Thursday, January 21, 2010

New Gift Tax Provision for Transfers to Irrevocable Trusts

Under the Economic Growth and Tax Relief Reconciliation Act of 2001 (P.L. 107-16), as amended in part by the Jobs Creation and Worker Assistance Act of 2002 (P.L. 107-147), collectively referred to as the Bush tax cuts, a new provision was added to the federal gift tax law, requiring that any transfer of money or other property to a trust after 12/31/2009 be deemed a taxable gift, subjecting the transferor to gift tax ramifications, unless the trust qualifies as a grantor trust of the transferor for income tax purposes (i.e., unless the trust is considered as wholly owned by the transferor or the transferor's spouse under the grantor trust rules of the income tax law).

This newly effective gift tax provision, codified as subsection (c) of Internal Revenue Code section 2511, was enacted by Congress with the intent of preventing higher-bracket taxpayers from shifting the income tax bite on their passive investment income to an irrevocable nongrantor trust created for the benefit of their children or other lower-bracket family members, while avoiding gift tax on the transfer. Legislators were concerned that the gift tax law could be circumvented simply by having the transfer made to a nongrantor trust with respect to which the transferor would retain sufficient control over the beneficial interests as to make the transfer "incomplete" (and thus nontaxable), for gift tax purposes.  

IRC §2511(c), though seemingly straightforward, has in fact caused a tremendous amount of confusion and consternation among tax practitioners across the nation. Whereas the statute, on its face, provides that any post-12/31/2009 transfer to a nongrantor trust is automatically to be treated as a completed gift, thereby trigerring gift tax consequences, the statutory language may be interpreted conversely to mean that any post-12/31/2009 transfer to a grantor trust is necessarily to be treated as an incomplete gift, thereby precluding gift taxation of such a transfer under any circumstances. If that interpretation were to be held valid by a federal court, then such commonly used estate planning strategies as the Grantor Retained Annuity Trust (GRAT) and the installment sale to an Intentionally Defective Irrevocable Trust (IDIT) may no longer be viable tax reduction techniques, as both require the underlying gift transfers to be deemed "completed" for gift tax purposes. Indeed, a literal reading of the statute raises the question of whether a post-12/31/2009 transfer to an irrevocable grantor trust can ever be subject to gift tax, even where the grantor trust is drafted for the specific purpose of excluding the gifted assets from the transferor's taxable estate upon death. In other words, under §2511(c), a transfer to a grantor trust which has been drafted so as to exclude the trust corpus from the transferor's taxable estate upon death may avoid gift taxes at the time of transfer, and then, upon the death of the transferor, avoid estate taxes as well!  Clearly, this result does not appear to have been the intent of Congress in enacting the statute. It is yet one more classic example of the law of unintended consequences which often arises when politicians try to remedy a specific tax problem without considering the larger picture.

IRC §2511(c) also fails to address the tax ramifications of a gift transfer to a grantor trust which later becomes a nongrantor trust during the transferor's lifetime. It would seem that a taxable gift should occur as of the date on which the trust changes its status from "grantor" to "nongrantor," the amount of the gift being determined by the gifted asset's fair market value as of the date of change.  But what if the trust no longer holds that particular asset at the time the change of status occurs? Determining the value of the gift under such circumstances may become extremely burdensome, if not impossible.

IRS, for its part, has publicly stated that it is well aware of the confusion surrounding section 2511(c), and that it will attempt to issue guidance and clarification on the statute as soon as possible.  Moreover, antiticpated new legislation by Congress this year to address estate tax reform may also impact the treatment of gifts to irrevocable trusts. In

For further information contact the writer, Keith Codron, toll-free, at (800) 497-0864, or online at keith@octrustlawyer.com.

Tuesday, January 12, 2010

New Rules in California for No-Contest Clauses

Effective January 1, 2010, the rules in California regarding no-contest clauses have dramatically changed, severely limiting their enforceability in wills and trusts, and doing away with the old declaratory relief procedure (commonly known as a "safe harbor petition") available under prior law to prospective litigants contemplating certain contests to a will or trust. As under prior law, the new law applies notwithstanding any contrary provision in the contested instrument.

Under the new law, a no-contest provision in a testamentary instrument will be enforceable only against direct contests lacking probable cause. For this purpose:  (1) a "direct contest" refers to any court pleading alleging that the will or trust instrument was procured by forgery, fraud, menace, duress or undue influence, or that the person making the instrument lacked sufficient mental capacity to sign the instrument, or that he or she did not properly execute the instrument or subsequently revoked the instrument, in whole or in part; and (2) "probable cause" exists if, at the time of the filing of a contest, the facts known to the contestant would cause a reasonable person to believe that there is a reasonable likelihood that the requested relief will be granted after an opportunity for further investigation or discovery.

An "indirect contest" refers to any court pleading other than a direct contest.

Under the new law, a no-contest provision in a testamentary instrument will be enforceable only against the following two types of indirect contests, and only if the instrument's no-contest clause expressly provides for such application: (1) a pleading to challenge a transfer of property on the grounds that it was not the transferor's property at the time of transfer; or (2) the filing of a creditor's claim or prosecution of an action based on a creditor's claim.

Although this leglislation is brand new, its application is retroactive to any will or trust instrument, regardless of when signed, which became irrevocable on or after January 1, 2001. Thus, for example, a will or revocable trust declaration signed in 1975, which became irrevocable 27 years later, in 2002, by reason of the signer's death in 2002, is subject to the new law.

For further information about the new no-contest clause statutes in California, contact Keith Codron, toll-free, at (800) 497-0864, or online at keith@octrustlawyer.com.

Friday, December 11, 2009

Taxation of Employer-Owned Life Insurance

Life insurance proceeds are generally received by the beneficiary free of income tax. However, as part of the Pension Protection Act of 2006 ["PPA 2006"] , proceeds from employer-owned life insurance ["EOLI"] contracts issued after August 17, 2006, are taxable to the beneficiary as ordinary income to the extent that such proceeds exceed the sum of the premiums and other amounts paid by the policyholder (cost basis).  This PPA 2006 legislation affects all businesses, regardless of size or type, where the employer is the owner and beneficiary of the contract and the employee is the insured. Specifically, it includes key-man coverage, buy-sell agreements and nonqualified deferred compensation plans.

Fortunately, there are certain exceptions to the general rule of tax inclusion. The first test which must be met in order for EOLI death benefits to remain tax-exempt is that, prior to issuance of the policy, the employer must provide written notice to the insured-employee stating that a policy is to be issued on the employee's life which will be owned by and payable to the employer. Further, the employer must obtain the employee's written consent to such policy's being issued, and the notice and consent form must satisfy the requirements set forth in Section 101(j)(4) of the Internal Revenue Code ["IRC"].

The second test to be met is that one or more of the following "safe harbors" must apply: (1) the insured is an employee of the employer at any time during the 12-month period preceding death; (2) at the time of policy issuance the insured is a director of the employer-corporation or a highly compensated employee thereof, as defined in IRC §414(q); or (3) the death benefit is either (i) payable to the insured's family members, estate or designated beneficiaries, or (ii) used to purchase an equity or capital interest in the employer from any of the persons described in clause (i), above.

If both the notice & consent and one or more of the safe harbor requirements are met, the EOLI death benefit will be received income-tax free, provided the policy's death benefit is otherwise eligible for favorable income tax treatment under IRC §101(a).

As a result of the PPA 2006 legislation, many of the EOLI policies issued after August 17, 2006, will be subject to income taxation when the employee dies, unless corrective measures are taken.  IRS requires reporting of all EOLI policies by the "applicable policyholder" (i.e., the employer), on Form 8925. That form is used to report whether the notice and consent requirements have been met for each and every employee whose life is insured under an EOLI contract held by that employer.

In order to bring a post-August 17, 2006 EOLI policy into compliance and thereby avoid income taxation on the portion of the proceeds in excess of cost basis, a new policy must be issued or an existing policy must be reissued with a "material change" to the death benefit (in either case, after the proper notice and consent form has been obtained from the insured-employee).  New guidance issued by IRS, in Notice 2009-48, states that if a Section 1035 exchange is made which includes a material modification of the policy, the notice and consent requirements will apply to the new policy. Thus it may be possible to bring a noncompliant policy into compliance by making a 1035 exchange to a policy with an increased death benefit or other change which constitutes a material modification. However, a death benefit increase made merely to meet the requirements of Section 7702, dealing with modified endowment contracts ["MECS"], will not be considered a material modification by IRS.

Monday, December 07, 2009

U.S. House of Representatives Passes Estate Tax Relief Bill

On December 3 2009, the U.S. House of Representatives, by a vote of 225 to 200, passed long-awaited legislation concerning proposed changes to the federal estate tax. The new bill, H.R. 4154, officially titled the Permanent Estate Tax Relief for Families, Farmers and Small Businesses Act of 2009, would, if eventually signed into law, permanently extend the 2009 top federal estate tax rate of 45% and provide for an estate tax exemption of $3.5 million ($7 million for married couples with properly drafted estate planning documents fully utilizing each spouse's exemption). The bill would also continue the 2009 rules permitting estates to pass on property with a stepped-up cost basis for income tax purposes.

As for the U.S. Senate, its schedule in December has been so dominated by the debate on health care reform that little time has been left for action on estate & gift taxes.  As a result, the estate tax is repealed for 1 year, effective January 1, 2010, returning in 2011 with a 55% top rate, while the gift tax is retained witha a 35% rate. Further, there is a step-up in basis for estates valued at up to $1.3 million. Because there is no basis step-up for estates values in excess of $1.3 million, children and other heirs of larger estates who later sell the inherited property may have to pay large capital gains taxes on the proceeds.

House Republicans were joined by 26 Democrats in voting against the bill. The Ranking Minority Member of the House Ways and Means Committee, Rep. Dave Camp (R-MI), stated: "Death should not be a taxable event. Death should not force the sale of family farms or the dissolution of small businesses."  Mr. Camp believes that the extension of the 45% rate is confiscatory and that no American should have the federal government take away nearly half of his or her net worth upon death. In addition, Rep. Camp stated his serious concerns with respect to the fact that the $3.5 million exemption would not be indexed for inflation. He noted that as property values increase in the future more family farms and small businesses will fall subject to the estate tax.

Rep. Earl Pomeroy (D-ND), supported the House bill to permanently extend the $3.5 million exemption and 45% estate tax rate. He noted that the repeal of the estate tax will result in larger capital gains taxes for many children and other heirs.

The congressional Joint Committee on Taxation estimates the cost of the bill to be $233.6 billion over 10 years.  Nevertheless, under an exception to the House of Representatives' typical pay-as-you-go ("PAY-GO") rules, this particular bill is not being offset by any tax increases.

A permanent extension of estate tax rates and exemptions was proposed by House Majority Leader Steny Hoyer (D-MD), who suggested that eliminating the estate tax would add billions to the federal deficit and cause even further economic inequality among Americans.