TAX
INSIGHTS:
ESTATE AND
CHARITABLE PLANNING UNDER THE ECONOMIC GROWTH AND TAX RELIEF RECONCILIATION ACT
OF 2001
by
John R. Price
Byrle M. Abbin
Jerry J. McCoy
Part One–Estate Planning Under the Economic Growth and Tax
Relief Reconciliation Act of 2001
Introduction -
General Description of 2001 Act
Miscellaneous
Changes Made by the 2001 Act
Planning
Implications of the 2001 Act
Conclusion
Part Two–Changes Affecting Individuals, Estates and Trusts
The Technical
Provisions
Avoiding Taxable
Gifts
Other Planning Aspects
Part Three–Charitable Giving Under the
Economic Growth and Tax Relief Reconciliation Act of 2001
Overview
The 2001 Act
Itself
The Incredible
Disappearing Tax Act
Other Charitable
Provisions
Practical
Implications for Charitable Planning
The Bottom Line
I. Introduction
- General Description of the 2001 Act
From an estate planning
perspective the most important provisions of the 2001 Act are the significant
ones that will, or are most likely, to take effect. They are the direct and indirect reductions in the estate, gift
and generation-skipping transfer (GST) taxes. The reductions, which extend from
2002 through 2009, take two forms: (1)
decreases in the maximum tax rates, which only benefit taxpayers with estates
of $2.5 million or more, and, (2) staged increases in the amount that can be
passed free of tax (the credit equivalent).
The increases in the estate tax credit equivalent will relieve the
estates of an increasingly large number of individuals from the obligation to
pay any federal estate tax. The 2001
Act also makes a number of generally helpful changes in a variety of
areas—including deferred payment of the estate tax under Section 6166 and
the GSTT. Those miscellaneous changes are summarized in Part II, below.
Unfortunately, the 2001 Act
partially reverses the unified gift and estate tax system that has been with us
since 1976. In particular, while the estate
and gift tax credit equivalent will both increase to $1 million on January 1,
2002, the gift tax credit equivalent will remain at that level
indefinitely. In contrast, the estate
tax credit equivalent and the GST exemption will increase in tandem at
irregular intervals until they cap out at $3.5 million on January 1, 2009.
The scheduled changes made by
the 2001 Act culminate in a repeal of the estate and GST taxes effective
January 1, 2010. However, the gift tax
will remain in effect after 2009 with a $1 million credit equivalent and a
maximum rate of 35 percent. The gift
tax was retained in order to discourage individuals from making sham gifts for
the purpose of shifting income to lower-bracket family members. If the estate and GST taxes are repealed on
January 1, 2010, they may be reinstated a year later by the Sunset provision of
the 2001 Act. Act
Section 901. Under the Sunset
provision, which was added for procedural reasons, none of the changes made by
the 2001 Act will have any effect after December 31, 2010. Future revenue needs, changes in the makeup
of Congress, the program of future presidents, and a host of other events will
determine the extent to which the scheduled tax cuts and repeal will actually
take place. Many commentators, including
this author, believe the scheduled estate and GST tax repeal will not take
effect.
Importantly, the 2001 Act has
relatively little present impact on existing estate planning strategies and
plans. Of at least equal importance,
the changes made by the 2001 Act do not have any significant adverse impact on
estate planning. Specifically, the 2001
Act does not impose any of the limits on existing estate planning strategies
that were proposed by the Clinton administration (e.g., limiting discounts in the
valuation of family limited partnerships and limited liability companies that
hold financial assets, eliminating the gift tax annual exclusion for gifts to Crummey
trusts, and ending the preferential gift tax treatment of transfers to Qualfied
Personal Residence Trusts (QPRTs)).
The prospective repeal of the
estate and GST taxes confirms that survival continues to be the best estate
planning strategy. The uncertainty of
the tax picture makes that even more true now.
In assisting our clients, we have never known when they would die, but
we have usually known the general nature of the federal transfer tax provisions
that would apply to them and their estates.
The repeal and Sunset provisions of the 2001 Act put a greater premium
on creating and maintaining estate plans that are as flexible as possible.
Under the 2001 Act, the estate
tax credit equivalent will increase in irregular stages, beginning in
2002: In 2002 and 2003, the estate and
gift credit equivalent will both be $1 million, in 2004 and 2005, the estate
tax credit equivalent and the GST exemption will increase to $1.5 million, in
2006-2008 to $2 million, and in 2009 they are scheduled to reach $3.5 million. The increased estate tax credit equivalent
will allow a married couple to make deathtime transfers of double the amount of
the credit equivalents (i.e., $2 million in 2002-2003, $3 million in 2004-2005,
$4 million in 2006-2008 and $7 million in 2009).
The GSTT $1 million exemption
(as adjusted for post 1997 inflation–$1,060,000 in 2001) will continue in
effect, with adjustments for post-1997 inflation until December 31, 2003. Beginning in 2004 the GSTT exemption will be
an amount equal to the estate tax credit equivalent (i.e., $1.5 million in
2004-2005, $2 million in 2006-2008, etc.).
B. Cuts in Tax Rates
In 2002, the maximum estate and
gift tax rate will drop from 55 to 50 percent.
The rate will drop an additional 1 percent per year for the next five
years before stabilizing (temporarily) at 45 percent in 2007. The GST tax rate,
which is pegged at 50 percent of the maximum estate tax rate, will decline
correspondingly. Thus, the present GSTT
rate of 27½ percent (.50 x .55) will decrease by half the cuts in the estate
tax rates, until it reaches 22½ percent (.50 x .45) in 2007. While the estate and GST taxes are scheduled
to expire at the end of 2009, on January 1, 2011, they may be revived by the
Sunset provision of the 2001 Act.
The gift tax will continue in effect
after 2009, but at somewhat reduced rates.
On January 1, 2010, the rate on taxable gifts of $250,000 to $500,000
will drop from 34 to 31 percent, and a flat rate of 35 percent will apply to
taxable gifts in excess of $500,000.
Prior to 2010, taxable gifts between $250,000 and $500,000 were subject
to a 34 percent rate and gifts above $500,000 would have been subject to rates
of between 37 and 45 percent. Under the
2001 Act, the maximum gift tax rate on post-2009 gifts is the same as the
maximum income tax rate applicable to individuals. Tying the maximum gift tax rate to the maximum income tax rate is
justified on the ground that the gift tax is retained after 2009 in order to
preserve the integrity of the income tax.
The credit equivalents
and maximum rates under the prior law and the 2001 Act are set forth in the
following table:
|
Calendar Year |
Estate and GST* Tax Deathtime Credit
Equivalents Prior Law 2001 Act |
Gift Tax Credit Equivalent 2001 Act |
Maximum Estate and Gift Tax Rates Prior Law 2001 Act |
||
|
2002 |
$700,000 |
$1 million |
$1 Million |
55% |
50% |
|
2003 |
$700,000 |
$1 million |
" |
" |
49% |
|
2004 |
$850,000 |
$1.5 million |
" |
" |
48% |
|
2005 |
$950,000 |
$1.5 million |
" |
" |
47% |
|
2006 |
$1 million |
$2 million |
" |
" |
46% |
|
2007 |
$700,000 |
$2 million |
" |
" |
45% |
|
2008 |
$700,000 |
$2 million |
" |
" |
45% |
|
2009 |
$850,000 |
$3.5 million |
" |
" |
45% |
|
2010 |
$950,000 |
Taxes
Repealed |
" |
" |
Gift Tax at Top Individual Income Tax Rate |
|
2011 |
Sunset provision of 2001 Act restores prior provisions of all taxes. |
||||
* Until January 1, 2004,
the GSTT exemption is fixed at $1 million, adjusted for post 1997 inflation
(i.e., $1,060,000 in 2001). Beginning
in 2004, the same amount will be allowed as the GSTT exemption and the estate
tax credit equivalent (i.e., $1.5 million in 2004-2005, etc.).
C. Winners
Under the 2001 Act
The big winners under the 2001
Act are wealthy individuals who survive until at least 2002, when upper estate
tax rates are cut by 3-5 percent. In
2001, amounts between $2.5 million and $3 million are subject to a 53 percent
estate tax rate and a rate of 55 percent applies to amounts above $3
million. In 2002, the rate on amounts
above $2.5 million is cut to 50 percent.
Thus, in 2002 the estate tax imposed on a taxable estate of $20 million
will be almost $900,000 lower than if the tax were imposed at the present
(2001) rates. The wealthiest taxpayers,
of course, also benefit the most from the income tax changes. The maximum income tax rate is scheduled to
drop from 39.6 percent to 35 percent.
In contrast, the 36 percent bracket will only drop to 33 percent, the 31
percent bracket to 28 percent and the 28 percent to 25 percent.
The 2001 Act does not cut the
estate tax rates that apply to taxable estates of $2.5 million or less. However, taxpayers with estates in that
range will benefit from the scheduled increases in the amount of the estate tax
credit equivalent that begin in 2002.
As explained below, later scheduled increases in the estate tax credit
equivalent will eliminate the estate tax for estates of $1.5 million in
2004-2005, $2 million in 2006-2008, and $3.5 million in 2009.
D. Losers Under the 2001 Act—States and
Charities
Curiously, the states are the
big losers under the 2001 Act—most of which will suffer substantial revenue
losses beginning in 2002 when the state death tax credit begins to phase
out. In 2002, the credit shrinks to 75
percent of the present amount, in 2003 it slips to 50 percent, in 2004 to 25
percent, and in 2005 it is replaced by a deduction. Is this the Bush administration's approach to revenue sharing?
Charities may also turn out to
be big losers under the 2001 Act—as a result of changes made, and not made, by
the 2001 Act. First, by reducing income
and transfer tax rates, the 2001 Act correspondingly diminishes the tax
benefits of making charitable gifts. Of
course, the extent to which tax cuts will discourage charitable gifts, if any,
is unknown. In addition, the 2001 Act
disappointed many charitable organizations and individual taxpayers who hoped
it would include changes that would further encourage an increase in charitable
giving by individuals. One hoped-for
change would have allowed taxpayers who do not itemize their deductions to
deduct the full amount of charitable gifts.
(From 1982 through 1986, taxpayers who did not itemize deductions were
allowed to claim a limited deduction for charitable contributions.) Another change sought by charities would
have allowed donors a charitable deduction for contributions of interests in
IRAs and qualified plans without including any amount in their income.
II. Miscellaneous
Changes Made by the 2001 Act
The 2001 Act changes many other
provisions, some of which are more important than others. While some of the changes are relatively
minor, even those are generally beneficial, including ones that affect the
exclusion for contributions of qualified conservation easements, the election
to defer payment of the estate tax for up to 15 years, and the use of the GSTT
exemption and the division of trusts for GSTT purposes. On the negative side, effective January 1,
2004, the 2001 Act repeals IRC Section 2057, the deduction for qualified
family owned business interests (QFOBI).
A. Qualified
Conservation Easements, IRC Section 2031(c)
The 2001 Act expands the scope
of the estate tax exclusion for gifts of conservation easements by eliminating
the requirement that the land subject to the easement be within specified
distances of a metropolitan area, national park, wilderness area, or urban
national forest. Under the amended provisions
of IRC Section 2031(c), which applies to decedents dying after 2000, the
exclusion is allowable for qualified conservation easements with respect to
land located anywhere in the United States or its possession. The maximum amount of the exclusion remains
unchanged by the 2001 Act, at $400,000 in 2001 and $500,000 thereafter. Some planners and environmental advocates
were disappointed by the failure to increase the maximum allowable amount of
the exclusion.
B. Deferred
Tax on Business Interests, IRC Section 6166
Effective with respect to
decedents dying after 2001, the 2001 Act extends the estate tax deferral
benefits of IRC Section 6166 to businesses with an increased number of
shareholders or partners (from 15 to 45).
Act Section 571(a). The
extension can be of substantial benefit to estates that will now be able to
satisfy the requirements of IRC Section 6166.
In a bit of special legislation,
Act Section 571(b), amended IRC Section 6166(b) to allow the
estate tax on interests in qualifying lending and finance businesses to be paid
in five equal installments.
C. GSTT
Changes
The 2001 Act made several welcome
changes in rules affecting the GSTT exemption and the division of trusts. Act Section 561(a) adds new subsections
(c) and (d) to IRC Section 2632.
Deemed Allocation of GST Exemption. New IRC subsection 2632(c), which applies to transfers
made after December 31, 2000, helpfully provides for the deemed allocation of a
grantor's unused GST exemption to a defined class of trusts called "GST
trusts"—which are ones to which deemed allocations would previously not
have been made. As defined, the term
GST trusts appropriately excludes trusts that provide for specific types of
distributions or are charitable lead annuity trusts or charitable remainder
trusts. The specific types of
distributions that will cause a trust to be excluded, and no deemed allocation
made to them, include ones, (1) with respect to which more than 25 percent of
the corpus must be distributed to or may be withdrawn by (a) one or more
nonskip persons before attaining age 46, or (b) one or more persons who are
living at the time of the death of another person who is their senior by 10
years or more; (2) any portion of which is includible in the estate of a
nonskip person other than the transferor if he or she died immediately after
the transfer. Under subsection (c)(5),
an election against the deemed allocation may be made on a timely filed gift
tax return. Consistent with other
provisions, a deemed allocation under the new rules will only occur at the end
of the estate tax inclusion period as defined in IRC
Section 2642(f)(3).
Retroactive Allocation of GST Exemption. New IRC subsection 2632(d) allows a transferor
retroactively to allocate his or her GST exemption to trusts to which an
allocation or deemed allocation had not previously been made. The allocation can be made upon death, in
2001 or later, of a nonskip person who was a lineal descendant of the
transferor's grandparent (or of the grandparent of the transferor's spouse or
former spouse), and who had an interest or future interest in a trust to which
the transferor had made a transfertypically the transferor's
child. The transferor's GST exemption
may be allocated on a chronological basis to any or all transfers made to the
trust on a gift tax return that is timely filed for gifts made in the year of
the nonskip person-descendant's death.
For purposes of the allocation, the value of the transfers are
determined as if the allocation had been made on timely filed gift tax returns.
Division of Trusts. An
addition to IRC Section 2462(a) recognizes the effect of a post-2000
division of a trust into two or more trusts that is a "qualified
severance." Importantly, the
amendment allows a qualified severance to be made at any time. A qualified severance means the division of
a single trust on a fractional share basis into two or more trusts that
provide, in the aggregate, for the same succession of interests of
beneficiaries as in the original trust.
If a trust has an inclusion ratio greater than zero and less than one, a
severance is a qualified severance only if it is divided into two trusts, one
of which receives a fractional share of all trust assets equal to the
applicable fraction of the single trust immediately before the severance. In such an allocation the trust that
receives the fractional share will have an inclusion ratio of zero and the
other trust will have an inclusion ratio of one. The amendment is most welcome—the existing regulations only
recognize the effect of divisions that were made at the inception of a
trust.
D. Qualified
Family Owned Business Interest Deduction, IRC Section 2057
Under IRC subsection 2057(a) of
existing law, estates that include a family owned business may benefit from
both the credit equivalent and the qualified family owned business interest (QFOBI)
deduction. In combination, the QFOBI
deduction and the unified credit allow as much as $1.3 million to pass tax-free
to a decedent's qualified heirs.
The 2001 Act repeals the QFOBI
deduction in 2004 when the credit equivalent reaches $1.5 million. In effect, the present combined benefit of
$1.3 million remains in effect until January 1, 2004, when the estate tax
credit equivalent becomes $1.5 million and the QFOBI deduction is repealed. The repeal will be hard to justify to the
owners of small businesses: Over the
next three years, the estate tax credit equivalent for ordinary taxpayers will
increase by $825,000 (from $675,000 in 2001 to $1.5 million in 2004). Over the same period, the combined benefit
of the credit equivalent and the QFOBI deduction will increase by only
$200,000. While the QFOBI deduction is
complex and recapture provisions require payment of some of the tax benefit if
the business interest is disposed of within ten years, it has been of
substantial benefit to the owners of many farms and small businesses.
E. Income Tax
Changes, IRAs, and Carryover Basis
The income tax changes made by the
2001 Act, including reductions in income tax rates and increases in the amount
of allowable contributions to IRAs and qualified plans, are of relatively
little significance to most estate planning clients. Section 601 of the 2001 Act amends IRC Section 219(b) to
increase the basic deductible amount for contributions to IRAs to $3,000 in 2002-2004,
$4,000 in 2005-2007, and $5,000 in 2008 and later. In addition, persons over age 50 may contribute an additional
$500 in 2002-2005 and $1,000 in 2005 and later.
Carryover Basis. Income tax considerations will have a major impact on
estate planning if the estate tax repeal takes effect as scheduled in
2010. If it does, the basis rules of
IRC Section 1014 are repealed, and the new rules of Section 1022 will
determine a recipient's basis in assets acquired from a decedent. Under the new rules, an aggregate basis of
up to $1.3 million could be allocated to assets that are included in a
decedent's estate and an additional $3 million in aggregate basis could be
allocated to assets that pass to a surviving spouse or to a qualified
terminable interest trust for his or her benefit. To the extent the basis in assets in community property assets is
stepped up by those provisions, the surviving spouse's basis in the other half
of those assets will also be stepped up.
A decedent's basis in all other assets would carry over and be adopted
by the recipients.
III. Planning Implications of the 2001
Act
The following analyses,
observations and suggestions are generally relevant to all clients—whether they
have, or do not have, estate plans in place.
The suggestions are, of course, particularly relevant to clients who are
in the process of planning their estates.
A. Overview
As indicated above, existing
estate planning strategies and techniques—and the existing plans of most
clients—are unaffected by the 2001 Act.
Accordingly, clients may adopt or continue sound estate planning
techniques, all of which remain available.
B. Review
Existing Plans
Existing estate plans should be
reviewed, particularly to determine whether the existing form of credit
shelter, marital deduction, and other formula gifts remain appropriate in light
of the increases in the estate tax credit equivalent that will take effect
beginning in 2002. It is also important
to determine whether trust documents or local law allow the qualified severance
of trusts—which could be important for GST purposes. The holdings of clients in closely held businesses should be
analyzed to determine whether they qualify, or could be modified to qualify,
for the deferred payment of estate taxes under the amended provisions of IRC
Section 6166.
C. Review
and Possibly Revise Formula Gifts in Wills and Trusts
Existing estate planning
documents should be reviewed, and new ones prepared, in light of the scheduled
increases in the amounts that can be passed free of tax and changes in the tax
rates. Thus, the formulas usually give
as much as possible to other beneficiaries—often outright to the children of a
prior marriage or to a credit shelter trust for their benefit. Accordingly, a formula gift could result in
too much passing to beneficiaries other than the surviving spouse.
The problem of unintentionally
passing too much property to the credit shelter trust does not arise, or at
least is not so intense, if the surviving spouse is also the sole, primary
lifetime beneficiary of the credit shelter trust. The problem also does not arise if the testator's entire estate
is left to a QTIP trust, of which the surviving spouse is necessarily the only
lifetime beneficiary, and with respect to which the decedent's executor could
make a partial QTIP election. (The
benefit of the decedent's remaining credit equivalent could be preserved by
making a partial QTIP election). Of
course, even in the case of a QTIP trust, the surviving spouse may need
additional protection if the trustee is, or may be, hostile to her interests
(possibly one or more of the decedent's children who are also the remaindermen
of the trust). In such a case the
surviving spouse could be given a 5 or 5 power of withdrawal—which could be
limited to the amount by which 5 percent of the principal value of the trust
exceeds the amount of income she received from it.
Some clients may wish to pursue
another alternative if the surviving spouse, or another person whose interests
will not be adverse to the surviving spouse, will have power to make a QTIP
election. Under it, the amount of
property passing to a QTIP and to a credit shelter trust (or to others) is
determined by the QTIP election itself.
The surviving spouse could have an interest in the credit shelter trust
and a special power of appointment over it. (The regulations allow the QTIP
election to control the extent of the property over which the surviving spouse
has the necessary qualifying income interest for life.[1]) The approach is akin to ones in which any interests in
a QTIP trust that the surviving spouse disclaims will pass to a credit shelter
trust or to others. However, in the
latter case the surviving spouse cannot retain a special power of appointment
over the property unless it is limited by an ascertainable standard.
Possible Solutions—Limits or Caps on Gifts to Others. In some cases, a husband or wife may wish to limit the
extent to which property would pass to or for the benefit of persons other than
the surviving spouse, who may be children of the testator by a prior
marriage. A client might choose to
resolve the matter in a variety of ways.
A testator might, for example, wish to make the children and the
surviving spouse beneficiaries of fixed separate shares of the credit shelter
trust. For example, the testator's
children might be the beneficiaries of a fractional share of the trust. The share might be determined by a fraction,
the numerator of which is $675,000 (the credit equivalent in 2001), and the
denominator of which is the estate tax credit equivalent allowable at the time
of the testator's death ($1 million in 2002-2003; $1.5 million in 2004-2005, $2
million in 2006-2008, and $3.5 million in 2009). The surviving spouse would be the beneficiary of the balance of the
trust. Some testators might, instead,
prefer to forego the full use of the credit equivalent by "capping"
the amount that would pass to the children or to a credit shelter trust. A cap might also be desirable if a
substantial part of the testator's estate consists of assets that fluctuate widely
in value (e.g., shares of high tech, bio-tech, and .com companies).
Formula gifts are usually tied to
the amount of the deceased spouse's remaining unified credit. They typically take the form of either: (1)
an upfront gift to the surviving spouse or to a trust for his or her benefit of
the required minimum amount; or (2) an upfront gift of the maximum amount to a
credit shelter trust. Whichever
approach is used, the scheduled increases in the credit equivalent will
allocate increasingly larger amounts to the nonmarital beneficiaries (i.e., the
credit shelter trust, the children of the deceased spouse, or others). The point is illustrated by the following
example.
Example: H's
will makes a formula gift to a credit shelter trust (the beneficiaries of which
are his children by his first marriage) of the maximum amount that can pass
without incurring any tax liability and leaves the balance of his estate to a
QTIP trust for his wife W. If H dies in
2001 the credit shelter trust will be funded with property worth $675,000; if
he dies in 2002 the trust will receive $1 million; if H dies in 2009 it will
receive $3.5 million, etc. The trust
for W will receive a correlatively smaller amount.
The
status of a client’s closely held business interests should be reviewed in
light of the increase from 15 to 45 in the number of shareholders or partners
allowed under IRC Section 6166(b).
Act Section 571(a). The
amendment is effective with respect to decedents dying after December 31,
2001. Because of the increase, the
estates of more owners of interests in family owned businesses may qualify, or
may be planned to qualify, for the 15 year deferred payment of the estate
tax. Few businesses will qualify for
the new provisions of IRC Section 6166(b)(10), Act Section 571(b),
that allow installment payment of the estate tax attributable to interests in
qualifying lending and finance businesses.
Businesses only qualify if they meet specific requirements regarding the
number of employees, amount of gross receipts, and sources of income.
E. Freeze
or Reduce the Tax Value of Assets
Clients should be encouraged to
consider ways in which the gift and estate tax value of assets may be frozen or
reduced. The outright gift is the
simplest way to freeze the gift and estate tax value of an asset. Of course, the tax value of more valuable
assets can be frozen by selling them to family members in an installment
sale. Value reduction techniques
include the formation of family limited partnerships, or LLCs, interests in
which usually qualify for substantial gift and estate tax discounts, and the
creation of grantor retained annuity trusts (GRATs), or irrevocable trusts of
other types. Gifts of fractional
interests in real property also qualify for discounts—most often in the 15-20
percent range. Thus, a gift of a
one-half interest in a parcel of real property worth $100,000 may have a gift
tax value of less than $50,000, quite possibly only $40,000. The value of the donor's retained interest
would be similarly reduced.
F. Gifts
and Other Basic Strategies
Most clients whose estates are
in a taxable range (i.e., more than $2 million per couple) should consider
making, or continuing to make, annual exclusion gifts. Doing so will remove from a donor's estate,
the value of the gift, including its future growth in value and any income it
generates. Annual exclusion gifts may
be made in various forms, most often outright or to discretionary trusts with Crummey
withdrawal provisions. Annual exclusion
gifts in trust may, of course, be made to the custodians for minor
beneficiaries under the Uniform Transfers to Minors Act or to trusts for minors
that meet the requirements of IRC Section 2503(c).
Clients with the capacity to
make substantial additional gifts should consider doing so early in 2002 in
order to take advantage of the $325,000 increase in the credit equivalent (from
$675,000 to $1 million). The same class
of clients should consider funding GSTT exempt trusts with all, or the
remainder, of their credit equivalent and their unused GST exemption. From the federal transfer tax perspective,
the potential benefit of such trusts is enhanced if the grantor is treated as
its owner for income tax purposes and, thus, remains taxable on its
income. Note, in this connection that
under the 2001 Act, post-2009 transfers made to a trust are not treated as
taxable gifts if the grantor is treated as the owner of the trust for income
tax purposes. Act Section 511,
amending IRC Section 2511(c).
The elements of a gifting plan
should, of course, take into account relevant nontax factors including the age,
health, experience, and capacity of a client and the client's dependents and
other intended donees or beneficiaries.
Somewhat different planning considerations will apply to clients who are
not likely to survive until 2009 (when the credit equivalent is scheduled to
become $3.5 million) or 2010, when the estate tax repeal may take effect. For example, in the latter case, it may be
appropriate to recommend making substantial taxable gifts. The gift tax paid with respect to taxable
gifts is not included in the donor's estate tax base if he or she survives for three
years or more following the gift.
Consider Making Use of Increased $1 Million Credit Equivalent in 2002. Clients who can afford to make substantial additional
gifts should consider doing so early in 2002 in order to take full advantage of
the $325,000 increase in the gift tax credit equivalent that becomes effective
on January 1, 2002. Depending on the
circumstances, a client might make additional gifts in various ways. Some might choose to make additional outright
gifts to adult children, while others would transfer larger amounts to grantor
retained annuity trusts (GRAT).
Significant overall tax benefits can result from transferring property
to a GRAT that is likely to appreciate substantially. Gift planning will be somewhat simpler in 2002 when the estate
and gift tax credit equivalent and the GST exemption will be at essentially the
same levels.
Consider Creating GSTT Exempt Dynasty Trusts. As suggested above some wealthier clients may wish to use
some or all of their gift tax credit equivalent and GST exemptions by creating
one or more GSTT exempt trusts. In
2002, a couple could transfer up to $2 million to a trust without incurring any
out-of-pocket gift or GST tax cost.
Clients can, by creating such a trust, provide benefits to their
descendants and insulate the trust property from the reach of the beneficiaries
creditors—and would be predators. In
the states that have repealed or modified the Rule Against Perpetuities (e.g.,
Alaska, Delaware, Florida, and South Dakota), a dynast trust could last for
many generations.
The trust could be defective for
income tax purposes, as a result of which the grantor would be treated as the
owner of the trust for income tax purposes and would be required to pay the
income tax attributable to the trust.
Such an approach is desirable in part because the income tax rates
applicable to estates and trusts were not reduced by the 2001 Act and, hence,
will be higher than the rates applicable to individual taxpayers.
A variety of techniques can be
used to cause the grantor to be treated as the owner of the corpus and income
of a trust. One popular approach is to
include a power that allows the grantor to reacquire the property of the trust
by substituting property of equal value.
See IRC Section 675(4).
Another is to give a nonadverse party, such as the trustee, the power to
add beneficiaries. The power to add
charitable beneficiaries is sufficient for this purpose. See Bernard Madorin, 84 T.C. 667
(1985) and PLR 199936021. The trust
would be more flexible if the trustee could terminate the status should it
become desirable to do so. Thus, the
trustee might be given the power to terminate the grantor's power to substitute
other property or to release the trustee's own power to add charitable beneficiaries. Under a slightly different approach, the
trust could allow the trustee later to amend the trust in ways that would give
the grantor a power that would cause the grantor thereafter being treated as
its owner for income tax purposes.
Again, the power might be subject to later termination by the
trustee. Inclusion of such a power is
also important because, after 2009 (i.e., after estate tax repeal), transfers
to a trust will be subject to the gift tax unless the grantor is treated as the
owner of the trust for income tax purposes.
Making Taxable Gifts in Excess of $1 Million Credit
Equivalent May be Hazardous to a Client's Wealth. Although the scheduled repeal of the estate and GST taxes
may not take place on January 1, 2010, clients should be reluctant to make
gifts that will require the payment of any gift tax. The reason is simple—Why should a client pay a gift tax at a
marginal rate of 41 percent on gifts in excess of the $1 million gift tax
credit equivalent, when the property might pass to the intended donees free of
any tax if the owner dies after 2009?
In some cases, making taxable
gifts could produce unfortunate results—particularly depending on whether the
donor dies before or after 2009.
Consider the following example:
Example: In 2002, Mr. Gotrocks, who had previously made no taxable
gifts, made taxable gifts of $1.5 million to his children. In April 2003, he paid a gift tax of
$210,000. Mr. Gotrocks made no more
taxable gifts and died in 2009, leaving a taxable estate of $2 million.
Combining the value of his taxable estate and his taxable gifts yields a total
of $3.5 million. As a result of the
increase in the estate tax credit equivalent to $3.5 million no estate tax is
due from Mr.Gotrock's estate.
Unfortunately, the gift tax he paid will not be refunded to his estate
or his beneficiaries.
In limited instances making
taxable gifts in excess of the credit equivalent may be appropriate. For example, taxable gifts may be of tax
benefit to a client who is expected to survive for three or more years and to
die before 2010, leaving a taxable estate that exceeds the amount of the
allowable estate tax credit equivalent.
Make Incomplete Gifts, Perhaps to Income and Gift Tax
Defective Trusts. Wealthier
clients may wish to make incomplete (i.e., nontaxable) gifts to an unusual type
of trust. The transfers would be
attractive, in part, as a low cost gamble that the estate tax will be
repealed. The approach is also
attractive because it has little, or no, downside tax risk.
The plan involves transferring
property to an irrevocable trust that is intentionally defective for income and gift tax purposes. Transfers to such a trust do not constitute
completed gifts. The desired tax status is achieved if the grantor retains a
special testamentary power of appointment and an independent trustee has
discretion to distribute income and principal to a class that includes the
grantor. Gifts to irrevocable income
and gift tax defective trusts may be attractive because of the scheduled repeal
of the estate tax. Transfers to such a
trust would be incomplete gifts that are not subject to any present gift tax
liability. The 2001 Act also amends IRC
Section 2511(c), to provide that post 2009 gifts to a trust are incomplete
if the trust is treated as wholly owned by the donor under IRC
Sections 671-677. In combination,
these rules mildly encourage clients who have already used their $1 million
credit equivalent to make transfers to trusts that would be treated as
incomplete and of which they are treated as the owner for income tax purposes. The latter feature also allows sales to be
made between the grantor and the trust without being subject to the capital
gains tax.
Most distributions of income or
principal to persons other than the grantor would be treated as gifts by the
donor. However, distributions that
constitute qualified transfers (i.e., the direct payment of tuition or the
medical care insurance or other medical expenses of children, grandchildren, or
others) are excludible for gift tax purposes and are not subject to the GSTT. IRC Sections 2503(e) and 2611(b). Thus, distributions from the trust could be
made to meet educational and medical expenses of the grantor's family. Taxable gifts would occur if the trustee
could make other distibutions to persons other than the grantor. Of course, if it appears desirable to do so,
the trustee could unwind the trust in whole or in part by making distributions
to the grantor. Because of the
grantor's retained interests, the trust would provide little, if any,
protection against the grantor's creditors.
Under existing law, no gift
would take place when the trust was created or when the donor dies and the
power of appointment is exercised or lapses.
Historically, the gift tax has not been applied to gifts that become
complete when the donor dies. If the
estate tax is no longer in effect when the grantor dies, the trust property
will pass to the appointees of the grantor or designated takers in default
without having been subject to any federal transfer tax.
Overall, the downside tax risk of the trust is limited. Gifts to such a trust would only be reached by the estate tax, which is scheduled to expire on January 1, 2010. If the estate tax is in effect at the time of the grantor's death (i.e., either the grantor dies before 2010 or the estate tax