Estate and Gift Tax Update November 6, 2013

1. Estate and Gift Tax UpdateNovember 6, 2013 Cheryl Jankowski, CPA Chiampou Travis Besaw & Kershner LLP cjankowski@chiampou.com (716)630-2457

2. American Taxpayer Relief Act of 2012 • Transfer Tax Highlights • Established permanent rules for estate and gift tax for 2013 going forward • Exemptions • $5mm estate, GST, and gift exemption amount, indexed for inflation ($5.25mm for 2013) • $13k/donee gift exemption for 2012 and $14k/donee for 2013 (indexed in $1k increments) • 40% tax rate on taxable estates and inter-vivos gifts (higher than 2011 35%, but lower than 2009 45%) • Other provisions • Portability – spouses can inherit any unused portion of exemption from each other • Deduction for state estate taxes • Other special provisions: • “Interest in closely held business” defined for purposes of the estate tax deferral and installment payments election. • Expanded availability of the estate tax exclusion of qualified conservation easements. • Repealed the estate tax deduction for qualified family-owned business interests (QFOBIs), for estates of decedents dying after 2003.

3. American Taxpayer Relief Act of 2012 • Notable Individual Income Tax Highlights that affect estates and trusts • Top marginal tax rate on “high earners” (taxable income over $400k Ind./$450k MFJ/$425k HoH) increased from 35% to 39.6% - This impacts estate and trusts with taxable income $11,950. • Tax rate on capital gains and dividends of “high earners” increased from 15% to 20%, with no change to 15% rate for all others – This impacts estate and trusts with taxable income - $11,950. • Planning Point – If you have a taxable estate, may need to look at whether the Estate would receive a larger benefit deducting the expenses on the Fiduciary income tax return now that the top Estate and Income tax rates are identical and the medicare tax may cause the income tax rates to exceed the estate tax rate.

4. Medicare Tax • 3.8% Medicare Tax on Net Investment Income • Applicability to Trusts and Estates • Trusts and estates are subject to Medicare Tax if they have undistributed Net investment income (NII) and AGI over the amount at which the highest tax bracket for a trust or estate begins for the taxable year ($11,950 for 2013) (i.e., Medicare Tax can “creep up” on trusts and estates faster than individuals due to tax bracket disparity) • Threshold tied to tax brackets rather than Medicare Tax provision, so threshold for trusts and estates is indexed for inflation • Medicare Tax applies to lesser of NII or amount in excess of threshold • Investment income includes, but is not limited to interest, dividends, capital gains, rental and royalty income, non-qualified annuities, business income from traders and businesses that are passive under section 469 • A non-passive trade or business income exception from the Medicare tax requires that (1) there be an activity that involves a trade or business and (2) the taxpayer materially participates. • Self-Rental Rule – For Medicare tax purposes, self-rental income is passive and therefore subject to the 3.8% Medicare tax.

5. Medicare Tax, Con’t • What is net investment income (NII)?: NII is investment income less expenses properly allocable to items of gross investment income. • Examples of allocable expenses include investment interest, advisory fees, rental expenses, etc. • Fiduciaries have wide discretion in allocating indirect expenses (e.g., administrative expenses) to gross investment income • Excluded Trusts • Medicare Tax does not apply to certain trusts, including charitable trusts pursuant to sections 501 or 664 and grantor trusts (i.e., because NII included with grantor) • Allocating Expenses • Direct Expenses - Expenses are first allocated directly to the income item that gave rise to the expense. Eg: Rental expenses must be allocated to rental income. • Indirect Expenses – Regulation under IRC Sec. 652 allow the fiduciary to allocate the expenses any way desired. Therefore, indirect expenses can be allocated against income that would be otherwise subject to the maximum tax rate of 39.6% plus Medicare tax. • Most tax preparation software allocate expense proportionately so additional work may be necessary to alter the allocation.

6. Medicare Tax, Con’t Potential Planning for capital gains Capital Gains – Capital gains cannot be distributed without authority in the trust instrument or state law for doing so. However, under regulation 1.643(a)-3(b), capital gains will be included in DNI if they are, (1) “pursuant to the terms of the governing instrument and applicable law” or (2) “pursuant to a reasonable and impartial exercise of discretion by the fiduciary (in accordance with a power granted to the fiduciary by applicable local law or by the governing instrument if not prohibited by applicable local law)— (1) Allocated to income (but if income under the state statute is defined as, or consists of, a unitrust amount, a discretionary power to allocate gains to income must also be exercised consistently and the amount so allocated may not be greater than the excess of the unitrust amount over the amount of distributable net income determined without regard to this subparagraph §1.643(a)-3(b)); (2) Allocated to corpus but treated consistently by the fiduciary on the trust's books, records, and tax returns as part of a distribution to a beneficiary; or (3) Allocated to corpus but actually distributed to the beneficiary or utilized by the fiduciary in determining the amount that is distributed or required to be distributed to a beneficiary.

7. Medicare Tax, Con’t Grantor Trust – Medicare tax does not apply to grantor trusts as the income from the trust is treated as owned by the grantor QSST – A qualified subchapter S Trust must pay all of its income to the sole beneficiary each year. Therefore, the beneficiary would compute the Medicare tax, if applicable, at the beneficiary level. ESBT – S-Corporation income of an ESBT is taxed at the trust level, even if distributed. Therefore, unless the trustee meets the material participation test, the income may be subject to the Medicare tax. Sale of S Corporation stock – A sale of S corporation stock ( or a partnership interest) is not subject to the net investment income tax if (1) the entity is engage in a trade or business not relating to the trading of financial instruments or commodities and (2) the transferor is engaged in a least one trade or business of the entity. The portion of the gain excluded from net investment income generally will be the portion of the gain attributable to the active trade or business. See Prop. Reg Sec 1.1411-7(c).

8. Medicare Tax, Con’t Kiddie tax: Although for income tax purposes, a child (person under age 19 or under the age of 24 if a full-time student), whose unearned income over $2,000 for 2013, will be taxed a the parent’s tax rate. However, for Medicare purposes, the child stands alone and is not aggregated with parents or other siblings income. 65 Day Rule – Consider election under IRC Sec. 663(b) – The fiduciary may elect to treat distributions made during the first days following the close of the taxable years as if the distribution had been made on the last day of the prior year.

9. Passive Activity Rules – Trusts and Estates • Material participation is determined at the taxpayer level– Who is the taxpayer for an Estate or Trust? • No authoritative guidance however the Senate Finance Committee report for the Tax Reform Act of 1986 stated that an estate or trust materially participates if its fiduciary, acting in a fiduciary capacity, materially participates [S. Rep. 99-313 (P.L. 99-514)]. • Ltr. Rul. 201029014, concluded that a trust materially participates in a business activity only if the trustee is involved in the operations of the activity on a regular, continuous, and substantial basis. Activities of the trustee's employees or the trust beneficiaries are ignored for this purpose. • TAM 201317010, concluded that a complex trust did not materially participate in relevant activities of S corporation during tax years under Code Sec. 469 because trustee and special trustee, in their capacity as trustees of stated trusts, weren’t involved in operations of S corp’s relevant activities on regular, continuous, and substantial basis during tax years as issue. • The passive loss rules do not apply to grantor trusts; instead, the rules apply at the grantor level [Temp. Reg. 1.469-1T(b)(2); FSA 200035006]. • Under the QSST rules, the beneficiary of a QSST is deemed to be the owner of the trust [IRC Sec. 1361(d)(1)(B)].

10. Gifting Strategies • Continue to encourage gifting – with indexing tied to inflation, the annual increase is generous – Estate, Gift & GST exemption amount increased to $5,340,000 for 2014. • Gift tax annual exclusion remains at $14,000 for 2014. Reminder: Amounts transferred on behalf of an individual (1) as tuition to qualifying education organization, or (2) for medical expenses to a medical care provider is excluded from the gift tax base. • Gift tax annual exclusion to noncitizen spouses increased to $145,000 for 2014. • NYS does not include prior gifts the calculation of the NYS estate tax. • Lifetime Credit Shelter Trust for Donor’s Spouse. • Donor may be willing to make a gift however he/she is concerned that the donor or spouse may need the funds someday. These trusts are often referred to as a Spousal Lifetime Access Trust (SLAT). • Using a SLAT prevents gift splitting if the spouse’s interest is not severable, ascertainable and de minimis. However, a portion of the trust may be able to be split if the likelihood of needing distributions is slim.

11. Gifting Strategies, Con’t • Sale of assets for a Note or Annuity to an Intentionally Defective Grantor Trust • Client may have higher level of comfort as he/she will have continual cash flow. • A lifetime annuity can assure the client will have funds for living expenses for life. • The drawback is the cash flow drain on the entity paying for the annuity. • Sale of Residence to a Qualified Personal Residence Trust (QPRT) • From a client perspective, tends to be easier to gift asset to a trust. • Make sure that grantor is paying fair rent after retained interest term • Exercise Swap Power or Repurchase Assets from Trust – • Can be useful if Grantor has a capital loss carryover or would like to swap assets back into his estate for potential step up in basis.

12. Administration’s FY 2014 Revenue Proposals • Highlights • Revert to $3.5mm estate and GST exemption, $1mm exemption for gifts, and 45% rate on taxable amounts – Effective date would begin 2018 • New executor and donor reporting requirements of value and basis to IRS and recipients – encourage consistent treatment of basis for transfer tax and income tax purposes • New GRAT requirements, including a 10-year minimum term, maximum term of life expectancy plus 10 years, ensuring remainder interests are greater than zero and that annuities do not decrease in value in any year over term • Symmetry in treatment of grantor trusts for income and estate tax purposes • Proposal narrows scope of provision to “transaction triggers,” which apply if a person who is a “deemed owner” of a grantor trust engages in a transaction with that trust that constitutes a sale, exchange, etc. disregarded for income tax purposes. • Portion of trust attributable to the property received in the sale, exchange, etc. (including retained income, appreciation, and re-investments), net of consideration received, would be includible in the deemed owner’s gross estate, or subject to gift tax on termination of trust during life, or treated as a gift by the deemed owner to the extent of any other distribution during their life • Payouts to non-spouse beneficiaries of inherited IRA • Limit Duration of GST Exemption – Limit GST exemption to 90 years after trust is created.