MERCER COUNTY CHAPTER OF THE NEW JERSEY SOCIETY OF CERTIFIED PUBLIC ACCOUNTANTS

Transcription

1 MERCER COUNTY CHAPTER OF THE NEW JERSEY SOCIETY OF CERTIFIED PUBLIC ACCOUNTANTS Recent Developments with Respect to the Tax Aspects of Estate Planning and Administration Wednesday, September 19, 2012 Mercer County Community College 1200 Old Trenton Road West Windsor, NJ Presented by: Bruce E. Mantell, C.P.A., Esq., LL.M. MANTELL, PRINCE & REYNOLDS, P.C. Mountain Heights Center at Berkeley Heights 430 Mountain Avenue, Suite 113 Murray Hill, New Jersey FAX:

2 RECENT DEVELOPMENTS WITH RESPECT TO THE TAX ASPECTS OF ESTATE PLANNING AND ADMINISTRATION Presented by: Bruce E. Mantell, CPA, Esq., LL.M. I. Estate, Gift and Generation Skipping Tax (GST) Provisions Exemptions and Rates Generally A. Estate, Gift and GST exemptions and rates as a result of the 2001 Bush Administration changes (See Exhibit A) a reminder and retrospective B. The Tax Relief, Unemployment and Insurance Reauthorization and Job Creation Act of 2010 (TRA 2010) 1. $5,000,000 exemption (truly unified for estate, gift and GST purposes) 2. Indexed from 2010 to nearest $10,000 beginning in In 2012 the exemption is $5,120, Estate and GST transfers beginning in Gifts Beginning in 2011 ($1 million in 2010) C. Rate: 35% (beginning in 2010) D. The default position in 2010 was for the estate tax to apply E. As of January 1, 2013, the Estate, Gift and Generation-Skipping law reverts back to the law in effect on December 31, It s anybody s guess whether this will occur. A reversion to December 31, 2001 law results in a $1,000,000 exemption 2. President Obama has already stated that he favors a $3,500,000 exemption and a 45% rate (essentially 2009 estate and gift tax law). This is not necessarily supported by all Democratic legislators 3. Many pundits believe Congress will simply extend the 2012 law for one year and give the new Congress an opportunity to further consider the course of action that will ultimately be taken with respect to the estate and gift tax

3 II. Carryover basis election for decedents dying in 2010 A. Executor can elect out of the estate tax and into carryover basis B. The impact of the 2010 IRC Section 1022 carryover basis election in 2012 and beyond is the effect it has on depreciation and gain recognition on capital asset sales in the future. See copy of Form 8939 at Exhibit B III. Portability A. Surviving spouse can use unused exemption of last deceased spouse B. Surviving spouse gets (a) basic exclusion amount, plus (b) deceased spouse unused exclusion amount (DSUEA) C. Joint Committee Examples 1. Example 1. Assume that Husband 1 dies in 2011, having made taxable transfers of $3 million and having no taxable estate. An election is made on Husband 1 s estate tax return to permit Wife to use Husband 1 s deceased spousal unused exclusion amount. As of Husband 1 s death, Wife has made no taxable gifts. Thereafter, Wife s applicable exclusion amount is $7 million (her $5 million basic exclusion amount plus $2 million deceased spousal unused exclusion amount from Husband 1), which she may use for lifetime gifts or for transfers at death 2. Example 2. Assume the same facts as in Example 1, except that Wife subsequently marries Husband 2. Husband 2 also predeceases Wife, having made $4 million in taxable transfers and having no taxable estate. An election is made on Husband 2 s estate tax return to permit Wife to use Husband 2 s deceased spousal unused exclusion amount. Although the combined amount of unused exclusion of Husband 1 and Husband 2 is $3 million ($2 million for Husband 1 and $1 million for Husband 2), only Husband 2 s $1 million unused exclusion is available for use by Wife, because the deceased spousal unused exclusion amount is limited to the lesser of the basic exclusion amount ($5 million) or the unused exclusion of the last deceased spouse of the surviving spouse (here, Husband 2 s $1 million unused exclusion). Thereafter, Wife s applicable exclusion amount is $6 million (her $5 million basic exclusion amount plus $1 million deceased spousal unused exclusion amount from Husband 2), which she may use for lifetime gifts or for transfers at death 2

4 3. Example 3. Assume the same facts as in Example 1 and 2, except that Wife predeceases Husband 2. Following Husband 1 s death, Wife s applicable exclusion amount is $7 million (her $5 million basic exclusion amount plus $2 million deceased spousal unused exclusion amount from Husband 1). Wife made no taxable transfers and has a taxable estate of $3 million. An election is made on Wife s estate tax return to permit Husband 2 to use Wife s deceased spousal unused exclusion amount, which is $4 million (Wife s $7 million applicable exclusion amount less her $3 million taxable estate). Under the provision, Husband 2 s applicable exclusion amount is increased by $4 million, i.e., the amount of deceased spousal unused exclusion amount of Wife (This is Joint Committee Example 3 and many Commentaries believe it is incorrect and that H2 should not benefit from H1 s unused exclusion amount. Therefore, H2 should only get use of $2 million from Wife) D. The IRS issued Temporary Regulations regarding the Portability Election on June 18, The Election a. Executors must timely file Form 706 even if the Estate is not otherwise required to file a Form 706 b. For Portability not to apply an affirmative election needs to be made on Form 706. If Form 706 is not required to be filed, the election out of Portability does not have to be made. The decision not to file the Form 706, in and of itself, is an election out c. Complete and properly prepared Form 706 needs to be made i. Executor, however, does not have to report the value of certain property that qualified for marital or charitable deduction ii. Instead, the property needs be described with an estimated value within ranges 3

5 2. Gifting a. Portability applies for gift tax purposes b. The DSUEA is deemed used before the donor s excmption amount 3. Statute of Limitations a. The Statute of Limitations does not expire with respect to a Form 706 with respect to the DSUEA b. Thus, even though IRS may not assess estate tax, if the Statute of Limitations has expired, it could review the Form 706 and recompute the DSUEA on the surviving spouse s death 4. Draft Form 706 as of August 16, 2012 a. The 2012 Form 706 is not yet finalized b. Section 6 (Portability of Deceased Spousal Unused Exclusion (DSUE)) has been added to the draft Form 706. See Exhibit C E. Only applies to last deceased spouse. Remarriage will not remove right to the unused exemption, but if new spouse predeceases, then only that spouse s unused exemption could be used F. Perhaps better to make gifts to use exemption to make sure it is not lost by remarriage and death of new spouse or by a law change G. Portability does not apply for GST purposes H. Portability may prove to be very useful if retirement benefits are major asset of the estate I. Notwithstanding Portability, planning for the funding of a Non-Marital Credit Shelter Trust will, more likely than not, provide better planning potential because of the tax shelter potential J. Like most of TRA 2010, Portability sunsets on January 1, Nevertheless, President Obama s proposal to re-enact the 2009 estate and gift tax law includes a change which allows Portability to continue. How 4

6 President Obama s Portability rules align with the existing Portability rules remain to be seen IV Gift Planning A. Beware of the Claw Back Rule which brings gifts back into the taxable estate at date of gift value 1. This will make 2011 and 2012 gifts somewhat illusory, especially if the death tax exemption drops back to $1,000, The most troubling aspect of the Claw Back Rule is the significance of the tax clause if the lion s share of the assets have already been gifted away. The estate may not have sufficient assets to pay the tax and testamentary beneficiaries may unintentionally be required to subsidize the estate tax on gifts to lifetime donees 3. However, most pundits believe that Congress will ameliorate the burden of the Claw Back Rule in the untenable scenario that the exemption decreases B. The increased lifetime gift tax exemption has a major impact on gift planning 1. The increase in lifetime gift tax exemption caught tax and trust and estate attorneys by surprise because the premise had been that Congress was adverse to larger lifetime gifts to limit income shifting opportunities. Furthermore, many practitioners felt that retaining the $1,000,000 lifetime exemption while the death exemption increased from 2002 through 2009 was evidence of the disingenuity of the 2001 estate tax changes 2. Some pundits feel the increase in the lifetime gift tax exemption is merely the next step toward the inevitable repeal of the federal estate tax. (See the book Death by a Thousand Cuts the Fight over Taxing Inherited Wealth by Michael J. Graetz and Ian Shapiro at Exhibit D) 3. Furthermore, the lifetime gift tax exemption increased to $5,120,000 in 2012 by the cost of living index (multiples of $10,000) 4. The lifetime gift tax exemption can actually be more than $5,000,000 + as a result of Portability 5

7 5. Example 4. John is married to Sue. John dies in 2011 and the portability election is made by his estate. His gross estate was $8,000,000, and he left $5,000,000 to his wife outright. The other $3,000,000 was left to their 3 children. Accordingly, the Deceased Spouse Unused Exemption Amount (DSUEA) is $2,000,000 ($5,000,000 - $3,000,000). Accordingly, Sue s lifetime gift tax exemption is $7,000,000 ($5,000,000 + $2,000,000) 6. The annual gift tax exemption remains at $13,000 for 2011, subject to future cost of living increases in multiples of $1,000. The annual exclusion will increase to $14,000 in The increase in the lifetime gift tax exemption is expected to spawn significant gifting through December 31, 2012 to take advantage of the $5,120,000 lifetime gift tax exemption amount a. However, the increased exemption is, to some extent, an illusion. The illusion is a function of the Claw Back which occurs at the death of the donor (See lines 4 and 7 on Page 1 of the Form 706 attached at Exhibit E) (i) Line 4 adds back the gifts in excess of the annual exclusion at the date of gift value (ii) Line 7 subtracts the gift tax paid or payable with respect to such gift (See the three worksheets included in the Form 706 Instructions at Exhibit F) b. Accordingly, a gift causes the shifting of income and appreciation to the donee. It does not, however, entirely remove the date of gift value from the estate c. A gift also removes the asset from the estate for New Jersey estate tax purposes, although the advantage is limited to some extent because NJ estate tax begins to be computed at amounts less than $675,000. See Forms IT- Estate and December 31, 2001 Forms 706 at Exhibit G d. Gifts also remove assets from the Estate for Medicaid qualification purposes as long as the gifts are made outside the Lookback Period. This, at first blush, seems inconsistent when planning for taxpayers utilizing the $5,120,000 gift tax exemption, but there still may be some overlap 6

8 e. The most significant advantage of the $5,120,000 lifetime gift tax exemption (which can be $10,240,000 for a husband and wife and even more if portability is factored in) is the use of leveraging of the value of the gift f. Gifts which include minority interest and lack of marketability discounts provide significant leverage in the context of a $5,120,000 to $10,240,000 transfer. The same holds true for gifts which are based upon actuarial discounts. Such popular tools as GRATs, sales to defective grantor trusts, QPRTs, and family limited partnerships are effective to achieve significant leveraging. Even on a more simplistic and straightforward level, aggressive valuation of the underlying asset or assets provide leverage C. Therefore, gift planning has become extremely attractive in light of the $5,120,000 lifetime gift tax exemption 1. Forgiveness of intra-family loans made to assist children and grandchildren with the purchase of a house, business, living expenses, investment leveraging, etc. as a result of the low applicable federal rate (See September, 2012 Applicable Federal Rates at Exhibit H). This straightforward gift tax approach is intended to simplify intra-family relationships and eliminate the need to compute and make periodic interest payments by the children and grandchildren to the parents. These loans, however, have no leveraging advantages (nor do straight gifts of cash or marketable securities) 2. Gifting Involving Irrevocable Life Insurance Trusts (ILIT) a. In the past, estate planners would attempt to maximize the number of annual exclusions available by providing for multiple and cascading Crummey beneficiaries. Furthermore, the administrative responsibility of keeping current with Crummey letters, while not difficult, has historically proven to be a practical problem b. The $5,120,000 lifetime gift tax exemption ($10,240,000 for husband and wife) allows the insured to purchase larger face value life insurance policies with greater annual premium payments because of the significantly greater lifetime gift tax exemption. In fact, the insurance industry is actively promoting single premium policies. This will reduce or eliminate the need for Crummey letters c. Furthermore, policies that have been minimum deposited to 7

9 pay premiums and interest on policy loans often face extinction as the policy loans become larger and larger because of erroneous initial financial assumptions by the insurance company. These policies can be saved by simply depositing a larger amount of funds in the ILIT without triggering a gift tax d. Finally, another possible approach to minimize the administrative burden of operating an ILIT is to make a large transfer of investment assets to the ILIT sheltered by the $5,120,000 ($10,240,000 when gift splitting) lifetime exemption. The side fund created could be invested and the income earned may exceed the annual premiums so that annual contributions and the Crummey letters that follow are no longer necessary 3. There are risks and concerns about making large gifts to utilize the $5,120,000 ($10,240,000 with gift splitting) lifetime gift exemption a. The gift may be too large and the donor may become uncomfortable giving up control of the assets or the donor may feel it is not in the donee s long term best interest to be the recipient of significant assets. SLATs (Spousal Lifetime Annuity Trusts) have been suggested as a solution to this dilemma b. The tax basis of the gift is not stepped up to the date of death value. Therefore, the federal and state estate tax savings must always be weighed against the future capital gain tax which will be imposed on the sale of the assets c. Some commentators have suggested ways for wealthy persons with a degree of insecurity in giving up significant assets to have their cake and eat it, too (i) (ii) Gifts could be made into trusts governed by laws of states (not New Jersey) that permit trustees to make discretionary distributions back to the Settlor. These are commonly known as self-settled trusts Married couples might consider making gifts to trusts for the benefit of each other, provided that the trusts are sufficiently distinguishable to avoid the so-called reciprocal trust doctrine 8

10 d. The practitioner, however, must ask himself of herself whether these sophisticated planning tools are really warranted if the client has expressed any degree of insecurity about gifting. The practitioner should not allow the tax tail to wag the practical dog e. Is there a disinclination to gifting because of greater possibility of repeal of the estate tax? V. GST TAX A. GST exemption in 2011 is $5.0 million and GST exemption in 2012 is $5,120,000 in light of index for inflation B. GST tax rate is 35% in 2011 and 2012 C. Like the estate and gift exemption, the GST exemption is scheduled to be based upon 2001 law on January 1, The GST exemption would, therefore, be approximately $1,400,000 in light of the cost of living adjustments that would have applied over the 12 year period D. President Obama has suggested reintroducing the 2009 law which would provide for a $3,500,000 GST exemption VI. What is the Impact of TRA 2010 upon: A. Estate planning B. Administering estates in New Jersey C. Life Insurance Planning and the Life Insurance Industry D. Retirement Planning and Planning for Distributions from Retirement Plans E. Charitable Giving and Charities VII. Planning to Unwind Transfers Made Under Prior Estate Tax Regime A. The loss of basis step up at death can mean that prior transfers are now a tax disadvantage B. Compare the income tax cost with the New Jersey estate tax savings C. Compare the income tax cost with the benefit of the removal of assets from the estate for Medicaid qualification purposes 9

11 VIII. Interaction with New Jersey State Estate Tax A. Higher Costs to Use Larger Federal Applicable Exclusion Amount 1. Funding the credit shelter trust with $5,120,000 upon the first spouse s death would require a payment of over $400,000 in state death taxes 2. If the state death tax is charged to the credit shelter trust this will result in a net funding of approximately $4,700, The ever increasing New Jersey estate tax cost of funding the larger federal credit shelter amount can be avoided by proper planning a. Structure estate plan via Disclaimer Will b. Provide that Credit Shelter Trust can qualify for QTIP Election B. In certain circumstances, the New Jersey Estate Tax and the Federal Estate Tax may create different tax basis for inherited assets which would result in inconsistent treatment for federal and state income tax purposes 1. New Jersey Only QTIP Trust carved out of Credit Shelter Trust a. Not included in estate of surviving spouse for federal estate tax purposes b. Included in estate of surviving spouse for New Jersey estate tax purposes 2. Election out of Federal Estate Tax for 2010 estates via the carryover basis regime a. No Form 706 filed for federal estate tax purposes and carryover basis reported on Form 8939 b. Form IT-Estate (NJ Estate Tax Return) and Deemed December 31, 2001 Form 706 filed for New Jersey estate tax purposes reflects fair market value of the assets of the estate and New Jersey estate tax is paid on the fair market value of the assets 3. Although not originally contemplated when the New Jersey Estate Tax law was enacted on July 1, 2002, there are now clearly 10

12 situations where the tax basis of the inherited assets for federal and NJ GIT purposes differ a. Carry Over Basis under I.R.C. Section 1022 (i) (ii) Estate of taxpayer who passes away in 2010 may elect out of the federal estate tax by filing Form In such case, adjusted carryover basis will apply for federal income tax purposes Example 5. John, whose wife Alice predeceased him, passes away a New Jersey resident on December 1, Alice had a simple Will and left everything to John. John has two children and leaves his entire estate to them in equal shares. John s estate assets are as follows: DOD Value Tax Basis at Cost Land $ 2,500,000 $ 1,000,000 Marketable Securities $20,000,000 $10,000,000 John s estate elects out of the federal estate tax and files a Form 8939 on the January 17, 2012 due date. The Executor of John s estate will allocate the $1,300,000 IRC Section 1022 add-on to basis to the marketable securities for federal income tax purposes. John s estate is not required to file a federal Form 706. John s estate will file a Form IT-Estate and Deemed December 31, 2001 Form 706 and pay New Jersey Estate Tax. On June 1, 2012, John s estate sells all the securities for $21,300,000. John s estate reports $10,000,000 of long term capital gain on the sale of the securities for federal income tax purposes. What is the gain recognized on the sale of the securities for NJ GIT purposes? 11

13 b. Alternate Valuation Date Under IRC 2032 (i) See December 2, 2008 letter from Fred M. Wagner, III of the NJ Division of Taxation attached at Exhibit I (ii) Example 6. John, who survives his wife, Alice, passes away a New Jersey resident on June 1, Alice had a simple will and left everything to John. John has 2 children and leaves his entire estate to them in equal shares. John s estate assets are as follows: DOD Value December 1, 2011 Value Land $2,500,000 $2,500,000 Marketable Securities $2,000,000 $1,800,000 John is not required to file a federal Form 706 because his estate is valued at less than $5,000,000. John is required to file a Form IT- Estate and Deemed December 31, 2001 Form 706. John s estate elects Alternate Valuation Date treatment because it reduces the New Jersey Estate Tax. John s estate files Form IT- Estate and pays New Jersey Estate Tax. On June 1, 2012, the marketable securities are valued at $2,300,000 and John s estate sells all the securities. For federal income tax purposes the estate reports a long term capital gain of $300,000 since there is no federal Form 706 filing and no federal Alternate Valuation Date election. What is the gain recognized on the sale of securities for NJ GIT purposes? (c) NJ Only QTIP Election (i) See January 31, 2011 letter from Fred M. Wagner, III of the NJ Division of Taxation attached at Exhibit J 12

14 (ii) Example 7. Alice, a New Jersey resident, predeceased her husband, John, on February 1, 2011 and left her entire $4,500,000 estate to a federal Credit Shelter Trust pursuant to the terms of her Will. The Credit Shelter Trust provided that all income is payable to John annually and the Trustee has the right to invade corpus for the benefit of John for his health, education, maintenance and support. At John s death, the Credit Shelter Trust is to pass to the two children in equal shares. Alice s assets at her date of death were as follows: Alice s Value DOD Land $2,500,000 Marketable Securities TOTAL ESTATE $2,000,000 $4,500,000 Alice s estate filed no federal Form 706 since her estate was valued at less than $5,000,000. Alice s estate decided not to pay any New Jersey Estate Tax and made a New Jersey Only QTIP Election to the extent of $3,825,000 with respect to the Credit Shelter Trust on Form IT-Estate and the Deemed December 31, 2001 Form 706. The $675,000 New Jersey Credit Shelter Trust is funded with only marketable securities. The NJ Only QTIP Trust is funded with the Land and $1,325,000 of marketable securities. The tax basis of the federal Credit Shelter Trust is $4,500,000, namely, the fair market value of all the assets of Alice s estate at her date of death. The tax basis of the assets of the New Jersey Credit Shelter Trust is $675,000 and the tax basis of the assets of the NJ Only QTIP Trust is $3,825,000. No federal or New Jersey estate tax is paid by Alice s Estate. 13

15 On December 8, 2015, John, a New Jersey resident, passes away with no assets of his own. It is assumed for this example that in 2015 the federal and New Jersey estate taxes are applied essentially similar to the way they are applied today. The assets held in the federal Credit Shelter Trust have all increased in value by 150% from February 1, 2011 and are valued as follows: John DOD Value Land $3,750,000 Marketable Securities TOTAL TRUST VALUE $3,000,000 $6,750,000 The New Jersey Credit Shelter Trust is valued as follows at John s death: John s DOD Value Marketable Securities $1,012,500 The New Jersey Only QTIP Trust from Alice s estate, which is now included in John s estate for New Jersey Estate Tax purposes, holds the following assets: John DOD Value Land $3,750,000 Marketable Securities TOTAL TRUST VALUE $1,987,500 $5,737,500 14

16 John s estate will pay New Jersey estate tax on $5,737,500. The New Jersey estate tax imposed upon John s Estate will be approximately $500,000. To pay the New Jersey Estate Tax and ready the federal Credit Shelter Trust for distribution to the two children, all the assets of the trust will be sold. For federal income tax purposes, assuming the assets in the federal Credit Shelter Trust have remained identical in form since Alice s death and in value from the date of John s death, the long term capital gain is $2,250,000 ($6,750,000 - $4,500,000) as of the date of sale. What is the gain recognized for New Jersey Gross Income Tax purposes upon the sale of all the assets of the federal Credit Shelter Trust? 4. Precedent Supporting Dual Tax Basis a. Internal Revenue Code Section 1014(a) provides that the basis of property in the hands of a person acquiring the property from a decedent or to whom the property passed from a decedent [is] (i) the fair market value of the property at the date of the decedent s death. There is no requirement that a federal Form 706 be filed to qualify for the IRC Section 1014 basis adjustment at death b. N.J.S.A. 54:38-1, enacted on July 1, 2002, provides that every New Jersey resident passing away on or after January 1, 2002 shall be subject to a New Jersey estate tax equal to the maximum state death tax credit allowable under the Internal Revenue Code in effect on December 31, 2001 c. In scenarios such as the I.R.C. Section 1022 carryover basis election in 2010, the New Jersey Alternate Valuation Date election, and the New Jersey Only QTIP Trust election, it has been illustrated above that the assets passing to the heirs may have different federal and state tax basis as a result of how the New Jersey Estate Tax is administered and applied d. The New Jersey Division of Taxation, however, has historically taken the position that tax basis for NJ GIT purposes is governed by N.J.S.A. 54A:15`-1(c) which sets forth three federal income tax concepts to be applied in calculating net gain from the disposition of property: (i) the method of accounting used for federal income tax purposes, 15

17 (ii) the use of the federal adjusted basis, and (iii) the exclusion of gains to the extent federal rules require nonrecognition e. At this time, there is no specific authority that tax basis for NJ GIT purposes will differ from federal adjusted tax basis notwithstanding how the New Jersey Estate Tax is administered and applied. However, if fairness and equity control, an asset which is taxed for New Jersey Estate Tax purposes based upon a certain valuation methodology should not then receive the advantage or be penalized by applying a tax basis inconsistent with the intent of I.R.C. Section 1014, thereby resulting in a double dip savings (Alternate Value Date) or a double dip tax (federal Carryover Basis Election and NJ Only QTIP Trust). See Oberhand v. Director, 193 N.J. 558, 940 A.2d 1202, in which the doctrine of manifest injustice was applied by the New Jersey Supreme Court to assure a fair and equitable result in a New Jersey Estate Tax case f. Although not in the context of the current New Jersey Estate Tax (which didn t exist at the time), the Supreme Court of New Jersey on January 14, 1999 in Koch v. Director, 157 NJ 1, 722 A.2d 918 concluded that tax basis for NJ GIT purposes should differ from federal adjusted tax basis. In Koch, the Taxpayer deducted partnership losses for federal income tax purposes, but was not allowed by law to deduct them for NJ GIT purposes. Koch then sold his partnership interest and reported different gains for federal and NJ GIT purposes. Koch reduced his tax basis in the partnership interest by the losses he had taken for federal income tax purposes and as a result reported more gain. Koch did not reduce his tax basis in the partnership interest for NJ GIT purposes since the NJ GIT precluded him from deducting any of the losses allocated to him by the partnership over the years. The NJ Supreme Court held that the basis cannot be the federal adjusted basis where the basis has been reduced by losses that are not deductible under the NJ GIT. Furthermore, the NJ Supreme Court held that N.J.S.A. 54A:5-1(c) is to be interpreted in an integrated way without undue emphasis on a particular word or phrase and, if possible, in a manner which harnesses all of its parts so as to do justice to its overall meaning 16

18 IX. Intra-Family Loans and Notes in Light of Low Interest Rate Environment A. The allure of intra-family loans is a function of the fact that the Applicable Federal Rate ( AFR ) is generally lower than the prevailing market interest rate in commercial transactions B. Possible uses of intra-family loans and notes include: 1. Loans to children with or without significant net worth 2. Loans to grantor trusts 3. Sales to children or grantor trusts for a note 4. Loans between related trusts (e.g., from a bypass trust to a marital trust, from a marital trust to a GST exempt trust, such as transactions to freeze the growth of the marital trust and transfer appreciation to the tax-advantaged trust) 5. Loans to an estate 6. Loans to trusts involving life insurance (including split dollar and financed premium plans--these are outside the scope of this outline) 7. Home mortgages for family members 8. Loans as vehicles for gifts over time by forgiveness of payments in some years, including forgiveness of payments in 2012 as a method of utilizing $5,120,000 gift exemption available in 2012; and 9. Notes from client to family members at a higher interest rate (to afford higher investment returns to those family members than they might otherwise receive) C. Advantages of Loans and Notes 1. If the asset that the family member acquires with the loan proceeds has combined income and appreciation above the interest rate that is paid on the note, there will be a wealth transfer without gift tax implications. With the current incredibly low interest rates, there is significant opportunity for wealth transfer 2. Interest payments remain in the family rather than being paid to outside banks 17

19 3. Intra-family loans may be the only source of needed liquidity for family members with poor credit histories 4. Borrowing from outside lenders may entail substantial closing costs and other expenses that can be avoided, or at least minimized, with intra-family loans D. Loan vs. Gift 1. A transfer of property in an intra-family situation will be presumed to be a gift unless the transferor can prove the receipt of an adequate and full consideration in money or money's worth 2. In the context of a transfer in return for a promissory note, the gift presumption can be overcome by an affirmative showing of a bona fide loan with a real expectation of repayment and an intention to enforce the debt. The court has applied seven factors in determining that there was not a bona fide loan: (1) existence of a note, (2) payment of reasonable interest, (3) fixed schedule of repayment of principal, (4) adequate security, (5) actual repayment, (6) reasonable expectation of repayment in light of the economic realities, and (7) conduct of the parties indicating a debtor-creditor relationship 3. Intent to Forgive Loan a. Revenue Ruling announced the IRS position that if a taxpayer ostensibly makes a loan and, as part of a prearranged plan, intends to forgive or not collect on the note, the note will not be considered valuable consideration and the donor will have made a gift at the time of the loan to the full extent of the loan b. Even if the lender actually intends to gradually forgive the entire loan, (1) he is free to change his mind at any time, (2) his interest in the note can be seized by a creditor or bankruptcy trustee, who will surely enforce it, and (3) if the lender dies, his executor will be under a duty to collect the note. Therefore, if the loan is documented and administered properly, this technique should work, even if there is a periodic forgiveness plan, since the intent to make a gift in the future is not the same as making a gift in the present. However, if the conduct of the parties negates the existence of an actual bona fide debtor-creditor relationship at all, the entire loan may be re-characterized as a gift at the 18

20 time the loan was made or the property lent may be included in the lender's estate, depending on whether the lender or the borrower is considered to really own the property c. If the borrower is insolvent (or otherwise clearly will not be able to pay the debt) when the loan is made, the lender may be treated as making a gift at the outset E. Points to Consider in Structuring Loan 1. Where the donor intends to forgive the note payments, it is especially important to structure the loan transaction to satisfy as many of the elements as possible discussed above in distinguishing debt from gift. In particular, there should be written loan documents, preferably the notes will be secured, and the borrower should have the ability to repay the notes. If palatable, do not forgive all payments, but have the borrowers make some of the annual payments 2. For a demand loan, the stated interest rate is compared to the AFR throughout the loan, and gifts will result for any period during which the stated interest rate is less than the AFR for that period. For term loans, however, the stated interest rate is compared to the AFR at the time the loan is originated to determine if the loan results in a gift. In light of this treatment, using term loans has two distinct advantages. First, there is no complexity of repeatedly determining the appropriate AFR for any particular period. Second, during the current incredibly low interest rate environment, there will be no gift tax consequences for the entire term of the note as long as the interest rate of the term note is at least equal to the AFR when the note is originated 3. One of the factors in determining whether the loan is a bona fide loan rather than an equity transfer is whether the borrower had the ability to repay. The borrower's ability to repay the loan is a very important factor in establishing that a bona fide debtor creditor relationship exists. This can be very important for income, gift and estate tax purposes. This includes loans to trusts; the trust should be funded with enough assets that it has the ability to repay the loan even if there is some decline in the value of the trust assets 4. Is the forgiveness of a large loan in the environment of a $5,120,000 lifetime exemption an effective gift? 19

21 a. No Interest Payments. Borrower avoids having to pay interest to the lender. But in low interest environment the interest paid is not significant and often the lender makes gifts to borrower to repay the interest (b) Claw Back. The claw back obviates the advantages of forgiving the loan as a gift because it is added back to the estate on Form 706 F. If a client inquires about making a loan to children, consider whether gifts would be more appropriate 1. Several circumstances suggesting that a gift may be preferable include: (i) the lender does not need the funds to be returned; (ii) the lender does not need cash flow from the interest on the loan; (iii) it is not apparent how the loan will ever be repaid; and/or (iv) the lender does not plan on collecting the loan 2. The Note Receivable will be included in the client's estate for estate tax purposes. In particular, make use of annual exclusion gifts, which allow asset transfers that are removed from the donor's estate and that do not use up any gift or estate exemption 3. The gift tax rate is applied to the net amount passing to the donee, whereas the estate tax rate is applied to the entire state, including the amount that will ultimately be paid in estate taxes. If the donor lives for three years, gift taxes paid are removed from the gross estate 4. If the client transfers a fractional interest or a minority interest in an asset owned by the client, the transfer may be valued with a fractionalization discount. On the other hand, if cash is loaned to the child, no fractionalization discounts are appropriate 5. Gifts remove assets from the donor's gross estate for state estate tax purposes without payment of any federal or state transfer taxes (assuming the state does not have a state gift tax or "contemplation of death" recapture of gifts back into the state gross estate) 6. If the transfer is structured as a loan, the parent will recognize interest income (typically ordinary income) at least equal to the AFR, either as actual interest or as imputed interest, thus increasing the parent's income tax liability 7. Someone must keep track of the interest as it accrues to make sure that it is paid regularly or is reported as income. This can be 20

22 particularly tedious for a demand loan or variable-rate term loan where the interest rate is changing periodically. There are additional complications for calculating the imputed interest for below-market loans (which means that loans should always bear interest at least equal to the AFR) 8. If interest is not paid annually, the original issue discount (OID) rules will probably require that a proportionate amount of the overall interest due on the note will have to be recognized each year by the seller, even if the seller is a cash basis taxpayer. Determining the precise amount of income that must be recognized each year can be complicated, particularly if some but not all interest payments are made. The OID complications can be avoided if the loan is made to a grantor trust 9. If the borrower does not make payments as they are due, additional complications arise: a. The IRS takes the position that if a taxpayer ostensibly makes a loan and, as part of a prearranged plan, intends to forgive or not collect on the note, the note will not be considered valuable consideration and the donor will have made a gift at the time of the loan to the full extent of the loan b. Even if the loan is not treated as a gift from the outset, forgiven interest may be treated the same as forgone interest in a below-market loan, resulting in an imputed gift to the borrower and imputed interest income to the lender c. If the parties agree to a loan modification, such as adding unpaid interest to the principal of the loan, the modification itself is treated as a new loan, subject to the AFRs in effect when the loan is made, thus further compounding the complexity of record keeping and reporting d. One of the advantages of making gifts to a grantor trust is that the grantor pays income taxes on the grantor trust income without being treated as making an additional gift. This allows the trust assets to grow faster (without having to pay taxes) and further reduces the grantor's estate for estate tax purposes. This same advantage is available if the loan is made to a grantor trust. In addition, making the loan to a grantor trust avoids having interest income taxed to the lender-grantor, and avoids having to deal with the complexity of the OID rules 21

23 G. Valuation of Notes 1. Discounting Notes in Subsequent Transactions a. Under gift and estate tax regulations, the value of a note is the unpaid principal plus accrued interest, unless the evidence shows that the note is worth less (e.g., because of the interest rate, date of maturity, security, etc.) or is uncollectible in whole or in part b. A wide variety of cases have valued notes at a discount from face value based on satisfactory evidence 2. Gift Tax Purposes a. Differential in Interest Rates is Not Gift. For gift tax purposes, a loan is not deemed to be worth less than face value because of the interest rate as long as the interest rate is at least equal to the AFR b. Other Factors. However, other factors can be considered (for example, the ability of the borrower to repay) in determining the value of the note, and if the note is worth less than the amount transferred a gift results 3. Estate Tax Purposes. a. For estate tax purposes, a note can be discounted because of interest rate changes or because of collectability problems (e.g., insolvency of the borrower or insufficiency of collateral) b. In addition, there may be the possibility of discounting a note merely because it uses the AFR interest rate, which is less than a commercially reasonable rate that would apply to such a loan c. There is no statute or final regulation requiring that 7872 principles for valuing notes using the AFR also apply for estate tax proposes. However, the IRS fights that argument H. Refinancing Notes to Utilize Lower Interest Rates 1. There are no cases, regulations or rulings that address the gift tax effects of refinancing notes. Proposed regulations under

24 include a section entitled Treatment of Renegotiations, but merely reserves the subject for later guidance, which has never been issued 2. If the borrower can prepay the note without a penalty at any time, and if prevailing interest rates decline, the borrower would likely pay off the original note and borrow the amount on a new note at current rates. That happens daily with thousands of homeowners refinancing their mortgages as interest rates have declined. The borrower could either (i) pay off the original loan (with the higher interest rate) and borrow again at the lower rate, or (ii) give a new note (at the current AFR) in substitution for the original note (with the higher interest rate) 3. A possible concern is that consistent refinancing of the note may be a factor in determining that the loan transaction does not result in bona fide debt, but should be treated as a gift transfer. In light of the lack of any case law or direct discussion of refinancings at lower AFRs in regulations or in any rulings, most planners suggest caution in this area, and not merely refinancing notes every time the AFR decreases 4. Some advisors believe that consideration should be given for a lower rate by the estate paying down the principal amount, shortening the maturity date, or adding more attractive collateral 5. The ability to repay the Note and then borrow again at lower rate is a compelling argument that the refinancing is valid and does not have a gift element. If no Prepayment Clause exists in the Note, then the refinancing may have gift elements. See Exhibit K for a Promissory Note with a Prepayment Clause I. Loans to Estates During Estate Administration 1. Estates often have liquidity needs for a variety of reasons, not the least of which is to be able to pay federal and state estate taxes within eight to nine months after the date of death a. Other family entities may have liquid assets that would permit loans to the estate. This is a very commonly occurring situation. A very important tax issue that arises is whether the estate will be entitled to an estate tax administrative expense deduction for the interest that it pays on the loan 23

25 b. Of less importance are situations in which beneficiaries need advances, before the executor is in a position to be able to make distributions. One possible scenario where this can occur is if only one beneficiary needs assets from the estate quickly, but the executor wants to make pro rata distributions when distributions are made. An advance could be made to the one beneficiary with needs until distributions can be made 2. Estate Tax Administrative Expense Deduction for Interest Payments a. I.R.C. Section 2053 does not refer to the deduction of interest as such. To be deductible, interest must qualify as an administration expense. Deducting interest as an estate tax deduction is not as attractive as it has been in the past because the interest would be recognized as income when received and the decrease in the estate tax rates reduces the amount of arbitrage on the rate differential between the estate tax savings and the income tax cost. Even so, substantial savings may be achieved because the estate tax reduction occurs eight to nine months after date of death whereas the interest income may not be recognized until later years b. Interest payable to the IRS on a federal estate tax deficiency is deductible as an administration expense to the extent the expense is allowable under local law. Unlike interest payable to the IRS on deferred estate tax payments, interest on private loans used to pay estate taxes is not automatically deductible. The IRS recognizes that interest is deductible on amounts borrowed to pay the federal estate tax where the borrowing is necessary in order to avoid a forced sale of assets. The interest is deductible only for the time period for which the loan is reasonably necessary for that purpose c. When the estate receives an extension to pay estate tax under 6161, the interest is deductible only when it is actually paid. In Rev. Rul , the IRS gave two reasons for refusing to allow an up-front deduction for the interest: (i) An estate can accelerate payment of the deferred tax 24

26 (ii) The interest rate of the deferred amount fluctuates, which makes it impossible to accurately estimate the projected interest expense d. Estate of Graegin v. Commissioner Approved Up-Front Deduction (i) (ii) (iii) (iv) The Tax Court in a memorandum decision allowed an estate to deduct projected interest on a loan that was obtained to avoid the sale of stock in a closelyheld corporation The court reasoned that the amount of the interest was sufficiently ascertainable to be currently deductible because of the fixed term of the note and because of the substantial prepayment penalty provisions in the note Most of the cases involving Graegin loans have allowed the up-front interest deduction, in situations where the estate could establish a reason for the borrowing other than to generate the estate tax deduction, and courts are reluctant to second guess the business judgment of the executor IRS officials have stated informally that the IRS is continuing to look for vehicles to contest Graegin loans, particularly in situations involving family limited partnerships. The IRS's concern is that a deduction will be allowed but the interest in fact will not have to be paid over the entire term of the note e. Example of Favorable Results of Graegin Loan. (i) The economics of the up-front Graegin deduction can be significant (ii) Example 8. Assume a $10,000,000 taxable estate. Assume the marginal estate tax bracket is 45%. Assume the estate would owe $4,500,000 ($10,000,000 x 45%) in estate taxes. [Obviously, those numbers are not accurate and are being used only for illustrative purposes] Assume the estate borrows $4,500,000 from a closely-held company under a 15 year note, at 6.0% interest, with a balloon payment at the end of the 15 25

27 year period to pay the estate tax. The accumulated interest payment due at the end of the 15 years would be $4,050,000 ($4,500,000 x 6% x 15). Under the Graegin analysis, the interest expense would be currently deductible for estate tax purposes, yielding a taxable estate of $5,950,000 ($10,000,000 - $4,050,000), which would result in a federal estate tax of $2,677,500 ($5,950,000 x 45%). The $4,050,000 of interest would be paid to the company (which, in turn, is owned primarily by family members). The overall result is a very considerable estate tax savings of $1,822,500 ($4,500,000 - $2,677,500). In New Jersey there will also be significant NJ estate tax savings. The quid pro quo, of course, is that the interest income will be subject to income tax at the end of the 15-year period. However, many families are willing to pay income taxes in 15 years if they can reduce the estate taxes that are due nine months after the date of death. f. New Regulation Project Considering Applying Present Value of Administration Expenses and Claims to Graegin Loans. The I.R.C. Section 2053 final regulations do not seem to impact Graegin loans at all. However, the Treasury Priority Guidance Plans for include a project to address when present value concepts should be applied to claims and administration expenses (including, for example, attorneys' fees, Tax Court litigation expenses, etc.). Graegin notes are also in the scope of that project X. The Case for Establishing Residency in Other States for Tax Purposes A. New Jersey has become the most tax onerous state in the United States of America according to a recent report released by the Washington, D.C. based Tax Foundation 1. New Jersey Gross Income Tax is computed at 8.97% for the highest earning New Jersey taxpayers 2. The New Jersey estate tax is imposed on all New Jersey taxable estates that exceed $675, New Jersey is one of but a few states that imposes an Inheritance Tax 4. New Jersey property owners pay the highest real estate taxes in the country 26

28 5. New Jersey imposes a 7% sales tax 6. Florida, among other states, imposes no income tax or state estate tax 7. See Exhibit L illustrating estate tax savings of a wealthy New Jersey citizen by changing residency from New Jersey to Florida B. The incentive of New Jersey residents to change residency, or create the appearance of a change of residency, is becoming more and more attractive as New Jersey tax laws become more onerous and the New Jersey Division of Taxation becomes more aggressive in imposing tax against its citizens and less reasonable in its negotiation position. See Article in NJBIZ on May 17, 2010 at Exhibit M 1. New Jersey estate, inheritance and gross income taxes can be avoided by changing residency - Florida is a favored destination 2. While the exodus of New Jersey residents is reaching epidemic levels, the New Jersey legislature has lagged behind in finding means to dissuade residents from leaving. Furthermore, the New Jersey Division of Taxation has not yet increased its enforcement efforts by closely scrutinizing the scenarios surrounding change in residence. Other states, such as New York and California, are more aggressive in their pursuits 3. While New Jersey imposes high tax rates upon its residents, it is incongruous that New Jersey does not impose New Jersey Estate Tax on out of state decedents with real estate located in New Jersey. However, NJ Senate Bill No has been introduced by Senator Andrew R. Ciesla earlier this year to end this inequity. Although this Bill has not yet become law, it reflects awareness of the unfairness of the current law. See Exhibit N 4. N.J.S.A. 54A:1-2(m)(2) defines a resident taxpayer as an individual who, although not domiciled in New Jersey, maintains a permanent place of abode in New Jersey and spends in the aggregate more than 183 days of the taxable year in New Jersey 5. If the federal estate tax, however, reverts back to December 31, 2001 law, the Florida estate tax will be resurrected and the estate tax advantage of establishing Florida residency will be minimized C. Below is a checklist of the primary steps that should be satisfied if a taxpayer is considering relocation or establishing domicile in Florida (or any other state). It is best to strive to satisfy as many of the checklist items as possible. The checklist is derived from case law, common sense and practical experience 27

29 1. Obtain a Florida driver s license and relinquish New Jersey driver s license 2. Acquire Florida license plates and register car in Florida and relinquish New Jersey license plates 3. Relinquish or change to non-resident status all other New Jersey licenses 4. Register to vote in Florida and actually vote 5. File a nonresident, rather than a resident, New Jersey Gross Income Tax Return if there is source income from New Jersey 6. File federal income tax returns with the corresponding IRS Service Center for Florida using the taxpayer s Florida address and mail the return to the IRS Center for Florida (which currently is Atlanta, Georgia) 7. Transfer safe deposit box contents to a safe deposit box in Florida 8. Open Florida bank account at bank in immediate vicinity of Florida residence 9. Open Florida investment accounts at institutions in immediate vicinity of Florida residence 10. Change credit cards to Florida address and make certain that charges are not made in New Jersey during periods that the taxpayer says he or she was in Florida 11. Execute new wills, powers of attorney, health care proxies and living wills, or at the very least, have Florida counsel review the existing estate planning documents for compliance with Florida law 12. The Florida address should be referenced in all estate planning documents 13. File a declaration of domicile in Florida, if applicable 14. File for a homestead exemption in Florida, if applicable 15. Affiliate with Florida clubs, houses of worship, social and other organizations 16. Where feasible, have family gatherings and social activities in Florida 28

30 17. Transfer works of art, expensive furniture and heirlooms to Florida 18. Consider acquiring cemetery plots in Florida 19. List Florida as the primary residence on all homeowners insurance policies 20. Make sure all mail is sent to a Florida address 21. Notify Social Security of a change of address 29

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