By Robert J. Lord
As most people have heard, the Federal Estate and Gift Tax Code is scheduled to change dramatically over the next several years. Under current law, each individual may pass up to $1,000,000 of wealth free of federal estate or gift tax to the next generation. That amount, the “exemption equivalent,” is scheduled to increase to $1,500,000 in 2004, then gradually increase further to $3,500,000 in 2009. In the year 2010, the estate tax is scheduled to be repealed, only to return in 2011, with an exemption equivalent of only $1,000,000. Undoubtedly, further changes will be made. Without further changes, the dilemma facing wealthy octogenarians in the year 2010 would be too unpleasant even for Congress to tolerate.
In light of the recent changes, and the uncertainties regarding the future direction of the federal estate and gift tax system, the question arises which estate and gift tax planning vehicles should you still consider and which vehicles no longer are viable? Do irrevocable life insurance trusts still make sense? How about family limited partnerships and limited liability companies? Are charitable remainder trusts as tax efficient as they used to be? This article discusses the ongoing viability of the traditional various tools used in the estate and gift tax planning process. As discussed below, the viability of some of those tools is unchanged by modifications in the tax law. The effectiveness of some of those tools, however, has been reduced sharply. In some circumstances, tools used for years by estate planners actually could result in increased tax liability.
The Traditional “A-B” or “Credit Shelter” Trust. The good news here is that the A-B or credit shelter trust generally still works, although it could prove unnecessary if the repeal of the estate tax scheduled for the year 2010 is made permanent. Prior to repeal of the estate tax, however, your use of an A-B trust to allow you to double up on your and your spouse’s exemption equivalents remains an important objective in the estate planning process.
If you have an A-B living trust from several years ago, it likely still works. It is important, however, to review the language of older A-B trusts. Some of those trusts refer to the dollar amount of the exemption equivalent at the time the trust was drafted. Trusts drafted in that manner may be deficient and they may prevent you from fully using the recent increase in the exemption equivalent.
Note also that the increase in the exemption equivalent could interfere with your non-tax concerns. For example, if you have structured your plan to allow children from a prior marriage to inherit the exemption equivalent immediately from you upon your death, rather than at the time of your spouse’s death, the scheduled increase in the exemption equivalent could cause a much larger share of your estate to pass to those children and a correspondingly smaller share of your estate to your spouse.
Charitable Remainder Trusts. The attractiveness of charitable remainder trusts certainly has diminished as a result of recent changes in the tax law. In the typical charitable remainder trust, you would contribute appreciated assets to a trust, retaining a lifetime interest in the trust and assigning the remainder interest in the trust to your children. The principal tax advantage to you would be the avoidance of capital gains tax upon the sale of appreciated assets contributed to the trust. The economic disadvantage of the charitable remainder trust to you would be the gifting of a remainder interest in the contributed assets to charity. Under current law, that disadvantage would be mitigated by the reduction in your estate tax liability resulting from the removal of the contributed assets from your estate.
Recent changes in the tax law have reduced the tax advantage of the charitable remainder trust and, at the same time, increased, or at least potentially increased, the economic disadvantage. Because the maximum rate for long-term capital gains has decreased, the value of avoiding tax on the sale of appreciated assets by a charitable remainder trust also has decreased. Because the exemption equivalent is scheduled to increase in future years and because the estate tax may be repealed entirely, the after tax “cost” of leaving a remainder interest to charity has increased.
Prior to the changes in the tax law, the tax benefit would be sufficient to warrant your consideration of a charitable remainder trust even if you had only modest charitable intent. In other words, the decision to establish a charitable remainder trust often had both a tax avoidance and a philanthropic component. Now, the charitable remainder trust should be considered only if philanthropy is your overriding objective. In other words, if you plan to leave money to charity anyhow, the charitable remainder trust may still be worthy of consideration. Otherwise, it probably is not.
Irrevocable Life Insurance Trusts. The irrevocable life insurance trust remains a viable tax planning vehicle. By having a life insurance policy held in an irrevocable trust, you are able to exclude the death benefit on the policy from your taxable estate. If the estate tax remains in place, the irrevocable life insurance trust may serve to reduce your ultimate estate tax liability. If the estate tax is repealed or if the exemption equivalent is raised to the point where your estate will not be taxable, the irrevocable life insurance trust would prove unnecessary. However, it would not result in any detriment to your situation. Thus, the only real factor to consider before establishing an irrevocable life insurance trust is cost. Any potential tax savings, however, is likely to outweigh the cost of establishing an irrevocable life insurance trust.
Qualified Personal Residence Trusts and Grantor Retained Annuity Trusts. The qualified personal residence trust and the grantor retained annuity trust both involve the use of the time value of money to generate a tax benefit. In a qualified personal residence trust, you contribute your personal residence to a trust and retain the right to use the residence for a period of years, with the remainder interest in the trust ultimately passing to your children. The grantor retained annuity trust is similarly structured except the asset contributed to the trust is something other than your personal residence and, instead of the right to use a residence, you retain an annuity payout over a term of years, with the remainder interest passing to your children after the expiration of that term. Under both structures, you are treated as having made a gift of the present value of the remainder interest. So, for example, if your house were worth $500,000 and you retained the right to live in the house for twenty years, the value of the amount of the gift would be the amount which, if invested for twenty years at the current market rate of return, would be worth $500,000.
Prior to the recent change in the tax law, the principal disadvantage of charitable remainder trusts and grantor retained annuity trusts was their complexity. Otherwise, if your estate were large enough, they represented powerful estate tax planning vehicles, with limited downside risk.
The potential repeal of the estate tax dramatically alters the equation regarding qualified personal residence trusts and grantor retained annuity trusts. If the estate tax is repealed, qualified personal residence trusts and grantor retained annuity trusts will not give rise to any tax benefit. However, they may give rise to an income tax detriment. Generally, your children may sell assets you leave to them in your estate without paying capital gains tax on the appreciation that occurred prior to the date of your death. That is because the cost basis of those assets is “stepped-up” to their fair market values as of the date of your death. If assets are contributed to a qualified personal residence trust or a grantor retained annuity trust, however, your death will not eliminate the capital gains tax to be paid upon the sale of those assets. Thus, qualified personal residence trusts and grantor retained annuity trusts have an income tax disadvantage associated with them. Prior to the recent changes in the tax law, that income tax disadvantage was more than overcome by an estate tax savings. With the possibility that the estate tax will be repealed entirely, however, that no longer is the case. Thus, it is quite possible that the establishment of a qualified personal residence trust or grantor retained annuity trust ultimately could result in a net tax disadvantage to you.
This is not to suggest that there will be no situations that warrant the use of a qualified personal residence trust or grantor retained annuity trust. However, there now is a real risk that such a trust could cost you tax-wise depending on how the estate tax ultimately is resolved. Thus, you should carefully consider this before going forward.
Family Limited Partnerships and Limited Liability Companies. The family limited partnership or limited liability company uses the illiquidity and lack of control associated with a limited partnership or limited liability company interest to create a discount in the value of stated assets, thereby reducing the ultimate estate tax liability. For example, if you contribute $1,000,000 worth of real estate to a family limited partnership and take back a 99% limited partnership interest along with a 1% general partnership interest, the limited partnership may be valued as low as $500,000 for estate tax purposes. Recently, however, the IRS has had several court victories in which they have challenged the tax treatment of family limited partnerships and limited liability companies. Nevertheless, they remain as viable planning vehicles under today’s tax law.
Family limited partnerships and limited liability companies have the same potential disadvantage associated with them as qualified personal residence trusts and grantor retained annuity trusts. That is, if the estate tax is repealed, the estate tax benefit associated with family limited partnerships and limited liability companies will be lost. At that point, it will be the IRS that will be arguing for a discount in the value of family limited partnership and limited liability company interests, in order to limit the step up in basis. The greater the discount, the more capital gains tax that ultimately will be paid upon the sale of assets contributed to a family limited partnership or limited liability company.
The downside risk associated with the family limited partnership or limited liability company, however, is not nearly as great as the downside risk associated with the qualified personal residence trust or grantor retained annuity trust. That is because the establishment of a family limited partnership or a limited liability company essentially can be reversed simply by liquidating the entity, whereas the qualified personal residence trust or grantor retained annuity trust, once created, cannot easily be undone. Thus, if a family limited partnership or limited liability company could save you significant estate tax dollars under today’s law, it still makes sense to move forward with your planning. If the repeal of the estate tax is made permanent, you may have to liquidate the partnership or limited liability company. You will have been inconvenienced and have paid some unnecessary costs, but will not have lost out tax-wise.
This article contains only general information and is not to be relied on as legal advice. For advice on your individual situation, consult a lawyer in your jurisdiction. No attorney/client relationship arises from use of this article.
By Robert J. Lord