Current Legislation Update: How to Navigate Through the Recent Tax Law Changes and Embrace the Future

1. Current Legislation Update: How to Navigate Through the Recent Tax Law Changes and Embrace the Future Joseph V. Falanga, CPA, AEP, TEP Chester County Estate Planning Council – March 15, 2012

2. Today’s Topics • How to Navigate Through the Recent Tax Law Changes • Administration’s 2013 Revenue Proposals • Intra-Family Loans • Grantor Retained Annuity Trusts • Sales to Defective Grantor Trusts • Charitable Lead Trusts 2

3. Overview – The Transfer Tax Landscape 3

4. Overview – The Transfer Tax Law in 2011 and 2012 • The federal estate, gift and generation-skipping transfer (GST) tax exemptions are unified • The exemption amount was $5,000,000 in 2011($10 Million for a married couple) • The exemption amount is indexed for post 2010 inflation and in 2012 rose to $5,120,000 • The maximum tax rate for all three transfer taxes is 35% • There is portability of the exemption between spouses for estate and gift tax purposes (but not for GST Tax purposes) 4

5. Overview – What did the Estate Tax Look Like in 2010 • With the retroactive rescission of the repeal of the estate tax by the 2010 Tax Relief Act, the Estate’s of 2010 decedents were given the ability to choose one of two different tax paths – the estate tax regime or the carryover basis regime • The default provision is the automatic application of the estate tax • There is a basis step-up – unless the estate elected out of the estate tax regime • If an election out was made, the modified carryover basis rules apply • Form 8939, which is used to elect out of the estate tax regime and report basis, was due on January 17, 2012 • Once made, the election out is revocable only with the IRS’ consent 5

6. Overview – What did the Gift Tax Look Like in 2010 • Unlike the estate tax, the gift tax was never repealed in 2010 • The 2010 exemption was $1,000,000 – unlike the estate and generation-skipping tax exemptions which were both increased to $5,000,000 for 2010 • The maximum rate was 35% • The gift tax became reunified with the estate tax in 2011 when the gift tax exemption was increased to $5,000,000 6

7. Overview – What did the Generation-Skipping Transfer Tax Look Like in 2010 • Like the estate tax, the GST Tax was repealed in 2010 • The 2010 Tax Act reinstated the GST Tax in 2010, with a $5,000,000 exemption • But the tax rate was 0% for 2010 only 7

8. Overview – Estate Tax Filing Extensions in 2010 • For 2010 decedents who died before December 17, 2010 - the date of enactment of the 2010 Tax Act - the filing of Form 706 and payment of the estate tax was originally extended to September 19, 2011 • IRS then extended the time to file the return and pay the tax to March 19, 2012 if Form 4768 was filed by September 19 (Notice 2011-76) • Interest accrues from September 19 on any underpayment of the tax but penalties will not be imposed 8

9. The 2010 Tax Relief Act – Unanswered Questions: Potential Clawback • Is there any danger of a “clawback” in the event that the $5,000,000 (adjusted for inflation) exemption is not extended past 2012? • Say a taxpayer uses all of the $5,000,000 gift tax exemption in 2011 and then in 2013 the gift and estate tax exemption reverts to $1,000,000. Will the $4,000,000 gift exceeding the then available $1,000,000 exemption generate a gift upon later lifetime transfers or an estate tax at death? • Most practitioners doubt this will occur but the outcome will not be certain until there is definitive guidance • Even if there is recapture, the growth earned on the transferred property will not be recaptured 9

10. Portability – Much Ado About Nothing? • For 2011 and 2012, the 2010 Act provides that the surviving spouse’s basic available exemption amount is increased by the Deceased Spouse’s Unused Exclusion Amount (DSUEA) • Note: The Act calls the $5,000,000 exemption (as indexed for inflation) the “basic exclusion amount” and defines the sum of the basic exclusion amount and the DSUEA as the “applicable exclusion amount” • Use of the DSUEA allows a surviving spouse to take advantage of the unused exemption amount of a deceased spouse without having to retitle assets thereby increasing the amount of the survivor’s unused exemption • Under the current law, portability sunsets in 2013 • Note: The Administration’s fiscal year 2013 Revenue Proposals would make portability permanent. 10

11. Portability – Much Ado About Nothing? • There are many complexities, conditions and rules concerning portability leading to confusion about the application of the rules, especially in remarriage situations • Some of the rules pertaining to the DSUEA in remarriage situations are: • The DSUEA is available only from the last deceased spouse • You cannot enter into serial marriages after you are widowed to keep collecting unused exemptions • This is called the last predeceased spouse rule • The survivor keeps the DSUEA from his/her last deceased spouse even if the survivor marries a new spouse. But if the new spouse dies before the survivor, the survivor looses the DSUEA of his/her first spouse and takes the DSUEA of the new spouse 11

12. Portability – Much Ado About Nothing? • Right now the utility of portability is limited – both spouses have to die within a two year term because of the sunset of the Act in 2013 • So, a surviving spouse only gets the benefit of portability from a deceased spouse who dies after 2010 and the survivor must die before 2013 • A portability election is made by filing a Form 706 for the estate of the first spouse to die – if the return is not filed the survivor will not be able to benefit from the DSUEA • Form 706 must be filed to elect portability even if the estate value is below the filing threshold • The election is simply made by filing Form 706 – there is no box to check • If Form 706 is filed and the estate does not want to make the election, an affirmative statement opting out of the election must be made on Form 706 • Once made, the election is irrevocable 12

13. Portability – Much Ado About Nothing? • IRS has recently issued guidance that extends the deadline to make the portability election for certain estates • The ability to take advantage of the extended deadline only applies to the estates of married decedents who died during the first six months of 2011 and which are worth $5 Million or less • The estate has to file a Form 4768 extension request no later than 15 months after the decedent’s date of death • This extension is available even if the estate did not file Form 4768 within nine months of the date of death 13

14. Portability – Much Ado About Nothing? • Portability was instituted by Congress to make planning for married couples easier and obviate the need to retitle assets and create by-pass trusts • Certainly the availability of portability will lead many couples to conclude that there is no need to have a comprehensive estate plan – “I love you Wills” will probably be used more frequently • But the question is: Should portability be relied on? Is it wise to leave all assets to the survivor outright or should a by-pass trust be used? 14

15. Portability – Much Ado About Nothing? • Reasons not to Rely on Portability: • Portability is due to expire in 2013 • Form 706 must be filed to elect portability and in turn IRS says that the statute of limitations stays open on the Form 706 for the deceased spouse’s estate until the statute closes on the Form 706 for the survivor’s estate • Portability cannot be relied on to benefit grandchildren – the deceased spouse’s GST Tax exemption is not portable so dynasty trusts should be used to take advantage of the GST exemption • Portability is not recognized under state law – since many states impose their own estate tax, the planning process has to take state law into consideration 15

16. Portability – Much Ado About Nothing? • Reasons not to Rely on Portability - Continued: • Remarriage can create portability havoc – the last predeceased spouse rule has many technicalities and until IRS offers further guidance is difficult to apply • Portability is rife with liability risks for practitioners and executors. For example: • Consider – remarriage situations and the need to address portability in pre-nuptial agreements • Consider -what if the children of a prior marriage are the executors and do not want to make the portability election which would benefit their step mother 16

17. Portability – Much Ado About Nothing? • Reasons not to Rely on Portability and to use a By-Pass Trust: • Funding a by-pass trust shelters future appreciation from the estate tax whereas the DSUEA amount is not indexed for inflation and remains frozen • Unlike trusts, portability does not provide any asset protection for claims by creditors, including claims made by in-laws in divorce situations • Unlike outright bequests, by-pass trusts offer control in the disposition of assets 17

18. What Advantages Can Portability Provide? • Portability can provide benefits in some situations (but caution – portability is scheduled to expire in 2013): • Portability allows for a step-up in basis while the assets in a by-pass trust do not get a basis step-up upon the survivor’s death • Portability provides flexibility in retirement account planning while leaving the plan to a trust involves many technical requirements 18

19. The Continued Tax Odyssey – Planning Issues • The increase in the transfer tax exemption amounts means that planning documents that use formula clauses will have to be reviewed to avoid unintended consequences • Moreover, there is no guarantee that the $5,000,000 exemption will be available after 2012 so planning documents will have to drafted with sufficient flexibility to take all possible scenarios into account 19

20. 2013 – It’s Back to Future Uncertainty • Under the terms of the 2010 Act, all of the changes made to the transfer tax system expire in 2013 • What happens in 2013? • Who knows, but if Congress does nothing, we will be back to the pre-Bush law – a $1,000,000 exemption for the estate tax and gift tax and a $1,000,000 exemption indexed for inflation for the GST Tax • The maximum rate will revert to 55% (with a 5% surcharge on large estates) 20

21. Take Advantage of the Window of Opportunity • Past history tells us that we cannot be sure of what Congress will do in 2013 – but we do know what the rules are now • So now is the time to take advantage of what we know we have • We have discussed what the 2010 Act did • This is some of the things the Act did not do: • Zeroed-out and short term GRATs are still viable – the Act did not adopt the proposed restrictions on their use • Note: Short term GRATs are more advantageous than long-term GRATs because there is less of a mortality risk and they are less susceptible to market volatility • The Act did not eliminate the use of valuation discounts for family entities • So we can still, for now, plan with zeroed-out and short term GRATS and use valuation discounts • Note: Along with other proposals contained in its 2013 Revenue Proposals, the Administration has again proposed eliminating the use of short term GRATS and restricting the use of valuation discounts 21

22. Take Advantage of the Window of Opportunity • So, planners should encourage their clients to take advantage of the remaining window of opportunity before any changes to the law are enacted – it has never been a better time to make gifts • The exemption amounts have never been higher • The transfer tax rates have never been lower • Some asset values remain low • The AFR is historically low 22

23. The Administration’s Fiscal Year 2013 Revenue Proposals • The recently released Revenue Proposals resurrect the restrictive proposals that were not passed as part of the 2010 Tax Act. Most of the 2013 Revenue Proposals were also included in the 2012 Proposals. But there is one new dramatic proposal that would effectively be the death knell of the grantor trust • The proposals include: • First some good news – portability would be made permanent. • The duration of dynasty trusts would be limited – the Administration wants to limit the allocation of GST exemption sheltering the trust from the tax to 90 years – then the trust’s exemption would be effectively eliminated 23

24. The Administration’s Fiscal Year 2013 Revenue Proposals • Restrictions would be placed on GRATS • They would have to have a minimum term of 10 years and a maximum term equal to the life of the annuitant plus ten years • The remainder interest would have to have a value greater than zero • The use of valuation discounts would be restricted • In applying valuation discounts, certain “applicable restrictions” are ignored and cannot be applied to discount the value of the gift – the Administration’s proposals would create the following additional categories of restrictions that would be ignored in the valuation process involving family owned entities: • Restrictions that may lapse or be removed by the family • Any limitation on a holder’s right to liquidate his/her interest that is more restrictive than standards to be set forth in Regulations • Limitations on a transferee’s ability to be admitted as a partner 24

25. The Administration’s Fiscal Year 2013 Revenue Proposals • The Administration’s Proposal would effectively eliminate the use of grantor trusts because the proposal provides that: • Grantor trusts would be includable in the grantor’s estate at death • Distributions from the trust to beneficiaries during the grantor’s lifetime would be gifts • If the trust ceased to be a grantor trust for income tax purposes, there would be a gift of the trust assets • Also, any non-grantor who is deemed to be the owner of the trust and sells to or exchanges property with the trust will be subject to estate tax on the portion of the trust attributable to that property Note: The intended target of the Administration’s Proposal is the sale to the grantor trust but the Administration’s Proposals extend well beyond the scope of that transaction. 25

26. The Administration’s Fiscal Year 2013 Revenue Proposals • What do the Administration Proposals say about the future tax exemptions and rates after 2012? • The transfer tax exemptions and rates would revert to 2009 levels: • The estate tax and GST exemptions would be $3.5 Million • The gift tax exemption would be $1 Million • The top tax rate would be 45% 26

27. The Administration’s Fiscal Year 2013 Revenue Proposals • The Administration Proposals are essentially a wish list and are not the current law • The proposals may never actually be enacted into law – if they are they would in general become effective as of the date of enactment • But since we cannot predict what will happen it is important to use the planning rules and tools that are now available 27

28. What Planning Tools Are Now Available? • Take advantage of tools that work well when interest rates are low, such as: • Family Loans • Short term, zeroed-out Grats* • Sales to grantor trusts* • Charitable lead annuity trusts *which the Administration Proposals want to eliminate • Also take advantage of the following tools that may be eliminated if the Administration’s Proposals are enacted: • Valuation Discounts • Dynasty Trusts 28

29. Take Advantage of Low Interest Rates • Opportune time to make gifts at reduced transfer tax cost • Leverage difference between IRS assumed rate of return (hurdle rate) and rate of return actually realized • You are betting that you can beat the IRS hurdle rate • In low interest rate environment, it is easier to beat hurdle rate • Potential to remove future appreciation from gross estate 29

30. IRS Assumed Rates • IRS sets minimum interest rates for family loans under Code Section 1274 • IRS requires use of the Code Section 7520 rate to measure the value of certain gifts • IRS assumes that the investment will grow at a certain rate • We will call the rates the AFR (assumed federal rate or hurdle rate) • AFR’s change monthly • For certain techniques, deflated interest rates lower the value of the taxable gift 30

31. Historical Review of Required Interest Rates Intra-Family Loans – Section 1274 Rate Note: The IRS’ assumed rate of interest applicable to a promissory note depends on the term of the note. A short-term rate applies to terms of 3 years or less; a mid-term rate applies to terms of more than 3 years but no greater than 9 years. The long-term rate applies to terms in excess of 9 years, and the rate for March 2012 is 2.65%. 31

32. Historical Review of Section 7520 Rate 32

33. Advantages of Low Interest Rates • Easier to produce an actual return that exceeds AFR • To extent actual rates exceed AFR, appreciation passes tax free to remainder beneficiaries 33

34. Technique Using Low Code Section 1274 Rate Intra-Family Loans: Loans to Children • An intra-family loan allows shifting of wealth to younger family members when the growth rate exceeds the Section 1274 rate • Parent charges minimum interest rate based on AFR and term of Note • Interest is includable as income on parent’s return • Parent can use annual exclusion/unified credit to forgive portion or all of interest • Note: Consider making loan to a grantor trust so interest is not includable in parent’s taxable income 34

35. Advantages of Intra-Family Loans When Interest Rates are Low Intra-Family Loans: Loans to Children • Easier for return on child’s investment to eventually beat interest on Note • If child’s investment return exceeds stated interest rate in Note, spread is a tax-free gift • Lower interest rates mean more easily manageable loan payments • Risk – if the child’s investment is not successful, he/she may not be able to repay loan 35

36. Illustration: Intra-Family Loan 36

37. GRATS • Grantor transfers assets to a Trust • Grantor retains fixed annuity for fixed term • At the end of term, remaining assets pass to remaining beneficiaries (children or trusts for their benefit) tax free 37

38. Gift Taxation of GRAT • Transfer is subject to gift tax upon formation • Value of taxable gift = value of gifted property less present value of annuity • So value of gift = present value of remainder interest • Determine present value of annuity actuarially using IRS Tables (AFR) • Use AFR for month of the gift 38

39. Good News: Can Structure GRAT So There is No Taxable Gift • Can “zero out” GRAT (Walton case) • This means that the gift of the remainder interest is valued at zero • This also means that no gift tax is payable and no gift tax exemption has to be used • Trust Agreement has to provide that annuity is paid for entire trust term • So, if Grantor dies during GRAT term, annuity has to be paid to his/her estate • Select combination of annuity/term that results in present value of annuity equaling amount contributed to GRAT 39

40. Why Use “Zeroed-Out” GRAT if Nothing Remains at End of Term for Children • Remember IRS assumes rate of return • Rate of return can potentially exceed IRS’ assumed rate • Achieve higher rate of return by gifting assets that Donor believes will appreciate in value 40

41. More Good News: Valuation Discounts • Valuation discounts may also be available to increase amount passing to children • Annual annuity paid to Grantor is based on discounted value 41

42. How Does a GRAT Work? 42

43. GRATS: Are There Risks? • Rate of return does not exceed AFR • If Grantor dies during term all or part of Trust assets are included in gross estate • Risks are not really significant • If use zeroed-out GRAT, no gift tax cost – only cost are the professional fees. Would be no worse off than if had not established GRAT 43

44. Installment Sale to IDGT • Simple theory behind intra-family loan can be elevated by using installment sale to intentionally defective grantor trust (IDGT) • Note: There is nothing wrong or “defective” about the trust – it is simply a trust that is intentionally designed as a grantor trust for income tax purposes but is not deemed to be a grantor trust for estate tax purposes • Note: Caution must be taken so that Grantor does not retain so much control over the trust so as to cause estate inclusion • Strategy usually combines sale and gift - Planners recommend that Grantor gift at least 10% of the value of the transferred assets to support the IDGT’s purchase of the assets 44

45. How is the Purchase Price Paid? • Balance of assets that are not gifted is sold to IDGT in exchange for a promissory note • Note must bear interest at Section 1274 rate • Note often provides for interest only payments for a term of years with a balloon payment at end • Trust appreciation that exceeds IRS hurdle rate passes to remainder beneficiaries free of transfer tax 45

46. Income Taxation of Sale to IDGT • Grantor does not recognize any gain upon the sale • Rev. Rul. 85-13 says that Grantor does not recognize gain or loss when he/she sells assets to a grantor trust • Grantor is deemed to have made a sale to himself • There is no income tax consequence as a result of a transaction with oneself • So interest on the Note is not included in gross income since the Grantor and the IDGT are deemed to be the same taxpayer – you are merely taking funds from one pocket and putting it into another pocket 46

47. Taxation of Gift • Initial gift to IDGT is a taxable gift • So, the Grantor’s gift tax exemption will be applied to eliminate or reduce the gift tax on the gift • If the Grantor has used all his exemption, he will have to pay a tax • If assets transferred to the IDGT do not appreciate in value, gift will have been wasted 47

48. Is There a Gift on Sale Portion of the Transaction? • Sale portion should not result in a taxable gift if value of the promissory note is equal to the fair market value of the property • Note must bear required IRS assumed interest rate 48

49. Is the Payment of Income Tax by the Grantor on Behalf of the Trust a Gift? • All of the income of a grantor trust is taxable to the grantor • The advantage of the grantor’s tax liability is that if the grantor is not reimbursed for the tax payment by the trust, in effect the grantor is making a tax free gift to the trust and is enabling the trust principal to be preserved for future generations • IRS has ruled that the grantor of a grantor trust is not deemed to make a taxable gift to the trust when he/she pays the income tax on behalf of the trust because the grantor is liable for the tax payment. Moreover, if the trust agreement is properly drafted (it does not mandate that the grantor be reimbursed for the tax payment), or if controlling state law mandates reimbursement but the trust provisions override the state law requirement, the trust will not be includable in the grantor’s estate (Rev. Rul. 2004-64) 49

50. Comparison of GRAT and Installment Sale to IDGT • Sale to IDGT has to beat Section 1274 rate; GRAT has to beat 7520 rate • Code Section 1274 rate is generally lower than 7520 rate • So since sale to IDGT generally has a lower rate of return to beat, general consensus is that IDGTs produce greater economic benefit than GRATs • But difference in two rates is generally not significant • So conventional thinking is that using an IDGT only produces a modestly better economic effect than the GRAT • Still, some analyses conclude that use of IDGTs provides the opportunity for significantly better returns than a GRAT 50