Top 10 Estate Planning Ideas for Year-End: Tax Savings Available in 2010 May Not Last

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1 Advisory Estates, Trusts & Tax Planning October 28, 2010 Top 10 Estate Planning Ideas for Year-End: Tax Savings Available in 2010 May Not Last by Jennifer Jordan McCall, Kim T. Schoknecht, Ellen K. Harrison and Elizabeth H. W. Fry Year-end 2010 provides opportunities to transfer assets to your desired beneficiaries at a greatly reduced tax cost. Attached is a brief summary of some of the more effective methods by which you can benefit from the favorable transfer tax rules, some of which are in effect only through the end of this calendar year. Next year, the rules may be much less favorable. Naturally, each person's circumstances and interests are different, so we recommend contacting a professional advisor regarding your personal situation and finding the best way for you to potentially save significant amounts of tax while preserving assets for your beneficiaries. 1. Gifts to Children and/or Grandchildren The maximum gift tax rate is at a historic low of 35% in Under existing law, the maximum gift tax rate will increase to 55% in Although Congress is expected to enact legislation that will lower the 55% rate, there is no assurance that this will happen. Therefore, year-end 2010 is an opportune time to make gifts (either outright or in trust) if financial circumstances permit and you are so inclined. Additionally, because there is no federal estate tax in 2010, we recommend that any year-end gifts be made to a revocable trust that would become irrevocable on December 31, 2010, provided the donor is still living. That's because if death occurs prior to 2011, transfers can be made free of federal estate tax. There is also currently no generation-skipping transfer ("GST") tax. This tax is expected to be reinstated in 2011 at a rate of 55%. Therefore, year-end 2010 affords a unique opportunity to make gifts to grandchildren and descendants of younger generations. The gift can be made outright, in the form of an LLC or LP interest (as further discussed below) or to a trust. Because there is some uncertainty whether a gift to a trust will avoid GST tax consequences when the tax is restored, we have crafted some trust structures that limit the tax risk to the family if the trust is exposed to GST tax. In addition, there may be opportunities to save substantial tax with distributions, either outright or in further trust, from trusts created in prior years that are not exempt from the GST tax. Pillsbury Winthrop Shaw Pittman LLP 1

2 2. Avoiding GST Tax on Assets in Irrevocable Trusts If anyone in your family is the beneficiary of an irrevocable trust that is not exempt from GST tax, it may be advisable to make distributions to beneficiaries to whom this tax would apply when the tax is restored (e.g., grandchildren of the donor). If a grandparent (whether now living or deceased) funded a trust for descendants that is not exempt from GST tax, distributions to grandchildren and descendants of younger generations that are made when this tax is in effect (i.e., after 2010) would be subject to GST tax. Such distributions may be made free of any tax while the GST tax is not in effect. A trust that was exempt from GST tax prior to 2011 may lose some or all of its exemption when the GST tax is restored in This is because certain favorable tax rules that applied beginning in 2001 will not be in effect beginning in For example, the GST tax exemption was $3.5 million in When the GST tax is restored in 2011, the exemption will be only $1,340,000. The reduced exemption may affect the exempt status of existing trusts. Because it is not clear that a trust that was wholly exempt from GST tax prior to 2011 will remain so after 2010, you may wish to make distributions to grandchildren and/or descendants of younger generations in 2010 to avoid the risk of the GST tax applying to those trusts. If you are not prepared to make large distributions to grandchildren (e.g., because you want to benefit children as well as younger descendants and continue to benefit from the trust structure), we have conceived a plan that limits exposure to GST tax while preserving such benefits. This plan involves making a distribution to a new trust that gives a present beneficial interest only to younger descendants and adds back children as beneficiaries at a later time. 3. Grantor Retained Annuity Trust ("GRAT") A GRAT is an irrevocable trust to which the "grantor" contributes cash, stock, partnership interests or other assets and retains the right to an annuity for a fixed term of years. If the grantor survives the fixed term, the value of the remainder interest is not included in the grantor's gross estate for estate tax purposes. If the grantor does not survive the fixed term, some or all of the trust will be included in the grantor's gross estate. The amount of the gift to the trust is the excess of the value of the property conveyed to the trust over the present value of the annuity. Typically, the gift amount is nominal. Any appreciation of the assets held in the trust over the annuity payments will pass to the beneficiaries free of gift tax. If the assets fail to appreciate, the remainder beneficiaries will not benefit from the GRAT but the grantor will not have incurred gift tax for enjoying the opportunity to benefit the remainder beneficiaries. To increase the probability of the grantor surviving the fixed term and to increase the probability of successful performance, shorter term GRATs have been popular. New legislation is expected to pass in 2011 requiring that GRATs have a minimum fixed term of 10 years and a remainder value of more than zero. This legislative change will make it more challenging to benefit from GRATs, particularly for older clients. If you own assets for which values are currently depressed, a GRAT may be an effective vehicle to shift the anticipated appreciation to your beneficiaries. It is especially effective when the grantor contributes rapidly appreciating assets to a GRAT. If you funded a GRAT in early 2009 that has enjoyed the improvement in the market that subsequently occurred, you may want to take steps to "lock in" that gain by exchanging the appreciated assets for cash or fixed income securities. Pillsbury Winthrop Shaw Pittman LLP 2

3 4. Intentionally Defective Grantor Trust ("IDGT") and Installment Sale An IDGT is an irrevocable trust that is intentionally "defective" because it is "incomplete" for income tax purposes (i.e. all income, deductions and credits against tax of the trust will be passed through to the grantor). The payment of income tax by the grantor is not considered to be a gift to the trust for gift tax purposes. Therefore, the grantor's payment of income tax is a tax-free gift to the trust. Any assets contributed to the IDGT will be excluded from the grantor's estate. The IDGT will purchase assets from the grantor in exchange for its promissory note bearing interest at the applicable federal rate (which currently is less than 2%). The grantor should contribute "seed" money to the IDGT sufficient to support the promissory note being recognized as bona fide debt. No gift tax will be owed if the "seed" gift is sheltered by the grantor's $1 million lifetime gift tax exemption. The sale will not be recognized for income tax purposes because the grantor is treated as still owning the assets of the IDGT. Interest payments on the note will not be included in the grantor's gross income because the grantor is treated as both the borrower and the lender for income tax purposes. Increases in the value of the purchased asset above the interest rate on the note will belong to the IDGT. 5. Qualified Personal Residence Trust ("QPRT") A QPRT is an irrevocable trust into which the grantor transfers all or a portion of the grantor's interest in his or her residence while retaining the right to live in the residence for a fixed term and the right to a reversion to his or her estate if the grantor does not survive the term. The value of the gift to a QPRT is the value of the residence or interest in the residence that is transferred minus the present value of the grantor's retained interest. At the end of the fixed term, if the grantor is living, the residence passes to the designated beneficiaries free of any gift tax. If the grantor survives the fixed term, the grantor may arrange to lease back the property at fair market value thereby removing additional assets from the grantor's taxable estate. If the owner is an IDGT, the rental payments are not taxable. A QPRT is beneficial for the following reasons: (i) the residence is transferred at its current value as opposed to a later, hopefully appreciated value; (ii) the gift is leveraged by reducing the taxable gift by the value of the grantor's retained interest; (iii) the effective rate of the gift tax is far less than the effective rate of the estate tax; and (iv) the historically low current gift tax rate of 35% enhances the tax savings through year-end The current low interest rates make a QPRT less attractive, but the depressed real estate values and potential for appreciation probably offset this disadvantage. As an alternative, the residence can be sold to the IDGT and leased back. In a low interest rate environment, this may be preferable. Fractional interests in residences may be transferred, which will be valued after giving consideration to the lack of marketability of a fractional interest. 6. Gifts of Interests in a Limited Liability Company ("LLC") or Limited Partnership ("LP") An LLC or LP provides administrative efficiencies by centralizing management of assets and may provide access to investment opportunities that are not open to investors who are not "qualified purchasers" under laws regulating the sale of securities. Such transfers will also educate younger generation family members and encourage their interest in the management of such assets, increasing the likelihood that assets will remain within the family. Making gifts of LLC or LP interests in 2010 is another way to take advantage of the favorable gift tax rate available until year end 2010 and the temporary lapse of the GST tax. If a grandchild is a minor, he Pillsbury Winthrop Shaw Pittman LLP 3

4 or she can be given an LLC or LP interest outright and free of trust. The manager or general partner will control the entity's investments and distributions. This is desirable because there is a risk that a gift to a trust will not be protected from GST tax when it is restored. In addition, gifts of LLC or LP interests may be valued for gift tax purposes at less than liquidation value due to the lack of control and lack of marketability. Legislation has been proposed that will restrict the ability to value LLC and LP interests at a discount. Transfers made before the effective date of this legislation should be eligible to be valued at a discount. 7. Private Annuity A private annuity is a transfer of cash or property to a person who is not an insurance company (usually a family member or a trust or entity owned by family members) in exchange for an annuity payable for the life of the annuitant. A private annuity is useful primarily in circumstances where the annuitant has a shorter life expectancy than the actuarial tables provide for a person of his or her age, but has a life expectancy of at least a year. The current low interest rates reduce the amount that the family will have to pay to the annuitant. Unless the issuer of the annuity is an IDGT, the transferor will have to recognize gain on the transfer of assets in exchange for a private annuity. The transferred property will be removed from the transferor's estate. If the transferor does not live to normal life expectancy, or if the assets appreciate in value more than is assumed by the Treasury valuation tables, the transferees will benefit. 8. Roth IRA Conversion Until 2010, only individuals with modified adjusted gross incomes of less than $100,000 were able to convert a traditional IRA to a Roth IRA. Beginning in 2010, however, there are no longer any income limitations for Roth IRA conversions. Whether or not such a conversion is a wise choice depends on an individual s circumstances. You should consider the following factors when deciding whether or not to convert: Amounts contributed to a traditional IRA are tax-deductible but earnings are taxable when withdrawn. In contrast, while amounts contributed to a Roth IRA are not tax-deductible, earnings may be withdrawn free of tax if the owner is at least 59 ½ and has had the Roth IRA for at least five years. Additionally, traditional IRAs require individuals to take minimum distributions beginning at 70 ½, while there is no such requirement with Roth IRAs. Conversion generally makes sense if the owner s income tax bracket in 2010 is expected to be lower than in future years. Conversion will trigger income tax. In 2010 only, there is a special rule that allows one to recognize 100% of the income recognized in 2010 or to split it equally between tax years 2011 and One should only make the conversion if there are sufficient assets outside of the IRA to pay the income tax so as to not lose the benefit of tax-free growth of the amounts already held in the IRA. If one has the liquidity to pay the income tax caused by the conversion, the amount paid will be removed from the payor s taxable estate and, because minimum distributions are not required to be made from a Roth IRA, the account will have a longer period of time during which it may benefit future generations. After the owner s death, the required minimum distributions are reduced if the designated beneficiaries are younger (e.g. grandchildren). This allows income to be compounded tax free for a longer period. Pillsbury Winthrop Shaw Pittman LLP 4

5 9. Irrevocable Life Insurance Trust ("ILIT") An ILIT is an irrevocable trust created to hold the life insurance policy(ies) on the life of the grantor. Generally, proceeds of a life insurance policy owned by an ILIT are not included in the insured's estate. Although contributions to the ILIT may be taxable gifts, an ILIT can be drafted so that the annual gift tax exclusion will shelter the gifts from gift tax. A life insurance policy enjoys certain income tax benefits. Generally, the increase in the cash value of the policy is not taxed and the death benefit is excluded from gross income. The yield on some policies exceeds the yield on other investments with comparable investment risk. An ILIT may be worthwhile when teamed with a GRAT or QPRT to cover the risk that assets owned by the GRAT or QPRT will be included in the grantor's estate because the grantor did not survive the term of the retained interest. 10. Charitable Lead Trust ("CLT") A CLT is an irrevocable trust that makes an annual payment either of a set dollar amount (called a charitable lead annuity trust or "CLAT") or a fixed percentage of the value of the trust (called a charitable lead unitrust or "CLUT") to one or more qualified charitable organizations for a defined term. At the end of the term, the remaining assets in the trust either pass to another trust or pay to named beneficiaries. A CLAT is especially effective in the current low interest rate environment. A CLAT can provide increasing annual payments to charity to obtain additional leverage from the current low interest rates (currently 2%). For further information, please contact the Pillsbury attorney with whom you usually work, or any of the authors listed below: Jennifer Jordan McCall (bio) Palo Alto, CA jmccall@pillsburylaw.com Kim T. Schoknecht (bio) Palo Alto, CA kim.schoknecht@pillsburylaw.com Ellen K. Harrison (bio) Elizabeth H. W. Fry (bio) Washington, DC New York, NY ellen.harrison@pillsburylaw.com elizabeth.fry@pillsburylaw.com This material is not intended to constitute a complete analysis of all tax considerations. Internal Revenue Service regulations generally provide that, for the purpose of avoiding United States federal tax penalties, a taxpayer may rely only on formal written opinions meeting specific regulatory requirements. This material does not meet those requirements. Accordingly, this material was not intended or written to be used, and a taxpayer cannot use it, for the purpose of avoiding United States federal or other tax penalties or of promoting, marketing or recommending to another party any tax-related matters. This publication is issued periodically to keep Pillsbury Winthrop Shaw Pittman LLP clients and other interested parties informed of current legal developments that may affect or otherwise be of interest to them. The comments contained herein do not constitute legal opinion and should not be regarded as a substitute for legal advice Pillsbury Winthrop Shaw Pittman LLP. All Rights Reserved. Pillsbury Winthrop Shaw Pittman LLP 5