ESTATE PLANNING OPPORTUNITIES UNDER THE TAX RELIEF ACT OF

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1 Tenth Floor Columbia Center 101 West Big Beaver Road Troy, Michigan (248) Fax (248) Winter Editor: Julius Giarmarco, J.D., LL.M. The Tax Relief Act of 2010 (the Act ) signed into law on December 17, 2010, unexpectedly and profoundly changed the rules governing wealth transfer. Perhaps the biggest impact of the Act is that it reunifies the estate, gift and generation skipping transfer (GST) tax exemptions. The Act also brings a new aspect to the estate tax with a portability provision, where a surviving spouse will be able to take advantage of any unused portion of his/her predeceased spouse s estate tax exemption. Since the Economic Growth and Tax Relief Reconciliation Act of 2001 ("EGTRRA"), the gift tax exemption ($1 million in 2009) has been "decoupled" from the estate tax exemption ($3.5 million in 2009). But for 2011 and 2012, the estate, gift and GST tax exemptions will be $5 million per person and $10 million per married couple. The exemption amount is indexed for inflation, in increments of $10,000, beginning in The Act also imposes a top tax rate of 35%. However, without further Congressional action, on December 31, 2012, the provisions of the Act will sunset. As a result, on January 1, 2013, the gift and estate tax exemptions will decrease to $1 million; the GST exemption will decrease to $1.4 million (estimate of inflation adjusted amount); and the top transfer tax rate will increase to 55%. Following is a discussion of some of the planning opportunities for wealth transfers under the Act. LIFETIME GIFTS ESTATE PLANNING OPPORTUNITIES UNDER THE TAX RELIEF ACT OF 2010 After 12 months of uncertainty, the period of "certainty" is limited to two years. Although the chances of such severe reductions in available exemptions and increases in rates probably will not, as an overriding political matter, be allowed to happen, persons contemplating making substantial gifts should be motivated to do so in 2011 or 2012 to lock in the benefits. However, if the estate tax exemption returns to $1 million in 2013, the calculation of adjusted taxable gifts in computing the estate tax will result in a clawback of the tax benefits that accrued as a result of using the increased exemption in 2011 or In other words, in order to prevent two bracket runs, taxable gifts are added back to the base upon which the estate tax is computed (with any gift tax By Julius Giarmarco, J.D., LL.M. COPYRIGHT 2011 JULIUS GIARMARCO, ESQ. PAGE 1 exemption previously used being restored), thus, subjecting tax exempt gifts in 2011 and 2012 to estate tax. As a result, use of the $5 million gift tax exemption in 2011 and 2012 will be beneficial only if the $5 million exemption is extended to 2013 and beyond. However, despite the risk of subjecting gifts made in 2011 and 2012 to estate tax at the donor s death, in most cases the gifts should be made. First, there is a chance that the $5 million gift tax exemption will become permanent. Congressional staffers have indicated that a clawback was not intended, and IRS guidance or technical corrections could make that clear. Second, even if the clawback applies, donors should be no worse off than those who did not make gifts. In either case, the gifts, whether made or foregone, will be included in the decedent s estate (and subject to estate tax at whatever rates and exemptions are then in effect). Third, the future growth and income on the gifted assets will not be subject to a clawback, even if the gifts themselves are. Finally, the ability to leverage gift transfers through installment sales to grantor trusts and/or purchases of life insurance (as discussed below) enables donors to transfer far more than their $5 million gift tax exemption. Following are some examples on how high net worth individuals can use the new $5 million ($10 million for married couples) gift tax exemption: Simple Gifts. Associate Editor: Salvatore J. LaMendola, J.D., C.P.A. The ability to transfer $5 million per person without paying gift taxes will encourage many individuals to make gifts to their children and grandchildren (either outright or in trust). Forgiving family loans is another way to use the increased gift tax exemption. The extra gift tax exemption may permit some donors to equalize gifts to all of their children and/or grandchildren when they did not have enough annual gift tax exclusion to do so in the past. The increased gift tax exemption also opens up significant opportunities for transferring assets between unmarried couples without transfer taxes. If the gifted assets qualify for valuation discounts (which were not touched by the Act as many feared), the $5 million / $10 million exemption is further expanded. For example, a gift of an undivided interest in real estate will result in

2 double leveraging, since both the transferred interest and the retained interest will receive a fractional interest discount. If one spouse has most of the marital wealth, the couple can "split" the gift to take advantage of both spouse's exemptions. Grantor Trusts. Making gifts to grantor trusts, where the grantor is responsible for paying income taxes on trust income, allows the trust assets to compound free of income tax, while the payment of income taxes by the grantor depletes his/her estate. The grantor s payment of the trust s income taxes is essentially a tax-free gift to the beneficiaries of the trust. These wealth transfer benefits can be further enhanced by having the grantor loan up to nine (9) times the equity in the trust with a very low Applicable Federal Rate note payable to the trust. A "seed" gift of $10 million by a married grantor to a grantor trust will permit a sale of $90 million of assets to the trust at current historically low interest rates. Further estate tax reduction occurs because the grantor is now paying income taxes on the income generated by the entire $100 million in the trust. Moreover, if the assets gifted and sold to the trust can be discounted (for lack of control and lack of marketability), the value that can be transferred via the trust is increased. If the grantor retains the power to substitute assets (one of the grantor trust triggers), the grantor can repurchase appreciated assets from the trust to achieve a basis step-up at his/ her death. Finally, additional leverage of the gift and GST tax exemption can be accomplished by having the trust use a portion of its cash flow to purchase life insurance on the life of the grantor or the joint lives of the grantor and the grantor s spouse (see below). Even without a sale, a simple gift of $5 million or $10 million to a grantor trust will have a huge impact on the amounts that can be transferred over time, which amounts can serve as the seed money for a sale to the trust in the future. Even though the Act did not touch zeroed-out Grantor Retained Annuity Trusts ( GRATs ) (as some in Congress proposed), the sale to a grantor trust has several advantages over GRATs, including no mortality risk and the opportunity to allocate GST exemption to the seed gift. In contrast, GST exemption cannot be allocated to GRATs until the end of the retained annuity term. But, unlike zeroed-out GRATs, a sale to a grantor trust requires a seed gift equal to 10% of the sale price. The Act's increased gift tax exemption makes this less problematic for sales to grantor trusts. Spousal Lifetime Access Trusts. While many high net worth married couples may like to take advantage of their $5 million gift tax exemptions, they may be reluctant to do so because they lose access to the gifted property s income and principal. One strategy to keep the income and principal within the reach of the donor is a Spousal Lifetime Access Trust ( SLAT ). In simple terms, a SLAT is an irrevocable trust set up by one spouse for the benefit of the other spouse. For example, assume a husband creates a SLAT for the benefit of his wife and funds it with his $5 million gift tax exemption. During the wife s lifetime, the Trustee (which may be the wife) can distribute to the wife income and principal as needed for her health, education, maintenance and support. The wife can also be given the power to withdraw the greater of $5,000 or 5% of the trust principal annually, and a testamentary limited power of appointment to rewrite the trust provisions upon her death. Thus, the husband has indirect access to the trust s income and principal. When the wife passes away, the unappointed trust property (including the appreciation thereon) passes - estate tax free - to the children (and possibly even more remote descendants depending on state law). An added benefit of a SLAT is that it protects the beneficiaries from creditors, including ex-spouses. Finally, a SLAT would likely be a grantor trust as to the donee spouse (unless the consent of an adverse party was required for distributions to the spouse). Thus, the SLAT s assets compound free of income taxes. One obvious problem with the above factual situation is that upon the wife s death, the husband loses his indirect access to the trust s income and principal. One simple solution to this problem is for the wife to create an irrevocable life insurance trust ( ILIT ) for the benefit of her husband. The ILIT would be funded with a life insurance policy on the wife s life to replace the wealth lost to the husband in the SLAT (in the event he survives his wife). If necessary, the SLAT can loan the ILIT the funds needed to pay premiums under a split-dollar arrangement. Can a married couple both create SLATs (and ILITs) for the benefit of each other so as to increase the gift to $10 million? It s possible, but the IRS could look through the transactions and apply the reciprocal trust doctrine. That doctrine assumes that each spouse established a trust for his/her own benefit, thus resulting in estate inclusion for each spouse of the trust property. Accordingly, the trusts must be drafted differently. For example, different trustees for each trust could be used; the beneficial interests could be made dissimilar by giving one spouse a 5% annual withdrawal power and the right to income but not principal, and the other spouse no 5% annual withdrawal power nor the right to income, but the right to principal; the trusts could be created at different times; and one spouse could be given a testamentary limited power of appointment but not the other. SLATs, like many other estate planning techniques, have some drawbacks. Access to trust assets is available only to the grantor s spouse (and/or other beneficiaries) - not to the grantor. Thus, the grantor only has indirect COPYRIGHT 2011 JULIUS GIARMARCO, ESQ. PAGE 2

3 access to the trust property through his/her spouse. Therefore, divorce or the death of the spouse will eliminate this limited access. But as mentioned above, by having the beneficiary-spouse establish an ILIT for the benefit of the grantor-spouse, the wealth lost to the grantor in the SLAT can be replaced by the ILIT. And the SLAT must be carefully drafted to avoid inadvertent estate tax inclusion - particularly if reciprocal SLATs are established. However, SLATs will be particularly attractive to many high net worth clients looking to maximize their $5 million gift tax exemptions. Split-Dollar Plans. In a split-dollar arrangement, one party provides the majority of the funding, while the other party (usually a trust) controls most of the death benefit. The party that provides the funding is entitled to receive back the greater of the cash outlay or the cash surrender value of the life insurance policy. Because the trust gets any death benefit over and above the cash outlay or cash surrender value, there is an economic benefit to the trust. Each year this is measured by the cost of one-year term insurance (IRS Table 2001). This cost gets expensive as the insured gets older, so a mechanism is needed to unwind the arrangement. As a result of the Act, a large gift can be made to the trust to enable it to "exit" from the split dollar arrangement. Life Insurance Transfers. Using the $5 million ($10 million per couple) gift tax exemption to make a single gift to an irrevocable life insurance trust ("ILIT") to purchase a single-premium policy (keeping in mind the potential problems with a modified endowment contract) or to pay future premiums that are due after 2012 can help individuals with illiquid estates solve their liquidity problem. It is simple and clean. The increased exemption will be particularly useful to grantors whose gifts were limited to their available Crummey powers and $1 million/$2 million lifetime exemption. Life insurance is also an excellent way to "leverage" the grantor's GST exemption. For example, a married couple can fund an ILIT (designed as a dynasty trust) with $10 million; deposit the $5 million into a second-to-die life insurance policy; and secure $50 million of coverage guaranteed for life. Even though the GST exemption may be reduced after 2012, by allocating the grantor s GST exemption to the $10 million gift in 2011 or 2012, it will not be taken away or reduced after The other $5 million can be invested in other assets (the "side fund"). If the ILIT is also designed as a grantor trust, the $5 million side fund compounds free of income tax, and the grantor's payment of the ILIT's income taxes further depletes the grantor s estate. At the death of the surviving spouse, the $50 million of insurance plus the amount in the side fund are all GST exempt. Thus, there is no estate or GST tax as the trust assets pass from one generation to the next (for the maximum period permitted under state law). Under Michigan law, the trust may have a perpetual term. Persons with non-taxable estates may forgo the complexities of an ILIT (i.e., Crummey letters, annual income tax returns (Form 1041), etc.) and simply own their life insurance policies personally. An added advantage of doing so is that the owner-insured can thereby retain direct access to the policy's cash value. GRATS AND VALUATION DISCOUNTS Equally key to what is in the Act is what is not in the Act. Valuation discounts are often used with various estate planning techniques (such as family LLCs). For example, as discussed above, valuation discounts can be used to enhance the benefits of a sale to a grantor trust. While it had been rumored that the new tax law would limit the ability to discount the value of assets in estate planning transactions, the Act does not include such limits. As a result, valuation discount planning continues to be an effective estate planning tool, and individuals may want to take advantage of such techniques in case Congress changes its mind in the future. In addition, prior legislative proposals would have instituted a minimum ten-year term for GRATs. This would have greatly reduced the planning opportunities associated with GRATs. However, no such provision is included in the Act. Thus, short-term zeroed-out GRATs (e.g., two to three years) appear likely to be viable, at least for the immediate future. A GRAT can also be used to assist in funding an ILIT. By distributing the assets remaining in a successful GRAT to an ILIT, funds are provided to finance premiums or to create an exit strategy for a split-dollar or premium financing arrangement. PORTABILITY Prior to the Act, for a married couple to take full advantage of both spouses estate tax exemption, the predeceased spouse s exemption had to be held in a "Credit Shelter" or "Family" Trust, thus requiring some advanced planning. Now, however, the Act allows the executor of a deceased spouse's estate to transfer any unused exemption to the surviving spouse without creating a Family Trust. Portability applies for the gift tax exemption as well as the estate tax exemption. But the portability provision only applies to the last deceased spouse of the surviving spouse, thus eliminating "serial marriages" for the purpose of accumulating unused estate tax exemptions. The portability option is only available if a deceased spouse's estate files an election on a timely filed estate tax return (Form 706) even if a return is not otherwise required to be filed (because of the size of the estate). COPYRIGHT 2011 JULIUS GIARMARCO, ESQ. PAGE 3

4 Family Trusts vs. Portability. Despite the relative simplicity of just letting the surviving spouse use the predeceased spouse s unused estate tax exemption in 2011 and 2012, there are several reasons for still using Family Trusts, including the following: The predeceased spouse s unused exemption is not indexed for inflation. The first predeceased spouse s unused exemption will be lost if the surviving spouse remarries and survives his/her next spouse. The appreciation in the assets in the Family Trust is removed from the surviving spouse s estate. The assets in the Family Trust are protected from the surviving spouse s creditors. Without a Family Trust, if the surviving spouse remarries and commingles his/her assets with the new spouse, there is the potential for disinheriting the children from the first marriage. The predeceased spouse (as opposed to the surviving spouse) controls the management and distribution of the assets in the Family Trust. There is no transfer to the surviving spouse of the predeceased spouse s unused GST tax exemption. The portability provision sunsets on December 31, Disclaimer Trusts. A Family Trust does have some disadvantages. The surviving spouse s access to the assets in the Family Trust, albeit broad, is restricted. And there is no steppedup basis at the surviving spouse s death for the assets in the Family Trust. The Family Trust also adds complexity to the surviving spouse s life in that separate records for the Family Trust must be maintained, and annual income tax returns (Form 1041) must be filed for the remainder of the surviving spouse s lifetime. Finally, if the first spouse to die has little or no assets other than an IRA, then for income tax reasons it s generally not advisable to use an IRA to fund a Family Trust (and forego a spousal rollover). Many couples with nontaxable estates, particularly those with children all from the same marriage, will prefer to simply leave their estate to the surviving spouse. But for the reasons mentioned above such couples may still want the ability to utilize a Family Trust. The solution could be a disclaimer trust. With a disclaimer trust, a married person s revocable living trust leaves his/her entire estate to the surviving spouse. The Family Trust is funded only if the surviving spouse then disclaims (refuses) part of the deceased spouse s estate. This enables the surviving spouse to decide how much to keep outright (to be taxed at the second death) and the amount to be allocated to the Family Trust (which is shielded from estate tax at the second death). For married couples who live in states that have their own estate tax, postponing the federal estate tax until the death of the surviving spouse (by using a Family Trust) could result in generating a state death tax at the first spouse s death. This can occur if the state s estate tax exemption is less than the federal estate tax exemption. Another consideration is whether state law provides for an unlimited marital deduction against the state death tax. By using a disclaimer trust, the surviving spouse, upon the advice of counsel, will be able to determine whether it is more or less advantageous to fully fund the Family Trust and pay any state death tax. In making an informed decision to disclaim and how much to disclaim, one must examine the size of the combined estate, the surviving spouse s age and health (which impacts the spouse s needs for funds), whether minor children will be beneficiaries of the Family Trust, the potential appreciation of the assets not disclaimed, the status of the estate tax exemption, and the applicability of a state death tax. The actual disclaimer must meet certain legal and filing requirements and the surviving spouse must not accept any benefits from the assets disclaimed before filing the disclaimer. OPTIONAL RETROACTIVITY FOR 2010 DECEDENTS For decedents dying in 2010, the estate tax is retroactively reinstated, with an exemption of $5 million; a top rate of 35%; and a stepped-up income tax basis for appreciated assets. The decedent's executor, however, can elect to opt out of the estate tax, in "exchange" for modified stepped-up basis ($1.3 million for non-spousal beneficiaries and an additional $3 million for property passing to a surviving spouse). For those decedents who died during 2010 with very large estates, the option to elect out of the estate tax may be an easy decision. For those decedents with estates under $5 million, no election will be necessary. But considerable analysis may need to be done for estates above $5 million to decide which path to choose (for the lowest overall tax consequences). This is particularly true where the estate owns fully-depreciated real estate because of the recapture rules. The election is revocable only with the consent of the IRS. IMPACT ON CHARITABLE PLANNING The higher estate tax exemption (at least for 2011 and 2012) will have an impact on charitable planning. Fewer persons will need to take advantage of the unlimited charitable estate tax deduction, particularly those who were not that charitably inclined to start with. However, COPYRIGHT 2011 JULIUS GIARMARCO, ESQ. PAGE 4

5 for those persons who are no longer concerned about estate taxes, their emphasis is likely to shift to the income tax incentives of charitable giving which were all left in place by the Act. In particular, charitable remainder trusts ("CRTs") will become more popular. A CRT is a tax-exempt irrevocable trust that will ultimately terminate in favor of one or more charities while first making payments to the donor (and the donor's spouse) for life. The CRT can create a source of lifetime income, reduce the donor's taxable estate, provide a charitable income tax deduction, defer tax realized by the donor on a sale of property, and secure a future gift to the donor's favorite charities. Moreover, by using the income tax savings to fund a Wealth Replacement Trust (for the benefit of the donor's heirs) with a life insurance policy, the donor is able to replace the wealth that eventually passes to charity. REVIEW FORMULA CLAUSES Applying the new $5 million estate and GST exemption in 2011 and 2012 could result in unintended financial consequences for a decedent's spouse and heirs. For example, allocating to the Family Trust "the maximum amount that can pass free of estate tax" now means $5 million (for 2011 and 2012). This could result in underfunding the marital gift (or marital trust), especially in those cases where a portion of the decedent's estate tax exemption was earmarked for children from a prior marriage. Another example is where the decedent's will or trust carved out the decedent's "available GST exemption" to pass to grandchildren. This now means $5 million (for 2011 and 2012) and could result in overfunding the grandchildren's bequest. Finally, formula bequests where the taxable portion of a decedent's estate was earmarked for charity could result in the charity now receiving nothing or much less than initially intended. Now, more than ever, estate planners must carefully review estate planning documents with their clients. CLOSING With a $5 million estate and gift tax exemption per person and $10 million per couple, the 2010 Tax Relief Act has effectively eliminated the estate tax for over 99% of Americans. Unfortunately, the Act only does this for two years, ending on December 31, On January 1, 2013, the estate and gift tax exemptions will revert to $1 million per person with a top rate of 55%. It will be up to Congress to determine whether the Act s provisions will become permanent after 2012 or if additional changes will be made. Thus, there will continue to be uncertainty in planning for federal estate, gift and generation skipping transfer taxes in 2011 and And we will again face the prospect of much higher rates and lower exemptions in the near future depending upon the political climate. Nevertheless, the $5 million/ $10 million gift tax exemption provides a two year window of opportunity for enhanced gifting by donors. In making gifts, keep in mind that donors should use their gift tax exemptions sooner rather than later so that the future income and growth on the gifted assets will not be included in their taxable estates. In addition, to make the most of one s gift tax exemption, the gifted assets should have strong return potential and, if possible, the gifted assets should also qualify for valuation discounts. Moreover, the best assets to gift are those with a higher cost basis because the donee receives the donor s cost basis. Finally, by making gifts to grantor trusts, the trust assets essentially grow income tax free (because the grantor is responsible for paying the trust s income taxes). Finally, the increased estate tax exemption may encourage some people to cancel their life insurance. But it's important to keep in mind that the tax cuts are temporary, particularly considering the government s likely need to raise taxes in the future. In fact, it s likely that many high net worth individuals will use all or part of their increased gift tax exemptions to fund new irrevocable life insurance trusts. In summary, the 2010 Tax Relief Act brings opportunity, complexity and uncertainty that can only be managed with advanced planning. But, because the provisions of the Act are scheduled to sunset on January 1, 2013, this may very well be a use it or lose it opportunity. With proper planning, perhaps now more than ever, it is possible to disinherit the IRS. This newsletter is designed to provide accurate (at the time of printing) and authoritative information with regard to the subject matter covered. It must not be used as the basis for legal or tax advice. In specific cases, the parties involved must always seek out and rely on the counsel of their own advisors. Thus, responsibility for modifying and guiding any party s action with respect to legal and tax matters is placed where it belongs - with his or her own advisors. CIRCULAR 230 DISCLAIMER: NONE OF THE ARTICLES IN THIS NEWSLETTER ARE INTENDED OR WRITTEN BY THE VARIOUS AU- THORS OR GIARMARCO, MULLINS & HORTON, P.C., TO BE USED, AND THEY CANNOT BE USED, BY YOU (OR ANY OTHER TAXPAYER) FOR THE PURPOSE OF AVOIDING PENALTIES THAT MAY BE IMPOSED ON YOU (OR ANY OTHER TAXPAYER) UNDER THE INTERNAL REVENUE CODE OF 1986, AS AMENDED. COPYRIGHT 2011 JULIUS GIARMARCO, ESQ. PAGE 5