ESTATE TAX REPEAL? LET’S KEEP PLANNING!

michael w. hoffmanDonald Trump’s surprise election gives us a tremendous amount of hope that the federal estate tax might finally be repealed. This concept runs in the face of candidate Clinton’s proposal to reduce the estate and gift tax exemption amounts and increase the tax rates from 40% to 65%.

While we do not want to celebrate too early, a critical message is that estate planning should continue with fervor! The Donald Trump phenomenon, which results in a Republican Presidency and a Republican Congress, gives us a great deal of confidence that tax reform will be among the items addressed early in Trump’s administration. Tax reform could and should include the repeal of the federal estate and gift taxes, and the elimination of the generation skipping transfer tax that has been hanging over our heads since 1976.

However, this will take some time, and the reality is that the U.S. still has huge deficits that must be serviced with tax revenue. Granted, the percentage of the federal revenue coming from death taxes is minimal, but there is also the argument that the tax on the transfer of wealth is “fair” in a system that allowed the accumulation of such wealth. This theory is combined with the tempering affect that the death tax has on the growth of family dynasty wealth (taking from the rich to provide for the poor).

It is likely that the current federal estate and gift tax laws will be replaced by a system more popular in other parts of the world, such as the capital gains calculation that takes place in Canada, Great Britain and other western civilizations. In those countries, at death, the difference between the tax basis of property and its fair market value will be subject to a tax similar to the capital gains tax that would have occurred had the decedent sold the appreciated assets. This accomplishes the practical role of allowing tax basis to be stepped up to fair market value at the death of an owner, and replaces the estate and gift tax revenue with a fair method of taxing growth as it is done in the income tax arena. Of course, there will have to be exemptions and exceptions made for family farms and businesses so these types of assets would not have to be leveraged or sold in order to pay Uncle Sam. All of these details, and many more, will have to be worked out by Congress and the U.S. Treasury Department (IRS).

In the meantime, it appears that some of the more popular techniques that we have been implementing over the last 20 or so years will become even more popular. The use of trusts has long been an important aspect of estate planning. Trusts can own property outside of a taxable estate, trusts can allow an orderly transition of control through the naming and choice of trustees, trusts can protect property from creditors and divorce, trusts avoid probate, and trusts provide significant income tax savings flexibility for current and future beneficiaries.

An important trust that we use in estate planning is the Family Trust, where parents set up trusts for their kids while they are alive, as opposed to waiting until both parents are deceased, and begin funding those trusts with assets by way of gift and otherwise, to remove property from the parents’ taxable estates.

One type of Family Trust that we often use is to make the trust a grantor trust for federal income tax purposes. That means for income tax purposes the IRS ignores the existence of the trust and all the taxable income and deductions associated with the Family Trust continue to be reported on the grantor’s individual income tax return. In our practice, we refer to these Family Trusts as “Defective Grantor Trusts”, or DGTs.

One of the features that allows a trust to be a grantor trust during the grantor’s lifetime is the ability to substitute property in the trust with other property from the grantor. This has been a popular benefit of using DGTs because the trust can hold appreciating assets, removing the appreciation from the grantor’s estate, but those appreciated assets can be swapped for cash or other assets, allowing the low-basis, highly-appreciated assets to come back into the grantor’s estate before death, in order to allow a step-up in tax basis at death for income tax purposes. This has always been kind of “have your cake and eat it too”, removing appreciating assets out of your estate, but retaining the ability to get those assets back in order to achieve an increase in tax basis at death. So, one of the things that we have tried to accomplish with our estate planning clients is to assist them in monitoring the assets in their Family Trusts, to determine if and when it would be desirable to substitute those highly appreciated assets for other assets out of our clients’ taxable estates. Of course, timing is everything, and there is always the risk that the substitution might not occur timely, but at least our clients have retained that flexibility.

Now, with the chance of repeal of our federal estate tax, the strategy with these same grantor trusts might change. In other words, since only appreciated assets would be subject to a capital gains tax at death, it may become more important than ever to remove these appreciated assets from the estate, put them in a grantor trust, and leave liquid, high basis assets in the parents’ taxable estates. Then, if the next President and/or Congress were to reinstate a federal estate tax, we can easily shift strategy and look to exercise the substitution power that exists with the DGTs.

Remember that we still have the evil overhang of the proposed 2704 regulations (see prior articles) which will eliminate much of the discounting that we have enjoyed for valuation purposes when gifting or selling hard to value assets to Family Trusts. These proposed rules will become effective, according to the IRS, 30 days after they become final. While we don’t know when these proposed regs will become final, it does take typically 12 to 18 months for these regulation projects to become completed. The regs were proposed in early August, so we are still “under the gun” for those clients who have situations that warrant this type of estate planning.

So, let’s be happy with the potential repeal of the estate tax but be realistic in what that means. If anything, as new rules evolve, we should be focusing on flexible estate planning now, more than ever, as future tax reform will create new tax regimes. For instance, if the new tax rules no longer encompass the concept of a $5,500,000 exemption per person, will all that exemption that was not used before the estate tax is repealed be lost forever? So, while President-Elect Trump goes about changing our tax system to make us more competitive in the world, and he is ”draining the swamp”, let us pay attention to details and reap the benefits of continuous planning.

For more information about this or any other estate planning topic, please contact us directly at 404-255-7400 or email us at info@hoffmanestatelaw.com.

Estate Planning Is in a Pressure Cooker!

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Not only has the IRS threatened to change the rules of valuing gifts, which will have a significant impact on many estate planning techniques used over the last several decades, the presidential elections will have a huge impact over whether the estate and gift tax law survives, or becomes extremely more expensive and complicated.

After an agonizing wait, the IRS issued Proposed Regulations on August 4th that will eliminate many of the valuation discounts applicable for family-owned businesses and wealth in general. These new rules will become effective thirty days after publication of final regulations, which are expected in the next 12 months.

That means gifts prior to the effective date of the regulations may continue taking into account all applicable valuation discounts and used over the last several decades, and those family business owners who postpone these estate planning techniques of transferring wealth to trusts for future generations will be hurt economically under the new rules. While we do not know for sure what the final regulations will say, the question is obvious, is any further postponement worth the risk?

Additionally, there is a substantial difference between the two presidential candidates’ tax policy proposals, particularly relating to the estate and gift tax. Donald Trump proposes to eliminate the estate and gift tax. Mrs. Clinton, however, proposes to reduce the estate tax exemption (which will be $5,490,000 in 2017) to $3,500,000 (per person) with no adjustment for inflation. She proposes to reduce the lifetime gift tax exemption from $5,490,000 (2017) to $1,000,000, with no adjustment for inflation.

This situation is reminiscent of the concern in 2012 when we feared the exemptions may go from $3,500,000 to $1,000,000. Many clients scurried to take advantage of estate and gift tax advantages before year-end. Those clients, by the way, are generally laughing all the way to the bank as not only have they moved significant wealth out of the gift tax system, but the statute of limitations on the IRS’ ability to review the substance of those transactions has just about expired.

Mrs. Clinton is not done there! She proposes to raise the current estate tax rate from a flat 40% to 45% on estates under $10,000,000, 50% for estates from $10,000,000 to $50,000,000, 55% for estates from $50,000,000 to $500,000,000, and 65% for estates for over $500,000,000. While this seems shocking, the maximum estate tax margin rates when I began practicing in 1976 was technically 77%!

Obviously, the double attack from the IRS and the potential Clinton Administration will raise havoc in the estate planning circles. Be ready to react relatively quickly as these proposals threaten to become reality.

For more information regarding this or any other estate planning concern, please contact us at 404-255-7400 or email us at info@hoffmanestatelaw.com.

The IRS is at it Again

michael w. hoffmanFamily Limited Partnerships (FLPs) and Family Limited Liability Companies (FLLCs) have long been used for a variety of purposes, including centralized asset management, creditor protection, efficient legacy planning, and implementing legitimate discounting and freezing techniques for estate planning purposes. Our estate and gift tax system relies on accurately determining the fair market value of the property being transferred. Fair market value is to be determined objectively considering hypothetical buyers and sellers. Appraisers must take into account valuation discounts for lack of control and lack of marketability. When property is transferred to descendants or trusts, the value of the particular property being transferred is what is reported for gift tax purposes, and then the property with all future appreciation is excluded from the grantor’s estate.

The IRS began a campaign of attacking FLPs back in 1997. Court decisions have generally rebuffed various tactics and positions taken by the IRS in the family limited partnership area.

The IRS publishes its priority guidance plan each year to emphasize areas of the tax law that the IRS may issue additional regulations. Additional regulations affecting valuations in an intra-family transfer context has been on the IRS’ priority guidance plan for the last 11 years. Now, it has been elevated to a proposal set forth in President Obama’s Administration’s 2013 Green Book. The IRS recently announced that it could issue proposed regulations as early as September, which would severely restrict valuation discounts for interests in FLPs and other family entities.

Articles are now appearing which are encouraging estate planners and clients to get ahead of these likely new rules. It is likely that the IRS position will be that any new rules will be effective upon the publication of the proposed regulations, even though they will not become “final” regulations until a much later date.

Earlier this summer, we sent messages to clients who are in the midst of their estate planning that they may want to expedite the process, before the IRS can issue proposed regulations which greatly curtail the legitimate discounting and freezing techniques that we’ve implemented with countless clients. One would think that only Congress can change the law with respect to re-defining the value of property for gift and estate tax purposes, but the Obama Administration has an historical edict of affecting change by more government regulation. The IRS, no doubt, is feeling very confident in their power to limit valuation discounts by way of their regulatory authority.

If you have put off further estate planning, time may be of the essence. If your planning should include the many benefits of FLPs and FLLCs, or if you have an FLP or FLLC and gifting may be appropriate, you may want to get with your advisor sooner, rather than later. If we can help, give us a call.

For more information regarding this or any other estate planning concern, please visit the Hoffman & Associates website at www.hoffmanestatelaw.com, call us at 404-255-7400 or send us an email.

Federal Estate Tax Planning

In order to keep the estate tax burden from continually growing in your estate with further appreciation, you may want to do what many other clients have done: introduce some discounting and freezing techniques to your overall estate plan.  Gifting is also important, as each individual can make annual and lifetime gifts tax-free and decrease the size of his or her estate.

A popular freeze technique is where a client’s interest in limited liability companies, corporations, partnerships or real estate (the “Property”) is sold to a defective grantor trust (DGT) in exchange for an installment note. The beneficiaries of the DGT will be the client’s children and their descendants.  It is called a “defective” trust because the trust is a grantor trust, meaning the IRS ignores it for income tax purposes, but not for estate tax purposes (i.e., the grantor trust is “defective” for income tax purposes).

A DGT allows the value of the assets in such trust to be removed from your estates for estate tax purposes; however, the trust and any transaction(s) between the grantor (you) and the trust is disregarded for income tax purposes. For example, you would still pay income taxes on taxable income of the DGT.  This is a good tax result.  Your assets are being used to cover tax liabilities attributable to a DGT. This “tax haircut” is, in essence, gifting (paying someone else’s tax liability), but the IRS does not interpret this activity as gifting.

Your interest in the Property will be sold to the DGT in return for an installment note payable to you.  This will “freeze” the entire value of the Property; for estate tax purposes the unpaid balance of the installment note remains in your taxable estate, while the Property is not.  An income stream is generated for you from the DGT via payments on the installment note.  The payments from the DGT to you are ignored by the IRS since the payments are coming from a grantor trust.  The only “leakage” is the unusually small interest rate we are able to put on the promissory note to you. As discussed, payments on the installment note are typically interest only but we can work with that number based on the income and cash flow generated by the LLC property.  However, keep in mind that it is advisable to pay the interest yearly as the IRS may frown upon a balloon note with the interest and principal payable at the end of the term of the note.

The sale to the DGT allows you to not only freeze the value of the Property in your taxable estate, but to also reduce the size of your taxable estate based on the income taxes paid by you for the DGT’s income taxes, again, the “tax haircut”.  Also, you are able to take advantage of significant discounting in valuing the fractional LLC interests being sold to the DGT.

The non-voting membership interest in the LLC would be partially gifted and partially sold to the DGT in exchange for an installment note.  This way you freeze most of the value of the LLC in your taxable estate, but retain control of the LLC via your continued ownership of the voting membership interest. The underlying property in the LLC would need to be appraised.  The fees for these appraisals can vary depending on the appraiser.  Once those appraisals are received, the non-voting membership interest of the LLC would be valued.  After the non-voting membership interest is valued, we would use this number to determine the sale price for the non-voting membership interest.

For more information regarding estate planning, business law or tax controversy and  compliance, please visit the Hoffman & Associates website at www.hoffmanestatelaw.com or call us at 404-255-7400.

 

In accordance with IRS Circular 230, this article is not to be considered a “covered opinion” or other written tax advice and should not be relied upon for IRS audit, tax dispute, or any other purpose.  The information contained herein is provided “as is” for general guidance on matters of interest only.  Hoffman & Associates, Attorneys-at-Law, LLC is not herein engaged in rendering legal, accounting, tax, or other professional advice and services.  Before making any decision or taking any action, you should consult a competent professional advisor.

June Letter from Mike

On January 1, 2013 (just 6 months from now), the estate tax and the gift tax exclusion is scheduled to be reduced from $5,120,000 to $1,000,000 per person.  That’s a decrease in the amount of property excluded from gift and estate tax of over 80%.  We are looking at  an increase in the estate tax rates from 35% to 55%, an increase of over 57%.

These tax changes are among the most significant that we will see in our lifetimes.  The potential effects on the number of people subject to a death tax and the amount of family wealth that will be transferred to the Federal Government is staggering.

Of course, we do not have a crystal ball.   We don’t know what the tax laws will be for sure next year, nor do we know what the situations will be 10 or 20 years from now.

What we do know is that for the last 18 months we have had a gift tax exclusion of  $5,000,000.  It jumped from $1,000,000 to $5,000,000 as a result of the mid-term elections and President Obama caving into Congressional pressure to reach a tax compromise in December of 2010.  There is a lot of “truth” to Professor James Casner’s statement to the House Ways and  Means Committee back in 1976,

“In fact, we haven’t got an estate tax, what we have is, you pay an estate tax if you want to; if you don’t want to, you don’t have to.”

What did he mean?  Those who properly and prudently plan, can all but eliminate gift and estate taxes.  Now it may mean that you have to start early in gifting property to your loved ones, but through proper planning and techniques, you may be able to retain almost complete control over the property conveyed.  It may mean that you’ll have to consider  whether you would like certain charitable organizations to spend your hard earned wealth, rather than the Federal Government.  This certainly is the choice of many well publicized billionaires, such as Warren Buffett and Bill Gates.  They are convinced that their charities can spend their money better than Congress and the President.

Gifting in 2012, for those who are able, is more attractive than ever before. The $5,120,000 personal exemption ($10,240,000 per couple) is scheduled to go away at December 31, 2012.  Therefore, there is a “use it or loose it” mentality.

We are coming out of one of the worst recessions since the Great Depression.  This has led to extremely low valuations on real estate and closely held business assets, which enhance the amount of property that can be given away through the use of exemptions and annual exclusions.

While the IRS has been attacking the use of valuation discounting, and lobbying for its elimination through  new legislation,  the ability to take advantage of marketability discounts and lack of control discounts generally reduces the value of property being gifted up to a third.

We are witnessing historically low interest rates.  In fact, the IRS published rate for June is a mere 1.2% (June’s mid-term rates are all 1.07%).  These low interest rates are very favorable for many estate planning techniques which are used in conjunction with gifting strategies.  These include grantor retained annuity trusts (GRATs), charitable lead annuity trusts (CLATs), and Sales to Defective Grantor Trusts.

All these favorable reasons for gifting, with the backdrop of rising taxes as soon as six months away from now, makes 2012 the opportune time to consider gifting.  Such planning takes time and analysis to do it right.  Therefore, it should not be left to the last minute.

Sincerely,

Michael W. Hoffman

 

If you have any questions regarding this letter, please contact Hoffman & Associates at 404-255-7400

Charitable Lead Annuity Trust (CLAT)

Current economic conditions have presented intriguing options for charitably oriented individuals looking to transfer wealth tax free. A Charitable Lead Annuity Trust (CLAT) is an alternative trust structure that transfers wealth free of gift tax to an heir and a charity. In a CLAT the donor creates a charitable trust that pays an annuity to the charity and at the end of the trust the principal often transfers to the heirs. The CLAT benefits from the historically low IRS discount rate (now hovering at around 1.4%) which makes it possible to avoid gift taxes when transferring assets remaining in the trust at its termination. For a CLAT to function properly it is important that the assets in the trust have an expected appreciation value greater than the hurdle of the IRS discount rate. Fortunately, the extremely low hurdle in place now vastly widens the pool of feasible favorable asset options.

The tax law on CLATs opens a window of opportunity that is particularly appealing in today’s economy. Tax law dictates that all payment amounts be known at the creation of the CLAT; however, the payment amounts do not need to be the same. A “Shark-Fin” CLAT takes advantage of this nuance of law by making minimal payments throughout the trust’s life and in the last year makes a balloon payment large enough to cover the amount necessary for the trust to earn a 100% gift tax deduction according to the IRS discount rate. By allowing the trust to grow rapidly through the small payments in the trust’s life, the large balloon payment is made possible as long as the trust achieves the discount rate. Anything made in excess of the low discount rate is passed to the heirs free of gift tax. The Shark-Fin strategy hedges against the possibility of poor investment results in the initial years of the trust and anticipates more favorable investment results in the long term. A Shark-Fin CLAT is particularly appealing when the economy is sluggish because it compounds the benefits of both the current low IRS discount rates and the long term prospect of economic recovery.

The negatives of a Shark-Fin CLAT are mostly shouldered by the charity. A charity is most likely going to want the steady flow of sizable payments rather than one large payment at the end of the trust, especially since the charity will be receiving the same amount whether a Shark-Fin CLAT or a normal CLAT is used. Also, time-value of money makes the wealth received from a Shark-Fin CLAT less valuable to the charity than an equal amount received through a normal CLAT. Another negative is the income tax under a Shark-Fin CLAT is likely to be greater. The trust is taxed on earned income in excess of the distributions and since the distributions to the charity are small in every year except the last, the deduction amount offsetting the tax is very small.

For more information on CLATs, please contact Hoffman & Associates at 404-255-7400

The SCIN: An Attractive Estate Planning Opportunity In 2012

2012 presents unique opportunities to do estate planning.  The reasons may be familiar to you by now:   lifetime gift and estate tax exemptions are $5 million (without Congressional action, it will go to $1 million in 2013), valuation discounts for family owned entities remain viable, and property values and interest rates at all time lows.  The catch:   There’s a limited time to capitalize on these opportunities.

This article will focus on one estate planning tool, the Self Canceling Installment Note (“SCIN”) whose benefit is magnified under 2012’s low interest rate environment. 

What is a SCIN?

SCINs are a planning technique used in a sale of an asset to either a trust or directly from an older family member to members of a younger generation.  Basically, the older generation sells the asset in exchange for an installment note with a term shorter than the seller’s life expectancy.  Life expectancies are found in IRS tables.   The installment note contains a provision by which the remaining balance is completely canceled upon the seller’s death.

What is the benefit of the SCIN?

What makes a SCIN a valuable tool is the fact that if the seller dies before the term of the note, the remaining balance is completely canceled and this canceled amount is not included in the seller’s taxable estate.   

The SCIN is especially beneficial if only annual interest payments are made until the end of the term, when a balloon principal payment is due.  By deferring the principal payment until the end of the term, the amount cancelled upon death can include the entire principal amount of the promissory note.

To illustrate, assume a client sells a small business worth $10 million to a trust for her children in return for a promissory note with annual interest payments and a balloon payment at the end of the term.  This simple sale would itself be beneficial for estate tax purposes.  If the business  appreciated to $20 million before client’s death, all $10 million of appreciation would be outside the client’s taxable estate, perhaps saving $3.5 million in estate taxes.    However, $10 million remaining principal balance on the note would remain in the taxpayer’s taxable estate, subject to a 35% tax rate.  If the client had used a SCIN rather than a simple promissory note,   the $10 million principal payment would cancel, leaving the trust with a windfall.  For estate tax purposes, this means that the entire $20 million asset escapes estate tax.

Is there any downside to a SCIN?

The IRS would not allow this transaction unless it is equivalent to an arms-length transaction between unrelated parties.   So in return for the self cancelling feature of the note,  a “mortality risk premium” is charged to the payor – typically an increased interest rate.  The older the seller is, the greater the mortality risk premium will be.    

This mortality risk premium is the downside of the SCIN transaction.  If the seller outlives the term of the SCIN, the trust will have paid the mortality risk premium interest rate to the seller for absolutely no benefit.[1] 

What makes 2012 an unusually good time to use a SCIN?

What makes the SCIN extremely attractive now is the historically low interest rate environment.  The SCIN interest rate is the base AFR rate which the IRS requires for all promissory notes, plus the mortality risk premium.  

Today, both the AFR rates and mortality risk premiums are very low.   Long term AFR rates for 2012 have hovered around 2.75%.  The largest the mortality rate premium has been for a 55-year-old male since January 2010 was only .58 percent.  The SCIN rate for a 70 year old in March 2012 was only 3.07 percent.    Thus, a 55 year old can do a SCIN at an interest rate of around 3.47%.  A 70 year old can do a SCIN for a rate of around 5.96%.  In both cases, the SCIN interest rates are below historical average prime rate of interest for third party loans.    Under these circumstances the downside risk of a SCIN is very small when compared to the huge estate tax benefit that could result. 

If you need help with your estate plan or want additional information, please contact us at (404) 255-7400.


[1] This downside risk can be mitigated by combining the SCIN strategy with a GRAT strategy.  The SCIN strategy only works if the seller passes away during the term of the SCIN. The GRAT strategy only works if the seller survives the term of the GRAT.  By combining the two, mortality risk can be greatly reduced if not eliminated.

2011/2012 Federal Estate, Gift and Generation Skipping Transfer Tax Update

December 2010 turned out to be an exciting month for estate and gift tax laws.  On December 17, 2010, President Obama signed the Tax Relief, Unemployment Insurance Reauthorization and Job Creation Act of 2010 (the “Act”).   The Act sets forth an exemption amount of $5,000,000 for federal gift, estate and generation skipping transfer taxes for years 2011 and 2012. In addition, the Act sets the top tax rate at 35 percent.  The Act further provides for portability between spouses in 2011 and 2012 to utilize the unused estate tax exemption amount of the first to die of the spouses if the second spouse dies before 2013. 

Since this Act is only good for 2011 and 2012, if Congress fails to act to extend this current law, the federal gift, estate and generation skipping transfer tax exemption amount reverts back to $1,000,000 and the top tax rate of 55 percent returns. 

With this two year Act, there are many planning opportunities.  Obviously, individuals can gift up to $5,000,000 without any federal gift taxes.  Gifts can be made to a grantor trust (which means the trust income is attributable to the grantor rather than the trust) that allows the gift to grow without incurring income taxes.  In the alternative, an individual can purchase a significant amount of life insurance coverage inside a life insurance trust utilizing the increased gifting exemption of $5,000,000 which can then pass free of probate, income and estate taxes to future generation. 

Because the Act is only temporary, it is a good idea to review your current estate planning documents to make sure it stills accomplishes the goal desired.