MICKEY R. DAVIS AND MELISSA J. WILLMS DAVIS & WILLMS, PLLC HOUSTON, TEXAS SEPTEMBER 16, 2016

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1 MICKEY R. DAVIS AND MELISSA J. WILLMS DAVIS & WILLMS, PLLC HOUSTON, TEXAS SEPTEMBER 16, 2016 "Permanent" Unified Transfer Tax System $5,000,000 exemption for gift, estate and GST tax Indexed for inflation $5.34 million for 2014; $5.43 million for 2015 $5.45 million for 2016 We predict $5.49 million for 2017 (Exhibit A) 40% rate on excess Income Tax Rates are Higher Trusts and estates hit the top bracket at: $12,300 for 2015; $12,400 for 2016 Not part of ATRA, but 3.8% additional NII tax Portability is Now Permanent Davis & Willms, PLLC,

2 Ordinary income tax rates exceed estate tax rates High capital gain rates (23.8%) make basis more important High estate tax exemptions make estate tax savings illusory for most people The definition of "married couple" has changed For couples in the $2 to $12 MM range, is the complexity and federal income tax exposure worth trusts' non tax benefits? Davis & Willms, PLLC, Allows surviving spouse to "inherit" or port" unused gift and estate tax exemption of deceased spouse Enacted in 2010; made permanent by ATRA 2012 Vocabulary: (p. 2) "Basic Exclusion Amount" "Deceased Spousal Unused Exclusion Amount" (DSUE amount) "Applicable Exclusion Amount" "Executor" "Last deceased spouse" Davis & Willms, PLLC,

3 H dies in 2011 with $3 million estate $2 million to spouse; $1 million to children DSUE amount available to W = $4,000,000 $5,000,000 $1,000,000=$4,000,000 Wife's 2011 Applicable Exclusion Amt=$9,000,000 Basic Exclusion Amount: $5,000,000 DSUE amount: $4,000,000 Applicable Exclusion Amount: $9,000,000 Wife's 2016 Applicable Exclusion Amt=$9,450,000 Basic Exclusion Amount: $5,450,000 DSUE amount*: $4,000,000 Applicable Exclusion Amount: $9,450,000 *DSUE amount does not adjust for inflation Davis & Willms, PLLC, Need to elect by filing IRS Form 706 No creditor or divorce protection for surviving spouse Spouse may dispose of inherited assets No estate tax shelter for appreciation No portability of GST exemption Possible loss on remarriage REMEMBER: You must still consider the portability election, even if trust planning used Davis & Willms, PLLC,

4 Gifts using DSUE amounts from multiple deceased spouses is permitted Consider authorizing (or directing) executor to file Form 706 at surviving spouse's request Consider addressing DSUE amount in pre or postnuptial agreements Must file timely estate tax return Automatic 6 month extension available for portability returns Possible 9100 relief You MUST discuss portability with every Executor of a married decedent and DOCUMENT the discussion and decision about filing (Exhibit B) Davis & Willms, PLLC, Are Bypass Trusts out? (pp. 4-5) Administrative cost/complexity No basis adjustment at second death High income tax rates on accumulated income Problems with special assets (retirement plans, residences, S corps and other pass through entities) Managing downsides (investments, distributions) Disclaimer Bypass Trusts (p. 5) Adds flexibility to the estate plan At cost of special power of appointment Not "simple", e.g. requires disclaimer within 9 months Davis & Willms, PLLC,

5 Control over ultimate disposition Creditor protection/divorce protection Management assistance Protection of governmental benefits Protection from state inheritance taxes Income shifting Shifting wealth to other family members No inflation adjustment for DSUE amount Risk of loss of DSUE amount No DSUE amount for GST taxes Must file estate tax return for portability Davis & Willms, PLLC, Compare/contrast QTIP Trusts (pp. 8-9) Creditor/divorce protection Less retained income for compressed tax brackets New cost basis at second death (if QTIP elected) Preserve GSTT exemption (by "reverse" QTIP election) No estate tax savings (but DSUE amount available) QTIP drawbacks (pp. 9-12) No "sprinkle" power Estate tax exposure (above DSUE amount) High income tax rates The Rev. Proc problem (pp ) Clayton QTIPs (p. 11) The QTIP Tax Apportionment Trap (pp ) Davis & Willms, PLLC,

6 Clayton QTIP election Choose between Bypass Trust or QTIP (Exhibit C) At least 15 months to decide Default is Bypass Trust, so election important Can the Spouse Be the Executor? Davis & Willms, PLLC, H dies leaving $10 million estate to QTIP Trust H's executor makes QTIP and portability elections W's Applicable Exclusion Amount = $10 million W makes gift of $10 million to her children Applicable Exclusion Amount then $0 W dies with $10 million in QTIP Trust QTIP Trust owes estate tax of $4,000,000 H's children receive only $6,000,000 Note: Same result if W merely keeps her $10 million until death Davis & Willms, PLLC,

7 Life Estate Power of Appointment Trust All income to spouse like QTIP Trust No need to file an estate tax return Spouse must have unrestricted GPA to appoint to self or estate Inter vivos vs. testamentary Automatic basis adjustment at death BUT: Spouse may appoint assets elsewhere Possible creditor issues inter vivos vs. testamentary? No "reverse LEPA" election for GSTT purposes Davis & Willms, PLLC, Outright to Spouse All to Bypass Trust All to QTIP Trust All to LEPA Trust Keep it Simple Y N N N Creditor/Divorce Protection N Y Y Y/N Control Ultimate Disposition N Y Y N Management Assistance N Y Y Y Sprinkle/Spray to Kids, etc. N* Y N N Preserve GST Exemption N Y Y N Avoid High Trust Income Taxes Y N Y** Y** Avoid Estate Tax on Appreciation N Y N N New Cost Basis at 2 nd Death Y N Y Y *But enhanced gifting possible using DSUE Amount **Due to less income accumulation, but no ability to shift income Davis & Willms, PLLC,

8 There is no one size fits all solution How do we explain it to our clients? Has your conversation changed? What factors lead you to recommending a structure for clients? Davis & Willms, PLLC, Total net worth Age (and age difference of spouses) Presence of out of state property (state death tax exposure) Occupation/creditor exposure Spending habits/growth expectations Client tolerance for complexity Client desire for control Blended family vs "traditional" family Clients' views of "permanency" of tax laws Asset mix Davis & Willms, PLLC,

9 "Step Up" Important Copyrights, Trademarks, Patents & Artwork Ordinary & Long Term "Negative Basis" Commercial Real Estate LPs Ordinary & Long Term Artwork, Gold & Other Collectibles 28% Long Term Low Basis Stock 20% Long Term Roth IRA Assets Tax Free No Surcharge High Basis Stock Minimal Gain Fixed Income Typically Minimal Gain Cash Basis = Face Passive Foreign Investment Co (PFIC) Shares No "Step up" Allowed Stock at Loss Losses Erased Variable Annuities Partially IRD Traditional IRA & Qualified Plan Assets Typically All IRD "Step Up" Not Important Davis & Willms, PLLC, Basis is benchmark to measure gain or loss on sale Gain or loss = Amount realized Basis General rule: Basis = cost of asset Special rules for property acquired from a decedent Generally, basis is fair market value at date of death Alternate valuation date value/special use valuation value In essence, estate tax value Applies regardless of whether estate tax is due Basis may step up OR down, i.e. basis adjustment Original cost basis is simply ignored Holding period automatically becomes long term Davis & Willms, PLLC,

10 Basis consistency and value reporting New IRC 1014(f) and 6035 Estate tax returns filed after 07/31/15 IRC 1014(f) = Basis consistency Applies to beneficiaries of estates required to file an estate tax return Initial basis cannot exceed final estate tax value Property that generates estate tax Not marital or charitable deduction property Not certain tangible personal property Zero basis rule: after acquired or omitted property Davis & Willms, PLLC, IRC 6035 = Value (not basis) reporting Applies to executors or other persons required to file an estate tax return Applies to all property (including marital or charitable deduction), EXCEPT: Cash, IRD, certain tangible personal property, property disposed of where CG/CL recognized Form 8971 to IRS and Schedules A to beneficiaries Earlier of 30 days after 706 due or filed Supplemental reporting Subsequent transfers Davis & Willms, PLLC,

11 1. Property acquired by will or intestacy 2. Revocable trust property 3. Property decedent transferred with retained right to control 4. Property subject to a general power of appointment 5. Both halves of community property 6. Other property included in gross estate 7. Former QTIP property Davis & Willms, PLLC, Income in Respect of a Decedent (IRD) Income "earned" by the decedent but not properly reported by him or her Decedent entered into legally significant transaction Decedent performed substantive tasks required No economically significant contingencies Decedent would have received property but for death Property re inherited within one year of gift Property subject to conservation easements Davis & Willms, PLLC,

12 Generally, carry over basis For losses, basis limited to FMV on date of gift Does not apply for gifts between spouses Basis increased by any gift and GST tax paid Gifting asset gets appreciation out of estate BUT loss of basis adjustment at death Davis & Willms, PLLC, K.I.S.S. and rely on portability Is it really simple? Will clients file the return? Risks and downsides to portability 2. Have parties enter into "contract to make a will" Certainty vs. flexibility Enforceability of contract varies by state (see, e.g., Tex. Ests. Code ) Consider impact on marital deduction Davis & Willms, PLLC,

13 3. Use QTIPable or Clayton QTIP Trust (p. 11) 4. Use LEPA Trust (p. 12) 5. Grant independent trustee distribution authority beyond H.E.M.S. ("for any reason") (pp ) 6. Give third party power to grant a general power (p. 14) 7. Grant non fiduciary power to appoint to spouse (p. 14) Davis & Willms, PLLC, Grant spouse a testamentary GPA over only non IRD appreciated assets Result: A "step up" in basis, but not a step down Subject the power to a formula to avoid estate tax when the spouse dies Designing the formula is not a trivial task "Cascading" power over most appreciated assets See Exhibit D (in context of Delaware Tax Trap) Complexity of administration Restrict the exercise of the power by spouse Testamentary GPA creditor exposure Davis & Willms, PLLC,

14 Husband and wife each create inter vivos QTIP Trusts On death of first spouse, QTIP Trust f/b/o deceased spouse becomes Bypass Trust for Grantor Spouse Hoped for result: Bypass Trust that is grantor trust as to surviving spouse Trustee can sell low basis assets with gain taxed to surviving grantor Grantor can swap high basis assets into trust in exchange for low basis assets Blattmachr et al.: Perhaps grantor trust assets get second basis adjustment at grantor's death (but Cf. CCA ) Davis & Willms, PLLC, Have Trustee distribute low basis assets to surviving spouse (p. 13) 11. Decant appreciated assets to estate tax includable trust (pp ) 12. Make (even very) late QTIP election (p. 15) Davis & Willms, PLLC,

15 Need only grant surviving spouse a special power of appointment (SPA) Spouse exercises SPA over appreciated assets to "spring" the trap. To spring the trap, one must: 1. Exercise a power of appointment 2. To create a second power of appointment 3. Which under local law can be validly exercised 4. To postpone vesting of estate or interest in (or suspend absolute ownership or power of alienation over) property 5. for a period ascertainable without regard to the date of the creation of the first power Common law: Granting someone a "presently exercisable general power" (PEG power) does this (See Exhibit D) Exercise = Estate tax inclusion = Basis step up! Davis & Willms, PLLC, Bypass Trust language only requires granting special power of appointment to first power holder Check your Rule Against Perpetuities savings language Costs of springing the trap: Assets subject to PEG power holder's creditors Trust income likely taxed to PEG power holder Distributions to others may be gift by PEG power holder Estate tax inclusion for PEG power holder Loss of GST tax exemption Assets may get step up or step down at power holder's death Moral: Choose your power holder carefully Davis & Willms, PLLC,

16 14. Transmute separate property into community property (pp ) 15. Give away low basis assets (p. 23) Gifted property re inherited within one year of death receive no basis adjustment 16. Grant GPA to terminal person (p. 23) 17. Swap high basis assets into grantor trust (p. 23) 18. Capture capital losses (p. 23) Selling depreciated assets avoids step down Can offset other gains, but lose net capital losses at death Davis & Willms, PLLC, Junior creates trust and gives or "sell" low basis assets to trust Trust grants low net worth senior beneficiary general power of appointment over appreciated assets GPA results in basis adjustment at death of senior RESULT: Assets pass back into creditor proof, estate tax exempt, GST tax exempt trust f/b/o junior, with new cost basis, without estate tax or gift tax Davis & Willms, PLLC,

17 Consider amending existing partnerships to minimize discounts at death Allow executors of deceased partners to require Section 754 election Grant less wealthy individuals "put" at death at liquidation value Proposed Treas. Reg may impact discounts when final (more about this later) Davis & Willms, PLLC, Intra Family Loans (pp ) Outright Gifting (pp ) Irrevocable Life Insurance Trusts (pp ) Sale to Intentionally Defective Grantor Trust (pp ) Accidentally Perfect Grantor Trusts (pp ) Grantor Retained Annuity Trusts (pp ) Qualified Personal Residence Trusts (pp ) Charitable Lead Annuity Trusts (pp ) Health and Education Exclusion Trusts (HEETs) (pp ) Self Cancelling Installment Notes (pp ) Private Annuities (pp ) The Preferred Partnership "Freeze" (pp ) Davis & Willms, PLLC,

18 Easy to understand IRS interest rates continue to be low Use term loans with stated interest Interest may generate taxable income to lender Consider using mortgage to make interest deductible to borrower Consider using grantor trust as borrower Davis & Willms, PLLC, Easy to understand Annual exclusion gifts and the power of compounding Giving discounted assets Larger gifts within gift tax exemption Effect of paying gift tax Post gift income shifted to donee Note: Carry over basis Davis & Willms, PLLC,

19 Est. of Bright v. Comm'r (658 F.2d 999, 5th Cir. 1981) (minority discount allowed for 50% CP interest) Est. of Harrison v. Comm'r 52 T.C.M (1987) (ignore voting rights lapsing at death for estate tax value) Response: Chapter 14 and Section 2704 (11/5/90) Rev. Rul (sole shareholder giving 20% interest to each of 5 children gets minority discount) Chapter 14 Regulations (1/28/92): Voting rights don't "lapse" if held by others after transfer Give effect to restrictions not greater than default state law Davis & Willms, PLLC, Applies to transfers between family members of interests in family controlled business entities Disregard any restriction preventing holder from: compelling liquidation or redemption of interest being paid within 6 months for cash or property (excluding most notes) in amount at least equal to "minimum value" "Minimum value": interest's pro rata share of net fair market value of assets of the entity Applies only if restriction can be eliminated by transferor or family (counting only "Gryphons"*) Not strict no discount value, but closer to it *Gryphon=owner holding 10% for 3yrs with 6 month put right, if family holds 80% Davis & Willms, PLLC,

20 Member of the Family: individual's spouse, ancestor or lineal descendant of individual or spouse, brother or sister of individual, and any spouse of the foregoing. Thus, e.g., cousins, nieces and nephews are not members of the family. Nonfamily Member (Gryphon): person other than a family member who: holds interest for at least 3 years prior to transfer owns 10% of total value of entity has combined ownership with other nonfamily members 20% of total value of entity has a put right (min. value, 6 mo., cash or property) Davis & Willms, PLLC, Applies to liquidation of business entity itself (not "interests") Ignore any provision that: effectively limits the ability of business to liquidate IF after transfer, restriction lapses or can be removed by transferor or member(s) of transferor's family does not apply to mandatory restriction imposed by federal or state law, i.e. can't be waived Exclusion of "imposed or required to be imposed by any Federal or State law" no longer means just "more restrictive than" Interests held by non Gryphons are ignored Davis & Willms, PLLC,

21 Transfer of interest more than 3 years before death resulting in lapse of voting or liquidation right is ignored if right not restricted or eliminated upon transfer Lapse of voting or liquidation right within 3 years of death treated as occurring on transferor's death, AND results in inclusion in transferor's gross estate WARNING: Unclear whether effective date applies to actual transfer or to transfer treated as occurring at transferor's death Transfer of interest that becomes assignee interest is lapse Post transfer liquidation rights are fixed by local law and governing documents, but ignore applicable and disregarded restrictions, and interests held by non Gryphons Amount included in estate is value of interest before lapse less value of interest after lapse Davis & Willms, PLLC, Controlled Entity: corporation, partnership, or other business entity or arrangement controlled by transferor, applicable family members, and/or any lineal descendants of parents of transferor or transferor's spouse Form of the entity determines test for control: Corporation: 50 % of total voting power or fair market value of equity interests Partnerships: 50 % of either capital interests or profits interests Limited partnerships: any equity interest as a general partner Other entities: 50 % of either capital interests or profits interests, or any equity interest that can cause any liquidation Applicable Family Members: for control purposes, defined in Section 2701 to include Members of the Family plus lineal descendants of parents of transferor or transferor's spouse (but not their spouses) Davis & Willms, PLLC,

22 Does Family Control Entity 2 Before Transfer? No 2704 Doesn t Apply Apply "Generally Applicable Valuation Principles" Decision Tree for Sections and Proposed Regulations Transfers of Interests to Family Members 1 Yes Consider Restriction Is Restriction Created after 10/8/90? No Ignore Applicable Restriction Ignore Disregarded Restriction Consider Restriction *Put = right to receive Minimum Value on 6 months' notice for cash, property or Qualified Note + Yes Commercially Reasonable? Required by Law? 2703 Applies? or All Holders Have Put*? Yes No Minimum Value = interest's % share of net value of entity on date of liquidation or redemption No All or Part of Entity Interest Does in Entity Restriction Affect Liquidation of Entity or Interest? Does Restriction Lapse or Can it Be Removed by Family 3? Yes Does Restriction Limit Right to Receive Minimum Value on 6 Yes Month Notice for Cash, Property or Qualified Note +? No Gryphon = a 10%, 3yr non family 1 member owner with a Put* if non family 1 members own 20% of business 1 Family Member = transferor/spouse, ancestor/descendant of transferor or spouse, sibling of transferor, or spouse of foregoing 2 Controlled Entity = control by Family Members and/or descendants of parent of transferor or transferor's spouse 3 Includes Family Members 1 and transferor's estate No Does Restriction Lapse? Yes No Can Restriction Be Removed? Yes Can "Gryphon" Prevent Removal of Restriction? Yes No + Qualified Note = issued by unrelated persons or entity if active trade or business and 60% = non passive assets; adequately secured, periodic payments, market interest, FMV = liquidation proceeds Davis & Willms, PLLC, 2016 Life insurance death benefit is included in insured's taxable estate if insured owns or controls the policy No estate tax if insured has no "incidents of ownership" Child owned insurance vs. ILIT Transfers of existing policies the three year rule Avoiding the three year rule: Have new insurance acquired by ILIT from inception Transfer of existing policy for "an adequate and full consideration in money or money s worth" Avoiding the "transfer for value" rules Other ideas for life insurance Davis & Willms, PLLC,

23 Sale and interest on note ignored for income tax purposes Trust must be credit worthy Best when appreciation exceeds AFR Best if sold assets appreciate rapidly Best if asset cash flow services the debt Can allocate GSTT exemption to trust Respect the transaction Davis & Willms, PLLC, Shifting wealth to older generation family members is no longer taboo Place property into trust to avoid senior's creditors and maintain control Junior can create grantor trust and give or "sell" low basis assets to trust Trust grants GPA over appreciated assets to low net worth senior beneficiary Davis & Willms, PLLC,

24 GPA results in basis adjustment at death of senior beneficiary If power is not exercised, trust remains grantor trust as to junior If power is exercised, trust becomes complex trust Limited by depreciation or depletion Allocate senior beneficiary's GST exemption RESULT: Assets pass back into creditor proof, estate tax exempt, GST tax exempt trust f/b/o junior, with new cost basis, without estate tax or gift tax Davis & Willms, PLLC, Expressly sanctioned by Code and Regulations Work whenever appreciation exceeds IRC 7520 rate Short term vs. Long term GRATs Best if gifted assets appreciate rapidly Best if annuity payments not made in kind Davis & Willms, PLLC,

25 Trust pays annuity to charity for number of years or lifetime; remainder passes to noncharities Gift to non charities is future interest so no annual exclusion IRS assumes assets will grow at 7520 rate "Best of" current or two preceding months rate Annuity and amount of taxable gift are valued at time of funding not at end of charitable term Can be inter vivos or testamentary Davis & Willms, PLLC, Income tax options at set up: Non Grantor Trust: no charitable deduction; trust pays tax on income less charitable deduction Grantor Trust: up front charitable deduction; Grantor pays all tax on trust income Grantor Trust risk: Upon termination of grantor trust status before term, must recapture part of income tax deduction May allocate GST exemption at funding but not finally determined until termination exemption grows at 7520 rate Transferred assets Caution about using closelyheld business interests or debt financed property Excess business holding and self dealing rules Davis & Willms, PLLC,

26 Health and Education Exclusion or 2503(e) Trust Provides for grandchildren or more remote beneficiaries without using GSTT exemption Qualified payments under 2503(e) (education and medical) aren't taxable gifts and therefore aren't GST taxable transfers Problem: Gift to trust for grandchildren alone is direct skip which is GST transfer, even if trust funds are later used for non taxable expenses Davis & Willms, PLLC, Trust for grandchildren plus non skip person (e.g., charity) is not a GSTT transfer Distributions from trust that are qualified transfers are not subject to GST tax Non skip beneficiary's interest must be significant No charitable deduction since not a CRT or CLT Creative uses: HEET as a remainder beneficiary of a GRAT or CLT? HEETs targeted in Administration's "Greenbook" Davis & Willms, PLLC,

27 Involves transfer of common interest, retention of preferred interest in family controlled entity Applicable retained interest per IRC 2701 Distribution or liquidation right, put, or call Valued at zero unless exception applies Exception to applicable retained interest rules if preferred interest provides for qualified payment Qualified payment Fixed annual payment Paid within 4 years or accrues interest Davis & Willms, PLLC, Technique Comparison Income to Grantor Decreases Estate Basis Adjust GST Funding? Outright Gifts N Y 1 N N N/A ILIT N Y Y Y N/A 9 Sale to Kids Y Y 1 Y 2 N Note Sale to Non Gr Trust Y Y 1 Y 2 Y Note Sale to IDGT Y Y 1 N 3 Y Note Accidentally Perfect Gr Trust Y Y 1 Y 5 Y Note GRAT Y Y 1 N N 6 Annuity 8 QPRT N Y N N 6 Occupancy 8 CLT N Y N Y 7 Remainder? CRT Y Y N 4 N 4 Ann. or uni. HEET N Y N Y N/A Private Annuity Y Y, maybe N Y Annuity SCIN Y Y, maybe Maybe Y Note SLAT? Y N Y N/A 1 By appreciation 6 Not until end of ETIP 2 But at cost of capital gain recognition 7 Funding amt plus growth at AFR, can allocate more at end of term 3 While grantor trust status stays in place 8 During initial term; with QPRT, rent obligation unless repurchase 4 Doesn t matter 9 Hedge technique 5 At death of power holder (not at time of transfer), plus 1014(b)(9) issue 27