11/9/2012. Estate and Charitable Planning Before the End of IRS Circular 230. Historical Estate Tax Rates and Exemptions

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1 Estate and Charitable Planning Before the End of 2012 SOL S. REIFER, J.D., LL.M. KYLE C. POST, J.D., LL.M. WRIGHT GINSBERG BRUSILOW P.C PRESTON ROAD, SUITE 600 DALLAS, TEXAS IRS Circular To ensure compliance with requirements imposed by the Internal Revenue Service, we hereby inform you that any tax advice contained herein was not intended or written to be used, and it cannot be used, by you for the purposes of avoiding any penalty that may be imposed by the Internal Revenue Service. Historical Estate Tax Rates and Exemptions 3 Exemption Top Tax Rate Top Tax Bracket 1916 $50,000 10% $5,000, $50,000 60% $10,000, $40,000 77% $10,000, $134,000 70% $5,000, $325,000 55% $3,000, $675,000 55% $3,000, $1,500,000 48% $3,000, $3,500,000 45% $3,500,000 1

2 Current Rates and Exemptions 4 Estate Tax Exemption Gift Tax Exemption GST Exemption Top Tax Rate 2010 $5,000,000* $5,000,000* $5,000,000* 35% 2011 $5,000,000 $5,000,000 $5,000,000 35% 2012 $5,120,000 $5,120,000 $5,120,000 35% 2013 $1,000,000 $1,000,000 $1,360,000 55% Current IRS Interest Rates Applicable Federal Rate Short-term (0-3 years): 0.23% Mid-term(3-9 years): 0.93% Long-term (over 9 years): 2.35% Section 7520 Rate 1.2% 5 Spousal Lifetime Access Trust 6 Basics One spouse creates an irrevocable trust for the benefit of the other spouse Children can also be named as beneficiaries Trustee has discretion to make distributions of income and principal to the beneficiary spouse Grantor trust so the settlor spouse is taxed on the trust income Allocate GST exemption so the trust passes transfer-tax-free to subsequent generations 2

3 Benefits Spousal Lifetime Access Trust The trust is not included in the settlor spouse s estate 7 With current high exemptions, the trust can pass free of gift, estate, and GST taxes If the spouses get along, the beneficiary spouse may use any distributions for the mutual benefit of the spouses Grantor trust status allows the trust to grow without reduction for income taxes Assets are protected from the creditors of the grantor spouse and the beneficiaries Spousal Access Lifetime Trust Concerns/Risks Beneficiary spouse does not share the distributions Divorce Death of beneficiary spouse 8 Basics Reciprocal Non-Reciprocal Trusts Each spouse creates a SLAT for the other spouse Children can also be beneficiaries 9 Trustee has discretion to make distributions of income and principal to the beneficiary spouse Grantor trust so the settlor spouse is taxed on the trust income Allocate GST exemption so the trust passes transfer-tax-free to subsequent generations 3

4 Benefits Reciprocal Non-Reciprocal Trusts The spouses can access trust funds if they need them 10 The trusts are not included in the settlor spouse s estate or the beneficiary spouse s estate With current high exemptions, the trusts can pass free of gift, estate, and GST taxes Grantor trust status allows the trust to grow without reduction for income taxes Assets are protected from the creditors of the grantor spouse and the beneficiaries Reciprocal Non-Reciprocal Trusts Concerns/Risks 11 The Reciprocal Trust Doctrine In some cases, the IRS can ignore the trusts and include the trust assets in the beneficiaries estates Creditors may also be able to undo the trusts When the trusts are identical (or nearly identical), the settlors have not really given up anything. Was the creation of one trust a quid pro quo for the other? If so, then the reciprocal trust doctrine will likely apply Even if no quid pro quo, if the trusts are sufficiently interrelated, the reciprocal trust doctrine may apply Death of a spouse Divorce Remedies Reciprocal Non-Reciprocal Trusts Create the trusts at different times Make the trusts different Different trustees Different beneficiaries Different beneficiary powers (i.e. Crummey powers, power of appointment) Different distribution provisions Different sizes 12 4

5 2-year zeroed-out GRAT (2007) 13 Grantor is 50 years old and contributes property worth $1,000,000 to a 2-year GRAT. Section 7520 rate is 5.2% (Nov. 2007). The annuity payment amounts are structured so that there is no taxable gift of the remainder. Assume the trust property earns 1% income and the principal grows at a rate of 7% annually. Principal Growth Income Required Annuity Remainder 1 $ 1,000, $ 70, $ 10, $ 539, $541, $ 541, $ 37, $ 5, $ 539, $ 45, SUMMARY $ 1,000, $ 107, $ 15, $ 1,078, $ 45, Taxable Gift: $ year zeroed-out GRAT (2012) 14 Grantor is 50 years old and contributes property worth $1,000,000 to a 2-year GRAT. Section 7520 rate is 1.2% (October 2012). The annuity payment amounts are structured so that there is no taxable gift of the remainder. Assume the trust property earns 1% income and the principal grows at a rate of 3% annually. 1 $ 1,000, $ 30, $ 10, $ 509, $531,140 2 $ 531, $ 15, $ 5, $ 509, $43,456 SUMMARY $ 1,000, $ 45, $ 15, $ 1,018, $ 43, Taxable Gift: $ year zeroed-out GRAT (2012) 15 Grantor is 50 years old and contributes property worth $1,000,000 to a 2-year GRAT. Section 7520 rate is 1.2% (October 2012). The annuity payment amounts are structured so that there is no taxable gift of the remainder. Assume the trust property earns 1% income and the principal grows at a rate of 7% annually. Principal Growth Income Required Annuity Remainder 1 $ 1,000, $ 70, $ 10, $ 509, $ 571, $ 571, $ 39, $ 5, $ 509, $ 108, SUMMARY $ 1,000, $ 109, $ 16, $ 1,018, $ 108, Taxable Gift: $0.00 5

6 10-year GRAT 16 Grantor is 50 years old and contributes property worth $4,000,000 to a 2-year GRAT. Section 7520 rate is 1.2% (October 2012). The annuity payment amounts are structured to be 5% of the initial principal. Assume the trust property earns 1% income and the principal grows at a rate of 7% annually. Principal Growth Income Required Annuity Remainder 1 $ 4,000, $ 280, $ 41, $ 200, $ 4,121, $ 5,518, $ 386, $ 57, $ 200, $ 5,7 61, SUMMARY $ 3,27 7, $ 484, $ 2,000, $ 5,761, Taxable Gift: $2,125, year zeroed-out GRAT 17 Grantor is 55 years old and contributes property worth $1,000,000 to a 100-year GRAT. Section 7520 rate at the time of the transfer is 1.2%. Assume the trust property earns 1% income and the principal grows at a rate of 7% annually. If grantor dies at the end of year 20, a portion of the GRAT assets are included in his estate. But how much? Assume the Section 7520 rate at the time of death is 4.5%. Principal Growth Income Required Annuity Remainder 20 $3,622, $253, $37, $ 17, $ 3,895, Amount included in estate $ 384, Wealth transferred $ 3,510, Taxable gift: $0 Installment Sale to Grantor Trust ( freeze ) 18 Grantor owns 100% of the LP interests in Family Business, LP. The LP interests are worth $2.5MM. Grantor wants to sell 40% of the LP interests to Grantor Trust. Grantor makes a $100,000 gift to Grantor Trust and then sells 40% of the LP interests to the trust for $1MM. Grantor receives a 7-year promissory note with principal amount of $1MM. The promissory note bears interest at the current mid-term AFR of 0.93%. Assume the LP interests generate $30,000 annual cash flow and appreciate 3% annually. Payments to Grantor Amount remaining in Trust Gift Tax Cost Interest $ 65, Cash $ 244, $100,000 of Exemption Principal $ 1,000, LP Interests $ 229, or $35,000 gift tax TOTAL $ 1,065, TOTAL $ 474,

7 Installment Sale to Grantor Trust ( superfreeze ) 19 Grantor owns 100% of the LP interests in Family Business, LP. The LP interests are worth $2.5MM. Grantor wants to sell 40% of the LP interests to Grantor Trust. Grantor makes a $100,000 gift to Grantor Trust and then sells 40% of the LP interests to the trust for $800,000 (based on a 20% valuation discount). Grantor receives a 7-year promissory note with principal amount of $800,000. The promissory note bears interest at the current mid-term AFR of 0.93%. Assume the LP interests generate $30,000 annual cash flow and appreciate 3% annually. Payments to Grantor Amount remaining in Trust Gift Tax Cost Interest $ 52, Cash $ 257, $100,000 of Exemption Principal $ 800, LP Interests $ 429, or $35,000 gift tax TOTAL $ 852, TOTAL $ 687, year CLAT 20 Taxpayer funds a 10-year CLAT with $1,000,000 of assets that are expected to appreciate 6% annually. The CLAT pays out a 3% annuity to charity and the remainder goes to the taxpayer s children at the end of the trust term. The CLAT is a grantor trust. Immediate income tax deduction: $281,115* Taxable Gift: $718,885 Principal Total Growth Summary: Total Payments to Charity Remainder to Beneficiaries $ 1,000, $ 695, $ 300, $ 1,395, * The grantor must include the trust s income in his/her income in order to claim income tax deduction. 20- CLAT 21 Taxpayer funds a 20-year CLAT with $1,000,000 of assets that are expected to appreciate 6% annually. The CLAT pays out a 3% annuity to charity and the remainder goes to the taxpayer s children at the end of the trust term. The CLAT is a grantor trust. Immediate income tax deduction: $530,619* Taxable Gift: $469,381 Summary: Principal Total Growth $ 1,000, ,703, Total Payments to Charity Remainder to Beneficiaries $ $ 600, $ 2,103, * The grantor must include the trust s income in his/her income in order to claim income tax deduction. 7

8 20-year zeroed-out CLAT 22 Taxpayer funds a 20-year CLAT with $1,000,000 of assets that are expected to appreciate 6% annually. The CLAT is zeroed out. The CLAT is a grantor trust. Immediate income tax deduction: $1,000, * Taxable Gift: $0 Summary: Principal Total Growth Total Payments to Charity Remainder to Beneficiaries $ 1,000, $ 1,258, $ 1,130, $ 1,127, * The grantor must include the trust s income in his/her income in order to claim income tax deduction. Loans to Trust 23 What if client is not sure about making a gift or does not want to make gifts of his or her assets if the law is not going to change? Example: Client has $6MM estate. Wants to give $3MM if the exemption is going to be reduced to $1MM. If the exemption is going to remain at $5MM, client does not want to make any gifts. By the time we know whether a new law will be passed, it may be too late to engage in any meaningful planning before the law change takes effect. So, making a loan now provides flexibility and allows the client to wait and see what happens with the law. Loans to Trust 24 Basics Client or third party create and fund an irrevocable trust (or use an existing trust) Client loans $$ to the trust using at least the current AFR for the term of the note Interest only with balloon payment? Demand loan? If client believes the exemption is going to be reduced, client forgives the debt before the current exemptions expire. This is treated as a gift at that time. If the client believes the exemption is going to remain high, the note will remain in place and the client will receive note payments and interest. The client can forgive the debt in the future if we don t have permanent reform and the exemption go down. 8

9 Benefits Provides flexibility Loans to Trust 25 Grantor trust status allows the trust assets to grow without reduction for taxes Grantor trust status means the interest payments on the note are not taxable income to the grantor Whether the debt is forgiven or remains in place, the trust can pass free of gift, estate, and GST taxes Trust assets are not included in the settlor or beneficiary s estate Loans to Trust Concerns/Risks IRS challenges the validity of the loan 26 This could cause the loan to be treated as a gift The trust assets could be included in the client s estate because the client has retained a benefit of receiving payments from the trust Can the trust assets outperform the AFR? If not, the trust will become insolvent and nothing will be left for the beneficiaries. Basics Beneficiary Defective Trust 27 Third party creates and funds an irrevocable trust for the benefit of client Settlor must not be a potential beneficiary of the trust Settlor should not be trustee Should fund with 10% of the value of the assets that the trust will purchase Client is given Crummey rights of withdrawal Client sells assets to the trust for a promissory note Trust is a grantor trust as to client Client is permissible beneficiary of trust 9

10 Benefits Beneficiary Defective Trust 28 Client is a beneficiary of the trust The trust assets are not included in the beneficiary s estate Except for the amount the client was entitled to withdraw The trusts can pass free of gift, estate, and GST taxes Grantor trust status allows the trust to grow without reduction for taxes Assets are protected from the creditors of the beneficiaries Beneficiary Defective Trust Concerns/Risks IRS may challenge Can it be collapsed due to lack of economic substance? Is the trust administered properly so it is not included in the beneficiary s estate? IRS law changes regarding grantor trusts? 29 Clawback 30 In 2012, taxpayer makes a gift of $5,000,000. There is no gift tax due because the gift is equal to the available exemption amount. However, Congress does nothing to extend the current estate and gift tax exemptions and the exemption amounts are reduced to $1,000,000. The taxpayer dies in 2013 with an estate of $1,000,000. Is the taxpayer s estate tax liability based on $1,000,000 or $5,000,000? 10

11 Questions? 31 Please feel free to contact me with any questions. Sol S. Reifer Kyle C. Post Wright Ginsberg Brusilow P.C Preston Road, Suite 600 Dallas, Texas

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