2012 IS A PERFECT STORM FOR GIFTING

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1 Summer 2012 Editor: Julius Giarmarco, J.D., LL.M. Tenth Floor Columbia Center 101 West Big Beaver Road Troy, Michigan (248) Fax (248) Assistant Editor: Salvatore J. LaMendola, J.D., C.P.A IS A PERFECT STORM FOR GIFTING By Julius Giarmarco, J.D., LL.M. The federal estate tax is only vulnerable to lifetime gifts and/or testamentary transfers to charity. Thus, in order to transfer wealth free of estate tax taxes to family members, high net worth individuals must make lifetime gifts. For the reasons discussed below, 2012 provides an unprecedented opportunity (a perfect storm in a good sense) to transfer wealth to future generations gift and estate tax free! Bush Tax Cuts Expiring The Tax Relief Act of 2010 increased the 2012 gift tax exemption to $5.12 million per person and lowered the top gift tax rate to 35%. However, on January 1, 2013, the estate and gift tax exemptions are scheduled to return to $1 million and the top gift and estate tax rates are scheduled to increase to 55%. Most Republicans (including Governor Romney) favor repealing the estate tax. On the other side of the aisle, the President has proposed for his 2013 budget a $3.5 million estate tax exemption, a $1 million gift tax exemption, and a top tax rate of 45%. Obviously, the fate of the gift and estate tax exemptions will rest with the election results. But anyone who dies after 2012 has no assurance he/she will be permitted to transfer $5.12 million tax free at death. Therefore, high net worth individuals are well advised to use their gift tax exemption in 2012 while it is still available. Historically Low Interest Rates Loans. Because of historically low interest rates, 2012 presents a unique opportunity for donors to transfer wealth to children and more remote descendants. The simplest technique is to lend money (or sell assets on installments) to a grantor trust for the benefit of family members in exchange for a promissory note. For estate tax reasons, the grantor should first gift to the trust 10% of the amount of the loan. The promissory note would bear interest at the Applicable Federal Rate (for July 2012: 0.24% for loans of three years or less [the short term rate]; 0.92% for loans of more than three years, but not more than nine years [the mid-term rate]; and 2.3% for loans of more than nine years [the long term rate]). The interest on the note is payable annually with a balloon payment due at the end of the term. If the trust earns a greater return than the interest rate on the note (i.e., the hurdle rate), the excess income and appreciation is removed from the grantor s estate - gift tax free! Additional wealth is transferred (gift tax free) by the grantor s payment of the trust s income taxes. For those persons who have already made loans to family members, now may be the time to refinance those loans to take advantage of the lower interest rates. SCINs. Two variations of a promissory note transaction are a self-cancelling installment note (SCIN) and a private annuity. In the typical SCIN transaction, the seller/lender is the parent and a trust for the benefit of children is the buyer/ borrower. If the parent dies prior to the end of the note term, no further payments are due. While the cancellation feature must be paid for (usually by an increased interest rate on the note), substantial INSIDE 2012 IS A PERFECT STORM FOR GIFTING A ROTH CONVERSION ALTERNATIVE PROPOSED PORTABILITY REGULATIONS SIGNIFICANT BENEFIT TO TAXPAYERS IF MADE PERMANENT COPYRIGHT 2012 JULIUS GIARMARCO, ESQ.

2 2 estate tax savings are possible, because the balance due on the note at the seller s death is not included in the seller s estate. Private Annuities. In the typical private annuity transaction, a parent transfers property to a child in return for the child s unsecured promise to make a fixed, periodic payment to the parent for life. If the fair market value of the property transferred equals the present value of the annuity (actuarially determined using the IRC Section 7520 rate), there is no gift tax due. Similar to the SCIN, a private annuity produces a benefit when the parent dies prior to his/her life expectancy, and a disadvantage if the parent outlives his/her life expectancy. Both the SCIN and private annuity are even more beneficial when interest rates are low. GRATs. A grantor retained annuity trust (GRAT) is another way to transfer wealth utilizing the current low interest rates. GRATs allow for the transfer of assets to family members at a nominal gift tax value. The grantor transfers assets to an irrevocable trust that pays the grantor a fixed annuity for a set term of years. The annuity is designed to return to the grantor the entire amount of the gift plus interest. The interest rate for a GRAT is the IRC Section 7520 rate which is 120% of the mid-term AFR (1.2% for July, 2012). To the extent the assets in the GRAT appreciate more than 1.2% (the hurdle rate), the assets remaining in the GRAT at the end of the term pass to the remaindermen (usually the grantor s children or a trust for their benefit) free of transfer taxes. CLATs. Lastly, a charitable lead annuity trust (CLAT) is a method for charitably minded donors to transfer assets to both charity and to family members in a tax efficient manner. A CLAT is an irrevocable trust that pays one or more charities a fixed annuity for a set term of years. In return, the grantor receives a gift tax charitable deduction. At the end of the term, any assets remaining in the CLAT pass to the non-charitable remainder beneficiaries (usually the grantor s children). Similar to the annuity payable to the grantor in a GRAT, the charitable annuity in a CLAT can be set for an amount and term that results in a nominal gift. To the extent the assets in the CLAT grow at a rate in excess of the Section 7520 rate, the grantor has made tax free gifts to his/her beneficiaries (or trusts for their benefit). Again, low interest rates make CLATs an even more effective wealth transfer strategy. Relatively Low Asset Values The value of real estate and securities are at low levels, making it more attractive to gift such assets to children and grandchildren. In addition, economic turmoil has created tremendous volatility and lots of fiscal challenges for business owners, making now the ideal time to gift business interests. Transferring assets when values are low relative to other times and circumstances can save substantial gift and estate tax dollars for families. This is especially true if values rebound or increase significantly following the transfer. President Obama s Budget Proposals As mentioned above, President Obama s proposed budget for 2013 (issued on February 13, 2012) would permanently restore the estate tax system that was in effect in 2009 a $3.5 million exemption with a top tax rate of 45%. Perhaps more importantly, the gift tax and GST exemption would be reduced to $1 million, bringing an end to the unification of the gift and estate tax exemptions. Other proposals include: Grantor Trusts. In a major rewrite of the estate tax provisions, any individual who is taxed as the owner of a trust for income tax purposes will have to include the trust assets in his/her gross estate for federal estate tax purposes. And, distributions from such grantor trusts to beneficiaries during the grantor s lifetime would be subject to gift tax. These rules would apply to trusts created on or after the enactment date and to any contributions made after the enactment date to grandfathered trusts. Although the proposal appears to be targeting installment sales to intentionally-defective grantor trusts, the implications are far greater. For example, most irrevocable life insurance trusts (ILITs) are grantor trusts under IRC Section 677(a)(3) (because trust income can be used to pay premiums on a policy insuring the life of the grantor or the grantor's spouse); or under IRC Section 677(a)(1) and (2) (because trust income may be distributed to the grantor's spouse without the consent of an adverse PAGE 2

3 3 party). Thus, if enacted, the proposal could result in the proceeds in an ILIT being subject to estate taxes. Dynasty Trusts. Dynasty trusts are also under attack. Under the President's proposal, the generation-skipping tax exemption would be limited to 90 years. Thus, distributions from trusts established in states that allow trusts to continue in perpetuity (like Michigan) or for a very long time (like 360 years in Florida) would be subject to generation-skipping taxes after 90 years. Trusts created before the enactment date of this proposal would be grandfathered. Short-Term GRATs. Two-year, zeroed-out grantor retained annuity trusts have become one of the most popular wealth transfer planning techniques in recent years due to the low Section 7520 hurdle rate (1.2% for July 2012). The President's proposal would do away with the technique by requiring a GRAT to have a minimum term of ten (10) years, greatly accentuating the mortality risk of using a GRAT. A ROTH CONVERSION ALTERNATIVE By Salvatore J. LaMendola, J.D., C.P.A. Valuation Discounts. Valuation discounts obtained through the use of family limited partnerships and family limited liability companies allow donors to "leverage" their $13,000 annual gift tax exclusion and $5.12 million gift tax exemption. Although lacking in details, the President's proposal would scale back the use of such discounts retroactively to October 8, 1990 (the effective date of IRC Section 2704). These proposed changes add further urgency to high net worth individuals to make discounted gifts in Conclusion The confluence of an historically high (though temporary) estate and gift tax exemption, historically low interest rates, and economic events depressing asset values have created a rare opportunity for proactive estate planning and represent a major window of opportunity for high net worth individuals to avoid estate taxes. In short, 2012 presents the greatest opportunity for wealth transfer planning to date. THIS ARTICLE MAY NOT BE USED FOR PENALTY PROTECTION. Back in 2010, the threat of across-the-board tax increases starting in 2011 coupled with the elimination of the $100,000 income limitation on Roth conversions prompted many retirement plan owners to consider converting all or a portion of their regular IRAs to Roth IRAs. Now in 2012, with across-the-board tax increases again on the horizon and the law allowing Roth conversions by anyone still in place, Roth IRA conversions are again on the table. But for those whose main objective in converting is to leave a larger inheritance to their heirs, an alternative strategy (that also includes charitable giving) is worth considering. It is described below. Assumptions Bill and Diane are both age 65 and in good health. (Their joint life expectancy is 20 years.) Bill owns a $500,000 regular IRA that he is considering converting to a Roth IRA. The couple will pay the conversion tax with other assets. Bill and Diane do not have a taxable estate for federal estate tax purposes. Roth Conversion In July, 2012, Bill converts his regular IRA to a Roth IRA. On April 15, 2013, the couple pays the $200,000 conversion tax (40%). At the second death in 2031, assuming a constant 5% return, Bill and Diane's heirs inherit a $1,326,649 Roth IRA income and estate tax free. Charity receives nothing. PAGE 3 COPYRIGHT 2012 JULIUS GIARMARCO, ESQ.

4 4 Alternative Strategy In July, 2012, Bill liquidates his regular IRA and uses the cash to fund a 10-year, 6.5% charitable remainder annuity trust (CRAT). On April 15, 2013, the couple pays $80,744 less in income taxes due to the $201,861 deduction derived from the CRAT. Bill and Diane use each of the 10 annual CRAT payments of $32,500 to fund a $1,600,000 second-to-die life insurance policy. At CRAT termination in 2021, assuming a constant 5% return, charity receives $405,665. At the second death in 2031, Bill and Diane's heirs inherit $1,600,000 income and estate tax free. Comparison - Non Taxable Estate Roth Conversion Alternative Strategy Children $1,326,649 $1,600,000 Charity $ -0- $405,665 Congress $200,000 $119,256 Taxable Estate What if Bill and Diane had a taxable estate? In that case their heirs would inherit an $862,322 (65% x $1,326,649) Roth IRA after estate taxes. But their heirs would still inherit $1,600,000 income and estate tax free under the alternative strategy if an ILIT is used. Comparison - Taxable Estate Roth Conversion Alternative Strategy Children $ 862,322 $1,600,000 Charity $ -0- $405,665 Congress $664,327 $119,256 Conclusion Whether with taxable estates or not, the use of charitable giving need not diminish inheritances. Rather, as shown above, it can augment them. THIS ARTICLE MAY NOT BE USED FOR PENALTY PROTECTION. PROPOSED PORTABILITY REGULATIONS SIGNIFICANT BENEFIT TO TAXPAYERS IF MADE PERMANENT By Thomas P. Cavanaugh, J.D. On June 15, 2012, the Treasury Department issued temporary regulations providing guidance on the estate and gift tax applicable exclusion amount and, particularly, the portability provisions of Internal Revenue Code Section The proposed regulations define the relevant terms and explain how to calculate the Deceased Spouse s Unused Exclusion Amount (DSUEA). Moreover, the proposed regulations detail how the DSUEA amount may be used by the surviving spouse. IRC Section 2010(c)(5)(A) details that the portability election must be made on the deceased spouse s timely filed estate tax return (Form 706). The Section also provides that no election can be made after the time prescribed by law (including extensions) for filing such return. In other words, the portability election must always be made within nine months of the deceased spouse s death, plus extension (if an extension is timely obtained). However, a question arises as to whether or not a PAGE 4

5 5 longer period of time exists for small estates (i.e., those taxable estates which are below the filing threshold set forth in IRC Section 6018(a)). Unfortunately, no guidance was provided in the proposed regulations and unless the Treasury Department provides otherwise, planners should approach this issue assuming that no relief is available for making a late election and plan accordingly. Since December 17, 2010 when President Obama signed the 2010 Tax Relief Act into law, there has been a general dissatisfaction regarding the filing requirement imposed upon estates in order for the surviving spouse to utilize the portability election. IRS Notice requires that the portability election must be made on a complete and properlyprepared estate tax return. The proposed regulations clarify that an estate tax return will be considered complete and properly prepared if (1) it is prepared in accordance with the instructions for the return and (2) the requirements of Treas. Reg. Sections , -3, and -4 (the person responsible for filing the return; that the return must contain adequate information regarding assets, deductions and credits; and that documents must accompany the return) are satisfied. In an unexpected and positive twist, the Treasury Regulations establish a new special rule designed to limit the expense associated with valuing certain assets held by estates which have a total value below the normal filing threshold for an estate tax return. Under this special rule, marital and charitable deduction property is not required to be valued and an executor is only required to report an estimated value, as detailed in the regulations. As to the unvalued assets in a small estate, the executor will only have to report the description, ownership, and/or beneficiary of such property. The executor will also have to provide other information necessary to establish the right of the estate/trust to the marital or charitable deduction. In other words, an executor has to file a standard Form 706 except for formal valuations of those assets for which a marital and/or charitable deduction is sought. It is important to note that the special rule does not apply if the value of such property is needed to determine the amount passing from the decedent to a non-spouse or non-charity. For example, if 75% of the estate is passing to the surviving spouse and 25% is passing to the decedent s children, a valuation of all estate property is needed and the special rule does not apply. There are other provisions of the proposed regulations which make the special rule unavailable. The special rule will benefit small estates where the assets are left outright to the surviving spouse or to charity. The proposed regulations require that the executor must include a computation of the DSUEA, as required by Section 2010(e)(5)(A). The Treasury Department contemplates that a new estate tax return form will provide the computation method for determining the DSUEA. However, under the current version of Form 706, there is no place to compute the DSUEA. Recognizing this failure, the Treasury Department has created a transitional rule until the new Form 706 is available. Under this transitional rule, as long as a complete and properly prepared estate tax return is timely filed, no computation will be necessary. However, it would be prudent for practitioners to still prepare a calculation to be used at the death of the surviving spouse. Moreover, the proposed regulations provide that estate tax returns filed under this transitional rule need not be supplemented or amended once the new estate tax form is published. The proposed regulations address the circumstance where the first spouse to die paid gift taxes on a taxable gift. For example, assume portability is extended to 2013, the lifetime gift exemption is $1 million, and the first spouse to die makes a one and only taxable gift of $2.5 million. The result is that the first spouse to die would have paid gift tax on $1.5 million (the difference between the amount of the $2.5 million taxable gift and the $1 million exemption). If the first spouse dies in a year when the basic exclusion amount is $5 million and leaves his/her entire estate to his/her spouse, the question arises as to whether $2.5 million or $4 million is portable. Under the proposed regulations, the $1.5 million gift (in excess of the lifetime gift exemption) would be excluded from the computation of the DSUEA amount, leaving $4 million portable to the surviving spouse. The proposed regulations also address non-us citizens, non-residents. As to estate taxes and as to PAGE 5 COPYRIGHT 2012 JULIUS GIARMARCO, ESQ.

6 6 gift taxes, the proposed regulations provide that a non-resident s surviving spouse who is not a US citizen at the time that the surviving spouse seeks to use the DSUEA, cannot use any of the DSUEA of the deceased spouse, except as allowed under any tax treaty. In other words, if the non-resident s surviving spouse does become a US citizen prior to making a transfer subject to gift and estate taxes, any available DSUEA should be available for use. However, the proposed regulations do not indicate if any current treaty would actually allow use of DSUEA in the case of a non-resident surviving spouse who is not a US citizen. When the regulations are made final, we will provide future updates. THIS ARTICLE MAY NOT BE USED FOR PENALTY PROTECTION. Our estate planning attorneys provide soundly based estate and business succession plans utilizing: Revocable Living Trusts Irrevocable Life Insurance Trusts Qualified Personal Residence Trusts Grantor Retained Annuity Trusts Sales to Grantor Trusts Business Succession Plans Split-Dollar Plans (Private and Employer) Generation Skipping Transfers Charitable Trusts Buy-Sell Agreements Retirement Plan Trusts Asset Protection Planning For a referral to one of our attorneys, please call Julius Giarmarco at (248) This newsletter is designed to provide accurate (at the time of printing) and authoritative information with regard to the subject matter covered. It must not be used as the basis for legal or tax advice. In specific cases, the parties involved must always seek out and rely on the counsel of their own advisors. Thus, responsibility for modifying and guiding any party s action with respect to legal and tax matters is placed where it belongs - with his or her own advisors. CIRCULAR 230 DISCLAIMER: NONE OF THE ARTICLES IN THIS NEWSLETTER ARE INTENDED OR WRITTEN BY THE VARIOUS AUTHORS OR GIARMARCO, MULLINS & HORTON, P.C., TO BE USED, AND THEY CANNOT BE USED, BY YOU (OR ANY OTHER TAXPAYER) FOR THE PURPOSE OF AVOIDING PENALTIES THAT MAY BE IMPOSED ON YOU (OR ANY OTHER TAXPAYER) UNDER THE INTERNAL REVENUE CODE OF 1986, AS AMENDED. PAGE 6

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