2012 Estate Planning. Martin Inc. Shenkman
grantor trusts will be treated in the future as completed gifts by the grantor at that time. If an irrevocable grantor trust is created and funded in 2012, it may be exempt from the provisions of the new law (i.e., grandfathered), at least as to transfers completed prior to any law change. This can have a tremendous planning benefit and is yet another reason you should plan before the end of 2012.
PLANNING NOTE: You might consider incorporating express language in your Trust Agreements so as to permit trustees to create separate sub-trusts for pre- and post-grantor trust law changes. This would allow the trust to be bifurcated as to any future component of the trust that either will be anon-grantor trust or would be included in the grantor’s estate at death under President Obama’s proposal.
Other grantor trust planning opportunities are discussed in later chapters.
Lock in Discounts
Favorable valuation discounts often provide the leverage that has imbued many estate planning techniques. Valuation discounts, in very simplistic terms, can be illustrated with an example. If a closely held business is worth $1 million, 30 percent of the business is worth less than $300,000 (30% x $1 million) because the owner of such a minority interest generally cannot control distributions to owners or make other important business decisions. Discounts have provided tremendous leverage to many tax-efficient wealth transfers.
There have been a host of proposals over recent years to restrict or eliminate valuation discounts on certain asset transfers among members of a family. If a gift is consummated before any such law changes, the favorable valuation discounts that are currently permitted should be locked in. Once the law changes, these favorable discounts may be lost on future transfers. Discounts can be more important than just adding leverage to a wealth transfer transaction (i.e., getting the biggest bang for the buck out of the donor’s available gift and GST exemptions). For instance, discounts may be critical to the transaction itself being viable in the first place. Discounts can be essential not only for certain estate plans, but for as-set protection as well. Asset protection planning as a separate motivation for 2012 transfers is discussed next.
EXAMPLE: A physician wishes to engage in asset protection planning. She owns interests in a number of real estate limited liability companies (LLCs) where her practice offices are based as well as in several surgical centers. The real estate alone is valued at $7 million. Relying on minority interest discounts on her ownership in the various LLCs, the physician can simply gift the LLC interests to a completed gift DAPT (explained later) without gift tax under the protection of the $5.12 million exemption and remove all future appreciation on this real estate from her estate. Perhaps, more important, the physician can also achieve meaningful asset protection planning. Without the discounts, the physician would have to gift one or more LLC interests to the DAPT and sell the remaining interests for a note in order to avoid gift tax. This would significantly increase the cost and complexity of the transaction and leave the note in her estate.
EXAMPLE: Entrepreneur A owns 50 percent of the interests in a real estate rental entity organized as an LLC. The business is valued at $40 million. Entrepreneur A wishes to gift $5 million worth of the LLC to a dynasty trust for his heirs to use his exemption. He also wishes to sell the balance of his interests in the LLC to the same trust. The goal is to shift all future appreciation in the value of the real estate business away from Entrepreneur A’s estate and to the dynastic trust while “freezing” the value of the business interests subject to the note sale.
Now is a perfect time to engage in this type of transaction because business valuations remain depressed due to the flailing economy, and the interest rate to be paid to Entrepreneur A on the note can be set at a historically low rate. While the LLC has always paid arm’s-length salaries, cash distributions to the members (owners) have been relatively modest compared to the revenues and earnings because most of the profits have historically been reinvested in the form of capital improvements to the real estate. Even with today’s historically low interest rate, the annual distributions that the real estate LLC could realistically make to the trust (as the new owner) would likely be insufficient to enable the trust to make current interest payments on the note. The attorney planning the transaction is of the opinion that interest on the note sale should be paid currently, not accrued, to bolster the likelihood of the IRS respecting the sale transaction. With an aggregate discount estimated by an appraiser at 40 percent, the value of the LLC membership interests sold (and given), the note sale portion of the transaction can be reduced to a level such that the annual distributions from the LLC may well be sufficient for the trust to make current interest payments on the note.
However, if the transaction is not completed in 2012, but in 2013 when these discounts may be restricted or eliminated, the annual distributions from the LLC would never suffice to make current interest payments. Thus, the discounts, apart from providing favorable leverage on the taxable value shifted out of the estate, may also be essential to the viability of the transaction itself.
Remove Appreciation from the Estate
If assets are transferred to an irrevocable trust in 2012, all post-transfer appreciation to those assets should benefit the trust and be outside your taxable estate. For any transfer (completed gift, sale, or a combination of both) to an irrevocable trust, this is a major planning objective for both transfer tax minimization and asset protection purposes. Apart from the prospect of unfavorable tax law changes, the fact that the economy remains soft in many parts of the country and for many industry sectors should facilitate intra-family transfers today at values that may prove to be quite low. This alone can support current 2012 planning.
Minimize Future State Income Tax
If you gift assets to a grantor trust today, there will be no current state income tax savings since the trust income and gains will be taxed to you, as grantor. However, following your death, the grantor trust status of the trust ends. At that point, the trust will become a separate taxpayer and, with proper planning, heirs residing in high income tax states may be able to minimize or even avoid state income tax on trust income by accumulating the income in the trust. For instance, if the trust is established in one of the trust-friendly states discussed throughout this book (e.g., Alaska, Delaware, Nevada, and South Dakota), there likely will be no state income tax on earnings retained in the trust for out-of-state beneficiaries. This can provide a significant benefit. In-state trust beneficiaries are taxed in Delaware, so caution must be exercised in making any assumptions about tax treatment from state to state.
EXAMPLE: Wealthy Taxpayer establishes a grantor “dynasty” trust in Alaska to which he gifts $5.12 million of marketable securities. During Taxpayer’s lifetime, there is no incremental state income tax savings because the trust earnings will be taxed by Taxpayer’s state of residence. On Taxpayer’s death, grantor trust status terminates. Taxpayer’s only heir is his daughter, age 50 at Taxpayer’s death. Daughter is gainfully employed and has no current need for distributions from the trust so she does not request the trustee to make any discretionary distributions. Daughter retires at age 60 and moves to a state that has no state income tax. At that point, she occasionally requests distributions from the trustee. State income tax will have been avoided for the entire 10-year period following her father’s death.