Year End Planning for 2011
Once again, we have had a year of changes and planning possibilities as to federal estate, gift and generation-skipping transfer (GST) taxes. On December 17, 2010, President Obama signed into law The Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 (the 2010 Act), that temporarily extended the Bush tax cuts for 2011 and 2012 and increased the gift, estate and generation skipping tax applicable exclusion amounts for that period to an historic high level of $5 million. This temporary increase provides significant tax saving opportunities. Because of the uncertainty that these opportunities will remain available until the end of 2012, given the current, ever-changing economic and political landscape, we strongly recommend that you contact us as soon as possible if you have any interest in taking advantage of gifting opportunities. In addition to the increased applicable exclusion amounts, the 2010 Act retroactively reinstated the federal estate tax for decedents dying in 2010, with an option to opt out of the estate tax and receive only a limited basis step-up.
Federal Estate, GST and Gift Tax Rates
The 2010 Act reunifies the gift and estate tax for the first time in years. The applicable exclusion amount for each of the gift, estate and GST taxes is $5 million with a top tax rate for each of 35%. For 2012, the $5 million is indexed for inflation and will increase to $5.12 million.
In addition, the 2010 Act creates “portability” between spouses for 2011 and 2012, meaning that when the first spouse dies any unused portion of his or her estate tax applicable exclusion amount may be used by the surviving spouse. However, the portability provision is of limited utility, as, under current law, the surviving spouse must also die by the end of 2012 in order to use the predeceased spouse’s applicable exclusion amount. To elect portability, the surviving spouse must timely file a federal estate tax return (706), regardless of whether any estate tax is due or payable.
Annual Gift Tax Exclusion
Each year individuals are entitled to make gifts of the Annual Gift Tax Exclusion Amount without incurring gift tax or using any of their lifetime applicable exclusion amount against estate and gift tax. The amount of the Annual Gift Tax Exclusion will remain at $13,000 per donee in 2012. Thus, a husband and wife together will be able to gift $26,000 to each donee. The amount of the Annual Gift Tax Exclusion with respect to gifts made to non-citizen spouses will increase from $136,000 to $139,000 in 2012.
Retroactive Reinstatement of Estate Tax for 2010 Decedents
The estate tax was reinstated retroactively for estates of decedents dying in 2010, with an estate tax applicable exclusion amount of $5 million and a rate of 35%. However, there is an option to “opt out” of the estate tax and instead elect to have limited carryover basis rules (with certain adjustments) apply to property passing from the decedent.
In general, 2010 decedents with estates of less than $5 million or which pass to a surviving spouse would not opt out of the estate tax, as the estate would not owe federal estate tax and would receive a step-up in basis of the estate assets to their fair market value at the date of the decedent’s death. Executors of estates of 2010 decedents with more than $5 million may want to opt out of the estate tax so that the estate does not pay estate tax, but advisers have to calculate whether paying capital gains tax on the appreciation over the decedent’s basis upon sale of property yields a better tax result than paying the estate tax.
Basis Increase Allocations
If an executor opts out of the estate tax for a 2010 decedent, assets will have a limited carryover basis (but not in excess of date of death fair market value), but that basis can be adjusted to a certain extent. The executor can allocate several adjustments to increase the basis of assets received by recipients that are both “property acquired from the decedent” and “property owned by the decedent.” The amount of increased basis from these allocations is referred to as the “Basis Increase.”
There is $3 million of Spousal Basis Increase that may be allocated to “qualified spousal property” acquired from the decedent by a surviving spouse. Qualified spousal property includes outright transfers of property and qualified terminable interest property.
The General Basis Increase, which can be allocated to property going to anyone, is $1.3 million. However, for a decedent who was neither a resident nor a citizen of the United States, the General Basis Increase is only $60,000.
The Carryover Basis Election Is Made by Filing Form 8939
The election to opt out of the federal estate tax and elect the carryover basis regime may be made up until January 17, 2012. The election in effect on the due date is irrevocable (except as provided in Notice 2011-66).
Filing Due Dates for 2010 Decedents
For estates of decedents who died before December 17, 2010, the due date for filing a Form 706 was September 19, 2011. However, IRS Notice 2011-76 acknowledges that because of the length of time that has been required to implement the carryover basis legislative changes and to issue Form 8939 and the related instructions, 2010 estates may not have had sufficient time by September 19, 2011, to decide how to proceed. The Notice makes clear that an automatic six-month extension of the time to file is available by filing Form 4768 (Application for Extension of Time to File a Return and/or Pay U.S. Estate (and Generation-Skipping Transfer) Taxes). There is no need to substantiate the reason an estate is requesting an extension. The automatic six-month extension makes the Form 706 due on March 19, 2012. For estates of decedents dying on or after December 17, 2011, the automatic six-month extension period will end 15 months after the decedent’s date of death.
President’s Budget Proposal for Fiscal Year 2012
The President’s budget proposal for Fiscal Year 2012 includes three transfer tax-related items that were proposed in each of the past two years and two new items dealing with estate and gift taxes.
Consistency of Basis Valuation
The proposal to require consistency in value for transfer and income tax purposes requires that the basis for income tax purposes be the same as that determined for estate and gift tax purposes.
Eliminating Certain Valuation Discounts
The budget proposal adds a new category of “disregarded restrictions” that would be ignored for transfer tax valuation purposes in valuing an interest in a family-controlled entity transferred to a member of the family.
Grantor Retained Annuity Trusts (GRATs) to Be Subject to New Rules
Three additional requirements would be imposed on Grantor Retained Annuity Trusts (GRATs): (i) they must have a 10-year minimum term; (ii) they must have a remainder interest greater than zero; and (iii) the annuity amount cannot decrease in any year during the annuity term.
Make Portability Permanent
The budget proposal seeks to make portability permanent by extending the provisions of the 2010 Act regarding the portability of unused exclusion between spouses.
Limiting the Duration of the GST Exemption
The exclusion from the imposition of GST tax would last only 90 years, regardless of whether a trust has a longer duration.
PLANNING OPPORTUNITIES TO CONSIDER IMMEDIATELY
Make Outright Gifts to Take Advantage of Reduced Gift Tax Rate and Increased Applicable Exclusion Amount
You now have a total of $5 million ($10 million for a married couple) that you can gift in the aggregate during your lifetime, subject to reduction for any gifts in excess of the Annual Gift Tax Exclusion Amount you have previously made. Gifts in excess of that amount are subject to a federal gift tax rate of only 35%. The $5 million applicable exclusion amount is substantially in excess of the $1 million applicable exclusion amount for gifting that was previously available. Therefore, making gifts before the end of 2011 may provide significant transfer tax savings. In addition to the reduced rate, it is always cheaper to make lifetime gifts rather than gifts at death. This result occurs because you do not pay a tax on the dollars used to pay gift tax, but you do pay estate tax on the dollars used to pay estate tax. The benefit is compounded further by the lower gift tax in 2011. We should note that under current law, there is a possibility that if the applicable exclusion amount is reduced in the future, there may be a “clawback” if amounts gifted during life exceed the applicable exclusion amount in place at the time of death. In that event, estate tax could be imposed on the amount gifted in excess of the applicable exclusion amount at the time of death. We believe this unintended “glitch” will be fixed. However, even if it is not, you will be no worse off than if you had not gifted and you will benefit by getting any appreciation on the gift out of your estate.
Grantor Retained Annuity Trusts (GRATs)
GRATs remain one of our most valuable planning tools, particularly in this time of historically low interest rates. Because of the possibility that legislation may soon pass changing how GRATs may be structured and interest rates may rise, GRATs should be created as soon as possible.
A GRAT provides you with a fixed annual amount (the annuity) from the trust for a term of years (currently as short as two years). The annuity you retain may be equal to 100% of the amount you use to fund the GRAT, plus the IRS-assumed rate of return applicable to GRATs (which for gifts made in December 2011 is 1.6%). As long as the GRAT assets outperform the applicable rate, at the end of the annuity term, you will be able to achieve a transfer tax-free gift of the spread between the actual growth of the assets and the applicable rate. Because you will retain the full value of the GRAT assets—as calculated using the IRS’s assumptions for growth—if you survive the annuity term, the value of the GRAT assets in excess of your retained annuity amount will then pass to whomever you have named with no gift or estate tax, either outright or in further trust.
Gift Residence or Vacation Home Using Qualified Personal Residence Trusts and Other Trusts
A discounted and leveraged gift of a residence is possible using a Qualified Personal Residence Trust (QPRT). After the gift to the QPRT, you can continue to reside in the residence until the QPRT ends and, even thereafter, if the property is leased back at fair market rent from the new owners.
This planning is most effective when the value of the residence to be given is low and the IRS assumed rate of return is high. However, even though the IRS assumed rate of return is now low, housing prices are dropping across the country, which makes use of a QPRT beneficial. As a result, QPRT gifting is an important alternative to consider, particularly in light of the increased gifting applicable exclusion amount. In addition, one can retain a contingent reversionary interest in case the donor dies during the QPRT term, further discounting the taxable value of the transferred interest—sometimes by a substantial amount in the case of older donors.
Another possibility, given the depressed real estate prices and the increased applicable exclusion amount, is to make a gift of real estate outright or to a trust that is not a QPRT. You may rent the house back from the trust for its fair market rental value and thus continue to use the house. If the trust is drafted as a defective grantor trust, the rent will not be subject to income tax, as for tax purposes it will be treated as though you are renting from yourself. The rent proceeds may be used to pay maintenance and taxes (which you will still be able to deduct). To the extent rent payments exceed expenses, you will have made additional transfer tax-free gifts to the trust.
Alternatives to Section 1031 Exchanges: Gifts to Charitable Remainder Trusts
Many taxpayers owning certain kinds of appreciated real estate sell that property and “roll over” the gain—using Section 1031 of the Internal Revenue Code (IRC)—into another property, using this “like kind exchange” to defer income taxes. However, the economy is such that taxpayers desiring to sell properties now are finding it harder to find properties to purchase to accomplish this rollover.
An alternate approach to consider is a gift of the property to a charitable remainder trust, retaining for life a payment equal to up to 90% of the value of the gifted property. You would be allowed an income tax deduction equal to a portion of the gifted property. (In the case where 90% of the value is retained by you in the form of lifetime payments, the deduction is equal to 10% of the value of the gifted property.)
When the charitable remainder trust sells the property it recognizes no gain or loss. When you receive payments from the charitable remainder trust, part will be taxed as income, part as capital gain and (potentially) part will be treated as a distribution from principal of the trust and not taxable at all.
At your death, the charitable remainder trust can pay over to a family foundation, allowing your family to use those funds to accomplish the family’s charitable goals.
Consider Buy-Back of Appreciated Low Basis Assets from Grantor Trusts
Some clients sold or gave (through a GRAT or other grantor trust) an asset that was expected to appreciate in value. The tax planning idea that motivated them was to pass that appreciation on to trusts for their children without gift or estate tax. The children’s trust that ends up owning the asset typically has a very low basis, meaning that a significant capital gains tax will be due if the trust sells the appreciated asset.
Where those plans succeeded, that appreciated asset now sits in a defective grantor trust for the children. That grantor trust has a low basis in the asset. If you purchase the asset back from the grantor trust for fair market value, no gain or loss is recognized. The trust would then hold cash equal to the value of the appreciated asset that was repurchased, leaving the same amount to escape estate tax. Alternatively, many grantor trust instruments give the grantor the power to substitute the trust’s assets with other assets, which would allow the appreciated assets to be removed from the trust.
The advantage is that, on your death, the purchased or reacquired asset will be included in your taxable estate and will receive a step-up in basis equal to fair market value. This means that the capital gains tax on sale of that asset is eliminated. The children benefit from the grantor trust’s cash—and each dollar of cash has a dollar of basis—so truly the capital gain is eliminated forever.
Use of Intra-Family Loans
Because interest rates are so low, many techniques involving use of intra-family loans should be considered, including:
• The purchase of life insurance on the life of one family member by an irrevocable life insurance trust, with premium payments funded by loans from other family members.
• The creation of trusts by older generation members for the benefit of younger family members, to which the older generation members loan funds. The spread between the investment return earned by the trust and the interest owed will create a transfer tax-free gift.
Upcoming in 2012:
• Effective January 1, 2012, S.B. 507 will take effect, under which the deadline to file a change of ownership statement with the local assessor will be extended from 45 days to 90 days. This bill applies to transferees of real property or manufactured homes; corporations, partnerships and other legal entitles that own real property; and legal entities that own real property for which ownership or control has been changed by more than 50%.
Additionally, this bill will increase the penalty cap for late filings from $2,500 to $5,000 for properties eligible for the homeowners’ exemption, and increase the penalty cap to $20,000 for properties that are ineligible for the homeowners’ exemption.
• Effective January 1, 2012, the value of estate assets that can be transferred without probate administration will increase due to the passage of Chapter 117, Statues of 2011 (AB 1305-Huber).
The size of estate trust assets—excluding joint tenancy assets, which pass under beneficiary designation, such as life insurance or retirement accounts—that can be collected by affidavit will increase from $100,000 to $150,000 (Probate Code Section 13100). Additionally, the value of the decedent’s salary or other compensation that is excluded from the value of the decedent’s property in California will increase from $5,000 to $15,000 (Probate Code Section 13050). These statutory increases will assist in the collection of small value accounts, investments or automobiles that were inadvertently not transferred to a decedent’s revocable living trust.
Year-End Checklist for 2011
In addition to the above planning ideas, consider the following before 2011 is over:
• Make year-end annual exclusion gifts of $13,000 ($26,000 for a married couple).
• Make year-end IRA contributions.
• Create 529 Plan accounts before year-end for children and grandchildren, and consider front-loading the accounts with five years’ worth of annual exclusion gifts, taking into account any gifts made during the year to children and grandchildren. Pay tuition and medical expenses directly to the school or medical provider.
• Consider making charitable gifts before year-end to use deduction on 2011 income tax return.
We Can Help
I hope that this Advisory helps you with your year-end estate and gift tax planning, and also provides you with some interesting ideas to consider for the future. Please immediately make an appointment to meet with me if your estate plan needs require any year end changes.
Sincerely yours,
CHRISTOPHER C. JONES
