (TRA 2010). Namely, ATRA maintains the reunification of the estate and gift tax regimes, an applicable exclusion amount of $5 million (as indexed for inflation, which is $5.25 million for 2013) for estate, gift, and GST tax purposes, and the “portability” of the applicable exclusion amount from a deceased spouse to a surviving spouse. In addition to making permanent the three hallmarks of TRA 2010, ATRA also makes permanent the deduction for state death taxes under §2058,2 liberalized provisions under §6166 related to the extension of time to pay estate tax with regard to certain closely held businesses, and certain GST “simplification” provisions, which are further discussed below.
ATRA also implements a technical correction to the portability provisions of TRA 2010. In calculating the deceased spousal unused exclusion amount under §2010(c)(4)(B), TRA 2010 referred to the “basic exclusion amount” of the last deceased spouse of the surviving spouse. Many practitioners thought this reference was erroneous given the now-famous example 3 of the Joint Committee on Taxation’s “Technical Explanation of the Revenue Provisions Contained in the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010.”3 Indeed, in March 2011, the Joint Committee on Taxation issued an errata statement suggesting that a technical correction may be necessary to substitute the term “applicable exclusion amount” for “basic exclusion amount.”4 The Treasury Department subsequently confirmed this thinking in promulgating the temporary treasury regulations regarding portability.5 ATRA now provides a statutory fix by substituting the term “applicable exclusion amount” for “basic exclusion amount.” This provides statutory confirmation of the regulatory fix.
ATRA is a relief in that it finally introduces some certainty into the transfer tax law. As practitioners and clients are well aware, ATRA’s predecessors, the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) and TRA 2010 both contained “sunset” provisions that made planning challenging.
Under EGTRRA, 1) the applicable exclusion amount for estate and GST taxes increased to $1 million in 2002 and 2003, $1.5 million in 2004 and 2005, $2 million in 2006, 2007, and 2008, and $3.5 million in 2009; 2) the applicable exclusion amount for purposes of the gift tax was fixed at $1 million; and 3) the estate, gift, and GST rates were reduced to 45 percent. EGTRRA culminated with the repeal of the estate tax in 2010 and the institution of the carryover basis regime under §1022. Well, at least it started out that way.
In December 2010, Congress passed TRA 2010. In addition to delaying the sunset of EGTRRA, TRA 2010 provided for an election for the estates of decedents dying in 2010 to choose between a new estate tax regime and the carryover basis regime. The estate tax regime applicable under TRA 2010 for 2010 included a $5 million applicable exclusion amount and a 35 percent rate. The gift tax applicable exclusion amount remained at $1 million and a 35 percent rate. No GST tax was imposed on GSTs occurring in 2010.
For 2011 and 2012, TRA 2010 then provided for the reunification of the estate and gift tax regimes, an applicable exclusion amount of $5 million, indexed for inflation, for estate, gift, and GST tax purposes, and “portability” of the applicable exclusion amount from a deceased spouse to a surviving spouse. TRA 2010 created a two-year period for these new provisions to apply, with a scheduled sunset of December 31, 2012. The sunset of TRA 2010 would have meant a return to a $1 million applicable exclusion amount (indexed for inflation in the case of the GST tax exemption) and a maximum rate of 55 percent, as well as the other EGTRRA provisions mentioned above.
ATRA, however, not only avoided the sunset of TRA 2010 and EGTRRA, but also made their provisions permanent. Clients and practitioners can breathe a sigh of relief knowing that the reunification of the estate and gift tax regimes, an applicable exclusion amount of $5 million, and portability are here to stay — at least for now.
• GST Simplification Provisions — As mentioned, ATRA also made permanent the GST “simplification” provisions ushered in by EGTRRA. Believe it or not, prior to EGTRRA, the GST tax provisions were even more complicated than they are today. Indeed, as an impetus to simplify such provisions, many professionals opined that the GST tax provisions, as they previously existed, were the cause of malpractice suits.6
A full discussion of EGTRRA’s changes to the GST tax provisions is beyond the scope of this article and probably unnecessary, as most practitioners believed that these noncontroversial provisions would eventually be made permanent regardless of any debate about the applicable exclusion amount and transfer tax rates. However, two often overlooked provisions should be addressed, as they are extremely helpful in curing past mistakes — namely, certain relief provisions under §2642(g)(1) and the substantial compliance provisions under §2642(g)(2). In addition, the “qualified severance” rules under §2642(a)(3), as discussed below, are here to stay as a result of ATRA.
Under §2642(g)(1), a taxpayer can obtain relief in the event the taxpayer has failed to timely file certain elections pertaining to the allocation of GST tax exemption. Pursuant to this provision, the treasury secretary is authorized to grant extensions of time to allocate GST tax exemption and to grant extensions to the time requirement, regardless of whether the period of limitations has expired. Moreover, in determining whether to grant an extension, the treasury secretary shall consider “all relevant circumstances, including evidence of intent contained in the trust instrument….”7
Under §2642(g)(2), a taxpayer can obtain relief in the event the taxpayer has not “literally” complied with the rules regarding the allocation of GST tax exemption. This provides that substantial compliance with the statutory and regulatory requirements for allocating GST tax exemption will suffice to establish a valid allocation to a particular transfer or a particular trust. If a taxpayer demonstrates substantial compliance, then so much of the taxpayer’s unused GST tax exemption will be allocated to the extent it produces the lowest possible inclusion ratio. Similar to the relief provisions under §2642(g)(1), in evaluating substantial compliance, the treasury secretary shall consider “all relevant circumstances, including evidence of intent contained in the trust instrument….”8
Practitioners should review a client’s past gift tax returns and previously established trusts to determine whether GST tax exemption was allocated properly or whether an election was properly made (or not made). If not, they should ask the IRS for relief in the form of a private letter ruling using §2642(g).
• “Omitted” Provisions — It is also important for practitioners to note what was not included in ATRA. The Obama Administration has long had loftier goals for the reformation of the transfer tax system than what made its way into ATRA. Among the targets on the “hit list” of the administration’s so-called “Green Books” have been proposals to curb the use of valuation discounts as applied to nonbusiness assets; to require a 10-year minimum term for grantor-retained annuity trusts (GRATs); to terminate the GST tax-exempt status of GST tax-exempt “dynasty” trusts after 90 years from the date of funding; and to treat transfers to defective grantor trusts, for all intents and purposes, as estate tax includible.9 It will be interesting to see whether any of these provisions are tacked on as “revenue raisers” as budget talks continue deeper into 2013.
Cleaning Up 2012
Now that there is some certainty in the transfer tax regime, many practitioners may need to refocus their attention on “cleaning up” some of the lingering transactions from 2012.
• Gift Tax Returns — For gifts made in 2012, federal gift tax returns (Form 709) are due on April 15, 2013. Of course, this date can be automatically extended until October 15, 2013, by filing for an income tax extension on Form 4868. Although many clients made gifts at or below the applicable exclusion amount and will not owe gift tax, some made cumulative gifts in excess of $5.12 million in contemplation of paying gift tax at the historically low rate of 35 percent. Although the due date for the gift tax return can be extended until October 15, 2013, the due date for the payment of gift tax cannot be extended. Thus, clients will need to raise cash to pay such tax on or before April 15. Additionally, if hard-to-value assets have been gifted, which generally requires an appraisal to substantiate the value of the gift, advisors must obtain values from the appraisers so that the gift tax can be computed. Gifts that were made using “defined value” or “formula” clauses may also raise some reporting complexities, as further discussed below. Finally, clients should keep in mind that in the event their planning contemplated gift splitting, they must elect to gift split on their gift tax returns.
• Implementation and Reporting of Defined Value Gifts — Because of timing issues associated with obtaining appraisals and the desire to “hit the nail on the head” in making gifts of exactly $5.12 million, many clients implemented 2012 gifting through the use of “defined value” or “formula” clauses. These gifts were most commonly made of a client’s interests in closely held entities, whether corporations, limited liability companies, or partnerships. This gifting technique was particularly attractive following the 2012 taxpayer victory in Wandry v. Commissioner, T.C. Memo 2012-88, notwithstanding the IRS’s later nonacquiescence.10 Although practitioners carefully navigated Wandry and other defined value clause cases11 in advising clients with respect to these gifts, it is equally important to implement and report such gifts properly to ensure the benefits of the planning.
From an implementation standpoint, the first step may very well be to obtain appropriate appraisals. In most cases, given the flurry of gifts made at the end of 2012, the appraisals of such gifts were not even started. It is important for practitioners to follow up with the appraisers as soon as possible to determine the interest in the entity (i.e., shares of stock, partnership interests, or membership interests) that corresponds with the formula, as based on the appraisal. Once the appraisal is finalized, the transferred interest needs to be properly reflected on the entity’s books and records, and administered accordingly.
When documenting a specific number of shares of stock, partnership interests, or membership interests for transfer on the entity’s books and records, the transfer should be caveated appropriately with a footnote or other cross-reference to the defined value or formula clause. Although it is likely acceptable to reflect a transfer of a specific interest on the entity’s books and records, it must be crystal clear that the specific interest is derivative of the appraisal, and not of the finally determined value used for federal transfer tax purposes, which ultimately controls the specific interest that is transferred pursuant to the clause.
Documenting this transfer as such is particularly important with respect to flow-through entities (i.e., subchapter S corporations, partnerships, and limited liability companies) as, generally, distributions are made on a pro rata basis and taxable income is allocated on a pro rata basis. Subchapter S corporations will require this information by the 15th day of the third month following the end of their tax years to file Forms 1120S timely and to provide shareholders with appropriate Form K-1; partnerships will have until the 15th day of the fourth month after the end of their tax years to file for Form 1065 and appropriate Form K-1. Of course, this issue is mitigated, at least from a tax liability standpoint, to the extent that the defined value or formula gifts were made to defective grantor trusts.
In addition, when interests are transferred by or to trustees of irrevocable trusts, the trustees will have fiduciary obligations that must be satisfied with respect to such gifts. Translating the formula into a specific interest, even if using the appraised value as an estimate until there is a finally determined value, helps to satisfy the trustees’ fiduciary obligations.
From a disclosure standpoint, the defined value or formula gift must be properly reported on the client’s gift tax return in order to start the running of the statute of limitations. This is not only important from an audit standpoint, but also from the perspective of reaching a finally determined value so that the terms of the formula clause can take effect with finality. The gift should be reported as a specific dollar amount, not as a specific interest in the entity. Clients should then disclose the specific interest that equals the defined value based on the appraisal, which should be attached to the gift tax return. Additionally, if the planning involved a sale transaction, the sale should be disclosed so that the statute of limitations can begin running instead of remaining open indefinitely, particularly when the client’s estate is required to check “yes” regarding prior sale transactions in answering question 13e of Part 4 of the estate tax return (Form 706).
• Clients Want to “Change” the Terms of the Trust — In the frenzy of signing and funding trusts prior to the end of 2012, many clients may not have had ample time to consider fully all the various provisions in quickly drafted trusts to which they made their 2012 gifts. For example, clients may want to consider different dispositive or fiduciary provisions than what were included in the instruments they signed. Indeed, if a trust was signed and funded toward the end of December, many clients may have used a “place holder” trustee to expedite the transaction. A simple “remove and replace” power in the trust instrument may permit flexibility in selecting a successor trustee. However, more significant changes may be in order. Relying on a decanting provision in the trust instrument or under state law can allow the trustee the flexibility to “change” the terms of the trust.12
Depending on the terms of the trust instrument or provisions of state law, the “changes” to a trust that can be achieved through a trust decanting can be broad. Under many state statutes, including F.S. §736.04117, the only changes that cannot be achieved through a trust decanting are the reduction or elimination of fixed income or annuity interests, the disqualification from a marital or charitable deduction, and the addition of trust beneficiaries. To the extent that the trust instrument and its governing law do not permit the trustees to decant the trust, the trustees should explore whether the governing law of the trust can be changed to a more favorable jurisdiction so that the decanting can be implemented. Additionally, clients might consider state statutes that provide for judicial or nonjudicial modification or reformation, such as F.S. §§736.04113, 736.04115, 736.0412, 736.0415, or 736.0416. In so doing, trust beneficiaries must be sensitive to possible transfer tax consequences in the event consent (or even notice) is required.
• Planning for Step-up in Basis — Because of timing constraints and liquidity issues, many clients may have funded irrevocable trusts with low-basis assets. These clients would do well to consider the income tax consequences to the trust beneficiaries as a result of the loss of a step-up in basis at death. Two possible solutions are available for these clients.
First, if the trust contains a power of substitution, or “swap power,” under §675(4)(c), the client can “swap in” assets of equal value with a higher basis and “swap out” the low-basis assets. In executing this “swap,” the trustees must ensure that the assets “swapped in” are equal in value to the assets “swapped out.” Not only is this part and parcel to the trustees’ fiduciary obligations, it is also necessary to avoid the imputation of any deemed gifts. Practitioners may wish to consider using a formula clause as a hedge on the “swap” in a similar manner to the way such clauses are used in gifting transactions. The best practice is to disclose such “swaps” on the client’s gift tax return.
Second, even if the trust does not contain a “swap power,” but is otherwise a grantor trust, the client can purchase assets from the trust. The purchase can even be done with a promissory note. This allows the client to regain the economic benefits of the assets, while still having completed the gift and having an obligation at death that reduces the client’s taxable estate. If, in making the gift, the client simply wanted to transfer an amount equal to the applicable exclusion amount, the note can be structured at the applicable federal rate to allow the client the benefit of any future appreciation. If the gift was intended to allow future appreciation to grow outside of the client’s estate, then the note can be structured at a higher rate to result in greater appreciation within the trust.
• Lack of GST Exemption — Most clients who used their entire applicable exclusion amount in 2011 and 2012 gifting will also allocate GST tax exemption to those transfers. This may cause problems for clients who need to continue to rely on annual exclusion gifts to fund life insurance premiums through life insurance trusts. If the policy is owned by an “old and cold” life insurance trust, then funding such trust with annual exclusion gifts may result in a mixed GST tax inclusion ratio (meaning that the trust’s inclusion ratio is greater than zero but less than one), as the client will no longer have GST exemption to allocate to the annual exclusion gifts. Some relief may be available year-by-year depending on the inflation adjustment of the applicable exclusion amount. For example, clients who maxed out their GST tax exemptions in 2012 will now have an additional $130,000 to allocate in 2013. This may go a long way for some clients in preserving the GST tax-exempt status of their life insurance trusts.
However, if the additional exemption made available through the inflation adjustment is insufficient, alternatives need to be considered. The most attractive option is likely to make sure that the life insurance policy is owned by the same trust to which the 2012 gifting was made, so that the income from the gift, or a portion of the gift itself, may be used to service the premium payments, thereby preserving the GST tax-exempt status of the trust. If the planning was not structured this way from the outset, several options may be available. First, the “old and cold” life insurance trust can be merged into the 2012 gifting trust under the terms of the trust instrument or under state law if such merger is so permitted.13 Second, the “old and cold” life insurance trust and the 2012 gifting trust can be decanted into a single new trust pursuant to the trust instrument or state decanting statutes. Third, if the prior two options are not available, the “old and cold” life insurance trust can sell the policy to the new trust. It is critical that the purchasing trust be treated as a grantor trust wholly owned by the insured in order to ensure that the transfer falls within the exception to the transfer for value rule of §101(a)(2).14
Alternatively, clients can consider lending to life insurance trusts so that the trustees can use the loan proceeds to pay the life insurance premiums. Practitioners should be sensitive to private split dollar rules in advising clients to make such loans.
• 2012 Gifting Results in Mixed Inclusion Ratio — Because ATRA preserves the EGTRRA provisions permitting qualified severances, practitioners and clients can rest assured that even if 2012 gifting (or gifting in 2013 and beyond) results in mixed inclusion ratio trusts, such trusts can be severed.
A qualified severance is a severance of a trust with a mixed inclusion ratio into two or more separate trusts, so that the resulting trusts have an inclusion ratio of one or zero. Generally, the severance must occur on a fractional basis and the terms of the new trusts, in the aggregate, must provide for the same succession of interests of beneficiaries as are provided in the original trust.15 The severance is reported on Form 706 GS(T) by writing “qualified severance” at the top of the form and attaching a statement to the form containing the name of the transferor, the name and date of creation of the original trust, the tax identification number of the original trust, the inclusion ratio before severance, the name and tax identification number of each resulting trust, the date of severance, the fraction of total assets of the original trust received by each resulting trust, the inclusion ratio of each resulting trust, and any other details explaining the basis for funding the resulting trusts.16
Reliance on the qualified severance provisions may be a huge relief for clients whose remaining applicable exclusion amount in 2012 exceeded their remaining GST tax exemption (most often on account of allocation to life insurance trusts or allocation upon the expiration of the annuity term of a GRAT). These clients wanted to maximize the amount they could give in 2012 at the higher exemption, but had concerns about the long-term consequences of administering mixed inclusion ratio trusts. Thankfully, qualified severances are here to stay as a result of ATRA.
After the 2012 cleanup is done, there are still plenty of options for clients who exhausted their entire $5.12 million applicable exclusion amount through 2011 and 2012 planning. The extra $130,000 inflation adjustment may add just enough cushion for certain techniques as well.
• Sales to Defective Grantor Trust — A sale to a defective grantor trust is the most logical and most powerful technique to implement as a follow-up to 2012 gifting. If the client’s gifts were made to a defective grantor trust, then the “seed” required for a sale to the trust has already been planted. Assuming that the client transferred $5.12 million to the trust and assuming a 10 percent seed consistent with the generally accepted rule of thumb, a client could sell more than $50 million of assets to a defective grantor trust. If the assets are closely held business interests and the client can substantiate a modest 25 percent valuation discount, the client can sell almost $67 million of assets to the trust. So long as the “Green Book” proposal to kill defect grantor trusts does not become a reality in 2013, sales will remain very much en vogue.
• Intrafamily Loans — An intrafamily loan is an often overlooked technique, perhaps given that it does not seem as appealing as other techniques. Yet in 2013, this technique should be at the top of practitioners’ lists. By loaning assets to family members, or, better yet, defective grantor trusts, the spread between the return on investment of the loaned assets and the historically low applicable federal rate passes transfer tax free. It is simple, effective, and risk free. Best of all, intrafamily loans do not result in any taxable gift and, thus, no remaining applicable exclusion amount is required to implement the planning on a tax-free basis.
• Grantor Retained Annuity Trusts — GRATs remain attractive options for many clients, especially with historically low applicable federal rates. If structured as a “zeroed-out” GRAT, this may be one of the most effective planning techniques for clients who have little or no applicable exclusion amount remaining. Of course, the inability to allocate GST exemption during the GRAT term makes the planning somewhat less attractive. But many clients considering this as a “zero-gift” technique may have little or no GST exemption remaining anyway. Even if the 10-year minimum term as proposed by the administration becomes reality, GRATs will remain a go-to technique in 2013 and beyond.
• Charitable Lead Annuity Trusts — Like a “zeroed-out” GRAT, a “zeroed-out” charitable lead annuity trust (CLAT) may be an attractive option for clients who are charitably inclined. Although the annuity payments to charity required to “zero out” a CLAT may be larger than what a client may typically prefer when the client has some remaining applicable exclusion amount, the ability to pass the remainder free of gift tax can still produce positive results.
• Qualified Personal Residence Trusts — A qualified personal residence trust (QPRT) also can be structured in a manner that results in a minimal taxable gift under the right set of circumstances. The taxable gift resulting from a QPRT is a function of the length of the QPRT term. By lengthening the QPRT term, the value of the remainder deceases, and, accordingly, so does the taxable gift. However, this carries with it the risk that the client may die during the term of the QPRT, resulting in the inclusion of most or all of the value of the transferred residence in the client’s estate under §2036.17 To mitigate this risk, the client may consider using the grantor’s life as the QPRT term and selling the remainder interest in a so-called “split-interest” purchase.18 If the client has an existing defective grantor trust with appropriate “seed” money, the defective grantor trust can use the seed money as the consideration to purchase the remainder interest in the QPRT simultaneous with its creation. The result is that there is no taxable gift. If the defective grantor trust is GST exempt, the value of the residence is covered by GST exemption upon the termination of the QPRT. This can produce very significant tax savings even in the absence of any remaining applicable exclusion amount.
The whirlwind that was 2012 is now in the history books, but the planning is far from over. Practitioners must continue to work to ensure that the plans they so diligently implemented before the clock struck midnight on December 31, 2012, are properly reported and administered in 2013. And even for clients who have made gifts equal to or exceeding their applicable exclusion amounts, there are still plenty of highly effective techniques to reduce their transfer tax exposure in 2013 and beyond.
1 American Taxpayer Relief Act of 2012, Public Law No. 112-240.
2 Unless otherwise noted, all citations are to the I.R.C. of 1986, as amended (the Code), and to the Treasury Regulations promulgated thereunder.
3 JCX-55-10 at 51–53.
4 JCS-2-11 at 554-556.
5 See Treas. Reg. §20.2010-2T(c)(2) (2012).
6 See, e.g., Proposals for Certain Amendments to the Generation-Skipping Transfer Tax, by members of the American Institute of Certified Public Accountants and other professional organizations (1998).
7 I.R.C. §2642(g)(1)(B).
8 I.R.C. §2642(g)(2).
9 See, e.g., General Explanation of the Administration’s Fiscal Year 2013 Revenue Proposals at 79-83 (Feb. 2012).
10 A.O.D. 2012-004, 2012-46 IRB.
11 See Estate of Petter v. Commissioner, 653 F.3d 1012 (9th Cir. 2011); Estate of Christiansen v. Commissioner, 586 F.3d 1061 (8th Cir. 2009); McCord v. Commissioner, 461 F.3d 614 (5th Cir. 2006); Hendrix v. Commissioner, T.C. Memo 2011-133.
12 See Fla. Stat. §736.04117.
13 See Fla. Stat. §736.0417.
14 See Rev. Rul. 2007-13, 2007-1 CB 684.
15 I.R.C. §2642(a)(3)(B).
16 Treas. Reg. §26.2642-6(e).
17 See Treas. Reg. §20.2036-1(c)(2) regarding the computation of the amount includible in the estate of a decedent who dies during the term of a QPRT.
18 See Private Letter Ruling 9841017.
David Pratt is a partner in the personal planning department of Proskauer Rose, LLP, and the managing partner of Proskauer’s Boca Raton office. He is a fellow of the American College of Trust and Estate Counsel and American College of Tax Counsel, is board certified in taxation and wills, trusts, and estates, and has served on the Real Property, Probate and Trust Law Section’s Wills, Trusts and Estates Certification Committee. He is also a past chair of the Tax Section and an adjunct professor at the University of Florida’s Levin College of Law, where he teaches a class on advanced estate tax planning in the LL.M. program.
Scott Andrew Bowman is an attorney at Proskauer Rose, LLP, in Boca Raton. He practices in the areas of domestic and international estate planning. He received his J.D. and LL.M. (taxation) from the University of Florida Levin College of Law. He is the vice chair of the International Tax Planning Committee of the Real Property, Trust and Estate Law Section of the American Bar Association.
This column is submitted on behalf of the Tax Law Section, Michael Allen Lampert, chair, Michael D. Miller and Benjamin Jablow, editors.