The Florida Bar
The Florida Bar Journal
February, 2012 Volume 86, No. 2
Estate Planning: The Clock is Ticking — Use it or Lose it Before 2013

by David Pratt, Lindsay A. Roshkind, and Scott L. Goldberger

Page 31

On December 17, 2010, President Obama signed into law the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010, Pub. L. No. 111-312, 124 Stat. 3296 (2010) (2010 act). The 2010 act ushered in some significant changes to the estate, gift, and generation-skipping transfer (GST) tax regimes, namely reducing the estate, gift, and GST tax rates to 35 percent, increasing the estate, gift, and GST tax exemptions to $5 million,1 and reunifying the estate and gift tax exemptions.2 However, these provisions of the 2010 act will remain in effect only through December 31, 2012, when the act is scheduled to sunset.3 Unless Congress enacts new legislation prior to then, on January 1, 2013, the law will revert to the laws in effect in 2001, with top estate, gift, and GST tax rates of 55 percent, estate and gift tax exemptions of only $1 million, and a GST tax exemption of only $1 million (indexed for inflation).4 Thus, in order for clients to avail themselves of the maximum benefits under the 2010 act, clients should consider engaging in one or more of the planning techniques discussed in this article as soon as possible. Each of these techniques can significantly reduce one’s taxable estate at death by taking advantage of the provisions of the 2010 act before they expire.

Clients Should Use Exemption to Make Nontaxable Gifts
With the increase in the gift tax exemption from $1 million to $5 million per person, clients may significantly reduce their estates simply by making direct gifts to their descendants or any other individual (or to trusts for their descendants or anyone else, as discussed below). In fact, a married couple can gift $10 million to their descendants or any other individual without paying gift tax.5 Additionally, clients should consider using their increased gift tax exemptions to forgive loans that were previously made to their descendants or others, particularly when such “loans” may be at risk of being recharacterized as gifts because they may not necessarily have been respected as a loan.6

By making gifts during life, clients can remove from their estates all of the future appreciation and income on the gifted property. This may be particularly appealing for clients who do not need or plan to spend such income. For example, if a client makes a $5 million gift this year and dies 25 years from now, the value of that gift, including appreciation, could range from over $13 million, assuming modest four percent growth, to over $54 million, assuming 10 percent growth.7 Additionally, if the gifted property produces income of $200,000 (four percent, for example) per year, then, over the 25-year period, $5,000,000 of income will be removed from the client’s estate (assuming the client would not have otherwise spent or gifted such income prior to the client’s death).

Gifts in Trust
Although it may be simpler to make direct gifts of property to individuals, there are many advantages of using a client’s gift tax exemption to make gifts of property in trust. The most significant advantage is the ability to allocate GST tax exemption to gifts to trusts for the benefit of a client’s descendants. Allocating GST tax exemption to such trusts enables the funds in the trust, plus all future income and appreciation, to pass to children, grandchildren, and more remote descendants without the imposition of any estate, gift, or GST tax at any generational level, subject to the rule against perpetuities. Moreover, if the trust is structured as a “grantor trust,” the trust’s income is taxed to the client instead of to the trust or the trust’s beneficiaries. This, in essence, allows clients to make additional tax-free gifts to the trust equal to the amount of the income tax that the trust or the beneficiaries would otherwise have to pay.8

Furthermore, gifts in trust are protected from claims by the beneficiaries’ creditors, including spouses (in the event of divorce), and can ensure that the assets do not pass outside of the family bloodline. This protection applies to every generation for the longest period allowed under law (i.e., a maximum of 360 years under Florida law).9

Leveraging Gifts
Rather than making gifts of cash or marketable securities, clients should consider gifting interests in a closely held corporation, partnership, or limited liability company (LLC) to descendants or others (or to a trust for the benefit of descendants or others). By doing so, clients can leverage their gift tax exemptions (and GST tax exemptions for gifts made to “skip persons,” such as grandchildren, or in trust) by applying minority interest and lack of marketability discounts to the gifted interest, thereby maximizing the use of the exemptions.

For example, assume a married client is willing to gift interests in a limited partnership to a trust for their descendants and that a valuation report by a qualified appraiser indicates that a 30 percent valuation discount may be applied to the interests that will be gifted. In this case, the client could gift interests in the limited partnership with an underlying value of $14 million and still be under the $10 million combined gift tax exemption for a married couple.10

Tax Rates for Taxable Gifts (Gifts Above the $5 Million Exemption)
Although the gift tax rate for 2012 is 35 percent, in 2013, the rate is scheduled to revert to 2001 rates (ranging from 41 percent to 55 percent for gifts over $3 million). Accordingly, to the extent that clients wish to make taxable gifts (i.e., gifts in excess of the clients’ available gift tax exemptions), they should consider making such gifts prior to 2013. In addition to paying the gift tax at a lower rate, all of the appreciation on the gifted property and the gift tax paid is removed from the clients’ estates.11

For example, a gift of $5 million made in 2012 by an unmarried individual who has already used his or her $5 million gift tax exemption would result in gift tax payable of $1,750,000. In 2013, however, the same $5 million gift would result in gift tax payable of $2,750,000. Assuming that the individual dies in 2020 and that the gifted property attained five percent growth, the gift tax of $1,750,000 and the appreciation of $2,387,27712 would be removed from the client’s estate tax-free. Further, if the client makes the gift to a “grantor trust,” the income tax paid by the client would also be removed from the client’s estate tax-free.

Nonreciprocal Trusts Created by Married Couples and Domestic Asset Protection Trusts for Single Individuals
If a client is reluctant to make a gift at this time, but also does not want to waste the savings available by the increased gift tax exemption amount, the client can have his or her cake and eat it too by creating a trust for the benefit of his or her spouse or a domestic asset protection trust (DAPT), of which the client is the beneficiary.

By creating “nonreciprocal trusts,”13 spouses can create trusts for each other’s benefit and the assets transferred to such trusts, plus any appreciation on such assets over time, may be removed from the clients’ estates. Additionally, if the clients need access to the assets during their lives, the spouse who is the beneficiary of the trust can receive a distribution from the trust. Further, if the clients include their descendants as possible beneficiaries of the trust, the trustee can make distributions from the trust to the descendants gift tax free.

For single individuals, a DAPT formed in a jurisdiction that has DAPT legislation, such as Delaware, can achieve similar results. By creating a DAPT, the assets transferred to the trust are removed from the client’s estate, but remain available for the client’s use during his or her lifetime, provided that a Delaware resident or trust company acts as a trustee of the trust and is responsible for making distributions from the trust. To the extent that distributions are not made, the trust principal and appreciation will accumulate within the DAPT free from any future estate or gift tax. Best of all, Delaware’s strong asset protection statutes and lack of a rule against perpetuities should protect the assets of the DAPT from the client’s creditors, and the creditors of any remainder beneficiaries for whom the trust assets are ultimately meant to benefit, for an indefinite period.

Furthermore, the nonreciprocal trusts or a DAPT can provide for a distribution of a certain dollar amount to another trust which could purchase an insurance policy on the grantor’s life (or a survivorship policy on the lives of the grantor and his or her spouse). The grantor would not be a beneficiary or trustee of this additional trust, but the annual distributions to such trust could be used to pay premiums on the insurance policy owned by such trust.

Whether using nonreciprocal trusts or a DAPT, the client(s) can allocate GST tax exemption to the trusts, thereby allowing the trust property to pass transfer tax-free from generation to generation. Moreover, because the trusts would necessarily be “grantor trusts,”14 the client(s) would pay the income tax on the trust property, which, in essence, are additional tax-free gifts to the trusts.15

Gifts of Real Property
Gift of Real Property to a Trust with a Lease Back Option A primary residence or vacation residence may be gifted to a trust for the benefit of the client’s descendants (or other beneficiaries). This may be an especially useful technique for clients who own real property, the value of which is currently depressed and is anticipated to appreciate. By gifting the residence to a trust, the client’s GST tax exemption may be allocated to the trust, enabling the residence, plus all future appreciation (including appreciation on trust property other than the residence, if the residence is sold and the proceeds are reinvested), to pass to the client’s children, grandchildren, and more remote descendants (or others) without the imposition of transfer taxes at any generational level. If the client has more than one descendant whom he or she wishes to benefit, the client may create multiple trusts and transfer partial tenant-in-common interests in the residence to each trust. By transferring partial interests, a fractional interest discount may be applied, thereby reducing the amount of gift tax exemption used.16

If the client wishes to continue to occupy the residence after transferring it to the trust, the client must lease the residence from the trust for its fair rental value. This lease should be in writing and may be done on an annual, seasonal, weekly, or daily basis, depending on how often the client uses the residence. The rent paid by the client to the trust is, in essence, a tax-free gift from the client to the trust, and, if the trust is structured as a grantor trust, the payment of rent will not constitute taxable income to the trust.

Gifts of Real Property to a Qualified Personal Residence Trust — The use of a qualified personal residence trust (QPRT) allows clients to transfer their primary residence (and/or a maximum of one additional personal residence) out of their estates at a reduced gift tax cost.17 With a QPRT, the client retains the exclusive right to live in the residence for a specified term of years. For the technique to work, the client must outlive the term; otherwise, the value of the residence would be included in the client’s estate upon his or her death.18 During the term, the client continues to be responsible for paying property taxes and other maintenance expenses with respect to the residence. Upon the expiration of the term, the personal residence, plus any appreciation thereon, passes to the trust’s remainder beneficiaries (typically, the client’s descendants or trusts for their benefit) without any further exposure to estate or gift tax. At that time, if the client wishes to continue to live in the residence, he or she would need to lease the residence from the beneficiaries for the residence’s fair rental value and should enter into a written lease agreement. Again, the rent paid by the client is, in essence, a tax-free gift from the client to the beneficiaries and, if the trust is structured as a grantor trust, the payment of rent will not constitute taxable income to the trust.

Upon the creation of the QPRT, the client makes a taxable gift equal to the fair market value of the residence at the time of the transfer less the actuarial value of the retained right to live in the residence during the term. Accordingly, to reduce the value of the gift, the client would want to increase the actuarial value of his or her retained right to live in the residence by increasing the term of the QPRT. By doing so, however, the client increases the risk of not outliving the term of the trust, which would render the technique ineffective. Therefore, the increased $5 million gift tax exemption gives older clients the opportunity to create shorter term QPRTs and still be able to shelter the gift of the remainder interest from gift tax.

Clients may also create more than one QPRT for different beneficiaries and transfer partial tenant-in-common interests in the property to each trust. As discussed above, by transferring partial interests in the property to each trust, a fractional interest discount may be applied, thereby reducing the amount of gift tax payable, if any.19

Purchasing Additional Life Insurance in Trust
If a client owns a life insurance policy on his or her life, the proceeds from such policy are subject to estate tax at the client’s death.20 In contrast, if an irrevocable life insurance trust (ILIT) owns a policy on the client’s life, the proceeds from such policy generally will pass free of estate tax at the client’s death. Thus, ILITs have been, and continue to be, a very useful estate planning technique. One difficulty, however, is determining how to fund ILITs with sufficient assets for the ILIT to pay premiums on the life insurance without incurring gift tax on the transfer to the ILIT, particularly with smaller families who may only have a few “Crummey” beneficiaries21 to include in an ILIT. The increased gift tax exemption has made such funding much easier.

Once an ILIT is created, funded, and has purchased life insurance, the client generally will make annual gifts to the ILIT to cover annual insurance premium. To escape gift taxes, such annual gifts must either qualify for the “gift tax annual exclusion” (currently $13,000 per donee, or $26,000 per donee if the gift is made by a married couple), multiplied by the number of the current beneficiaries of the trust, or be sheltered by the client’s lifetime gift tax exemption. For clients who may not have a sufficient number of beneficiaries to cover the premium using annual exclusion gifts or who would prefer to make such gifts outside of the ILIT, rather than making transfers to the ILIT when premiums are due, clients can utilize the increased gift tax exemption to make large gifts to their ILITs now with the increased exemption to cover premiums in future years. Additionally, because of the uncertainty of the estate tax system after 2012, it may be more important than ever for clients to include life insurance as part of their estate plan to offset the potential estate taxes that could be assessed upon their deaths. Accordingly, clients that already have ILITs may want to consider purchasing additional life insurance or keeping policies that they were thinking of terminating.

Gift/Sale to an Intentionally Defective Grantor Trust
An intentionally defective grantor trust (IDGT) is an irrevocable trust that is a “grantor trust” for income tax purposes. A common estate planning transaction used to reduce estate tax exposure is the sale of property to such a trust for an interest only note. The benefit is the ability to sell the assets at a discounted value and freeze the value at the time the sale is made so that future appreciation inures to the trust beneficiaries. Typically, the IDGT is funded with a gift of “seed money” equal to at least 10 percent of the value of the property that will be sold to the irrevocable trust. Although the seed money is a taxable gift, this is often a highly effective way to leverage the client’s gift tax exemption. With the increased gift tax exemption of $5 million, a married couple can “seed” the IDGT with a significant tax-free gift of up to $10 million. This “seed money” would enable the IDGT to purchase additional assets from the client (up to $100 million for a married couple), the appreciation on which is removed from the client’s estate tax-free. Under prior law, a married couple could only sell assets with a value of $20 million if they wanted to seed the trust without paying gift tax and stay within the 10 percent threshold.

After seeding the IDGT, the client then sells assets to the irrevocable trust in exchange for the promissory note. The note must require that the trust pay interest to the client equal to at least the applicable federal rate (AFR) in effect at the time of the sale. Because the trust is a grantor trust for income tax purposes, the sale and annual payment of interest are disregarded for income tax purposes and, thus, no income tax is imposed on the sale or interest payments.22

A gift/sale to an IDGT is a powerful “freeze” technique because the appreciation on the property inures to the benefit of the trust and is removed from the client’s estate.23 The “freeze” occurs as a result of the sale of the assets to the trust in exchange for the promissory note, which has a stated interest rate and principal amount. Therefore, although the outstanding balance due under the promissory note may be included in the client’s estate, all of the appreciation on the property sold to the trust is removed from the client’s estate. Further, if the assets sold to the trust are interests in a limited partnership, LLC, or closely held corporation, valuation discounts should apply to the sale price and reduce the stated principal amount of the note, thereby reducing the amount that may ultimately be included in the client’s estate.

Debt Ceiling Bill
Last year, Congress approved the “debt ceiling bill,” which was signed by President Obama on August 2, 2011, and calls for a joint committee to consider tax law changes. In the past, legislation was considered that would effectively eliminate valuation discounts of closely held interests such as family limited partnerships.24 Currently, such discounts are considered to determine the fair market value of assets involved in intra-family transactions, such as the gifts and sales to trusts for descendants discussed above. These discounts generally lower asset values by 30 to 40 percent, thereby reducing the value for transfer tax purposes. Under current proposals,25 these discounts would no longer be permissible, and the cost of intra-family transactions would, therefore, be increased. If clients are considering a plan to gift or sell interests in a closely held business or family limited partnership to their family members or trusts for their benefit, now may be the time to act.

The Clawback
Some practitioners have raised the concern that if a client uses the increased exemption of $5 million during 2011 and 2012, and, in 2013, that exemption is reduced back to $1 million, then, upon the client’s death, there could be a potential “clawback” of the gifts made in excess of that reduced exemption when determining the estate tax owed by the client’s estate. However, there is nothing in the current law to suggest that the government would take this approach. Moreover, even if there were a clawback of the value of the gifted property as of the date of the gift, the gift would still result in transferring future appreciation and income out of the client’s estate. In other words, the client wins either way. Thus, the authors believe that individuals should take full advantage of the current exemption amounts and rates while the opportunity exists.

The favorable provisions of the 2010 act remain in effect only through the end of this year, when the act is scheduled to sunset. Unless the law changes, in 2013, the law will revert to the 2001 law with top estate, gift, and GST tax rates of 55 percent, estate and gift tax exemptions of $1 million, and a GST tax exemption of $1 million (indexed for inflation). Accordingly, while clients still have the opportunity, they should take full advantage of the current exemption amounts and rates by engaging in one or more of the techniques discussed in this article.

1 This amount is indexed for inflation beginning in 2012. See IRC §§2010(c), 2505(a), and 2631(c). The inflation adjusted exemption amount for 2012 is $5,120,000. See Rev. Proc. 2011-52, 2011-45 I.R.B. 701.

2 In addition, the 2010 act introduced “portability” into the transfer tax system and extended for two more years the “Bush income tax cuts” that were enacted as part of the Economic Growth and Tax Relief Reconciliation Act of 2001, Pub. L. No. 107-16, 115 Stat. 38 (2001).

3 Note that in late 2011 it was rumored, through the “super committee,” that Congress was considering reducing the gift tax exemption to $1,000,000 prior to the sunset of the 2010 act; however, as of the date this article was submitted for publication, the overwhelming majority of the estate planning community, including the authors, believed that the chances of such a drastic change were slim to none.

4 While it is impossible to predict the future of the estate, gift, and GST tax laws, the exemptions under the 2010 act are indexed for inflation. Thus, it would be very easy for Congress to simply extend the 2010 act. Stay tuned . . . there should be a lot of action after the November elections.

5 Even if a client has already used his or her previously available $1 million gift tax exemption, such client now has an additional $4 million of gift tax exemption available (or, an additional $8 million in the case of a married couple that has already used their previously available combined $2 million gift tax exemption).

6 For a list of factors to consider in determining whether a loan will be respected as such, see Estate of Lillie Rosen, et al., T.C. Memo 2006-115, 862-67.

7 The value of the gift would be over $34 million, assuming eight percent growth, or over $21 million, assuming six percent growth.

8 Rev. Rul. 2004-64, 2004-2 C.B. 7.

9 See Fla. Stat. §689.225.

10 $14,000,000 x .30 = $4,200,000; $14,000,000 - $4,200,000 = $9,800,000.

11 The gift tax paid will be removed from a client’s estate only if he or she survives for three years or more from the date of the gift. See I.R.C. §2035.

12 This amount represents the appreciation on the $5 million gifted property compounded annually over eight years.

13 The trusts would need to be nonreciprocal to avoid potentially being disregarded for tax purposes. Reciprocal trusts can be avoided by varying the terms of the each trust.

14 See I.R.C. §677(a)(1).

15 See note 8.

16 See Estate of Williams v. Comm’r, T.C. Memo 1998-59 (44 percent fractional interest discount allowed with respect to one-half interest in undeveloped Florida timberland, despite IRS’s argument that no discount should be permitted beyond the cost of partitioning the property); see also Estate of Baird v. Comm’r, T.C. Memo 2001-258 (60 percent fractional interest discounts allowed for two undivided interests in Louisiana timberland); Estate of Forbes v. Comm’r, T.C. Memo 2001-72 (30 percent fractional discount allowed for two parcels of real property).

17 See I.R.C. §2702.

18 Whenever a QPRT is created, an insurance policy should be considered (to be owned by an irrevocable life insurance trust) because if the grantor predeceases the term of the QPRT, the assets are included in the grantor’s estate. The insurance “insures” a premature death.

19 See note 16 and accompanying text.

20 See I.R.C. §2042.

21 A gift to a trust is usually not a gift of a present interest in property because the beneficiaries of the trust receive the proceeds at a future date. If, however, pursuant to the terms of the trust, the beneficiaries are allowed certain withdrawal powers and the beneficiaries are notified of these withdrawal powers, the gift to the trust will be deemed to be a gift of a present interest, and the annual exclusion from gift tax will be available for such gifts. Accordingly, for example, if there are five beneficiaries of a trust, each with a “Crummey” power and the individual making a contribution to the trust has not made any other annual exclusion gifts to such beneficiaries during the calendar year, the contribution of $65,000 will qualify for the annual exclusion (i.e., 5 x $13,000) and will not result in any use of gift tax exemption or payment of gift tax if such beneficiaries are notified of their withdrawal rights over the contribution. The notices given to trust beneficiaries informing them of their withdrawal rights are called “Crummey” notices, the withdrawal powers are referred to as “Crummey” powers and the beneficiaries are referred to as “Crummey” beneficiaries because of the case Crummey v. C.I.R., 397 F.2d 82 (9th Cir. 1968).

22 Rev. Rul. 85-13, 1985-1 C.B. 184.

23 Additionally, a portion or all of the client’s GST tax exemption may be allocated to the IDGT to allow for distributions to grandchildren or more remote descendants without the imposition of GST tax.

24 See H.R. 436, Certain Estate Tax Relief Act of 2009 (111th Cong., 1st Sess.)

25 See Department of the Treasury, General Explanations of the Administration’s Fiscal Year 2012 Revenue Proposals at 127 (Feb. 2011), available at

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.

Lindsay A. Roshkind is an associate in the Personal Planning Deptartment of Proskauer Rose, LLP, in Boca Raton. She received her J.D. and LL.M. in taxation from the University of Florida Levin College of Law.

Scott L. Goldberger is an associate in the Personal Planning Department of Proskauer Rose, LLP, in Boca Raton. He received his J.D. from Georgetown University Law Center and a master and B.S. in accounting from the University of Florida.

This column is submitted on behalf of the Tax Section, Domenick R. Lioce, chair, and Michael D. Miller and Benjamin Jablow, editors.

[Revised: 02-10-2012]