Wills, Trusts & Estates Prof Blog

IRS Addresses Income Tax Basis Increases for Assets Held in Grantor Trusts

In a recent private letter ruling, the IRS found assets in a foreign grantor trust received an income tax basis increase upon the death of the grantor. 

The non-citizen grantor created a foreign grantor trust funded with shares of non-U.S. corporations.  The trust provided that, upon the grantor’s death, its assets would be distributed to the grantor’s children who were U.S. taxpayers.  This trust property was not subject to the U.S. estate tax, but did “receive a fair market value income tax basis under IRC Section 1014(b)(1).”

The IRS would probably not agree that a wholly domestic grantor trust would receive such a basis increase upon the death of the grantor.

See Loeb & Loeb LLP, Private Letter Ruling Suggests That Assets Held in a Grantor Trust and Not Included in Grantor’s Estate May Nevertheless Receive a Basis Increase, Lexology, May 20, 2013.

Which States Impose Harsh Inheritance Taxes?

Not to be confused with the estate tax, which taxes an estate before heirs receive any payouts, the inheritance tax is taken directly from the heir after receipt of the inheritance.

The six states that impose a tough inheritance tax are New Jersey, Maryland, Iowa, Kentucky, Nebraska, and Pennsylvania.  These states typically charge an inheritance tax between 4% and 16%.  However, most of these states include exemptions for children, spouses, close family members, and charities.

See Dan Caplinger, These 6 States Tax Inheritances the Hardest, The Motley Fool, May 18, 2013.

Connecticut Rakes in Inheritance Taxes

Connecticut state officials estimated that they would collect about $150 million in inheritance taxes in 2012, but due to the death of an unprecedented amount of wealthy people, Connecticut will collect a staggering $428 million. 

This unexpected record amount is also due to an increase in gift taxes, a result of wealthy individuals making huge transfers in gifts before the higher federal gift tax rate increased from 35 to 40 percent on January 1, 2013. 

The wealthiest Connecticut residents to die in 2012 include Goldman Sachs investment partner Richard M. Ruzika, Standard Oil heir Lucie Cunningham Warren, and Wall Street investor Barton Biggs.

See Christopher Keating, Inheritance Windfall: Record-Breaking Year for Estate Taxes Helps Fuel Budget Surplus, Hartford Courant, May 11, 2013.

Take Advantage of Family Discounts Now

The Treasury Department has long maintained it has the authority under Internal Revenue Code § 2704(b)(4) to restrict or eliminate valuation discounts for transfers of interests in family-controlled entities, and Obama’s new budget proposal echoes this sentiment. 

Traditional planning techniques use “valuation discounts to enhance the transfer of wealth to heirs with little or no gift or estate tax consequences.”  The absence of the perennial proposal to restrict or eliminate intra-family valuation discounts in the Treasury Department’s “Greenbook” signals the likelihood of proposed § 2704 regulations.  Therefore, estate planners should promptly take advantage of valuation discounts before any regulations are enacted.

See Gordon A. Schaller & Scott A. Harshman, The “Death Knell” for Family Discounts?, Jeffer, Mangels, Butler & Mitchell, LLP, Apr. 24, 2013.

Tips To Help Achieve A Negative Tax Result

As the tax rules change financial, advisors are responsible for weighing the different tax implications of their advice. Recently, there has been a change of conventional thinking regarding trust strategy. It was believed that assets should be held in a bypass trust. The rational behind the bypass trust was to have the assets grow out of the estate. However, with higher capital gains taxes the opposite might be more accurate. Many people say that equities should be held in the spouse's name and bonds should be put in a bypass trust. However, the yield for bonds is flat and interest rates are rising. As a result, the increase in rates would have a negative impact on bonds.

In the current economy, many wealthy people have turned to fixed-income substitutes such as master limited partnerships in oil, or sovereign debt funds. A person with these substitutes might want to consider holding them in a bypass trust. Nonetheless, the trustee making this decision would still face challenges. Trustees owe a duty to all beneficiaries not just the spouse. Additionally, provisions in the will are not enough to offer a fiduciary only investing in these asset types.It will be up to the financial advisor to alleviate the negative income tax result. According to financial advisor Martin Shenkmen, any combination of the following might help with that goal:

1. Modify asset location decisions to favor investments generating cash flow in an individual client's name to cover income tax costs, or non-income-producing assets (such as growth stocks) in the trust, to lessen the income tax burdens added by the trust.
2. Favor tax-advantaged investments, such as tax-exempt bonds and insurance products inside the trust. If life insurance is to be used, be certain that the trust is suitable for holding the insurance since it may not have been designed with that purpose in mind.
3. Harvest gains and losses more aggressively and coordinate planning to reduce the income tax burden.

See Martin Shenkman, New Take on Trust Strategy, financialplanning.com, May 1, 2013.

Special thanks to Brian Cohan (Attorney at Law, Law Offices of Brian J. Cohan, P.C.) for bringing this article to my attention.

Estate Planning Important at All Income Levels

The American Taxpayer Relief Act made the exemption permanent at $5.25 million or $10.5 million for a couple, and it may seem like only the wealthy need to worry about estate planning. The New York Times reminds readers why individuals at all income levels need to have an estate plan in order.

An estate plan can insure that you have up to date beneficiaries listed on beneficiary designation forms. Many people designate a beneficiary when they initiate the forms and then forget about it. Intervening divorces or new additions to family could have an impact that requires a change in the listed beneficiary. 

People with dependent children should make sure that they have an estate plan that ensures they have lifes insurance and guardians for their children.  

Finally, when a person dies without a will, some states step in to sort things out and charge fees to do that, so it is best to have an estate plan in order to avoid such charges or an unwanted disposition of the person's estate. 

See Paul Sullivan, Estate Planning Remains a Moving Target Under The New Tax Law, The New York Times, Apr. 26, 2013. 

Special thanks to Jim Hillhouse (Professional Legal Marketing (PLM, Inc.)) for bringing this article to my attention.

State Gift and Estate Taxes Are Alive and Well

Even with the large federal unified credit, a taxpayer might still have to pay state estate taxes following their death. There are still 21 states with a state estate tax. The District of Columbia also imposes a state estate tax. The problem is that most of these do not have a large unified credit like at the federal level that excludes a good amount of income from taxation. For example, in New Jersey the exclusion limit is $675,000, in Rhode Island the limit is $910,725, and in New York the limit is $1 million. In each of these states, the top rate on income exceeding the exclusion is 16%.

remember, all of a person's assets are included in this amount. This could also include life insurance depending on who receives the policy and how the policy is owned. Furthermore, several states impose an inheritance tax, which is different from the estate tax. An inheritance tax is imposed on the beneficiaries after the distribution of property, with the exception of spouses is most states and children and relatives in some. The two states that impose an inheritance tax on Maryland and New Jersey. There are ways to reduce the amount that a person will pay in estate taxes. For example, a person could give deathbed gifts which are exactly what they sound. A person could technically give away enough money to decrease their estate to below the threshold amount, but that is not always the best. A better strategy might be to discuss things with an estate planning attorney in the person's state to figure out the best possible strategies. 

See Sandra Block, Retirement: State Estate Taxes Are Alive and Well, The Chicago Tribune, Apr. 16, 2013.

New Inheritance Tax Agreement Between France and Switzerland?

French Finance Minister recently announced that, in May, France will sign a new inheritance tax agreement with Switzerland. This agreement will replace a 1953 treaty that still existed between the two countries until France denounced it last year.

The new convention states that the succession and inheritance tax law to be applied is the law of the beneficiary's county of residence, not the deceased's.

As long as the parliaments in both countries approve the new convention, it will go into effect from January 1, 2014 forward.

See Ulrika Lomas, France, Switzerland Edge Closer to Inheritance Tax Deal, LowTax, Apr. 23, 2013. 

Pre-1990 Buy-Sell Agreements Not Subject to Code § 2703

A recent private letter ruling issued by the IRS verifies that buy-sell agreements entered into before October 8, 1990 are not subject to Internal Revenue Code § 2703. 

Code § 2703 “restricts the ability of a buy-sell agreement to control estate tax values in a closely held entity.”  These older agreements are not subject to § 2703 as long as they are not “substantially modified.”  Certain changes that are not viewed as substantial modifications include extending repayment terms and adjusting option prices to more closely approximate fair market value.  Even though older agreements may not be subject to Code § 2703, they “still must meet the requirements of Treas. Reg. § 20.2031-2(h), Rev. Rul. 59-60, 1959-1 CB 237, and applicable case law before the purchase price provided therein will control for federal estate tax valuation purposes.”

See Charles Rubin, Grandfathered Buy-Sell Agreements, Rubin on Tax, Apr. 7, 2013.

Obama’s Recent Budget Proposal Tough on Seniors

Barack Obama’s most recent budget proposal may not be too popular amongst senior citizens.  According to Merrill Matthews, “if Congress were to pass the president’s budget, seniors would have less money and worse health care, and pay more for the ‘privilege.’” 

In order to slow the growth of federal spending, Obama proposes social security cuts, medicare cuts, estate tax hikes, and 401(k) tax hikes.  To “cut” social security, Obama would reduce seniors’ annual cost of living adjustment (COLA), which is an increase in Social Security payments that reflects inflation.  Known as the “chained CPI,” this measure purports to save $130 billion over 10 years.  Additionally, Obama’s proposal cuts over $300 billion to Medicare Advantage plans and over $300 billion in reimbursements to Medicare providers.  The budget proposal would also increase the estate tax to 45 percent, hoping to save around $79 billion.  The proposal also tackles 401(k) retirement savings, placing a $3 million cap on tax free retirement savings and requiring non-spouse beneficiaries of 401(k) accounts to withdraw within five years, which would save an estimated $14 billion over 10 years.  Although these figures may be alarming to seniors, this budget proposal is unlikely to be passed.

See Merrill Matthews, Obama to Seniors: It’s Time for You to Pay, Forbes, Apr. 11, 2013.

Are Philanthropists Avoiding the Estate Tax?

Michael Krasny, the host of Forum, asked Grover Norquist about the pledge made by Bill Gates and Warren Buffett to give away half of their wealth. In response, Norquist suggested that these great philanthropists are actually trying to avoid the estate tax.  Instead of allowing the government to redistribute their wealth through the estate tax, Norquist believes philanthropists would rather choose the beneficiaries of their wealth themselves.  A downside to this assertion is that these philanthropists are deciding exactly what they wish to fund “and in many cases we’re talking about museums and universities, not homeless shelters and indigent mental-health programs.”

See Tim Redmond, Norquist Exposes Tax Avoiders, San Francisco Bay Guardian, Apr. 3, 2013.

Indiana Might Repeal Their Inheritance Tax

From the bill, it appears that the State Legislature of Indiana will attempt to repeal their inheritance tax. The text of bill alters the date that the inheritance tax is suppose to expire from January 1, 2022 to January 1, 2013. Additionally, the new bill states that the individual counties are "not entitled to an inheritance tax replacement amount for a state fiscal year beginning after June 30, 2013."

See Digest of House BIll 1001, 2013 First Regular Session, Apr. 9, 2013.

Special thanks to Sean J. Fahey (Hall Render Killian Heath & Lyman, P.C.) for bringing this article to my attention.

Article on Achieving Horizontal Equity Through Estate and Gift Tax Reformation of Valuation

John F. Coverdale (Professor of Law, St. John's University) recently published an article entitled, Of Red Bags and Family Limited Partnerships: Reforming the Estate and Gift Tax Valuation Rules to Achieve Horizontal Equity, 51 U. Louisvile L. Rev. 239 (2013). Provided below is the introduction to his article:

Imagine a primitive society in which people store gold nuggets in bags. Neither buyers nor sellers of nuggets care what color the bags are because the value of the nuggets is set solely by their weight and purity. The only time anyone cares about the color of the bag is at death, because for purposes of the estate tax, the government assigns nuggets stored in red bags a much lower value than nuggets stored in any other color bag. This means that decedents who have stored their nuggets in red bags will owe substantially less tax than those who have used any other color.

The red bag discount flies in the face of economic reality because the color of the bag does not change the value of the nuggets. It also violates the principle of horizontal equity, which requires that similarly situated taxpayers pay the same amount of tax. For any given level of revenues, the red bag discount means that the rate of tax levied on nuggets stored in any other color bag must be higher than it otherwise would be. This leads to gross inequity: those who are well-enough advised to store their nuggets in red bags will pay less than their fair share of the total tax and all others will pay more than their fair share.

In the United States today, family limited partnerships (“FLPs”) are the red bags. The minority and marketability discounts granted for estate and gift tax to interests in FLPs are as out of touch with economic reality and as unfair as the red bag discount of the hypothetical society.

To illustrate this point and see the inequities it engenders, consider the case of three taxpayers, each of whom has three children and owns $10 million worth of Google stock that she wishes to transmit to her children. Taxpayer A gives the shares directly to her children or leaves the shares to them in her will. Her gifts or estate will be valued at $10 million. Taxpayer B creates an FLP to which she contributes the stock and leaves the interests in the FLP to her children in her will. Her estate will be granted a marketability discount on grounds that an outsider buyer would not pay net asset value for interests in the FLP because the lack of a market for those interests makes them illiquid, and buyers prefer liquid assets. The discount will be granted even if the FLP immediately distributes the Google shares to the children or sells them for $10 million and distributes the cash to the children. Taxpayer C contributes her Google shares to an FLP and gives one-third interests in the FLP to each of her children. In addition to a marketability discount, she will be granted a minority interest discount on grounds that the value to an outsider of a one-third interest in an FLP is reduced by being a minority partner who has no control over the FLP. Again, the discounts will be granted even if the next day the FLP distributes the Google shares or sells them and distributes the cash.

Taxpayers A, B, and C each give their children stock worth $10 million, which they can easily and quickly turn into $10 million in cash. There is no difference in the value of what is transmitted and received in the three cases. Yet they are treated very differently for estate and gift tax purposes, in flagrant violation of the principle of horizontal equity. In a typical recent case, for example, a family limited partnership that held $1,163,015 in cash and marketable securities and no other assets was valued at only $788,059 for estate tax purposes after minority and marketability. The issue is not a small one. In 2004, over half of all the discounts on estate tax returns were claimed for FLPs.

These bizarre results are the product of the formalism with which the courts have approached the problem of valuing FLPs. They have focused on the Treasury Regulation’s definition of value as “fair market value,” that is, “the price at which the property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or to sell and both having reasonable knowledge of relevant facts.” The “willing buyer” and “willing seller” in the definition, courts have insisted, are hypothetical persons who are unrelated to each other. On the basis of these definitions, courts have valued interests in FLPs by inquiring what an outsider would pay for them. They have concluded that an outsider would require a steep discount from the value of the assets, because he would own a minority interest in the FLP and because there is little or no market for interests in the FLP.

It is true that if an outsider were to purchase an interest in an FLP, he would require a discount for the reasons the courts give. In fact, however, interests in FLPs are never sold to anyone outside the family. They are “specifically designed to be given away during life or at death . . . .” Subsequently, they are either liquidated, redeemed, or transferred among family members. The holders of the interests are always related parties, not outsiders. What is bought and sold in transactions with non-family members are not the interests in the FLP but the underlying assets. For these reasons, “the notion of fair market value, premised on a voluntary arm’s-length exchange [between unrelated parties], is profoundly unrealistic” when applied to FLPs.

The reasons given in the organizational documents for the formation of FLPs often include liability protection, succession planning, and centralization of investment decisions. In a few cases, non-tax purposes may actually matter to the people who form the FLPs. Three-fourths of all the assets held by FLPs, however, consist of cash, marketable securities, and real estate, and “there is usually little reason to put marketable securities in an [FLP] except for the discounts.” My point, however, is not that FLPs should not give rise to discounts because they are tax-motivated. It is, rather, that placing assets in an FLP should not give rise to discounts because it has no more effect on value than placing gold nuggets in a red bag.

The IRS has made numerous attempts to curb this abuse, both by attributing the interests held by one family member to other family members in a manner similar to what this Article proposes and by applying various statutory provisions. One of its more interesting approaches involved finding a gift on creation of the family limited partnership. The courts have, however, frustrated all these efforts except in cases where the taxpayers were poorly advised or excessively greedy. The weight of precedent in this area is so great that it is extremely unlikely that these abuses can be curbed without legislation. 

This Article suggests legislation to bring estate and gift tax valuation of assets held by FLPs back in touch with economic reality. It proposes using family attribution to deny minority discounts for entities controlled by members of a family. It further recommends disallowing marketability discounts for family-controlled entities that do not conduct an active trade or business. These measures would restore a measure of horizontal equity to estate and gift taxes, in addition to making the tax system more economically efficient by eliminating the incentive to spend money to form, operate, and wind up entities that generally have little utility other than their ability to reduce taxes.

Part I provides essential background on the valuation of closely held businesses. Part I.A gives an overview of the process of valuing a business as a whole, focusing especially on how it applies in the estate and gift tax context. Part I.B explores control premiums and minority discounts. Part I.C examines the marketability discount. Part II.A discusses minority discounts as applied to FLPs and proposes legislation to disallow them through family attribution. Part II.B explores marketability discounts as applied to FLPs and proposes legislation to deny them where the FLP does not conduct an active trade or business.

Not So Permanent

As I have previously discussed, President Obama has released his proposed budget proposal, and he seeks to revisit the unified credit. Under the President proposed budget, the unified credit would be reduced to this 2009 level of $3.5 million, and the estate tax rate would be set at 45%. Furthermore, President Obama would like to place a cap on the amount that individuals can invest in IRAs and Roth IRAs. It would also require beneficiaries to begin distributions from the IRA within 5 years. Additionally, Obama's proposal would affect several tools, like grantor trusts, that estate planning attorneys have traditionally used to take advantage of the unified credit.

However, some estate planning attorneys argue that altering these commonly used methods will not generate as much revenue as President Obama hopes it will produce because if people will probably not use that technique any more and instead look to use other tools. For example, some "people may look instead to save in traditional investment accounts where long-term capital gains are taxed at lower rates than ordinary income."

See Bloomberg, Surprise! Obama Revisits Estate Tax Exemption, Investment News, Apr. 11, 2013.

Special thanks to Brian Cohan (Attorney at Law, Law Offices of Brian J. Cohan, P.C.) for bringing this article to my attention.

Obama Attempts To Resurrect Estate Tax

As I have previously discussed, the President released his proposed budget and several of his proposals might affect the techniques that estate planners use. Now, it appears that the President wants to reinstate the estate tax rate that taxpayers paid in 2009. President Obama hopes that this will increase tax revenue by $79 billion over the next decade. Under the President's proposal, the unified credit would drop to $3.5 million and the tax rate would increase to 45%. This comes at a time when most estate planners probably thought that the discussion about the estate tax had come to an end.

See Dave Boyer, Obama Budget Resurrects The Estate Tax, The Washington Times, Apr. 10, 2013.

Special thanks to Brian Cohan (Attorney at Law, Law Offices of Brian J. Cohan, P.C.) for bringing this article to my attention.

IRS Focused on Estate Tax Returns in 2011

According to the "2012 Internal Revenue Service Data Book," the 2011 estate tax returns had a 29.9 percent rate of audit, which was more than any other category of individual tax returns.  This increased focus on estate tax returns resulted in $1.1 million more additional tax revenue for 2011.

See Frank Byrt, IRS 2011 Audit Rates Show Estate Tax Returns Under the Microscope, accountingweb.com, Mar. 27, 2013.

The Fiscal Cliff Tax Deal Is a Game Changer for Estate Planners

The complexities of the fiscal cliff tax deal have great implications on income tax planning.  Martin Shenkman predicts that the new estate tax rules have changed estate planning forever, especially for high-net-worth clients.  In the aftermath of the fiscal cliff tax deal, advisors will need to anticipate the new challenges that arise concerning higher tax rates, life insurance, charitable planning, bypass trusts, assigning title to assets, and the harvesting of gains and losses during an estate planning move.

Shenkman also warns that “the combined impact of the fiscal cliff tax deal - increased marginal tax rates, the new Medicare tax on passive investment income and changing techniques for drafting and planning trusts - have changed the ground rules for many estate planning strategies.”  Options that estate planners should consider include the use of “sprinkling” trusts that distribute income into lower tax brackets, the process of “decanting” into a new trust, and the practice of using a bypass trust to lower state estate taxes.

See Martin Shenkman, The Post-Fiscal Cliff Estate Plan, onwallstreet.com, Apr. 1, 2013 and Martin Shenkman, Time for a New Estate Planning Strategy?, financial-planning.com, Apr. 1, 2013.

Special thanks to Brian Cohan (Attorney at Law, Law Offices of Brian J. Cohan, P.C.) for bringing this article to my attention.

Taxpayer Relies on Attorney’s Erroneous Advice, Comes Out Ahead

In Estate of Liftin v. United States, the executor of the estate, the decedent’s son, wanted to avoid penalties for the late filing of an estate tax return. 

The executor wanted to delay the filing until the surviving spouse of the decedent determined whether or not to become a citizen.  She later did choose to become a citizen, thus qualifying the estate for a marital deduction.

The lawyer incorrectly advised the executor that he could delay filing the estate tax return until the surviving spouse attained citizenship without suffering a penalty.  The Federal Claims Court held that the estate was liable for the amount of the late filing penalty, but by waiting to claim the marital deduction, the executor saved $266,284.97 in taxes, almost twice the amount of the penalty.

See Liftin: Executor Scores Half a Loaf from Late Filing, CharitablePlanning.com, Apr. 1, 2013.

CLE on Multistate Estate and Gift Planning

On Tuesday, April 23, 2013, the ABA is hosting a telephone seminar and audio webcast entitled Multistate Estate and Gift Planning. The telephone seminar and webcast is from 12 p.m. to 1 p.m. Eastern.  Topics will include: 

• Overview of which states have estate or gift taxes
• Determination of taxes based on domicile, location of assets, and location of beneficiaries
• How elective shares, bequests to a former spouse, community property, homestead protection, and prenuptial agreements can override estate planning documents
• State law restrictions on the ability to choose trusts (corporate or individual) executors, and others who will make investment, distribution or administrative decisions
• Deciding primary jurisdiction and which state's law applies
• And more! 

Please click here for more information. 

Estate Tax Discount Available For Fractional Interests In Artwork

Recently, the tax court addressed the issue of whether a discount should be permitted in a deceased’s estate for fractional interests in art. Over a thirty-year period, the deceased and his spouse acquired 64 pieces of art. The couple placed three of the masterpieces in a trust. After a ten year period, the remainder of the trust would be distributed to their three children. When the trust expired, each child received 16.67% of each of the three masterpieces. Additionally, the children received an 8.98167% undivided interest in the other 61 pieces. The children agreed to a co-tenancy. As a result, the art could only be sold if they all agreed and the proceeds would be shared according to their percentage of ownership. The deceased’s executor claimed a discount on the estate tax return. The executor reasoned that because 44.75% of the interest in the artwork was not the deceased, the deceased could not control that interest and marketability. 

In Estate of Elkins v. Commissioner, the Tax Court held that a ten percent discount would be permitted in assessing a deceased's fractional interest in artwork. The court suggests this discount would compensate a potential buyer facing uncertainty in selling the fractional interests of the artwork. The court was not persuaded by the government's argument that the agreement not to partition the artwork was a constraint on the ability to sell. The court reasoned that the agreement did not literally prohibit the sale of the fractional interests. Further, the court stated it was possible that a buyer would take a title to a fractional interest even though the children retained an interest to sell it to the children themselves. As a result, the selling price would be close to the fair market value of the fractional interests. However, the court concluded that a ten percent discount would be fair to a potential buyer who would likely ask for a price break for the risk the buyer may face when trying to sell the interest.

See  Elkins: Tax Court Allows Modest Discount for Partial Interest in Artwork, Charitableplanning.com Mar. 13, 2013.

Special thanks to Jim Hillhouse (Professional Legal Marketing (PLM, Inc.)) for bringing this article to my attention.