Significant recent developments in estate planning.

• Author: Ransome, Justin P.
• Position: Part 1

This two-part article examines developments in estate, gift, and generation-skipping tax planning and compliance between June 2009 and May 2010. Part I discusses legislative developments, an outlook on estate tax reform, and gift tax cases and rulings. Part II, in the October issue, will cover the estate tax, generation-skipping transfers, trusts, changes made by the Economic Growth and Tax Relief Reconciliation Act of 2001, and the annual inflation adjustments for 2010 relevant to estate and gift tax.

Legislative Developments

Two major pieces of legislation were passed by Congress and signed by President Obama over the past year that affect the practice of estate planning.

On March 18, 2010, the president signed the Hiring Incentives to Restore Employment (HIRE) Act (1) into law. It provides tax breaks for businesses to encourage the hiring of unemployed workers. The act also includes as revenue raisers the following international reporting requirements affecting individuals who have offshore accounts, investments, or interests in foreign trusts:

* It imposes a 30% withholding tax on income from U.S. financial assets held by foreign financial institutions unless the institutions enter into an agreement to disclose certain U.S. account holders, annually report the account balance, gross receipts, and gross withdrawals, and comply with certain Other requirements; (2)

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* It imposes a 30% withholding tax on any withholdable payment (generally, certain passive-type income and proceeds from the disposition of such assets) to a foreign entity that is not a financial institution if that foreign entity, or another nonfinancial foreign entity, is the beneficial owner of the payment, unless the beneficial owner or the payee provides the withholding agent with either a certification that the beneficial owner does not have any substantial U.S. owners or the name, address, and taxpayer identification number of each such substantial U.S. owner of that beneficial owner; (3)

* It requires individuals to report offshore accounts or assets worth over $50,000 on their tax returns; (4)

* It imposes a 40% penalty for Understatements attributable to an undisclosed foreign financial asset;

* It increases the statute of limitation for omissions on a tax return of items over $5,000 that are attributable to one or more reportable foreign assets; (5)

* It expands the definition of a U.S. beneficiary relating to foreign grantor trusts, makes certain agreements between a U.S. transferor of property to a foreign trust and foreign persons part of the trust agreement, (6) requires a U.S. person to comply with certain information requests by the IRS regarding foreign trusts, (7) and increases the minimum penalty for failure to file certain informational returns to $10,000; (8) and

* It treats as a distribution from a non-grantor foreign trust for income tax purposes the uncompensated use of foreign trust property by a U.S. grantor, a U.S. beneficiary, or a related U.S. person. (9)

On March 23, 2010, the president signed the Patient Protection and Affordable Care Act (10) into law. It contains the following two provisions that will affect wealthy individuals starting in 2013:

* It increases the employee portion of the FICA health insurance tax by 0.9% on wages in excess of $200,000 ($250,000 if married filing jointly); (11) and

* It imposes a new 3.8% Medicare tax on unearned income, such as capital gains, dividends, and interest, to the extent that modified adjusted gross income exceeds $200,000 ($250,000 if married filing jointly). (12)

Outlook on Estate Tax Reform

At the time of this writing, there is no clear indication as to whether Congress will enact legislation on estate tax reform in 2010. Currently, there is no estate tax and no generation-skipping transfer (GST) tax. The step-up in basis for inherited assets has been replaced by modified carryover basis. However, there continues to be a gift tax.

On December 2, 2009, the U.S. House of Representatives passed H.R. 4154, which would make permanent the 2009 levels with a top marginal rate of 45% and an estate and GST exemption amount of $3.5 million. However, the Senate has failed to act on the legislation. Prior to the end of 2009, Senate Finance Committee chair Max Baucus (D-MT) attempted to extend to 2010 the 2009 rates and exemption amounts by unanimous consent in the Senate, but that attempt failed.

There are many possibilities as to what Congress may or may not do in 2010. Among the most commonly discussed are that it could:

* Enact legislation that retroactively reinstates the estate and GST taxes to January 1, 2010;

* Enact estate and GST taxes effective prospectively but leave a gap in time when neither of these taxes apply; or

* Do nothing and allow the estate and GST taxes to disappear in 2010 and be reinstated in 2011.

For a decedent who died on January 1, 2010, the federal estate tax return would be due without extensions on October 1, 2010. Conceivably, Congress could wait until then and reinstate the estate and GST taxes retroactively to January 1, 2010. It is likely that the estate of a significantly wealthy decedent who dies in 2010 prior to the enactment of such legislation will have incentive to challenge the constitutionality of such a change. Whether the retroactive provision in any reform legislation would withstand a constitutional challenge remains to be seen. However, there is precedent that such a provision might withstand such a challenge. (13)

Congress could allow a gap period where no estate tax applies to decedents who die in that period. Whether the gap period would also cover GSTs is another question. Allowing a few estates of people who happen to die in the gap period to escape estate tax is entirely different from allowing taxpayers to intentionally make inter vivos multigenerational transfers and avoid the GST tax. Nonetheless, it could happen.

If Congress allows a gap period, it also remains to be seen whether it will leave carryover basis in place or repeal it retroactively. Some members of Congress have suggested that if there were a gap period, the estates of decedents dying during that period would be able to choose carryover basis or the regime enacted by estate tax reform legislation (which would presumably allow a step-up in basis). This election would benefit those smaller estates that would otherwise be affected by the modified carryover basis rules but would not be subject to estate tax due to the estate tax exemption amount.

Congress could do nothing and allow the estate and GST taxes to be repealed in 2010 and then reinstated in 2011 at rates and exemption amounts reverting to the levels set forth in the Economic Growth and Tax Relief Reconciliation Act of 2001 (14) (EGTRRA) for 2011 and beyond. This would mean going back to top marginal rates of 55%, with the exemption amount reverting to $1 million and only the GST exemption amount being indexed for inflation.

In February 2010, the president released his 2011 fiscal-year budget. The budget contains the following proposals related to estate tax reform (much the same as contained in his 2010 fiscal-year budget):

* Retroactive and permanent extension of the estate, gift, and GST tax rules applicable in 2009, including the tax rates (45%) and exemption amounts ($3.5 million for estates).

* Creation of an additional category of disregarded restrictions under Sec. 2704 that would be ignored in valuing an interest in a family limited partnership (FLP). In certain circumstances, this would curb the discounts taxpayers can achieve for transfer tax purposes by putting assets in an FLP. The IRS would be granted broad regulatory authority to determine which restrictions should be disregarded and to create safe harbors to permit taxpayers to avoid these restrictions.

* Imposition of a minimum annuity term of 10 years and a remainder interest valued at an amount other than zero for grantor retained annuity trusts (GRATs). The minimum term increases the risk that the grantor might die during the annuity term, requiring all or part of the GRAT's assets to be included in the annuitant's estate for estate tax purposes. The "amount other than zero" would require that the transfer to a GRAT be disclosed on a gift tax return. This provision has already made it into recent legislation. (15)

* Limitation of the basis of inherited property to the value the property is assigned for estate tax purposes (subject to subsequent adjustments). The executor of an estate would be required to report the valuations used in filing the estate tax return.

Gift Tax

Gift Tax Annual Exclusion

Sec. 2503(b) excludes from gift tax the first $13,000 (16) of present interest gifts a donor makes to any person or persons during a calendar year. Regs. Sec. 25.2503-3(b) defines the term "present interest" as the unrestricted right to the immediate use, possession, or enjoyment of property or the income from property. In contrast, Regs. Sec. 25.2503-3(a) provides that a future interest in property, for which the annual exclusion is not available, includes reversions, remainders, and other interests or estates, whether vested or contingent and whether supported by a particular interest or estate, that are limited to commence in use, possession, or enjoyment at some future date or time.

Since the explosion of the use of FLPs in estate planning in the late 1990s, the IRS has taken the position that, due to the restrictions on distributions from and transferability of FLP interests generally contained in FLP agreements, the donees of FLP interests derived no present economic benefit from the transfer. As a result, it concludes that transfers of FLP interests are gifts of a future interest and are thus not eligible for the gift tax annual exclusion. In Hackl, (17) the Tax Court agreed with the IRS that the restrictive FLP agreement that was the subject of the case made gifts of the FLP interests...