ALI-ABA Course of Study Estate Planning in Depth

Transcription

1 957 ALI-ABA Course of Study Estate Planning in Depth Cosponsored by Continuing Legal Education for Wisconsin (CLEW) of the University of Wisconsin Law School June 12-17, 2011 Madison, Wisconsin Estate and Income Tax Planning for the Passage of Family Homes Using QPRTs, Split Interest Purchases, Family LLCs, Dynasty Trusts, and Other Strategies (Including a Discussion of Non-Tax Considerations) By Nancy G. Henderson Henderson, Caverly, Pum & Charney LLP San Diego, California 2011 Nancy G. Henderson

2 958 TABLE OF CONTENTS INTRODUCTION...1 I. TAX CONSIDERATIONS IN PLANNING FOR FAMILY HOMES...1 A. Federal Estate Tax...1 B. State Inheritable Tax...2 C. Gift Tax...3 D. Generation-Skipping Transfer Tax...4 E. Income and Capital Gains Tax...5 F. Property Tax...6 II. III. IV. GIFT AND ESTATE TAX STRATEGIES FOR TRANSFERRING FAMILY HOMES...6 A. Outright Gifting of Property Interests...6 B. Family Limited Partnership and LLCs...11 C. Gifting of Property Interests in Trust...14 D. Qualified Personal Residence Trusts (QPRTs)...18 E. Personal Residence Trusts (PRTs)...29 F. Remainder Interest Purchases...29 G. When Section 2702 Does Not Apply-The House GRIT...31 H. Sale to an Intentionally Defective Grantor Trust...32 I. Intervivos QTIP Trusts J. Remainder Purchase Marital ( RPM ) Trusts..34 THE IMPORTANCE OF A FEASIBILITY ANALYSIS...36 A. Understand the Significance of the Property as an Estate Asset...37 B. Identify and Understand the Nature of the Property...37 C. Create Detailed Expense Projections and Calculate the Required Endowment...41 D. Detailed Tax Projections...42 E. Hold a Family Meeting or Conduct Family Interviews...43 DISPUTE AVOIDANCE AND RESOLUTION...43 A. Carrying Out the Donor s Purposes for Preserving the Property...43 B. Paying the Expenses of the Property...44 C. Addressing Issues of Accessibility and Encouraging Use of the Property...44 D. Protection of Owners from Liability Arising from the Property...44 E. Protecting Property from the Liabilities of the Owners...45 F. Managing the Property...45 G. Renting the Property...45 H. Use of the Property by Non-Family Members...46 I. Establishing the Rules for the Use of the Property...46 J. Storage of Personal Items...46 K. Improvements...46 L. Rule Enforcement...46 M. Dispute Resolution...47 N. Selling the Property and Other Exit Strategies....47

3 959 Estate and Income Tax Planning for the Passage of Family Homes Using QPRTs, Split Interest Purchases, Family LLCs, Dynasty Trusts, and Other Strategies (Including a Discussion of Non-Tax Considerations) by Nancy G. Henderson 2011 Nancy G. Henderson Introduction For many families, a family home is among the most cherished assets. Whether a family home is a beach front condominium in Florida, a ranch in Montana, a cabin on Lake Michigan, or a historic Victorian home in San Francisco, the goal of preserving that property as a family asset for the use and enjoyment of successive generations can present significant challenges to the estate planner. This Outline addresses some of the key issues to consider in planning for intergenerational succession for family homes. The first part of the Outline provides an overview of the primary tax considerations in planning for succession to a cherished family home. The second part of the Outline provides an overview of a number of estate, gift and generationskipping transfer (GST) tax planning techniques that should be considered in the context of planning for family homes. The third part of the Outline highlights the importance of conducting a feasibility study before proceeding with any planning for the preservation of a family home and the issues that need to be addressed in a feasibility study. The Outline concludes with a discussion of how to anticipate and avoid common disputes that arise in the context of the coownership of family properties and means for resolving disputes if and when they do arise. I. Tax Considerations in Planning for Family Homes Estate planning for the succession to family properties requires careful consideration of a number of complicated, and sometimes conflicting, tax laws. The primary tax considerations in estate planning for family homes are discussed below. A. Federal Estate Tax. For most property owners, the primary impediment to a successful transfer of a valuable family home to children and grandchildren is the federal estate tax. The federal estate tax is imposed upon the cumulative fair market value of all of a decedent s assets held at death (or otherwise included in the decedent s taxable estate), net of enforceable debts against the decedent, certain expenses, and allowable deductions and exclusions. 1 Important in the context of planning for family homes is that, included in the decedent s taxable estate are not only assets legally owned by the decedent at the time of death, 1 See Chapter 11 of the Internal Revenue Code. 1

4 960 but also assets which the decedent may have given away from a state property law perspective, but over which the decedent held impermissible strings attached for federal estate tax purposes. Such impermissible strings include, for example, the right to retained use or enjoyment of transferred property without adequate consideration to the donee, the right to receive the income generated from transferred property, or the right to control the donees beneficial interests in transferred property (or the income therefrom) in a manner that is not limited to a reasonably definite standard. 2 The decedent s taxable estate will also include assets transferred by others, in trust or otherwise, over which the decedent held a general power of appointment exercisable during life or upon death. 3 Such a power would include any power to appoint the property to the decedent, the decedent s estate, the decedent s creditors, or the creditors of the decedent s estate unless such power is limited to an ascertainable standard related to the decedent s health, maintenance, support or education or is exercisable only with the consent of an adverse party or the creator of the power. 4 No estate tax is imposed upon transfers at death to qualified charities or to U.S. citizen spouses (outright or in a qualifying trust for such spouse) due to the availability of the unlimited estate tax charitable deduction 5 and unlimited estate tax marital deduction, 6 respectively. Estate tax can also be deferred upon transfers at death to the decedent s non-u.s. citizen spouse so long as the transfer is made to a qualified domestic trust or QDOT. 7 In addition to the foregoing exclusions and deductions, a decedent s estate is entitled to an estate tax applicable exclusion. Under the Tax Relief, Unemployment Insurance Reauthorization and Job Creation Act of 2010 (the 2010 Tax Relief Act ), the estate tax applicable exclusion shelters the first $5,000,000 of net taxable value of a decedent s estate from federal estate tax. This exclusion, if applicable, is reduced dollar for dollar by lifetime gifts made by the decedent using the decedent s $5,000,000 gift tax applicable exclusion. The tax imposed upon the otherwise taxable value of the decedent s estate in excess of the applicable exclusion is presently 35%. Unless action is taken by Congress, the estate tax will return to its pre-2001 form as of January 1, 2013, after which there will be a $1,000,000 estate tax applicable exclusion and graduated estate tax rates that will be as high as 55% (with a 5% surcharge on certain estates intended to result in a flat tax on 55%). B. State Inheritance Tax. Until EGTRRA 2001, decedents estates were entitled to a federal estate tax credit for state inheritance taxes or other state death taxes up to certain maximum thresholds. As a result, most states enacted inheritance tax laws that simply absorbed the maximum amount of the state death tax credit (a pickup tax ). However, EGTRRA 2001 eliminated the state death tax credit and replaced the credit with a deduction for state death taxes. (This has been extended for two years by the 2010 Tax Relief Act.) In reaction to this change in federal tax law, many, if not most states have since enacted inheritance tax laws that impose a state inheritance tax in addition to the federal estate tax See I.R.C. 2036(a)(1), 2036(a)(2) and I.R.C I.R.C. 2041(b)(1)(c). I.R.C I.R.C I.R.C. 2056A. 2

5 961 Importantly in the context of planning for family homes, if real property is located in a state that imposes a separate inheritance tax, the property will likely be subject to such tax even if the decedent resided at the time of death in a different state. Further, many states that impose inheritance taxes have decoupled their inheritance tax system from the federal estate tax system, meaning that state inheritance taxes might be imposed upon an estate that has no federal estate tax liability (such as because the state inheritance tax exclusion is less than the federal estate tax applicable exclusion). It is therefore of utmost importance for the estate planner advising clients with family homes in other states to research the state inheritance tax rules that will apply and to consider strategies to avoid or minimize the imposition of the state inheritance tax, such as by placing the property in a limited liability company or gifting the property during life (assuming the state in which the property is located does not have gift tax, as discussed below). C. Gift Tax. The second most important tax imposed in connection with succession planning for family homes is the federal gift tax. Under current federal tax law, lifetime transfers of real property made out of detached and disinterested generosity (other than a transfer for full and adequate consideration in money or money s worth) will give rise to a federal gift tax unless a transfer qualifies for certain statutory exclusions or deductions. 8 Among the available deductions are the unlimited gift tax marital deduction for transfers to U.S. citizen spouses (or certain qualifying trusts for the benefit of U.S. citizen spouses) 9 and the unlimited gift tax charitable deduction for transfers to qualified charitable organizations. 10 Also excluded from gift taxation are gifts of present interests in property, provided that the cumulative amount of all such gifts from one donor to one donee in any one calendar year does not exceed the amount of the gift tax annual exclusion, which is presently $13, Once a donor s cumulative gifts to a donee in any given year exceed the gift tax annual exclusion, or if the gift is not a gift of a present interest, and if no other exclusion from gift tax applies, the donor must begin to consume his or her lifetime applicable exclusion from gift tax, which presently shelters from gift taxation the first $5,000,000 of such otherwise taxable gifts (computed cumulatively for all donees over the donor s lifetime). 12 Absent new legislation, the gift tax will also revert to a $1,000,000 gift tax applicable exclusion and a 55% maximum rate on January 1, To keep the Internal Revenue Service (the Service ) apprised of the use of the donor s gift tax applicable exclusion, a gift tax return is required to be filed for any calendar year in which the donor makes gifts to which the applicable exclusion will apply. In the case of gifts of real property or real property interests, the federal gift tax is imposed upon (or the amount of the exclusion that is utilized is determined based upon) the value 8 See Chapter 12 of the Internal Revenue Code. 9 I.R.C I.R.C I.R.C. 2503(b). The gift tax annual exclusion is indexed for inflation in $1,000 increments (rounded down to the nearest $1,000). In addition, I.R.C. 2523(i) provides a gift tax annual exclusion for certain transfers to non- U.S. citizen spouses. The amount of that exclusion is presently $136,000 and is also indexed for inflation. Note that there is no lifetime QDOT available to shelter from gift taxation transfers to non-u.s. citizen spouses which exceed the annual exclusion (or which do not otherwise qualify for the exclusion). 12 I.R.C. 2505(a)(1). 3