The discussions at the Annual Heckerling Institute on Estate Planning, held in January each year in Orlando, Fla., are extensive. In spite of this, we have included some of the key points presented on a number of topics they discussed :

Family Owned Businesses

 1. Can non-working spouse survive comfortably? A frequent problem in a closely held or family business is how to provide cash flow to the non-involved spouse if the working spouse dies. This issue will be compounded as more closely held business interests are transferred to irrevocable trusts this year. Consider implementing a salary continuation agreement while the working spouse is alive and well. The business corporation can enter into an agreement with the working spouse, which assures that as a component of current compensation, payments will continue to the surviving spouse.

 2. Pre-death business planning. If the value of the family business is approximately one-third of the estate, it won't satisfy the 35 percent of gross estate requirement to qualify for estate tax deferral under Internal Revenue Code Section 6166. As a result, the ability to defer for 14 years the payment of the estate tax will be lost. If an investment is made in the business, it will increase the value of the business as a percentage of the overall estate. This could transform otherwise non-qualifying cash into qualifying business interests and push the entire business value over the threshold. Alternatively, use the $5.12 million gift tax exemption to make a gift of non-business assets to change the percentages, thereby increasing the relative value of business interests in the estate. Remember that in "decoupled" states, the use of the deferral payment isn't available, as it's a federal benefit only.

 3. Step transactions. The Internal Revenue Service has used the step-transaction doctrine to attack a range of estate plans. The typical sequence of planning events can add to the exposure to this type of challenge. Assume a client discussed with his advisors making gifts before the $5.12 million exemption changes. The client might also have discussed creating an irrevocable trust to which the gifts would be made. Thereafter, the client formed a limited liability company (LLC) and transferred assets to the LLC. Once the LLC was formed and funded, the client then consummated a gift of LLC interests to "seed" the trust. Finally, the client sells LLC interests to the trust. If the IRS can demonstrate that this was all part of one integrated plan, and each step is dependent on the other, then it will treat these steps as if they all happened at one time. If this occurs, any discount on the LLC interests your client gifts and sells to the trust won't be realized. Real intervening economic events may break the "chain." For example, declaring a dividend if a corporation is involved in the planning might change values. If the entity for which interests will be given is a real estate holding company, you may break the sequence from an economic perspective by entering into a new lease after the property was transferred into the LLC, but before the gift/sale to the trust, after a gift to a spouse who will fund the trust or between a gift to the trust but before a sale to the trust.

Gift Planning

 1. Gifts of interests that could cause estate inclusion. Too often, gift planning is focused on large and obvious assets. For some clients, carefully identifying less obvious but very nettlesome assets to gift may have a beneficial impact. The client's interests or rights may cause estate tax inclusion at death. These rights might include: a retained life estate, the retained power to vote stock in a closely held company, the power to remove and replace a trustee and incidence of ownership in life insurance. Now's an ideal time to review existing estate-planning documents, especially older trusts that haven't been given attention in years. Identify possible powers or rights that might taint trust assets as includible in the client's estate and gift or terminate them now. While the exemption can shelter the possible gift, don't forget to disclose these gifts on a 2012 gift tax return.

2. Gift equalization. Equalizing gifts have always been a concern for many clients seeking to maintain some sense of equality among the family lines of various children (or other heirs). If clients have made annual exclusion gifts to children, spouses and grandchildren over time, the different family lines may have become quite unequal. Some clients would like to equalize this imbalance, but many haven't addressed it. The $5.12 million exemption affords a great opportunity to effectuate an equalization plan. If the exemption drops to $1 million in 2013, as the law presently provides, this opportunity may disappear.

3. Gifting in trust? Make it a grantor trust. While practitioners are well aware of the potential advantages of a grantor trust, with the attention being given in 2012 to large gifts to use the $5.12 million exemption before it expires, you should remind clients of the substantial advantages of making large gifts to trusts that are intentionally structured as grantor trusts. The estate-planning advantages are hard Heckernng family businesses gift planning to overlook. First, someone has to pay the income tax with respect to the income earned on the assets transferred to the trust. With a grantor trust, the grantor pays it, thereby further depleting the estate-and retaining in full the assets of the trust. While it might appear that the tax payment constitutes a taxable gift, after all, the grantor is assuming the tax with respect to assets owned by the trust, Revenue Ruling 2004-64 holds that the grantor's payment of the tax is an obligation and therefore not a gift. What if the income tax cost becomes too expensive for the grantor's comfort? Some might consider a tax reimbursement provision, although this has to be handled properly to avoid an estate inclusion issue. Another approach is to turn off grantor trust status, which may be feasible in some trust structures.

Other advantages of the grantor trust, while obvious to practitioners, elude many clients. While sales of appreciated assets to the defective or grantor trust would ordinarily cause income tax to the grantor, Rev. Rul. 85-13 assures that transactions between the grantor and his grantor trust aren't recognized for income tax purposes. Similarly, the interest income earned by the grantor with respect to the note used in connection with the sale also isn't taxable.

4. Gifting may save state estate taxes. Many states impose estate taxes based upon the application of the now non-existent state death tax credit and don't have a gift  tax (two states do, but most don't, for example, New Jersey). The state death tax credit was calculated based on the decedent's net taxable estate. However, it didn't account for adjusted taxable gifts. Therefore, gifts generally aren't taxed when made, nor when added back into the calculation of the state estate tax upon death.  For example, assume a client has a $5.12 million estate and dies in 2012 in a state that imposes tax in the manner stated above. The client's estate will pay no federal  estate tax (assuming no prior adjusted taxable gifts), but will pay a state estate tax equal to $405,200. Suppose instead the client consummates a gift in 2012 of the  entire $5.12 million prior to death. No federal gift tax is incurred, there will be no state gift tax (excluding two states) and since the state death tax credit is calculated without adding back adjusted taxable gifts, there's nothing left in the net taxable estate and, accordingly, no state estate tax in most decoupled states. The result is a $J05.200,,savings with a pre-death transfer in lieu of a transfer on death.

5. Gifting may save estate taxes but cost more in income taxes. Gifting, whether to save state estate taxes or eliminate post-transfer appreciation from the estate can be productive in many cases. With the advent of the $5.12 million exemption, there's a tendency to want to take advantage of Congress' recent generosity. However, gifts carry with them a potentially costly income tax problem. An asset that's gifted retains the donor's basis; there's no step-up in income tax basis. With substantially appreciated assets, the income tax cost to the donee on the eventual sale of the asset may be greater than the estate tax savings. Take the case of a client with a $5 million estate-all of which is stock with a basis of $1 million. If the client gifts the stock to a child immediately prior to death, the estate will save $391,600 in state estate taxes. However, when the child later sells the stock for $5 million, the child will realize a $4 million capital gain, a $600,000 federal income tax (at current rates) and perhaps a state income tax as an add-on as well. Worse, if the Buffet tax (that is, a minimum 30 percent tax rate on incomes exceeding $1 million) or something akin to it is enacted, the child may face a much greater tax of perhaps $1.2 million, with little or no ability to plan around it.

6. IRS gift scrutiny. If a client made an "informal" gift of a vacation home or other property to his children, but didn't report it, a current IRS audit initiative may be quite a surprise. The IRS has been scrutinizing local property tax records. It has now investigated property transfer records in 15 states and, presumably, will examine records in more states in the future. The IRS has found that 60 percent to 90 percent of gratuitous non-spousal real estate transfers weren't reported on gift tax returns. If clients have such unreported gifts, it may behoove them to take the lead and file the missing gift tax returns. For most transfers made in 2011 and 2012, there's not likely to be a gift tax issue because of the $5 million and $5.12 million exemptions, respectively. However, for prior transfers made when the gift exemption was $1 million (or less in earlier years), there may be an issue. Clients may assume that the only implication of the failure to report is the gift tax return, but this issue can extend further than the one return. If the client makes future taxable gifts and has to file a gift tax return to report those gifts, those future returns must disclose prior gifts. This means all future gift tax returns would also be incorrect, because the figure for prior taxable gifts would be incorrect. If the client's executor becomes aware of an unreported gift and files an estate tax return, that too would be an incorrect return. This is a potentially substantial risk awaiting many unsuspecting taxpayers.

7. Gift tax liability exposure. Clients are likely to view exposure for unpaid gift tax as a non-issue because of the large current exemption. But, there's a potential risk that many clients wouldn't suspect. The law is clear that the donor should pay any applicable gift tax. But if the donor doesn't pay, then the donee of the gift is  personally liable for the gift tax. This rule has a much broader reach than many would imagine. A donee can be responsible for a tax even if it's not his gift that triggered the gift tax. For example, say a client made a large a gift to his new spouse, which qualifies for gift tax marital deduction, so that there was no gift tax attributable to that gift. The client also made a separate large taxable gift to another donee, perhaps a child from his prior marriage. The donor then fell into financial difficulties and didn't pay the gift tax. While the child/donee would then be liable for the gift tax, the spouse is also subject to liability for that tax. Even though the client's new spouse received a gift that didn't trigger any gift tax, she's liable for the entirety of the gift tax on the gift made to the child under IRe Section 6324. These rules could create even more havoc in some circumstances. For example, say a son is named agent under his father's power of attorney. His father used up his $5 million gift exemption, then fell ill. Any new gifts will be taxable. The son makes gifts to his siblings of $2 million and to his father's new wife of $1 million, but doesn't pay the gift tax from his father's funds as agent or from his own funds. The new wife can be held liable for $700,000 (35 percent), representing the gift tax on the $2 million gifts to the father's children from a prior marriage.

 8. Gifting with the ultimate security blanket using a self-settled trust. As 2012 moves forward, an increasing number of clients should evaluate the benefits of making large taxable gifts prior to 2013. A significant impediment for many "mid-wealth" clients is the concern that they'll need the funds that, for tax purposes, might make sense to gift. Using a domestic asset protection trust (DAFT), also known as a self-settled trust, may provide the wherewithal for an independent trustee to distribute assets back to the grantor if needed. This could present the ultimate" do over" if the trustee determines that the grantor needs the funds. The problem with a DAPT permitting distributions back to the grantor is that the transfer is to a self-settled trust, which in most states subjects the assets of the trust to creditors. As such, the right of creditors to attach trust assets renders the assets of the trust includible in the grantor's estate pursuant to IRC Section 2036, thereby undoing the desired planning. Several states allow self-settled trusts without subjecting the trust to creditors. Without such creditor attachment, Section 2036 doesn't apply, and the assets of the trust shouldn't be included in the grantor's estate. Note that the IRS will apply Section 2036 if there's an implied understanding that the assets will be made available to the grantor. Trustees should use great care to minimize the use of the power. The IRS has focused attention on the course of conduct of the trustee and grantor to determine if there was an implied understanding. The trustee should exhibit great care in following an independent discretionary standard, uninfluenced by the grantor.

Current Developments

Congress may have unintentionally provided for "clawback" of pre-2013 gifts in excess of the donor’s estate tax exemption after 2012. For example, suppose a donor gives away $5,000,000 in 2012; the estate tax exemption reverts to $1,000,000 in 2013; and then the donor dies. Clawback would mean that the $5,000,000 gift would be subject to estate taxation using only the $1,000,000 exemption. Under current (i.e., 2012) law, there should be no clawback, because Internal Revenue Code section 2011 provides a credit for the gift tax that would have been paid on lifetime gifts, and the credit is based on the rates in effect when the gift was made, rather than the rates in effect on the date of death. Unfortunately, the provisions in Code section 2011 that allow this favorable credit expire on December 31, 2012. Thus, unless Congress extends the favorable credit, clawback may result by default.

The $5,490,000 gift tax exemption ($5,000,000 indexed for inflation) in effect for the rest of 2076 makes large gifts attractive, especially in light of the possibility that the estate and gift tax exemptions could revert to lower amounts in the future considering the large federal deficits. There are many ways to take advantage of the large gift tax exemption, including discounted gifts using entities (which are no longer available starting in 2016), grantor retained annuity trusts ("GRATs") that are not zeroed-out for gift tax purposes, and grantor trusts for the benefit of a donor’s spouse and descendants.

Children who have more assets than their parents should consider making gifts to their parents. The gifts could be annual exclusion gifts or zeroed-out GRATs, in order to minimize the use of the child’s gift and estate tax exemptions. The parents then could structure their estate planning so that the gifted assets would not pass back to the donor child upon the death of the parents.

Reliance upon portability of the federal estate tax exemption is generally less effective than traditional bypass trust planning, due to the creditor protection benefits of a bypass trust, the ability of a bypass trust to shelter appreciation of assets, the fact that the portable exemption is not indexed for inflation after the first spouse’s death, and the possibility that portability will be eliminated in the future. On the other hand, portability may be extremely useful for retirement benefits, which might suffer adverse income tax implications if used to fund a bypass trust.

If a qualified terminable interest property ("QTIP") election is not necessary in order to reduce federal estate tax, then an estate may not elect QTIP treatment for the purpose of permitting a step up in basis for the QTIP trust assets remaining at the surviving spouse’s death. Rev. Proc. 2001-38; PLR 201112001. In order to achieve a step up in basis, the surviving spouse could be granted a general power of appointment (for example, a power of appointment in favor of the creditors of the surviving spouse’s estate).

A surviving spouse who has received a required minimum distribution ("RMD") from an individual retirement account ("IRA") may not disclaim the RMD or the income attributable to it, but may disclaim all or a portion of the balance of the IRA. Rev. Rul. 2005-36; PLR 201125009.

In an era of historically low interest rates, extremely long term GRATs may be an effective strategy for reducing federal estate tax. For example, a grantor could create a 99-year GRAT, knowing that the grantor will die during the GRAT term, causing inclusion in the grantor’s estate. The amount includable is the amount required to produce the annuity using the Code section 7520 rate in effect at the grantor’s death. If interest rates rise significantly between the creation of the GRAT and the grantor’s death, then the amount required to produce the annuity (and thus the amount included in the grantor’s estate) could decline substantially.

Subchapter S Corporations

The death of a shareholder does not terminate an S election, but distribution of S corporation stock from a decedent’s estate to an ineligible shareholder does terminate the S election. For the year of an S corporation shareholder’s death, S corporation income, losses, deductions, credits, etc. are reported pro rata on the decedent’s final income tax return and on the estate’s first fiduciary income tax return. 

Generally, there is no income in respect of a decedent ("IRD"), because the decedent has reported his or her share of the S corporation income. Nevertheless, if the S corporation (at the date of death) had a right to an item that would have been IRD if held by the decedent directly, then the decedent’s share of that item would be IRD to the recipient of the decedent’s stock. The portion of the value of the stock that is attributable to IRD is not entitled to a step up in basis.


When an S corporation shareholder dies, the corporation may elect (with the consent of all shareholders) to treat the current tax year as if it consisted of two separate tax years, the first of which ends on the date of death.

There is no restriction in the Internal Revenue Code on how long an estate may own S corporation stock. Nevertheless, state law may require that the estate distribute assets within a reasonable amount of time. Because the estate itself is the S corporation owner while the estate is administered, S corporation income potentially could flow through an estate to a beneficiary who otherwise would be ineligible to own S corporation stock.

Certain trusts are eligible S corporation shareholders, including grantor trusts, a trust that was a grantor trust prior to the grantor’s death (but only for two years after the date of death), a testamentary trust (but only for two years after the transfer of assets to the trust), a qualified Subchapter S trust ("QSST"), and an electing small business trust ("ESBT").


A QSST must distribute (or be required to distribute) all of its income to one U.S. citizen or resident beneficiary and may not distribute principal other than to the income beneficiary. The income beneficiary’s interest must terminate at the earlier of the income beneficiary’s death or when the trust terminates. If the trust terminates during the income beneficiary’s life, then the trust assets must be distributed to the income beneficiary. The income beneficiary must elect to be treated as owner of the portion of the trust consisting of S corporation stock. Generally, the election must be made within two months and sixteen days after the S corporation stock is transferred to the trust.

An ESBT is more flexible than a QSST, because an ESBT may (1) have more than one beneficiary; (2) accumulate income; and (3) sprinkle income and principal among beneficiaries. Nevertheless, there is a cost for this flexibility. The portion of the trust that consists of the S corporation stock is treated as a separate trust for income tax purposes, and the trust is taxed on the S corporation income at the highest income tax rate for trusts. An ESBT election is made by the trustee.

A QTIP trust cannot be an eligible S corporation shareholder unless it also qualifies as either a QSST or an ESBT. A qualified domestic trust ("QDOT") cannot be an eligible S corporation shareholder unless the spouse becomes as U.S. citizen. A section 2503(c) trust can qualify as a QSST as long as the trustee distributes or is required to distribute the income at least annually to the benefi ciary. A charitable remainder annuity trust ("CRAT") or a charitable remainder unitrust ("CRUT") cannot qualify as a QSST.

Trust Administration

In a trust that gives the trustee discretion to distribute income or principal, a trustee must act, rather than remain passive. A trustee breaches its fiduciary duty to the benefi ciary if the trustee refuses to make a determination whether or not to make a distribution. The trustee must be reasonably informed regarding the terms of the governing document and the circumstances surrounding a beneficiary’s request for a distribution. A trustee must act impartially and in good faith regarding distributions to beneficiaries. A grantor might create discretionary distribution powers in order to give beneficiaries incentives (for example, to obtain an education, embark upon a career, pursue charitable goals, or raise a family). Internal Revenue Code section 2041(b)(1)(A) provides that a discretionary distribution provision that is limited to an "ascertainable standard" related to "health, education, support, or maintenance" does not constitute a general power of appointment. Accordingly, discretionary distribution powers often contain the so-called "HEMS" standard or similar language. Under Treasury Regulations section 20.2041-1, the term "comfort" does not constitute an ascertainable standard when it is used alone, but it can form an ascertainable standard when it is used in conjunction with one of the other "HEMS" magic words. According to the regulations, the terms "welfare" and "happiness" do not constitute ascertainable standards. The regulations provide that the term "health" includes "medical, dental, hospital and nursing expenses and expenses of invalidism." The regulations also specify that "education" includes college and professional education. Under the Restatement (Third) of Trusts, section 50 (2003), the term "education" also includes living expenses, fees, and other costs of attending an institution of higher education. The regulations treat "support" and "maintenance" as synonymous. According to the Restatement, these terms extend beyond bare necessities to a beneficiary’s accustomed standard of living. The regulations state that it is "immaterial" whether a beneficiary must exhaust his or her own income in order to receive a discretionary distribution from a trust.


The seminar materials contain an extensive discussion of the "prudent investor" rule, under which a trustee has a duty to "invest and manage trust assets as a prudent investor would." The prudent investor rule draws heavily upon the concept of "modern portfolio theory," including an emphasis on diversity and total return (both income, and capital appreciation) from assets. The prudent investor rule is embodied in the Uniform Prudent Investor Act, and the Restatement (Third) of Trusts, section 90 (2003)). Note that under Maryland Annotated Code, Estates & Trusts Article, Section 15 114, the prudent investor rule applies to some trustees automatically, and to other trustees only if they elect to have the prudent investor rule apply to them.

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