Estate Planning IRS Circular 230 Disclosure To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. federal tax advice contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or tax related matter. in Uncertain Times 2010 Doc #76565844.2 1
Overview of Presentation The Current Transfer Tax System Uncertainty What Does the Future Hold? Reasons for Planning Non-Tax Reasons for Planning Tax Reasons for Planning Planning Strategies to Leverage Exemptions Lifetime Gifts Life Insurance Trusts (ILITs) Family Limited Partnerships (FLPs) Grantor Retained Annuity Trusts (GRATs) Sales to Grantor Trusts (IDITs) 2
Basic Components of the Current System Estate Tax (but not during 2010!) Gift Tax Generation-Skipping Transfer Tax (but not during 2010!) Basis Step-Up at Death (but not during 2010!) 3
Estate Tax ESTATE TAX (applies to transfers at death) 2009 2010 2011 and thereafter Estate Tax Free Amount $3,500,000 No Estate Tax $1,000,000??? Top Marginal Tax Rate 45% N/A 55%??? 4
Gift Tax $1,000,000 = Exempt Amount Year 2009 2010 2011 Top Marginal Tax Rate 45% 35% 55% NOTE: The 2001 Tax Act did not repeal the gift tax. The Act de-coupled the estate tax from the gift tax beginning in 2002. 5
Generation-Skipping Transfer Tax 2009 2010 2011 and thereafter Exemption $3,500,000 No GST Tax $1,000,000 (indexed for inflation)??? Rate of Tax (on all amounts in excess of exemption) 45% N/A 55%??? 6
Generation-Skipping Transfer Tax Examples of Generation-Skips (Subject to GST Tax): Outright Gift to Grandchild (Direct Skip Transfer) Gift to Child in trust, remainder to Grandchild: Non-exempt Trust Trust assets are subject to GST Tax upon death of all in the next lower generation (i.e., a Taxable Termination) Exempt Trust A trust to which the grantor allocates a portion of the grantor s lifetime GST Tax exemption to cover the initial gift to the trust (and any further gifts thereafter) Gift to Child and Grandchildren in Trust: Only distributions made to Grandchildren are subject to GST tax (i.e.,taxable Distributions) 7
Basis Adjustment at Death Old Law (until 1/1/2010, and after 1/1/2011): Step-up at Death Example: Joe buys stock for $10/share At death the stock is worth $100/share If heirs sell stock for $105/share only realize $5 gain per share (basis = $100 share) New Law for Year 2010 (But commencing on 1/1/2011 the estate tax law reverts to that in the year 2000): Example: Joe buys stock for $10/share At death the stock is worth $100/share If heirs sell stock for $105/share will realize $95 gain per share Note: $3,000,000 property step-up between spouses $1,300,000 property step-up for all other heirs 8
What Does the Future Hold? Permanent repeal of the estate tax is no longer considered a realistic expectation. General consensus was that Congress would act to prevent 2010 repeal from taking place - wrong! Congress may not act to retroactively re-instate a permanent estate and GST Tax during 2010, so uncertainty may continue to abound until 2011. Without Congress acting during 2010, 2011 will be a Back to the Future or Bobby Ewing s dream in Dallas because the rates and exemptions will reset to 2002 levels (55% top marginal estate tax rate and $1,000,000 individual lifetime or death time exemption amount). 9
Selected Pending Legislation H.R. 3841 proposal is an immediate increase of the exemption to $5M (no phase-in period) and a 45% maximum rate. H.R. 3905 proposal for $5M exemption indexed after 2019 and lowering top rate from 45% to 35%; all changes phased in over 10-year period (47 cosponsors). S. 2784 $3.5M exemption indexed for inflation with re-unification of the estate and gift tax exemptions; 45% top rate; portability between spouses. 10
Selected Pending Legislation H.R. 5029 proposes to make Federal repeal of estate and generation-skipping transfer tax permanent. H.R. 436 provide for $3.5M exemption and 45% maximum rate; contains provisions about the valuation rules for certain business interests. S. 722 makes permanent rules in effect in 2009 ($3.5M exemption; 45% rate) and provides for portability between spouses of any unused exemption. H.R. 498 provides for $5M exemption by 2015 and reunification of estate and gift exemptions; provides for inflation adjustment after 2015; reduces estate tax brackets to capital gains rates up to $25M and twice capital gains rates over $25M; allows for portability between spouses (7 co-sponsors). H.R. 4899 passed House July 1, 2010, and mandates a 10- year minimum term for GRATs. 11
What Congress Will Decide Is Unknown But Consider This: Table I. Percentage of Decedents Subject to Estate Tax Exemption Level $1 million $3.5 million $3.5 million, indexed for inflation $5 million $5 million, indexed for inflation 2011 1.76 0.25 0.24 0.14 0.14 2019 3.00 0.46 0.32 0.23 0.18 Source: Congressional Research Service, Estate Tax Options dated April 20, 2010. 12
What Congress Will Decide Is Unknown And Consider This: Table II. Estate Tax Liability Under Alternative Proposals ($billions) $1 million, 55% rate $5 million/ 35% rate Exemption Level $3.5 million/ 45% rate $3.5 million, indexed for inflation/ 45% rate $5 million, indexed for inflation/ 35% rate 2011 34.4 18.1 17.9 11.2 11.2 2019 62.2 31.5 28.9 20.9 17.9 Source: Congressional Research Service, Estate Tax Options dated April 20, 2010. 13
What Congress Will Decide Is Unknown And, Finally, This: Table 5. Percentage Distribution of Estate Tax Revenue by Type of Return, 2011 Size of Estate ($millions) 1-2 2-3.5 3.5-5 5-10 10-20 Over 20 Total $1 Million Exemption, 55% Rate ($34.4 billion total) 7.5 15.9 10.8 18.3 13.9 33.7 100.0 3.5 Million Exemption, 45% Rate ($18.1 billion total) 0.0 0.0 2.4 16.1 18.3 62.3 100.0 $5 Million Exemption, 35% Rate (11.2 billion total) 0.0 0.0 0.0 9.5 18.0 72.5 100.0 Source: Congressional Research Service, Estate Tax Options dated April 20, 2010. 14
Reasons for Planning Non-Tax Reasons: You determine to whom your property passes Expenses will be minimized Guardianships may be avoided Offers opportunity to: Protect beneficiaries against creditors and divorcing spouses Keep property in the family Provide for ongoing management of assets 15
The Basic Components: Either a Will or Pour-Over Will and a Living Trust Statutory Durable Power of Attorney Medical Power of Attorney Directive to Physicians and Family or Surrogates Beneficiary Designations Life Insurance IRA Accounts Retirement Plans Consider multi-party accounts like JTWROS/POD 16
Beneficiary Designations: Beneficiary Designations Cover: Life Insurance Policies IRA Accounts and 401K Accounts Retirement Plans The critical component of dealing all types of nonprobate assets is properly coordinating their passage with the overall estate plan, the tax and expense allocations, etc. to achieve the testator s overall objectives. 17
When is Estate Tax Planning Needed? If combined property (including equity in residence, investments, life insurance proceeds, retirement accounts, etc.) exceeds $3.5M (in 2009) or maybe $1.0M (in 2011)... Assume total estate of $10,000,000 (all community) Leave everything to spouse (unlimited marital deduction) If spouse not living, all to children This is a common estate plan, but... What are the tax results? 18
Assuming $10,000,000 Total Community Property Estate Husband $5,000,000 Wife $5,000,000 After death of husband $10,000,000 Year 2009 2010 2011* Tax on Wife s Death $2,925,000 N/A $4,795,000 Assets to Children $7,075,000 $10,000,000 $5,205,000 No tax on Husband s death *Assumes no reform is passed and pre-egtrra rules apply starting 1/1/2011. 19
Credit Shelter Bypass Trust Funded at death with the decedent s available applicable exclusion amount (AEA) Creates a taxable estate, but the federal estate taxes are offset by the AEA Lifetime taxable gifts reduce (AEA) at death Trust bypasses the surviving spouse s estate, but may provide spouse with lifetime benefits Zero estate-tax plan combines marital and nonmarital bequests in a way that minimizes taxes across both spouse s estates 20
Wills with Credit Shelter Bypass Assuming $10,000,000 Total Community Property Estate Husband $5,000,000 Wife $5,000,000 Applicable Exclusion Amount to Bypass Trust for Wife and children (No estate tax) Excess over Applicable Exclusion Amount to Wife Year 2009 2010 Tax on Wife s Death $1,350,000 N/A Children $8,650,000 $10,000,000 2011 $2,870,000 $7,130,000 (No estate tax on Wife s death) Children (Less estate tax due on Wife s death) 21
Compare Bypass / No Bypass Year Net to Children With Bypass Net to Children Without Bypass Difference 2009 $8,650,000 $7,075,000 $1,575,000 2010 $10,000,000 $10,000,000 N/A 2011 $7,130,000 $5,205,000 $1,925,000 22
Other Issues Marital Trusts Trusts for descendants Appointment of fiduciaries Designation of contingent takers Generation-Skipping Planning Charitable dispositions 23
Lifetime Giving Annual Exclusion from Gift Tax (2010 = $13,000) Use of Lifetime $1,000,000 Gift Tax Exemption * Ongoing use of annual exclusions for gifts can be powerful over time *Congress kept the lifetime gift tax exemption at its pre-2001 Act level of $1,000,000, thereby decoupling the gift tax system from the estate tax system under EGTRRA. 24
Benefits of Making Gifts Lifetime Giving Donor enjoys personal benefits of assisting donee Reduces taxable estate Donor controls timing of transfer Income-tax savings if donee is in lower tax bracket Drawbacks of Making Gifts Transfer is irrevocable Loss of income on transferred property Donor may owe gift taxes Carryover basis treatment for donee 25
Lifetime Giving Annual exclusion cash gifts over 10-year period 2 donees with gift-splitting 45% marginal estate tax bracket will apply 6% annual growth rate $800 $700 $600 $500 $400 $300 $200 $100 Wealth Transfer Comparison in $Thousands $0 Value of Gifts Taxes Saved 26
Section 529 Plans Tax free growth Tax free withdrawal for qualified educational expenses Flexible in choice of schools State residency is neutral Allows switching eligible beneficiaries Allows front-end funding initially of 5X annual exclusion 27
Lifetime Giving Other strategies that leverage amount gifted Life Insurance Trusts (ILITs) Family Limited Partnerships (FLPs) Grantor Retained Annuity Trusts (GRATs) Sales to Grantor Trusts (IDITs) 28
Life Insurance Trust Know the following about life insurance policies: The Owner The Insured The Beneficiary Fact: Life insurance is an asset of the Owner s Estate 29
Life Insurance Trust Trust as owner and beneficiary of policy Moves proceeds out of insured s estate Gifts to trust can qualify for annual exclusion Spouse can be beneficiary Mechanics very important 30
Family Limited Partnership (FLP) Concept: A method of consolidation of asset management and ownership as well as insulating estate assets from creditors and liability claims. Clients (H&W) form a FLP for the purpose of holding certain of their assets (ideally, the assets should be ones expected to appreciate in value over time). Clients form a Limited Liability Company (LLC) to act as the general partner of the FLP (this provides an additional layer of creditor and liability protection as well as providing for control the FLP). The clients now own limited partner interests in a FLP rather than the assets they have contributed to the FLP; if transfers are made, the FLP interests will have to be appraised to determine fair market value (due to associated lack of control and lack of marketability). Congress is considering the elimination of any valuation discounts through legislation. 31
FLP (Example) Illustration of Client s Balance Sheet Before and After FLP Transfer Description Current To FLP After FLP Cash & Liquid Investments $15,000,000 $(10,000,000) $ 5,000,000 Closely Held Stock 12,000,000 (12,000,000) 0 Retirement Plan 1,200,000 0 1,200,000 Real Estate 1,200,000 (1,200,000) 0 Personal Residence 500,000 0 500,000 Automobiles 50,000 0 50,000 Other Miscellaneous Assets 50,000 0 50,000 Subtotal 30,000,000 (23,200,000) 6,800,000 Family Limited Partnership 0 23,200,000 15,080,000 Less: Assumed 35% Discount N/A (8,120,000) N/A Total Assets (for Estate Tax) $30,000,000 $15,080,000 $21,880,000 32
FLP (Example) Graphic Illustration of FLP Structure General Partner LLC 1.00% $232,000 * Owner Holdings, Ltd. Total Assets 23,200,000 Mr. Owner, Limited Partner 49.25% Trust for Children, Limited Partner.50% Mrs. Owner, Limited Partner 49.25% * Owners first fund LLC with $232,000 which LLC contributes to FLP for its 1.0% General Partnership interest. 33
FLP (Example) Illustration of Estate Taxes Due NO Family Partnership At Husband s At Wife s Without Family Partnership Death in 2009 Death in 2009 Gross Estate $ 15,000,000 $ 15,000,000 (1) Marital Deduction Gift (15,000,000) 15,000,000 (1) Taxable Estate -0-30,000,000 Gross Estate Tax -0- at 45% 13,380,800 at 45% Less: Estate Tax Credit -0- (1,455,800) Total Estate Tax Due -0- $ 11,925,000 NOTES: ( 1 ) This illustration assumes no increase or decrease in the estate assets from Husband s death until Wife s death. 34
FLP (Example) Illustration of Estate Tax Savings WITH Family Partnership Assumed Discount Rate = 35% At Husband s At Wife s Without Family Partnership Death in 2009 Death in 2009 Gross Estate $ 10,940,000 $ 10,940,000 (1) Marital Deduction Gift (10,940,000) 10,940,000 (1) Taxable Estate -0-21,880,000 Gross Estate Tax -0- at 45% 9,726,800 at 45% Less: Estate Tax Credit -0- (1,455,800) Total Estate Tax Due -0- $ 8,271,000 Potential Estate Tax Savings Resulting from Family Partnership: $ 3,654,000 (2) NOTES: ( 1 ) This illustration assumes no increase or decrease in the estate assets from Husband s death until Wife s death. ( 2 ) Estate Tax without FLP of $11,925,000 less $8,271,000 estate tax with FLP results in savings of $3,654,000. 35
GRAT (Grantor Retained Annuity Trust) Concept: A method of gifting property with reduced or eliminated gift tax. Transfer an asset to a trust (GRAT) in exchange for an annuity payment from the trust for a term of years (the taxable gift, if any, is equal to the value of the property transferred to the trust less the present value of the annuity payments). If the grantor survives the term of years, the remaining trust principal passes to the beneficiaries free of transfer taxes and the donor s interest in the trust terminates. If the grantor dies prior to expiration of the term, the trust property is included in his estate. The longer the term and the lower the AFR rate when the property is transferred, the higher the value of the annuity which reduces the amount of the taxable gift (which may approach zero with prudent planning). Congress is considering 10-year minimum terms for GRATs. 36
Example: GRAT (Cont.) Glen (regardless of age) owns a commercial building in San Antonio which is worth $1,000,000 and generates net rental income annually of $100,000. Glen transfers the building to a GRAT retaining an annual annuity of $116,038 from the GRAT for 10 years. Gift Tax Result: (Current Sec. 7520 Rate = 2.8% for 7/2010) Fair Market Value of Property $1,000,000 Retained interest (Value of the Annuity) $999,999 Net Gift Tax Value of $1.00 (a zero-out GRAT) Grantor pays trust s income tax further reducing Grantor s estate Caveat: Glen must live 10 years for gift not to be in Glen s gross estate No generation-skipping permitted 37
GRAT (Cont.) Glen $1 Million transferred to Fund Trust (Gift Tax Negligible) Trust with a 10 Year Term Annuity to Glen for 10 Years (beginning at $116,038 annually) Balance of Trust $ to Children after 10 Year Term* * At 6.0% annual growth, after 10 year term, remainder is $328,624. 38
GRAT (Cont.) Glen $1 Million transferred to Fund GRAT (Gift Tax Negligible) GRAT with a 5 Year Term Annuity to Glen for 5 Years (ranging from $147K to $305K annually) Balance of GRAT $ to Children after 5 Year Term* * At 12.0% annual growth, after 5 year term ends, remainder is $425,326. 39
Sale to Grantor Trust Concept: A method of freezing the value of one s estate by transferring in trust to descendants tax free certain assets expected to appreciate in exchange for either cash, a note, or private annuity. Clients form a defective grantor trust for the benefit of their children (i.e., the trust is not recognized for federal income tax purposes, but considered a valid trust for estate tax purposes). Clients sell assets that are expected to appreciate in value to the grantor trust in exchange for cash, a note, or a private annuity. The use of a promissory note with a favorable AFR interest rate as consideration can help solve liquidity problems and reduce the present value cost of the transaction. 40
Sale to Grantor Trust (Cont.) Example: Clients own FLP interests valued at $3.0 million (a 35% discount from the value of underlying FLP assets of $4.6 million). Clients form a trust for the benefit of their children (the trust is a grantor trust for federal income tax purposes). Clients gift $100,000 of seed capital to the trust. Clients sell 1/3 of their FLP interests to the grantor trust for $1.0 million in exchange for a note (capable of being paid off from trust income) at current AFR interest rate. No gift or income tax is incurred by the clients, their children or the trust as a result of the sale and the gifts. The value of the clients estates is frozen equal to the value of their proceeds from the sale to the trust for the FLP interest sold. All future appreciation on the assets sold to the trust is removed from the clients estates. Except in 2010, the trust can be made exempt from GST tax and last in perpetuity (depending on state in which it established). 41
Sale to Grantor Trust (Cont.) Clients Leveraged Sale of Property to IDIT at Discounted FMV (no taxable gain) Intentionally Defective Irrevocable Trust ( IDIT ) $100K Cash Gift and $1 Million Sale Clients Estate is Frozen at the Value of the Note 9 Year Note Appreciation in Value of the Property to Children Free of Estate Tax* * At 6.0% annual growth, the trust corpus is $426,947 after payment of note in 9 years. 42
Importance of Planning In the space of two days, I had evolved two plans, wholly distinct, both of which were equally feasible. The point I am trying to bring out is that one does not plan and then tries to make circumstances for those plans. One tries to make plans fit the circumstances. General George Patton, Jr. 43