Portability in Estate Planning: Game Changing Approach to Maximize Tax Benefits? Evaluating Advantages of Portability vs Traditional Bypass Trusts

Transcription

1 Presenting a live 90 minute teleconference with interactive Q&A Portability in Estate Planning: Game Changing Approach to Maximize Tax Benefits? Evaluating Advantages of Portability vs Traditional Bypass Trusts THURSDAY, OCTOBER 10, pm Eastern 12pm Central 11am Mountain 10am Pacific Today s faculty features: George D. Karibjanian, Senior Counsel, Proskauer Rose, Boca Raton, Fla. Richard S. Franklin, Member, McArthur Franklin, Washington, D.C. Lester B. Law, Attorney, Naples, Fla. The audio portion of the conference may be accessed via the telephone or by using your computer's speakers. Please refer to the instructions ed to registrants for additional information. If you have any questions, please contact Customer Service at ext. 10.

2 Portability s Role in the Evolution Away from Traditional By-Pass Trusts to Grantor Trusts By Richard S. Franklin and Lester B. Law This article was originally published in the Bloomberg BNA Tax Management Estates, Gifts & Trusts Journal (March-April 2012). This article is reprinted with permission from Bloomberg BNA Tax Management. For more information, visit Bloomberg BNA Tax Management s website at

3 Portability s Role in the Evolution Away from Traditional By-Pass Trusts to Grantor Trusts by Richard S. Franklin, Esq., and Lester B. Law 1 INTRODUCTION Over the past 30 years, 2 marital planning has evolved. It started with the traditional credit shelter or by-pass trust, 3 which was arguably surpassed by the- 1 Richard S. Franklin, Esq., is a member of McArthur Franklin PLLC in Washington, D.C. He is a member of the District of Columbia and Florida Bars. He is board certified in Wills, Trusts and Estates Law by the Florida Bar. He is a Fellow of the American Council of Trusts and Estates Counsel. He is co-chair of the Estate and Gift Tax Committee of the Income and Transfer Tax Planning Group of the American Bar Association s Real Property Trust and Estate law section (ABA-RPTE-I&TPG-E&G-TC). Lester B. Law is a managing director at U.S. Trust, Bank of America Private Wealth Management. He is board certified in Wills, Trusts and Estate Law by the Florida Bar. He is a vice chair of the ABA- RPTE-I&TPG-E&G-TC. Lester is also active on a few committees for the Florida Bar s Real Property Probate and Trust Law Section. 2 Arguably, in the past 30 years, one of the most significant provisions in estate planning for married couples was the passage of the unlimited marital deduction as part of the Economic Recovery Tax Act of 1981 (P.L ) ( ERTA ). This legislation allowed for the use of credit shelter or by-pass trusts in marital estate planning. The combination of the credit shelter amount and the marital deduction allowed taxpayers to pass assets, upon the deceased spouse s death, in a manner that deferred all estate tax to the time of the surviving spouse s death and used both spouses applicable credit amounts, if properly planned. 3 The term by-pass trust is used synonymously with credit shelter trust to mean a trust created upon the death of the first spouse to die (the deceased spouse ) and funded with an amount equal to the deceased spouse s unused applicable exclusion amount. 2010(c)(3)(A) (all section references herein are to the Supercharged Credit Shelter Trust SM ( SCST ), 4 and now, with portability, 5 there will be a further evolution to the Irrevocable Grantor Inter Vivos Exclusion Trust (the IGIVE Trust ). Traditional by-pass trusts have been used by many married couples with taxable estates primarily to take full advantage of both of the spouses applicable exclusion amounts. Assuming that portability remains a mainstay in the federal transfer tax system, it allows for the full utilization of both spouses applicable exclusion amounts, while not having to rely on utilizing such amounts immediately at the first spouse s death (the deceased spouse ). Rather, for the first time (in 30 years), portability allows the couple to take advantage of both spouses applicable exclusion amounts at any time. As a result of this significant change in the law, portability allows us to evolve away from the rigidity of creating traditional by-pass trusts at the deceased spouse s death, in favor of creating trusts at any time prior to the surviving spouse s death, and more importantly, having all the benefits of the traditional by-pass trusts, and more Internal Revenue Code of 1986, as amended, and the regulations thereunder, unless otherwise stated); Rev. Proc , I.R.B. 701, Typically, such a by-pass trust would provide benefits to the surviving spouse and perhaps descendants, but would be structured to avoid estate taxation in the surviving spouse s estate. The balance of the deceased spouse s estate would typically pass to a marital trust. The marital trust could be a general power of appointment ( GPOA ) trust or a qualified terminable interest property ( QTIP ) trust that qualifies for the marital deduction under 2056(b)(5) or (7), respectively. Alternatively, the balance could be directed to pass outright to the surviving spouse if the couple so choose. The goal is to utilize the applicable credit amount of the deceased spouse, as well as that of the surviving spouse, in the transfer of the aggregate estate for estate tax purposes. 4 Blattmachr, Gans & Zeydel, Supercharged Credit Shelter Trust SM, 21 Prob. & Prop. 52 (July/Aug. 2007). The authors of this article described using the estate tax applicable exclusion amount of the deceased spouse for a trust that would be a grantor trust as to the surviving spouse (herein referred to as the SCST ). 5 The portability provisions were added as part of the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010, P.L (Dec. 17, 2010) ( 2010 TRA ). Generally, portability refers to 2010(c)(2) through (6). Tax Management Estates, Gifts and Trusts Journal 2012 Tax Management Inc., a subsidiary of The Bureau of National Affairs, Inc. 1 ISSN

4 much more. 6 This article explains why IGIVE Trusts are a better estate planning option for married couples and portability s role in enabling such trusts. ANALYZING THE TYPICAL COMPARISON OF A TRADITIONAL BY-PASS PLAN TO A PORTABILITY-DRIVEN PLAN When considering the planning potential of portability, existing analyses appear to have an assumption that may not be entirely accurate. The common analysis seen by the authors is a comparison of using a traditional by-pass trust to using a portability-driven plan, where the assets are held jointly with right of survivorship by the couple or each spouse has an I love you will that leaves all property to the surviving spouse. In the portability-driven plan, the general assumption is that the surviving spouse would wait until his or her death to use the ported unused exclusion. The analysis then compares the estate tax savings of using a traditional by-pass trust to the benefit of an increased income tax basis that would be available if the entire estate receives a step up in basis upon the surviving spouse s death in a portabilitydriven plan. The shortcoming of that comparison is the assumption that the surviving spouse will not use the ported exclusion until his or her death. As discussed below, we advocate using the ported exclusion soon (or immediately) after the deceased spouse s death; thus, the estate tax savings would be roughly the same, and there would be the added benefit derived from the IGIVE Trust being a grantor trust. Additionally, as explained in detail below, we believe the better analysis is to compare a traditional by-pass trust plan, which creates a non-grantor trust funded with the applicable exclusion of the deceased spouse, to a plan that creates a trust with all of the following characteristics: (a) a trust that is a grantor trust as to the surviving spouse; (b) a trust that takes advantage of the ported applicable exclusion amount, preferably soon (or immediately) after the deceased spouse s death; and (c) a trust that can be created at any time (before, at the time of, or after the death of the deceased spouse). Portability enables the creation of such a trust the IGIVE Trust. 6 For instance, by using the IGIVE Trust, for those individuals who are in states that assess a state estate (or death) tax, it may be possible to avoid all or part of the state estate taxes, while accomplishing all of the same federal estate tax savings that one would have been able to accomplish if they used traditional by-pass trusts. We discuss a planning strategy to accomplish state death tax savings below. Additionally, with IGIVE Trusts, which are grantor trusts, aside from the income tax benefits, there could be administrative cost savings associated with not having to prepare non-grantor trust tax returns (which are required to be prepared (and filed) with traditional by-pass trusts). CERTAIN IGIVE TRUSTS ALREADY MADE TRADITIONAL BY-PASS PLANNING LESS BENEFICIAL Even before the advent of portability, the SCST 7 and domestic asset protection trusts ( DAPTs ) appeared to be better planning tools, by comparison to traditional by-pass planning. Following the general acceptance of the idea that grantor trusts provide superior tax and estate planning benefits, 8 these innovative planning tools started an evolution away from traditional by-pass trust planning, as they each enable the use of applicable exclusion through trusts that are grantor trusts as to the beneficiary spouse. Portability creates new avenues to do likewise and arguably completes the evolution to grantor trusts for the use of all applicable exclusion amounts, thereby making traditional by-pass trusts a relic of the past. 9 TYPES OF IGIVE TRUSTS 10 The SCST One spouse creates an inter vivos QTIP trust for the other. By example, W establishes an inter vivos QTIP trust for H s benefit and transfers $5.12 million of assets to the trust. W elects QTIP treatment to qualify the trust for the federal gift tax marital deduction on a timely filed gift tax return reporting her gift. Because the QTIP election is made, W s gift to the inter vivos QTIP trust would not cause any federal gift tax liability at the time of the trust funding and the value of the trust would be included in H s estate for federal estate tax purposes at the time of his death pursuant to Additionally, W could make a reverse QTIP 7 See note 4, above. 8 See Zaritsky, Open Issues and Close Calls Using Grantor Trusts in Modern Estate Planning, 42 U. Miami Heckerling Inst. on Est. Plan. (2009); Akers, Blattmachr & Boyle, Creating Intentional Grantor Trusts, 44 Real Prop., Tr. & Est. L.J. 207 (Summer 2009); 819 T.M., Grantor Trusts: Income Taxation Under Subpart E; Huffaker & Kessel, How the Disconnect Between the Income and Estate Tax Rules Created Planning for Grantor Trusts, 100 J. Tax n 206 (Apr. 2004). 9 Again, the assumption is that portability will be made permanent. We also assume that the clawback and portability recapture issues will be fixed to eliminate those concerns. For a full discussion of these issues, see Portability Part One, Estate & Gift Committee of the ABA s RPTE Section (hereinafter referred to as Portability Part One ). 10 All of the types of IGIVE Trusts discussed herein are complicated devices with numerous features, options, and risks. This article is not intended to provide an analysis of these trust arrangements or the background to enable implementation of them. This article provides a brief overview of how these trusts could be used in planning for married couples as an alternative to traditional bypass trusts. 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5 11 To qualify for the gift tax marital deduction under 2523(f), all of the income must be paid to H. The trustee could have the authority to distribute principal for H s health, education, support, and maintenance, and an independent trustee could be appointed to have the authority to distribute additional amounts of principal to or for H s benefit for any reason. 12 Regs (f)-1(f), Exs. 10, Generally, this means that to accomplish the tax objectives, it is preferable to situs or locate the trust in a state such as Alaska, Nevada, or Delaware and use their laws to govern the administration of the trust. Carefully giving attention to this feature makes the trust protected from the claims of the beneficiaries creditors, including W s creditors. This should eliminate any concerns with inclusion of the SCST in W s estate for estate tax purposes under the authority of Some non-dapt states have enacted statues to abrogate the self-settled spendthrift trust rule in this circumstance. See, e.g., Fla. Stat (3); Va. Code Ann (B)(3). election under 2652(a)(3) so that the trust is exempt for generation-skipping transfer ( GST ) tax purposes. The SCST is shown in Illustration #1, at the end of this article. The primary reason for establishing the inter vivos QTIP trust is to set the stage for creating the SCST in the event that W survives H. W has to put the plan into effect while H is living think of it as staging before the important and critical second act. During the first act, while H is alive, he would be the sole beneficiary of the inter vivos QTIP trust. 11 Therefore, during this period of time, the assets are just for H s benefit. Upon H s death, if W is then living, an amount of the inter vivos QTIP trust s assets equal to H s applicable exclusion amount could be distributed to the SCST for W s benefit and the balance (if any) could be held in a survivor s QTIP trust for W s benefit. A QTIP election would be made for the survivor s QTIP trust on H s estate tax return. The SCST would provide for W and any of W and H s descendants (i.e., similar to a by-pass trust). The creation of this SCST is the key to this plan. Because the trust was included in H s estate under 2044, the SCST will not be included in W s estate pursuant to 2036 or Careful attention must also be given to avoid inclusion in W s estate pursuant to 2041 (e.g., based on application of the rule against self-settled spendthrift trusts thereby enabling W s creditors to reach her interests in the trust). 13 For GST tax purposes, if W made a reverse QTIP election, W will be deemed to be the transferor, and as such the assets in both the SCST and the survivor s QTIP trust would be GST-tax exempt. For income tax purposes, W is still the grantor of any continuing trust for her benefit. This allows W to have the benefits of grantor trust status as to the SCST and to be a beneficiary of the trust. This combination of benefits makes the SCST special. A traditional bypass trust is not a grantor trust and, thus, not as special. The Standard IGIVE Trust The standard IGIVE Trust is simply a label for an irrevocable trust into which the donor transfers assets that will be a completed gift for gift tax purposes, a grantor trust for income tax purposes (as to the donor), and excluded from the donor s estate for estate tax purposes. The donor may allocate GST exemption to the trust and, in general, the idea would be to make this type of trust exempt from the GST tax to the extent GST exemption is available. The donor s spouse might be a beneficiary of this trust and, in general, the donor would not be a beneficiary. The DAPT-IGIVE Trust This is the same type of trust as the standard IGIVE Trust except that this trust is established in one of the domestic asset protection states and the donor is a discretionary beneficiary. This type of trust is described in PLR PORTABILITY AND IGIVE TRUSTS IN PLANNING Estate plans can be constructed using combinations of IGIVE Trusts and testamentary QTIP trusts to achieve the general goals of a traditional by-pass trust (i.e., estate tax protection, use of both spouses GST exemptions, creditor protection, and disposition control) and obtain the benefits of grantor trust treatment. Among other benefits, the grantor trust feature would allow the basis of the trust s assets to be increased during the grantor s lifetime and, therefore, virtually enable the step up in basis upon the surviving spouse s death 15 (i.e., the principal tax benefit of ascribed to plans featuring portability). Examples are used below to illustrate these ideas. The suggested plans are simply possible approaches to addressing the hypothetical couple s estate plan- 14 See Rothschild, Blattmachr & Gans, IRS Rules Self-Settled Alaska Trust Will Not Be in Grantor s Estate, 37 Est. Plan. (Jan. 2010). 15 To accomplish this virtual basis step-up, the trustee should have the power to sell any of the trust s assets, and perhaps there would be a specific power to swap assets of equivalent value in the grantor (a la 675(4)(C)). Accordingly, the trustee could swap appreciated trust assets for cash or higher basis assets of the surviving spouse/grantor, therefore effectively stepping up the basis of the trust assets. This requires the surviving spouse (or his or her agents) to be diligent in monitoring both the value and basis of the trust s investments and continuously implementing the swapping of assets for other higher basis assets over time. Tax Management Estates, Gifts and Trusts Journal 2012 Tax Management Inc., a subsidiary of The Bureau of National Affairs, Inc. 3 ISSN

6 ning needs. The goal of these examples is to illustrate the idea and premise of this article that applicable exclusion amounts can and should be used in grantor trusts, rather than traditional non-grantor by-pass trusts, and the important role that portability plays in making this possible. Example 1 Facts: H and W have always resided in Florida (a common law state with no state estate tax). H is 73 years old; W is 68 years old. They are receptive to any form of asset ownership and are willing to shift ownership, provided there are no adverse income tax consequences. 16 Their descendants will survive both H and W. They wish to provide for each other and, upon the surviving spouse s death, to pass the net assets in trusts to the descendants. H and W make no lifetime taxable gifts. The estate, gift, and GST tax laws, as they exist today, will continue through the surviving spouse s year of death. The couple s combined net worth is $14 million, each having $7 million in his or her individual name. W is expected to be the surviving spouse. Proposed Plan #1 Illustration #2, at the end of this article, depicts a simple plan that H and W could implement. By each of H s and W s wills, the deceased spouse leaves all of his or her assets in a testamentary QTIP trust for the surviving spouse. 17 For example, if H predeceases W, the plan is to make a QTIP election for all of the assets, 18 and upon W s death, the QTIP trust assets pass to continuing lifetime trusts for the children and their descendants. H s executor would file a timely estate tax return electing portability. 19 Discussion If H Dies First: If H dies first, as expected, his applicable exclusion amount is inherited by W via the portability election. H s GST exemption would be used by making the reverse QTIP election with respect to the testamentary QTIP trust (for the benefit of W) created under his will. 16 Section 1041 provides that asset ownership can be shifted from one spouse to the other without tax consequence for most assets. The major exceptions are IRAs and other forms of deferred compensation. 17 Of course, a revocable trust could be used to create such plans, but for simplicity purposes, this article just refers to wills. 18 A disclaimer by-pass trust is illustrated as a failsafe e.g., in the event portability is not made permanent. 19 An issue that arises is whether Rev. Proc , I.R.B. 1335, applies when there is only a QTIP trust in the estate plan. In this case, because the gross estate exceeds H s basic exclusion amount, that Revenue Procedure would be inapplicable. However, when planning with portability, that Revenue Procedure may be more relevant with smaller estates. See Portability Part One at VIII.B. W would have some options following H s death for use of their combined applicable exclusion amounts: Option 1 The Standard IGIVE Trust. Immediately following H s death, W could create and fund a standard IGIVE Trust with some part of her assets. Recall, at H s death, W s applicable exclusion amount included not only her $5.12 million basic exclusion amount, but also H s $5.12 million unused exclusion amount (which we call W s inherited exclusion amount ), giving W a total applicable exclusion amount of $10.24 million. Thus, following H s death, W could fund a standard IGIVE Trust with an amount roughly equal to H s $5.12 million basic exclusion amount i.e., the amount that H could have transferred to a traditional by-pass trust. W would begin to rely on her remaining $1.88 million and the QTIP trust created by H. Option 2 The DAPT-IGIVE Trust. If W feels that she may need access to some of the amounts she would transfer to the IGIVE Trust, she could instead establish a DAPT-IGIVE Trust (i.e., immediately after H s death). In either case, the standard IGIVE Trust or DAPT- IGIVE Trust would be a grantor trust as to W, whereas a traditional by-pass trust would be a nongrantor trust. The grantor trust feature of IGIVE Trusts will help W to reduce the value of her taxable estate during her lifetime. In planning, the drafter should draft the QTIP trust (created by H s will for W s benefit) flexibly enough to allow principal distributions to W to pay income taxes on the IGIVE Trust (thereby depleting the QTIP trust s value), and perhaps to allow W to fund the IGIVE Trust to a higher amount. 20 Some argue that a traditional by-pass trust is superior to utilizing portability, because the traditional bypass trust s growth escapes estate tax upon the second spouse s death, whereas any ported exclusion is not even indexed for inflation and, thus, it is inferior. This argument would be correct if the surviving spouse could only use the ported exclusion at the time of the second spouse s death. However, as we discussed above, portability allows the use of both exclusions at any time before the second spouse dies. If the surviving spouse used the deceased spouse s ported exclusion immediately following the deceased spouse s death by creating an IGIVE Trust, the future appreciation is protected from estate tax just like the 20 Such distributions should be made from the non-gst part of the QTIP trust created by H s will. Tax Management Estates, Gifts and Trusts Journal Tax Management Inc., a subsidiary of The Bureau of National Affairs, Inc. ISSN

7 21 It is important to note that an IGIVE Trust is more flexible than a traditional by-pass trust from a funding and investment standpoint, too. In our planning suggestions, we advocate that W could fund the IGIVE Trust immediately upon H s death. In fact, W need not fund the trust immediately; she can wait if it makes sense. If, for instance, H s entire estate were comprised of marketable securities and W was uncomfortable with the direction and volatility of the market, yet she understood the importance of staying invested in the market, W could either wait awhile and then fund the IGIVE Trust, or she could create the IGIVE Trust immediately, and the trustee could swap assets in and out of the IGIVE Trust, depending upon market conditions. Importantly, if she opts to create and fund the trust immediately, and if she uses the strategy of swapping assets, she could do so without any potential capital gain recognition issues (because the IGIVE Trust is a grantor trust). Thus, the IGIVE Trust also provides the additional layer of funding and investment flexibility. 22 The proposed plan is just one possible approach and is used to illustrate the ideas discussed herein. 23 Of course, a revocable trust could be used to create such a QTIP trust upon H s death, but for simplicity purposes this article just refers to wills. 24 This is the current applicable exclusion amount. 2010(c)(3)(B); Rev. Proc If the amount increased due to inflation, additional funds could be given to the inter vivos QTIP trust to match the inflation adjustment. 25 Recall that W had $7 million, thus, after forming the $5.12 million inter vivos QTIP trust, the balance of her assets would be $1.88 million. 26 This inter vivos QTIP trust could be established currently or at any time prior to H s death. W could establish the arrangement under a revocable trust as to W and plan to release her interests in the revocable trust when it appears that H s death is imminent, thereby triggering the irrevocable gift to the inter vivos QTIP trust. traditional by-pass trust. 21 Thus, the IGIVE Trust yields the same estate tax benefit, while having the added benefit of being a grantor trust as to the surviving spouse. Proposed Plan #2 Illustration #3, at the end of this article, depicts a sophisticated alternative suggested plan that H and W in Example 1 could implement to utilize their estate and gift tax applicable exclusion and GST exemption amounts. 22 By H s will, H leaves all of his assets in a testamentary QTIP trust. 23 If H predeceases W, the plan is to make a QTIP election for all of the assets, and upon W s death, the QTIP trust assets pass to continuing lifetime trusts for the children and their descendants. W establishes an inter vivos QTIP trust with $5.12 million 24 of her assets and keeps $1.88 million 25 of her assets. 26 She makes the gift tax QTIP election on a timely filed gift tax return. The goal is to use H s applicable exclusion amount upon H s death. Because the value of the inter vivos QTIP trust during H s lifetime will fluctuate up and down, W will need to monitor its value and perhaps make subsequent additions to keep the QTIP trust s value near H s applicable exclusion amount (and with each addition, W would make the gift tax QTIP election). 27 The inter vivos QTIP trust provides H with beneficial interests sufficient to qualify for QTIP treatment. Upon H s death, the language of the trust instrument would provide that the portion of this trust that is equal to H s remaining applicable exclusion amount is distributed to the SCST and the balance to the survivor s QTIP trust for W. Importantly, the SCST is a grantor trust as to W and provides benefits to her and the descendants. 28 This is the key advantage of this trust over the traditional by-pass trust! W also implements a will that leaves the balance of her assets 29 to H or, if H predeceases W, to continuing lifetime trusts for the children and their descendants. And, if H predeceases W, when W dies, the remaining assets under the inter vivos QTIP trust pass to continuing lifetime trusts for the children and their descendants. Discussion If H Dies First: If H dies first, as expected, his applicable exclusion amount is used through the inter vivos QTIP trust established by W. 30 The SCST and survivor s QTIP trust created under the inter vivos QTIP trust for W are grantor trusts as to W, which provide the desired advantage of grantor trust status that a traditional by-pass trust cannot provide. A significant advantage of the SCST is that W s interest in the SCST is not subject to attack under On the other hand, W would have risks associated with 2036 if a DAPT-IGIVE Trust is created following H s death in Proposed Plan #1 (e.g., if the Service could prove a pre-existing understanding that distributions would be made to W). 32 H s GST exemption would be used by making the reverse QTIP election with respect to the testamentary QTIP trust (for the benefit of W) created under his will. While H s GST exemption could also be allocated to the inter vivos QTIP trust created by W when included in his estate under 2044, this would be unnecessary as W will likely allocate her GST exemption to the inter vivos QTIP trust at the time she creates it by making the reverse QTIP election. W will 27 We assume that the GST exemption would likely be tied to the gift tax exemption; accordingly, W would likely make a reverse QTIP election for GST tax purposes, too. 28 The survivor s QTIP trust is also a grantor trust as to W. This trust is less important and could, for example, be terminated by an independent trustee with unlimited discretion back to W. 29 Recall that she would have roughly $1.88 million after implementing the inter vivos QTIP trust. 30 H s executor or personal representative would not make a QTIP election for the SCST trust; however, a QTIP election would be made for the survivor s QTIP trust. 31 See note 12, above. 32 See note 14, above. Tax Management Estates, Gifts and Trusts Journal 2012 Tax Management Inc., a subsidiary of The Bureau of National Affairs, Inc. 5 ISSN

8 make the reverse QTIP election at the time of the gift for two reasons: (i) if W unexpectedly dies before H, the allocation of her GST exemption to the inter vivos QTIP trust preserves the use of her GST exemption, and (ii) W s allocation to the inter vivos QTIP trust potentially leverages the use of her GST exemption during the period from establishing the trust to the death of H. Discussion If W Dies First: If W unexpectedly dies before H, W leaves (by will) her remaining estate (i.e., the $1.88 million) outright to H. W s executor would file a timely estate tax return electing portability. W s unused applicable exclusion amount (i.e., $5.12 million (as it may increase for inflation)) would port to H. Portability prevents the waste of W s applicable exclusion amount (for estate and gift tax purposes). While the GST exemption is not portable, as mentioned above, W would have allocated her GST exemption to the inter vivos QTIP trust, and because she made a reverse QTIP election, her GST exemption has virtually ported to H and is not wasted. 33 H would have some options following W s death for use of their combined applicable exclusion amounts: Option 1 The Standard IGIVE Trust. Immediately after W s death, H could create and fund a standard IGIVE Trust with some part of his now $8.88 million of assets. Recall, at W s death, H s applicable exclusion amount included not only his $5.12 million basic exclusion amount, but also H s inherited exclusion amount (i.e., W s unused exclusion amount), which was an additional $5.12 million. Accordingly, H s applicable exclusion amount would total $10.24 million. Thus, after W s death, H could fund a standard IGIVE Trust with an amount roughly equal to his $5.12 million basic exclusion amount, and he would begin to rely on his remaining $3.76 million of assets (i.e., $1.88 million of his own assets and $1.88 million from W) for his lifestyle. The inter vivos QTIP trust created by W is also available to H, however, recall that it is GST tax-exempt. 34 Option 2 The DAPT-IGIVE Trust. If H feels that he may need access to some of the amounts 33 A frequent criticism is that portability does not apply to the GST exemption, thus, one should not rely on portability. The first half of the proposition is correct (i.e., the GST exemption is not portable), but the second half of the proposition does not necessarily follow (i.e., that, because of the inability to port one s GST exemption, portability planning should not be relied upon). The reverse QTIP election, when applied to an inter vivos QTIP trust (or a testamentary QTIP), effectively ports one s GST exemption. 34 From an investment standpoint, H would likely invest the $3.76 million to generate more income and the trustee of the inter vivos QTIP trust would likely invest to generate less income and more growth. This would likely maximize the overall estate and GST tax potential. he would transfer to the IGIVE Trust, he could instead establish a DAPT-IGIVE Trust (i.e., immediately upon W s death). Option 3 Combination. As an alternative, H can create both a DAPT and a standard IGIVE Trust; this allows him to utilize the DAPT-IGIVE Trust if necessary and it allows the standard IGIVE Trust to grow for the benefit of his descendants. Suffice to say, the options could vary based upon client circumstances. In either case, the standard IGIVE Trust or DAPT- IGIVE Trust would be a grantor trust as to H, whereas a traditional by-pass trust would not. This grantor trust feature will help enable H to reduce the value of his taxable estate during his lifetime. The inter vivos QTIP trust created by W should be flexible enough to allow principal distributions to H to pay income taxes on the IGIVE Trust (thereby depleting the QTIP trust s value). 35 Is Asset Protection Sacrificed? Will Assets Be Distributed as Requested? Another criticism of portability is that, with portability planning, there may be less asset protection and assets may not pass as the deceased spouse wishes. Well, that may be true if one has an oversimplified estate plan that leaves all assets to the survivor (e.g., holding all assets in joint names with survivorship). Under either of the proposed plans above, the testamentary QTIP trust created under H s will is creditor protected for W and the assets will pass as H desires (after W s death). Likewise, in Proposed Plan #2, the inter vivos QTIP trust created by W is both creditor protected for H (and W) and the assets will pass as W directed in the inter vivos QTIP trust. Therefore, moving away from the traditional by-pass trust planning does not mean sacrificing asset protection or not being assured of the final disposition of assets. Is This a More Complicated Plan? One complaint that may be leveled against this planning is that it is complicated. This is especially so given that many planners have devolved into using one standard formula traditional by-pass trust plan. 36 It is important to remember that 30 years ago, when traditional by-pass trust planning developed, the 35 Such distributions should be made from the non-gst part of the QTIP trust created by W s will. 36 Portability was designed to simplify the planning. See General Explanations of the Administration s Fiscal Year 2012 Revenue Proposals (a.k.a., the 2012 Greenbook ), p. 123, Department of the Treasury. A copy of the 2012 Greenbook is available at: Documents/General-Explanations-FY2012.pdf. The administra- Tax Management Estates, Gifts and Trusts Journal Tax Management Inc., a subsidiary of The Bureau of National Affairs, Inc. ISSN

9 credit equivalent amount was $175, Now that each spouse s exclusion is $5.12 million, planning with such larger amounts is more complicated and should be done thoughtfully. The value of the surviving spouse having grantor trust status as to the trust created with the applicable exclusion amount of the deceased spouse is much more valuable by comparison to simply relying upon traditional non-grantor bypass trust planning. Portability and the Ultra-Wealthy Client Yet another oft-heard shortcoming of portability is its lack of utility for the ultra-wealthy client. In certain circumstances, however, even the ultra-wealthy can use portability to their advantage, and can do so on a tax-efficient basis. Example 2 Facts: H and W, U.S. citizens, have always resided in the District of Columbia (a common law jurisdiction with a separate estate tax). H is 65 years old; W is 58 years old. The couple s combined net worth is $240 million; H and W own a portfolio of marketable securities and private equity investments of $140 million in their joint individual names as tenancy by the entirety. H has $100 million in private operating companies. Before 2010, both H and W had used their entire $1 million gift tax exclusion amounts. Each of H and W plan to fund standard IGIVE Trusts to use their additional $4.12 million of applicable exclusion amounts by making taxable gifts. 38 Because their assets are so extensive, neither H nor W feels he or she needs access to the gift funds. Before making the tion has continued to advocate the continuation of portability in its most recent publication of the General Explanations of the Administration s Fiscal Year 2013 Revenue Proposals (a.k.a., the 2013 Greenbook ), p. 76, Department of the Treasury. A copy of the 2013 Greenbook may be obtained at: Explanations-FY2013.pdf. 37 See Jacobson, Raub & Johnson, The Estate Tax: Ninety Years and Counting, a copy of which is available at: pub/irs-soi/ninetyestate.pdf. Under ERTA, recall that the estate and gift tax credit was originally $47,000 (which translated to a credit equivalent amount of $175,625 in 1982) and was to be phased in over six years to increase the credit to $192,800 (and the credit equivalent amount to $600,000). 38 H and W represent the ultra-wealthy couple (i.e., a couple with over $100 million in net asset value) who can afford to and are planning to give the additional $4.12 million of applicable exclusion allowed by the 2010 TRA. Many of these ultra-wealthy clients have used their $1 million exclusion before 2010 and some have also paid gift taxes. The existing wills/revocable trust plans for such persons frequently devise the balance of their property to a testamentary QTIP trust upon the deceased spouse s death (perhaps some devise to charity is also made). A traditional by-pass trust may not be provided in these situations as the expectation is that no estate exclusion would exist. gifts, they plan to fund a family limited partnership with private equity interests, so their children have exposure to these investments (i.e., through the standard IGIVE Trust). Upon death, each spouse leaves his or her entire estate in a QTIP trust for the benefit of the survivor and, upon the survivor s death, 25% is given to the family foundation and the balance to trusts for the children (and their descendants). Assume the estate, gift, and GST tax laws, as they exist today, will continue through the surviving spouse s year of death. Assume H dies tragically in 2012 before the gifts are made. Discussion: Because H died in 2012 before he had a chance to use his additional $4.12 million basic exclusion amount, H s personal representative would have three options. The first two options contemplate using H s $4.12 million unused exclusion amount at H s death, and the third option contemplates electing portability. The personal representative could make a partial QTIP election to use H s remaining applicable exclusion, effectively creating a traditional by-pass trust. Alternatively, W could disclaim enough of the QTIP trust to use H s remaining applicable exclusion, effectively passing those assets into trusts for the children (and grandchildren). The other option is that the personal representative could make a full QTIP election and elect portability (thereby H s $4.12 unused exclusion amount would port to W). If H s personal representative makes a partial QTIP election, because H and W lived in the District of Colombia, a D.C. estate tax of roughly $450,000 would be triggered. This onerous D.C. estate tax result would apply equally to the disclaimer option. However, if portability is elected, there would be no D.C. estate tax. By relying on portability, W could then immediately (following H s death) make gifts to a standard IGIVE Trust to use her applicable exclusion, which would include not only her additional basic exclusion amount of $4.12 million, but also the inherited exclusion amount of $4.12 million from H (totaling $8.24 million), which would be consistent with their plan prior to H s death. Thus, electing portability has the benefit of saving the D.C. estate tax (of roughly $450,000) that would have been assessed on H s estate. 39 If partial QTIP or disclaimer is chosen, the resulting trusts will not be grantor trusts (i.e., similar to a traditional by-pass trust). However, if portability is selected and W makes the gifts of $8.24 million to a standard IGIVE Trust, as suggested above, the entire standard IGIVE Trust would be a grantor trust for federal income tax purposes as to W. Regardless of which option is selected, H s personal representative can make a reverse QTIP election 39 D.C. does not impose a gift tax. Tax Management Estates, Gifts and Trusts Journal 2012 Tax Management Inc., a subsidiary of The Bureau of National Affairs, Inc. 7 ISSN

10 on the QTIP trust that remains, thereby virtually porting the GST exemption. The QTIP trust would provide asset protection under any of the options. CONCLUSION Portability enables greater use of trusts funded with applicable exclusion amounts to be grantor trusts as to the surviving spouse. 40 That is a game changer! Portability planning furthers the evolution that had already begun away from traditional by-pass trusts. In this approach to planning, portability offers the same or better estate tax benefits, 41 the GST exemptions of both spouses are utilized, creditor protection is preserved, and state death taxes and administrative costs are potentially lower. This change in approach to using grantor trusts, like the IGIVE Trust, will require some effort. We believe, however, that the stakes are higher now and the benefits will be commensurate to the effort. 40 Note that the 2013 Greenbook includes a new provision at page 83 designed to eliminate the benefits of grantor trusts for gift and estate tax purposes. At this point, it is just a proposal and a signal of potential governmental concern (a laproposals to eliminate valuation discounts). It is not cause to change planning solutions. Even under this proposal, it appears that pre-effective date grantor trusts will be unaffected, except to the extent of contributions after the effective date. 41 The estate tax savings are potentially better than the traditional by-pass trust because of the benefits associated with the types of exclusion trusts discussed herein being grantor trusts. Tax Management Estates, Gifts and Trusts Journal Tax Management Inc., a subsidiary of The Bureau of National Affairs, Inc. ISSN

11 Wife Donor Illustration #1 W gives up to $5.12 million of assets to the Marital Trust Irrevocable Inter Vivos QTIP Trust (Lifetime QTIP Trust) (irrevocable grantor trust) Trusts are grantor trusts during W's lifetime Upon H s death, applicable exclusion amt. to SCST During H s lifetime Marital Trust For Husband Upon H's death, excess over applicable exclusion amt. to Second Marital Trust SCST For Wife and Descendants Survivors r QTIPTr Trust For Wife Upon W's Ws later death Family Trust For Descendants Tax Management Estates, Gifts and Trusts Journal 2012 Tax Management Inc., a subsidiary of The Bureau of National Affairs, Inc. 9 ISSN

12 Illustration #2 Hs Will/Revocable Trust Ws Will/Revocable Trust W predeceases W survives H survives H predeceases All to QTIP All to QTIP QTIP Trust W is beneficiary QTIP Trust H is beneficiary Any QTIP disclaimed by Wife Any QTIP disclaimed by Husband By-Pass Trust W and descendants are beneficiaries By-Pass Trust H and descendants are beneficiaries After Ws Death After Hs Death Children Descendants Trust Provisions Tax Management Estates, Gifts and Trusts Journal Tax Management Inc., a subsidiary of The Bureau of National Affairs, Inc. ISSN

13 Illustration #3 Hs Will/Revocable Trust Ws Will/Revocable Trust Irrevocable Lifetime QTIP Trust (created by Wife with $5.12 million) W predeceases All to QTIP W survives All to Husband H survives H predeceases Marital Trust H is beneficiary Any QTIP disclaimed by Wife QTIP Trust W is beneficiary By-Pass Trust W and descendants are beneficiaries Any gift disclaimed by Husband (not relying on portability) Any QTIP disclaimed by Husband Husband (relying on portability for any unused exclusion) QTIP Trust H is beneficiary By-Pass Trust H and descendants are beneficiaries Exclusion Amount Amount over Exclusion SCST W and descendants are beneficiaries Survivors QTIP Trust W is beneficiary After Husband and Wifes Deaths After Ws Death After Hs Death Children Descendants Trust Provisions Tax Management Estates, Gifts and Trusts Journal 2012 Tax Management Inc., a subsidiary of The Bureau of National Affairs, Inc. 11 ISSN

14 PURPOSE: Portability The Accretion Factor Richard S. Franklin, Esq., and Lester B. Law The purpose of this analysis is to examine when portability planning may be better for a client. Using examples and number-crunching helps to illustrate the potential benefits / detriments of a portability type plan. To that end, four different major patterns were used to demonstrate the benefits and burdens of portability type planning: (i) $5 million estate; (ii) a $10 million estate, (iii) $15 million estate; and (v) $30 million estate. These fact patterns are then changed slightly to see the impact of estate size and taxes. AUTHORS NOTE: The authors would like to thank Aaron Shamshonian, Vice President and Associate Wealth Strategist at U.S. Trust for his assistance in creating the spreadsheets that generated the results shown herein. DISCLAIMERS and DISCLOSURES: The examples are used for illustrative and education purposes; they are not designed or intended to provide financial, tax, legal, accounting, or other professional advice. The reader is cautioned that changes in law may be applicable, that these materials only provide a general discussion, that critical information may be omitted, and that any ideas, concepts or strategies discussed herein may not be suitable for any particular individual. The opinions of Richard S. Franklin, Esq., expressed herein are his own and do not necessarily reflect that of his law firm, McArthur Franklin, PLLC, and/or any member of such firm. The opinions of Lester B. Law expressed herein are his own and do not necessarily reflect that of U.S. Trust Bank of America Private Wealth Management, Bank of America, N.A., Bank of America Corporation, any of its subsidiaries and/or affiliates. U.S. Trust, Bank of America Private Wealth Management operates through Bank of America, N.A. and other subsidiaries of Bank of America Corporation. Bank of America, N.A., Member FDIC. To ensure compliance with IRS requirements, please be advised that any discussion of U.S. tax matters contained in or attached to these materials is not intended or written to be used, and cannot be used, for the purposes of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing, or recommending to another party any transaction or matter discussed herein. 1

15 Basic Fact Pattern - $5 Million Total: This fact pattern for the $5 million estate will set the stage for the other three fact patterns. The difference between the fact patterns is the size of the gross estates. The following are the basic facts for the $5 million estate: H and W are U.S. citizens and have only been married to each other. H and W live in a common law state. Neither H nor W has ever made a taxable gift. Each of H and W has assets of $2.5 million, which are only marketable securities held in their individual name. There are no deferred compensation assets (e.g., IRAs) or life insurance. H dies in 2013 and W, who remains a widow, dies in The basic exclusion amount is $5.25 million in 2013 and is estimated to be $6.53 million in At the time of H s death, his assets tax bases were equal to their fair market value (i.e., full step up in basis). W s assets tax bases are 80% of their fair market values (or $2 million). After H s death, W will consume $150,000 per year (as increased by a cost of living adjustment (COLA) factor. The COLA factor is 2.45%. The following pre-income tax rates of return apply: o principal growth rate of return is 5%; o ordinary income rate of return is 1.5%; and o qualified dividend rate of return is 1.5%. The portfolio turns over at a rate of 20% annually. The following flat income tax rates apply to the following individuals: o Federal capital gains and qualified dividend tax rates for the surviving spouse and any trust is 23.8%; o Federal ordinary income tax rate for the spouse is 35%; o Federal ordinary income tax rate for the trust is 39%; o Federal capital gains and qualified dividend tax rates for descendants is 15%; o Federal ordinary income tax rate for descendants is 31%; o State income tax rates (if any) for spouse and trust is 6%; and o State income tax rate (if any) for descendants is 5%. The estate and gift tax regime that exists in 2013 will be the same through When W s dies, the assets are all sold and converted to cash, regardless of whether the assets are held in a by-pass or marital trust. The reason for this assumption is that we can compare cash to cash. Additional Facts for Plans #1, #2 and #3: Three different plans are illustrated under the $5 million scenario. There is a comparison of the results of a traditional by-pass trust plan, with a plan that incorporates the use of portability. Plan #1 - $5 Million Total Assets Traditional Plan #1 - $5 Million Total There is no state estate tax. Upon H s death, the estate plan provides that a by-pass trust will be funded with H s assets (i.e., $2.5 million). All income from the by-pass trust is to be distributed to W for her life. W, as H s personal representative, will elect portability. Thus, $2.75 million DSUE amount will be ported to W. 2

16 Portability Plan #1 - $5 Million Total Same as Traditional Plan #1 - $5 Million Total, except instead of funding the by-pass trust, the assets will go to a marital trust where a QTIP election can be made. 1 All income will be distributed to W for life. W, as H s personal representative, will make the portability election. Thus, $5.25 million DSUE amount will be ported to W. Compare Traditional Plan #1 - $5 Million Total with Portability Plan #1 - $5 Million Total The comparative results of the plans showing assets passing to the beneficiaries after W s death are as follows: Traditional Plan Assets Passing to Portability Plan Assets Passing to Year Difference 2013 $5,146,400 $5,170,200 $ (23,800) ,299,701 5,343,674 $ (43,973) ,459,932 5,521,187 $ (61,254) ,627,181 5,703,420 $ (76,238) ,801,587 5,890,991 $ (89,404) ,983,328 6,084,474 $ (101,145) ,172,631 6,284,409 $ (111,778) ,369,750 6,491,312 $ (121,561) ,574,978 6,705,684 $ (130,707) ,788,638 6,928,021 $ (139,384) Plans #2 The next examples demonstrate the impact of state estate taxes. In these scenarios, H and W live in State X, which has a $1 million state estate tax exemption and the estate tax rate is equal to the Federal credit for state estate taxes. Traditional Plan #2 - $5 Million Total Full Funding of By-Pass Trust Same as Traditional Plan #1 - $5 Million Total, except that H and W live in a state which imposes income and estate taxes. In this case, full funding of the by-pass trust would cause a state death tax to be imposed of approximately $138,800, which reduces the actual funding of the trust to $2,361,200. Additionally, the DSUE amount passing to the surviving spouse would be the sum of the unused exemption which is $5.25 million, less $2,361,200, which is $2,888,800 Portability Plan #2 - $5 Million Total Funding $1 million in By-Pass Trust Same as Portability Plan #1 - $5 Million Total, except that H and W live in a state which imposes income and estate taxes. In this case, the plan provides for the funding of a by-pass trust with the maximum state death tax exemption of $1 million. In this case, no state death tax is paid on the first spouse s estate. This plan would have the balance of assets (i.e., $1.5 million) funding a QTIP Trust for the surviving spouse. 2 Additionally, the DSUE amount ported to the surviving spouse would be $4.25 million (i.e., $5.25 million of the decedent s lifetime exclusion amount less $1 million used by funding by-pass trust). 1 Assume that Rev. Proc would allow for the full marital deduction to be made. 2 Assume that Rev. Proc would allow for the full marital deduction to be made. 3