Trusts & Estates. Many Estate Planning Opportunities May End in 2012 The Time to Act is Now

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1 ALBANY AMSTERDAM ATLANTA AUSTIN BOSTON CHICAGO DALLAS DELAWARE DENVER FORT LAUDERDALE HOUSTON LAS VEGAS LONDON* LOS ANGELES MEXICO CITY+ MIAMI NEW JERSEY NEW YORK ORANGE COUNTY ORLANDO PALM BEACH COUNTY PHILADELPHIA PHOENIX SACRAMENTO SAN FRANCISCO SHANGHAI SILICON VALLEY TALLAHASSEE TAMPA TEL AVIV^ TYSONS CORNER WARSAW~ WASHINGTON, D.C. WHITE PLAINS Strategic Alliances with Independent Law Firms** MILAN ROME Many Estate Planning Opportunities May End in 2012 The Time to Act is Now The rapidly changing political climate continues to create estate, gift and generation-skipping transfer (GST) tax planning instability. Just this year, the Obama administration made a number of proposals that would substantially reduce the opportunities to engage in tax efficient estate planning. In addition, at the end of 2012, unless the law is changed, the favorable estate, gift and GST tax rates and the amounts sheltered from those taxes under the Tax Relief Act of 2010 would end and, as indicated below, less favorable ones reinstated. We encourage our clients to undertake an immediate review of their estate plans to determine if it is appropriate to take advantage of the opportunities under current law before they may expire. This GT Alert provides a brief overview of the estate planning techniques affected by the potential changes in the law. Estate, Gift and Generation-Skipping Tax Rates and Exemptions In 2012, the maximum Federal estate, gift and GST tax rates are capped at 35 percent. The maximum shelters from estate, gift and GST tax are unified at $5,120,000. At the end of 2012, the maximum estate, gift and GST tax rates will revert to 55 percent. The maximum estate and gift tax shelter will revert to $1 million, and the GST exemption will revert to $1 million indexed for inflation. The administration s proposals would restore the Federal estate, gift and GST tax rates and shelters to their 2009 levels. If enacted into law, the proposals would set the maximum estate, gift and GST tax rate at 45 percent. The estate and GST tax shelters would be $3.5 million, but the gift tax shelter would be only $1 million, restoring the disincentive to engage in lifetime wealth transfers. Estate taxes imposed by certain States may increase the tax burdens just described for clients domiciled in those States. Create trusts for taxable beneficiaries. In view of the potential increases in rates and reduction in shelters, clients should consider strategies to use their shelters currently. One possibility is to create one or more trusts for descendants or other intended beneficiaries. If no prior taxable gifts have been made, a couple could fund a trust prior to year end with $10,240,000 without incurring any gift tax. If GST exemption is applied to the trust, no estate, gift or GST tax would ever be incurred so long as the property remains in trust. A so-called dynasty trust that permits property to pass from one generation to the next could be designed with sufficient flexibility to permit the beneficiaries access to the funds while at the same time preserving the tax benefits for future generations. 1

2 Married persons can create trusts for each other. Another possibility is for each spouse to create a trust of $5,120,000 for the other spouse. Descendants may also be discretionary beneficiaries of the trusts. The trusts must have different terms, and must give the spouses different economic interests. Each spouse may have access to the trust for his or her benefit, provided that access is not identical or reciprocal to the other spouse s trust. Case law has permitted each spouse to receive an income interest in the trust for his or her benefit, if one of the spouses, but not the other, has a special power of appointment over trust assets exercisable during lifetime. If each spouse will create a gift trust, it is best not to fund the trusts with the same assets and not to create the trusts at the same time. Such planning therefore needs to be undertaken as soon as possible. Even if you cannot make substantial gifts, you still can use your increased GST exemption GST planning using marital trusts. Some clients may not feel able to part with significant wealth, without the assurance of at least an income interest in the property. In that case, spouses may wish to consider creating marital trusts for one another, with the trust property to pass in further trust for their descendants following the spouses deaths. Even though this would not take advantage of the increased gift tax shelter, nor exclude assets from the taxable estates of the spouses, a marital trust may receive a current allocation of GST exemption. As the property in the marital trusts appreciates, the benefits of an early allocation of GST exemption increases. For example, a middle aged couple with assets worth $30 million may shelter 40 percent more property from GST tax by creating marital trusts today, rather than waiting until death. Allocating GST exemption to existing trusts. Another alternative is to consider sheltering existing trusts from GST tax by making a so-called late allocation of GST exemption to an existing trust that is not already exempt from GST tax. It may even be possible, prior to any such allocation, to extend the duration of the existing trust, if it would otherwise terminate, for example, at a stated age of the beneficiary. The longer the property remains in trust, the more beneficial an allocation of GST exemption becomes. There are several ways that the duration of an existing trust might be extended, but the most common one is through a technique called decanting whereby a trustee with discretionary authority to distribute principal may be authorized, by the governing instrument or State law, to distribute the trust estate to a new trust. The new trust might give the beneficiary a power of appointment that could be exercised to extend the duration of the original trust. Alternatively, the new trust created by the trustee might extend the duration of the original trust to one that lasts for the lifetime of the beneficiary or even becomes a dynasty trust for multiple generations. As with any gifting strategy, asset selection can be important, and we are pleased to work with our clients and their financial advisors to determine the most appropriate assets to use in order to capture the benefits without creating financial discomfort. Valuation Discounts Under current law, in valuing an interest in a closely held corporation, partnership or other entity, subject to certain statutory limitations, an individual may apply discounts in valuation (typically established by a qualified independent appraiser) for purposes of determining the gift, estate and GST tax due upon a transfer of interests in the entity to family members. 2

3 The administration has proposed reducing the valuation discounts that may be applied to the transfer of an interest in a family controlled entity by disregarding certain restrictions on the ownership rights of the entity. The disregarded restrictions would include (i) certain limitations on an owner s right to liquidate the owner s interest and (ii) any restriction on a transferee s ability to be admitted as a full partner or to hold an equity interest in the entity. By disregarding these restrictions, the value of a gifted interest in a family entity may increase significantly. Over the years, Congress also has proposed legislation to limit the ability to apply valuation discounts to transfers of interests in family controlled entities in a more comprehensive way. Therefore, any planning that benefits from the availability of valuation discounts should be undertaken as promptly as possible while the law supporting valuation discounts remains in effect. Minimum and Maximum Terms for GRATs Grantor retained annuity trusts ( GRATs ) are an effective estate planning technique to transfer an appreciating asset at a reduced gift tax cost. In a GRAT, the donor transfers assets to a trust retaining an annuity payable for a term of years. The annuity typically has a value actuarially near or equal to the value of the asset transferred to the GRAT, minimizing the value of the taxable gift upon formation of the GRAT. If the donor survives the annuity term, any appreciation in the value of the asset above the IRS assumed rate of return passes to the remainder beneficiaries of the trust free of further gift tax. At the present time, the hurdle rate is only 1.2 percent. If the donor does not survive the annuity term, the assets held in the GRAT are generally includible in the donor s estate. The administration has proposed requiring a minimum GRAT term of ten years, prohibiting the remainder interest to be reduced to zero and also prohibiting the amounts of the annuity payments to decline during the term of the GRAT. These restrictions are likely to reduce significantly the gift tax efficiency of using GRATs. A GRAT is most efficient if the term is short and the payments are high in the early years because that structure is most likely to capture the volatility of the asset contributed to the GRAT. The longer the GRAT term and the lower the early payments in many instances (depending on the assets transferred), the more likely periods of appreciation would be offset with periods of depreciation, reducing the likelihood of delivering substantial value to the remainder beneficiaries. In addition, a longer term increases the likelihood that the donor will not survive the term, causing at least a portion of the assets of the GRAT to be included in the donor s estate for estate tax purposes. The administration has also proposed limiting the maximum term of a GRAT to the life expectancy of the donor plus 10 years. A very long term GRAT (for example 60 or 70 years) has the potential to exclude substantial assets from the donor s gross estate for estate tax purposes. The portion of a GRAT included in a donor s gross estate is computed by determining the portion of the principal of the trust needed to produce income, at the prevailing interest rates at the time of the donor s death, sufficient to pay the annuity required under the GRAT. The lower the interest rates at the time the GRAT is created, and the longer the GRAT term, the lower the annuity payment needed to produce a small remainder interest in a GRAT. If interest rates rise between the time a long term GRAT is created and the donor s death, a significant portion of the GRAT s assets can escape estate tax, even if virtually no gift tax was paid when the GRAT was created. 3

4 Rumor has it that the legislation changing the GRAT rules has already been drafted and can be added to any tax bill as a revenue raiser. Therefore, if GRATs are your technique of choice, you need to consider implementing any additional GRATs as soon as possible. Generation-Skipping Transfer Tax Limitation GST tax generally applies when property is transferred from a grandparent to a grandchild or more remote descendant. GST tax is applied at the flat marginal rate of the estate tax currently 35 percent but scheduled to increase to 55 percent in The maximum GST exemption under current law is $5,120,000. GST exemption may be allocated to a transfer in trust so that any future distributions from the trust to a grandchild or family members in succeeding generations would not be subject to GST tax, even if rates increase. The longer property stays in trust, the longer it remains insulated from the application of the tax. Propelled by concerns raised by certain academics about so-called dead hand control, the administration has proposed that a trust to which GST exemption is applied will remain GST exempt only for a period of 90 years. The proposal would be effective for trusts created on or after the date of enactment, and to contributions made to existing trusts on or after the date of enactment. The proposal would reduce the efficiency of planning with dynasty trusts, particularly planning that involves leveraging GST exemption by not only contributing, but also selling, appreciating assets to a dynasty trust. Over a period of two or three generations, the proportion of family wealth that would escape estate, gift and GST tax can be four or five times what it would be without dynasty trust planning. Accordingly, any planning involving the use of dynasty trusts to which GST exemption will be allocated should be implemented before adverse changes in the law take effect. Coordination of Income and Transfer Tax Rules for Grantor Trusts A grantor trust is a trust with respect to which the donor is treated as the owner for income tax purposes. The donor is required to pay the taxes on all income, including capital gains, generated by the assets of a wholly grantor trust. Because a grantor trust is treated as owned by its donor, transactions between the donor and a grantor trust are disregarded for income tax purposes. Thus, a sale of assets by a grantor to a grantor trust does not result in the realization of any capital gain. Nevertheless, under current law, a grantor trust need not be included in the donor s estate for estate tax purposes. A grantor trust can be a very efficient wealth transfer structure because it permits the donor to pay income tax on assets that will not be included in the donor s gross estate. The payment of the trust s income tax liability is not treated as a gift by the donor to the trust for gift tax purposes. Thus, the grantor trust can grow income tax free while the grantor s assets are depleted by the payment of income tax, resulting in a substantial shift of wealth over time. The administration has proposed coordinating the income and transfer tax rules in such a way that if a donor is treated as the owner of a grantor trust for income tax purposes, the trust also would be includible in the donor s estate for estate tax purposes. Specifically, the proposal would (1) include the trust assets in the gross estate of the grantor for estate tax purposes, (2) treat any distribution from the trust during the grantor s life as subject to gift tax, and (3) treat all the trust assets as subject to gift tax if the grantor ceases to be treated as the owner during the grantor s life. The proposal would not apply to any trusts already includable in the grantor s 4

5 gross estate. The proposal also would apply under certain circumstances to a beneficiary who is treated as the owner of a trust for income tax purposes. The proposal appears to target tax benefits currently available in the case of donors sales to grantor trusts, but, if enacted, could have a significant effect on many estate planning vehicles that utilize grantor trusts (such as GRATs, qualified personal residence trusts, certain charitable lead trusts, irrevocable life insurance trusts, certain gift trusts, and sales to grantor trusts). The proposal would be effective for trusts created on or after the date of enactment, and to contributions made to existing grantor trusts on or after the date of enactment. The proposal would constitute a significant change in the law. Grantor trusts have been in the law for a very long time and were designed to avoid the shifting of taxable income to lower brackets. As income tax rates increase, the original purpose of the grantor trust rules may continue to be applicable. Given its far reaching effects, including the effect on many structures apparently not viewed as abusive, it may be that the proposal is not on a fast track. Nevertheless, because it is always possible that Congressional action can take place swiftly, it seems prudent to complete sooner than later any pending transactions in which grantor trust status is important to the wealth transfer benefits sought to be achieved. Don t Wait Until the Last Minute Planning and implementing any substantial wealth transfer strategy always takes time. The law on the books currently is favorable, but may have a limited shelf-life. Low interest rates and depressed asset values continue to create opportunities for tax efficient transfers of wealth. Those opportunities may not be available in the future. An estate planning review will determine how you and your family can benefit by engaging in current planning. Greenberg Traurig, LLP is committed to working with clients and their advisors to plan and effect strategies that will achieve the most efficient transfer tax results and estate planning structures that will maximize the transfer tax benefits currently available in This GT Alert was prepared by Norman J. Benford, Linda B. Hirschson and Diana S.C. Zeydel. Questions about this information can be directed to: Norman J. Benford Linda B. Hirschson Diana S.C. Zeydel Or your Greenberg Traurig attorney 5

6 Albany Delaware Mexico City Palm Beach County S Tallahassee Amsterdam Denver Miami Philadelphia Tampa Atlanta Fort Lauderdale New Jersey Phoenix Tel Aviv^ Austin Houston New York Sacramento Tysons Corner Boston Las Vegas Orange County San Francisco Warsaw~ Chicago London* +44 (0) Orlando Shanghai Washington, D.C Dallas Los Angeles Palm Beach County N Silicon Valley White Plains Tax Advice Disclosure: To ensure compliance with requirements imposed by the IRS under Circular 230, we inform you that any U.S. federal tax advice contained in this communication (including any attachments), unless otherwise specifically stated, was not intended or written to be used, and cannot be used, for the purpose of (1) avoiding penalties under the Internal Revenue Code or (2) promoting, marketing or recommending to another party any matters addressed herein. This Greenberg Traurig Alert is issued for informational purposes only and is not intended to be construed or used as general legal advice. Please contact the author(s) or your Greenberg Traurig contact if you have questions regarding the currency of this information. The hiring of a lawyer is an important decision. Before you decide, ask for written information about the lawyer s legal qualifications and experience. Greenberg Traurig is a service mark and trade name of Greenberg Traurig, LLP and Greenberg Traurig, P.A Greenberg Traurig, LLP. All rights reserved. *Operates as Greenberg Traurig Maher LLP. **Greenberg Traurig is not responsible for any legal or other services rendered by attorneys employed by the strategic alliance firms. +Greenberg Traurig s Mexico City office is operated by Greenberg Traurig, S.C., an affiliate of Greenberg Traurig, P.A. and Greenberg Traurig, LLP. ^Greenberg Traurig's Tel Aviv office is a branch of Greenberg Traurig, P.A., Florida, USA. ~Greenberg Traurig s Warsaw office is operated by Greenberg Traurig Grzesiak sp.k., an affiliate of Greenberg Traurig, P.A. and Greenberg Traurig, LLP. Certain partners in Greenberg Traurig Grzesiak sp.k. are also shareholders in Greenberg Traurig, P.A. 6

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