The next nine months are an exceptional window of opportunity for
your clients to make family wealth transfers. The federal gift and
estate tax exemption is $5,120,000, and both income tax rates and
interest rates are at the lowest point in a generation. With federal
deficit spending also at record levels, tax and interest rates seem sure
to rise. Unless the President, the Senate, and the House of
Representatives all agree otherwise, income and estate taxes will
increase dramatically on January 1, 2013.
There is also the risk
that long-used planning strategies such as charitable deductions and
valuation adjustments will soon be eliminated or limited. Advisors who
understand this situation will be well positioned to help their clients
take full advantage of this estate planning opportunity while it lasts.
In this edition of The Wealth Counselor,
we will explore how the current deficit spending is making the case to
increase taxes, what your clients can expect in 2013 unless the
President, the Senate, and the House of Representatives all agree
otherwise, and how you can help your clients use advanced irrevocable
trusts now to take advantage of this opportunity and save income and
estate taxes.
The Case for New Taxes
The
U.S. government is spending a lot more money than it is taking in,
creating the largest deficits in our history. The projection for 2012
is:
U.S. Tax Revenue............................................ $2,310,000,000,000
U.S. Government Spending.............................. $3,614,000,000,000
New Debt......................................................... $1,303,000,000,000
National Debt.................................................. $15,114,000,000,000
Recent Federal Budget Cuts................................ $385,000,000,000
These
are staggeringly large numbers. It’s easy to lose sight of their
meaning because there are so many zeros at the end of each one. But if
you drop eight of the zeros and consider this to be the budget for a
young family or single adult, the numbers take on real meaning:
Annual Income.................................................................... $23,100
Money Spent...................................................................... $36,140
New Credit Card Debt........................................................ $13,030
Outstanding Credit Card Debt........................................... $151,140
Total Budget Cuts............................................................... $3,850
Both
are train wrecks waiting to happen. Spending is more than 150% of
income, yet budget cuts planned are less than 17% of income. Talk about
“Another day older and deeper in debt”!
For the federal
government, it seems that either deeper budget cuts will have to be
made, or income…in the form of taxes …will have to increase. The federal
government can also print more money, which will eventually lead to
inflation.
Taxes…Now and in Nine Months
In
2012, the federal estate, gift, and generation-skipping transfer tax
(GSTT) exemptions are all $5,120,000 and the tax rate on any excess is
35%. Unless the President, the Senate, and the House of Representatives
all agree otherwise, on January 1, all three exemptions will drop to
$1,390,000 plus an adjustment for 2012 inflation and the tax rate on any
excess will start at 45% and increase to 55%. In addition, the estate
and gift tax “portability” provision will expire.
Unless the
President, the Senate, and the House of Representatives all agree
otherwise, taxes on income, dividends, and long-term capital gains, will
also increase on January 1. In addition, a new 3.8% healthcare
surcharge will go into effect for married taxpayers with adjusted gross
income (AGI) of $250,000 or more ($200,000 or more for single
taxpayers). Here’s a chart to show the income tax rate change:
|
Long Term Gains
|
Ordinary Income
& Short-Tem Gains
|
|
2012
|
2013
|
2012
|
2013
|
Top Federal Tax
|
15%
|
20%
|
35%
|
39.8%
|
Healthcare Surcharge
|
0%
|
3.8%
|
0%
|
3.8%
|
Total
|
15%
|
23.8%
|
35%
|
43.6%
|
Unless
the President, the Senate, and the House of Representatives all agree
otherwise, your clients’ favorable tax-planning window will close in
January:
* The most favorable estate/gift tax we have ever had
will be gone ($5 million exemption to $1 million; 35% rate to 55%
rate).
* Interest rates, now at lows not seen in our lifetimes (2%
overall, 1.4% AFR for intra-family gifts), will almost surely increase.
* Charitable deductions, now fully deductible, may be limited to those in a 28% income tax bracket.
* Long-term capital gain rates will increase from 15% to 20%.
* Dividend rates will increase from 15% to ordinary income rates, which can be as high as 43.6%.
*
Valuation adjustments for family controlled limited partnerships and
limited liability companies may be legislated or regulated away.
Planning Tip: Encourage your clients to complete their planning before the end of 2012 to take advantage of this unique planning window.
Irrevocable Trusts Can Help Your Clients
There
are a wide variety of irrevocable trusts that your clients can use now
to help save income and estate taxes. These include:
- 2503(c)
Minor’s Trust: Used instead of a Uniform Transfers to Minors Account
(UTMA) or Uniform Gifts to Minors Account (UGMA), must provide that any
remaining trust assets will pass to the child on reaching age 21.
- Family
Bank Trust: An inter vivos bypass trust that mimics the tax avoidance
benefits available after one spouse passes away but lets you have these
benefits while someone is living.
- Gifting Trust: Used for
lifetime annual exclusion gifts (currently $13,000 per donor per donee)
to children, grandchildren, and others to avoid the problem of the
beneficiary having full control of sizeable assets at age 18 or 21.
- Health
and Education Exclusion Trust (HEET): Requires a significant charity
beneficiary. For non-charity beneficiaries, distributions are limited
to payments directly to an institution that is providing health care or
education. Because of these limitations, neither contributions to nor
distributions from the HEET are taxable. The HEET is especially useful
when the client’s GSTT exemption has already been used.
- Intentionally
Defective Grantor Trust (IDGT) or Intentional Trust: Allows your client
to use taxes on trust income to reduce his or her estate taxes. The
grantor’s paying the income tax due because of the trust’s income is not
an additional gift to the trust.
- Inheritor’s Trust: Created at
the beneficiary’s request for the benefit of a beneficiary. Typically
used when a grandparent or parent doesn’t want to go to the trouble to
create a trust that would keep their resources out of the beneficiary’s
estate when they die. (E.g., the physician beneficiary who already has a
taxable estate and wants asset protection for the inheritance.) The
beneficiary’s child, sibling, friend, or spouse can set up the
inheritor’s trust.
- Life Insurance Trust: Set up by someone to
hold life insurance on his or her life. Variations to the single-life
insurance policy trust include second-to-die policy trust and spousal
access life insurance trust.
- Split-Interest Charitable Trusts: Charitable remainder trusts and charitable lead trusts.
Planning Tip: Current
interest rates, as low as they are, make charitable remainder trusts
the least attractive, and charitable lead trusts the most attractive,
they have been in a very long time, if ever.
- Split-Interest
Non-Charitable Trusts: These include grantor retained annuity trusts
(GRATs), grantor retained income trusts (GRITs), qualified personal
residence trusts (QPRTs) and qualified terminal interest property trusts
(QTIPs).
- There are also a several types of irrevocable trusts
that your clients with particular situations can establish now that have
purposes other than saving income and estate taxes. These include:
- Special
Needs Trust: Allows for provision of additional benefits and services
for family members with special needs (children, parents) without
disrupting valuable government benefits.
- Retirement Trusts
(Stand Alone): Designed specifically to ensure the maximum stretch out
for tax-deferred plans after the participant/owner’s death.
Planning Tip: The
Advisors Forum provides in-depth programs and additional information on
all of these irrevocable trusts. Go to www.advisorsforum.com for more
information.
Amending an Irrevocable Trust
Even
though an irrevocable trust once established cannot be revoked or
amended by the trustmaker, careful planning at its establishment can
empower someone other than the trustmaker to make changes. For example, a
lifetime power of appointment given to someone other than the
trustmaker can allow the term of the trust to be extended or a
beneficiary (including a charity) to be added or dropped. Assets can be
sold by the trustee to a new irrevocable trust with different
beneficiaries and provisions. Non-judicial modification is allowed under
the Uniform Trust Code if the trustmaker, trustee, and all
beneficiaries agree. Decanting (transferring to another trust for the
same beneficiaries) is a trust feature that is now allowed in 14 states,
with four more pending.
Planning Tip:
A trust protector, whose role differs from a trustee’s and is common in
offshore jurisdictions, is now often being used in domestic irrevocable
trusts to allow for more flexibility without adverse tax consequences.
The Family Bank Trust
An
inter vivos bypass trust can create a lifetime benefit for the grantor
with assets he or she “gives away.” For example, a wife can create a
family bank trust with appreciating assets. As the trustee, her husband
has access to the assets, can withdraw them and can even lend or give
them back to his wife. Because they live in the same household, both
will enjoy the benefits. A limited power of appointment can be given to
the husband in the event he should die before she does and he can even
appoint the property back to his wife.
Generation Skipping Transfer Tax (GSTT) Exemptions
There
are two GSTT exclusions. There is an annual exclusion (currently
$13,000 per year per done per donor) for outright gifts and gifts to
qualifying trusts. To be a qualifying trust, a trust must have only one
current beneficiary and have provisions that will cause the trust assets
to be included in the beneficiary’s estate for estate tax purposes.
There is also the lifetime GST exemption ($5,120,000 million in 2012)
that can be applied to transfers to non-qualifying trusts such as
dynasty trusts and trusts with multiple beneficiaries.
The Lifetime QTIP Trust
This
is a split-interest trust. It is created by one “propertied” spouse for
the benefit of the other “non-propertied” spouse as a method of
equalizing the estates without the propertied spouse giving up control.
All income must be paid at least annually to the beneficiary spouse to
qualify gifts to the trust for the gift tax marital deduction.
During
the life of the beneficiary spouse, the QTIP trust can be a spendthrift
trust, but any income that is generated in the QTIP trust is subject to
attachment by the beneficiary spouse’s creditors.
To qualify
gifts to the trust for the gift tax marital deduction, the QTIP election
must be timely made on the donor spouse’s Form 709 gift tax return and
there is no cure if the return filing deadline is missed. The death of
the beneficiary spouse before the donor spouse renders the beneficiary
spouse the transferor for future trusts to which the QTIP trust assets
are appointed. The donor spouse’s GSTT exemption can be allocated to the
QTIP trust.
Grantor Trusts and Wealth Transfer
The balance of this newsletter will focus on various grantor trusts.
Tax
code sections 671-679, which define and govern “grantor” trusts, were
written in the 1950s as a deterrent to taxpayers transferring their
assets to trusts to remove the assets from their estate to take
advantage of the then-lower income tax brackets and rates that trusts
enjoyed. If a trust is a grantor trust, these sections cause attribution
to the grantor of all income and deductions associated with the trust
assets. Some, but not all, trust characteristics that will cause a trust
to be a grantor trust will also cause the trust’s assets to be included
in the grantor’s estate for estate tax and GSTT purposes.
Today,
the grantor trust income and deduction attribution is used by estate
planners in several ways to the taxpayer’s advantage. For example, a
transfer of appreciated assets (real estate, stock portfolio, privately
owned business) to a grantor trust is not an income tax recognition
event. So, too, transferring assets to a grantor trust before they
appreciate allows future appreciation to be removed from the grantor’s
estate.
Another grantor trust use is the “tax burn,” which
occurs when the grantor pays the income tax on income the grantor trust
generates, thereby removing assets from the estate without using any of
the grantor’s annual exclusion or lifetime exemption from gift taxes.
The
grantor trust is also a permissible purchaser of existing insurance on
the grantor’s life, which avoids the transfer for value rules.
Planning Tip:
Careful drafting of grantor trust provisions can provide certainty
while giving more flexibility. For example, should the income being
generated by the trust cause the grantor to pay more in income taxes
than desired, if the trust is properly drafted the grantor trust
provision can be turned off without affecting the estate tax exclusion
feature of the trust. The trustee can also be given the discretion to
reimburse the grantor for income taxes paid because of the income
attribution.
Planning Tip:
For income tax reporting, the trust can have its own tax identification
number, in which case a Form 1041 is required, or the grantor’s social
security number can be used with no 1041 required.
Creating Lifetime Benefits
A
grantor trust can allow loans to the grantor. For example, the trustee
can borrow against a life insurance policy or the trust assets and
re-loan the proceeds to the grantor. If adequately documented and
secured, there should be no “incidents of ownership” that would cause
the trust assets to be brought back into the grantor’s estate. The
entire loan balance, including any accrued interest at the grantor’s
death, would reduce the grantor’s estate. Making the loan interest
commercially reasonable but higher than that required by law can be used
to remove even more from the grantor’s estate—another example of “tax
burning.”
Irrevocable Life Insurance Trust (ILIT)
An
ILIT lets your client remove life insurance death benefits and policy
cash value from your client’s taxable estate, control the disposition of
the death proceeds, and utilize the annual gift tax exclusion
(currently $13,000 per person) for “Crummey” gifts to the trust so it
can pay insurance premiums. It provides asset protection for the
proceeds and creates liquidity at the grantor’s death by giving the
trustee authorization to lend proceeds to the estate (to pay estate
taxes and other expenses) and to buy assets from the estate.
Planning Tip:
In community property states, the non-insured spouse cannot contribute
to the trust of which he or she is a beneficiary without causing
inclusion in the beneficiary spouse’s estate. If the insured spouse does
not have separate property sufficient to make the contribution, a
partition agreement can solve this issue.
Sales to Grantor Trusts
With
the current $5 million gift tax exemption, commercially reasonable
installment sales to grantor trusts are now more commonly available to
use and so are often preferred to grantor retained annuity trusts
(GRATs). A sale provides more tax certainty than a GRAT because, for
estate tax purposes, trust assets are included in the grantor’s estate
if the Grantor dies during the GRAT term.
To make the sale
commercially reasonable, the grantor establishes an intentionally
defective grantor trust, contributes assets to it and allocates GSTT
exemption to the gift. This gift serves as the security for an
installment sale of assets having a value many times that of the initial
gift. It is common for the grantor’s gift to be 10% of the value of the
assets sold, but as an alternative, financially solvent trust
beneficiaries can guarantee the trust’s performance under the sale
agreement.
Asset Protection Trusts and Self-Settled Trusts
Whether
creditors can reach a beneficiary’s interest in an irrevocable trust
established by a third party is determined based on the enforceability
of the trust’s spendthrift provisions, the beneficiary’s degree of
control of the trust, and whether the beneficiary has an interest in the
trust property. Typically, no creditor protection is provided for the
grantor of a trust who is also the trust’s beneficiary. Such trusts are
called “self settled.” There are, however, certain states (see below)
and some offshore jurisdictions whose statutes provide grantors of
certain types of self-settled trusts protection from some or all
creditors. Common types of self-settled trusts include revocable living
trusts, charitable remainder trusts and grantor retained annuity trusts.
A grantor’s judgment creditors can reach the grantor’s interest in the
assets in these types of trusts. Creditors can also reach mandatory
distributions to beneficiaries such as the income interest in QTIPs,
GRTs and CRTs.
Planning Tip: It is especially important not to include mandatory distributions to a beneficiary from a special needs trust.
Planning Tip:
A special needs trust funded with assets that require mandatory
distributions (such as a 401(k) or IRA) should not be a “conduit” trust.
The
states that currently provide creditor protection for certain
self-settled trusts (domestic asset protection) are: Alaska, Delaware,
Nevada, Rhode Island, Utah, South Dakota, Oklahoma, Missouri, Tennessee,
New Hampshire, Wyoming, and Colorado (a Virginia statute is on the
Governor’s desk).
Planning Tip: Your
client will want to weigh the costs and benefits of a self-settled
trust vs. a non-self-settled trust, equitable division in case of
divorce, and offshore vs. domestic asset protection trusts.
Split-Interest Grantor Trusts
These
are techniques for leveraging gifts with distinct economic interests,
with a division over time of ownership and the type of interest. The
portion that is given away (the remainder) is taxed as a gift; that
which is not given away is a retained benefit and is not taxed as a
gift. Common split-interest trusts include charitable remainder and lead
trusts (CRTs, CLTs), grantor retained annuity trusts (GRATs) and
qualified personal residence trusts (QPRTs).
Chapter 14 of the
Internal Revenue Code was designed to reduce intra-family
undervaluations of split-interest transfers and valuation provisions
were put in place. Fixed annuity or unitrust amounts, exceptions under
Code Sec. 2702, are most commonly used.
Planning Tip: Split-interest
trust tax calculations are made using the Code Sec. 7520 rate (120% of
the federal mid-term applicable federal rate (AFR)) at the time the
trust is established. Current low interest rates (mid-term AFR of 1.3%
and 7520 rate of 1.56% are record lows) allow a grantor to make very
large gifts to his/her family without using the gift tax exemption by
using split-interest trusts.
Planning Tip: The
GSTT exemption can only be applied at the end of the estate tax
inclusion period (ETIP). This is the time during which, if the grantor
dies, the property will revert to the grantor’s gross estate. For
example, if a QPRT is established for a ten-year period, the GSTT
exemption can only be determined and applied at the end of the ten years
when it is known that the grantor has survived the trust term and the
property will not revert to the grantor’s estate. As a result,
split-interest trusts are not appropriate for use as dynasty trusts.
Planning Tip: A
longer term means more risk that the grantor may not survive the term.
Life insurance can be used to offset risk. A split-interest trust may or
may not be a grantor trust during or after its initial term.
Grantor Retained Income Trust (GRIT)
With
a GRIT, the grantor receives income from the trust assets for a certain
length of time, then the remainder is paid to or held for the benefit
of a remainder beneficiary. There is significant wealth transfer
opportunity with low or non-income producing property. GRITs are no
longer available to use with transfers to immediate family members, but
they can still be used for business situations and for gifts to nieces
and nephews, and are especially useful for non-marital life partners.
Qualified Personal Residence Trust (QPRT)
A
QPRT lets the grantor make a gift of his/her personal residence to
family members while retaining the right to live in the residence for a
term of years. QPRT gift tax calculations assume no appreciation of the
home during the primary term. A QPRT is a grantor trust during the trust
primary term, so the grantor continues to receive the mortgage interest
deduction. The grantor also retains the exclusion under IRC Sec. 121
($250,000 for a single person, $500,000 for a married couple) if the
home is sold during the trust primary term. If the grantor dies during
the trust primary term, the residence is included in the grantor’s gross
estate.
Planning Tip:
Use multiple QPRTs of minority interests in the home to hedge the risk
of the grantor’s and take advantage of the valuation adjustment
appropriate for gifts of minority interests in real estate.
Planning Tip:
QPRTs have not been used as much lately due to low interest rates.
However, if the grantor lives in a state that has a state estate tax and
wants to make a gift to a child who expects to live in the house,
assuming the grantor survives the term, any state estate tax can be
eliminated.
Grantor Retained Annuity Trusts (GRAT)
GRATs
are less popular now that the gift tax exemption is $5 million.
Nevertheless, they are well-suited for appreciating assets and discounts
provide leverage. If the grantor dies during the trust term, the
property is included in his/her gross estate. Multiple or “rolling”
GRATs (e.g., maturing every two years) can lessen risk and, over time,
provide remainder benefits for the beneficiary.
Conclusion
Our
very favorable planning time—with favorable interest rates, estate/gift
taxes exemptions and rates, full charitable deductions, low capital
gains and dividend rates, and available strategies—is very likely to end
on December 31, 2012. The advisor who understands the various
irrevocable trusts explained here and the urgency for clients to
implement their plans during the balance of 2012 is in a unique position
to help clients save substantial estate and income taxes, and will
undoubtedly be a highly valued member of the advisory team.
To
comply with the U.S. Treasury regulations, we must inform you that (i)
any U.S. federal tax advice contained in this newsletter was not
intended or written to be used, and cannot be used, by any person for
the purpose of avoiding U.S. federal tax penalties that may be imposed
on such person and (ii) each taxpayer should seek advice from their tax
adviser based on the taxpayer's particular circumstances.