The recently concluded 45th annual Heckerling Institute on Estate Planning (2011 Heckerling Conference) in Orlando, Fla. had a vibe unlike any other. The overarching dynamic, of course, was the massive changes to the estate, gift and generation-skipping transfer (GST) tax landscape brought about by The Tax Relief, Unemployment Insurance Reauthorization and Job Creation Act of 2010 (TRA 2010), which President Obama signed into law on Dec. 17, 2010. The techniques in the estate planner’s toolbox all of a sudden require reexamination with the increased gift, estate and generation-skipping transfer (GST) tax exemptions unified at $5 million with a 35 percent maximum tax rate beginning in 2011 and the introduction of portability of lifetime exemption amounts between spouses for estate and gift (but not GST tax) purposes. And for those who may have thought that 2010 had already been confined to the history books, TRA 2010 retroactively restored the estate and GST tax systems as of Jan. 1, 2010 (subject to an “opt out” for 2010 decedents for purposes of the estate tax) and established a maximum tax rate of 35 percent, with the notable exception that GSTs occurring during 2010 are instead subject to a zero percent tax rate. But alas, permanence isn’t to be found in the new law, as it’s scheduled to sunset after Dec. 31, 2012.
So what were the principal themes that dominated the 2011 Heckerling conference?
Two-Year Patches: The New Norm
A number of speakers suggested that we may be looking at a series of legislative patches going forward, perhaps every two years. TRA 2010 expires after Dec. 31, 2012. That means that unless Congress takes further action, come Jan. 1, 2013 the tax laws that existed prior to the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA)—including the $1 million estate, gift and GST tax exemptions and the 55 percent top estate, gift and GST tax rates—come roaring back. None of the speakers expected that result to occur (other than perhaps temporarily subject to retroactive adjustment). The majority view was that $5 million exemptions (with indexing) and 35 percent tax rates may be with us for a while.
Estate Tax Repeal Still on the Horizon?
A few speakers—including Louis A. Mezzullo, a partner at Luce, Forward, Hamilton & Scripps LLP in Rancho Santa Fe, Calif.—expressed the view that we may not have seen the last of federal estate and GST tax repeal. Rather, with a $5 million exemption, a 35 percent top rate and portability of the exemption between spouses, the estate tax now provides a dwindling amount of revenues. Combined with the strength and persistence of the lobby for repeal of the “death tax” that Yale Law School Professor Michael V. Graetz spoke on, and—depending upon what happens in the 2012 elections—it shouldn’t be a shock if estate tax repeal occurs again in 2013. Accordingly, because we don’t know what the future holds, planners should focus on flexibility in their estate planning documents to be able to adapt to various circumstances. The best way to accomplish such flexibility is to contemplate the use of disclaimers and to authorize an independent trustee to change the default terms of the instrument to adjust to potential changed circumstances.
Opportunity for Gifting and Leveraged Transfers
TRA 2010 maintained the lifetime gift tax exemption at $1 million in 2010, but increased it (beginning in 2011) to be “unified” with the amount of the estate tax applicable exclusion amount (for example, $5 million), with such amount to be indexed from 2010 beginning in 2012. This means that married couples, with gift splitting, can make transfers of up to $10 million per couple without having to pay any gift taxes. The speakers unanimously concurred that this paves the way for leveraging strategies that can transfer vast amounts of wealth outside the gross estate. In addition to outright gifts, the most favored approach was the use of grantor trusts. The primary example proposed posited a married couple that would transfer $10 million to a grantor trust as a “10 percent seed capital gift” and then sell $90 million of assets to such trust in a nontaxable transaction in exchange for a promissory note bearing interest at the applicable federal rate.1 The couple would continue to pay all of the income taxes on the grantor trust, further depleting their estates and allowing the property in the trust to compound tax-free.2
Recapture or “Clawback” Risk
There was considerable debate as to whether a material risk exists that clients who gift away $5 million during their lifetimes may later become subject to estate tax on such gifts if the estate tax applicable exclusion amount is later reduced below $5 million. As a number of speakers pointed out, the instructions to the Form 706 (the United States Estate and Generation-Skipping Transfer Tax Return) suggest this result. The majority view of the speakers, however, was that it’s unlikely that the Internal Revenue Service would punish taxpayers who gifted away $5 million during their lifetimes in reliance on current law exemptions that ceased to exist at their death.
Rescission to Undo Gifts in 2010
A number of speakers—including those on the excellent “Recent Developments” panel: Dennis I. Belcher, a partner at McGuireWoods LLP in Richmond, Va., Samuel A. Donaldson, associate dean and professor of law at of the University of Washington School of Law in Seattle and Beth Shapiro Kaufman, a member at Caplin & Drysdale in Washington, D.C.—addressed the issue of how one can undo a gift made in 2010 in excess of the $1 million gift tax exemption that produced gift taxes that wouldn’t have been incurred had the client waited until 2011 to make such gift. The consensus was that, while this is ultimately a matter of state law, the ability to invoke rescission to undo a gift will generally be unavailable in many jurisdictions. This is because the client and the client’s advisor weren’t proceeding under any mistake of fact or law concerning the 2010 gift tax exemption amount. Rather, the client and the advisor simply guessed wrong about the law to be in effect in 2011. The better route to undo such a transfer would be through qualified disclaimers (provided that the gift hadn’t yet been accepted by the donor within the guidelines set forth in the Internal Revenue Code Section 2518 regulations), or through what was sometimes described by the speakers as “self-help.”
Marriage of Convenience and Portability
Considerable attention was devoted to TRA 2010’s portability provisions, which combine the applicable exclusion amounts of both spouses to prevent their waste if a poorer spouse predeceases a richer spouse without fully utilizing his $5 million exclusion amount.
TRA 2010 allows the executor of a deceased spouse’s estate to transfer any unused estate tax exemption to the surviving spouse.3 As Prof. Donaldson humorously noted, it wouldn’t be so far-fetched if some marriages were to occur solely to take advantage of a poorer spouse’s $5 million applicable exclusion amount.
Credit Shelter Trusts vs. Portability
Portability will ensure a step-up in basis of the subject assets at the surviving spouse’s death and may appeal to clients as a reason to avoid having to plan their estates. As the speakers emphasized, however, portability doesn’t dispense with the need to use credit shelter trusts in estate planning. The following considerations support the use of credit shelter trusts, in lieu of relying on portability:
- There are substantial non-tax benefits from using trusts, including asset protection, asset management and restricting transfers of assets by a surviving spouse;
- The deceased spousal unused exclusion amount for portability purposes isn't indexed;
- The unused exclusion amount from a particular predeceased spouse will be lost if the surviving spouse remarries and survives his next spouse;
- With portability, growth in the assets isn’t excluded from the gross estate of the surviving spouse—in contrast, growth in the assets of a credit shelter trust is excluded from the gross estate of the surviving spouse; and
- There’s no portability of the GST tax exemption.
Step-Up in Basis for Property in the Credit Shelter Trust
The Heckerling speakers emphasized that estate planners who advise clients to fully fund their credit shelter trusts will need to consider techniques to achieve a step-up in basis of the assets held in the credit shelter trust. They discussed the following techniques at the conference:
- Include a broad distribution standard in favor of the surviving spouse in the credit shelter trust—such as in the best interests of the surviving spouse—so that additional property can be distributed to the surviving spouse that can qualify for the step-up in basis upon such spouse’s death.
- Consider giving an independent trustee the ability to confer a testamentary general power of appointment upon the surviving spouse to produce estate tax inclusion equal to the unused exemption amount. That, however, could expose the independent trustee to fiduciary liability for his actions or inactions, so the governing instrument should include broad exoneration provisions.
- Consider including a formula provision in the will or trust conferring a testamentary general power of appointment upon the surviving spouse in an amount equal to the unused exemption amount. This eliminates the complexities that attend to giving an independent trustee distribution authority. The trade-off, however, is that it creates a real risk that assets will be diverted to individuals that the first spouse to die didn’t want to benefit (such as another spouse or that spouse’s children).
- If applicable state law permits the rule against perpetuities not to be anchored by reference to the date of creation of an instrument that confers a limited power of appointment, consider exercising such limited power of appointment to trigger estate tax inclusion (and therefore a step-up in basis) through an appointment in further trust that comports with the “Delaware tax trap” provisions of IRC Section 2041(a)(3).
Elect Out of Automatic Allocation of GST Tax Exemption
The speakers’ most pervasive admonition was that taxpayers will generally need to elect out of the automatic allocation of GST tax exemption for 2010 GST transfers on a timely filed gift tax return. Taxpayers should take this action to prevent the GST tax exemption from being wasted on a transaction occurring during 2010 for which a zero percent GST tax rate applies.4 If, however, it’s possible that further distributions may be made to great-grandchildren or their descendants from a trust to which a direct skip has been made in 2010, then—notwithstanding the zero percent GST tax rate in 2010—circumstances could still render the allocation of GST tax exemption to such trust advisable. That’s because the application of the “move-down” rule of IRC Section 2653 will place the transferor one generation above the grandchildren (for instance, the children’s generation) and thereby expose subsequent distributions or terminations in favor of great-grandchildren or their descendants to GST tax. If, however, the possibility of that occurring is remote, the planner should advise the client to elect out of the automatic allocation of GST tax exemption on 2010 GST transfers.
1. See Internal Revenue Code Section 1274(d); Revenue Ruling 85-13.
2. See Rev. Rul. 2004-64.
3. The Tax Relief, Unemployment Insurance Reauthorization and Job Creation Act of 2010, Section 303.
4. IRC Section 2632(b)(3); Treasury Regulations Section 26.2632-1(b)(1).