Planning Opportunities In Light Of The 2001 Tax Act

The enactment of the Economic Growth and Tax Relief Act of 2001 (“2001 Act”), as most people are well aware, repeals the estate and generation-skipping tax in the year 2010 while the gift tax remains in effect. Between January 1, 2002 and 2009, there is a gradual decrease in the estate tax rates and a gradual increase in the estate tax applicable credit, but the gift tax applicable credit remains at $1 million. Additionally, in year 2010, when the estate and generation-skipping taxes are repealed, a modified carry-over income tax basis system becomes effective.

The most astonishing provision in this bill is that all of these changes simply disappear in year 2011 under the so-called “sunset provision.” It is the belief generally sponsored by nationally respected commentators in the estate planning field and by all of us at The Busch Firm that the 2001 Act will be significantly revised prior to year 2009. However, considering the fact that the 2001 Act is now the current law regarding the estate, gift, and generation-skipping taxes, this raises some planning opportunities and the need for individuals to review their current estate planning documents.

Lifetime Gifts and Transfers

An exciting opportunity for you in light of the 2001 Act is that the applicable credit for gift, estate, and generation-skipping tax will increase to $1 million in year 2002. For individuals who have previously used all of their applicable credit of $675,000, this will provide an additional $325,000 to make lifetime gifts or other transfers without paying any gift tax. There has been no change to the allowance of the $10,000 per year, per donee annual exclusion gifts, so we encourage you to continue making these annual exclusion gifts. It is possible that the cost-of-living adjustment that will be triggered in 2002 may increase the annual gift tax exclusion to $11,000.

The most beneficial gifts to family members are those that involve a family limited partnership or limited liability company, due to the significant minority and marketability discounts that can be obtained with these entities. Rather than simply making a gift of $100,000 to a family member and using such donor’s applicable credit, the donor can instead transfer assets to a family limited partnership or limited liability company and obtain a discount ranging from 20% - 40% on the partnership interest or liability company units. The donor can transfer $100,000 in assets to a family member (assuming a 30% discount) and use up only $70,000 of the donor’s applicable credit.

Three recent family limited partnership cases indicate that the IRS has consistently lost at the tax court level in challenging such discounts and these cases have proved that the tax court is unlikely to invalidate these entities on the basis of business purpose. Additionally, a partnership or limited liability company that contains only marketable securities can be formed and still obtain minority and marketability discounts, although the discount will be less than an entity that contains an operating company or real property. This is a significant planning opportunity that you should explore.

Sale to Intentionally Defective Grantor Trust

The most effective strategy, notwithstanding the 2001 Act, is the installment sale of value-discounted business interests to a “defective grantor trust” that is created by you for the benefit of your children, grandchildren, and/or other beneficiaries.

1. Step one is typically the creation of a limited liability company to which the investment assets are transferred, Ownership rights or “units” are divided into voting and nonvoting units.
2. Step two involves the creation of an irrevocable trust that is considered “defective” for income tax purposes because the grantor is considered the owner of the trust.
3. Step three involves the transfer (or “funding”) of “seed money” or “seed assets” into the trust as a gift. From the perspective of the IRS, the validity of the transaction may depend on the existence of assets other than those being purchased. As a rule of thumb, the assets contributed to the trust as a gift should be at least 10% of the combined value of the assets to be acquired by gift and by purchase.
4. Step four is to have the nonvoting LLC units appraised by a qualified appraiser of closely held businesses. The LLC ownership “units” will be subject to both minority and marketability discounts, which provide the ability to sell the units at a reduced value.
5. Step five is the purchase of the nonvoting LLC interests by the trustee of the trust from you. You receive a promissory note for the purchase price, and the promissory note is the asset that remains in your estate.
   The sale to the defective grantor trust is not a taxable event to either the trust or to you. After the LLC units are transferred to the trust, the units and all appreciation will be outside of your estate for estate tax purposes. The income generated by the trust is taxed to you as the grantor until you decide to require the trust to pay its own income tax, further reducing your estate, and allowing the trust to grow tax free for the benefit of your children and/or grandchildren.

Qualified Personal Residence Trust

The increase in the applicable credit in year 2002 may provide you further incentive to implement a qualified personal residence trust (“QPRT”). The QPRT can be an extremely effective estate and income tax planning device as it allows you as the grantor to transfer a personal residence to a trust and retain the use of the residence for a term of years. At the end of the term, the property is held in trust for the benefit of the beneficiaries (i.e. your children) and can be rented back to you. Upon expiration of the term, the residence and all appreciation are excluded from your estate for estate tax purposes. After the term, you can then make rental payments to the trust to further reduce your taxable estate so that the investments made with those payments increase your beneficiaries’ estates, not yours.
There is a gift associated with this transaction; however, it is discounted and you can use your applicable credit so that there is no gift tax to be paid. The QPRT becomes an excellent device in light of the increase in the applicable credit in year 2002.

The Living Trust

Due to the increase in the applicable credit from now until year 2009, it will be necessary for all clients to review the current provisions of their living trusts. The most important item to be reviewed by the client is the formula clause that allocates assets to the various subtrusts upon the death of the first spouse.

The Busch Firm has typically allocated the decedent’s assets to a credit-shelter trust, a marital trust and a survivor’s trust. These three subtrusts are created upon the death of the first spouse. The credit-shelter trust would normally be allocated the decedent’s remaining applicable credit upon his or her death and the marital trust would be funded with the remaining assets of the decedent. This formula clause becomes particularly important to the surviving spouse because the amount allocated to the credit-shelter trust will become larger and larger until 2009. In 2009, it is possible that the credit-shelter trust could be funded with as much as $3.5 million. Since this is such a large number, it is possible that all of the decedent’s assets will be allocated to the credit-shelter trust. If the provisions of the credit-shelter trust do not provide for the surviving spouse to receive distributions, then this was likely not the intent of either spouse in creating this living trust. This could be extremely detrimental to the surviving spouse and result in the surviving spouse not retaining access to sufficient assets to live on for the remainder of his or her life.

Typically, in The Busch Firm documents, we have drafted the provisions of the credit-shelter trust to allow the surviving spouse access to both the income and principal. However, there have been situations where custom provisions were drafted, and the credit-shelter trust either provided exclusively for the children, or gave the surviving spouse only limited access. Additionally, The Busch Firm may not have drafted your living trust. We strongly recommend that each client review his or her living trust, and we would be pleased to meet with you to discuss the specific provisions of your living trust.

Often there will be a provision in the living trust that allocates the unused generation-skipping tax exemption of the spouse to a grandchildren’s trust or a “dynasty trust” (a trust that will benefit grandchildren and future generations). There is a substantial increase in the generation-skipping tax exemption through year 2009 to a maximum of $3.5 million. This may result in more assets being allocated to the grandchildren’s trust or dynasty trust than originally contemplated. In the year 2010, there will be no remaining GST exemption, and therefore it is unclear whether any funds will be allocated to such a trust. Thus, it is extremely important to review the allocation of assets to a grandchildren’s trust or dynasty trust with regard to a living trust, or any other irrevocable trust. Although it is more difficult to amend an irrevocable trust, there are ways to do this.

In many cases, a beneficiary’s access to principal under an irrevocable trust, or dynasty trust, is tied to the “exempt” or “non-exempt” portion of the trust for generation-skipping tax purposes. A beneficiary’s access to the principal of a trust should be carefully reviewed since the increase in the generation-skipping tax exemption under the 2001 Act may lead to a beneficiary’s complete loss of withdrawal rights regarding his or her share of the trust principal, which may not have been the intended result when the trust was established. We encourage all of our clients to review their trust periodically with us to ensure their current objectives are being met, regardless of the changes made in the 2001 Act.

Additionally, a little publicized change in the 2001 Act by the news media is that the state death tax credit, which in California provides that California will receive a portion of the federal estate taxes that are due and will be reflected as a credit on the federal estate tax return, will become a deduction in year 2005 as opposed to a credit. The importance of this in California is that once the credit changes to a deduction, California will no longer receive revenue from the state death tax. Additionally, in California’s constitution, the legislature may not provide for any additional death tax. Thus, California will be losing an extraordinary amount of revenue, which means that the State will need to raise this revenue in some other way, possibly through an increase in the sales tax. Many living trusts refer to a “state death tax credit” in the document. In light of the 2001 Act, the formula for allocation to the credit-shelter trust may need to be revised and it is likely that all living trusts will need to take into consideration this deduction rather than credit.

Life Insurance

Besides the use of life insurance as an income tax-free investment vehicle, the primary purposes for obtaining life insurance have been to provide liquidity to pay estate tax, to fund a buy-sell agreement, to provide for the payment of other liabilities that may exist at the time of the first spouse’s death, and to provide an inheritance for family members who will not be participating in the inheritance of other assets (such as a family business). Many clients have asked whether they should continue to pay premiums on their existing life insurance.

Everyone should keep in mind that under the 2001 Act, the repeal of the estate tax is only scheduled for one year, the year 2010. In the year 2011, the estate and generation-skipping taxes go back into effect under the law prior to enactment of the 2001 Act. This would mean that individuals would have a $3.5 million applicable credit in 2009, no estate and generation-skipping tax in 2010, and finally in 2011 the reinstatement of the estate and generation-skipping tax with an applicable credit of only $1 million. Due to the uncertainty surrounding the 2001 Act and the fact that the estate and generation-skipping taxes are repealed for only one year, life insurance will continue to be an extremely important device in providing for various estate planning goals. We strongly recommend against canceling existing life insurance if the sole reason for cancellation is attributable to the 2001 Act.

The irrevocable life insurance trust is still an extremely viable option and provides an extraordinary amount of leveraging of both the applicable credit and the generation-skipping tax exemption amount.

However, should the estate tax ever be repealed and the need for life insurance diminish, it might be appropriate for clients to consider investing in policies such as a variable universal life insurance policy (“VUL”) that build up considerable cash value and provide for income tax-free growth to the individual. Additionally, with this type of policy, the owner can control investments inside the VUL which grow tax free, and at some later point in time begin to extract proceeds out of the policy as a non-taxable loan against the policy. You should consult with your financial advisor concerning a VUL product, or any other financial product.

College Savings Plans

There are various vehicles that are beneficial to provide for college expenses for children in the future, some of these being the education IRA, the prepaid tuition plan, and, likely the most beneficial of all of these plans, the Section 529 plan. In the 2001 Tax Act, Congress made 529 plans considerably more favorable to taxpayers.

Under the 529 plan, an individual may contribute up to $50,000 per beneficiary on a gift tax-free basis. The account for this beneficiary may have a total of $246,000 in contributions, which may come from parents, grandparents, or any other individual. The account is then allowed to grow income tax free until the child needs the funds for “qualified” higher education expenses. These expenses may consist of college tuition, room, board, and fees, as well as the cost of equipment, books and supplies required for attendance at a private, secondary educational institution. The plan can be extremely flexible as it allows the parent to change the beneficiaries of an individual account without adverse tax consequences, this most likely occurring in a situation where a child does not end up going to college or needing all of the funds.

The most significant change in the 2001 Act is that all withdrawals from this account for qualified higher education expenses are not taxable to the beneficiary. If, for some reason, the proceeds are paid to a beneficiary for other than qualified education expenses, or are returned to the parent, then a 10% penalty applies and only the earnings or income on the original contributions will be taxed at ordinary income tax rates.

The contributions to a 529 plan are gift tax free as they use up five years of the donor’s annual exclusion amounts, and the amount passing to the account is not included in the donor’s estate for estate tax purposes.

Conclusion

Unfortunately, the 2001 Act has brought considerable uncertainty to the estate planning community, and has increased complexity particularly in the area of the generation-skipping transfer tax. Lifetime gifting and transfers will continue to play a significant role in reducing the taxable estate as well as the use of life insurance. Each of you should immediately review the provisions of your living trust and consult with your advisor, which we hope will be The Busch Firm, as we appreciate and welcome your business.