BASIC ESTATE PLANNING FOR YOU AND YOUR CLIENTS

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1 BASIC ESTATE PLANNING FOR YOU AND YOUR CLIENTS I. INTRODUCTION The purpose of this manuscript is to revisit basic estate planning concepts and techniques. The manuscript will revisit basic estate planning regarding apportionment of the estate between the marital deduction and the credit shelter share; revisit basic estate planning with respect to disposition of the marital deduction share; and revisit basic estate planning with respect to disposition of the credit shelter share. In addition, this manuscript will review the Statutes and Regulations on portability. The manuscript is only a primer. Complete and exhaustive works on virtually every aspect of estate planning are available. The author relied heavily on three treatises which deserve special mention: (i) Covey, Marital Deduction and Credit Shelter Dispositions and the Use of Formula Provisions (United States Trust Company of New York, 1984), hereinafter referred to as "Covey"; (ii) Bittker, Federal Taxation of Income, Estates and Gifts (Warren, Gorham & Lamont, 1984), hereinafter referred to as "Bittker"; and (iii) Stephens, Maxfield, Lind and Calfee, Federal Estate and Gift Taxation (Warren, Gorham & Lamont, 1983), hereinafter referred to as "Stephens". For purposes of this manuscript, and unless otherwise indicated: references to "Section" are to the Internal Revenue Code of 1986; references to "Regulations" sections are to the pertinent estate and gift tax regulations to the Internal Revenue Code of 1986; references to "estate tax" are to the Federal estate tax imposed by Chapter 11 of the Internal Revenue Code of 1986; references to "gift tax" are to the Federal gift tax as imposed by Chapter 12 of the Internal Revenue Code of 1986; and references to "GST tax" are to 1

2 the Federal generation skipping tax as imposed by Chapter 13 of the Internal Revenue Code of II. UNIFIED CREDIT AGAINST DEATH TAX A. Unified Credit. The Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 ("TRA 2010") and the American Taxpayer Relief Act of 2012 ("ATRA") significantly increased the amount of the unified credit afforded under Section In 2010, the unified credit increased to $1,730, and the exemption equivalent increased to $5,000, The unified credit is non-refundable. The unified credit must be reduced with respect to gifts made after September 8, 1976, and before January 1, A schedule of transfer tax credits and exclusion amounts is included herewith as Exhibit A. B. Applicable Exclusion Amount. A credit is a dollar for dollar offset against tax. The applicable exclusion amount is the dollar value of property which may be sheltered from tax by a given credit. The gross estate tax on a $5,340, taxable estate is $2,081,800.00, against which the current Section 2010 credit of $2,081, could be applied, resulting in zero estate tax liability. Thus, the application of the unified credit will afford the estate owner the opportunity to pass $5,340, (the applicable exclusion of the unified credit) free from estate tax, to persons other than his surviving spouse. C. Unified. Section 2010 creates a unified credit that is allowed against estate tax and Section 2505 contains an identical credit allowed against gift tax. While there are two separate credits specified in the Internal Revenue Code, the credits are, in fact, unified. Any credit used to offset gift tax will not be available at death to offset death tax. Thus, the unified credit may be utilized to shelter from estate tax and gift tax both lifetime transfers and death transfers, in the total aggregate amount of $5,340, The 2

3 unified credit applies to shelter any otherwise taxable transfer. The use of the unified credit during life to shelter otherwise taxable gifts is mandatory rather than elective. Section 2505(a)(2). The mechanism by which this unification was accomplished is the concept of adjusted taxable gifts. Adjusted taxable gifts are defined in Section 2001(b) as the total amount of taxable gifts (within the meaning of Section 2503) made by the decedent after December 31, 1976, which are not otherwise includable in the decedent's gross estate. Taxable gifts are gifts after gift-splitting allowed by Section 2513, exclusions allowed by Section 2503, and deductions allowed by Section 2522 and Section Gifts included as adjusted taxable gifts are to be valued at their fair market value as of the date of the gift. III. PORTABILITY On January 15, 2012, the Service issued temporary regulations that provide guidance on the estate and gift tax applicable exclusion amount, in general, as well as on the applicable requirements for electing portability of a deceased spousal unused exclusion (DSUE) amount to the surviving spouse, and on the applicable rules for the surviving spouse's use of this DSUE amount. The statutory provisions underlying the portability rules were enacted as part of TRA The portability rules affect married spouses where the death of the first spouse to die occurs on or after January 1, The text of the temporary regulations also serves as the text of proposed regulations. See Exhibit B included herewith. IV. MARITAL DEDUCTION A. Federal Statute. Section 2056(a) provides: "For purposes of the tax imposed by Section 2001, the value of the taxable estate shall, except as limited by Subsection (b), be determined by deducting from the value of the gross estate an amount equal to the value of any interest in property which passes or has passed from 3

4 the decedent to a surviving spouse, but only to the extent that such interest is included in determining the value of the gross estate." B. Origin. The forefather of the current marital deduction came on the scene in The stated purpose of the original marital deduction was to equalize the effect of estate taxes in community property and common law jurisdictions. Under a community property system, the spouse receives outright ownership in one-half of the community property and only the other one-half is included in the decedent's estate. Thus, the primary thrust of the early marital deduction was to extend to taxpayers in common law states the advantages of "estate splitting" otherwise available only in community property states. Under the 1948 Act, the marital deduction was generally limited to one-half of the decedent's "adjusted gross estate". The Tax Reform Act of 1976 liberalized the deduction limit. The limitation on the deduction was expanded to the greater of $250,000.00, or one-half of the decedent's adjusted gross estate. The Economic Recovery Tax Act of 1981 abolished the limit on the amount of the marital deduction entirely, allowing unlimited interspousal transfers of deductible property interests between spouses. C. Deferral. Ostensibly, the marital deduction permits a deferral of estate tax from the death of the first spouse to die until the death of the surviving spouse. Thus, the marital deduction can be viewed as a device for deferring, rather than eliminating a couple's tax liability. Deferral, per se, has no advantage. However, many things can happen after the death of the first spouse to die to reduce or eliminate the "deferred estate tax." The property transferred via the marital deduction may be consumed in living expenses; the subject property may be given away via annual exclusion gifts or via the unlimited exclusion for tuition and medical expenses; the subject property may be lost, or squandered; and the subject property may be sheltered from all estate tax by virtue of 4

5 the surviving spouse's unified credit, and the DSUE amount. Deferral in these situations becomes avoidance. V. APPORTIONMENT - FORMULA CLAUSES A. In General. When a decedent is survived by a spouse, estate tax may be avoided through the use of the unified credit and other credits, or the marital deduction, or both. Thus, through proper planning, an estate owner who is survived by a spouse will be able to insure that no estate tax is levied upon his death. The basic choice is between relying on the marital deduction in conjunction with portability; or utilizing the unified credit (applicable exclusion amount) in conjunction with the marital deduction. A credit shelter disposition does not require inclusion of the affected property in the surviving spouse's estate for estate tax purposes. However, a credit shelter disposition will not receive a step-up in basis at the surviving spouse's death. A marital deduction disposition will be included in the surviving spouse's estate for estate tax purposes. Accordingly, the marital deduction disposition will receive a step-up in basis at the surviving spouse's death. Where the unified credit and marital deduction are utilized, estate planners have become accustomed to apportioning the estate owner's estate between a credit shelter share and a marital deduction share, in order to eliminate the imposition of estate tax upon the death of the first spouse to die. The apportionment gives preference to the credit shelter share so as to pass as a marital deduction distribution the minimum amount required to eliminate payment of any estate tax upon the death of the first spouse to die. Thus, the credit shelter share is to be fully funded, if possible, prior to funding of the marital deduction share. The primary thrust of "standard apportionment" is to: (i) shelter the maximum amount of property by use of the unified credit and dispose of the sheltered property in such 5

6 a way as will not subject it to estate tax in the surviving spouse's estate (hereinafter referred to as the "credit shelter share"), and (ii) dispose of the balance of the estate to the surviving spouse in a manner qualifying for the marital deduction and thus insure that this property is sheltered from estate tax in the estate of the first spouse to die (hereinafter referred to as the "marital deduction share"). The preference given to the credit shelter share will effect the surviving spouse's elective share rights. In making a decision as to whether or not standard apportionment should be followed, the draftsman must consider the surviving spouse's right of dissent. 1. $5,340, Rule. If the combined net worth of both spouses is $5,340,000.00, or less, no estate tax will be payable by either spouse, even if both spouses leave whatever they own to the survivor, and even if no portability election was made at the death of the first spouse to die. No estate tax will be payable whether the unified credit or the marital deduction is used to shelter property, regardless of the size of the separate estates of the spouses, and regardless of the order of death of the spouses. Generally, where the net worth of both spouses is $5,340,000.00, or less, there is no need for apportionment in either estate, and no need for the portability election at the death of the first spouse to die. 2. $10,680, Rule. If the net worth of both spouses is greater than $5,340,000.00, but not greater than $10,680,000.00, proper estate planning is still essential to insure that no estate tax will be payable by either spouse. In such a case, the amount of estate tax payable on the death of either or both of the spouses will be dependent upon whether the unified credit or portability is used to shelter property, the size of the respective estates of the spouses, and the order of deaths. Through utilization of the unified 6

7 credit by both spouses, or portability, as much as $10,680, can pass free from estate tax at their deaths, on to their children or other beneficiaries. Proper planning in such a case may require apportionment of one or both of the spouses' estates, and perhaps inter vivos gifts in order to equalize the assets in the hands of the spouses, and perhaps the portability election at the death of the first spouse to die. 3. $10,680, Rule. Once the combined net worth of both spouses exceeds $10,680,001.00, testamentary drafting, utilizing the unified credit and the marital deduction, and/or the marital deduction and portability will not be effective to eliminate estate tax upon the death of both spouses. When the combined net worth of both spouses exceeds $10,680,001.00, charitable bequests by the spouses and/or inter vivos gifts by the spouses to children and third parties take on more importance. 4. $20,000,000, Rule. Regardless of the size of the estate of the first spouse to die, all estate tax can be eliminated through use of the unified credit and the unlimited marital deduction. Regardless of the size of the estate of the last spouse to die, all estate tax can be eliminated through use of unified credit and the unlimited charitable deduction. B. Apportionment Methods. If separate dispositions of the credit shelter share and the marital deduction share are to be made, the estate must be apportioned in some fashion. There are three possible methods of apportioning the estate into the credit shelter share and the marital deduction share: (i) the credit shelter may be expressed as a pecuniary amount and the marital deduction as a residuary disposition; (ii) the marital deduction may be expressed as a pecuniary amount and the credit shelter as a residuary disposition; or 7

8 (iii) the credit shelter and the marital deduction may each be expressed as fractional shares of the residuary estate. Covey, P Pecuniary Apportionment. A pecuniary disposition gives the beneficiary a specific dollar amount. The simplest pecuniary bequest is a non-formula bequest, for example: "$100, to my spouse, if she shall survive me." A formula pecuniary bequest is a slight variation in which the sum is determined pursuant to a formula. An example of a formula pecuniary bequest is a bequest to the surviving spouse of: "the smallest sum that can pass to my surviving spouse and will result in the lowest federal estate tax on my estate". Whether the apportionment is in the form of a formula or non-formula pecuniary bequest, the effect is to establish a specific obligation which the executor or trustee must satisfy. The following factors should be considered: (i) A pecuniary bequest to the surviving spouse, with the remainder of the estate to the credit shelter share, and with the valuation of property distributed in kind to be made on the date or dates of distribution, shifts post-death appreciation from the surviving spouse to the credit shelter share beneficiaries, who, however, are also called upon to absorb post-death shrinkage in value. (ii) A pecuniary bequest of the credit shelter share, with the remainder of the estate to the surviving spouse, and with the valuation of property distributed in kind to be made on the date or dates of distribution, shifts post-death appreciation from the credit shelter share to the surviving spouse; and the surviving spouse will also be called upon to absorb post-death shrinkage in value. 8

9 (iii) A pecuniary bequest, whether a marital or credit shelter bequest, remains constant in value and does not share or receive gains and losses, realized and unrealized, during the period of administration. (iv) A pecuniary bequest of the marital or credit shelter share, with the residuary estate representing the portion allocated to the other share is substantially easier for the personal representative to administer than a fractional share disposition. (v) Satisfaction of a pecuniary bequest with appreciated assets will generate taxable gain to the estate. (vi) Satisfaction of a pecuniary bequest with an item of income in respect of a decedent (IRD), will result in acceleration of the income reportable. (vii) A formula pecuniary bequest does not qualify as a Section 663(a)(1), "specific bequest." Regulations, Section 1.663(a)-l(b)(1). 2. Fractional Share Apportionment. A fractional share disposition is a disposition of some fractional part of the residuary estate or trust property. Again, the fractional share disposition may be a formula or non-formula bequest. A simple non-formula fractional share bequest would be a bequest of: "one-half of my residuary estate", OR "the smallest fractional share of my residuary estate which will result in the lowest federal estate tax on my estate." The formula fractional share bequest varies from the straight fractional share approach only in that the fraction is fixed by a formula. The primary difference between a pecuniary amount bequest and a fractional share bequest is that the latter shares in gains and losses, realized and unrealized, during the period of 9

10 administration while a pecuniary amount bequest remains constant in value. When the credit shelter and marital deduction dispositions are each a fractional share of the residuary estate, the gains and losses during the period of administration are allocated in proportion to the respective shares. The fractional share disposition is more difficult for the personal representative to administer than the pecuniary amount disposition. The personal representative may be required to recompute the fraction and revalue estate assets with virtually every distribution, unless the distributions are made pro rata. 3. Revenue Procedure In Revenue Procedure 64-19, (Part 1), C.B. 682, the Treasury announced that it would not allow the marital deduction in the case of a pecuniary bequest to a spouse, unless certain conditions were met. The Procedure deals only with pecuniary bequests and does not apply to transfers of specific assets or a fractional share apportionment of the estate. In essence, the Procedure provides that no marital deduction will be allowed if the fiduciary is required or has an opportunity to satisfy the marital bequest by a transfer of property in kind, using estate tax values, unless applicable state laws or the provisions of the instrument require the fiduciary to distribute to the surviving spouse either: (i) assets having an aggregate fair market value, upon the date or dates of distribution, not less than the amount of the pecuniary bequest as finally determined for federal estate tax purposes; or (ii) assets fairly representative of appreciation or depreciation in the value of all property available for distribution in satisfaction of the pecuniary bequest. The prohibited leveraging which is condemned in Revenue Procedure can occur when any non-marital pecuniary bequest is placed "in front of" a residuary marital disposition, if the non-marital pecuniary bequest does not comply with Revenue Procedure

11 4. Planning. In choosing among one of the three possible alternative apportionment methods, a number of factors must be considered. Choice of a pecuniary amount marital deduction bequest with the credit shelter share as the residuary disposition may result in a very favorable shifting of post-death appreciation to the credit shelter beneficiaries. Just as post-death appreciation in assets would inure to the benefit of the credit shelter beneficiaries, post-death depreciation would work to their detriment. It should be noted that the alternate valuation date provided for in Section 2032 will not afford an "escape valve" for a personal representative, where he must fund a pecuniary marital deduction bequest with assets that have depreciated during the estate administration. The alternate valuation date cannot be elected unless the election will decrease both the value of the gross estate, and the sum of the estate tax and the generation skipping tax. Section 2032(c). In estates of $8,000, and under, choice of a fractional share disposition of the credit shelter share and the marital deduction share appears to be the more conservative course of action. The potential of shifting post-death appreciation to the credit shelter share is not available, but neither is the danger attendant with a pecuniary amount marital deduction bequest if estate assets should depreciate in value. As stated earlier, a pecuniary amount disposition can result in unanticipated "Kenan Gain". Kenan vs. Commissioner, 114 F.2d 217 (2d Cir. 1940) can be cited for the general proposition that there is a realization of income where a fixed obligation is discharged by a transfer of appreciated property. The Service ruled in Revenue Ruling , C.B. 243, that an estate would realize Kenan Gain where appreciated assets were used to fund a pecuniary bequest, even though the available assets were insufficient to completely satisfy the full amount of the pecuniary bequest. As a rule of thumb, it has been suggested that in order to avoid the Kenan Gain problem, a pecuniary disposition of either the 11

12 marital deduction share or credit shelter share should be avoided if such share may exceed one-fourth of the estate assets. Covey, p Where the pecuniary disposition, either marital or credit shelter, is small in proportion to the disposable estate, a pecuniary disposition of the smaller share may be attractive since it is easier to administer than fractional share apportionment. VI. DISPOSITION - MARITAL DEDUCTION SHARE A. In General. By virtue of the operation of the terminable interest rule, and its exceptions, an estate tax marital deduction may be had for the full value of all property interests passing to the surviving spouse: (i) outright, (ii) pursuant to a Section 2056(b)(5)trust requiring distribution of income to the spouse and a general power of appointment in the spouse, (iii) pursuant to a Section 2056(b)(7) QTIP trust, (iv) pursuant to a Section 2056(b)(8) charitable remainder trust, (v) pursuant to an estate trust, or (vi) pursuant to a qualified domestic trust. B. Outright Bequest. An outright bequest to the surviving spouse has much to recommend it as a method of disposing of the marital deduction share. The basic choice is between an outright disposition and a disposition in trust. This basic choice is influenced by mostly non-tax factors, including the business acumen of the surviving spouse, trustee's fees, susceptibility of the surviving spouse to undue influence, the possibility of the surviving spouse's remarriage, the availability of funds for a gifting program by the surviving spouse, etc. C. Section 2056(b)(5) Trust. The life estate with general power of appointment trust is a tried and true technique in the estate 12

13 planner's arsenal. The salient characteristic, as compared to other trust dispositions, is that the surviving spouse, via her general power of appointment, has the power to dispose of the trust property. D. Section 2056(b)(7) Trust/QTIP Trust. The QTIP trust affords the decedent a marital deduction for a transfer in trust to the surviving spouse, where the decedent controls ultimate distribution of the trust property. This has much to recommend it in the case of dispositions to a second or successive spouse. By virtue of the election afforded by Section 2652(a)(3), use of a QTIP disposition has an additional transfer tax incentive not available with the other methods of disposing of the marital deduction share. With standard apportionment between the credit shelter share and the marital deduction share on the death of the first to die, the maximum amount of the decedent's GST exemption (Section 2631) that can be claimed against the credit shelter share is $5,340, If the decedent has adjusted taxable gifts, his remaining credit shelter share may be less than his remaining GST exemption. Thus, part of the decedent's GST exemption will be lost unless the decedent pays estate tax on an amount sufficient to make full use of the GST exemption, or creates a QTIP trust and makes the special election under Section 2652(a)(3). By virtue of Section 2652(a)(3), the decedent creating the QTIP trust may elect to be treated as the "transferor" of such trust for purposes of the generation skipping tax. Such an election would allow the decedent maximum use of his GST exemption in conjunction with standard apportionment. E. Charitable Remainder Trust. When the decedent desires the marital deduction share to pass to charity upon the surviving spouse's death, he has two choices. He may establish a Section 2056(b)(8) charitable remainder trust, or a Section 2056(b)(7) QTIP trust. 13

14 F. Estate Trust. An estate trust is a trust under which corpus and accumulated income are payable to the estate of the surviving spouse. In contrast to a Section 2056(b)(5) trust or a Section 2056(b)(7) trust, an estate trust does not require that income be distributed at least annually to the surviving spouse. Part or all of the income may be accumulated. Upon the death of the surviving spouse, all of the trust property, including accumulated income, must be paid to the surviving spouse's estate. Since no person other than the surviving spouse has an interest in the trust property, the terminable interest rule is not applicable. Revenue Ruling, , C.B. 412, holds that an estate trust qualifies for the marital deduction. The estate trust permits the use of the trust as a separate income taxpayer. G. Qualified Domestic Trust. Section 2056(d) disallows the marital deduction where the surviving spouse is not a citizen of the United States. Section 2056(d) further specifies that a marital deduction is allowable, even though the surviving spouse is not a citizen of the United States, where the marital bequest passes to a qualified domestic trust ("QDT"). Section 2056A defines qualified domestic trust, and gives the requirements therefor. A qualified domestic trust is one where: (i) the trust instrument requires that at least one trustee be an individual citizen of the United States or a domestic corporation, and further provides that no distribution (other than distribution of income) may be made from the trust unless a trustee who is an individual citizen of the United States or domestic corporation has a right to withhold from such distribution the tax imposed by Section 2056A on such distribution; (ii) the trust meets further requirements as may be set forth by the Secretary of Revenue by regulations; and (iii) an election is made by the executor to have such trust qualify as a QDT. Care must be taken to verify the citizenship of both spouses. A QDT is the only method of disposition for which an estate tax marital 14

15 deduction is available for a surviving spouse who is not a United States citizen. VII. DISPOSITION - CREDIT SHELTER SHARE A. In General. The application of the unified credit will afford the estate owner the opportunity to pass $5,340, (the applicable exclusion amount or the exemption equivalent of the unified credit) free from estate tax, to persons other than his surviving spouse. The unified credit applies to shelter any otherwise taxable transfer. Thus, the credit shelter share disposition does not require inclusion of the affected property in the surviving spouse's estate for estate tax purposes. In fact, if the net worth of both spouses is greater than $10,680,000.00, disposition of the credit shelter share should be accomplished in such a way as to insure that the affected property is not included in the surviving spouse's estate for estate tax purposes. B. Outright Bequest. An outright bequest to persons other than the surviving spouse has much to recommend it as a method of disposing of the credit shelter share. The basic choice is between an outright disposition and a disposition in trust. Typically, the testator will have the credit shelter share earmarked for ultimate distribution to his issue. An initial decision must be made by the spouses as to whether or not the surviving spouse needs to be a beneficiary of the credit shelter share. That is, an initial decision must be made by the spouses as to whether or not the separate property of the surviving spouse, plus the marital deduction share passing to the surviving spouse from the first to die, will be sufficient (exclusive of the credit shelter share set aside by the first to die) to sustain the surviving spouse. For example, if both spouses have separate estates of $6,340,000.00, it would be fair to assume that the surviving spouse would not need to be a beneficiary of the credit shelter share passing at the death of the first to die. This is because 15

16 the separate estate of the surviving spouse ($6,340,000.00) plus the marital deduction share passing for the benefit of the surviving spouse at the death of the first to die ($1,000,000.00) should be sufficient to sustain the surviving spouse, exclusive of the credit shelter share ($5,340,000.00) set aside by the first to die. C. By-Pass Trust. In more modest estates, the spouses may determine that the credit shelter share passing at the death of the first to die must be made available to the surviving spouse, if he or she should need the same. In such a case, the credit shelter share is typically placed in trust for the surviving spouse. This trust is commonly known as the "by-pass trust". The by-pass trust is drafted to insure that the affected property, i.e. the credit shelter share set aside by the first to die, will not be included in the surviving spouse's estate for estate tax purposes. The by-pass trust will typically take the form of a spousal trust, pot trust, or separate trusts for spouse and issue. D. Spousal Trust. A spousal trust is one in which the only beneficiary is the surviving spouse. The trust may provide that all of the income is paid to the spouse monthly, quarterly, or at such other convenient installments as may be directed by the surviving spouse. Typically, the trustee has the discretion to distribute principal to the surviving spouse for specified purposes, i.e. health, maintenance, and support. Alternatively, the spousal trust may provide that income and/or principal may be distributed to the surviving spouse in the trustee's discretion, for the specified purposes. Under such arrangement, the Trustee could decide to accumulate income, rather than pay it to the surviving spouse. Such income accumulation would mean that the separate tax rates of the spousal trust apply. Of course, with the compression of the trust and estate income tax rates, income accumulation in an estate or trust is much less attractive. The surviving spouse may be given a special power of appointment (but not a general power of appointment) over 16

17 the spousal trust. The special power of appointment may be to appoint the trust income or principal to anyone other than the surviving spouse, his creditors, his estate, or the creditors of his estate. However, most often the surviving spouse is given a more limited special power of appointment to appoint only to children or more remote issue of the testator. Upon the death of the surviving spouse, the spousal trust will typically terminate and the remaining income and corpus will be distributed to the ultimate beneficiaries, i.e. children and grandchildren. E. Pot Trust. As noted above, the only beneficiary of the spousal trust is the surviving spouse. The pot trust is designed so that not only the surviving spouse, but also other beneficiaries, i.e. children and grandchildren, are permissible beneficiaries. The trustee is given discretion to pay income and/or principal to the surviving spouse or to any of the other beneficiaries of the pot trust. The pot trust affords the trustee the ability to "sprinkle" the income generated by the trust among those permissible beneficiaries who have the greatest need. The pot trust also affords the trustee the ability to "spread" the taxable income of the trust among a number of beneficiaries, so as to minimize the income tax associated with such income. As with the spousal trust, the surviving spouse may be given a special power of appointment over the pot trust. As with the spousal trust, upon the death of the surviving spouse, the pot trust will typically terminate and the remaining income and corpus will be distributed to the ultimate beneficiaries, i.e. children and grandchildren. F. Separate Trusts for Spouse and Issue. Alternatively, the credit shelter share can be divided into separate trusts for each of the children, or more remote descendants. For example, if the first to die has three children, the credit shelter share could be divided into three separate trusts of $1,780, each. The beneficiaries of each trust would be the surviving spouse, the child for whom the 17

18 separate trust was set aside, and all of that child's issue. Accordingly, the surviving spouse would be a beneficiary of all three of the separate trusts. Typically, the trustee would be given the discretion to sprinkle income and/or principal from each trust among the permissible beneficiaries of that trust. By establishing separate trusts, the needs and desires of each child can be dealt with separately by the trustee without concern for the impact of a particular distribution on that child's siblings. As with the spousal trust and pot trust, the separate trust would typically terminate upon the death of the surviving spouse. Upon termination, the income and principal remaining in the separate trust will typically be distributed to the child for whom the separate trust was established. Again, as with the spousal trust and pot trust, the surviving spouse may be given a special power of appointment to appoint each of the separate trusts to the child for whom the trust was established, or to his issue. G. Holdback Trust. However when the credit shelter share is to be disposed of, one issue must always be addressed. That issue is at what age should the credit shelter share be distributed outright to the ultimate recipients. As noted, typically the credit shelter share will be earmarked for children and more remote descendants of the testator. The question becomes at what age are the children mature enough to receive an outright distribution of the credit shelter share. Obviously, this decision is influenced by mostly non-tax factors, including the business acumen of the children, trustee's fees, susceptibility of the children to undue influence, the maturity and initiative exhibited by the children, any disability (mental or physical) under which the children may be laboring, etc. As noted above, the spousal trust, pot trust, and separate trusts for spouse and issue usually terminate at the death of the surviving spouse. Those trusts typically provide that the remaining income and/or corpus be distributed to children or more remote issue. Just as 18

19 typically, those trusts will usually provide that if the child or more remote issue has not reached a specified age, his or her share shall be held back in trust until that age is attained. Thus, the term holdback trust is given to the trust designed to hold a beneficiary's share until that beneficiary reaches the specified age. The trustee under the holdback trust is usually given authority to sprinkle income or principal to the beneficiary prior to his or her attaining the specified age. VIII. CHARITABLE DEDUCTION A. Federal Statute. Section 2055 provides that for purposes of the tax imposed by Section 2001, the value of the taxable estate shall be determined by deducting from the value of the gross estate the amount of all bequests, legacies, devises, or transfers to certain charitable entities. The deduction afforded by Section 2055 cannot exceed the value of the transferred property required to be included in the gross estate. Section 2055(d). Also, the amount of the deduction under Section 2055 is to be reduced by the amount of any taxes payable out of the charitable bequest. Section 2055 affords an "unlimited" deduction, for estate tax purposes for bequests passing in a qualified manner to a qualified charity. By far, the most common type of charitable bequest is an outright bequest of a specific sum of money or specific property to a charity. B. Split-Gifts. A partial deduction is allowed for gifts benefiting both charity and non-charitable beneficiaries, in certain limited circumstances. A partial charitable deduction is available for a remainder interest left to charity, where such remainder interest is in trust and the trust constitutes a charitable remainder annuity trust or a charitable remainder unitrust (as described in Section 664) or a pooled income fund (as described in Section 642(c)(5)). A partial charitable deduction is allowed for an income interest payable to charity where such interest is in the form of 19

20 a guaranteed annuity or is a fixed percentage distributed yearly of the fair market value of the property. These restrictions with respect to charitable income interests adopt essentially the unitrust and annuity trust principles applicable to bequests of remainder interests. IX. TAXABLE GIFTS A. In General. Section 2502(a) bases the gift tax computation on the sum of taxable gifts. Section 2503(a) provides as follows: "The term 'taxable gifts' means the total amount of gifts made during the calendar year, less the deductions provided in subchapter C (Section 2522 and following)." Thus, the taxable gifts for the calendar year are arrived at by subtracting from "the total amount of gifts" for the year the deductions authorized by Section 2522 and Section The meaning of the term "gifts" is developed in Section 2511 through Section B. Annual Exclusion. Section 2503(b) provides an exclusion from what must otherwise be included in "the total amount of gifts" for a particular period. In the case of gifts (other than gifts of future interests in property) made to any person by the donor during the calendar year, the first $14, of such gifts to such person shall not be included in the total amount of gifts made during such year. Thus, Section 2503(b) provides a $14, per year, per donee exclusion. This annual exclusion only applies to gifts of a present interest. The Regulations, Section provide that the entire value of any gift of a future interest in property must be included in the "total amount of gifts" for the calendar year in which the gift is made. Said another way, the Regulations, Section (a) provide that no part of the value of a gift of a future interest may be excluded in determining the total amount of gifts made during the calendar year. The Regulations, Section (a) define future interest as follows: 20

21 "'Future interest' is a legal term, and includes reversions, remainders, and other interests or estates, whether vested or contingent, and whether or not supported by a particular interest or estate, which are limited to commence in use, possession or enjoyment at some future date or time...an unrestricted right to the immediate use, possession, or enjoyment of property or the income from property (such as a life estate or term certain) is a present interest in property." C. Trust for Minors. Section 2503(c) provides an exception to the future interest rule for certain transfers for the benefit of minors. If property is gifted in accordance with the requirements specified in Section 2503(c)(1) and (2), the gifted property will be deemed to be a gift of a present interest, thus qualifying for the $14, annual exclusion. The requirements of Section 2503(c) are as follows: (i) the gifted property and the income therefrom may be expended by, or for the benefit of, the donee before he reaches age twenty-one, (ii) to the extent the gifted property and the income therefrom is not so expended, the same will pass to the donee on his attaining age twenty-one, and (iii) in the event that the donee dies prior to attaining age twenty-one, the gifted property and income therefrom will be payable to the donee's estate or as he may appoint under a general power of appointment. D. Crummey Powers. Often the grantor of a trust will wish for his initial funding and any subsequent gifts to the trust to qualify for the annual exclusion. If no beneficiary of the trust has a present interest in the trust corpus or the additions thereto, the annual exclusion will not be available. Crummey powers are powers of withdrawal granted under the trust document to one or more beneficiaries. The purpose of the Crummey powers is to create in the power holder a present interest in the trust, so that transfers by the grantor or other donors will qualify for the annual exclusion. 21

22 E. Exclusion for Tuition and Medical Expenses. Section 2503(e) provides an unlimited exclusion from the total amount of gifts for certain transfers for educational expenses or medical expenses. There is an unlimited exclusion for amounts paid on behalf of an individual as tuition to an educational organization described in Section 170(b)(1)(A)(ii) for the education or training of such individual. Section 2503(e)(2)(A). The educational organization described in Section 170 is one which normally maintains a regular faculty and curriculum and normally has a regularly enrolled body of pupils or students in attendance at the place where its educational activities are regularly carried on. There is an unlimited exclusion for amounts paid on behalf of an individual to any person who provides medical care (as defined in Section 213(d)) with respect to such individual as payment for such medical care. Section 2503(e)(2)(B). To be excludable, the medical expenses and tuition expenses must be unreimbursed. To be excludable, the payments for medical care must be made directly to the one who provides the services. To be excludable, the payments for tuition must be made directly to the educational organization. F. Observations. The annual exclusion is just as generous as it appears and offers substantial and well documented estate planning opportunities. The use of the $14, annual exclusion for several donees and over the donor's life span may result in a very large tax-free transmission of property. The exclusion operates not only to eliminate gifts of $14, or less from total taxable gifts, it also operates to scale down larger gifts. G. Basis. Section 1014(a) provides that the basis of property in the hands of a person acquiring the property from a decedent shall be the fair market value of the property at the date of the decedent's death. The fair market value of the property at the date of the decedent's death is the value at which it is included in the decedent's gross estate. Section 1014(a) does not apply to property 22

23 which constitutes a right to receive an item of income in respect of a decedent under Section 691. Section 1014(c). Section 1014(a) does not apply to appreciated property acquired by the decedent by gift within one year of death, and left back to the donor. Section 1014(e). That is, if the decedent acquired appreciated property within one year of his death by gift, and then that property passes from the decedent, at his death, to the donor of the property (or to the donor's spouse), the basis of such property in the hands of the donor (or the donor's spouse) shall be the adjusted basis of such property in the hands of the decedent immediately before the death of the decedent. Section 1015 provides that the donee's basis in property acquired by gift, for purposes of determining the donee's gain, shall be the same as the basis of the property in the hands of the donor or the last preceding owner by whom it was not acquired by gift. That same Section provides that the donee's basis in property acquired by gift, for purposes of determining loss, shall be the lesser of: (1) the fair market value of the property at the time of the gift, or (2) the basis of the property in the hands of the donor or the last preceding owner by whom it was not acquired by gift. The decedent's beneficiaries generally take, as their basis in property passing from the decedent, a value equal to its fair market value at the date of the decedent's death. Accordingly, if the decedent dies with appreciated property (property with a fair market value in excess of its basis) the decedent's beneficiaries are entitled to a "step-up" in basis in the appreciated property to a value equivalent to its fair market value at the date of the decedent's death. By the same token, if the decedent dies with depreciated property (property with a fair market value which is less than its basis) the decedent's beneficiaries receive a "step-down" in basis equivalent to its fair market value at the date of the decedent's death. Because the decedent's beneficiary may receive a 23

24 step-up in basis at the date of the decedent's death, any potential gain which the decedent would have recognized on a sale of property prior to his death is eliminated. Where a donor, during his lifetime, transfers appreciated property to a donee, the donee must take as his basis in the gifted property the basis of the donor. Accordingly, any gain which the donor would have recognized on a sale of the property is not eliminated by a gift of that property. X. DISCLAIMERS A. In General. Section 2518(a) provides that if a person makes a qualified disclaimer with respect to any interest in property, the transfer tax laws shall apply to such interest as if the interest had never been transferred to such person. Section 2518(b) provides that the term "qualified disclaimer" means an irrevocable and unqualified refusal by a person to accept an interest in property, but only if: (i) the refusal is in writing; (ii) the refusal is received by the transferor within nine months after the later of (a) the date of the transfer, or (b) the date the transferee attains age twenty-one; (iii) the person disclaiming has not accepted any benefits of the transferred interest; and (iv) as a result of the disclaimer the transferred interest passes, without any direction by the person disclaiming, to either the spouse of the descendant, or to a person other than the person disclaiming. B. Observations. The Regulations, Section (c)(3), deal with the nine-month requirement. In the case of transfers made by a decedent at death or transfers which become irrevocable at death, the required time period runs from the date of death. In the case of lifetime gifts, it runs from the date the gift is completed for gift tax purposes. In the case of a general power of appointment, 24

25 the holder has nine months after the creation of the power in which to disclaim. A person to whom the property passes on the exercise or lapse of a general power of appointment has nine months after the exercise or lapse of the power to disclaim. In the case of a special power of appointment, the holder of the power, permissible appointees, and takers in default of appointment must disclaim within a nine-month period after the creation of the power. In the case of a remainder interest in property for which the QTIP election has been made, the remainderman must disclaim within nine months of the transfer creating the interest, rather than nine months from the date such interest is subject to tax under Section 2044 or Section XI. GST TAX - EXCLUDED TRANSFERS A. Nontaxable Gifts Exemption. Any direct skip which is not treated as a taxable gift because of the annual exclusion (including split gifts) or the exclusion for certain tuition expenses or medical expenses, is exempt from the GST tax, because the inclusion ratio is deemed to be zero. Section 2642(c)(1). The exemption from GST tax does not apply to any transfer to a trust for the benefit of an individual, unless during the life of such individual no portion of the corpus or income of the trust may be distributed to any person other than such individual, and if the trust does not terminate before the individual dies, the assets of the trust will be includable in the gross estate of the individual. Section 2642(c)(2). B. $5,340, GST Exemption. Every individual has a GST exemption of $5,340,000.00, which may be allocated by the individual or his executor to any property with respect to which such individual is the transferor. Section 2631(a). C. Prior GST Tax Exemption. There is an exemption for any transfer to the extent: (i) the property transferred was subject to a prior GST tax; (ii) the transferee in the prior transfer was in the same or a lower generation than the transferee in the subject 25

26 transfer; and (iii) the transfer does not have the effect of avoiding the GST tax. Section 2611(b)(2). D. Predeceased Child Exemption. For purposes of determining whether the transfer is a direct skip, if a transferee is a grandchild of the transferor, and at the time of such transfer, the parent of such transferee who is a lineal descendant of the transferor is dead, then the transferee is treated as the child of the transferor. According, the transferee is a non-skip person and therefore the transfer is exempt. All other issue of the transferee are similarly moved up one generation. Section 2612(c)(2). CGJ/rnb #