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- Written by: Martin M. Shenkman
Since so few clients have estates subject to federal estate tax ($10.5M+ for a couple) income tax has really become the focal point of estate planning, trust management and estate administration. The good news for CPAs is, this is “right up their alley.” In fact, for astute practitioners this change in tax focus could shift significant estate planning from attorneys to CPAs. This article will give you a tool to begin capitalizing on this change.
√ 754 Elections
With so few clients subject to federal estate tax, and with the marginal state estate tax in decoupled states at a 16% rate, the capital gains costs (20% federal capital gains + 3.8% Medicare tax on passive income + state capital gains costs) will exceed the estate tax costs for most clients under the federal estate tax exemption levels. So maximizing tax basis on the death of a client will be the post-mortem planning focus. For partnerships, and limited liability companies (LLCs) taxed as partnerships, the inclusion of interests in the entity in the decedent’s estate will qualify those interests for a step up in income tax basis to the fair value of those interests on death. However, that alone will not provide the tax results sought. If the partnership (LLC) also makes an election under IRC Sec. 754 to adjust the inside basis of the decedent’s share of FLP/LLC assets, then the decedent’s “interest” in those assets will be determined (stepped up) as of the date of the decedent under IRC Sec. 1014. The tax basis needs to be compared to the fair market value of all FLP/LLC assets as of the date of the decedent’s death to determine whether the 754 basis adjustment should be elected. Assuming that it would be advantageous for the FLP/LLC to adjust the deceased client's basis on death (or any other event permitted under applicable law), there must be a basis for authorization of the election under Code Section §754 and §743 (b) to be made under the governing legal document (partnership agreement for the partnership or the operating agreement for the LLC). If the terms of the governing agreement don't mandate that the election must be made, or give a partner/member the right to demand that it be made, the basis step up may be only of academic benefit. However, the partner/member may be able to request that the partnership/LLC make the election. That might require a negotiation process and payment from the partner/member. In all events the conditions of the governing agreement must be complied with unless waived. The basis adjustment under IRC Sec. 743(b) is generally not reflected in the member's capital account. Treas. Reg. Sec. 1.704-1(b) (2) (IV) (m). The bottom in many cases will be that unless the deceased partner/member’s estate has the clout to push the election be made, absent an agreement mandating it, the entity may not comply. Given the significant importance of this election it may be advantageous to negotiate rights to insist on the election in advance. In that way, none of the other partners/ members know who will be the one benefiting from the election (it might be their estate) so that the dynamic of the negotiation will be different than what an individual deceased partner/member will face when it is only his or her estate that will benefit.
√ Entity Discounts
For many years practitioners have endeavored to maximize valuation discounts for gift transfers and the value of interests in any assets included in a client’s estate. A key component of the documentation of many gift plans, and estate tax returns, has been the formal appraisal of the discount applicable to the non-controlling interest in an asset or entity involved. The IRS has often challenged discounts as excessive. Post-ATRA the vast majority of clients will not face a federal estate tax. Discounts for these clients will not provide any estate tax benefit whatsoever, but they will reduce the value of the basis step up and thereby increase the future capital gains costs the client’s heirs will face. So in marked contrast to past practices practitioners may now be on the side of the table the IRS had previously occupied, arguing for lower discounts. In instances when a client owns an interest in an entity, for example, and discounts won’t benefit the client’s estate, it may be advantageous to recommend that the client discuss with the attorney for the entity whether and how the entity governing document (e.g., partnership agreement for a partnership, shareholders’ agreement for a corporation or operating agreement for an LLC) can be amended to minimize discounts. For example, if a member is permitted to sell his or her LLC interest to the LLC for the fair market value of that interest determined without discounts, then arguably there might be little or no discount as the interest is liquid at its fair value. However, these types of changes may not be agreeable to other members if their estates are large enough to face a federal estate tax. Also, some of the changes in the governing document that might vitiate discounts might also emasculate asset protection benefits. Other equity owners may object to such changes on those grounds.
√ QTIP Funding and Discounts
In post-mortem planning the determination of how to fund various trusts, and which assets to use to fund those trusts, has new importance and different nuances, post-ATRA. Consider a decedent that owns 100% of the interests in a family S corporation. Assume that the decedent’s estate values that interest at $2 million and that the client lives in a state that has a $1 million state estate tax exemption. On the client’s death $1 million of S corporation interests may be distributed to a state only bypass (exemption or credit shelter) trust to endeavor to minimize state estate tax on the death of the surviving spouse. This has always been rather common planning. The remaining $1 million or 50% interest in the S corporation stock is transferred to the marital or QTIP trust formed under the deceased client’s will. Clearly the value of the S corporation stock in the client’s estate is worth $2 million. However, if $1 million or 50% went to the QTIP trust, the IRS could argue that under current law the value of that 50% interest is less then the 50% of the $2 million value because it is a non-controlling interest that must be discounted. That discount would reduce the marital deduction to less than $1 million and thereby result in a gross estate that may not be fully offset by the marital deduction. Under prior law, depending on the exemption level, that could have resulted in a federal estate tax because of the disparities in value resulting from the discount. Under the post-ATRA structure there may be no estate tax involved because of the high exemption. However, for an estate that transfers, as in the preceding example, a percentage of an entity to a bypass trust and a percentage to a QTIP or other marital trust (all of which may remain common planning in decoupled states) the discount would reduce the income tax basis step up regardless of whether or not there is any estate tax implications to the discount. Might the IRS argue positions like this on future income tax audits?
√ QPRTs
Qualified Personal Residence Trusts (QPRTs) have been commonly used for many years to leverage the value of a personal residence, a home, and future appreciation in that home, outside a client’s taxable estate. The concept can be illustrated with an example. The client made a gift to a trust and reserved the right to live in the home for some specified number of years (the longer the number of years the greater the discount on the value of the future gift to the heirs). If the client survived the number of years used in the formula to calculate the gift then the value of the house would be removed in its entirety from the client’s taxable estate. The dilemma faced by many clients who created QPRTs in the past is that with the substantial increase in the estate tax exemption many (perhaps most) of the client’s that created QPRTs won’t face a federal estate tax. Thus, there may be no federal estate tax benefit from the technique. But the result is that if the house value is removed from the client’s estate the house won’t qualify for a basis step up on the client’s death. Since in many if not most cases the heirs will not use the house as a principal residence, they will not qualify for a home sale exclusion. Thus, when the heirs sell the house there will be the potential for a significant capital gains tax to be incurred. Planning after the end of the QPRT term (the number of years the benefactor, typically the parent, reserved to live in the house before title transfers to the heirs or a trust for the heirs) may be the opposite of what it has historically since the tax objective has become maximizing basis for clients not subject to a federal estate tax. In the past, following the QPRT term, the title (ownership) of the house would have been deeded by the client’s attorney to the heirs (or trust for them, whatever the QPRT document provided for). The parents/benefactors would sign a written arm’s-length lease and pay a fair rent to continue using the house. This was all done to minimize the risks of the IRS arguing that the parents/benefactors retained an interest in the house under Code Section 2036. Properly done this would enhance the likelihood of the QPRT plan being respected and the house being removed from the parent’s estate. However, that would assure that the house would not qualify for a basis step up either. Since most clients won’t face an estate tax, minimizing the potential capital gains costs to heirs will be the priority. That may be achieved by endeavoring to include the house in the parent’s estate. If the heirs sign a lease for life, payable at $1/year with the parents, that may suffice to force estate tax inclusion, at no federal estate tax (assuming that the parent’s aggregate estates remain under the available estate tax exemptions with consideration to portability).
√ Appraisals
For many years, perhaps decades, the focus of gift and estate valuations was to support the lowest feasible/reasonable valuation to minimize transfer taxes. Now, however, with permanent high exemptions and portability, many clients will never face an estate tax on the federal level. For clients domiciled in states that have decoupled from the federal estate tax they may face a state estate tax but no federal estate tax. Thus, the optimal (not legitimate) valuations for clients would fall into the following categories. In all instances understanding the optimal appraisal target must give way to the legitimate fair value of the assets being appraised. The key point is that the appraisal paradigm is dramatically different post-ATRA.
- Clients over the federal estate tax exemption – minimize values to minimize federal estate tax (and state estate tax if applicable).
- Client’s under the federal estate tax exemption but over their state estate tax exemption. This is a tougher call as it will require an analysis of the marginal tax impact of the state estate tax compared to the possible capital gains tax savings to the decedent’s heirs. Considerations of marginal tax rates, anticipated holding periods, whether tax free conversion options exist (e.g., a 1031 tax deferred like kind exchange), etc. will all have to be factored into the analysis.
- Clients under the federal estate tax exemption but domiciled in a state that does not have a state estate or other death tax. For these clients maximizing the valuations of all estate assets so long as the client’s estate remains under the federal exemption will provide the heirs with the most favorable tax basis/capital gains result at no estate tax cost.
- Clients under the federal estate tax exemption and under their decoupled state’s estate tax exemption. For these clients maximizing the valuations of all estate assets so long as the client’s estate remains under the state estate tax exemption (which is always less then the federal exemption) will provide the heirs with the most favorable tax basis/capital gains result at no estate tax cost.
√ Decoupled States and Bypass Trusts
In the past bypass trusts were often funded with assets most likely to appreciate. Now, post-ATRA, however, that may not be the optimal strategy since the assets in the bypass trust will not be included in the surviving spouse’s estate (generally, see below). Therefore, those assets won’t qualify for a step up in income tax basis on the second death. So, in contrast, to what may have been typical planning prior to ATRA, it may not be advisable for clients to fund bypass trusts when the family won’t face a federal estate tax with maximally appreciating assets. For example, the client’s bonds or other income assets may best be held in the bypass trust and equities most likely to appreciate in the marital trust or by the surviving spouse. In that way, all the assets without appreciation potential will remain removed from the estate, while those with appreciation potential will be included in the surviving spouse’s estate to qualify for a basis step up. There is an important exception to this planning approach which practitioners must be careful to consider. If the provisions of the bypass trust permit distributions of principal to the surviving spouse, then perhaps appreciated assets can be distributed to the surviving spouse prior to death and qualify for a basis step up. In such instances the planning approach may differ. This is not necessarily a simple determination. Will typical and general language in a bypass trust that permits principal distributions permit distributions of appreciated assets? Some bypass trusts in the future may specifically address this issue, many may not. If in doubt practitioners should recommend that the client have their estate planning attorney make this determination so that the client and other advisers will know how to proceed.
√ Existing Bypass Trusts
Many clients have existing bypass trusts formed on the death of a spouse. When those trusts were planned and funded the exemption amounts may have been much lower and there would have been an anticipated estate tax savings from the effort. Now, the client may be saddled with the costs of administration, including annual trust income tax returns, and no anticipated estate tax benefit. In some instances, it may be advantageous if the terms of the trust permit to distribute out some or all of the principal so that those assets will be included in the surviving spouse’s estate and obtain a basis step on the second spouse’s death. Other assets may be beneficial to be left in the trust earning income, especially if the trust is broadly drafted to include descendants as beneficiaries. In many cases distributions from bypass trusts are only made to the surviving spouse when in fact other family members are permissible beneficiaries. In such instances it may be beneficial to re-examine who are permissible beneficiaries and make distributions to family members in the lowest tax bracket. If the trust only permits the surviving spouse to be a beneficiary during his or her lifetime, it may be possible to transfer the existing bypass trust into a new bypass trust (a process called decanting). Alternatively, if the exemption is so large relative to family wealth it may be possible to distribute assets to the surviving spouse and have him or her contribute by gift those same assets to a new trust designed to take better advantage of the new income tax environment. Be cautious that the potential tax benefits not be pursued without due consideration to all other relevant factors: What does the trust provide? Who are the beneficiaries of the trust? Are they the same as the beneficiaries of the surviving spouse’s estate? Will the beneficiaries agree to a change in distributions that maximizes income tax benefits but that is different than historical distribution patterns? What type of liability exposure does the trustee face under each course of action?
√ Partnership Closing of Books
When a partnership (or LLC taxed as a partnership) must close its taxable year, such as on the termination of a partner during the year, the economic results of the partnership must be allocated for that partner to the time period prior to the closing of the FLP/LLC books, and to the period after the closing. There are two methods that can be used to make this allocation the interim closing of the FLP/LLC books, or the pro-ration method. Treas. Reg. Sec. 1.706-1(c)(2)(ii); Richardson v. Comr., 693 F.2d 1189 (5th Cir. 1982). The selection of which method can be used may have significant tax and economic impact on the partners/members and may depend on the language of the governing partnership or operating agreement. Since ATRA has increased the progressivity of the income tax rates so that the differential between high tax bracket partners/members and those in lower brackets may be more significant than in many years, the method selected should, in the family partnership/LLC context, be the one that shifts the most income to the lower bracket members/partners.
Under the interim closing of the books method, the books of the FLP/LLC are closed (as to the partner in question) and all items occurring before the date of closing are allocated to the partner/member who was the partner/member prior to the closing. All items of income, expense, gain or loss occurring after the closing of the books inure to the partner/member holding the interest after the closing date. The pro-ration method presumes all income, expense, gain and loss was earned equally throughout the tax year.
Martin M. Shenkman, CPA, MBA, PFS, JD is a regular tax expert source in The Wall Street Journal, Fortune, Money and The New York Times.
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Insurance has, and will always remain, an integral part of many estate plans, regardless of the status of the estate tax. Life insurance can be used, as it has for many decades, to build an estate (e.g., for a young client with a modest estate and a family to support in the event of premature death), provide liquidity to an estate (e.g., a client the whose estate is primarily comprised of real estate or business interests), for funding buyout agreements, and more. The American Taxpayer Relief Act of 2012 (“ATRA”) has changed the use of life insurance in profound ways. What are some of the new factors practitioners should consider?
√ Don’t Cancel Existing Life Insurance Without Reviewing All Options: Insurance was frequently purchased as a means of paying estate tax. A classic tax plan for many clients was to purchase survivorship life insurance payable on the death of the second spouse to die and held in an insurance trust to cover the estate tax. For many clients the primary purpose for these policies is not irrelevant. Unless the client’s estate will exceed the $5.25 million exemption, or $10.5 million for a couple, no federal estate tax will be due. What should be done with the policy? Consider the options:
• Cancel the policy for the cash value. If the policy is held by a trust, the cash value should be paid to the trustee and distributed pursuant to the terms of the trust. While this is the simplest and obvious step, it is often not the best for the client.
• Consummate a tax-free exchange for another policy that will provide advantageous income tax planning benefits or better serve the clients new post-ATRA objectives.
• Use the existing policy, a paid up policy, or a scaled back death benefit to cover estate liquidity needs (perhaps reduced to reflect the reduction or elimination of federal estate taxes as a liquidity need).
• Exchange the policy for an annuity that meets cash flow needs and is consistent with the client's current financial and retirement plans.
• Sell the policy into the secondary market, which might net the client more than the cash surrender value.
√ Review Adequacy of Existing Coverage: If insurance is held for personal wealth creation or income replacement (e.g., a young person seeking to provide for his or her family in the event of premature death), be certain that the assumptions underlying the policy are reviewed. Too often clients assumed much higher investment returns on insurance proceeds than may be realistic now. If the client’s net worth was adversely affected by the recession, is the coverage still adequate? While tax and asset protection are important issues, assuring adequate and appropriate coverage is essential. Remember that in many situations life insurance is purchased online, sold to a client by an insurance consultant, or purchased on the recommendation of an estate-planning attorney, and no projection of what the client’s real needs are, may have ever been done. Even when projections are done, if they are not revisited periodically they may be useless. Even a rudimentary budget and projection will often demonstrate that clients are dangerously underinsured, or over insured with costly policies that don’t serve their needs.
√ Be Sure Any Changes to Trust Owned Insurance Comply with the Trust Requirements: If the life insurance is held by a trust, be certain that the client has his or her estate planning attorney review the trust to assure that the desired transaction is permissible. Practitioners, post-ATRA, have frequently been asked to help with transactions to terminate policies or change policies. Caution: Be careful not to help facilitate a transaction that violates the terms of the trust unless there is guidance from an attorney supporting what is being done. If a beneficiary later sues the trustee for violating the terms of the trust you don’t want the figures pointing at you. The mere fact that the client that established the trust wants to do something does not mean it is permissible. The trustee, not the client who formed the trust, is the decision maker.
√ Gifting Assets to Avoid State Estate Tax May be a Costly Strategy: Insurance may be better than gift strategies many are considering. Many clients might benefit from gifting away assets before death to avoid tax in a decoupled state. However, this is not always the optimal strategy. Assume for example, that your client owns a business structured as an S corporation that she started with a negligible investment decades ago. The business is presently worth approximately $4 million. Her investment assets are worth about $1 million, so that her estate has a total value of $5 million. She is domiciled in a decoupled state with a $1 million exemption. One planning option would be for her to gift her S corporation stock to an irrevocable self-settled domestic asset protection ("DAPT") trust. That would permit her to receive trust distributions in future years if she needed, but nevertheless have the assets and any growth in them removed from her estate. Most important, if she lives in any decoupled state (other than Connecticut which has a gift tax) there will be no gift tax consequences to her gift. This can be a simple and effective way to avoid state estate tax. That could provide a state estate tax savings of approximately $400,000. That tax savings could be especially important to realize if your client wished to bequeath the business intact to her son and her remaining assets to her daughter. Under this dispositive scheme the state estate tax, if paid from the residuary bequeathed to her daughter would eliminate almost half of the daughter's inheritance thereby benefiting the son in an even more lopsided manner. If instead the state estate tax were made the burden of the son, it could prove a difficult cash flow drain on the business the taxpayer wishes to retain intact. But a very different approach may be preferable. Leave the business interests in the estate so that the tax basis is stepped up on death and use life insurance to cover the state estate tax.
√ Consider Life Insurance to pay State Estate Tax: Life insurance can be used to address state estate tax in a decoupled state. Permanent life insurance may grow in use as a simple solution to the state estate tax cost faced by clients domiciled in decoupled states. Regardless of the federal estate tax, more than 20 states have decoupled from the federal estate tax system, and many have exemption amounts much lower than the federal level. The practical issue is to what degree clients who believe that their wealth levels will never subject them to federal estate tax will be willing to accept (for many "tolerate" may be a more apt description) the cost and complexity of sophisticated estate planning if the only "assured" savings will be a reduction in state estate tax. But even that might not be assured if a surviving spouse moves to a new state: the state changes its laws, etc. Client hesitancy to undertake more comprehensive planning may be compounded by the fact that successful estate planning that shifts assets outside the state taxable estate will be offset to some degree, perhaps to the point of generating negative overall tax consequences, by a loss in basis step up because assets are removed from the estate. With capital gains tax rates higher than state estate tax rates, this will be a significant issue for many. Many clients may opt to avoid the decision of whether to undertake more involved planning, or the complexity of whether and how to use portability and/or a bypass trust and the myriad of ancillary decisions, by looking to life insurance to address the state estate tax costs, or alternatively the capital gains cost heirs may face.
√ Does Your Client Really Have to Keep Doing Annual Crummey Notices: Crummey powers have been used in almost every life insurance trust. But as common as they are, they are a constant source of confusion and frustration for clients. While insurance trusts should continue to be used regardless of whether the client is subject to an estate tax (to protect and control the insurance proceeds), are Crummey powers really necessary? Historically a key step in every life insurance trust plan was to assure that gifts to the life insurance trust qualified for the gift tax annual exclusion ($10,000 inflation adjusted, $14,000 in 2013). But if the client will never be subject to an estate tax why bother? The exclusion is $14,000/donee in 2013. These are the annual notice provisions whereby the trustee notifies every beneficiary that a gift was made to the trust and that the beneficiary has a time period during which he or she may withdraw it. The beneficiaries would typically be notified in writing. In many cases the beneficiaries would be requested to sign a counterpart to the written notification confirming their receipt of the notice. Might it now become practical to actually draft Irrevocable Life Insurance Trusts (ILITs) without Crummey powers? For clients with moderate wealth estates, if they are really certain that they will never be subject to a federal estate tax, why burden them with annual homework they don't want to do and too often don't handle properly if at all? Note that if a trust doesn’t include annual demand powers, a gift tax return will be required each year gifts are made to allocate gift tax exemption since gifts to the trust will not qualify for the annual gift exclusion. Perhaps there is another alternative that no practitioners would have recommended prior to ATRA. Consider having beneficiaries sign a one-time statement waiving the right to future written Crummey notices and acknowledging that they will be made orally and the trustee signing agreeing to give verbal notice. While the common advice in the past was to use written notices so that there would be proof to show the IRS that notice was given on an audit, the only 709 or 706 most clients will ever file will be one to secure portability on the death of a first spouse. There seems to be no reason why a verbal notification should not suffice to meet the requirements of a present interest gift. Caution: Be certain that the trust document does not require an annual written notice be given if the intent is for the trustee to merely give an oral notice.
√ Consider Income Tax Advantages of Life Insurance: Because of the post-ATRA environment of higher income taxes and the 3.8% Medicare tax on passive investment income, the special income tax treatment afforded life insurance will have increased importance. For the wealthy client unconcerned about federal estate taxes, the favorable income tax attributes of life insurance may outweigh the estate tax benefits that had previously proven the draw. The higher income tax rates ATRA imposed enhance the use of permanent life insurance as a savings vehicle. The long-term returns on a properly structured traditional cash value life insurance policy are attractive. While many may believe that the cost structure of life insurance is such that the use of life insurance as part of an investment plan is inadvisable, look again at the actual returns the particular client has realized from his or her investment portfolio over time. Many clients have so lacked the discipline necessary for investment success that a quality like insurance policy will have actually outperformed what the client has realized. Life insurance companies, by law, are required to keep substantial reserves. The reserves are low risk. The fear created by the recent recession has made many clients worried over their investment portfolio. Adding a reasonable component of permanent life insurance as ballast to the client's investment portfolio may be appealing to some clients. The post-ATRA income tax benefits may enhance that.
√ Clients can Access Insurance Cash Value (even in trust) Tax Free: A valuable benefit of permanent life insurance is the tax-free build up of value inside of the policy. Clients can, with a modicum of monitoring and planning, access this cash value in the future if desired. Even if the policy is held in trust this may be feasible. For example, wife establishes an insurance trust to own permanent insurance on her life and names her husband and children as beneficiaries. An independent trustee may be able to borrow money out of the policy in future years and distribute those funds to the husband, all income tax free. Unless the policy is characterized as a modified endowment contract ("MEC"), and if the policy isn't surrendered and withdrawals don't exceed the client's tax basis in the policy, the excess of the policy cash value above the income tax basis in the policy is not subject to income tax. The client can avoid income tax when withdrawing money from the policy if the withdrawals are limited to the income tax basis, and then thereafter cash is withdrawn in the form of loans taken out for the excess above basis. If the insured dies with a policy in force, any cash value above the income tax basis not previously withdrawn is also not subject to income tax, even if the policy is a characterized as a MEC.
√ Watch the Transfer for Value Rules Trap When Moving Policies: Post-ATRA many clients may seek to move life insurance policies around to meet the new planning realities. For example, a client may have a life insurance policy held in a corporation that was to be used for a redemption buy out. Now, they may wish to simply transfer a policy that may no longer be needed for that purpose into an insurance trust to protect it, and retain the policy for its income tax advantages. Be careful not to inadvertently trigger the transfer for value rules in this type of transaction as that could make all the death proceeds taxable. Unless improperly transferred, the death benefit paid under a life insurance policy is not generally subject to income tax.
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- Written by: Martin M. Shenkman
Introduction
SALY (same as last year) can be a recipe for disaster if you don’t verify the current state of facts. The American Taxpayer Relief Act of 2012 (ATRA) has dramatically, and forever, changed the face of estate planning. Practitioners are no doubt familiar with the key changes (permanent $5 million inflation adjusted exemption, permanent portability, higher income tax rates) the effects of ATRA have been compounded by the new 3.8% Medicare tax on passive investment income. How does all of this affect compliance and related practices for the CPA? The planning tips below focus solely on estate and related planning matters, but are presented by the tax returns they affect. CPAs often use tax returns as the starting point to identify tax issues, and identifying estate planning opportunities for clients can be viewed in the same way.
Form 1040 Individual Income Tax Returns
√ Itemized Deductions: In light of the new phase out of itemized deductions carefully review which taxpayer (client individually, family LP or LLC, or trust) can or should pay for various investment, legal and other expenses.
√ Defined Valuation Clauses: See the comments below concerning defined value clauses and consider whether a disclosure statement should be attached to the income tax return for the client. This may be advisable when the income tax return reflects the income from various grantor trust Forms 1041 which were party to defined value clause transactions.
√ Grantor Trusts: See the comments below concerning proper determination of grantor trust status. Do not assume based on SALY (same as last year) what the character of a trust is if you have not confirmed it.
√ Tax Reimbursement Clauses: Some trusts include a provision that permits the trustee to reimburse the client/grantor for income taxes the client has paid on income earned by a grantor trust. Be certain to review the clause, and involve the drafting attorney if you feel it necessary, before making any calculation of the amount of tax that can be reimbursed. Some trusts have specific formulas or criteria for how this should be calculated. Also, caution the client that regular ongoing reimbursement of all taxes may be argued by the IRS to indicate an implied agreement between the client and the trustee as to the client/grantor’s continued interest or retained power over the trust. Also, be certain that the state that governs the trust permits this type of clause. Trust friendly states like Delaware do, but many states do not and the inclusion of such a clause would expose the trust assets to the reach of the client’s creditors and cause inclusion in the client’s estate. If this risk exists be certain to involve counsel as steps might be taken, like decanting the trust (pouring over the old defective trust into a new improved trust) to address the issue.
√ Schedule B and Bank Accounts: Many clients set up Spousal Lifetime Access Trusts (SLATs) for estate planning. Example: Wife sets up a trust for husband and all descendants. Be certain that the husband in this scenario has his own bank account to which distributions from the SLAT can be made to him. If husband were to deposit trust distributions from a SLAT into a joint account it would appear that wife has retained control over the distributions of a trust she formed. This could undermine all estate and asset protection objectives for the trust.
√ Life Insurance: Evaluate, or have the client’s investment and insurance consultants evaluate, the potential benefits of the tax free build up of investment value inside a permanent life insurance policy in light of the new higher income tax rates and the 3.8% Medicare tax on passive investment income. Many clients only view insurance from an estate planning perspective but the changes of ATRA may make the income tax benefits more important.
Form 709 Gift Tax Returns
√ Extend: 2012 will be the most challenging gift tax return season CPAs will ever face. Most returns will be extended (and should have been) given the sheer dollars involved and the complexity. Use extensions to provide adequate time to address the unique complexity and reporting positions that you will need to disclose.
√ Identify All Gifts: 2012 was a unique year in estate planning history. Never before have so many gifts been consummated, and many were completed in the last few months of the year. The turmoil and pressure of completing these gifts may result in a host of complications. Confirm with the client, the client’s estate planner, trust officer, financial planner and insurance consultant whether each of them is aware of any gifts. Unlike prior years don’t assume the client or their estate planning attorney is aware of every gift. Many might not be. Clients may have made last minute transfers to get gifts in under the possible 2013 changes that no one else knows about. 2012 was also unique because of the incredible time pressure involved.
√ Trust Funding Tranches: In most years when a client makes transfers to a trust, the trust is completed, the advisers plan the gifts or sales and the transactions are consummated. Unlike any other year in history many estate planners had clients fund trusts in tranches. An initial gift might have been made. Again, unlike all prior years, many of these initial gifts may have been large dollar amounts, not just the nominal $100 used historically to fund an initial gift to a trust. Some time later, when an appraisal was completed or other approvals received, interests in a business may have been transferred to the trust. In 2012 it was not unusual for a trust to have three or more separate transfers. Be certain to identify all of them.
√ Appraisals: Many 2012 gifts were made with estimates not final appraisal reports. Be certain to obtain final appraisals and not erroneously file with a draft or preliminary report. Also, check all the numbers before filing; in the haste to complete appraisals lots of points may have been missed. Example, if a couple each made a gift of a one-half tenants in common interest in their residence to Qualified Personal Residence Trusts (QPRTs) the discounts available on these interests are often overlooked by real estate appraisers and if a separate discount appraisal was not received it may not have been addressed. Be certain to compare the final appraisals to the preliminary estimates and if there are differences discuss them with the client and advisory team before filing.
√ Adequate Disclosure: To run the statute of limitations for gift tax audit purposes you must disclose sufficient information in the gift tax return attachments. Be certain to review the regulations and be sure to address every required item. Do not assume that what the client’s attorney or wealth manager sent you is sufficient. It often is not. It is your responsibility to seek out this information.
Form 1041 Trust Tax Returns
√ Understand the Trust: You cannot file a trust unless you are clear as to the appropriate income tax status for the trust. The name of the trust or the client’s comments are rarely sufficient to rely upon. In most cases the smartest approach is a two-pronged approach. Directly ask the attorney who prepared the trust what the intended income tax status was to be. Regardless of the reply, note it, then review the trust document and be certain you concur. If you don’t feel anyone in your practice has the capability to read a complex trust and properly identify its status, insist that the client permit you to meet once with the attorney who prepared the trust to review the document with the draft-person. Having the correct current classification and being aware of how and when that might change are vital to your properly meeting your compliance responsibilities.
√ Reciprocal Trust Doctrine: This tax doctrine can permit the IRS to unwind related trusts if the provisions are too similar. This is a particularly common risk where each spouse or partner set up a similar trust for the other. These are sometimes called Spousal Lifetime Access Trusts (SLATs) but often are not identified by name. If you have similar 1041s for trusts (for a couple) raise the issue and recommend that a post-tax season meeting be held with the attorney and investment adviser to determine what steps can be taken to further differentiate the trusts. It is not always enough that the trusts were drafted by the attorney with some legal differences; the manner in which they are operated could be important to that determination as well. Much of this data as to how they are operated will appear in the trust income tax returns you are preparing.
√ Valuation Adjustment Clauses: Many gifts and sales to trusts were planned to include valuation adjustment clauses. These can be illustrated quite simply for those readers not familiar with the concept. Example: Client owns 100% of the stock in a family S corporation. 40 shares, or 40% of the stock, net of discounts for lack of marketability and control are valued at $5 million. If the IRS successfully audited the gift and demonstrated the value was $7 million a gift tax of over $700,000 would be due. If instead the client gave $5 million of shares, with the number of shares, not the value to be determined on audit, arguably no taxable gift would be made. While this illustrates only one type of defined value clause, whatever type is used presents particular compliance issues for CPAs. Consider attaching a disclosure statement to every tax return (gift and income) indicating that a defined value clause was used. For example, attach to the Form 1120S K-1 for the above example a statement indicating that while the K-1 indicates figures based on 40 shares of stock that the actual number of shares is merely an estimate and that the final number will be determined based on a defined value clause. If this is not done, the manner of reporting the transactions may contradict the intent of the defined value clause.
√ Grantor Trust: Many, but far from all, sophisticated gift trusts were set up as grantor trusts. While many clients may have appreciated this in theory, issues may arise over time as clients are called upon to write out large estimated or balance due tax checks while the funds are being held in a trust and not their personal account. Coordinate this in advance with clients. Also, as discussed elsewhere in this article, confirm that the trust is in fact a grantor trust and that the mechanism to create that income tax status remains in force. Example: If a trust is set up as a grantor trust because the client/grantor was given a right to substitute property, but after execution the client signed a separate document waiving that right, the trust may no longer be a grantor trust. You cannot be assured of the current income tax status of any trust without confirming what, if any, actions were taken after the trust was established by the grantor, trustee or perhaps other persons.
√ Old Bypass Trusts: Many clients have bypass (also known as credit shelter trusts or by other names) trusts that were established on the death of their spouse. While those trusts may have made sense when the federal estate tax exemption was much lower, they may no longer be necessary in some cases. Worse, in some cases there may no longer be any federal estate tax savings generated by the trust, but retaining assets in the trust may prevent a step up in income tax basis on the death of the second spouse. And all this while the client is paying for a tax return and enduring additional complexity. If you’re completing the 1041 for such a trust, and you are certain that the combined estate of the surviving spouse and the bypass will be under the federal exemption, raise the issue in a letter to the client. Depending on how the bypass trust was drafted (a decision the client’s lawyer can address) it may be as simple as distributing the assets to the spouse and ending the trust. In other cases ending the trust may not be possible but better investment planning can minimize the tax negatives. Also consider state estate tax if the client is in a decoupled state (and has a separate estate exclusion amount).
√ S Corporations: Be very careful that only a Grantor Trust, Electing Small Business Trust or Qualified subchapter S Corporation Trust (QSST) can own stock in an S corporation. If S corporation stock is held in a trust be certain that you have carefully verified that one of these requirements are met. If the trust is a grantor trust, be very mindful that on the death of the client, or the relinquishment of certain powers (e.g., the right for someone to loan funds to the client/grantor without adequate security, the right to add a charitable or other beneficiary, or the grantor’s right to swap assets) are terminated, grantor trust status will end and that trust will no longer be permitted to own S corporation stock unless an affirmative ESBT or QSST election is filed. Do not file any trust income tax return in any year without confirming for that year that the above issues have been properly addressed.
706 Estate Tax Returns
√ Portability Returns: In order to qualify a surviving spouse to use the “first to die” spouses unused estate tax exemption, the Deceased Spouse Unused Exemption (DSUE) a federal estate tax return has to be filed for that “first to die” spouse’s estate. Where many estate planning attorneys traditionally prepared these forms, CPA firms may be able to do so more cost effectively. Given that the vast majority of estate tax returns will be filed for this purpose, will have no tax due, and can rely on simplifying estimates, this may be a lucrative practice area for CPAs.
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- Written by: Martin M. Shenkman
There are over two million S corporations. In 2012 there has been a tremendous shift of wealth to trusts as taxpayers endeavor to take advantage of what might be a final window of wealth transfer opportunity before 2013. The result is the transfer of significant assets, including S corporations into trusts. What types of issues should practitioners be alert for?
Specific S Corporation Trusts
1 Qualified Subchapter S Trust (QSST) is perhaps the most well known of all trusts that hold stock in an S corporation. To qualify as a QSST all trust accounting income of the trust must be distributed currently to a single individual shareholder. During the current income beneficiary’s lifetime distributions of principal of the trust can only be made to that current beneficiary. The beneficiary must make the QSST election by filing a signed election statement with the IRS within 2 1/2 months of becoming a shareholder. IRC Sec. 1361(d)(2)(D). If assets other than S corporation stock are held in the same trust they are not subject to the QSST rules and can be treated separately.
2 Electing Small Business Trust (ESBT) can provide a more flexible option for a trust to be an S corporation shareholder. A sprinkle or spray trust with multiple beneficiaries, like many bypass trusts, may retain S corporation stock as an ESBT.
3 All of the “potential beneficiaries” must, however, be individuals, estates or qualified charitable organizations. None of the interests of the trust in the S corporation stock could have been acquired by purchase. The trust itself must make the ESBT election by filing a statement with the IRS within 2 1/2 months of becoming an S corporation shareholder.
4 The trust must pay income tax on the S portion of any income at the highest applicable income tax rate. There is no offsetting deduction for income distributed to beneficiaries. Thus, the new 3.8% Medicaid tax on passive investment income may be incurred on top of the highest marginal tax rate with no opportunity to distribute to beneficiaries to mitigate it. As with the QSST above, if the trust owns other assets, non-S corporation income is not subject to the harsh ESBT rules.
5 Grantor trusts have become common vehicles for holding S corporation stock, especially with the substantial transfers following the 2010 tax act. A grantor trust is a trust that is treated as wholly owned by an individual under the provisions of Code Section 678. While generally this individual is the settlor or trustor establishing the trust, this is not always the case. Some trust drafting techniques will intentionally result in a person other than the settlor being taxed as the grantor for income tax purposes.
6 Occasionally this occurs inadvertently, so practitioners must be careful to review trusts to assure the appropriate status is determined, and that correct grantor is identified. Following death of the grantor the status of the trust as a grantor trust will end. The trust may continue for the twoyear period noted above for estates to hold S corporation stock. That period may be extended if the formerly grantor trust was a revocable living trust that can make the election under Code Section 645 to be taxed as part of the estate. Following these periods, whichever apply, the trust must meet other criteria to continue to hold S corporation stock.
7 Voting trust can be used to control the vote of stock in a closely held S corporation while the beneficial owners of the stock, each of whom qualifies as an S corporation shareholder, continue to benefit as owners from their economic interests in the stock. IRC Sec. 1361(c)(2)(A)(iv).
Estates and Testamentary Trusts Generally
8 During the period an estate holds the S corporation stock, there should generally be no issue of S status as an estate is an S corporation shareholder. IRC Sec. 1361(b)(1)(B).
9 If the administration of the estate is extended unreasonably, the IRS can argue that the estate has been terminated and S status could be in jeopardy.
10 Testamentary trusts, funded on a client’s death, will have to qualify to hold S corporation stock for two years without meeting any other special S corporation requirements. IRC Sec 1361(c)(2)(A)(iii). After the second anniversary of the date the S corporation stock is transferred to a testamentary trust, the trust will have to meet general S corporation trust requirements, e.g., QSST or ESBT.
Common Estate Planning Trusts
11 Martial trusts, such as a qualified terminable interest property (QTIP) will meet the requirements to hold stock in an S corporation. The common testamentary (formed on death under a will or revocable living trust) QTIP trust should qualify to meet the requirements of a Qualified Subchapter S Trust (“QSST”) IRC Sec. 2056(b)(7). A lifetime (inter vivos) QTIP trust may be treated as a grantor trust and thereby qualify to hold S corporation stock. IRC Sec. 1361(c)(2)(A)(i).
12 Credit Shelter Trusts, also known as “bypass trusts” or “applicable exclusion trusts” can be structured in many different ways so no conclusion should be drawn as to whether or not it will qualify as any particular type of S corporation trust without first reviewing the terms of the trust. Some bypass trusts are designed so that one beneficiary must receive current income and hence qualify as a QSST. Many, perhaps most, bypass trusts have multiple current beneficiaries and will have to elect to be taxed as an ESBT to qualify to hold S corporation stock.
13 Grantor Retained Annuity Trusts (GRATs) are grantor trusts during the annuity term and can therefore hold S corporation stock during that period. Following the termination of the annuity term some GRATs distribute assets to children outright. In such cases, if the children qualify as S corporation shareholders, S corporation status will not be jeopardized. However, many perhaps most GRATs name trusts to hold the remainder interests. Some of these trusts are designed to continue to be grantor trusts as to the settlor of the GRAT. Those will continue to qualify to hold S corporation stock. If the remainder trust is not a grantor trust then the QSST and ESBT provisions have to be reviewed to ascertain if the trust can meet either of them.
14 Dynastic Trusts are often, but not always, designed to be grantor trusts. If it is not a grantor trust then QSST and ESBT provisions will have to be reviewed to ascertain if the trust can qualify.
15 Self Settled or Domestic Asset Protection Trusts are trusts formed in a state, typically Alaska, Delaware, Nevada or South Dakota, which permit the person establishing the trust to be a discretionary beneficiary. These trusts are grantor trusts during the settlor’s lifetime and can hold S corporation stock.
16 Beneficiary Defective Irrevocable Trust (BDIT) is intentionally designed to qualify as a grantor trust as to the beneficiary, not the settlor. As such, BDITs can hold S corporation stock and the beneficiary will report his or her share of S corporation income.
17 Insurance trusts generally hold fe assets other than a bank account and an insurance policy while the settlor/insured is alive. However, many insurance trusts are grantor trusts during this time period. Following the death of the settlor/insured the insurance trust may purchase S corporation stock from the settlor’s estate. But following death the trust cannot be a grantor trust (except perhaps as to the beneficiaries as a result of the Crummey powers) so that the trust may have to qualify at that point as a QSST or ESBT.
Common Trust Transactions
18 Modification of a trust by fiduciaries, such as a trustee or trust protector, exercising powers granted under the trust agreement might be feasible. These may suffice to change the trust to one that qualifies as a grantor trust or QSST.
19 Many trust agreements permit the trustee to subdivide the trust into separate trusts. This might be used to isolate the S corporation stock in one trust that can meet S corporation requirements. Non- S corporation stock can be held in other sub-trusts. This approach might enhance the results of the trust overall.
20 The trustee could petition a court to modify a trust to make the trust meet the requirements to hold S corporation stock.
21 Decanting is a process by which one trust is poured over into another trust. If the existing trust cannot hold S corporation stock that was transferred to it, the trustee might move the trust to a state like Alaska; and then use Alaska law to decant the existing problematic trust into a newly created and better designed trust.
Martin M. Shenkman, CPA, MBA, PFS, JD is a regular tax expert source in The Wall Street Journal, Fortune, Money and The New York Times.
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- Written by: Martin M. Shenkman
If you are considering making large gifts in 2012, you may be concerned about whether you can have access to money you gift to a trust should you need it. While ultra-high net worth taxpayers may not worry about a $5 to $10 million transfer, many people who can benefit from 2012 gift transfers simply don’t have the kind of wealth to make even a $1 million gift. This is one of the key planning ideas to address. You will want to understand the various ways you may be able to access value inside such a trust. The checklist that follows lists various ways you may benefit from assets transferred to a domestic asset protection trust (DAPT), including transferring flow-through entity interest into such sophisticated irrevocable trusts in 2012 to use your $5 million gift tax exemption.
1. If you transfer entity interests by gift (or even sale) to a DAPT or other irrevocable trust in 2012, any entity distributions made after the transfer should be paid to the then record owner that will be the trust (or proportionate to the interests the trust holds). Prior to transfer of a flow-through entity to the trust, all distributions should be paid to the then owner of record, you, in your personal capacity. Thus, to assure continued distributions from interests in a family business, a family limited partnership (FLP) that holds investment assets, or other entity, you should evaluate retaining a portion of the equity interests in order to continue receiving at least some distributions.
2. Because most dynasty trusts, DAPTs, and beneficiary defective irrevocable trusts (BDITs) are designed as grantor trusts, all of the trust’s income will be reported on your personal income tax return. You should file a Form 1041 tax return for the trust including a statement that the trust is a grantor trust and that all items of income, gain deduction, and other items of the trust will be reported on your personal tax return, Form 1040. This is actually a negative cash flow each year that you must factor into your analysis. In the event that your payment of tax on the trust’s income and gains becomes a real financial burden, it can be dealt with in a number of ways:
3. The trust could include a provision authorizing an independent trustee to reimburse you as the grantor for the income tax you had to pay on income retained in the trust. While this can be a valuable cash flow safety valve not all estate planners are comfortable using this technique because of a concern that the distribution reduces the assets protected in the trust thus defeating a portion of the plan. Some are concerned that in some instances the reimbursement might cause the trust to be included back in your taxable estate if it is deemed by the IRS to evidence an understanding you had with the trustee.
4. The trust can loan money to you to pay income tax, or to use for living expenses, or anything else. In fact, many of these sophisticated trusts expressly include a provision authorizing a named person to make loans to you without requiring adequate security, as this is one of the mechanisms used to create grantor trust status.
5. If you transfer interests in a family business entity to the trust and you remain active in that business, the business entity can pay (or continue to pay) a reasonable compensation to you.
6. Many entity governing instruments (e.g., operating agreements for an LLC) mandate minimum annual distributions to fund income tax payments by the equity holders. For example, a family S corporation distributes 40% of its annual income so shareholders will have enough cash to pay the income taxes on their distributable share of S corporation income. The estate plan of transferring interests to a trust will complicate this mechanism. Once the flow-through entity interests have been transferred to the grantor trust, all distributions attributable to the transferred interests must be directed to the trust as the record owner (member, partner, S shareholder). Unfortunately, that won’t infuse funds into your bank account for you to pay income tax on the earnings of the flow-through entity that will remain taxable to you due to grantor trust status. However, such a mandatory distribution provision will infuse cash into the trust which can then be loaned or distributed by the trustee to you.
7. The optimal means of handling this situation from a tax and asset protection perspective is to not make any distribution from the trust to fund your expenses or taxes because the payments you make will reduce the size of your taxable estate. This is one of the key leveraging benefits of structuring trusts to be treated as grantor trusts. The greater the unreimbursed tax burden, the smaller the taxable estate and the lower the estate tax.
8. So, like the old Wendy’s commercial, “Where’s the beef?” Well Clara, here it is:
- Salary and compensation may still be paid from the entities when appropriate.
- Distributions may be able to be made to your spouse from your trust (i.e., if you’re married and your spouse is a beneficiary of the trust).
- Distributions may be able to be made from your spouse’s trust to you and perhaps your spouse (if it’s a DAPT) (i.e., assuming each spouse creates a similar but non-reciprocal trust).
- The trust could make a loan for adequate interest to you or perhaps your spouse.
9. If any of these possible distributions follow a regular pattern or appear to correlate with your tax or other expenditures, the IRS may argue that there was an implied understanding between the trustee and you as to these distributions. This could be used by the IRS as a means to disregard the trust and pull all trust assets back into your taxable estate.
10. The valuation of the entity interests to be transferred to the trust may have to consider forthcoming distributions, and if there is a pattern of making distributions so members can pay income tax on their pro-rata share of income, that pattern of payments may be viewed as reducing available discounts.
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