Planning With the Clock Running


Planning with the Clock Running:
2010 Is Just Around the Corner

by

M. Neil Solarz
Weinstock, Manion, Reisman, Shore & Neumann

Written materials prepared with the assistance of Kiley MacDonald

30th Annual
USC Law School 2004 Probate & Trust Conference
November 19, 2004

TABLE OF CONTENTS

  1. Introduction

  2. Overview of EGTRRA Provisions

    1. Legislative Update: The Future of Taxes

    2. Carryover Basis Rules Under the EGTRRA

  3. Building Flexibility into Estate Plans

  4. Ballooning Exemptions

  5. Giftng Strategies

    1. Taxable Gifts

    2. GRATs vs. IDGTs

    3. Crummey Trusts

  6. Incurring Estate Tax Upon the First Spouse's Death

  7. Basis Planning

  8. GST Trust Planning

  9. Conclusion

I.   Introduction

When the Economic Growth and Tax Relief Reconciliation Act of 2001 ("EGTRRA" or the "Act") was signed into law in June of 2001, the clock started ticking on the future of the federal estate tax and generation-skipping transfer ("GST") tax. Under the Act, the federal estate tax and GST tax both phase out over a nine year period (with the most dramatic reduction occurring in the eighth year), before their total repeal in 2010. However, as everyone knows by now, 2010 may not be the end of the day for estate and GST taxes. EGTRRA provisions are scheduled to expire in 2011. Thus, absent future Congressional action, the pre-EGTRRA rules governing the estate and GST transfer tax systems magically resurrect themselves in 2011. It should be noted that the third transfer tax, the gift tax, is not scheduled for repeal in 2010 and that the applicable exclusion amount for taxable gifts is frozen at $1,000,000.

Resurrection of the pre-EGTRRA rules is just one of several possibilities for the ultimate future of the estate and GST taxes. Other possibilities include the permanent repeal of the estate and GST taxes, or a freezing of exemptions at relatively high levels (i.e., in the $3 million to $5 million range). Three years have ticked away since the enactment of EGTRRA, leaving just six years left in the countdown to 2010. Yet, we still can only guess at what the ultimate outcome will be for the estate and GST tax systems.

One thing that is abundantly clear is that revisiting existing estate plans, and carefully drafting new estate plans, is more critical than ever. Estate planning documents need to be sophisticated and flexible enough to address the shifting exemptions and rates through 2009, the scheduled repeal in 2010 and the array of future transfer tax possibilities. These materials attempt to give some guidance on planning while the clock is still running.

To that end, these materials will first briefly review the changes introduced by EGTRRA. These materials also will (i) provide an update on the current political climate in Washington with respect to the future of the transfer tax system; (ii) review the substantially changed basis rules that go into effect should an estate tax repeal occur; and (iii) give guidance on planning considerations during this uncertain time, with particular focus on suggestions to deal with the ballooning exemption, gifting strategies, GST and trust planning, and basis planning.

II.   Overview of EGTRRA Provisions

Under EGTRRA, both the estate tax and GST tax are scheduled to phase out gradually until their eventual repeal in 2010. From 2004 to 2009, the exemption amount increases from $1.5 million to $3.5 million while the top marginal rate decreases from 48% to 45%.

The gift tax exemption remains at $1 million through 2010 and beyond. The top marginal gift tax rate declines in step with estate and GST tax rates until their elimination in 2010, at which point the gift tax will be imposed at the highest marginal income tax rate. It is presumed that the gift tax was retained so that taxpayers could not easily reduce their income tax liabilities by shifting income-producing assets to family members in lower income tax brackets.

The annual gift tax exclusion remains at its current $11,000 per donee level (subject to future inflation adjustments). However, after the estate tax repeal, gifts to non-grantor trusts (as to the donor or the donor's spouse) may not qualify for the annual exclusion. The effect of this rule on Crummey powers is discussed in more detail below. This change in the law was motivated by the same desire to prevent circumvention of income tax liability by shifting assets to lower-bracket individuals. There are continued gift tax exclusions for direct medical and tuition payments.

Set forth below are EGTTRA's scheduled transfer tax exemptions and highest marginal rates:

 

Calendar Year

 

Estate and GST Tax Exemption

Gift Tax Exemption

 

Top Estate, GST and Gift Tax Rates

 

2004

 

$1.5 million

 

$1 million

 

48%

 

2005

 

$1.5 million

 

$1 million

 

47%

 

2006

 

$2 million

 

$1 million

 

46%

 

2007

 

$2 million

 

$1 million

 

45%

 

2008

 

$2 million

 

$1 million

 

45%

 

2009

 

$3.5 million

 

$1 million

 

45%

 

2010

 

N/A

 

$1 million

 

0% (Estate/GST) 35% (Gift)

 

2011

 

$1 million (adjusted for inflation for GST only)

 

$1 million

 

55%

Thus, EGTRRA's repeal of the estate and GST tax in 2010 is effective for one calendar year only. Absent further action by Congress, the tax laws in effect prior to EGTRRA are scheduled to be reinstated in 2011.

EGTRRA also gradually phases out the state death tax over a four year period which began in January 2002. The state death tax credit was reduced by 25% annually beginning January 2002 and, as of January 1, 2005, will be eliminated.

Because California's estate tax is a "pick-up" tax (i.e., the amount of tax imposed by California is equal to the amount of the state death tax credit), the elimination of the state death tax credit will effectively eliminate California's estate tax, and thus result in the loss of a significant amount of revenue for California. Some states with such "pick-up" tax schemes may be motivated to amend their estate tax statutes to institute a separate estate or inheritance tax to replace their pick-up tax. However, the imposition of an estate or inheritance tax in California may be hindered by the fact that California's former inheritance tax was repealed by a voter initiative in 1982. The California Constitution provides that an initiative measure may only be amended or repealed with the approval of the electorate, unless the initiative measure specifically provides otherwise.   Because the 1982 voter initiative expressly provided that the initiative could not be amended or repealed by the Legislature unless approved by a majority of the electorate, California legislators may determine that the enactment of a new estate or inheritance tax is not a viable option to replace the lost revenues created by the elimination of California's pick-up tax. It is therefore more than likely that the lost revenues will have to be made up through taxes that are much more regressive (such as the sales tax or income tax) than the estate tax. It should be noted that once repealed, EGTRRA replaces the state death tax credit with a deduction against federal estate tax for any state inheritance or estate tax actually paid.

A.  Legislative Update: The Future of Transfer Taxes

The future of the transfer tax remains uncertain as of this writing. Senator John Kerry, the Democratic nominee for President, favors retaining an estate tax. He advocates a $2 million estate tax exemption (up to $10 million for estates with family-owned farms or businesses) with a top estate tax rate of 48%. President George W. Bush, on the other hand, has continued to support efforts to make the repeal of the estate tax permanent. He and more than 250 members of Congress have signed a "no new taxes" pledge directed in part toward this end. However, discussions have also been held in Congress regarding alternative legislative proposals to permanently increase the applicable exclusion amount to as much as $5 million.

The results of the Presidential election should be finalized by the time these materials are distributed, perhaps shedding additional light on the future of the transfer tax system.

B. Carryover Basis Rules Under the EGTRRA

Currently, the basis for property acquired from a decedent (for purposes of measuring gain or loss on sale) is adjusted to fair market value as of the decedent's death (or the alternate valuation date). For an appreciating asset, this step-up in basis means that the recipient heir escapes capital gains tax liability attributable to any increase in the value of the asset above the decedent's basis occurring prior to the applicable valuation date. For a depreciating asset, the recipient heir's basis would be "stepped down" to its fair market value as of the applicable valuation date.

Concurrently with the repeal of the estate and GST taxes in 2010, EGTRRA provides for a partial elimination of the basis step-up (or step-down) rule. The usual rationale given for the basis step-up is to prevent appreciated assets from being subject to 'double-taxation' (both estate and capital gains tax). With the repeal of the estate tax, this rationale is no longer valid.

Instead, under EGTRRA, heirs will receive inherited assets at the lesser of the decedent's adjusted basis or their fair market value as of the decedent's death. For appreciated assets, this generally means that heirs will inherit the decedent's basis (a carry-over basis) and incur capital gains liability upon sale. However, there are three important exceptions to the new basis rules under EGTRRA. 

First, for property passing to a surviving spouse or to a marital deduction qualifying trust for the benefit of the surviving spouse (such as a QTIP Trust, which is sometimes referred to herein as a "Marital Trust"), the decedent's executor will be allowed to increase the basis of appreciated assets to their fair market value as of the decedent's death, subject to an inflation-adjusted cap of $3 million. For assets held as community property, the $3 million available increase may be applied to the survivor's half of the property, as well as the decedent's half, but the total elected basis increase may not exceed the $3 million adjusted cap. For assets held by spouses in joint tenancy, only the decedent's portion can be allocated a basis increase.

Second, the basis of a decedent's property is entitled to an additional $1.3 million increase in value (adjusted for inflation), which may be allocated to assets received by any individual heir. Each asset may only be adjusted up to its fair market value as of the applicable valuation date.

Third, EGTRRA permits a decedent's estate, living trust or recipient heir to use the available $250,000 exclusion for capital gains resulting from a.sale of a decedent's principal residence. To qualify for the exclusion, the period of residency of the decedent, recipient heir or both (in combination) may be considered in determining whether the minimum residency requirement has been met (i.e., residency for two out of the preceding five years). This exception was apparently enacted so that after the scheduled basis step-up elimination, sick and elderly taxpayers would not be 'forced' out of their appreciated homes solely for tax reasons.

Not all property is eligible for the $4.3 million total available basis increase. For example, property gifted to the decedent within the three year period immediately preceding death is not eligible (unless the gift was from the decedent's spouse, who had not received the property as a gift within said three year period). Other ineligible assets include assets over which the decedent held a unexercised general power of appointment, IRD-type assets (e.g., retirement benefits) and stock in certain foreign corporations. Note also that the assets of the QTIP Trust will not qualify as assets available for a basis increase on the surviving spouse's death.

III.  Building Flexibility into Estate Plans

EGTRRA rules are both complex, with ballooning exemptions and declining tax rates, and uncertain, with the scheduled repeal of the estate and GST taxes, followed by the sunset of the Act. Obviously, planning becomes more than difficult in such a climate.

Estate plan documents therefore should ideally be flexible enough to adjust to the range of potential future outcomes of the transfer tax system. Revocable or amendable documents are flexible by their very nature. Irrevocable documents are much more challenging.

For amendable and newly drafted documents, provisions should be made for dealing with a permanent repeal, in case it actually occurs. Some commentators have suggested giving an independent person the power to modify an irrevocable instrument if the estate tax is permanently repealed, or if transfer tax considerations become irrelevant in view of increasing  exemptions. Obviously, any person given such extraordinary power should be chosen with the utmost care and, to the extent possible, be provided with specific instructions and guidelines as to how and under what circumstances to exercise that power.

For those taxpayers who would elect to leave assets outright to their intended beneficiaries (whether a surviving spouse, children, grandchildren or others) but for the adverse transfer tax impact on such simple planning, it may be advisable to build into such taxpayers' plans a mechanism to terminate unwanted trusts should the estate and GST taxes actually be and remain repealed. For example, it may be possible to provide a beneficiary with a general power of appointment over his or her trust should the estate and GST taxes be repealed and remain repealed for a continuous period of time (such as 15 months).

Set forth below is sample language to accomplish such a result.

General Power of Appointment—Repeal of Federal Estate Tax. Notwithstanding anything contained in this Trust to the contrary, if at any time on or after the Trustor's death, the federal estate tax and generation-skipping transfer tax have been completely repealed for a period of fifteen (15) consecutive months, the child, at any time and from time to time thereafter, shall have the power to appoint all or any part of the principal of the child's Generation-Skipping Trust to one or more persons or entities (including the child's estate), either outright or in trust, as the child shall direct Notwithstanding the foregoing, the child may not exercise such power of appointment unless no federal Generation-Skipping Transfer Tax is in effect at the time of the exercise.

The exercise of the power of appointment described in this Subparagraph shall be pursuant to a duly acknowledged instrument, the original of which shall be delivered to the Trustee of the child's Generation-Skipping Trust. Further, the power of appointment described in this Subparagraph may be exercised by an attorney-in-fact appointed by the child under a power of attorney then in effect, to the extent authorized in such power of attorney.

The Trustor understands that it is in the best interests of the child to consult with the child's professional advisors prior to exercising the power of appointment described in this Subparagraph, as such exercise may have important tax consequences, both for the child and for other beneficiaries under this Trust.

Another obvious approach for taxpayers who would choose to forego trust planning is to simply direct that, upon the first death, the entire estate remain in a revocable living trust for the benefit of the surviving spouse, with a back-up provision for a disclaimer bypass-type trust. Such a plan provides flexibility for the surviving spouse to engage in post-mortem planning to create a bypass trust, if the estate tax has not then been repealed, and if the increasing exemptions are not sufficient to eliminate an estate tax risk upon the second death. Although the disclaimer trust approach has the advantages of flexibility and simplicity, there is risk that the surviving spouse will not elect to disclaim when the time comes, due to incapacity, undue influence, lack of attention or a myriad of other reasons.

Set forth below is sample language to accomplish the disclaimer trust option.

A.  SURVIVOR'S TRUST. Upon the death of the Decedent, the Trustee shall administer the entire trust estate (including all property received as a result of the Decedent's death) as a single trust, referred to in this Trust as the "SURVIVOR'S TRUST."

B.  DISCLAIMER TRUST.   Notwithstanding the foregoing, any assets allocable to the SURVIVOR'S TRUST, or any interest in the SURVIVOR'S TRUST, which is disclaimed by the Survivor, shall pass to the DISCLAIMER TRUST, to be administered as provided in Article VII of this Trust.

In a typical A/B estate plan, upon the death of the decedent, his or her property is allocated among two separate trusts: (i) the "Marital Trust" (which consists of the decedent's separate property and one-half of the community property, other than a pecuniary amount or fractional share of the trust estate equal to the decedent's applicable exclusion amount); and (ii) the "Exemption Trust" (which is allocated the decedent's applicable exclusion amount). If a taxpayer wishes to maintain a lifetime trust for his or her surviving spouse solely for non-tax reasons (such as protection from a future spouse, other creditors, and/or to provide financial management), there would appear to be no reason to maintain two separate trusts for the surviving spouse, if the estate and GST taxes are repealed. Under such circumstances, a flexible plan could provide the surviving spouse with a special power of appointment to combine the two trusts into a single trust.

Set forth below is sample language to accomplish this result.

Special Power of Appointment—Repeal of Federal Estate Tax. Notwithstanding anything contained in this Trust to the contrary, if at any time on or after the Decedent's death, the federal estate tax has been completely repealed for a period of fifteen (15) consecutive months, the Survivor, at any time and from time to time thereafter, shall have the power to appoint all or any part of the principal of the EXEMPTION TRUST to the Trustee of the MARITAL TRUST, to be administered as a part of the MARITAL TRUST. Notwithstanding the foregoing, the Survivor may not exercise such power of appointment unless no federal estate tax is in effect at the time of the exercise.

The exercise of the power of appointment described in this Paragraph shall be pursuant to a duly acknowledged instrument, the original of which shall be delivered to the Trustee of the MARITAL TRUST and the Trustee of the EXEMPTION TRUST. Further, the power of appointment described in this Paragraph may be exercised by an attorney-in-fact appointed by the Survivor under a power of attorney then in effect, to the extent authorized in such power of attorney.

The Trustors understand that it is in the best interests of the Survivor to consult with the Survivor's professional advisors prior to exercising the power of appointment described in this Paragraph, as such exercise may have important tax consequences, both for the Survivor and for other beneficiaries under this Trust.

IV.  Ballooning Exemptions

Many existing estate plan documents include funding formulas for the establishment of sub-trusts. For example, a formula clause in a typical estate plan might direct that the maximum available applicable exclusion amount be allocated to a credit shelter trust or "Exemption Trust." If a decedent died in 2001, $675,000 would have been allocated to such an Exemption Trust. However, if a decedent dies in 2009, $3.5 million would be allocated to such an Exemption Trust.

It is critical that older estate plans be reviewed to determine whether the funding formulas still make sense and are consistent with the testamentary desires of the clients. Because EGTRRA increases the applicable exclusion amount so significantly, a pre-Act funding formula may result in an over-funded Exemption Trust relative to the desires of the trustors. This may be particularly true in circumstances where the applicable exclusion amount represents a significant portion of the estate, or where the surviving spouse is not a beneficiary of the Exemption Trust. (Many plans provide that the children or other lineal descendants of the trustors are beneficiaries of the Exemption Trust on the first death.)

Problems can arise in estate planning documents whenever formulas are pegged to the now-shifting applicable exclusion amount, such as for charitable gifts or for GST gifts. Further, if the estate tax actually is repealed, the provisions in trust documents that distribute property by reference to the applicable exclusion amount may no longer be operative.

Example: Joe, who has a net worth of $3 million, created his estate plan in 2000, prior to the enactment of EGTRRA. Anticipating that the applicable exclusion amount would be $1 million, he directed that the applicable exclusion amount fund the Exemption Trust for his children from a previous marriage, with the balance of his estate passing to his wife. If Joe dies in 2009 without adjusting his documents, his entire estate will be used to fund the Exemption Trust, leaving nothing for his surviving spouse.

One solution available to a taxpayer in this situation would be to split the Exemption Trust into two separate trust shares. The first trust share could be distributed or held in trust for the benefit of the taxpayer's children, and could be capped at an acceptable maximum value. The balance of the applicable exclusion amount then could be held in a separate Exemption Trust for the benefit of the surviving spouse during her lifetime. Thus, the estate plan could provide that:  (i) a portion of decedent's applicable exclusion amount (up to a stated maximum such as $1 million), be used to fund an Exemption Trust for the benefit of decedent's children from a previous marriage, (ii) the remaining balance of the applicable exclusion amount be held in an Exemption Trust for the surviving spouse, and (iii) the entire remaining estate pass to the surviving spouse (either outright or in a qualifying marital deduction trust).

Set forth below is sample language to accomplish this result.

The EXEMPTION TRUST shall be administered as follows:

A. Division of EXEMPTION TRUST Into Sub-Trusts. Upon the Decedent's death, the Trustee shall divide the EXEMPTION TRUST into two separate sub-trusts, referred to in this Trust as the "CHILDREN'S EXEMPTION TRUST" and the "SURVIVOR'S EXEMPTION TRUST."

1. Allocation of Assets to CHILDREN'S EXEMPTION TRUST. The Trustee shall allocate to the CHILDREN'S EXEMPTION TRUST a fractional share of the EXEMPTION TRUST equal to the lesser of the following:

(a) One Million Dollars ($ 1,000,000.00); or

(b) The entire EXEMPTION TRUST.

The assets to be allocated to the CHILDREN'S EXEMPTION TRUST pursuant to the provisions of this Subparagraph 1 may be allocated in cash or in kind or partly in each, on a pro rata or non-pro rata basis, in either divided or undivided interests, and valued, for purposes of allocation only, on the date or dates that such assets are actually allocated to the CHILDREN'S EXEMPTION TRUST.

2. Allocation to the SURVIVOR'S EXEMPTION TRUST. The Trustee shall allocate to the SURVIVOR'S EXEMPTION TRUST the entire remaining balance of the EXEMPTION TRUST, if any.

3. Alternative Disposition of EXEMPTION TRUST. Notwithstanding the foregoing, in the event that none of the Trustor's children nor any of their respective issue survive the Decedent, then no separate CHILDREN'S EXEMPTION TRUST shall be established, and the entire EXEMPTION TRUST shall be allocated to the SURVIVOR'S EXEMPTION TRUST.

V. Gifting Strategies

A. Taxable Gifts

Taxable gifting beyond the available $1 million applicable exclusion amount is now a questionable strategy in light of the possible repeal of the estate tax. However, willing taxpayers who can afford to do so should be encouraged to continue to make non-taxable lifetime transfers (i.e., annual exclusion gifts and direct payment of tuition and medical expenses), as well as taxable gifts up to the applicable exclusion amount.

Prior to the enactment of EGTRRA, making taxable gifts was sensible because gift tax is effectively "cheaper" than estate tax. Even though the gift tax and estate tax have identical rate structures, gift tax is imposed on an amount exclusive of the tax payable, while the estate tax is imposed on an amount including the tax. This results in the gift tax being effectively one-third cheaper than the estate tax (assuming the donor survives for three years after making the gift). The tax-exclusive nature of the gift tax, combined with the benefit of shifting post-gift appreciation and income attributable to the gifted asset out of a donor's estate, made taxable gifting an attractive strategy in the past.

Post-EGTRRA, most taxpayers whose taxable gifting strategy was motivated largely by transfer tax avoidance should instead take a wait-and-see approach. As long as there remains a real possibility of permanent estate tax repeal, these taxpayers generally should not make taxable gifts beyond the applicable exclusion amount.

Gifts which result in the payment of gift tax may remain a sensible strategy for sick or elderly taxpayers likely to die prior to 2010 who anticipate having a taxable estate above the applicable exclusion amount. For such taxpayers, the decision to incur gift tax should take into consideration the donor's life expectancy, as well as the timing of the scheduled exemption increases.

B. GRATs vs. IDGTs

Transfer tax planning through grantor retained annuity trusts ("GRATs") and sales to intentionally defective grantor trusts ("IDGTs") are two alternative techniques often used to transfer assets that are expected to experience significant post-gift appreciation out of a taxpayer's estate at discounted values for transfer tax purposes. Prior to EGTRRA, one of the criteria that taxpayers considered in choosing between the two strategies was the possibility that gift tax might be incurred if an BDGT was used. However, a gift to a properly structured zeroed-out GRAT guarantees that there will be no gift tax liability.

Despite the risk of potential gift tax liability, IDGTs have often been considered the better choice based on the following: (i) increased flexibility; (ii) no mortality risk; and (iii) significant GST planning advantages. Because a donor's GST exemption cannot be allocated to a GRAT until the end of the initial trust term (at the termination of the "estate tax inclusion period"), the donor's GST exemption cannot be leveraged with a GRAT.

In the post-EGTRRA world, the choice between IDGTs and GRATs is less clear. If the estate and GST taxes are in fact repealed, IDGTs lose their advantage in GST tax savings and have increased risk with respect to gift tax liability. If it becomes clear that repeal of the estate tax is likely, taxpayers should more carefully consider using GRATs. However, until there is more certainty with respect to the repeal of the federal estate and generation-skipping transfer taxes, taxpayers should be aware of these factors when choosing between the two strategies.

C. Crummey Trusts

Under EGTRRA, upon repeal of the estate tax, gifts to trusts that are not grantor trusts of the donor or the donor's spouse may not qualify for the annual gift tax exclusion. There is some debate whether it was the intention of Congress to abrogate the use of Crummey powers, but as currently drafted, Crummey gifts to non-grantor trusts will either eat into the taxpayer's $1 million lifetime gift exemption or incur gift tax, if no exemption remains.

For existing Crummey trusts that do not qualify as grantor trusts, this result may be alarming. For example, an irrevocable life insurance trust which requires Crummey gifts for funding may force the taxpayer to eat into his or her lifetime exemption or incur gift tax on annual transfers designed to provide the trustee with funds needed to pay life insurance premiums.

Future Crummey trusts should be drafted such that the grantor retains sufficient powers for the trust to qualify as a grantor trust (e.g., the power to purchase trust assets without adequate security or to replace trust assets with assets of equal value) so that Crummey gifts can still be effective post-repeal. The grantor should be permitted to release these powers to relieve himself from income tax liability if no further gifting will take place.

VI.  Incurring Estate Tax Upon the First Spouse's Death

Conceptually related to the issue of not incurring gift tax currently in light of the uncertain future of the estate tax is the decision to have the first spouse to die incur estate tax liability to take advantage of lower marginal estate tax brackets. For spouses whose combined estates exceed their combined exemption amounts, it often made sense to provide for a "taxable" distribution of assets upon the first spouse's death to take advantage of the decedent's lower marginal estate tax rates and the credit for previously-taxed property.

This planning technique obviously becomes less attractive as the estate tax rates flatten, and as the odds increase that the surviving spouse will die during a time when the estate tax has been repealed. Documents with provisions for taxable distributions at the first death for the purpose of reducing the overall marginal estate tax rate or to take advantage of the previously taxed property credit should be carefully monitored. If it becomes clear that a future permanent repeal is likely, such documents should be revised so that estate tax liability is not incurred unnecessarily. 

VII.    Basis Planning

If (or when) the estate tax is actually repealed, income tax planning to maximize the benefit of the new basis rules that go into effect will take on critical importance. Taxpayers will need to carefully plan for which assets and which recipients will be the beneficiaries of the elected basis increase, as well as to ensure that sufficient appreciated assets pass to a surviving spouse to maximize the benefit of the additional spousal basis increase.

Example: Seth dies when the estate tax has been repealed and the new basis rules are in effect. He leaves an estate consisting of his home with a basis of $1 million and a fair market value of $1.25 million and appreciated stock with a zero-basis and a fair market value of $5 million. He wishes to leave his home to his son, $2 million dollars of assets to his sister, and the balance to his spouse. To achieve his goal of minimizing capital gains liability for his heirs, Seth leaves $3.0 million of stock to his surviving spouse, and directs his executor to allocate his entire available spousal basis increase to this bequest. He leaves his home to his son, who uses Seth's $250,000 capital gains tax exclusion for a principal residence. Finally, Seth leaves $2.0 million of stock to his sister and directs that his $1.3 million general basis increase be allocated to this bequest. The only future capital gains tax liability that would result if the assets were sold immediately following Seth's death would be the capital gain resulting from the sale of the stock distributed to his sister, illustrated as follows:

 Asset  FMV Basis  Gain
 

Wife's stock

 

$3 million

 

$3 million

 

$0

Son's residence

$1.25 million 

 

$1 million (plus $250,000 principal residence exclusion)

 

$0

Sister's stock

 

$2 million

 

$1.3 million

 

$700,000

In situations where the available basis increase will not be sufficient to cover the unrealized appreciation in the decedent's assets, the decedent's executor (or other responsible individual, such as the successor trustee of the decedent's living trust) should be given specific guidance as to how the basis increase should be allocated. The personal representative's decision as to how to allocate the available basis increase may result in obvious conflicts of interest, particularly if the personal representative is also a beneficiary of the decedent's estate (as is often the case with the surviving spouse). In such circumstances, taxpayers should consider including an appropriate indemnification provision in the governing instrument, releasing the personal representative from liability for his or decisions regarding the allocation of the basis increase.

Taxpayers with unrealized appreciation above their available basis increase may include provisions setting forth the priority of the basis increase allocation for the spousal and the general basis increase. This prioritization could be based on: (i) the income-tax characterization of the gain inherent in the asset, (ii) the recipient of the asset or (iii) the type of asset.

Set forth below is sample language for ordering based on the tax treatment of the unrealized gain inherent in the asset:

Allocation of Aggregate Basis Increase: If the Trustor dies when an aggregate basis increase is allowed under IRC §1022(b), the Trustee shall allocate the increase to assets eligible for such increase (other than IRC §121 gain) in the following order:

(a)  First, to assets from which the proceeds of a sale would constitute ordinary income;

(b)  Second,  to  assets,  the  sale  of which would  cause depreciation recapture under IRC §1245;

(c)  Third, to assets from which the proceeds of a sale would constitute a short-term capital gain; and

(d)   Finally, to assets from which the proceeds of a sale would constitute a long-term capital gain.

[Similar language could be used for prioritizing the spousal property basis increase under IRC§1022(c).]

Set forth below is sample language for ordering based on the recipient of the asset:

Allocation of Aggregate Basis Increase: If the Trustor dies when an aggregate basis increase is allowed under IRC §1022(b), the Trustee shall allocate the increase to assets eligible for such increase (other than IRC §121 gain) in the following order:

(a)  First, to any property passing to or for the benefit of the Trustor's surviving spouse that is eligible for such increase, to the extent that the appreciation of such property exceeds the amount of the spousal property basis increase that has already been fully utilized;

(b)   Second, to any property passing to the separate trusts established hereunder for:  (i) each then living child of the Trustor; and/or (ii) the group consisting of the then living issue of a deceased child of the Trustor, on an equal basis per trust share; and

(c)  Finally, the balance shall be allocated in such manner as the Trustee, in the Trustee's sole and absolute discretion, deems advisable.

Set forth below is sample language for ordering based on the type of asset:

Allocation of Aggregate Basis Increase: If the Trustor dies when an aggregate basis increase is allowed under IRC §1022(b), the Trustee shall allocate the increase to assets eligible for such increase (other than IRC §121 gain) in the following order:

(a) First,  to  the Trustor's  interest  in the commercial  real property commonly known as 12 Main Street ;

(b) Second, to the Trustor's interest in XYZ, a limited partnership, or any successor business entity thereto; and

(c)  Finally, the balance shall be allocated in such manner as the Trustee, in the Trustee's sole and absolute discretion, deems advisable.

[Similar language could be used for prioritizing the spousal property basis increase under IRC§1022(c).]

Taxpayers may also consider creating QTIP-like trusts to designate assets for the spousal basis increase. During any period in which the estate tax is no longer in effect, estate planning documents providing for the funding of Marital Trusts should make reference to assets that qualify for the spousal basis increase, rather than to the then-irrelevant marital deduction. Note also that because QTIP Trust assets will not qualify for the surviving spouse's basis increase (at the second death), an independent trustee should be given the power to distribute QTIP assets to the surviving spouse in the event the surviving spouse needs them to fully utilize the surviving spouse's available basis increase.

For taxpayers who have charitable intent and appreciated assets above their available basis increase ($4.3 million for married taxpayers or $1.3 million for single taxpayers) or appreciated assets that are ineligible for the basis increase, charitable remainder trusts ("CRTs") may be an attractive strategy. CRTs are able to sell appreciated assets without incurring capital gains liability, and can provide for a lifetime annuity interest to beneficiaries.

VIII.  GST Trust Planning

The increasing GST exemption creates many of the same pitfalls discussed above in reference to the estate tax. Estate planning documents that allocate the 'maximum' amount of the GST exemption to grandchildren may result in gifts disproportionate to the desires of the decedent because of the scheduled exemption increases ($2 million in 2006, then $3.5 million in 2009). Taxpayers may want to incorporate a cap on the amount allocated to their grandchildren, as described above, to avoid this problem.

Another potential problem is created by language directing that a child's GST exempt share be retained in trust for the child's lifetime, while the child's non-exempt share be distributed outright. As the GST exemption amount increases, the child may be receiving  significantly less in outright bequests than the decedent intended. Documents should be drafted or amended to provide for this possibility. (The taxpayer may want to include language in the trust document specifically acknowledging the taxpayer's desire not to fully utilize the amount of the taxpayer's available GST exemption in such circumstances.)

Taxpayers with significant assets that they intend to leave to future generations should consider "locking in" the increasing GST exemption. If this strategy is pursued, taxpayers will be able to secure up to $2 million beginning in 2006 or $3.5 million in 2009 free from GST taxes, regardless of whether the GST exemption amount is subsequently reduced to $1 million. This can result in significant transfer tax savings for taxpayers and their descendants over time. If death occurs in 2010, a dynasty trust of any desired amount can be created (which can continue for as long as the perpetuities period, if any), which should be effective in escaping GST tax liability even if the tax is reinstated as scheduled.

Alternatively, if the GST tax is permanently repealed, there may be situations in which multi-generational lifetime trusts are no longer necessary or desirable. Absent significant non-tax reasons to maintain such trusts (e.g., protection from divorcing spouses or other creditors or for beneficiaries incapable of managing their financial affairs), the inflexibility, administrative burdens and costs may be such that these trusts should be terminated.

When possible, trusts should be drafted (or amended) so that termination is a possibility in such circumstances. As noted above, a possible solution is to give a general power of appointment that is conditional on the estate and GST taxes being permanently repealed and remaining so for a stated period of time. Another solution is to provide for the automatic termination of the trust in such situation.

Set forth below is sample language to accomplish this result.

Withdrawal Right if Federal Estate Tax and Generation-Skipping Transfer Tax Repealed. Notwithstanding the foregoing, if at any time during the existence of the child's Generation-Skipping Trust, the federal estate tax and generation-skipping transfer tax have been completely repealed, and remain repealed for a period of thirty six (36) consecutive months, and there is no legislation then pending in Congress to reinstate the federal estate tax or generation-skipping transfer tax in whole or in part, then the child may, at any time and from time to time thereafter, withdraw all or any portion of the undistributed balance of the child's Generation-Skipping Trust.

IX. Conclusion

Flexible estate plans are especially critical in view of the complexity and uncertainty surrounding EGTRRA, and the future of the transfer tax system. Existing documents should be revised where possible to take into account the changing tax environment. New documents should be flexible enough to adjust to the various possible tax scenarios that may be in effect upon the taxpayer's death. If taxpayers wish to ensure that their testamentary desires are effectuated in this shifting tax environment, they should revise their documents while the clock is still ticking. Some planners are advocating a wait-and-see approach, but such an approach runs the risk that taxpayers may lose capacity or motivation and miss important planning opportunities.

Even in the face of a permanent repeal of the federal estate tax, estate planning will remain critical for reasons as varied as the orderly disposition of assets, basis increase allocation, IRD issues, creditor protection, incapacity, health care directives, guardian appointments for minor children, and probate and conflict avoidance. Thus, there is no reason to believe that the repeal of the federal estate tax and GST tax will result in the demise of the estate planner.