Legal & Tax Trends A Publication of Business and Individual Planning June 2003 A NOTE TO OUR READERS This issue of Legal & Tax Trends discusses recent developments in estate, business and employee benefit planning. As in the past, we will be publishing several more issues in the current year. In addition to keeping you informed about recent developments that may impact your practice or business, we will take selected topics concerning estate, business and employee benefit planning and will present an in-depth discussion of the issues involved. Your comments are invited and appreciated. INSIDE THIS ISSUE: Recent Developments in Estate, Business and Employee Benefit Planning Page 2 Cost of Living Adjustments for 2003 Page 3 Retirement Benefits and Qualified Domestic Trusts (QDOTs) Page 4 Assets Transferred to Family Limited Partnership Included in Estate Page 5 Exchange of Annuity Contracts Qualifies for Section 1035 Treatment Page 6 Sale of Life Insurance Policy From One Grantor Trust to a Second Grantor Trust Not a Transfer-for-Value Page 7 Long-term Disability Benefits Excludable from Income
Cost of Living Adjustments for 2003 IR-2002-111 Revenue Procedure 2002-70 Social Security The FICA tax rate, which is the combined social security tax rate of 6.2% and the Medicare tax rate of 1.45%, will remain at 7.65% for the year 2003. However, the social security wage base will increase from $84,900 to $87,000. The maximum social security tax that employees and employers will each pay is $5,394, an increase of $130.20. There is no limit to the wages subject to the 1.45% Medicare tax. Qualified Plans The Economic Growth and Tax Relief Reconciliation Act of 2001 substantially increased the statutory thresholds for dollar limitations on benefits and contributions under qualified retirement plans. Many of the limitations will not change in 2003, and the cost-of-living increases for 2003 generally are below the thresholds that would otherwise trigger the adjustment. On the other hand, some of the limitations will increase as provided for in the 2001 tax act. The IRS has announced the following cost-of-living limits for qualified plans, effective January 1, 2003: 1. The limitation on the annual benefit under a defined benefit plan remains unchanged at $160,000. 2. The limitation for contributions to defined contribution plans remains unchanged at $40,000. 3. The maximum amount of compensation that can be considered for qualified plan purposes will remain at $200,000. 4. The dollar limitation concerning the definition of a key employee in a top-heavy plan will remain at $130,000. Limitations changing as a result of the Economic Growth and Tax Relief Reconciliation Act include the following: 1. The limit on elective deferrals for 401(k) plans increases to $12,000. 2. The limit regarding SIMPLE retirement accounts is increased from $7,000 to $8,000. 3. The dollar limitation for catch-up provisions for 401(k) plans for individuals aged 50 and over increases to $2,000. Gift and Generation-Skipping Tax The following cost-of-living adjustments for gift and generation-skipping tax purposes have been made for the year 2003: 1. Annual Exclusion- the annual exclusion for taxable gifts will remain at $11,000 for the year 2003 2. Exclusion for Gifts to Non-Citizen Spouses- the annual exclusion for gifts to non-citizen spouses will increase to $112,000. 3. Generation-Skipping Transfer Tax Exemption- the exemption will increase to $1,120,000. Page 2
Retirement Benefits and Qualified Domestic Trusts (QDOTs) PLR 200241012 Decedent executed a revocable trust that created a marital deduction trust and a residuary trust designed to take advantage of the applicable credit against estate taxes. The transfer of any assets, including retirement assets, to the marital trust was intended to qualify for the unlimited marital deduction as a qualified terminable interest property trust (QTIP). The spouse had a qualifying income interest for life, and no person other than the spouse could receive distributions of principal during the spouse s lifetime. Decedent s spouse was not a United States citizen. Under section 2056 of the Code, a marital deduction is generally disallowed for any property passing to a non-citizen spouse. If the spouse becomes a citizen prior to the filing of the estate tax return for the decedent s estate, and if the spouse was a U.S. resident at all times after the decedent s death until becoming a citizen, the normal marital deduction is available. Otherwise, in order to get the deduction the property must pass to the spouse in a qualified domestic trust (QDOT). The trust in question provided that so long as the spouse was not a U.S. citizen at least one trustee had to be a U.S. citizen or domestic corporation, and if any distributions of principal were made from the trust the trustee had to withhold federal estate tax from those distributions. The IRS ruled that the trust qualified both as a QTIP and a QDOT. The marital trust also contained language that was specifically applicable to retirement benefits in case any benefits payable under a qualified plan or IRA were paid to the trust as the designated beneficiary. To satisfy the requirement under Revenue Ruling 2000-2 dealing with qualifying retirement benefits for the marital deduction, the trust contained provisions requiring the trustee to withdraw from each retirement plan each year an amount that was the greater of the net income from the plan or the required minimum distribution. Each of the distributions was to be allocated to the income of the marital trust and distributed to the trust. Therefore the IRS further ruled that the Spouse would receive a qualifying income interest for life in the retirement benefits. Proper planning for the distribution of retirement benefits to surviving spouses is critical, particularly since the retirement benefits are often one of the largest assets of the client s estate. Consideration needs to be given to the spouse s need for income, qualification for the marital deduction, the impact of the required minimum distribution rules, and whether to leave the benefits directly to the spouse or to take advantage of trusts. If the decision is made to use a marital trust, the trust is often a QTIP, which requires that all trust income must be paid at least annually to the surviving spouse. If the spouse is not a United States citizen the planning can be even more complicated. Since the general rule is that property passing to a surviving spouse who is not a United States citizen will not qualify for the normal marital deduction, a QDOT is frequently used to qualify for a modified version of the marital deduction. Under such an arrangement, the marital property is not simply deducted from a decedent s estate and added to the surviving spouse s estate. Instead, the estate tax is deferred until a non-hardship distribution of principal is made to the spouse or until the surviving spouse dies. Page 3
The facts in PLR 200241012 demonstrate the proper way to create a trust that qualifies both as a QTIP and as a QDOT in order to qualify retirement benefits for the marital deduction. Assets Transferred to Family Limited Partnership Included in Estate Kimbell v. U.S., 244 F. Supp 2d 700 (2003) Less than three months prior to her death, the decedent established a limited liability company (LLC) with her son and her son s wife. Fifty percent of the LLC was owned by decedent s revocable trust, twenty-five percent by her son, and twenty-five percent by her daughter-in-law. Three weeks later the revocable trust and the LLC created a family limited partnership whereby the revocable trust received a 99 percent limited partnership interest in exchange for its contribution, and the LLC received a one percent general partnership interest. The assets that the decedent transferred to the partnership had a value of approximately $2.643 million prior to the transfer, and the estate of the decedent reported that the value of her interest in the partnership was approximately $1.257 million. The IRS audited the estate, taking the position that Section 2036 of the Code was applicable and included the full value of $2.643 million in the estate. The court agreed with the IRS and held that the transfer by the decedent to the limited partnership was subject to Section 2036. Section 2036 includes in the gross estate the value of all property transferred during lifetime with respect to which a decedent retains the right to the use and enjoyment of the property. If the transfer of property is a bona fide sale for adequate and full consideration, the section is inapplicable. The court held that the formation of the limited partnership was not an arm s-length transaction because the decedent, by virtue of her interests in the trust and the LLC, stood on both sides of the transaction. Because the decedent had the right to remove the general partner, she had the right to personally benefit from the income and/or to designate the persons who could enjoy the income. Furthermore, the court ruled that general partner had no fiduciary duty to the partnership that would have prevented the decedent from exercising those rights. Family limited partnerships have been and continue to be a popular estate planning technique for clients with significant closely held business assets, real estate, or investment portfolios. A partnership can be used to consolidate the management of a family s business and/or investment interests. Forming a partnership can also facilitate annual exclusion gift to family members, as well as potentially providing significant valuation discounts. Successful planning, however, requires that the partnership be recognized for tax purposes. The Kimbell case is an example of how the deathbed transfer of assets to a family partnership can result in estate tax inclusion. Fortunately, the rationale of the court in including the full value of the partnership assets in the decedent s estate may be limited to deathbed situations. In general, the IRS has not had significant success in challenging valuation discounts in nondeathbed situations when the partnerships have been validly formed and have a legitimate business purpose. Page 4
Exchange of Annuity Contracts Qualifies for Section 1035 Treatment PLR 200243047; Revenue Ruling 2002-75 Section 1035 provides, in part, that no gain or loss shall be recognized on the exchange of an annuity contract for another annuity contract. In two different rulings in the last quarter of 2002, the IRS ruled positively on proposed exchanges that involved more than an exchange of one contract for another contract. In PLR 200243047 the taxpayer owned a deferred annuity contract and proposed to exchange it for two new annuity contracts in a single transaction with the same insurance company. Upon the exchange, part of the amount transferred from the original contract was to be applied to the first scheduled payment of one of the newly issued contracts (hereinafter referred to as the first contract), and the balance was to be applied to the other newly issued contract (hereinafter referred to as the second contract). The two new contracts were separate contracts and served somewhat different purposes. The first contract was specifically aimed at providing retirement income and contained a guaranteed minimum income feature under which the insurance company regardless of the investment performance of the contract would guarantee a specified level of monthly annuity payments. The second contract was a variable annuity contract that would invest in equity securities, debt securities and foreign securities. The taxpayer would choose all investment options and would bear all the investment risks. In addition to the different investment choices, the two contracts had different payout options. On the annuity starting date, the first contract would be converted into a variable monthly income benefit selected by the taxpayer at the time the contract was issued, that being a life annuity plan with a period certain of at least ten years. The second contract would be converted into either a fixed or variable monthly income plan, with several different payout options, on the annuity starting date. Although there were clearly two new contracts, with two different policy numbers, the insurance company would track the contracts as a single contract for tax reporting purposes. The contracts would represent a single aggregate investment and, while transfers were contemplated between the two contracts, the transfers would not result in any change in the aggregated investment. The IRS ruled that the exchange would qualify as a tax-free exchange under section 1035. Comparing section 1035 to section 1031 that deals with exchanges of certain real property, the Service determined that the transfer of property otherwise qualifying as a tax-free exchange should still be tax-free even if the taxpayer receives more than one property in exchange for only one property. The IRS further ruled that the policies would be treated as one contract for income tax purposes under section 72 of the Code. Therefore, the transfer of funds within the policies would be considered to be a movement of funds within a single annuity and would not be treated as a taxable distribution. In Revenue Ruling 2002-75 the IRS addressed a different issue, the aggregation of annuity contracts. The issue was whether the transfer of an entire annuity contract issued Page 5
by one company into another pre-existing contract issued by another company would qualify as a tax-free exchange under section 1035 of the Code. Corollary issues were the determination of the basis under section 1035 and the determination of the investment in the surviving contract under section 72 of the Code. Under the facts of the ruling, individual A owned annuity contract B, issued by Company B, and also owned annuity contract C, issued by Company C. A assigned contract B to Company C and Company B transferred the entire cash surrender value of Contract B directly to Company C. A would not receive any of the cash surrender value of Contract B, and no other consideration would be paid by A in the transaction. The IRS ruled that the assignment of Contract B to Company C for consolidation with the pre-existing Contract C was a tax-free exchange under section 1035. After the assignment, A s basis in the consolidated contract equaled the sum of his basis in the first contract and the second contract. Finally, under section 72, A s investment in the consolidated contract equaled the sum of A s investment in the first and second contract immediately prior to the exchange. These two rulings are good news. Section 1035 of the Code was designed to eliminate taxation in the case of individuals who have exchanged one annuity contract for another better suited to their needs, but really did not recognize any gain. PLR 200243047, while it is a private letter ruling applicable only to the taxpayer who requested the ruling, allowed a one for two annuity swap. This is an example of the IRS adopting a flexible rather than a restrictive approach to section 1035. This approach helps provide assurances that there will be opportunities to adjust a client s annuity holdings to meet his or her investment objectives. Revenue Ruling 2002-75 held that the consolidation of two annuity contracts issued by different companies, if the proper formalities are followed, will be tax-free under section 1035. A revenue ruling, unlike a private letter ruling, can be relied upon by future taxpayers. Therefore, the ruling provides certainty and a roadmap to follow for taxpayers who wish to consolidate contracts. Sale of Life Insurance Policy From One Grantor Trust to a Second Grantor Trust Not a Transfer-for-Value PLR 200247006 Section 101 of the Code, in general, provides that the proceeds of life insurance contracts payable by reason of death are specifically excluded from gross income. However, in the case of a transfer of a policy for a valuable consideration, the amount excluded from gross income shall not exceed the actual value of such consideration and the premiums and other amounts subsequently paid by the transferee. This transfer-for-value rule subjecting death benefits to taxation does not apply if the transfer is to the insured, to a partner of the insured, to a partnership in which the insured is a partner, or to a corporation in the insured is a shareholder or officer. The rule also does not apply if the transferee s basis in the policy is determined in whole or in part by reference to the transferor s basis. Page 6
Given the significant income tax benefits afforded life insurance, avoiding the transfer-forvalue rule is extremely important. In PLR 2002247006 husband and wife initially created two grantor trusts. The first trust was created by the husband and the second trust was created by the husband and the wife. The first trust owned single life policies on the life of the husband. The second trust owned survivorship policies on the joint lives of the husband and wife. Husband and wife then created a second set of trusts. They proposed to transfer the life insurance policies on the life of the husband from the first trust created by him to the second trust created by him, and they proposed to transfer the survivorship policies from the first jointly created trust to the second one. In each case, the new trusts were to purchase the policies from the old trust. The taxpayers requested a ruling that the transfers of the policy for valuable consideration would not subject the proceeds to income taxation. The Service ruled that if a grantor is treated as owner of the entire trust, the grantor is considered to be the owner of the trust assets for federal income tax purposes. There is no recognition of gain or loss upon a sale of assets from a person to himself or herself. Therefore, the transfer is disregarded for federal income tax purposes and the death proceeds will not be subject to income tax. PLR 200247006 suggests that through the proper use of intentionally defective or grantor trusts, it is potentially possible to add flexibility to an estate plan by removing policies from one trust and transferring them into another. However, before placing too much reliance on the ruling, several factors should be considered. The IRS did rule favorably on the transfer-for-value issue, but it based its ruling on the representations from the taxpayer that the trusts in question were grantor trusts. It should be noted that the IRS will not issue advance rulings on whether a trust that has substantially all of its assets in life insurance is a grantor trust. Furthermore, the IRS did not address any gift or estate tax issues in the ruling. It will be important to check the specific terms of the trusts in question. Also, in order to avoid gift tax consequences, the consideration paid for the policy needs to be equal to the fair market value of the policy. Long-term Disability Benefits Excludable from Income PLR 200312001 Under section 104(a)(3) of the Code a taxpayer, with certain exceptions, does not have to include amounts received through accident or health insurance coverage for personal injuries or sickness. This exclusion extends to disability income benefits and there is no limit on the amount of benefits that can be received tax-free. However, Section 105 of the Code specifically provides that amounts received by an employee through accident or health insurance will be included in gross income to the extent that such amounts are paid by the employer or are attributable to contributions by the employer that were not includable in the gross income of the employee. Under the facts of PLR 200312001 an employer sponsored an employee welfare benefit plan. The plan provided long-term disability coverage for all of the employer s eligible employees under a group insurance policy issued by a third-party insurance carrier. Under Page 7
the plan, employees could pay the premium for coverage on an after-tax basis, otherwise the employer would pay the premium for coverage. If the employer paid for the coverage, the premium amount is not included in the gross income of the employee. The employees must decide each year to elect to have the employer pay the group disability insurance premiums charged by the insurance carrier, or elect to pay the insurance premiums themselves with after-tax dollars. The employees must decide in writing prior to the beginning of each plan year during which the payments are to be made to either have the employer pay for the long-term disability coverage or to have the premium amounts treated as bonuses and included in their gross income. Once made the election is irrevocable for the plan year once the plan year begins. Eligible employees will be able to make a new premium payment election for the following plan year prior to the beginning of the next plan year. The IRS ruled that long-term disability benefits paid to an employee who had elected to have the premiums included in gross income for the plan year in which he or she becomes disabled are attributable solely to after-tax employee contributions and therefore are excluded from the employee s gross income. On the other hand, the Service ruled that benefits paid to an employee who has decided, under the same plan, to have the employer pay for the premiums for the plan year in which he or she becomes disabled are attributable solely to the employer s contribution and are includable in the employee s gross income. The rules concerning the taxation of disability benefits are governed by the same Code sections, as are the rules for personal health benefits. In general, as a matter of public policy, Congress has determined that certain benefits should be income tax-free. This is the case for disability benefits if the taxpayer either paid for the insurance providing those benefits or reported income on the cost of the premiums. PLR 200312001 illustrates that there is flexibility in determining the potential tax consequences upon the receipt of long-term disability payments. In this case the taxpayer created a plan that took maximum advantage of that flexibility by allowing the employees to choose which option they wanted on an annual basis. is jointly published by the Business and Individual Planning attorneys of MetLife, GenAmerica Financial and New England Financial. The following individuals contribute to this publication: At MetLife: Lori Epstein, Jeffrey Hollander and Jeffrey Jenei; At GenAmerica Financial: Andrew Weinhaus, Thomas Barrett, Sonja Hayes and Benjamin Trujillo; At New England Financial: Stephen Chiumenti, Kenneth Cymbal, Stephen Houlihan, Margaret Muldoon, and Stacy Wolfe. The information provided is derived from sources believed to be accurate. This publication is not intended as legal advice; for this you should consult your attorney. L0306H1FY (exp 0606)NEF-LD Page 8