2012 Estate Planning. Martin Inc. Shenkman
a portion of the exemption used in 2012) that could unwind some of the 2012 tax planning benefit, few tax commentators believe the risk is real and, even if it is, in most cases it won’t eliminate all 2012 planning benefits. The issue of clawback is discussed in greater detail in Chapter 6.
While you might be concerned about the cost of the 2012 planning, the transfer tax savings alone, if any of several potential adverse scenarios do in fact occur, could easily exceed several millions of dollars, and, for ultra-high net worth taxpayers, it could be in the tens or even hundreds of millions. Even factoring in uncertainty and costs associated with planning, for a substantial number of taxpayers, 2012 planning should have a worthwhile cost to potential benefit payoff ratio.
Save on State Estate Tax
Many states have their own estate tax and about 20 states have disconnected from the federal estate tax system. Many of these state estate tax regimes have lower exemption amounts than the current 2012 $5.12 million federal exemption amount. These states are said to have “decoupled” their estate tax from the federal estate tax system. Planning to minimize state death tax for taxpayers domiciled in these decoupled states is more important for many taxpayers than the federal estate tax (which under 2012 law may not apply because of the large federal exemption). Next year, 2013, could dramatically change that paradigm.
While those living in decoupled states may be aware of the tax impact of decoupling, most people are predominantly or solely focused on the federal estate tax. The fact that you would not face an estate tax on a federal level today does not mean that you cannot save hundreds of thousands of dollars, or more, in state estate tax with some basic gift planning. But this type of planning could be curtailed by a 2013 reduction in the gift exemption to $1 million. It is important to note that while most people seem to believe that the “exemption” will never be permitted to drop as low as $1 million (President Obama’s proposal was for a $3.5 million exemption), this does not assure that the gift tax exemption may not revert to its pre-2010 Tax Act level of $1 million.
Under current law, if you have a $5 million estate, are domiciled in a decoupled state with a $1 million exemption, you could gift $4 million and avoid all (or almost all depending on the calculation) state estate tax. This does, however, assume no state gift tax to be factored into the analysis which isn’t the case in Connecticut and Tennessee—the two states with such taxes. However, if the gift tax exemption reverts to $1 million, that gift will no longer be practical since you would have to pay a federal gift tax on the $3 million federal gift ($4 million gift less $1 million possible 2013 exemption). If the exemption remains unified (the same for gift, estate, and GST taxes) but is reduced to the $3.5 million proposed by President Obama, you could face a $225,000 gift tax [45% rate x ($4 million gift - $3.5 million exemption)] if the same gift were made in 2013. That could be an incredible payoff for an elderly or a terminally ill person to make. However, see the discussions that follow concerning income tax basis. The decision whether to proceed is not simple.
PLANNING NOTE: For many taxpayers, the 2010 Act made the state estate tax the only estate tax they need to consider. The calculus for these people became such that more traditional planning steps, such as transfers to irrevocable trusts, became impractical if evaluated in the vacuum of only the state estate tax sting. For some of these taxpayers, the focus of planning shifted to a change of their domicile from a high estate tax state (e.g., New Jersey) to a no estate tax state (e.g., Florida). Some of these purported changes in domicile were questionable at best as ties with the home state were insufficiently severed to break domicile. If, in fact, the federal exemption declines sufficiently in 2013, these taxpayers may again find themselves in the position of having to undertake more significant estate tax minimization planning to avoid both a federal and state estate tax. However, if many of the planning techniques now available are restricted or curtailed, this may be more difficult to accomplish. Taxpayers who fall in this under $5 million category living in decoupled states should consider the benefits of planning in 2012.
Grandfathering Trusts for GST Purposes
The generation-skipping transfer (GST) tax is quite complex and is explained in greater detail in Chapter 2. For multi-generational planning (that is, planning for children, grandchildren, and even more remote descendants), optimizing the amount of family wealth that can be transferred free of the GST tax is clearly the elixir that drives much of the estate planning effort for high net worth clients.
President Obama has proposed limiting the number of years for which a donor’s GST exemption can be allocated to gifts made to a multi-generational trust. If the trust is formed in 2012 and the gifts made to it are completed prior to the effective date of any such legislation, the amounts gifted to the trust may be grandfathered for GST purposes and thus not affected by any such restriction, if enacted in the future. The benefits of obtaining favorable grandfathering for GST purposes could have a dramatic impact on future transfer taxes of your descendants younger than children (e.g., grandchildren). But the transfer tax savings are not the only potential benefit. If the assets are paid out of the trust when the GST allocation ends, that would also undermine the asset protection planning and other benefits that such a spendthrift trust affords the future generations.
This will all be discussed in greater detail and planning techniques illustrated later in Chapters 5 and 10. The key point for this introduction is that this incredibly valuable transfer tax benefit could be eliminated by the laws scheduled to take effect in 2013 and by other tax proposals that might be enacted.
Grandfathering for Grantor Trust Purposes
A grantor trust is a trust that you establish and for which you will remain liable for all income taxes. You, as the “grantor,” pay the income tax on trust earnings. At the heart of much sophisticated estate planning is an irrevocable (you cannot change it) grantor trust to which you make a completed gift (so that the future value of that gifted asset will not be included in your estate). Even though you remain liable for the income tax on income and gains generated from the assets held in that trust, the trust assets are removed from your estate. This is a rather incongruous result. It is treated as a completed gift for gift, estate, and GST tax purposes, but the gift is essentially ignored for income tax purposes (i.e., you as the grantor are still treated as owning the trust property for income tax purposes only).The benefits of making a completed gift to a grantor trust cannot be overstated. Grantor trust status is a keystone of much of modern estate and trust planning. For example:
•A trust’s status as a “grantor” trust for income tax purposes permits the much coveted “estate tax burn” in your estate. As you pay income taxon earnings accumulating inside an irrevocable trust, your estate is further diminished by the annual tax payments. For many taxpayers, the impact of this estate tax burn can far exceed the benefit of pushing the envelope on valuation discounts that many practitioners continue to focus on.
•With grantor trust characterization, highly appreciated assets can be sold to an irrevocable trust without triggering any capital gains tax. For wealthy taxpayers seeking to shift large asset values (e.g., well above the $5.12 million exemption amount) out of their taxable estates, and for those of more modest wealth seeking to shift assets into the protective envelope of a trust in order to protect them from potential claims of future creditors, including divorce or lawsuits, grantor trust status may be critical. See the discussions that follow concerning DAPTs and BDITs.
•Grantor trust status can often help to avoid some of the thorny income and estate tax issues associated with transfers of life insurance policies to and from trusts.
President Obama’s Greenbook proposal (the General Explanations of the Ad-ministration’s Fiscal Year 2013 Revenue Proposals, released February 13, 2012), if enacted, would undermine this critical component to many estate plans by requiring that assets held in any grantor trust (even an irrevocable completed gift trust) will be included in the grantor’s taxable