ADVANCED PLANNING CONCEPTS IN LIGHT OF THE AMERICAN TAXPAYER RELIEF ACT (October 11, 2013)

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1 ADVANCED PLANNING CONCEPTS IN LIGHT OF THE AMERICAN TAXPAYER RELIEF ACT (October 11, 2013) By: Phoebe Moffatt, Attorney CERTIFIED AS A SPECIALIST IN ESTATE AND TRUST LAW STATE BAR OF ARIZONA BOARD OF LEGAL SPECIALIZATION SACKS TIERNEY P.A N. Drinkwater Blvd., Fourth Floor Scottsdale, Arizona Phone: Phone:

2 Highlights: American Taxpayer Relief Act of 2012 On January 2, 2013, President Obama signed the American Taxpayer Relief Act of 2012 (the ATRA ). NO MORE SUNSETS: ATRA operates by sunsetting the Sunset of the Bush tax cuts enacted May 2001 by the Economic Growth and Tax Relief Reconciliation Act of 2001 ( the 2001 law ) which was scheduled to sunset on January 1, 2011, and the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 (the 2010 Tax Relief Act ) which was scheduled to sunset on January 1, The estate, gift, and generation skipping transfer tax provisions of 2012 remain in effect (including the $5,000,000 indexed estate, gift, and generation skipping exemptions), with some modifications. Estate, gift and GST tax rates to 40% in UNIFICATION MADE PERMANENT: Makes permanent the reunified estate and gift tax exemptions so an individual can give away at life or at death an amount of $5,250,000 in year 2013.

3 Four key transfer changes under ATRA are permanence, indexing, unification, and portability Tax Exemption Rate Tax Exemption Rate Gift $1M 45% Gift $1M 35% Estate $3.5M 45% Estate $5M* 35%* GST $3.5M 45% GST $5M 35% Tax Exemption Rate Gift $5,000,000** 35% Estate $5,000,000** 35% *Personal Representatives for 2010 decedents could have elected into the no estate/modified carry over basis regime GST $5,000,000** 35% 2013 Tax Exemption Rate Gift $5,250,000** 40% Estate $5,250,000** 40% GST $5,250,000** 40% ** Indexed for inflation beginning in 2012

4 1. Gift Tax Individuals seeking to make gifts in excess of the annual exclusion amount (which for 2013 is $14,000 per person per calendar year) now have the opportunity to make lifetime gifts up to $5,250,000 tax free in 2013; however, lifetime gifts exceeding $5,250,000 are subject to 40% gift tax. Contrast 2010, gifts made during an individual s life which did not exceed $1,000,000 could be sheltered from gift tax, but over $1,000,000 subjected to 35% gift tax. Had ATRA not become law, gift tax in year 2013 could have been at a rate of 55% for every lifetime gift exceeding $1,000,000 (which was the law prior to 2001). Now, under ATRA, if an individual makes a full lifetime gift of an amount not to exceed $5,250,000 in year 2013, the entire gift is exempt from gift taxes and thus free from estate taxes at client s death. Indexed from $5,120,000 in 2012 to $5,250,000 in 2013 ($130,000 index); with indexing, the exemption may grow at roughly the same rate as the client s estate. Now, under ATRA, reunification of the estate and gift tax systems gives unprecedented opportunity for lifetime wealth transfer. 2. Estate Tax ATRA operates to impose an estate tax of 40% on the taxable assets of a decedent who dies in 2013; however, the estate tax owed is imposed only on the value of taxable assets which exceeds $5,250,000. The tradeoff for the estate tax on the decedent s taxable assets is that ALL of the decedent s appreciated assets receive a step-up in basis as of the decedent s date of death. Indexed from $5,120,000 in 2012 to $5,250,000 in 2013 ($130,000 index); with indexing, the exemption may grow at roughly the same rate as a client s estate.

5 3. Portability of Estate Tax Exemption The 2010 Tax Relief Act introduced the concept of portability of the estate tax exemption at the death of a spouse. ATRA made a technical correction to portability by defining the applicable exclusion amount to be the basic exclusion amount that could be ported to the surviving spouse. Portability allows the second spouse to die to share any unused estate tax exemption of the first spouse to die. Portability only applies in limited circumstances and only if the election is timely made on an estate tax return. The executor of the first spouse to die must elect on an estate tax return (form 706) to transfer the deceased spouse s unused exemption amount ( deceased spousal unused exclusion amount ) to the surviving spouse within nine months of the date of the death of the first to die, subject to an automatic six month extension. The election entitles the estate of the second spouse to die to use their own estate tax exemption plus the remaining amount of the deceased spouse s exemption. However, if the surviving spouse remarries, any of the deceased prior spouse s unused exemption is lost. Under prior law, the estate tax exemption of the first spouse to die was a use it or lose it rule, and many clients had therefore been counseled to establish a Bypass/Credit Shelter Trust in order to maximize the exemption of the first spouse to die. The 2010 Tax Relief Act provided an opportunity for spouses to receive a combined $10,000,000 exemption from gift and estate taxes regardless of whether they had estate planning documents utilizing a credit shelter trust. Now, ATRA makes portability permanent and in 2013, spouses can receive a combined $10,500,000 exemption. At the first death, however, the executor of the deceased spouse must elect for the surviving spouse to use the unused deceased spouse s exemption (DSUE) and the election must be made not later than fifteen months from the deceased spouse s date of death. Married clients choosing to rely on portability and not opting for a Bypass/Credit Shelter Trust have risks: (1) Portability is lost if surviving spouse remarries; (2) Portability only locks in $5,250,000 (this year) exemption and not the appreciation on the $5,250,000 (in future years);

6 (3) The $5,250,000 exemption is scheduled to be indexed for inflation but portability will be locked in at the amount available when first spouse dies without the indexing; (4) The non-tax benefit of the credit shelter trust of protection trust assets from the reach of the surviving spouse s creditors and future ex-spouses is lost; and 4. GST Tax (5) Portability does not extend to the GST tax. Under ATRA, individuals may make transfers of up to $5,250,000 to skip persons outright or in trust tax free. Wealth transfers made to skip persons (e.g. family members two or more generations younger than the transferor and non-family members more than 37 ½ years younger than the transferor) in excess of $5,250,000 are subject to 40% GST Tax. The $5,250,000 GST Tax exemption, as indexed, now available may be used to exempt gifts to GST trusts that are expected to benefit multiple generations, so that generation-skipping transfers from the trusts in subsequent years are also exempt from GST tax. 5. Other Important Changes made by ATRA The thresholds for the new maximum 39.6% ordinary income tax and 20% capital gains tax rate are $450,000 joint/$400,000 single of taxable income. The thresholds for 3.8% Medicare tax to net investment income are $250,000 joint/$200,000 single of adjusted gross income. The top federal rate on investment income for high earners will be 43.4% (not including state income taxes). This could create some strange tax rate results. If the 3.8% net investment income tax (based on Modified AGI) will apply in many cases where the top income tax bracket (based on taxable income) will not, then a large number of taxpayers could wind up paying up to 23.8% on dividends and capital gains.

7 Advanced Planning Concepts in light of the American Taxpayer Relief Act 1. Pros/Cons of drafting a Bypass/Credit Shelter Trust in Joint/CP Trust especially for married clients under the exemption equivalent amount (i.e. combined wealth under $10,500,000 this year) PROs of Bypass/Credit Shelter Trust : * Irrevocable at first death. * Uses the exemption of the first spouse to die, so remove the value of the assets from Surviving Spouse s estate at second death. (If the combined net worth of the married couple exceeds $10,500,000 this year, the better choice would likely be to draft a bypass trust with a Marital Trust to hold assets over the exemption equivalent amount of the first to die, depending on the funding formula chosen). * Provides surviving spouse with the non-tax benefit of protecting trust assets from the reach of the surviving spouse s creditors and future ex-spouses. * Could provide more security to children/descendants of first spouse that their inheritance will be available to them during the life of the surviving spouse because children/descendants of first spouse will be entitled to receive information regarding the administration of the Bypass/Credit Shelter Trust during the life of the surviving spouse. * Could provide additional security if trust names a trustee other than the surviving spouse to act as trustee of the Bypass/Credit Shelter Trust. * Could provide language for income to be distributed to children/descendants who are in a lower tax bracket. * The trustee could be given the power to distribute income among various lower income tax beneficiaries to reduce the exposure to the net investment income tax ( NII tax ). CONs of Bypass/Credit Shelter Trust : * Irrevocable at first death.

8 * Must obtain new taxpayer number to establish account in name of Bypass/Credit Shelter Trust - thus, 1041 administration costs moving forward. * Post death - funding issues - what type of formula is used? Fractional share, smallest pecuniary, largest pecuniary? * DSUE election on an estate tax return * No Step up in Basis on assets of the Bypass/Credit Shelter Trust at death of second spouse. * Notice Requirements if children/descendants of first spouse are included as current income beneficiaries of the Bypass/Credit Shelter Trust, they are entitled to receive trustee's reports and other information reasonably related to the administration of a trust See A.R.S. Section Under A.R.S. Section (B)(8) cannot draft around this requirement if the beneficiaries are qualified and under A.R.S Section (13) a qualified beneficiary is a permissible distributee of trust income. Language could be drafted providing surviving spouse a special power of appointment to redirect the principal of the trust assets to keep children/descendants of first spouse in check). 2. Pros/Cons of drafting a Disclaimer Trust in Joint/CP Trust for married clients under the exemption equivalent amount (i.e. combined wealth under $10,500,000 this year) PROs of Disclaimer Trust : * Disclaimer Trust can provide the surviving spouse with the same tax and non-tax benefits as a Bypass/Credit Shelter Trust (i.e. uses the exemption of the first spouse to die, so irrevocably removes the value of the assets from surviving spouse s estate at second death). * Disclaimer Trust option is more flexible - Surviving spouse has option to create a new (bypass/credit shelter) trust at death of first spouse because the default is all assets pass to the survivor unless the survivor disclaims them. The Disclaimer Trust (i.e. a Bypass/Credit Shelter Trust) is only created after the first death and only if the surviving spouse properly disclaims assets of the deceased spouse into the Disclaimer Trust. * Contrast the Bypass/Credit Shelter Trust which is mandatory - upon the first death, the language requires the Bypass/Credit Shelter Trust to be created.

9 * Surviving spouse can choose to disclaim some or none of the deceased spouse s assets. Any assets not disclaimed pass automatically to the survivor usually into a survivor s trust so survivor has unfettered access to all assets of the first spouse to die. * The trustee could be given the power to distribute income among various lower income tax beneficiaries to reduce the exposure to the NII tax. CONs of Disclaimer Trust : * Strong likelihood that no Disclaimer Trust will be created at first death so why have the language? What s the benefit? There is nothing stopping a surviving spouse from executing a disclaimer even if there is no disclaimer language in the trust. * Disclaimer Trust is generally not the better choice in a situation where there are children of a prior marriage. * Timing is of the essence from a tax perspective. If the goal is to have the Disclaimer Trust recognized as a Bypass/Credit Shelter Trust from a taxing perspective, the surviving spouse must properly disclaim the assets of the deceased spouse not later than nine months from the date of the first spouse s death. A surviving spouse may be mourning the loss and not thinking of tax planning or making a decision about disclaiming assets. * Disclaimer Trust is not a good choice for clients who are at or near a combined wealth of $5,250,000. When married client s net worth is over $5,250,000, the likelihood that no disclaimer will be made after the first death and thus estate taxes will be owed at the second death is a real one. The planner should consider issues such as whether the surviving spouse could become incapacitated after the first death or may not act timely due to mourning or other life reasons and, so during nine month period so didn t consult a tax advisor. * Qualified disclaimer - if the couple is worth over $5,250,000 at the first death and if the surviving spouse wants to disclaim within the nine month window, the planner should also consider whether the IRS will recognize a surviving spouse s disclaimer as being qualified? That is, can the surviving spouse rightfully assert he/she has not accepted any of the benefit of the joint trust property that is being disclaimed? What if the asset is a retirement interest? Do community property law principals thwart the effort to disclaim any of the property in the joint trust? * Drafting a proper Disclaimer Trust is especially important to make sure the disclaimer is qualified. Does the language provide the

10 surviving spouse does not have the right to amend or change the Disclaimer Trust? Is the Disclaimer Trust drafted to make sure that surviving spouse does not have any special or general power of appointment over the principal of the Disclaimer Trust? The drafter should review 26 USC 2518 to make sure to draft the Disclaimer Trust in a way that it will be qualified if the surviving spouse chooses to see the drafter after the first death for the purpose of disclaiming. * Because of the restrictions on the surviving spouse s ability to redirect the Disclaimer Trust property during the surviving spouse s lifetime, flexibility after the first death is generally lost with a Disclaimer Trust. * If surviving spouse properly disclaims within the nine month period and creates the Disclaimer Trust, and subsequently runs out of assets in the survivor trust, can the surviving spouse later sue the attorney claiming he/she would not have disclaimed such property if he/she had known the consequence of not having unfettered access to the principal of the Disclaimer Trust. Practice pointer: make sure to prepare letter to clients carefully advising and explaining the consequence of creating the Disclaimer Trust after the first death, and make sure to prepare a letter to the widow/widower advising and explaining the consequence of disclaiming assets to the Disclaimer Trust. * Once Disclaimer Trust is created, Must obtain new taxpayer number to establish account in name of Disclaimer Trust - thus, 1041 administration costs moving forward. * DSUE election on an estate tax return? * No step up in basis on assets of the Disclaimer Trust at death of second spouse. 3. Pros/Cons of drafting a QTIP Marital Trust (or optional QTIP) in Joint/CP Trust for married clients under the exemption equivalent amount (i.e. combined wealth under $10,500,000 this year) PROs of QTIP Marital Trust : * In 2010, when the estate tax was repealed (and hence there was no exemption equivalent amount) the step up in basis on a decedent s assets also went away. ATRA now calls for the highest exemption equivalent amount in the history of our country. There is a larger audience of clients with assets under the exemption equivalent amount than ever before.

11 * Now, in addition, the bonus under ATRA, is that clients also receive a step-up in basis on all assets includible in their estate at their death. * Under 26 USC 1014, the basis of property in the hands of a person acquiring the property from a decedent is the fair market value of the property at the date of the decedent s death. Under 26 USC 1014 (b) (6), property that is considered to have been acquired from the decedent includes property which represents the surviving spouse s one-half share of community property held by the decedent and the surviving spouse under the community property laws of any State, or possession of the United States or any foreign country, if at least one-half of the whole of the community interest in such property was includible in determining the value of the decedent s gross estate * Assets in a Bypass/Credit Shelter Trust are not includible in the estate of the second spouse to die (because the assets are included in the estate of the first to die), and therefore do not receive a step-up in basis at the second death (though the assets of the first spouse to die are stepped up at the first death) under 26 USC * The QTIP Marital Trust is a method to employ in those cases where the married couple would like the assets of the first spouse to die to be included in the second to die spouse s estate so that the married couple s heirs can receive a step up in basis at the second death, while at the same time avoiding giving those assets outright to the surviving spouse where such assets could otherwise become subject to the claims of the surviving spouse s creditors or new spouse. * A joint trust can be drafted to provide for the creation of a Marital Trust at the first death, giving the surviving spouse the option to elect the Marital Trust as a QTIP, i.e. elected to be a Qualified Terminal Interest in Property under 26 USC 2056(b)(7). Property of the first spouse which is allocated into a properly elected QTIP Marital Trust would be included in the estate of the second spouse to die. See 26 USC * Irrevocable at first death. * Provides surviving spouse with the non-tax benefit of protecting trust assets from the reach of the surviving spouse s creditors and future ex-spouses. * Language in the joint trust mandates that the Marital Trust be established (contrast the discretionary decision to be made by the surviving spouse if Disclaimer Trust is used).

12 * Language in joint trust can be drafted providing that the exemption of the first spouse to die be used to the extent so elected by the surviving spouse (i.e. a non-qtip Marital Trust) or a mandatory default to a Bypass Trust if no QTIP Marital Trust is elected (so as to remove the value of any of the assets of the first to die from second to die spouse s estate at second death). * Provides more flexibility to during the surviving spouse s lifetime because can also use a SPOA. * Offers more security to children/descendants of first spouse that their inheritance will be available to them after the death of the surviving spouse as opposed to the assets being distributed outright to the surviving spouse or to a survivor s trust, especially with if a trustee other than the surviving spouse is named as trust over the QTIP Marital Trust. death. * Provides for a step up in basis on the QTIP assets at survivor s CONs of QTIP Marital Trust : * Irrevocable at first death. * Estate tax return (form 706) at the first death to make the election to use the QTIP Marital Trust. * After ATRA, one must ask whether an estate tax return should be prepared as a matter of course for any married couple in order to make the DSUE election. * Must obtain new taxpayer number to establish account in name of QTIP Marital Trust - thus, 1041 administration costs moving forward. * Does not provide the ability to have income distributed to children/ descendants who may be in a lower tax bracket. In order for the Marital Trust to qualify, all of the income of the Marital Trust must be distributed to the surviving spouse, and no person is allowed to have a power to appoint any part of the QTIP Marital property to any person other than the surviving spouse. * Consider burden of estate taxes being imposed in unintended ways under 26 USC Estate taxes owed in QTIP Marital come off the top of the QTIP. In other words, DSUE first applies to assets in the surviving spouse s estate/trust after the use of the surviving spouse s

13 exemption equivalent amount. So, the right of recovery in the QTIP Marital Trust could operate (in a second marriage situation) to charge the descendants of the first spouse more in estate taxes than the descendants of the second spouse. * Cannot reduce NII by distributing to lower bracket income beneficiaries as the surviving spouse must be the only beneficiary. 3.8% Net Investment Income Tax ( NII Tax ) Medicare Tax 1. Net Investment Income Tax - 26 USC 1411: (a) Individuals - the tax is 3.8% of the lesser of the net investment income, or the excess of the modified adjusted gross income (MAGI) over the threshold amount. Threshold amounts: for joint filers or surviving spouse $250,000; married filing separately, $125,000; and all others, $200,000. (b) Trusts and Estates - the tax is 3.8% of the lesser of the undistributed net investment income, or the excess of AGI over the dollar amount at which the highest trust/estate tax income bracket begins (in above $11,950). (c) Considerations: What is the probability the tax will increase? What does this tax have to do with medicare? 2. What is Net Investment Income? * NII INCLUDES: gross income from interest, dividends, annuities, royalties and rents (unless earned in the ordinary course of an active trade or business); and includes gross income from passive activities and trading in financial instruments or commodities; and includes net gain from the disposition of property, including property held for use in passive activities. * To determine if taxpayer s investment in a trade or business is passive, a material participation test is applied - was the taxpayer s involvement in the business regular, continuous, substantial - ie more than 500 hours per year. * If the taxpayer meets the requirements to be a real estate professional, the rental real estate activities of the taxpayer will not be passive activities if the taxpayer materially participates in each of those activities. The taxpayer must also be engaged in a trade or business with respect to the rental real estate activities in order

14 for the rents to be excluded from the definition of net investment income. * NII DOES NOT INCLUDE: IRA distributions, qualified plan distributions, tax exempt bond interest, municipal bond interest, selfemployment income, active trade or business income where the taxpayer materially participates in the business (within the meaning of IRC 469), life insurance proceeds, veteran s benefits, social security benefits, nonqualified deferred compensation plan distributions, and gain on the sale of a principal residence. * DEDUCTIONS ALLOWED: investment interest expense (subject to the usual limitations), investment and advisory fees and expenses (e.g. management fees, subject to the 2% floor and phase-out), and taxes allocable to expenses (any reasonable method ), expenses related to rental and royalty income, and state and local income taxes 3. Strategies to: REDUCE NET INVESTMENT INCOME & REDUCE MODIFIED AGI * Switch from corporate bonds to tax exempt bonds * Purchase a deferred annuity with the idea of deferring NII and MAGI to years when they do not give rise to any NII tax * Use buy & hold strategy to defer NII tax on capital gains * Maximize use of contributions to qualified plans & IRAs (reduces MAGI for current year and converts otherwise taxable income to income exempt from NII) * Reallocate investment dollars from assets that produce NII or MAGI into a whole life insurance policy that produces neither * Gift assets that trigger the NII tax to individuals below the MAGI thresholds * Use S Corporations for business activities (salary is excluded from NII, dividends are excluded from NII if the S corp is engaged in an active trade or business, and the income is derived from the active trade or business & the taxpayer materially participates in the trade or business activity) *Include provisions in Wills and Trust Agreements which allow capital gains to be included in income and in DNI * Include provisions in Wills and Trust Agreements which allow a trustee to make charitable distributions of current gross income * Include provisions in Wills and Trust Agreements which give the trustee the power to distribute income among various income beneficiaries

15 CONCLUSION Do not let net investment income accumulate in those bypass/credit shelter trusts which could result in the imposition of an additional 3.8% NII tax. We are now living in a period where the federal tax laws have been made permanent and unified, without the fear of a sunset. The Bypass/Credit Shelter Trust may continue to prove useful for those married couples over the exemption equivalent amount, or for those with descendants of prior marriages, but may not always be the best choice for those married couples under the exemption equivalent amount (this year, $10,500,000). While ATRA has extended some existing law, it made permanent the new concept of portability. As a result, post mortem strategizing and planning opportunities are now more important than ever. Consult with married clients about the benefit of making an election to use DSUE after the first death. If a primary goal for married clients is to receive a step up in basis on assets at the second death, consider the benefit of using a QTIP Marital Trust, especially for those married clients under the exemption equivalent amount (this year, $10,500,000) who intend for the same descendants to inherit at the second death, and especially if there is a strong likelihood of making the DSUE election at the first death.

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