The Economic Growth and Tax Relief

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1 March 2002 E STATE P LANNING U PDATE Tax Law Changes for 2002 The Economic Growth and Tax Relief Reconciliation Act of 2001 (the 2001 Act ) made major changes to federal income and transfer tax laws. Although most of the changes are to be phased in over the coming decade, several significant changes are now in effect for the 2002 tax year. In this update, we will briefly discuss the latest changes, one of which in the generation-skipping transfer tax area requires quick attention in certain cases. We will also discuss planning techniques that are particularly beneficial in today s low interest rate environment. We encourage you to call your attorney in Drinker s Personal and Fiduciary Law Department to discuss how the latest tax law changes affect you and to see whether any of the planning techniques discussed here could benefit you. AUTOMATIC GST EXEMPTION A LLOCATION The 2001 Act changed the rules concerning how a person can allocate his or her generation-skipping transfer ( GST ) tax exemption the current $1.1 million exemption that allows a person to transfer wealth to grandchildren (or other beneficiaries who are at least two generations younger than the person) without incurring GST tax. In the past, a person generally allocated GST exemption to a transfer to a trust by filing a federal gift tax return and allocating exemption on the return. The 2001 Act attempted to ease this burden by providing, for transfers occurring after December 2000, that GST exemption will be allocated automatically to transfers to certain kinds of trusts unless the taxpayer opts out of the automatic allocation by making an election on a timely filed gift tax return (including extensions). Unfortunately, the statute potentially reaches many more trusts than it was designed to with the result that many taxpayers could end up having inadvertently wasted GST exemption on trusts that were never intended to be exempt from the GST tax. It is possible that the Internal Revenue Service may fix this problem by issuing a notice limiting the new rule s application. Nevertheless, the new rule is currently in place, and taxpayers will need to decide now whether to file a gift tax return in 2002 to opt out of the automatic allocation or wait and see whether the Service clarifies the situation. Revocable trusts and the following kinds of irrevocable trusts will not be affected by the new rule: 2503(c) trusts ( minor s trusts ), charitable remainder annuity trusts or unitrusts and charitable lead annuity trusts. Determining whether or not other trusts, including irrevocable insurance trusts, fall within the rule generally will require an examination of the trust terms. PLEASE NOTE: If at any time in 2001 you transferred cash or other property to an irrevocable trust that you do not intend to be exempt from the GST tax, or if you established a grantor retained annuity trust, qualified personal residence trust or any other trust whose initial trust term ended in 2001, you may want us to review your trust to determine whether or not you should file a gift tax return in 2002 to ensure that none of your GST exemption is wasted. This type of transfer includes a premium payment in connection with an insurance trust. If you would like us to review your situation, please contact your Personal and Fiduciary Law attorney at Drinker NO LATER THAN APRIL 1, We will be happy to advise you and, if necessary, review your trust to determine whether or not you should opt out of the automatic GST exemption allocation. Estate Planning Update March 2002

2 I NCREASES IN E STATE, GIFT AND GST E XEMPTIONS AND E XCLUSIONS, D ECREASES IN M AXIMUM R ATES Many of the 2001 Act s favorable changes in the estate, gift and GST tax laws took effect as of January 1, Here are the main changes, each effective as of January 1, 2002: The estate and gift tax exemption (technically known as the applicable exclusion amount ) increased from $675,000 to $1 million. The gift tax annual exclusion increased from $10,000 to $11,000 per donee. The gift tax annual exclusion for gifts to non-u.s. citizen spouses increased from $106,000 to $110,000. The GST tax exemption increased from $1.06 million to $1.1 million. The maximum tax rate for estate, gift and GST taxes decreased from 55% to 50%. The 5% surtax on wealthy individuals who have made cumulative taxable transfers (whether through lifetime gifts or at death) of between $10 million and approximately $17.2 million has been eliminated. Planning Pointers Even though the gift tax exemption increased by $325,000 this year (from $675,000 to $1 million), a taxable gift in 2002 of $325,000 or perhaps even far less will result in gift tax if you have made taxable gifts in the past. If you have made taxable gifts in prior years and are interested in making significant gifts this year, please contact us to determine how much you can give in 2002 without incurring gift tax. The increase to $1 million in the federal estate tax exemption may cause unintended consequences in certain estate plans. Many estate plans are based on a formula that divides the estate into a credit shelter portion based on the amount of the available federal estate tax exemption and a marital portion consisting of the balance. The spouse may have no interest in the credit shelter portion, or that portion may be held in a trust with significantly more restrictive provisions vis-à-vis the spouse. Either way, the spouse may not be pleased if $1 million rather than $675,000 passes under the credit shelter portion. Or, for example, in a second marriage the credit shelter and the marital portions could ultimately pass to entirely different beneficiaries, to the advantage of the ultimate beneficiaries of the credit shelter portion and the detriment of the ultimate beneficiaries of the marital portion. These issues will intensify over the coming decade. Under the 2001 Act, the estate tax exemption, but not the gift tax exemption, is scheduled to increase in stages, to $1.5 million in 2004, $2 million in 2006 and $3.5 million in 2009, with a one-year repeal in 2010 (followed by a return to the levels that would then have been in effect under pre-act law). These examples are not intended to be an exhaustive list. Other circumstances will also benefit from a current examination. If you would like to discuss how any of these changes might affect you, please feel free to contact us. Estate Planning Techniques That Are Well Suited to a Low Interest Rate Environment Interest rates are currently near historic lows. Each month since the mid-1980s, the Treasury Department has published the applicable federal rate under 7520 of the Internal Revenue Code. The 7520 rate is the rate used by the Internal Revenue Service to value annuities, life estates, term interests and remainder interests. This month, March, 2002, the 7520 rate is 5.4%. It has been lower only twice, and rarely has it dipped below 6%. It has been as high as 11.6%. While many people are aware that the current low interest rate environment provides special opportunities (and pitfalls) for investors, they may not be aware that low interest rates afford some highly effective estate planning opportunities. We will Estate Planning Update March 2002 Page 2

3 briefly examine several estate planning techniques that are particularly well suited to a low interest rate environment. C HARITABLE L EAD A NNUITY T RUST A charitable lead annuity trust is a trust that provides for a fixed annual payment for a specified number of years to a charity selected by the donor. At the end of the trust term, the remaining principal of the trust is distributed to or held in further trust for the benefit of one or more individuals specified in the trust instrument. Depending on the terms of the trust, the donor may or may not be entitled to an income tax charitable deduction in the year that the gift is made to the trust. If the individual who is to receive the property at the end of the trust term (the remainderman ) is someone other than the donor, the donor will be deemed to have made a taxable gift to the remainderman in an amount equal to the value of the property donated to the trust, reduced by the value of the charity s lead interest in the trust. As interest rates decline, the value of the charity s lead interest increases. Thus, if interest rates are low, the donor may be entitled to an increased income tax charitable deduction, and the value of the gift to the remainderman accordingly will be reduced. Suppose that a donor contributes $1 million to a charitable lead annuity trust that provides for a $100,000 payment to a charity each year for a period of five years. At the end of the five years, the remaining trust assets will be paid to the donor s children. If the trust is funded in March 2002 (with a 7520 rate of 5.4%), the charity s lead interest will be valued at $428,200, the donor may be entitled to an income tax charitable deduction in that amount and the gift of the remainder interest would be valued at $571,800. In contrast, if the applicable rate were 11.6%, the maximum charitable deduction would be only $364,080, and the donor would have made a taxable gift of $635,920. G RANTOR R ETAINED A NNUITY T RUST Another estate planning device that is particularly well suited to a low interest rate environment is the grantor retained annuity trust, or GRAT. A GRAT is a type of trust that provides for a fixed annual payment to the grantor the person who created the trust for a specified number of years. At the end of the trust term, the remaining trust assets (if any) pass to the beneficiaries specified in the trust instrument (the remaindermen ). If the assets in the GRAT appreciate at a rate exceeding the applicable 7520 rate, the grantor will have succeeded in transferring additional assets to the remaindermen without any additional gift tax consequences. If, however, the grantor dies during the trust term, the trust assets are pulled back into the grantor s estate. Assume that a 65-year-old grantor creates a four-year GRAT, funded with $1 million. If the trust is funded in March 2002, when the 7520 rate was 5.4%, the grantor would need to receive an annuity payment of about $285,000 each year in order not to have made a taxable gift in connection with the transfer. If, however, the 7520 rate were 11.6%, the annuity payments to the grantor would need to be approximately $325,000 each year (again, to avoid having made a taxable gift in connection with the transfer), which would be less desirable from an estate planning standpoint. Plainly, then, funding a GRAT becomes a much more attractive proposition when interest rates are low. I NSTALLMENT S ALE TO A G RANTOR T RUST A grantor trust is one in which the grantor of the trust is treated as the owner of all trust property for income tax purposes. As a result, the grantor is taxed on all income (ordinary and capital gain) earned by a grantor trust. In addition, a sale between a grantor and a grantor trust has no income tax effect; no gain is realized and the income tax basis of the property does not change. Generally, in a sale to a grantor trust, the grantor sells assets to the trust at a discounted value in exchange for payments in the form of cash or stock on an installment basis for the term of the note at the applicable federal rate (which for this type of transaction is lower than the 7520 rate). At the end of the note term, the assets (and all of the appreciation) are owned outright by the trust without Estate Planning Update March 2002 Page 3

4 incurring any transfer tax liability. If the trust assets appreciate at a faster rate than the applicable federal rate, the transfer tax benefits can be significant. Thus, like the GRAT, this technique can be particularly advantageous when interest rates are low. Like most sophisticated estate planning techniques, an installment sale to a grantor trust involves some risk. For example, the IRS has taken the position that the death of the grantor during the trust term accelerates the capital gain that was deferred on the original sale. Nevertheless, in the right circumstances, the potential benefits of this technique can be significant, given the lower applicable interest rate. that more assets would be included in the parent s estate. (If the applicable 7520 rate were 11.6%, the required annuity payment would increase to approximately $250,000, with the child having paid the parent $1 million in the first instance, and $3.75 million in the second.) Thus, depending on the amount of the annuity payment and the life expectancy of the annuitant, a private annuity can produce quite different estate tax results. In appropriate circumstances, however, it can produce substantial tax savings, which can be maximized in a low interest rate environment. P RIVATE A NNUITY A private annuity can offer both income and estate tax advantages in certain situations. In a typical private annuity transaction, a parent transfers to a child property in exchange for the child s promise to pay a fixed amount at fixed intervals for the parent s life. If the amount the child is required to pay is sufficiently high, the transaction will not result in any taxable gift from the parent to the child. For the grantor, each payment will be divided between income, capital gain and return of basis. This technique generally will be more favorable from an estate planning standpoint if the child s required payments can be made as low as possible without causing adverse gift tax consequences. This calculation depends in part on the applicable 7520 rate the lower, the better. Say, for example, a 70-year-old parent in March 2002 transferred securities with a market value of $1.5 million to her child in exchange for the right to receive approximately $170,000 a year, the annuity payment under the current rate. If the parent died at the end of the fourth year, the child would have paid the parent a total of $680,000 of annuity payments. The remaining $820,000 of the original transfer (plus any appreciation) would not be included in the parent s estate. If the parent died at the end of the 15th year, the child would have paid the parent $2,550,000, with the undesirable result C HARITABLE T RANSFER OF R EMAINDER I NTEREST IN R ESIDENCE OR FARM Under the Internal Revenue Code, a person can take an immediate income tax charitable deduction by transferring a remainder interest in a residence or farm to a qualified charity. The donor may retain ownership of the residence or farm for life, and the charity becomes entitled to possession of the property only upon the donor s death. The value of the charity s interest (and therefore the value of the income tax charitable deduction) depends upon several factors, including the donor s age, the property s expected rate of depreciation, and the prevailing interest rate at the time the transaction occurs. Suppose a 65-year-old donor irrevocably transfers to a charity the right to own and possess her $1 million farm upon her death. Depending upon the precise nature of the property, the donor may be entitled to an income tax charitable deduction as high as $449,120, if the applicable rate is 5.4%. In contrast, if the applicable rate were 11.6%, the donor s maximum charitable deduction would be $234,820. These and other estate planning techniques can offer significant tax benefits to individuals during times when interest rates are at or near historic lows. If you would like to explore how any of these techniques might benefit you, please feel free to call us. Estate Planning Update March 2002 Page 4

5 Personal & Fiduciary Law Department Marsha W. William C. Edward A. Gramigna, Samuel W. Lambert, Nora E. Lisa S. Charles H. Wampold, Susan G. Regina R. Alvin C. Joan Leslie Gillin Diane Jill R. Shauna B. Carolyn Purcell Matthew L. a Pennsylvania Limited Liability Partnership, is a full service law firm headquartered since 1849 in Philadelphia, PA. practices as Drinker Biddle & Shanley LLP in New Jersey. With more than 425 attorneys, the firm represents a broad spectrum of public and private, commercial, financial and educational enterprises, governmental authorities, charities and individuals throughout the United States and abroad. This summary was prepared by the members of the Personal & Fiduciary Law Department of. It is intended to apprise our clients of developments in the law and to provide information of general interest. It is not intended to constitute legal advice regarding a client s specific legal problems and should not be relied upon as such. Est All rights reserved. PHILADELPHIA One Logan Square 18th and Cherry Streets Philadelphia, PA (fax) BERWYN Suite Westlakes Drive Berwyn, PA (fax) PRINCETON Drinker Biddle & Shanley LLP Suite College Road East Princeton, NJ (fax) Jonathan I. Epstein, Partner in charge WASHINGTON,DC Suite K Street, N.W. Washington, DC /66 (fax) LOS ANGELES Wells Fargo Building 333 South Grand Avenue Suite 1700 Los Angeles, CA (fax) SAN FRANCISCO 225 Bush Street, 15th Floor San Francisco, CA (fax) FLORHAM PARK Drinker Biddle & Shanley LLP 500 Campus Drive Florham Park, NJ (fax) Daniel F. O Connell, Partner in charge NEW YORK 11 Penn Plaza, 5th Floor. New York, NY (fax) To access and share with colleagues this and other Drinker newsletters, please visit our website at Estate Planning Update March 2002 Page 5